By John Filar Atwood
The Second Circuit Court of Appeals affirmed the district court’s dismissal of a complaint alleging violations of 1933 Act Sections 10(b) and 20(a) because the plaintiff did not allege facts that give rise to a strong inference of scienter. The court agreed with the lower court’s holding that the complaint fails plausibly to allege motive and opportunity to commit fraud. The court also held that the plaintiff’s allegations do not satisfy the recklessness standard, stating that it is a more compelling inference that the company and its executives negligently made an accounting error and subsequently corrected their public disclosures when they became aware of the error (Rotunno v. Wood, October 27, 2022, Livingston, D.).
Underlying facts. The shareholder alleged that Gulfport Energy Corp. and its former officers violated federal securities laws by making materially false and misleading statements concerning the manner in which they accounted for their oil and gas properties in Eastern Ohio and Central Oklahoma. The suit arose from a February 2020 press release in which Gulfport included a restatement of the Q3 2019 financial results after management discovered “an error related to the transfer of certain unevaluated leasehold costs to the amortization base.”
Gulfport further explained the accounting error, noting that management had determined that it did not effectively design and maintain controls over the completeness and accuracy of the accounting of transfers of unevaluated capitalized costs into the amortization base for the three- and nine-month periods ending on September 30, 2019 and the 12-month period ending on December 31, 2019. The shareholder alleged securities fraud arising from false and misleading statements and material omissions related to the company’s 2019 filings.
The federal court for the Southern District of New York granted a motion to dismiss, finding that absent a showing that the officers benefitted in some concrete and personal way, the shareholder could not establish the requisite scienter to satisfy the PSLRA threshold. The shareholder appealed.
Motive and opportunity. The appeals court holds that the complaint’s motive and opportunity allegations are insufficient to support scienter. The court notes that the complaint asserts that activist shareholder pressure motivated the individual defendants to conceal Gulfport’s material weakness in internal controls and make false or misleading representations in Gulfport’s financial statements, in order to improve the company’s stock performance. According to the court, this motive allegation is insufficient because it alleges “goals that are possessed by virtually all corporate insiders, such as the desire to . . . sustain the appearance of corporate profitability . . . or the desire to maintain a high stock price.” The court adds that it has rejected similar alleged motives even when the complaint alleged that executives were personally motivated to protect their jobs and compensation.
No personal motive. The court notes that the complaint concedes that the defendants owned only a small amount of Gulfport stock and did not allege that they sold it during the class period. Consequently, the court finds that they did not possess the kind of personal financial motive that is sufficient, typically evidenced by insider trading for significant financial gain. As it has ruled in another instance, the court states that the sale of stock by one company executive does not give rise to a strong inference of the company’s fraudulent intent where the fact that other defendants did not sell their shares during the relevant class period sufficiently undermines plaintiffs’ claim regarding motive.
The appeals court then applied the higher standard which states that where motive is not apparent, it is still possible to plead scienter by identifying circumstances indicating conscious behavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater. Here the court notes that recklessness in the securities fraud context is defined as “conscious recklessness—i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence.” The court concludes that the allegations do not satisfy the recklessness standard, which in the securities fraud context requires “conduct that is highly unreasonable, representing an extreme departure from the standards of ordinary care.”
A more compelling inference. Considering all of the alleged facts, the court said, no “reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” The court finds that it is a more compelling inference that Gulfport and its executives negligently made an accounting error and subsequently corrected their SEC disclosures when they became aware of the error.
The court further concludes that the complaint’s references to an unrelated SEC investigation and the resignations of executives do not add to the plausibility of the scienter allegations. While an SEC investigation may provide relevant evidence, the court noted, in this case the investigation concerns unrelated conduct that occurred prior to the class period.
Regarding the resignations of certain Gulfport executives, the court notes the allegation that one person’s resignation was suspicious because it occurred in August 2019, shortly before she would have been required to sign the third quarter report containing financial results that understated the impairment of Gulfport’s assets. The complaint also describes other executives’ resignations as a response to shareholder pressure to change the composition of the board. The court was not persuaded, concluding that rather than supporting an inference of fraudulent intent, it is more persuasive to conclude that these executives resigned to respond to the wishes of the shareholders, or for any number of other reasons that executives change positions.
Finally, the court considered the allegations that the defendants were aware of contradictory underlying accounting data and changes in commodities prices, failed to maintain adequate internal controls, submitted false Sarbanes-Oxley certifications, and committed a significant accounting error that violated GAAP. In the court’s opinion, the most compelling inference from these allegations is negligence, and it cannot find scienter without additional, concrete allegations of fraudulent intent. The court states that because such allegations are lacking, the district court did not err in dismissing the complaint.
The case is No. 22-502.