Class Action Claiming Fraud Regarding High Yield Investments Is Dismissed

In a decision which may become of increasing importance as the market crisis deepens, the court in In re: American Express Co. Sec. Litig., 02 cv 5533 (S.D.N.Y. Sept. 26, 2008) dismissed a securities class action based on allegations that the company and senior management fraudulently misrepresented and concealed the risk of the company’s high yield investments. Specifically, plaintiffs claimed that the defendants falsely misrepresented its high yield investments as conservative, concealed the extent of the company’s high yield exposure, failed to disclose the lack of risk management controls and failed to disclose the fact that the accounting was not in accord with GAAP. The suit was brought against the company and seven of its senior officers.

The court dismissed the suit, concluding that plaintiffs had failed to plead a strong inference of scienter as required by the Private Securities Litigation Reform Act. To plead a strong inference of scienter as required under Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the court held that plaintiffs must plead facts which give rise to a strong inference of scienter after taking into account plausible opposing inferences. This can be established by showing that the defendants: (1) benefited in a concrete personal way; (2) engaged in deliberately illegal behavior; (3) knew or had access to facts suggesting that their public statements were not accurate; or (4) failed to check information they had a duty to monitor. This approach is based in part on the Second Circuit’s traditional “motive and opportunity” test which predates Tellabs and the Reform Act.

In reviewing plaintiffs’ allegations, the court began by rejecting claims that the defendants were motivated to commit fraud to meet aggressive income targets and because two of the individual defendants had incentive compensation. The court concluded that these claims were “not entitled to any weight,” although the allegations in the complaint must be viewed collectively under Tellabs.

The court also rejected plaintiffs’ contention that defendants were “reckless” if they did not know of the risks of the high yield investments and that the public disclosures of the company about those investments misrepresented that risk. Those allegations, the court concluded, “do no more than state in conclusory fashion what Defendants should have known, they are not entitled to any weight.”

The court also rejected as insufficient allegations from seven confidential informants. Citing the Second Circuit’s decision in Novak v. Kasaks, 216 F.3d 300 (2nd Cir. 2000), the opinion notes that these sources can be sufficient under Reform Act standards if there is an adequate basis for believing that the defendants’ statements were false and if the confidential sources are described with sufficient particularity to “support the probability that a person in the position occupied by the source would possess the information alleged.”

In this case, although the job position of each source was specified, “[n]one of the confidential sources specifically states that any Individual Defendant had information or access to information indicating that Amex was not properly valuing the High Yield Debt, that its risk control policies were inadequate, that Amex was violating GAAP, or that contradicted the Company’s statements ….” Rather, the allegations from these sources were vague or general statements such as “there was pressure to conceal the impaired …” investments. These allegations did not speak directly about the individual defendants. While there were claims that two individual defendants were warned about the risks of the investments, the claims are meaningless, the court concluded, unless plaintiffs establish what the two individual defendants knew or should have known.

Similarly, allegations that two of the individual defendants had access to information regarding the investments and their risk is not sufficient to plead a strong inference of scienter. While those facts might support an inference of scienter, the more compelling inference is that defendants were not acting with an intent to deceive, since immediately after learning these risks the two men analyzed the investments and announced the results. This fact also undermines plaintiffs’ claims that there was a failure to monitor and, like the other allegations in the complaint, is insufficient to plead a strong inference of scienter as to each defendant.