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Securities Law Commentary
Seventh Circuit Looks at Corporate Scienter and Scheme Liability Rules in Pugh v. Tribune Co.
Pugh, et al. v. Tribune Company, et al.
Posted: 05/21/2008
By: Joel B. Ginsberg, Esq.
Companies Mentioned: City of Philadelphia Board of Pensions and Retirement, Tribune Company
Introduction
At the heart of these two consolidated cases is the clear, admitted, egregious fraud perpetrated by employees of a subsidiary of the Tribune Company. The plaintiffs in both cases (a securities case and an ERISA case) tried to extend liability for those fraudulent acts up through the corporate ranks of the Tribune Company, arguing that higher-ups knew or should have known of the fraud while it was happening. Unfortunately for the plaintiffs, their allegations were based primarily on conclusory statements, speculative inferences and tenuous links. Their cases were dismissed with prejudice early in the litigation, and the 7th Circuit affirmed those dismissals, as discussed below. There has been, and still is, a split among jurisdictions as to the proper standard for proving corporate scienter for purposes of corporate liability under Section 10(b) of the 1934 Act. In Pugh, the 7th Circuit dismisses the collective scienter approach relied upon by a minority of courts and applies the more traditional, majority rule requiring individual scienter by officials who contributed to the public statements at issue in some meaningful way. Also, notably, in Pugh, the 7th Circuit became the first federal court to apply the U.S. Supreme Court’s ruling regarding scheme liability in Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., 128 S.Ct. 761 (2008).
Detailed Commentary
Background
The Tribune Company (the “Tribune”) is a multi-billion dollar media and entertainment company. Certain high-level employees of the Tribune subsidiary responsible for publishing Newsday and Hoy (a division of Newsday), falsely boosted circulation figures of Newsday and Hoy, which increased the amount they were able to charge advertisers and, in turn, inflated their revenues.
In February 2004, advertisers of the two papers filed lawsuits against them, alleging overstated circulation. Though it issued the perfunctory press release denying the allegations, the Tribune immediately initiated its own internal investigation and audit of the subsidiary. Through its aggressive investigation, Tribune discovered the fraud and publicly disclosed its findings in a series of press releases – those press releases also announced Tribune’s intention to reserve many millions of dollars of its revenue to pay for the lawsuits and related investigations.
The Pugh case is the consolidation of two cases: the first is a securities fraud case filed by a class of stockholders, the second is an ERISA case filed by participants in Tribune’s sponsored retirement plans whose accounts held shares in the company’s ESOP. In affirming the lower court’s dismissal of both cases on 12(b)(6) motions, the 7th Circuit addressed the securities case first, and piggy-backed much of that analysis in its discussion affirming the ERISA case dismissal.
The securities action failed for lack of scienter and proximate relation
In the securities action, the plaintiffs claimed that the defendants breached Section 10(b) of the Securities Exchange Act of 1934 – the plaintiffs named three groups of defendants: four executive officers of the Tribune (the “Tribune defendants”), certain employees of Newsday and Hoy (the “Newsday-Hoy defendants”), and the Tribune itself.
To prove a violation of 10(b), the plaintiff must prove: 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 on the misrepresentation or omission; 5) economic loss; and 6) loss causation. The Pugh court focused exclusively on scienter and the proximate causation factors, finding that the plaintiffs utterly failed to establish either one against any defendant.
Individual scienter applied, collective scienter rejected
Federal courts have struggled with how to define and apply the notion of corporate scienter, or fraudulent intent, in 10(b) actions. A minority of courts use the “collective scienter” approach – the state of mind defined by the collective mass of the officers’ and employees’ knowledge. Under this theory, the corporation’s awareness can generally be inferred from information available somewhere in the company, and a plaintiff can prevail without proving that any one employee acted with scienter.1 Among courts that have applied collective scienter, however, there is a tremendous lack of judicial uniformity as to which employees can have their minds imputed to the corporation.
The traditional, and apparently majority rule, is a more straightforward approach, requiring proof that the same officer or employee who was responsible for the allegedly untrue or misleading statement attributed to the corporation possess individual fraudulent intent.2 This doctrine works in application much like respondeat superior, in that the individual’s scienter is imputed to the company.
As the result of the confusion, a hybrid scienter theory has developed, allowing a plaintiff to prove corporate scienter if a high-level employee of the company acted with knowledge or recklessness, even if he is not an individual defendant and even if he did not make any of the false statements.3 As with the collective scienter theory, courts applying this approach have lacked judicial uniformity in determining which employees’ minds may be attributed to the company.
The Pugh court specifically adopted the traditional approach to corporate scienter, requiring the plaintiffs to prove the individual scienter. The court specifically adopted the standard recently set forth in Makor Issues & Rights Ltd. v. Tellabs Inc., 513 F3d 702 (7th Cir. 2008), that the corporate scienter inquiry must focus on:
“[T]he state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like) rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.”
Id. at 708.
Applying the individual scienter approach, the Pugh court found that plaintiffs had fallen far short of being able to establish the requisite scienter of the individual defendants in any of the three defendant groups.
Regarding the Tribune defendants, the plaintiffs tried to infer knowledge and scienter by the fact that these defendants received the falsified reports, acknowledged weak control systems by taking subsequent remedial measures after the problem became known, bought stock during the period in question, and, at the very least, knew of the problem when the advertisers filed their lawsuit. But the court found all of these allegations conclusory and, in some instances, bordering on absurd.
For example, though the Tribune defendants did receive the reports, the court said that is very different from knowing that the reports contained false information, which was not obvious on the face of the report. The court scolded the plaintiffs for trying to show knowledge and liability by virtue of subsequent remedial measures, saying that not only does that position break basic evidentiary rules, it also asks the court to find fraud-in-hindsight, which it would not do. Though the Tribune defendants bought stock, they held on to it – if they knew of fraud that would make the stock tumble, they would have sold it when it was still high. Finally, the court pointed out that as soon as the Tribune defendants knew of the advertiser lawsuit, they reacted promptly and properly, the opposite of fraudulent intent.
Regarding the Newsday-Hoy defendants, most of these defendants, while they may have known about or participated in the fraud, had nothing to do with the statements made to the public by the Tribune that were the basis of plaintiffs’ claims. In order to establish 10(b) claims under individual scienter theory, the employees with scienter must be the same as the employees responsible for making the offending statements. Without that proximate link, the claim fails.4
Applying Stoneridge to analyze scheme liability
One Newsday-Hoy defendant warranted special discussion, however. Louis Sito, who at various times held titles with Newsday and Hoy, and ultimately became Vice-President of Hispanic Media for the Tribune, was labeled the “mastermind” of the fraudulent scheme. The plaintiffs argued that it was foreseeable – and Sito knew or should have known—that the scheme would result in improper revenue, which would ultimately be reflected in Tribune’s published financial statements. The court found that this allegation of so-called “scheme liability” had to fail under the recent U.S. Supreme Court ruling in Stoneridge Investment Partners LLC v. Scientific-Atlanta Inc., 128 S.Ct. 761 (2008).
In Stoneridge, Scientific-Atlanta and Motorola had knowingly engaged in a scheme that allowed their business partner, Charter Communications, to artificially inflate its reported revenues. The plaintiffs – investors who claimed reliance on Charter’s inflated financial statements – sought to hold Scientific-Atlanta and Motorola liable for the misstatements under the theory of “scheme liability.”
While it was clear that Scientific-Atlanta and Motorola did deliberately and knowingly engage in the underlying fraud, the Supreme Court held that there was no basis for a finding that investors could have relied upon the deceptive acts in buying or selling securities. Investors had not been directly told about the two companies’ acts – they would only have information related to those acts indirectly in the results reported in Charter’s statements. Accordingly, the Court held that the investors could not “show reliance upon any of respondents’ actions except in an indirect chain that we find too remote for liability.” Id. at 769.
The Pugh court likened Sito and the effect of his conduct to the respondents in Stoneridge. Sito had no role in preparing or disseminating the Tribune’s public statements, and Tribune investors were never informed of Sito’s fraudulent conduct and therefore they could not have relied on it directly. Sito himself may have been able to foresee how the results of his actions may ultimately be reflected in the Tribune’s public statements, but, like in Stoneridge, that indirect chain is too remote to establish primary liability against Sito and, by imputation, the Tribune.
Tribune also not liable under respondeat superior
The Pugh plaintiffs tried to allege primary liability under Section 10(b) against the Tribune itself under an agency theory. However, the court had already established that the plaintiffs failed to establish that any of the Tribune defendants had the requisite scienter, so Tribune liability could not be based on any of them.
The plaintiffs tried to argue that Sito’s scienter could be imputed to Tribune by respondeat superior, but the court rejected that argument. Not only had the plaintiffs failed to prove primary liability for Sito, he was not a senior officer with Tribune itself, he did not take any action on behalf of Tribune, and his actions were not taken for the benefit of Tribune – indeed, they caused Tribune significant harm. The court reminded the plaintiffs that the misconduct of a subsidiary’s employee is not normally attributed to the parent company, unless there are grounds for piercing the corporate veil.
No breach in fiduciary duties under ERISA
The second of the two lawsuits consolidated in Pugh was brought by participants in two ERISA benefit plans offered to Tribune employees, whose accounts held shares in the company ESOP. These plaintiffs filed this lawsuit against the Tribune Employee Benefits Committee and 11 of its current or former members, 13 members of the Tribune’s board of directors, and the Tribune itself.
The lawsuit claimed that the defendants breached ERISA and their fiduciary duty to the plaintiffs by continuing to offer the plaintiffs Tribune stock when it was imprudent to do so. Plaintiffs claim that the defendants should have investigated the situation when “red flags” arose. But the court rejected all of plaintiffs’ claims, treating some of them as though they border on the ridiculous, and accusing most of them of being conclusory and wholly unsubstantiated.
For example, one “red flag” identified by the plaintiffs was the advertiser lawsuit, but the court emphasizes that the Tribune did in fact launch an investigation immediately upon learning of the lawsuit. The court explained that it’s inappropriate to speculate or infer that any of the defendants would have been alerted to the fraud merely because of their roles in the company for a variety of reasons, including the fact that the Newsday and Hoy revenues were tiny percentages of the Tribune’s overall revenue, and previous third party audits of Newsday and Hoy had not revealed anything suspicious.
Finally, the court rejected the argument that the Tribune stock was in such trouble that a reasonable fiduciary would realize that he needed to stop complying with the ESOP’s purpose and direction and stop investing exclusively in Tribune stock. The stock price had gone up and down during the period in question and the plaintiffs had not offered any evidence to connect the stock drops to any financial statements reflecting the fraudulent conduct. Notably, the total $90-95million charge against earnings that the company would incur resulting from the fraud was still less than 2% of one year of Tribune revenues –not enough of a dramatic negative impact to force a fiduciary to make a drastic change and divert from the ESOP’s purpose.
Because the ERISA plaintiffs failed to meet even the lenient standard to survive a 12(b)(6) motion, the court affirmed the dismissal of their action with prejudice.
The author, Joel B. Ginsberg, Esq., is an associate in the transactional department of Zuber & Taillieu LLP, focusing on corporate law, and securities and finance law.
1See, e.g., In re Motorola Secs. Litig., No. 03 Civ. 287, 2004 WL 203769 (ND Ill. Sept. 9 2004) (dismissing the claims against individual defendants because plaintiff failed to allege that they had individual scienter, but upholding the complaint against Motorola because of general knowledge within the company); City of Monroe Employees Retirement Sys. V. Bridgestone Corp., 387 F.3d 467 (6th Cir. 2004) (finding that Bridgestone as a company had the requisite scienter based on the knowledge of employees who did not allegedly make the false statements and who were not even senior personnel).
2 See, e.g. In re Apple Computer Inc., 127 Fed. Appx 296 (9th Cir. 2005) (“A corporation is deemed to have the requisite scienter for fraud only if the individual corporate officer making the statement has the requisite level of scienter at the time that he or she makes the statement.); Southland Secs Corp. v. INSpire Ins. Solutions Inc., 365 F.3d 353 (5th Cir. 2004) (specifically adopting the traditional approach and rejecting the collective scienter approach).
3 See, e.g. In re Sonus Networks Inc. Secs. Litig., No. 04 Civ. 10294, 2006 WL 1308165 (D. Mass. May 10, 2006) (finding that the intent of the mid-management level controller could be imputed to the company); In re NUI Secs. Litig., 314 F. Supp. 2d 388 (D.N.J. 2004) (imputing to the company the knowledge of the associate general counsel).
4Claims against one Newsday-Hoy defendant, Raymond Jansen, were thrown out for the opposite reason – though he made some of the public statements, there was no evidence that he knew of or participated in the fraud. Indeed, he was the only Newsday-Hoy defendant who did not plead guilty to fraud.
Securities Law Summary
Read the related Securities Law summary: Seventh Circuit Dismisses Circulation Fraud Suit Filed Against Tribune Co.
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