2nd Circuit Interprets Scienter Requirement in Class Actions

In Teamsters Local 445 Freight Division Pension Fund, v. Dynex Capital, Inc., and Merit Securities Corporation, the Second Circuit Court of Appeals analyzed the scienter requirements for actions brought under the Public Securities Litigation Reform Act.

Between 1996 and 1999 Dynex and one of its subsidiaries, Merit, made loans to people seeking to buy manufactured housing. The companies pooled the loans and issued asset-backed securities secured by the loans. The Teamsters Pension Fund purchased $450,000 of the bonds in 2002.

The collateral for the securities was the income generated by the housing loans. After the securities offering, the income dropped sharply, leading to a significant fall in the the value of the collateral for the securities. In April 2004 Merit disclosed what it identified as “an internal control deficiency” related to the recording of loan losses. As a result, the company announced that it would restate its earnings for two quarters of 2003. In February 2005, the Teamsters brought a class action suit against Dynex, Merit, and two officers of the companies, alleging violations section 10(b) and 20(a) of the Securities Exchange of 1934.

The district court granted a motion to dismiss the complaint against the two officers of Dynex and Merit, holding that the complaint had failed to adequately plead scienter with regard to the officers. Specifically, the court said that the complaint failed to allege that the officers saw or had access to specific reports showing wrongdoing. Moreover, the complaint failed to allege direct supervision over anyone identified as having engaged in fraudulent behavior. Thus, as to the corporate officers, the complaint failed to meet the heightened pleading standards for scienter under the PSLRA. However, the district court held that the complaint had adequately pleaded scienter by the companies through a ‘”pattern of reckless corporate behavior.”‘ The court pointed to allegation in the Teamsters’ complaint that “‘Dynex systematically originated defective loans, despite clear signs that borrowers were not creditworthy” as a pattern of reckless corporate behavior that created an inference of corporate officers and employees acting with a motive to defraud. Thus, the court ruled that the action against Dynex and Merit would proceed. Nevertheless, the court certified issue for an interlocutory appeal. Dynex and Merit exercised their appeal rights.

The Second Circuit vacated the holding of the district order and remanded the matter to the lower court to dismiss the complaint against Dynex and Merit with leave for the plaintiffs to refile the action.

As an initial matter, the Second Circuit determined that the PSLRA did not require that an action must adequately plead scienter against an individual official or employee before the complaint could adequately plead fraud against a corporation. The court held that to charge a corporation under the PSLRA, the complaint had to plead facts that “must create a strong inference that someone whose intent could be imputed to the corporation acted with requisite scienter.” While the most straight forward way to meet this pleading burden is to adequately plead scienter on the part of an employee, it may also be done without pleading scienter as to a specific individual named defendant.

The Second Circuit decided that in the present case, the Teamsters’ complaint had not adequately alleged scienter on the part of the corporation or unnamed agents of it. To meet the pleading burden as to scienter, the complaint must do at least one of the following: 1) specifically identify the reports or statements containing information contradicting information released by the defendant and/or 2) specifically identify reports or statements that would have been discovered in a reasonable investigation, which would have shown the falsity of the challenged statements. Finally, the complaint must allege more than a motive by corporate insiders to maintain an appearance of profitability.

The court determined that the Teamsters’ complaint failed to meet these requirements and held that the lower court must dismiss the action. In its original decision the district court had granted the plaintiffs 30 days to correct the pleading deficiencies and refile the action. The circuit court adopted this approach and remanded with an order to dismiss with a grant of 30 days to refile the action.

About Richard Serafini

Welcome to my blog. I am an attorney and practice in the area of corporate trial work. Areas of particular emphasis are white collar defense, securities litigation, health care litigation, internal investigations, RICO, and financial litigation. I will be posting interesting developments in my areas of interest. I hope that you find this blog helpful and informative.