D&O Liability - Second Circuit Holds that Securities Fraud Suit Against Company Can Survive Absent Adequate Allegations of Scienter As to Any Named Individual Defendant
On June 26, 2008, in Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc., et al., No. 06-2902, the United States Court of Appeals for the Second Circuit reversed the district court’s denial of the
motion to dismiss of the two corporate defendants in a securities class action. Although the Court rejected the defendants’ contention that a plaintiff’s failure to plead scienter as to specifically named individual
defendants precludes, as a matter of law, the finding of a strong inference of scienter as to a corporate defendant, it nonetheless concluded that, in this case, plaintiff failed adequately to plead scienter based on other factors.
The allegations at issue in Dynex are now commonplace, in the midst of the current credit crisis and housing decline. Merit Securities Corporation (“Merit”), a subsidiary of Dynex Capital Inc. (“Dynex”),
extended loans to purchasers of manufactured housing, and then pooled the loans and issued two sets of bonds backed by mortgages. After the bond issue, the value of the collateral began a sharp decline, and increasing numbers of
borrowers defaulted on their loans. Dynex subsequently announced that it had understated the repossession rates on the collateral, and the bonds then were downgraded by Moody’s. Merit later announced it would restate its earnings
for two periods because of an internal control deficiency. In the aftermath, the price of the bonds fell significantly. In the complaint, plaintiff alleged that Merit, Dynex and two officers misrepresented the cause of the bond collateral’s
poor performance, misrepresented the reasons for restating loan loss reserves, and concealed the loans’ faulty underwriting. The defendants moved to dismiss the complaint on the basis that plaintiff had failed to plead scienter.
The district court agreed that plaintiff had failed to plead scienter as to the individual defendants, but found the complaint to be sufficient as to the corporate defendants.
On appeal, defendants argued that the district court’s dismissal of the individual defendants based on the failure adequately to plead scienter precluded, as a matter of law, the finding of scienter as to Dynex and Merit.
They contended that the court’s holding was tantamount to an endorsement of the doctrine of “collective scienter,” under which a corporate entity can act with an intent that is not derivative of the intent of
one of its agents. Defendants cited State Teachers Retirement Board v. Fluor Corp., 654 F.2d 843 (2d Cir. 1981), in which the Court had affirmed summary judgment for a corporate defendant in a securities fraud action because
“there [wa]s no evidence on the record…that [the individual defendant] or any other [company] officer acted with scienter.”
In Dynex, the Second Circuit rejected defendants’ argument that dismissal of the individual defendants required the dismissal of the corporate defendants. The Court distinguished Fluor on the grounds that,
in that case, there was no evidence of scienter as to any company officer. The Court held that the scienter of a corporate defendant may be pleaded with reference to facts creating a strong inference that someone
whose intent could be imputed to the corporation – whether or not that individual is named as a defendant – acted with the requisite scienter. While “the most straightforward way to raise such an inference will
be to plead it for an individual defendant…it is possible to raise the required inference with regard to a corporate defendant without doing so with regard to a specific individual defendant.”
Nevertheless, the Court held that, in this case, plaintiff had failed to plead a strong inference of scienter as to the corporate defendants because it failed to allege that any officer had the requisite knowledge of or access to
information demonstrating the inaccuracy of Dynex’s public statements, and failed to plead that any individual had a compelling motive to mislead investors regarding the bonds. Thus, the Court could not find that the inference
urged by the plaintiff was at least as compelling as the competing inferences, citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007). The Second Circuit therefore vacated the district court’s
denial of the motion to dismiss, and remanded with instructions that the complaint be dismissed with leave to amend.