D&O Liability - Ninth Circuit Affirms Dismissal of Securities Fraud Suit With Prejudice For Failure to Plead Loss Causation, Scienter, and Falsity
On July 25, 2008, in Metzler Inv. GMBH v. Corinthian Colleges, Inc., No. 06-55826 (9th Cir.), the United States Court of Appeals for the Ninth Circuit affirmed the dismissal of a securities fraud class action with prejudice
for failure to plead loss causation, scienter and falsity.
Metzler Investment GMBH (“Metzler”), an institutional investor, brought a putative federal securities fraud class action against Corinthian Colleges, Inc. (“Corinthian”), one of the nation’s largest
operators of private, for-profit vocational colleges, and three of its officers. Metzler’s third amended complaint (“TAC”) alleged that Corinthian’s colleges were pervaded by fraudulent practices designed
to maximize the amount of federal Title IV funding, a major source of Corinthian’s revenue, and that Corinthian violated Generally Accepted Accounting Principles (“GAAP”) by improperly recognizing revenue. Metzler
contended that the fraudulent scheme involved, among other things, the falsification of financial aid applications and student grades, the manipulation of student enrollment and job placement data, and the concealment of Department
of Education (“DOE”) and California Attorney General investigations. The TAC also alleged that Corinthian violated GAAP by improperly recognizing an entire month’s worth of tuition revenue for a student’s
first full month of attendance regardless of when the student actually started. In August and November 2005, Corinthian released restated financials.
The TAC alleged that suspicious stock sales made by officers during the alleged class period evidenced an intentional fraud. It also urged that, because Corinthian’s management exercised close oversight of the schools and
had access to sophisticated information systems concerning operating information, Corinthian’s management must have known about the alleged fraud. The TAC also relied on allegations derived from numerous confidential witnesses.
The TAC pointed to two disclosures that purportedly revealed Corinthian’s fraudulent student enrollment and financial aid practices to the market: (1) a June 24, 2004 Financial Times story reporting the DOE investigation,
and (2) an August 2, 2004 press release disclosing reduced earnings and earning projections. According to the TAC, when read in tandem, these two disclosures revealed “the truth regarding [Corinthian’s] fraudulent practices
and deception,” and precipitated considerable drops in the value of Corinthian stock.
The district court held that these allegations failed to satisfy the pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”). The Ninth Circuit affirmed, holding that, “despite its lengthy
and far-ranging allegations,” the TAC did not: (1) plead loss causation, (2) raise a strong inference of scienter, or (3) allege falsity with the specificity required by the PSLRA.
First, the Ninth Circuit held that the TAC failed to plead loss causation because it did “not allege that the…announcements disclosed – or even suggested – to the market that Corinthian was manipulating
student enrollment figures company-wide in order to procure excess federal funding, which is the fraudulent activity that Metzler contends forced down the stock that caused its losses.” Although neither In re Daou Sys. Inc.,
411 F.3d 1006 (9th Cir. 2005) nor Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005) require an admission or finding of fraud before loss causation can be properly plead, according to the Court, “that does not allow
a plaintiff to plead loss causation through ‘euphemism’ and thereby avoid alleging the necessary connection between defendant’s fraud and the actual loss.” The Court continued:
So long as there is a drop in a stock’s price, a plaintiff will always be able to contend that the market “understood” a defendant’s statement precipitating a loss as a coded message revealing the fraud. Enabling a plaintiff to proceed on such a theory would effectively resurrect what Dura discredited – that loss causation is established through an allegation that a stock was purchased at an inflated price….Loss causation requires more.Second, the Court held that Metzler had failed adequately to plead scienter under the standard set forth by the United States Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). The Court noted that the TAC principally relied on three factors to establish scienter: (1) management’s stock sales during the class period; (2) the existence of a “sophisticated information management system” that would have enabled management to access “all student and financial aid records for all Corinthian schools;” and (3) management’s involvement in Corinthian’s revenue recognition policies and rejection of alternate accounting methods. As an initial matter, the Court explained that, while “‘suspicious’ stock sales by corporate insiders may constitute circumstantial evidence of scienter,” such sales only give rise to an inference of scienter when they are “‘dramatically out of line with prior trading practices at times calculated to maximize the personal benefit from undisclosed inside information’” – factors not established in this case. The Court also reasoned that “corporate management’s general awareness of the day-to-day workings of the company’s business does not establish scienter – at least absent some additional allegation of specific information conveyed to management and related to the fraud.” The Court further concluded that the allegations concerning Corinthian’s revenue recognition practices failed to raise a strong inference of scienter because the TAC did not sufficiently allege that management knowingly and recklessly engaged in an improper accounting practice.
Finally, the Court held that Metzler failed to meet the PSLRA’s “exacting requirements” for pleading falsity, noting that “[a] litany of alleged false statements, unaccompanied by the pleading of specific facts indicating why those statements were false, does not meet this standard.”