Fourth Circuit Court Of Appeals Affirms Dismissal Of Securities Fraud Class Action, Stating That Scienter Cannot Be Pled By "Stacking Inference Upon Inference"

by Shearman & Sterling LLP
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On November 15, 2017, the United States Court of Appeals for the Fourth Circuit affirmed the dismissal of a putative securities fraud class action against PowerSecure International, Inc. (the “Company” or “PowerSecure”), and Sidney Hinton, its president and CEO.  Maguire Fin. LP v. PowerSecure Int’l Inc., No. 16-2163 (4th Cir. Nov. 15, 2017).  Plaintiffs alleged that defendants defrauded investors by knowingly making misrepresentations about the renewal of a major contract in violation of Section 10(b) of the Securities Exchange Act of 1934.  The district court dismissed the complaint after finding that plaintiffs failed to adequately allege scienter.  The Fourth Circuit affirmed, stating that “[a] plaintiff may not stack inference upon inference” to satisfy the PSLRA’s heightened pleading requirements for scienter. 

PowerSecure provides utility and energy solutions to electric utilities and their customers.  One of the Company’s major contracts was with Florida Power & Light (“FP&L”), the largest electric utility in Florida.  In a press release in June 2013, the Company announced that it had “renewed and expanded three year utility infrastructure . . . award to serve one of the nation’s largest investor owned utilities.”  Hinton reiterated this statement on an analyst call in August, stating that PowerSecure was “blessed to announce securing a $49 million three-year contract renewal, both the renewal and expansion with one of the largest investor [owned] utilities in the country.”  The following May, PowerSecure reported a first quarter loss of almost $4.3 million.  It attributed the loss to substantial increases in operating expenses due to the fact that FP&L had changed the geographies the Company was serving from West Palm Beach to Ft. Myers.  The Company also stated that it “probably underestimated the negativity [and] the complexity of basically starting from scratch in a new territory,” including losing employees who did not want to commute over 100 miles to fulfill the new contract and hiring and training new workers at significant expense.  PowerSecure’s stock price fell more than 62% the following day, and shareholders filed suit.   

The Fourth Circuit affirmed the district court’s dismissal of the complaint on the basis that plaintiffs failed to adequately allege scienter.  In so doing, the Court rejected plaintiffs’ primary argument that defendants’ alleged knowledge that the statement was false was sufficient to show scienter.  The Court explained that plaintiffs’ “argument fuses an inference that Hinton knew enough to realize that his characterization was technically incorrect with an inference that he intended it to deceive.” “Stacking inference upon inference,” the Fourth Circuit held, “violates [the PSLRA’s] mandate that the strong inference of scienter be supported by facts, not other inferences.”

The Fourth Circuit also found that the complaint, when taken as a whole, did not allow the Court to draw a strong inference of scienter.  First, The Court found that the statement at issue did not support an inference that defendants intended to deceive investors into thinking that the Company could continue to serve the same region or otherwise maintain its profitability.  Second, the Court declined to find intent to deceive from defendants’ use of a “single possibly ambiguous word,” noting that the fact of the contract’s renewal “itself embraces the possibility that the new contract was not a renewal on identical terms.”  Finally, the Court rejected plaintiffs’ attempt to establish scienter through Hinton’s own sale and transfer of PowerSecure stock, observing that Hinton did not sell his shares when their value was at the highest and that the transfer of shares was made months after the alleged misstatement.

This case highlights the difficulty of pleading scienter and further reinforces that, in order to do so, a plaintiff must plead facts that give rise to a strong inference that defendants intentionally or recklessly deceived, manipulated, or defrauded investors.

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