Institutional Investors Group v. Avaya: Clarifying Safe Harbor and Scienter Provisions of PSLRA

The Third Circuit provided important guidance regarding both the types of statements protectable under the PSLRA’s “Safe Harbor” provisions, and proper application of the Tellabs standard for alleging a “strong inference” of scienter in securities fraud cases. In Institutional Investors Group v. Avaya, 564 F.3d 242 (3rd Cir. 2009), the Court largely upheld a lower court’s dismissal of a shareholder lawsuit against Avaya, Inc. that challenged certain financial projections and other statements made by the company. The Court held that the projections were protected by Safe Harbor provisions, and that plaintiffs failed to adequately allege scienter as to most of the other statements.

BACKGROUND

Avaya, Inc. is a company that sells communications products and services. Plaintiffs brought a putative shareholder class action against Avaya, its CEO, and CFO, regarding two different sets of statements:

Forecasting Statements

Plaintiffs alleged that beginning in fiscal year 2005, Avaya issued projections for increased revenue and operating margins. When the company announced it 1Q results for FY2005, which were consistent with analyst expectations, it stated that the results “position[ed]” the company to meet its FY2005 goals and that the company was “on track” to meet those goals. On March 2, 2005, Avaya raised its projected annual revenue growth from the 25-27% range to 28%.

Pricing Statements

Also on March 2, 2005, Avaya responded to analyst inquiries regarding pricing pressure – the company asserted that there had been no significant change in the market, a statement that the company repeated two subsequent times in the following weeks. On March 4, however, an independent market research group reported that a “sales channel check” revealed that “spending” for Avaya products was “weak” and that the company had fired salespeople to cut costs. A subsequent Lehman Brothers report showed that Avaya was offering 20-40% discounts for some products. The plaintiffs also produced statements by various “confidential witnesses” – previous Avaya employees – who stated that Avaya had been giving substantial discounts to many customers, perhaps for as long as one year.

In mid-April, Avaya announced that its 2Q FY2005 revenues had increased only 21% compared to the previous year, and that the company would not meet its previously stated financial projections. The next day, the stock dropped by 25%.

Plaintiffs filed suit, alleging that Avaya’s projections and statements were fraudulently misleading in violation of Rule 10b-5. The District Court dismissed the lawsuit, holding that: 1) the allegedly false forecasting statements were protected by the PSLRA’s “Safe Harbor” provisions; 2) plaintiffs had failed to allege that other statements were actionably false; and 3) plaintiffs had failed to allege with particularity facts giving rise to the “strong inference of scienter” required by the PSLRA. Plaintiffs appealed. Institutional Investors Group v. Avaya, 564 F.3d 242 (3rd Cir. 2009).

The forecast statements were protected by Safe Harbor provisions

The Private Securities Litigation Reform Act (PSLRA) contains safe harbors for forward-looking statements, set forth in 15 U.S.C. section 78u-5(c). The provisions protect statements that are: 1) identified as forward-looking and are accompanied by meaningful cautionary language; 2) immaterial; or 3) made without actual knowledge of falsity. The Third Circuit determined that Avaya’s general projections fell into the first category – forward looking statements accompanied by cautionary language. 564 F.3d at 258.

The court took a closer look at Avaya’s language that it was “position[ed]” and “on track” to meet its 2005 projections, and ultimately decided that, when read in context, those statements were “too vague to be actionable,” and, rather than justifying the financial projections, those statements merely said that “whatever that situation is, it makes the future projection attainable.” 564 F.3d at 255.

The court further found that all forecasting statements were “accompanied by meaningful cautionary statements identifying important factors” that might affect the projections. In particular, all of Avaya’s SEC filings contained a detailed list of all factors that might impact the company’s future economic results, including the “product and price competition” that plaintiffs asserted as the cause of Avaya missing its projections.The court further noted that the company included brief cautionary statements about the risks and uncertainties in all press releases and at the beginning of every conference call, and that the cautionary statements summarized risks specific to Avaya, not just those generally applicable to all companies. 564 F.3d at 256 - 257.

Plaintiffs failed to adequately allege scienter regarding forecasting statements

The plaintiffs argued that Avaya’s statements should not enjoy Safe Harbor protection even if they were forward-looking statements accompanied by cautionary language, because Avaya knew the statements were false when it made them. The court looked to the third category of Safe Harbor protection, provision that a forward-looking statement could receive protection if the defendant lacked “actual knowledge… that the statement was false or misleading.” 15 U.S.C. section 78u-5(c)(1)(B).

Based on this language, the court concluded that to plead scienter with respect to forward-looking statements, the plaintiff must plead facts giving rise to a strong inference that the defendant had actual knowledge that the statement was false. Given this requirement, the court paid closest attention to the company’s March 2 increase in projected revenue growth, but ultimately determined that at most, the plaintiffs pleaded recklessness, but not actual knowledge of falsity. 564 F.3d at 259. Due to the fine but critical line between actual knowledge and recklessness, the court upheld the lower court’s dismissal of all allegations regarding the forecasting statements.

The use of confidential witnesses to prove scienter cannot be automatically discounted

The PSLRA requires plaintiffs to plead allegations of fraud and misrepresentation with particularly, including specific as to why the particular statements at issue were false and/or misleading. Among the specific evidence plaintiffs presented in order to meet this requirement regarding the pricing statements were statements made by confidential witnesses. Avaya pointed to a recent Seventh Circuit decision indicating that allegations made by confidential witnesses should be severely discounted. (Higginbotham v. Baxter Int’l Inc., 495 F.3d 753 (7th Cir. 2007)). But the Seventh Circuit was alone in its position. Every other circuit court to consider the issue, including the Third Circuit in a previous decision, had determined that such allegations should not be automatically discounted. 564 F.3d at 262.

Allegations of scienter regarding some of the pricing statements were sufficient

Before the U.S. Supreme Court’s decision in Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007), the Third Circuit had held that “alleging facts establishing a motive and opportunity to commit fraud” was sufficient by itself to raise the strong inference of scienter required by the PSLRA. 564 F.3d at 276. However, Tellabs taught that, in determining scienter, a court must view all allegations holistically, weighing both culpable and nonculpable explanations for a defendant’s conduct, to determine whether the allegations in the complaint raise a strong inference of scienter. The Avaya court determined that the Tellabs “holistic” approach eliminated allegations “motive and opportunity” as sufficiently to solely support a pleading of scienter. Id.

The court emphasized that three times, Avaya was asked specifically about pricing pressure, and each time, it affirmatively denied that widespread discounting had occurred. These questions and answers were directed to a specific item that directly related to Avaya’s operations and forecasts. The court that, therefore, competing inferences that Avaya did not know of the discounting were not plausible. That lack of knowledge, combined with the confidential witness statements, the “sales channel check” by the independent research group, the Lehman Brothers’ report, and the significant decrease in revenue growth compared to projections, all combined to support a strong inference of recklessness. The court ultimately determined that plaintiffs’ allegations regarding only the pricing statements Avaya made in March 2005 sufficiently alleged scienter, thus limiting the plaintiff class period to March 2005 through April 19, 2005. The court determined that all statements Avaya made prior to March 2005 lacked the “inculpating circumstances surrounding the March discounting statements.” 564 F.3d at 273.

CONCLUSION

In Avaya, the Third Circuit has added significant, authoritative guidance on the interpretation and application of the PSLRA. In particular, the opinion clarifies that meaningful cautionary language – even the risk summaries in press releases and conference calls – will effectively enable safe harbor protection for forward-looking statements. Companies following this guidance should ensure, however, that the risk factors referenced are specific to the company.

The Avaya opinion clarifies that recklessness, as opposed to actual knowledge of falsity, will not void safe harbor protection for forward-looking statements that otherwise meet the requirements for protection. Finally, with this opinion adds the Third Circuit to the list of federal circuits interpreting Tellabs as requiring the court to consider all allegations concerning, including nonculpable explanations of, defendant’s actions, and that allegations of “motive and opportunity to commit fraud” may not alone be sufficient to establish the “strong inference” of scienter required by the PSLRA.

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Josh Lawler

Also See:

Lawson et al. v. FMR LLC: Sarbanes-Oxley’s Whistleblower Protection Is Limited to Employees of Publicly Traded Companies

Matrixx Initiatives, Inc., et al. v. Siracusano: Securities Plaintiffs Can Use Inferences to Show Materiality and Scienter at the Pleading Stages

Parkcentral Global v. Brown Investment: Hedge Fund Investors Are Entitled to Ownership Lists

Malack v. BDO Seidman: Rejecting the “Fraud-Created-The-Market” Theory of Reliance

PIMCO v. Mayer Brown: Adopting the “Attribution” Standard for Secondary Actors