InsideCounsel » April 2008
Court Weighs Whether a Corporation can Commit Securities Fraud
Can a company be sued for federal securities fraud when the corporate executives who made false statements to the public did not have fraudulent intent? That question will be squarely addressed for the first time by the 2nd Circuit, which heard oral arguments Jan. 30 on the pleading and proof of corporate scienter—the intent to deceive, manipulate or defraud—in a securities fraud class action involving sub-prime loans.
The representative plaintiff, Teamsters Local 445 Freight Division Pension Fund, alleges that Dynex Capital Inc., its subsidiary Merit Securities Corp. and two corporate officers violated the Securities Exchange Act of 1934 by knowingly or recklessly making false or misleading statements to investors during a five-year period about the creditworthiness of $665 million in asset-backed bonds Merit issued in 1999.
The price of the bonds, which were secured by mobile home loans, plummeted after Dynex disclosed unexpectedly high losses from defaults and foreclosures, and the credit rating agency Moody’s Investor Service downgraded the bonds in 2004. The pension fund alleges that the defendants failed to disclose to investors lax underwriting standards and misrepresented the reasons for the bonds’ collateral’s poor performance by blaming market conditions.
The U.S. District Court for the Southern District of New York partially granted the defendants’ motion to dismiss prior to discovery in 2006. The judge threw out the case against the two individual defendants because the plaintiff didn’t show the executives ever saw or had access to specific reports or statements that indicated malfeasance or contradicted the pair’s public statements. But the court held the class action could proceed.
On appeal, Dynex told the 2nd Circuit it would be illogical to permit the class action to proceed because the executives did not have scienter and a corporation has no mind of its own.
“It is nonsensical to state that having failed to plead that any particular Dynex employee intended to commit fraud, the company itself somehow intended to commit fraud,” insists Dynex’s lead counsel Edward Fuhr, a partner with Hunton & Williams in Richmond, Va.
Revolutionary Approach
Backed by the Business Roundtable and the U.S. Chamber of Commerce as amici curiae, Fuhr also contends that the District Court’s “revolutionary, collective” approach to corporate scienter undercuts strict pleading requirements imposed by both Congress and the Supreme Court to discourage frivolous allegations of securities fraud every time a company’s stock price drops.
The amici curiae in support of the plaintiff—including Mississippi, New Jersey and several state pension plans—say Dynex’s argument would heighten the already extraordinary hurdles facing plaintiffs in securities fraud class actions.
“It’s clearly not just or fair because you’d have a situation where there is all of this evidence of fraud, but because you can’t finger a particular individual [before discovery], the case gets dismissed,” says Ethan Wohl, a partner with Labaton Sucharow in New York. Wohl represents the amicus curiae National Association of Shareholder and Consumer Attorneys.
The Private Securities Litigation Reform Act of 1995 provides that a plaintiff’s complaint can survive a defense motion to dismiss only if it pleads cogent and compelling evidence that suggests a “strong inference that the defendant acted with the required state of mind.”
