Sixth Circuit Clarifies Standard for Pleading "Collective Knowledge" Scienter in Securities Fraud Cases

A recently issued decision from the Sixth Circuit adopts a modified “collective knowledge” theory for determining corporate scienter and clarifies the standard for pleading corporate scienter in a securities fraud action. The decision pares back the Circuit’s more expansive position in an earlier decision that permitted knowledge of all of the corporation’s officers and employees to be imputed to the corporation. The decision also highlights for senior executives of public corporations the importance of internal review and oversight of public statements.

On October 10, 2014, in Ansfield v. Omnicare, Inc., No. 13-5597 (“Omnicare”), a three-judge panel for the U.S. Court of Appeals for the Sixth Circuit clarified the standard in securities fraud suits for alleging the necessary element of “scienter,” or the mental state embracing intent to deceive, manipulate or defraud, with respect to corporate defendants. In Omnicare, the plaintiffs alleged that a corporation and several corporate officers, employees and agents had committed securities fraud by making various material misrepresentations and omissions in public and in SEC filings regarding the corporation’s compliance with Medicare and Medicaid regulations. In several years of the corporation’s SEC filings, the corporation had stated that it believed it was complying in all material respects with federal, state and local law, and further that its billing practices materially complied with applicable state and federal requirements. However, plaintiffs alleged that the corporation had conducted three internal audits that showed that the corporation’s billing and records practices were not in compliance with Medicare and Medicaid regulations, rendering those statements fraudulent.

The panel noted that a securities fraud suit must plead facts to show the following six elements: (1) a material misrepresentation or omission by the defendant, (2) scienter, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) reliance upon the misrepresentation or omission, (5) economic loss and (6) loss causation. The panel ruled that there are different standards for a misrepresentation that concerns “hard information” than for one concerning “soft information.” A misrepresentation regarding historical or factual and objectively verifiable information (hard information) is actionable if a plaintiff pleads facts to show the statement was objectively false and the defendant acted with at least recklessness. However, a misrepresentation concerning soft information, such as predictions or opinions, is actionable only if the plaintiff pleads facts to show that the statement was made with knowledge that the statement was false and for the purpose of deceiving, manipulating or defrauding the public.

While the panel found that the Omnicare plaintiffs were able to plead facts adequately showing the first element, it nevertheless held that the Omnicare plaintiffs were unable to meet the heightened particularity standard for pleading scienter for any of the named corporate officers, employees and agents (or, ultimately, the corporation itself). Allegations against the individual defendants “on information and belief” that such individuals had received the results of the audits at issue were not sufficiently particular. Likewise, alleging only generally that the audits that were conducted “revealed fraud and compliance issues,” and that a compliance officer raised “compliance related concerns” to the attention of corporate executives and officers, did not meet plaintiffs’ heightened pleading standard of alleging with particularity “that Person A did Act B at Time C.” Slip op. at 33.

After examining the allegations against the individual defendants, the Omnicare panel then analyzed the standard for pleading scienter as it relates to a corporate defendant. It noted that the heightened standard for pleading scienter in securities fraud cases can be even more complicated when considering a defendant that is itself a corporation “because there is the additional question of whose knowledge and state of mind matters.” Slip op. at 20. The panel first surveyed the predominant views on corporate scienter in securities fraud cases in its sister circuits. It noted that the Fifth and Eleventh Circuits had adopted a narrow view of corporate scienter, in keeping with common law fraud principles, by allowing scienter to be imputed to a corporation only upon examining the state of mind of specific individual corporate officials who make, issue, furnish information for or approve false or misleading statements. In contrast, the Second, Sixth, Seventh and Ninth Circuits had all held to varying degrees that some form of collective knowledge may be imputed to a corporate defendant for purposes of finding scienter. In other words, under a broader collective view of corporate scienter, knowledge of a corporate officer, agent or employee may be imputed to a corporation even though that officer, agent or employee did not actually make or approve the false or misleading statement at issue.

In Omnicare, the Sixth Circuit panel noted that neither approach, at least when taken to its logical extreme, would be ideal. In its attempt to find middle ground, the panel scaled back on the dicta contained in its prior scienter ruling, in which it had stated that “knowledge of a corporate officer or agent acting within the scope of [his] authority is attributable to a corporation.” Slip op. at 23 (quoting City of Monroe Emps. Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 688 (6th Cir. 2005)). The panel noted that reading that decision too broadly could expose corporations to liability beyond Congress’s intent, and that a statement made by a low-level employee, perhaps even in a different country, could needlessly cause a corporation to face liability. Determining that such a result runs contrary to Congress’s heightened pleading standard for scienter in securities fraud cases, the Sixth Circuit panel adopted the following test:

The state(s) of mind of any of the following are probative for purposes of determining whether a misrepresentation made by a corporation was made by it with the requisite scienter under Section 10(b):…

(a) The individual agent who uttered or issued the misrepresentation;

(b) Any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance; or

(c) Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance. Slip op. at 24.

Satisfied that the above test mitigated some of the Sixth Circuit’s earlier statements as to imputing the knowledge of agents at all levels to corporate defendants, the Sixth Circuit panel further stated that the above test “largely prevents corporations from evading liability through tacit encouragement and willful ignorance” (a potential issue with the Fifth and Eleventh Circuits’ more narrow tests), and would further not provide corporate insulation “if lower-level employees, contributing to the misstatement, knowingly provide false information to their superiors with the intent to defraud the public. As a result, corporations that willfully permit or encourage the shielding of bad news from management will potentially be liable.” Slip op. at 25.

Although the Sixth Circuit panel agreed with plaintiffs that the corporation’s public statements and omissions were both material and false or misleading, the panel still held that the plaintiffs had failed to plead adequately and with particularity facts sufficient to show scienter, both as to the individual defendants and the corporation itself, and affirmed the lower court’s dismissal of the plaintiffs’ claims.

While the Sixth Circuit panel explicitly adopted its formulation of a modified “collective knowledge” theory for determining corporate scienter in securities fraud cases, it remains to be seen whether any other circuit will endorse it or whether the Supreme Court will ultimately weigh in to resolve the split among the circuits.

We hope you find this information helpful. If you have any questions about the material presented in this alert, please contact any member of BakerHostetler’s Corporate Governance or Securities Offerings and Compliance teams.

Authorship Credit: Jessica J. Wade and Amy M. Shepherd