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From Securities Regulation Daily, October 10, 2014

Appeals court elucidates collective corporate scienter, material misrepresentation pleading standards

By Anne Sherry, J.D.

The appeal of an order dismissing a case against Omnicare, Inc. led the Sixth Circuit to reexamine the pleading requirements for two of the six elements of a securities fraud claim before concluding that the plaintiff indeed failed to clear the PSLRA’s hurdles. The court lamented that “for all of [its] efforts and many pronouncements, the precise requirements for sufficiently pleading” material misrepresentations or omissions and scienter “remain somewhat hazy and muddled” (In re Omnicare, Inc., October 10, 2014, Moore, K.).

Background. The case arose from claims that Omnicare, Inc.’s executives misrepresented its billing practices in violation of Exchange Act Sec. 10(b) and Rule 10b-5. The complaint was based on allegations contained in an earlier, dismissed qui tam action in Illinois by former Omnicare vice president of internal audit, John Stone. The district court dismissed the securities fraud claims and the related Exchange Act Sec. 20 controlling person claims, noting in particular that most of the alleged misstatements consisted of “soft” information that need not be disclosed and that the plaintiffs failed to show that the statements were made with actual knowledge that they were false.

Material misrepresentation or omission. The Sixth Circuit took the opportunity to revisit the pleading standards for the two elements at issue on appeal: material misrepresentations or omissions and scienter. Recitation of the standards for pleading an actionable misrepresentation or omission does little to clarify the doctrine, the court wrote, because it had “created and conflated different tests and concepts” in its prior decisions. Specifically, the court said that its earlier decisions failed to recognize that a different analytical framework applies to affirmative misrepresentations as opposed to omissions, and that different rules apply when the misrepresentation or omission concerns hard, as opposed to soft, information.

A particular quandary is that an alleged misrepresentation concerning “soft information” — such as predictions and matters of opinion, as in this case — introduces a subjective inquiry to an otherwise objective element, thus conflating the elements of misrepresentation and scienter. The appeals court said that it matters little whether courts evaluate the subjective component as part of their material misrepresentation or scienter analysis, but decided to adopt the approach of the First Circuit and treat the subjective inquiry as raising the bar for alleging scienter. This approach allows courts tackle the objective inquiries of materiality and falsity under the material misrepresentation prong and save the subjective analysis for the scienter element. Furthermore, whether someone made a statement with the knowledge that it was false is a question of state of mind, which is already the general subject of a scienter inquiry.

The court also cautioned that while the “reasonable investor” standard for materiality may at first appear clever and intuitively sensible, it has the potential to look more like a heuristic when used at the motion to dismiss stage, before the fact question of materiality has been decided. “In general,” the court acknowledged, “the federal judiciary has a limited understanding of investor behavior and the actual economic consequences of certain statements” and must tread lightly on motions to dismiss to avoid “prematurely dismissing suits on the basis of our intuition.”

Scienter. The scienter analysis is further complicated where there is a corporate defendant because it raises the additional question of whose knowledge and state of mind matters. After reviewing the existing landscape and weighing the merits of the two prevailing approaches — the narrow view that looks to the state of mind of the individual official or officials who make or issue the statement and the broader view that imputes upon the corporation the knowledge of a corporate officer who did not issue the statement in question — the court concluded that a middle ground was necessary. Going forward, the rule in the circuit will be to consider the state of mind of (1) the individual agent who uttered or issued the misrepresentation; (2) any individual agent who authorized, requested, commanded, furnished information for, prepared, reviewed, or approved the statement before it was made; and (3) any high managerial agent or director who ratified, recklessly disregarded, or tolerated the misrepresentation after it was made.

Application. Applying these guidelines to the case before it, the court determined that the district court was correct to dismiss the suit against the pharmaceutical company. The plaintiff met its burden for proving a material misrepresentation or omission, but the complaint fell apart on the scienter prong as it failed to sufficiently tie Omnicare’s former CEO or any of the individual defendants to the problematic internal audits. Because the Form 10-K statements at issue concerned soft information, the lack of sufficient facts showing that the individuals had actual knowledge of their falsity was fatal to the fraud claims. As to the corporate defendant, although the court’s formulation of collective corporate scienter permitted the internal auditor’s knowledge to be imputed to Omnicare, the complaint pleaded too few facts to give rise to an inference of fraudulent intent sufficient to overcome the countervailing inferences.

The case is No. 13-5597.

Attorneys: Peter S. Linden (Kirby McInerney) and Gary J. Sergent (O'Hara Ruberg Taylor Sloan & Sergent) for KBC Asset Management N.V. Richard W. Reinthaler (Winston & Strawn) and Michael Eugene Nitardy (Frost Brown Todd) for Omnicare, Inc.

Companies: KBC Asset Management N.V.; Omnicare, Inc.

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