Two recent cases from the Southern District of New York discussed the application of the Supreme Court’s opinion in Janus to pleading corporate scienter in Reform Act cases. Judge Pauley, in Pennsylvania Public School Employee’s Retirement System v. Bank of America Corporation, came to the conclusion that Janus does not inform the pleading of corporate scienter, although perhaps only on procedural grounds. Judge Sullivan in In re UBS AG Securities Litigation, came to a similar result, while concluding that Janus put an end to the “group pleading doctrine.” The cases highlight the difficulties courts face, on a motion to dismiss, in applying tests for scienter, when the issue is not the scienter of an individual defendant, but the scienter of a corporate defendant. As a practical matter, that may mean that motions to dismiss for failure to adequately plead scienter of a corporate defendant may be more difficult to obtain.
Despite the view of some that “corporations are people too,” corporations cannot literally speak or think, and cannot therefore literally make a false statement or form an intent to defraud. They speak and think only through their agents. In the typical securities case, the individual director or officer defendants are the “agents” who both make a statement and allegedly know of its falsity. But what of the case where the pleadings do not adequately allege that the individual defendants spoke with the requisite scienter, can the pleadings still demonstrate that the corporate defendant had any intent to defraud?
The Second Circuit, in Teamster’s Local 455 Freight Persian Fund v. Dynex Capital Inc. observed that “it is possible to raise the required inference [of corporate scienter] without doing so with regard to a specific individual defendant.” And in a well-known hypothetical, the Seventh Circuit, on remand, following the Supreme Court’s decision in Tellabs, hypothesized:
Suppose General Motors announced that it had sold one million SUVs in 2006 and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.
Inferring corporate scienter makes some sense in such a situation because what the court is really inferring is that someone who can be held responsible for making the statement knew that it was false. This makes the corporate scienter inquiry very similar to the “core operations” inference, under which, courts can infer scienter in certain situations involving such blatant falsity that it would be “absurd to suggest” that management was without knowledge of the matter.
But, beyond such dramatic or absurd situations, allowing the knowledge of someone who did not make the challenged statement to count for the corporation’s scienter makes little or no sense. Scienter, in a disclosure case, means intent to mislead purchasers (or sellers) of the company’s stock through a false statement. If the maker of the challenged statement does not know it is false, the corporation cannot have scienter either, through the maker’s state of mind. If someone who did not make the challenged statement has adverse information – notice I didn’t say “scienter” or “knew it was false” since that is intent to mislead through the making of a statement, and here the person with the adverse information didn’t make the statement – what is imputed to the corporation is that someone who didn’t make the statement knew of information that renders the statement false. But that person didn’t make the statement, so can it really be said that the corporation knew the statement was false? No, not without serious mental gymnastics.
In Pennsylvania Public School Employee’s Retirement System v. Bank of America, the complaint’s allegations centered on B of A’s disclosures regarding rates of residential mortgage foreclosures and B of A’s potential obligation to repurchase mortgage-back securities it had sold, and warranted, to others. Judge Pauley found that as to each of the individual defendants, the pleadings did not sufficiently allege scienter. He then turned to corporate scienter, and the Dynex comment that a properly pleaded complaint could raise an inference of corporate scienter without doing so with regard to a specific individual defendant, and he recited the General Motors hypothetical from Tellabs. He noted the alleged knowledge of a vice president and an assistant vice president, the asserted knowledge of B of A’s general counsel, and the pleaded knowledge of others who were “Bank of America’s senior managers.” None of those individuals were named defendants. However, on the basis of the alleged knowledge of those identified agents, which, if true, would contradict the truth of B of A’s public statements, he determined that corporate scienter had been adequately pleaded.
On a motion for reconsideration, B of A asserted that Janus, when read in conjunction with Dynex, imposed an additional requirement for corporate scienter, that an individual whose scienter is imputed to a corporation must also be the “maker” of the statement at issue. And B of A claimed the complaint failed to allege that those agents whose scienter was to be imputed to B of A had also “made” the allegedly misleading statements. Judge Pauley rejected the argument out of hand, first on the procedural ground that it had not been timely raised, but then also because “Janus does not concern corporate scienter. Rather, Janus addresses what it means to ‘make’ a statement for purposes of 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5) promulgated thereunder.”
Judge Sullivan faced a similar issue in In re UBS AG Securities Litigation, in which he dealt extensively with the allegations in an even more extensive complaint (which totalled 548 pages and 1,477 paragraphs). The complaint alleged that several individual defendants, by virtue of their corporate position, could be presumed to have made the corporation’s statements. As to those individual defendants, Judge Sullivan noted that the plaintiffs’ opposition to the motions to dismiss relied on the “group pleading” doctrine, which allows the court to presume that certain group published documents (SEC filings and press releases) are attributable to certain corporate insiders. Judge Sullivan determined that the group pleading doctrine did not survive Janus; individual defendants must have actually “made” the statements under the new Janus standard to be held liable under section 10(b). He cited with approval, however, the comment in Orlon v. Spongetech Delivery Sys., Inc., that whether or not the group pleading doctrine survived Janus, the group pleading doctrine is irrelevant to the pleading of scienter. Because the group pleading doctrine is a way to “attribute” a corporate statement to a particular person, and because attribution of a statement to a particular defendant is at the core of Janus, Judge Sullivan seems to echo Judge Pauley’s opinion that Janus does not address the corporate scienter issue.
At any rate, Judge Sullivan did not use Janus in his analysis of the allegations of scienter as they applied to all UBS defendants. First, he concluded that the factual allegations of “motive” as to the individual defendants and the corporate defendant were not sufficient to give rise to a “strong inference of scienter.” Then turning to the scienter test of “conscious misbehavior or recklessness,” and the UBS corporate scienter, Judge Sullivan noted the allegations that one “Confidential Witness” had warned in a letter to the UBS Board that the company’s risk valuation methodologies overvalued the company’s mortgage portfolio, and that the Board ignored that “red flag” about the quality of the company’s balance sheet. But Judge Sullivan concluded that the allegations failed to demonstrate that the CW’s letter highlighted a serious flaw in the UBS methodology made known to the Board; rather, the allegations simply demonstrated a business judgment by the Board that differed from the business judgment of the CW, citing In re Salomon Analyst Level 3 Litigation, for the observation that the fact that some individuals in a company may hold a view different from another’s does not make the first group’s view “the true institutional opinion, if such a concept is even meaningful.”
So what do we make of Judge Sullivan’s apparent view that a corporation may be of two minds, one infused with knowledge that makes a corporation’s public statement misleading, and one with contradictory knowledge? And what do we make of Judge Sullivan’s determination that the allegation regarding the CW’s letter and the Board’s failure to act upon it was just an example of different business judgments among a corporation’s employees and agents? Irrespective of CW’s corporation position, Judge Sullivan did not use an agency analysis to come to his conclusion. Instead, he used the competing inferences analysis directed by Tellabs. (Although some might argue he did not weigh them correctly.) And recall that in Dynex, the court used the Tellabs analysis to determine that, because there were no allegations to support an inference that identified corporate officers actually knew information that contradicted the company’s public statement, the competing non-culpable inferences that no one at Dynex responsible for the statements had reason to believe the public statements were false prevailed, and the pleadings failed to allege facts to support an inference of corporate scienter.
However, determining corporate scienter on a pleading basis is, in a significant way, different from determining scienter for an individual defendant. Tellabs instructs that determining scienter at the pleading stage involves inferring an individual’s state of mind from particular pleaded facts, and weighing culpable inferences against non-culpable inferences, each discovered or discerned from the facts alleged. But, in many corporate scienter cases — particularly those involving the wrongful conduct test of scienter — an individual’s state of mind is the pleaded fact. On the pleadings, one corporate agent knows X, one knows not–X. So, we are back to the question, what does the corporation know, or not know?
In those cases, a court may be tempted to fall back on an agency analysis: was it a president who observed a fact contrary to the company’s public statement? Was it the company’s general counsel who signed a letter containing information contrary to the company’s public statement? Unfortunately, that agency analysis can lead a court to ignore a consideration of the relationship between a statement and the knowledge of an identified maker that the statement is false. If Janus makes the group pleading doctrine inapplicable in class action securities cases, because that doctrine ignores the need to attribute a statement to a particular “maker,” doesn’t Janus also inform the scienter analysis? Otherwise, group pleading may come in through the backdoor of corporate scienter, and the often difficult work of examining pleaded facts and weighing culpable and non-culpable inferences of a defendant’s state of mind may be overlooked.