Third Circuit Court Of Appeals Finds Plaintiff Failed To Meet PSLRA’s Scienter Pleading Requirement

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Rahman v. Kid Brands, Inc., 2013 WL 6038246

Shah Rahman, the plaintiff and appellant, brought a federal securities class action in March 2011 against defendant Kid Brands, Inc. and against individual defendants Bruce Crain, Guy Paglinco and Raphael Benaroya, officers of Kid Brands.  In the Second Amended Complaint, Rahman alleged that the defendants mislead investors in Kid Brands by artificially inflating its stock price and issuing deceptive public financial reports and press releases dealing with Kid Brands’ compliance with custom laws and Kid Brands’ overall financial performance.  The putative class included the plaintiff and all others who were similarly situated or purchased or obtained Kid Brands’ common stock between March 26, 2010 and August 16, 2011.  The complaint alleged that the defendants, who are in the business of importing infant furniture and products, violated § 10(b) of the Securities Exchange Act, SEC Rule 10b-5, and § 20(a) of the Exchange Act.

The case has its origin in 2010.  Kid Brands does its business through four wholly-owned subsidiaries: Kids Line, LLC, Sassy, Inc., LaJobi, Inc., and CoCaLo, Inc.  In December 2010, the U.S. Customs and Border Protection informed Kid Brands it was conducting a “focused assessment” of its import practices and procedures.  In response, Kid Brands looked into its practices and hired an outside law firm to investigate.  Kid Brands did not disclose it was the subject of a focused assessment or that it had hired the firm.  On March 15, 2011, Kid Brands revealed that LaJobi had violated United States law by misidentifying the manufacturer and shipper of certain products, that it had fired two LaJobi employees, and that it anticipated needing to pay millions of dollars in fines.  This information hurt Kid Brands’ stock price.

Rahman alleged that Kid Brands and the individual defendants had failed to give timely notice of the “focused assessment” and the results of its investigation, and in the Second Amended Complaint, alleged that Kid Brands intentionally mislabeled Chinese manufactured products to reduce import duties and increase profits and made misleading statements regarding its financial health.  He supported his claim of scienter with statements from six confidential witnesses, employees of Kid Brands subsidiaries LaJobi, Inc. and Kid Line, LLC, as well as a Kid Brands employee.  The defendants moved to dismiss the Second Amended Complaint.  The District Court, applying the heightened scienter pleading standard of the Private Securities Litigation Reform Act (“PSLRA”), granted the motion, and the plaintiffs appealed.

The Third Circuit affirmed the decision of the District Court.  First, and most importantly, it held that Rahman had failed to plead scienter with sufficient particularity because the testimony of the confidential witnesses on which Rahman had relied needed to be discounted.  The court explained that confidential witness one had no way of knowing what was discussed in meetings between LaJobi and Kids Brands; confidential witness two did not begin work for LaJobi until June of 2011 and could not have had personal knowledge regarding pre-investigation violations; confidential witness five offered only general information about meetings between leadership of Kid Brands and LaJobi; confidential witness three provided only abstract commentary about a “feeling something suspicious was going on,” and confidential witness four offered only generalized allegations with very few specific details and very little concrete support.

The Third Circuit also held that: (a) the plaintiff had not demonstrated that the individual defendants had a motive for their alleged wrongful conduct; (b) the allegations in the Second Amended Complaint could not support the existence of corporate or collective scienter (the court also went to great pains to clarify that it was not ruling on this doctrine); (c) the District Court had properly reviewed the Second Amended Complaint in its entirety and rightfully found that it failed to meet the heightened pleading requirements of the PSLRA; and (d) the § 20(a) claim failed because controlling personal liability is derivative of an underlying violation of Section 10(b).