January 2013: Securities Litigation Update

by Quinn Emanuel Urquhart & Sullivan, LLP


Viability of Core Operations Doctrine Still Unsettled in Second Circuit: Securities fraud plaintiffs continue to attempt to plead scienter by invoking the “core operations” doctrine, which imputes to key company officers and directors knowledge of facts relating to the company’s “core” businesses. In the Second Circuit, the doctrine originates from Cosmas v. Hassett, 886 F.2d 8 (2d Cir. 1989), in which a company announced that sales to China would constitute a significant revenue source for the company, despite Chinese regulations preventing exactly those sales. The Second Circuit imputed knowledge of the regulations to the defendant directors, given that “the restrictions apparently eliminated a potentially significant source of income for the company.” Id. at 13.   

The Second Circuit has not determined, however, what if any of this doctrine survived the passage of the PSLRA. See Frederick v. Mechel OAO, 2012 WL 1193724, at *2 (2d Cir. Apr. 11, 2012) (“Cosmas was decided prior to the enactment of the PSLRA, and we have not yet expressly addressed whether, and in what form, the ‘core operations’ doctrine survives as a viable theory of scienter.”). Nonetheless, New Orleans Employees Retirement Sys. v. Celestica, Inc., 2011 WL 6823204 (2d Cir. Dec. 29, 2011), decided late last year, explained in a footnote that “allegations of a company’s core operations . . . can provide supplemental support for allegations of scienter, even if they cannot establish scienter independently.” Id. at *2, n.3 (emphasis added). But the Court declined to address core-operations allegations because plaintiff had otherwise pleaded sufficiently that the CEO and CFO knowingly made false statements concerning the company’s inventory. Id. at *2. See also City of Pontiac Gen’l Employees’ Retirement System v. Lockheed Martin Corp., 2012 WL 2866425 (S.D.N.Y. July 13, 2012) (interpreting Celestica to suggest that the Second Circuit “endorsed the idea behind the core operations doctrine as enhancing, if not independently supporting, an inference of scienter.”).  

Recent cases indicate that courts in the Southern District of New York may impute knowledge of the company’s financial statements to key officers and/or directors. In In re Longtop Financial Technologies Ltd. Securities Litigation, 2012 WL 2512280 (S.D.N.Y. June 29, 2012) (SHS), for instance, Judge Scheindlin found it appropriate to impute to the defendant CFO knowledge of “information [that] was available to [defendant] that would have made him aware of the falsity of the financial statements (which he signed) and his own oral and written statements.” Id. at *11. The allegations there related to specific filings or press releases, signed by the CFO, that contained false statements or were based upon false information. Id. at *4.  

In Dobina v. Weatherford Int’l Ltd., 2012 WL 545148 (S.D.N.Y. Nov. 7, 2012), the Court explained that the doctrine imputes knowledge of a company’s false financial statements to senior officers “who should have known of facts relating to the core operations of their company that would have led them to the realization that the company’s financial statements were false when issued.” (quoting In re Atlas Worldwide Holdings, Inc. Secs. Litig., 324 F. Supp. 2d 474, 490 (SDNY 2004)). The Court also noted, however, that the doctrine’s post-PSLRA survival is an “open question,” id. at *11, and even assumed that the “tax rates” at issue were sufficiently important to the company’s financials to constitute “core operations.” Id. But the Court nonetheless declined to determine the doctrine’s viability, since a simple mistake in the company’s financials was the most plausible inference. See also Ho v. Duoyuan Global Water, Inc., 2012 WL 3647043, at *18 (S.D.N.Y. Aug. 24, 2012) (imputing knowledge of company’s financials to CEO and CFO, particularly where revenue and net income in an SEC filing was reported to be one-hundred times greater than what was reported in an SAIC filing).  

Given the frequency with which securities class action plaintiffs rely on the core operations doctrine, courts will have ample future opportunities to consider the question of whether the doctrine survives the passage of the PSLRA which established a heightened pleading requirement for scienter. Even if so, the precise contours of the doctrine remain to be defined.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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