Appellate Courts Struggle with "Core Operations," "Collective Scienter" Inferences

By N. Peter Rasmussen, J.D.

Courts have long recognized that an actionable inference of scienter may not be drawn merely from the fact that individual defendants were senior officers of a company. However, recent circuit court cases issued in light of the Supreme Court's Tellabs, Inc. v. Makor Issues & Rights decision have reached different conclusions on the question of whether an inference may be drawn that senior management must be aware of matters involving the company's "core operations," including any fraudulent conduct, and whether "collective scienter" may be actionable in the absence of a sufficient inference of scienter attributable to a particular individual.

Core Operations Inference

The 9th Circuit has addressed this issue in two recent and somewhat contradictory decisions. In Berson v. Applied Signal Technology, Inc., issued in June 2008, a 9th Circuit panel found that the plaintiffs pleaded with sufficient particularity that the contractor's alleged practice of counting work suspended to government "stop-work orders" as "backlog" could be actionable. Because the named CEO and CFO "were directly responsible for Applied Signal's day-to-day operations," the court observed that "it is hard to believe that they would not have known about stop-work orders that allegedly halted tens of millions of dollars of the company's work" and that these facts were prominent enough that it would be `absurd to suggest' that top management was unaware of them.

However, three months later in South Ferry LP, #2 v. Killinger, the same court severely narrowed Berson. In distinguishing its earlier opinion, the court specifically noted that the defendants in Berson knew of the adverse conditions two weeks after they made their statements. However, despite this fact, that the awareness came after the statements were made, the 9th Circuit relegated Berson to that "exceedingly rare category of cases in which the core operations inference, without more, is sufficient under the PLSRA."

In South Ferry, the 9th Circuit held that allegations that rely on the core-operations inference are "among the allegations that may be considered in a complete PSLRA analysis." The court noted, though, that a "question remains, however, about reliance on the core-operations inference when it is the only basis for scienter in the complaint...where a complaint relies on allegations that management had an important role in the company but does not contain additional detailed allegations about the defendants' actual exposure to information, it will usually fall short of the PSLRA standard."

According to the 9th Circuit panel, the core operations pleadings could be relevant in three circumstances, when 1) the allegations are used in conjunction with other allegations that together raise an inference of scienter that is "cogent and compelling," thus strong in light of other explanations, 2) the allegations alone are "particular and suggest that defendants had actual access to the disputed information," or 3) the allegations, although lacking additional particular allegations, are based upon a "relevant fact" so prominent that it is "absurd" to suggest that management was without knowledge of the matter.

An obvious difficulty with the panel's holding is the notion of "absurdity." As Tellabs requires courts to weigh and evaluate competing inferences qualitatively and quantitatively, a standard of absurdity" seems ambiguous and difficult to apply.

In its review on remand of the Tellabs case, the 7th Circuit seemed to embrace the core operations inference. According to Judge Posner, it was "extremely unlikely" that the allegedly false statements "were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference." The reason for such a conclusion, said Judge Posner, was that the products in question "were Tellabs's most important products"...described by the company as its "flagship." Because of the importance of these products to the company, Judge Posner wrote "that no member of the company's senior management who was involved in authorizing or making public statements about the demand for the 5500 and 6500 knew that they were false is very hard to credit, and no plausible story has yet been told by the defendants that might dispel our incredulity."

The 11th Circuit rejected the core operations presumption in Mizzaro v. Home Depot, Inc. in October 2008. The court stated that "we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management `must have known' everything that was happening in a company as large as Home Depot" and that the complaint "must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management."

The 8th Circuit expressed doubts about the viability of a core operations inference in an October 2008 decision, Elam v. Neidorff. The plaintiffs argued that the company "must have known about the additional $9.7 million in medical costs in April and June of 2006, when the allegedly false statements were made, because Centene touts its ability to predict medical costs." The court found the complaint inadequate without squarely addressing the core operations question. "We need not determine whether the core operations approach can be utilized to plead scienter," stated the court. The panel stated that "even if the proper factual allegations could warrant its application, plaintiffs have not made such a showing...in order to attribute knowledge of the additional medical costs to Centene's officers at the time of the April or June statements on this basis, we would at least require a showing that this information was known within the company at that time."

One observation by the Eighth Circuit panel merits closer examination. In refusing to recognize the core operations inference, the court stated that "the Fifth and Ninth Circuits have rejected it," and cited the In re Read-Rite Corp. Securities Litigation decision in support of that proposition. This is significant because the 8th Circuit did not address the South Ferry decision above, entered more than a month earlier, in which the 9th Circuit stated that Tellabs "suggests that perhaps Silicon Graphics, Vantive and Read-Rite are too demanding and focused too narrowly in dismissing vague, ambiguous, or general allegations outright." Although the 9th Circuit in South Ferry found the pleadings to be insufficient, that panel clearly used a different analytical frame than that applied by the Read-Rite court.


Collective or Corporate Scienter

Corporations can only act through their agents, their officers and directors. An important issue addressed by several circuit courts with different results recently has been the question of whether a corporation can be found to have acted with the requisite scienter if no individual officer or director possessed that level of intent. Under a "collective scienter" approach, courts consider the state of mind and conduct of individual actors collectively, and that in the aggregate can constitute corporate scienter even if insufficient to show scienter in any individual instance.

In a 2004 decision, Southland Securities Corp. v. Inspire Insurance Solutions, Inc., the 5th Circuit rejected this notion According to the court, a "defendant corporation is deemed to have the requisite scienter for fraud only if the individual corporate officer making the statement has the requisite level of scienter, i.e., knows that the statement is false, or is at least deliberately reckless as to its falsity, at the time he or she makes the statement. This is consistent with the general common law rule that where, as in fraud, an essentially subjective state of mind is an element of a cause of action also involving some sort of conduct, such as a misrepresentation, the required state of mind must actually exist in the individual making (or being a cause of the making of) the misrepresentation, and may not simply be imputed to that individual on general principles of agency."

In a 2005 case, City of Monroe Employees Retirement System v. Bridgestone Corp., the 6th Circuit took the opposite view. The court found specifically that the officer in question did not act with scienter, but found that sufficient intent could be imputed to the corporate defendant. The court recognized that "at first glance, it might seem incongruous to reach this conclusion after relying in part on Ono's knowledge of the claims settlements as a basis for Bridgestone's scienter on that claim," but concluded that "while an individual officer's knowledge may be attributed to the corporation, liability for the corporation's act does not, absent independent evidence, generally flow from the corporation to the corporate officer."

Finally, in 2008, the 2nd Circuit reached a mixed result on the question in Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc. The panel concluded that the lack of individual scienter did not preclude a similar finding against the corporate entity, but in this instance, the plaintiffs failed to show the requisite fraudulent intent by other means. As the court stated, although there are circumstances in which a plaintiff may plead the requisite scienter against a corporate defendant without successfully pleading scienter against a specifically named individual defendant, the plaintiff here has failed to do so.

In this case, the district court held that the fraud complaint against the defendant, a financial services company, for misrepresentations concerning its underwriting guidelines for bonds collateralized by pools of mobile home installment sales contracts was sufficient to survive a motion to dismiss. While the complaint failed to establish a strong inference of scienter against individual company officers, the allegations that the corporation systematically disregarded various indicia of borrowers' creditworthiness in order to quickly consummate large volumes of loans and ignored signs that the bond collateral was defective after the loans were originated were sufficient to infer scienter on the part of the corporation itself, held the court.

Subsequently the district court declined to reconsider its finding on collective scienter, but certified the question for interlocutory appeal. Judge Baer wrote that the defendants "have not demonstrated that I overlooked controlling authority in denying Dynex's motion to dismiss. However, defendants have demonstrated that the permissibility of pleading corporate or collective scienter within this Circuit constitutes `a controlling question of law' as to which there is substantial ground for difference of opinion on the issue.

On appeal, the 2nd Circuit, despite its recognition that a lack of individual scienter is not conclusive at the pleading stage, used language in the opinion that seems to suggest otherwise, at least with regard to proving the claim as compared to pleading it and surviving an initial motion to dismiss. The court stated that in order to recover, "someone whose scienter is imputable to the corporate defendants and who was responsible for the statements made was at least reckless toward the alleged falsity of those statements." Accordingly, it is important to distinguish between what must be pleaded to raise a sufficient inference and what must be proven in order to recover. To prevail and recover, "a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation." The court in this case found that the inferences raised in the complaint were not "at least as compelling as the competing inference and that "the statements either were not misleading or were the result of merely careless mistakes at the management level based on false information fed it from below. "

A collective scienter inference in the absence of actionable individual intent has been criticized for effectively divorcing the culpable conduct from the culpable state of mind. As described by Bruce G. Vanyo of Katten Muchin Rosenman LLP at PLI's recent Securities Litigation and Enforcement Institute, collective scienter is adding zero plus zero plus zero and coming up with actionable intent. In contrast, however, as described by Seth Aronson of O'Melveny & Myers LLP, the collective scienter inference may be reconciled with the PSLRA strong inference standard through the Supreme Court's "holistic" view of fraud complaints as set forth in Tellabs.

The various circuit courts that have addressed collective scienter or the core operations inference after the Tellabs decision have reached different and often contradictory results. Courts seem to be trending away from finding these inferences sufficient, but given the conflicts between and sometimes within the circuits, the fact-intensive nature of these questions and the introduction of potentially ambiguous standards such as "absurdity" into the mix, the balkanization of fraud litigation and circuit-specific pleading appears likely.