Scienter, Confidential Witnesses And The Corporation
In Bucks County Retirement Board v. Home Depot, Inc., Case No. 07-13810 (11th Cir. Oct. 8, 2008), the court affirmed the dismissal of a securities class action brought against Home Depot and six of its senior officers for failure to adequately plead a strong inference of scienter as required by the PSLRA. The complaint was based on a claimed accounting fraud which improperly inflated earnings of the company.
The opinion contains four key points. After citing the test for pleading a strong inference of scienter from the Supreme Court’s recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the Eleventh Circuit distinguished the “strong inference” test from that used for summary judgment. Under Tellabs, the allegations of the complaint must be taken as true and, when viewed collectively, the court must determine if a reasonable person would deem the inference at least as strong as any competing inference. This test, the court stressed, asks what a reasonable person would do. In contrast, on summary judgment the question is what a reasonable person could find, citing Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 252 (1986).
Second, the court notes that Tellabs did not address the question of confidential witnesses. The court rejected the notion that there should be a per se rule precluding the use of such witnesses, citing criminal law probable cause cases. Rather, the court adopted essentially the position of the Second Circuit in Novak v. Kasaks, 216 F.3d 300 (2nd Cir. 2000) requiring that the complaint “unambiguously” provide the basis of the witnesses’ knowledge. After carefully reviewing the allegations, the court concluded that they failed to link the individual defendants to the claimed fraud.
Third, the court rejected plaintiffs’ claim that because the fraud was widespread the individual defendants must have known about it. In this regard, the court noted that the fraud was a simple one which could have been done by lower level employees. This undercuts the notion that because it was widespread the senior executives named as defendants must have known about it.
Likewise, the failure of plaintiff to offer any proof that the senior officials named as defendants had any communications with subordinates who would have been necessary to carry out the fraud bolstered this point. Indeed, the allegations in the complaint suggest that some of the store managers may have carried out the scheme to meet aggressive company targets, the court noted. And, in any event, “we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management ‘must have known’ everything that was happening in a company as large as Home Depot, which operates over 2,000 stores. … The amended complaint, therefore, must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management. The amended complaint does not come close to accomplishing that task.” (emphasis original)
Finally, while the amended complaint could in theory still create a strong inference as to the corporate defendant after failing as to the individuals, that is not the case here the court concluded. To determine the state of mind of the entity, the court must look to its agents. Here, the complaint focuses on claimed fraudulent public statements of individual officers. Accordingly, since it failed to plead sufficient facts to establish a strong inference of scienter as to those individuals, it necessarily fails as to the corporation.