THE STRINGENT PSLRA PLEADING STANDARDS
The stringent pleading standards incorporated by Congress in the Private Securities Litigation Reform Act continue to have a significant impact on private securities actions. The Eleventh Circuit recently emphasized the unique nature of these constrictions in affirming the dismissal of a securities class action based on option backdating claims. Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., No. 09-10954 (11th Cir Decided Jan. 19, 2010).
Plaintiffs alleged in their complaint against Jabil, a Florida based electronics and technology company, and certain of its officers that the defendants had fraudulently backdated stock option grants. As a result, earnings were overstated by $54.3 million. A restatement was required to correct the errors.
The compensation program at the company authorized issuing stock options to officers, directors and employees. That policy required that the options be issued at fair market value. Following a WALL STREET JOURNAL article in March 2006 – one of two which initiated the backdating scandal and which listed Jabil and others – the SEC launched an informal inquiry.
The company conducted an internal investigation. The inquiry concluded that there was no evidence of high level employees issuing themselves backdated options. The investigators did determine, however, that APB 25, regarding accounting for options, had been misapplied. Investigators also concluded that options had been misdated, but not backdated. Of the restated amount, $48.9 million resulted from increased compensation expense for non-executive employees.
The circuit court began by rejecting the district court’s conclusion about false statements. In reaching its conclusion about false statements, the district court concluded that the complaint failed to adequately plead a backdating scheme by the executive officers since it lacked facts about the particular involvement of any individual defendant. While it may be true that the complaint lacks facts about an option backdating scheme, at the same time it does state that the financial reports and policy statements were false. This, the court concluded, is a plausible claim.
The circuit court agreed with the district court, however, that scienter had not been adequately pleaded under Tellabs, Inc. v. Makor Issues & Rights, 551 U.S. 308 (2007), discussed here. The standard for scienter in the Eleventh Circuit is “severe recklessness.” Although the plaintiffs did not plead particularized facts that any individual officer knew about the option practices, they claim that the restatement is a virtual admission of liability, particularly in view of its magnitude. Plaintiff sought to bolster this claim by arguing that a significant percentage net income was misstated each year as illustrated by a table in the complaint. A number of executives also sold shares during the period, bolstering the inference of scienter, according to plaintiff.
The court rejected these claims as inadequate. Backdating options is not, in and of itself, improper. The critical question is whether the accounting is done correctly. Here, there are no facts to demonstrate that any individual defendant knew the accounting standards had been violated. Likewise, plaintiff’s claims regarding the percentage of net income are unavailing. Basing those claims on percentages of net income was inappropriate since that metric can vary widely, the court noted. Plaintiffs should have used total revenue as a baseline for comparison. In this regard, the court noted that a pleading strategy – which is based on “picking the metric that will yield the highest percentage of values – adds nothing to the inference of scienter that the shareholders attempt to create.” Thus, plaintiff’s claim that the amount of the misstatement was so large that it must have been a red flag does not support its contention about scienter.
Likewise, plaintiff’s claims regarding the trading of various executives also fails to support its claims. Again without context such as the history of the individual’s trades, the claim can not be evaluated. Accordingly, the court concluded that when viewed collectively the allegations did not constitute a strong inference of scienter.
In reaching its conclusions, the court pointed out the unique nature of the inquiry required by the PSLRA: “We emphasize that the unique nature of the PLSRA requires us to resolve this question, whether the alleged conduct is severely reckless, at the pleading stage, though doing so would be improper in most other contexts.”