United States: Circuits Split On When To Impute Employees’ Knowledge To Corporation For Section 10(b) Claims

One of the most significant challenges facing plaintiffs in pleading a violation of Section 10(b) of the Securities Exchange Act of 1934 is sufficiently alleging that the defendant company possessed scienter, or an "intent to deceive."  Because a corporation can only act through its employees, the challenge is to determine which employees' alleged state of mind should be imputed to the company.

On October 10, 2014, the Sixth Circuit considered that question in In re Omnicare Sec. Litig., No. 13-5597, 2014 WL 5066826 (6th Cir. Oct. 10, 2014).  Omnicare involved a Section 10(b) shareholder class action against Omnicare, Inc., a pharmaceutical manufacturer, alleging that Omnicare's financial statements and other public disclosures contained misstatements regarding the company's compliance with Medicare and Medicaid regulations.  In particular, plaintiffs alleged that although Omnicare's internal audit group discovered that certain company facilities had submitted false reimbursement claims, Omnicare failed to disclose the fraud and, in publicly-filed documents signed by the CEO and CFO, asserted that Omnicare's "billing practices materially comply with applicable state and federal requirements."

The district court dismissed plaintiffs' claims on the ground, among others, that the compliance-related statements at issue were "soft information" and plaintiffs therefore were required to demonstrate that Omnicare had "actual knowledge" that the statements were false.  While Sixth Circuit precedent permitted a plaintiff to impute a corporate employee's knowledge to his employer, the district court found that the complaint failed to allege that Omnicare (even by imputation) had actual knowledge that its compliance-related statements were false.

On appeal, the Sixth Circuit considered whether the knowledge of certain employees (internal audit and compliance personnel who were aware of the false reimbursement claims) could be imputed to Omnicare.  The Court recognized that there was significant disagreement among the Circuits on this issue.  The Fifth Circuit, for example, has rejected such a theory of "collective scienter," whereby a plaintiff can prove intent to deceive on the part of a corporation without actually connecting that intent to a specific individual.  Rather, the Fifth Circuit looks "to the state of mind of the individual corporate official or officials who make or issue the statement."  Southland Sec. Corp. v. Inspire Ins. Solutions, Inc., 365 F.3d 353, 366 (5th Cir. 2004).  In other words, an "intent to deceive" cannot be imputed ("on general principles of agency") to the corporation from an individual other than the one who made the statement.  In 2005, another Sixth Circuit panel came to the opposite conclusion, broadly finding that the knowledge of a "corporate officer or agent" could be imputed to the corporation even though he did not issue the misstatement.  See City of Monroe Emp. Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 688-90 (6th Cir. 2005).  The Second Circuit also agreed that plaintiffs could plead collective corporate scienter: "it is possible to raise the required ["strong inference" of scienter] with regard to a corporate defendant without doing so with regard to a specific individual defendant."  Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 195 (2d Cir. 2008).  The Seventh and Ninth Circuits have endorsed comparable positions.  See, e.g., Makor Issues & Rights v. Tellabs Inc., 513 F.3d 702, 710 (7th Cir. 2008); Glazer Capital Mgmt., L.P. v. Magistri, 549 F.3d 736, 744 (9th Cir. 2008).

In Omnicare, the Sixth Circuit found that all of the foregoing approaches were flawed, particularly if taken to extremes.  For example, the Court observed that the Fifth Circuit's position that only the state of mind of the statement-maker is relevant could encourage "conscious ignorance" by those who speak publicly on behalf of corporations, and runs counter to the "goals and purposes of the 1934 Act—which include fostering 'an attitude of full disclosure.'"  The Omnicare panel also found that under the City of Monroe analysis "it is possible that a company could be liable for a statement . . . so long as a low-level employee, perhaps in another country, knew something to the contrary."

In light of these perceived shortcomings, the Omnicare panel adopted what it termed a "middle ground" approach.  To determine whether to impute an employee's knowledge to a corporation for the purposes of pleading scienter, Omnicare found that courts in the Sixth Circuit must consider the state of mind of certain specific individuals, namely: (1) the individual who made the alleged misstatement; (2) the individual who authorized, furnished, reviewed or approved the alleged misstatement; and (3) any high ranking executive or board member who "ratified, recklessly disregarded, or tolerated" the alleged misrepresentation after it was issued.  This analysis, the Court found, is broad enough to prevent corporations from "evading liability through tacit encouragement and willful ignorance," but, by focusing on particular employees, considerably limits the scope of employees whose knowledge can be imputed to the corporation.

Using this formulation, Omnicare affirmed the district court's dismissal of the action, holding that, among other things, plaintiffs had not sufficiently pled corporate scienter.  In particular, the Court found that two of the individuals at issue either did not know about the false reimbursement claims or had nothing to do with the public statements.  Although the knowledge of the third individual proffered by plaintiffs could be imputed to Omnicare under the new approach (he was a high-ranking executive with knowledge of the audit), the Court found that, even imputing such knowledge to the company, plaintiffs had not pled facts giving rise to a strong inference that Omnicare acted to defraud the public.

While its impact on the other Circuits remains to be seen, at least in the Sixth Circuit, Omnicare has narrowed the universe of individuals whose knowledge can be imputed to the corporation.  This important development could have the effect of discouraging plaintiffs from filing suit where the facts supporting scienter are thin or, alternatively, motivate them to bring suit in other courts.  Because of this potential for forum shopping in light of the divergent approaches taken by the federal appellate courts, it is possible that the Supreme Court will at some point step in to resolve this split.

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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