By James Hamilton, J.D., LL.M.
Interpreting the US Supreme Court’s recent ruling on how to plead scienter in a securities fraud class action, a Fifth Circuit panel rejected a reading that would allow the drawing of a strong inference of scienter from the fact that the senior executive and financial officers signed a Sarbanes-Oxley Section 302 certification. Investors were unable to explain the link between the certification statement that the signing officers designed effective internal controls and the actual accounting and reporting problems. (Central Laborers’ Pension Fund v. Integrated Electrical Services, Inc., CA-5, No.06-20135, Aug. 21, 2007).
Investors filed a securities fraud class action against the company, its CEO, and two CFOs who served at different times. They alleged that a number of false statements by the company regarding its financial condition caused an artificial inflation in the market price of the company’s securities. Under Section 302, the senior executive and financial officers have to sign the certification.
In Tellabs, the Supreme Court said that investors in a private securities fraud action must state facts that the defendants acted with a strong inference of scienter, which means that the fraud claim will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference. (Tellabs, Inc. v. Makor Issues & Rights, Ltd., Dkt. No. 06-484, FSLR ¶94,335.).
The appeals court rejected a reading of Tellabs that would allow a strong inference of scienter from the Sarbanes-Oxley certification alone. If this interpretation were accepted, reasoned the court, scienter would be established in every case where there was an accounting error or auditing mistake made by a publicly traded company, thereby eviscerating the pleading requirements for scienter set forth in the Private Securities Litigation Reform Act.
An inference of fraud might be proper in a Sarbanes-Oxley certification if the person signing the certification had reason to know, or should have suspected, due to the presence of glaring accounting irregularities or other red flags, that the financial statements contained material misstatements or omissions. But such was not the case here, said the court, and thus the certifications at issue did not allow an inference of scienter.