Securities Law | Expert Legal Commentary

September 19, 2008

Teamsters Local 445 v. Dynex: “Corporate Scienter” Possible Without Naming Names

Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc.

By Joel Ginsberg

Teamsters Local 445 v. Dynex: “Corporate Scienter” Possible Without Naming Names

In its highly anticipated opinion in Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190 (2nd Cir. 2008), the Second Circuit affirmed that a securities fraud plaintiff can plead corporate scienter without specifically identifying the culpable corporate officer or director whose individual scienter could be imputed to the corporation. The plaintiff need only plead facts sufficient to establish a “strong inference” that someone in the corporation whose acts could be imputed to the corporation acted with the requisite scienter. However, the court warns that the standard for making such a pleading is very high, requiring heightened specificity.

Background

In Dynex, the corporate defendants were a financial services company and its subsidiary (collectively, “Dynex”) that issued two sets of securities secured by thousands of mortgage loans the company had made to people seeking to purchase manufactured homes. Not long after issuance of the securities, the value of its collateral dropped sharply due an increase in defaults on the underlying loans and a decrease in the profits of post-foreclosure sales.

Dynex disclosed errors in its previous reporting, and bond rating companies downgraded the securities significantly. In the end, the prices of the two sets of securities dropped by as much as 85%.

The plaintiff, a teamsters pension fund (“Teamsters”), was a bond holder in one of the sets of securities. It filed this putative class action suit in the Southern District of New York against the corporate defendants and two individual corporate principals, alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. section 78(a) et. seq. Specifically, the Teamsters alleged that Dynex knowingly bought risky loans and failed to disclose that in the materials that accompanied the securities offering. The Teamsters further alleged that Dynex misrepresented the “real” reason for the poor performance of the securities, i.e. because they were based on high risks and poor underwriting.

Dynex moved to dismiss the complaint, claiming that the Teamsters had failed to adequately plead the element of scienter. The district court agreed that the Teamsters had failed to adequately plead scienter as to the individual defendants. However, the court determined that the Teamsters had adequately alleged scienter as to the corporate defendants, stating: “A plaintiff may, and in this case has, alleged scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation.” In re Dynex Capital Inc. Sec. Litig. (Dynex I), No. 05-CIV-1897, 2006 WL314524 (S.D.N.Y. 2006), at p*9. The district court held that the Teamster’s allegations indicated recklessness by circumstantial evidence, allowing the “inference” that Dynex’s officers and employees had committed fraud. Id. at pp. *9-10.

Dynex successfully petitioned for interlocutory appeal, arguing that the dismissal of the individual defendants automatically precludes any inference of scienter against the corporate defendants. The Second Circuit’s opinion on the appeal is located at Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190 (2nd Cir. 2008).

The complaint must allege a “strong inference” of scienter

The Public Securities Litigation Reform Act of 1995 (the “PSLRA”), section 21D(b)(2), governs the pleading of scienter in securities fraud actions. That section requires that a plaintiff’s complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. section 78u-4(b)(2).

The U.S. Supreme Court has held that a “strong inference” of scienter under the PSLRA “must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Tellabs, Inc., v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499, 2504-05 (2007). The Second Circuit has determined that an adequate allegation of “recklessness” is sufficient to establish the scienter required in securities fraud claims. Novak v. Kasaks, 215 F. 3d 300, 308-09 (2nd Cir. 2000).

The complaint can allege corporate scienter without identifying a culpable officer

In its appeal, Dynex argued against the district court’s allowance of the securities fraud claim against the corporate defendants after it had dismissed the individual defendants. Dynex claimed that the district court essentially endorsed the doctrine of “collective scienter,” permitting a finding of corporate intent that does not specifically derive from one of its agents. Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 194-195 (2nd Cir. 2008).

Dynex pointed to the court’s previous decision in State Teachers Retirement Board v. Fluor Corp., 654 F.2d 843 (2nd Cir. 1981), in which the court granted summary judgment to a corporate defendant because “there was no evidence” that any of the defendant’s officers acted with scienter.

The Dynex court, however, rejected the applicability of Fluor to the Dynex case for two reasons. First, in Fluor, the court found no evidence of any scienter by any officer of Fluor. By contrast, in Dynex, the district court determined that the allegations of scienter against the two named officers were insufficient, though allegations of scienter against other, unnamed officers of the company were sufficient. 531 F.3d at 195. Second, the court stated that it was inappropriate to compare Fluor, in which the court granted summary judgment because the plaintiff had failed to establish the liability of the defendants, with Dynex, in which only a Rule 12(b)(6) motion was pending to dismiss the case for insufficient allegations in the complaint. Id.

The court noted that, in order to prevail on his claims ultimately, a plaintiff has to prove the fraudulent acts of a culpable corporate agent that are attributable to the company. Id. However, in order to survive an initial motion to dismiss, the plaintiff need only plead facts sufficient to create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter. Id. (emphasis added).

Ultimately, the Second Circuit left open the possibility that corporate scienter could be pleaded without identifying the culpable officer in the complaint. The court stated: “Congress has imposed strict requirements on securities fraud pleading, but we do not believe they have imposed the rule urged by defendants, that in no case can corporate scienter be pleaded in the absence of successfully pleading scienter to an expressly named officer.” Id. at 196.

The Dynex plaintiff failed to properly establish corporate scienter

Even though the Second Circuit upheld the notion that a plaintiff could plead corporate scienter in a complaint without specifically identifying culpable officers or directors, the court determined that the Teamsters had failed to sufficiently allege corporate scienter under this standard. For example, the court noted that while the Teamsters made general allegations that Dynex agents had information to indicate that its public statements were not accurate, the Teamsters did not specifically identify those reports or information as required. 531 F.3d at 196.

The Court applied the Tellabs standard, finding that the Teamsters’ alleged inferences of scienter were not significantly more compelling than the competing inferences, including an inference that the statements were not misleading when made or that they were “the result of merely careless mistakes at the management level based on false information fed it from below” as opposed to recklessness that arises to the level of culpable scienter. Id. at 197.

As a result, the Court dismissed the Teamster’s complaint, but allowed the Teamsters 30 days to revise the complaint and replead to reflect the specificity required.

Conclusion

The Dynex decision is both good news and bad news for securities fraud plaintiffs. On the plus side, the court has confirmed a plaintiff’s ability to plead corporate scienter without having to specifically identify the culpable officers or directors whose acts form the basis of corporate liability. On the other hand, the Dynex court reiterates the heightened pleading standard for securities fraud plaintiffs, especially those alleging corporate scienter without identifying culpable corporate officers. Such plaintiffs must plead specific facts that sufficiently create an inference of scienter that is more compelling than any competing inference of innocence.

About the Author

Joel Ginsberg is Deputy General Counsel at Guidance Software, an industry leader in digital investigative solutions.

Image Credit: ©iStockphoto.com/bedo

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Joel Ginsberg

Companies Mentioned

Dynex Capital Inc.

Merit Securities Corp.

Teamsters Local 445 Freight Division Pension Fund

Also See:

Amgen Inc. v. Connecticut Retirement Plans & Trust Funds: Supreme Court Sides with Investors in Securities Fraud Class Action

Gabelli v. SEC: Unanimous Supreme Court Rejects Extending Statute of Limitations in SEC Enforcement Actions

In re Rigel Pharmaceuticals, Inc.: Ninth Circuit Increases Difficulty for Investors to Sue Drug Companies Based on Clinical Trial Results

Mastick v. TD Ameritrade, Inc.: Court Upholds Use of California Arbitration Act in Contracts Governed by California Law

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

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Companies Mentioned

Securities Law

The following companies are mentioned in Securities Law Updates:

Securities and Exchange Commission

Harris Associates, L.P.

Citicorp USA, Inc.

Banc of America Securities LLC

The Public Employees’ Retirement System of Mississippi

Morgan Stanley & Co., Inc.

Jan Charles Finance S.A.

Park East, Inc.

CIBC World Markets Corp.

Citigroup Inc.

Barclays Capital Inc.

Citigroup Global Markets, Inc.

Calyon Securities (USA), Inc. f.k.a. Credit Lyonnais Securities (USA) Inc.

Salomon Smith Barney, Inc.

Calyon New York Branch (successor by operation of law to Credit Lyonnais New York Branch)

Dynex Capital Inc.

Citigroup, Inc.

JPMorgan Chase & Co.

Merit Securities Corp.

JPMorgan Securities Inc.

Scotia Capital (USA), Inc.,

Teamsters Local 445 Freight Division Pension Fund

Aetna, Inc.

Cowen & Co., LLC f.k.a. SG Cowen Securities Corp.

Societe Generale

SunTrust Bank

TD Securities (USA), Inc.

BMO Nesbitt Burns Corp. n.k.a. Harris Nesbitt Burns Corp.

Buchanan Ingersoll & Rooney Professional Corporation

Consolidated Leasing Hugoton Joint Venture #2

W. R. Huff Asset Management Co., LLC

Consolidated Leasing Anadarko Joint Venture

ABN AMRO Bank N.V.

Guardian Capital Management

Free Enterprise Fund

Banc of America, N.A.

Vesta Insurance Group, Inc.

Beckstead and Watts, LLP

Barclays Bank PLC

Torchmark Corp.

Public Company Accounting Oversight Board

BNY Capital Markets, Inc.

KPMG Peat Marwick, LLP

Deloitte & Touche LLP

Credit Lyonnais Securities (USA) Inc.

Florida State Board of Administration

Credit Suisse Securities (USA) LLC

Deutsche Bank AG

The Cleaners & Caulkers Local 1 Pension Fund

Credit Suisse, New York Branch

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