Pleading A Strong Inference Of Scienter, Tellabs And Core Operations
Last week, the Eighth Circuit Court of Appeals handed down its second decision in the last few weeks affirming the dismissal of securities class action for failure to plead a strong inference of scienter as required by the PSLRA and the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues and Rights, Ltd., 127 S.Ct. 2499 (2007). Elam v. Neidorff, Case No. 07-2833 (8th Cir. Oct. 16, 2008). In mid-September, the Court affirmed the dismissal of another securities class action for failure to plead scienter as required by Tellabs. The analytical approach in Neidorff differs from the Court’s earlier decision. It is also the first Eighth Circuit opinion to discuss the use of “core operations” as a method to plead scienter.
Neidorff is a securities fraud action brought against Centene Corporation and its CEO Michael Neidorff, Vice President Karey Witty and CFO J. Per Bordin. Centene, which acts as an intermediary between the government and Medicaid recipients in certain states, reports in its quarterly income the costs incurred and billed for the quarter and an estimate of claims liability for certain events. In making those reports, the company cautions that the estimates may be inaccurate.
In July 2006, Centene issued a press release which announced that its second quarter earnings would be substantially lower than expected based as a result of additional claims in March. April and June statements regarding the financial position of the company made by the individual defendants did not mention these additional claims or that the company results would fall below guidance. According to the press release, the lower income resulted from adjustments which had to be made as a result of unexpected claims relating to March. Following the announcement the share price of the company dropped from $21.04 to $13.60 or about 35%. Plaintiffs filed suit alleging that the April and June statements were false. The district court granted a motion to dismiss.
The Eighth Circuit affirmed the dismissal of the complaint. Initially, the court rejected the claim of plaintiffs that the defendants must have know about the extra March costs at the time of the April and June statements because the company touts its ability to estimate medical claims. Noting that the “pleading fails to point to any contemporaneous reports, witness statements, or any information that had actually been provided to defendants as of April or June that indicated that Centene would need to increase estimated medical costs” the court rejected plaintiff’s argument.
The court also rejected plaintiff’s claim that they had adequately pled a strong inference of scienter. Scienter can be established in three ways: 1) from facts establishing a mental state embracing an intent to deceive; 2) from conduct which amounts to severe recklessness; or 3) from allegations of motive and opportunity. Here, plaintiffs failed to plead such facts.
Plaintiff’s claims that stock sales by defendants support a strong inference of scienter are belied by the fact that those sales were small percentages of their total holdings and made under a Rule 10b5-1 plan. Equally flawed is plaintiff’s claim that defendants made the April and June statements while in possession of conflicting information. That claim is based on the supposition that defendants must have known of the extra March costs because of their skill in estimating claims. The court rejected this argument noting that “[t]hese conclusory allegations do not give rise to an inference of scienter.”
The court also rejected the plaintiff’s contention that because medical costs are at the core of Centene’s business defendants must have known about the March expenses. Noting that it had not addressed the “core operations” method of pleading scienter, the court concluded it need not do so here. The application of that doctrine would “at least require a showing that this information [March expenses] was known within the company at the time.” Here plaintiffs have failed to make that showing. While the Court noted that it was “troubled” by the fact that the April and June statements were closely followed by the July disclosure, that temporally proximity standing alone was not sufficient for plaintiff to meet its burden.
Neidorff is the second Eighth Circuit decision to apply Tellabs in the last several weeks. This case, consistent with the Court’s approach immediately after Tellabs, analyzed the issue using the Tellabs test in combination with the circuit’s pre-Tellabs approach which essentially followed the Second Circuit’s motive and opportunity analysis. In contrast, the Circuit’s decision last month did not use the motive and opportunity test. Western Pa. Electrical Employees Benefits Fund v. Ceridian Corp., No. 07-2707 (8th Cir. Sept. 11, 2008). Nevertheless, both cases affirmed the dismissal of the complaint.
Neidorff is also the second circuit court decision in recent weeks to consider the “core operations” approach to pleading scienter. In its opinion, the Eighth Circuit noted that the Fifth and Ninth Circuits had rejected the approach. Neidorff did not adopt the theory. The court did however discuss its requirements while concluding that plaintiff had failed to plead sufficient facts.
At the same time the court’s statement about the Ninth Circuit’s view of the core operations method of pleading scienter appears is questionable. In support of its statement the court cited In re Read-Rite Corp. Sec. Litig., 335 F.3d 843 (9th Cir. 2003). Last month in South Ferry LP v. Killinger, Case No. 06-35511 (Sept. 9, 2008), discussed here, however the Ninth Circuit noted when discussing pleading scienter that “[a]llegations that rely on the core-operations inference are among the allegations that may be considered in the complete PSLRA analysis.” Use of the core operations method may require further clarification in both the Ninth and Eighth Circuits.