Northern District of California Partially Dismisses "Defeat Device" Claims Against Volkswagen For Failure to Plead Scienter

by Shearman & Sterling LLP

On July 19, 2017, Judge Charles R. Breyer of the United States District Court for the Northern District of California partially dismissed a putative class action against Volkswagen Aktiengesellschaf (“VW AG”), Volkswagen Group of America, Inc. (“VWGoA”), Volkswagen Group of America Finance, LLC (“VWGoAF”), and former executives of VW AG and VWGoA.  In re: Volkswagen “Clean Diesel” Marketing, Sales Practices, And Products Liability Litigation, MDL No. 2762 CRB (JSC) (N.D. Cal. July 19, 2017).  Plaintiffs are institutional investors who purchased bonds offered by VWGoAF.  VWGoAF is a wholly-owned subsidiary of VWGoA, and the bonds were guaranteed by VW AG, the ultimate parent of VWGoA and VWGoAF.  Plaintiffs alleged that defendants failed to disclose Volkswagen’s use of “defeat device” software to mask emissions in the company’s diesel engines, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”).  The Court concluded that plaintiffs had plausibly alleged that the bond offering memorandum was misleading, and that some, but not all, of the defendants made statements and omissions in the offering memorandum with scienter.

As a threshold matter, the Court rejected defendants’ argument that the lead plaintiff lacked standing to bring claims on behalf of holders of classes of bonds other than the offering in which the lead plaintiff participated.  The Court noted that, under Ninth Circuit law, “representative parties who have a direct and substantial interest have standing,” and whether they could present claims on behalf of others with similar, but not identical, interests would be adjudicated through the class certification process rather than as a standing question.  The Court also rejected defendants’ contention that risk factor disclosures regarding laws and regulations were not actionable, finding that statements that Volkswagen was a good investment because of its commitment to emissions-reducing technology were misleading in light of the intentional cheating of emissions requirements.

Turning to scienter, the Court held that plaintiffs had sufficiently alleged that both executives had “ultimate authority” over the offering memorandum because they were able to and did control its content.  The Court found a strong inference that Martin Winterkorn, VW AG’s former CEO and Chairman of its Management Board, knew of the defeat device prior to the bond offering in May 2014, noting that Winterkorn’s “attention to detail, his close relationship with aid[e]s that were directly involved with the scheme, and the importance of the ‘clean diesel’ vehicles for Volkswagen’s growth strategy” were, “while not of the smoking-gun variety,” enough to render it highly plausible that Winterkorn was aware of the scheme.  However, as to Michael Horn, VWGoA’s former President and CEO, the Court noted that Horn did not join VWGoA until January 2014, and the earliest allegation supporting that he was aware of the defeat device was on the same date VWGoAF issued the May 2014 offering memorandum, when Horn allegedly received an email informing him of the diesel scandal.  Citing precedent that managers are permitted a reasonable amount of time to consider, digest, and investigate negative information before they disclose that information to the public, the Court found that “it would have been reasonable for Horn to have obtained [the email] and to have considered and investigated the issue for more than a week before disclosing the information to potential bondholders or the public.”  Thus, the email could not support a strong inference that Horn made misleading statements in the 2014 offering memorandum with scienter.  Noting that “a corporation is responsible for a corporate officer’s fraud committed within the scope of his employment,” the Court held that Winterkorn’s scienter could be imputed to VW AG, and that because Winterkorn plausibly participated in and had authority over the offering memorandum, his scienter could be imputed to VWGoAF.  However, because plaintiffs had failed to plead scienter as to Horn, they also failed to plead scienter as to VWGoA.

The nuanced decision highlights the importance of analyzing scienter allegations as to all defendants separately, and serves as a reminder of courts’ willingness to grant management a reasonable period of time to consider and investigate potentially negative information before being required to disclose it to the investing public.

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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