United States: Third Circuit Clarifies Applicability For PSLRA Safe Harbors And Standards For Alleging Scienter In Securities Fraud Cases

Last Updated: May 11 2009
Article by Joseph O. Click

Late last week, the U.S. Court of Appeals for the Third Circuit made a substantial contribution to the list of important securities fraud cases interpreting the Private Securities Litigation Reform Act ("PSLRA") with a 91-page opinion in Institutional Investors Group v. Avaya, Inc., No. 06-4595 (3d Cir. Apr. 30, 2009). This new opinion provides guidance on the types of forward-looking statements subject to protection under the PSLRA's so-called "Safe Harbors" for such statements, and further explains how courts should apply the Supreme Court's decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), when determining whether a complaint's allegations raise a "strong inference" of scienter.


The case in the trial court is a putative class action against defendant Avaya, Inc., a company that sold communications products and services, and its CEO and CFO based on two sets of allegations. The first set concerned financial projections for fiscal year 2005. The plaintiffs alleged that at the beginning of fiscal year 2005, Avaya issued projections for increased revenue and operating margins for the year. Later, in announcing its first quarter results for FY2005, the company stated that those results, which were in line with analysts' expectations, "position[ed]" the company to meet its 2005 financial goals, and that the company was "on track" to meet those goals. Finally, on March 2, 2005 (the third month of Avaya's FY2005 second quarter), Avaya adjusted its projected annual revenue growth from the previously forecast 25-27% to 28%.

The second set of allegedly false statements concerned discount pricing by Avaya. On the same day that it adjusted its 2005 revenue-growth projections to 28%, Avaya responded to analysts' inquiries regarding pricing pressure by asserting that there had been no significant price changes in the market. Avaya repeated this answer in response to analysts' questions on March 7 and 10. On March 4, however, an independent market research group reported that a "sales channel check" showed that "spending" for Avaya products was "weak" and that Avaya had fired sales staff to cut costs. And on March 21, a Lehman Brothers analyst reported that, according to resellers, in March Avaya was offering 20%-40% discounts for its mid-range products. Finally, the complaint alleged that various "confidential witnesses" who had previously worked for Avaya had stated that Avaya had been giving substantial discounts to many of its customers, with some saying that the discounting began in early- to mid-2004.

On April 19, 2005—six weeks after Avaya raised its revenue—growth projection to 28%—Avaya announced that revenues for the second quarter of fiscal year 2005 had increased only 21% over second quarter FY2004 revenues, and that the company would not meet its FY2005 projections for revenue growth, operating income and operating margin.

Based on the above, the plaintiffs' complaint alleged that Avaya's projections and statements concerning pricing were fraudulently misleading. The lower court dismissed the lawsuit, holding that (1) the alleged false projections were protected by the PSLRA's "Safe Harbor" for forward-looking statements, (2) the plaintiffs had failed to allege that other statements were actionably false, and (3) the plaintiffs had failed to allege with particularity facts giving rise to a "strong inference of scienter," as required by the PSLRA.

The Court Of Appeals Decision

The court of appeals ultimately affirmed the district court's dismissal of the allegations concerning Avaya's forecasts of increased revenue and operating margins, but reversed the district court's dismissal of the allegations based on Avaya's March 2005 denials that it was discounting its prices. In reaching this result, the court considered a number of issues, many of which involved the particular facts of the case. Several holdings were of wider interest, however.

The Forecast Related Statements

The Safe Harbor. The Third Circuit first considered whether Avaya's statements concerning its fiscal year 2005 projections were protected from liability under the PSLRA's Safe Harbors for forward-looking statements, set forth in 15 U.S.C. § 78u-5(c), which protects a forward-looking statement such as a financial projection, if the statement is (1) identified as a forward-looking statement and accompanied by meaningful cautionary language, or (2) is immaterial, or (3) is made without actual knowledge that it is false. The court held that Avaya's October 2004 projections were classic forward-looking statements. Avaya's January 2005 statements that the company was "position[ed]" and "on track" to meet 2005 projections presented a closer question. According to plaintiffs, these statements mixed unprotected historical facts with forward-looking statements, and thus were not protected. The court found, however, that when read in context, the statements were "too vague to be actionable" and could not be meaningfully distinguished from the 2005 projections. The court reasoned that the "position" and "on track" statements did not justify the financial projections with respect to a particular aspect Avaya's financial situation, but merely stated that "whatever that situation is, it makes the future projection attainable." Such a statement, the court concluded, "is necessarily implicit in every future projection."

The court also found that these statements were identified as forward-looking and "accompanied by meaningful cautionary statements identifying important factors" that might affect the projections. In particular, the court noted that all of Avaya's SEC filings contained a detailed list of specific factors and uncertainties that could affect future economic results, including "the 'product and price competition' Shareholders assert was responsible for Avaya's missing its projections." The court noted that in its press releases and at the beginning of each conference call, Avaya "explained" that the forward-looking statements involved risks and uncertainties that could negatively affect financial results. Significantly, the cautionary statements relied upon by the court were the type of statements typically made by companies in such settings, consisting of a summary of risk factors tailored specifically to Avaya, accompanied by a referral to the company's SEC filings for more information.

Scienter. Plaintiffs argued that even though Avaya's forecast related statements met the Safe Harbor for forward looking statements accompanied by meaningful cautionary language, they were not subject to Safe Harbor protection because Avaya knew they were false when made. The court found the March 2, 2005 increase in projected revenue growth provided the closest case for alleging scienter, but concluded plaintiffs' allegations here failed. It held that to allege scienter with respect to forward-looking statements, plaintiffs must allege that a defendant actually knew that the forward-looking statement was false. Conversely, plaintiffs cannot adequately plead scienter with allegations that only establish recklessness. The court reasoned a forward-looking statement receives protection under one of the PSLRA Safe Harbors if, among other things, the defendant lacked "actual knowledge ...that the statement was false or misleading." See 15 U.S.C. § 78u-5(c)(1)(B). It thus concluded that to plead scienter with respect to a forward-looking statement, a plaintiff must plead facts giving rise to a strong inference that the speaker had actual knowledge that the statement was false. Here, while plaintiffs may have pleaded recklessness, the allegations did not give rise to an inference that Avaya actually knew its increase in the projections was unattainable or otherwise false.

The Price Discounting Statements

As noted, on March 2, 7 and 10, Avaya responded to analysts' questions concerning pricing pressure by stating that there were no significant changes in pricing. The district court dismissed the claims based on these statements. The court of appeals reversed, however.

Pleading Falsity. As noted, the PSLRA requires that allegations of fraud and misrepresentation be pleaded with particularity, including particular allegations as to why the allegedly false or misleading statements are false. The court had little difficulty finding that plaintiffs had met the PSLRA standard in this regard, based on the allegations of reports from the various former-employee confidential witnesses that Avaya had been feeling competitive and pricing pressure, and was in fact offering discounts, as well as the "sales channel check" reported by the independent research firm and the report of price discounting issued by the Lehman Brothers analyst. In reaching this result, the Third Circuit considered whether plaintiffs may continue to use "confidential witnesses" to plead fraud after the Supreme Court's decision in Tellabs decision. Although every circuit court of appeals to consider this issue had endorsed the practice, the Seventh Circuit court of appeals had indicated that such allegations should, as a rule, be severely discounted. The Third Circuit, like the other courts, affirmed the practice, and further held that such allegations should not be automatically discounted.

Scienter. The court also found that the plaintiffs' allegations were sufficient to raise a strong inference of scienter. In this regard, the court emphasized the Supreme Court's statements in Tellabs that, in determining scienter, a court must view all of the allegations holistically, and not separately, to determine whether they raise a strong inference, and that courts should weigh the resulting inferences against nonculpable explanations for a defendant's conduct.

The court found the "content and context" of Avaya's pricing statements of particular importance, emphasizing that three times Avaya was asked specifically about pricing, and responded with statements that were not merely inconsistent with discount pricing, but affirmatively denied that widespread discounting had occurred. It contrasted the situation where a company stands by its forecast of earnings in the face of declining product prices, noting that earnings are determined by a number of variables, whereas here the questions and answers went to a specific item—discounting prices for Avaya products—that directly related to Avaya's forecast of increasing revenue.

More importantly, the court noted that a competing inference that Avaya did not know of the discounting was not plausible, and actually supported an inference of scienter because widespread discounting, as alleged in the complaint, concerned a matter central to Avaya's operations and forecasts. Lacking knowledge of such discounting thus supported an inference of recklessness.

The court thus concluded that a lack of knowledge of the discounting, along with (1) the confidential witnesses' allegations of wide spread discounting, (2) the "sales channel check" reported by the independent research group, (3) the Lehman Brothers' report of substantial discounting, and (4) the significant decrease in second-quarter revenue growth versus projected annual revenue growth (i.e., 21% for the former versus 28% for the latter) raised a strong inference of recklessness.

Finally, the court rejected the plaintiffs' argument that allegations of motive and opportunity to commit fraud alone sufficed to meet the PSLRA's "strong inference of scienter" requirement. Prior to the Supreme Court's Tellabs decision, the Third Circuit had held that "alleging facts establishing a motive and opportunity to commit fraud" was sufficient by itself to raise a strong inference of scienter. The court interpreted Tellabs' direction to view all of the allegations holistically and to weigh culpable and nonculpable inferences as eliminating "motive and opportunity" as a sole ground for pleading scienter. Rather, courts are to consider allegations relating to motive and opportunity along with all other pertinent allegations and plausible nonculpable explanations for a defendant's conduct in determining whether a complaint's allegations raise a strong inference of scienter. What is not clear, however, is whether allegations of motive and opportunity are sufficient if they are particularly strong, and are the only allegations that support an inference of scienter.


The Third Circuit's Avaya decision provides helpful guidance to publicly-held companies with respect to the PSLRA's Safe Harbor provisions. In this case, the company's press releases, like the press releases of most companies, included a cautionary statement that identified the types of statements that were forward looking, set forth a summary of the types of risks that could affect such statements and referred the reader to the company's SEC filings for more information on such risks. And at the outset of each in-person or telephonic conference with analysts and investors, the company read a similar cautionary statement that expressly referred the participants to the company's SEC filings for a specific discussion of risk factors. While companies routinely do the same, it has not been clear that such statements—which are necessarily shorter and more succinct that the discussion contained in an SEC filing—satisfied the PSLRA Safe Harbor requirements that such forward-looking statements be specifically identified as such and accompanied by "meaningful cautionary language." The Third Circuit determination makes clear that these measures will be effective. Companies should be careful to assure, however, that the summary of risk factors includes matters that are specific to the company rather than a laundry list of risks that are applicable to all companies.

The Avaya opinion also establishes for the first time that recklessness is not a sufficient basis for liability with respect to a forward looking statement. Instead a plaintiff must allege specific facts giving rise to a strong inference that the company or its officials actually knew that a forward-looking statement was false (e.g., unattainable) in order to satisfy the PSLRA standard. The Avaya decision also adds the Third Circuit to the growing list of federal circuits holding that allegations of a "motive and opportunity" to commit fraud must be considered with all other allegations concerning, as well as nonculpatory explanations of, a defendant's state of mind, and ordinarily will not alone satisfy the PSLRA "strong inference" standard."

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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