United States: Fifth Circuit Upholds Dismissal Of Securities Fraud Cases For Failure To Allege Scienter

The heightened pleading requirements of the Private Litigation Securities Reform Act (PSLRA) remain strong in the 5th Circuit. On January 13, 2016, the 5th Circuit in Local 731 I.B. of T. Excavators and Pavers Pension Trust Fund v. Diodes, Inc., 810 F.3d 951 (5th Cir. 2016) affirmed the district court's dismissal of a securities class action, holding that the complaint failed to adequately allege facts concerning the defendants' state of mind in making alleged misstatements or omissions to stockholders. In its decision, the court reaffirmed several principles establishing a high bar to satisfying the PSLRA's scienter pleading requirements. The court additionally reined in the somewhat nebulous line of cases, holding that an officer's position in a company may support an inference of scienter when "special circumstances" are present.

Plaintiffs in the case were putative stockholders in Diodes, Inc., a Texas-based semiconductor company with a major manufacturing operation in China. In February of 2011, Diodes warned its investors of anticipated labor shortages in China which would adversely affect the company's manufacturing output. Based on the expected shortages, the company predicted that revenue would be down in the first quarter while Diodes hired and trained new workers. Diodes followed this announcement with a statement in May 2011 that the company expected that the labor shortage would be resolved in the second quarter, with gross profit margins being comparable to the first quarter. In June 2011, Diodes noted a "slower than expected" recovery in China and revised its guidance to predict a slightly lower gross profit margin. Following both the May and June announcements, Diodes' stock price dropped.

Plaintiffs filed their securities fraud class action suit almost two years later against Diodes and two of its corporate officers. Plaintiffs did not allege that the company's forward-looking statements in the first two quarters of 2011 were false—indeed, Diodes' predictions largely turned out to be accurate. Rather, plaintiffs claimed that the statements were misleading because defendants improperly omitted details regarding the extent and cause of the labor shortages, which plaintiffs alleged were due to the company's labor policies in China. Plaintiffs argued that there were three different factors that raised a strong inference that defendants "must have known" that Diodes' internal policies would cause the labor shortage.

First, plaintiffs argued that the corporate officer defendants must have known by virtue of their positions as top company executives. While plaintiffs acknowledged the "predominant theme" in 5th Circuit case law that an officer's position with a company does not suffice to create an inference of scienter, plaintiffs nonetheless argued that defendants' positions, taken together with "special circumstances," were sufficient to infer a culpable mental state. Plaintiffs based this argument on a handful of 5th Circuit cases. Surveying these cases, the court in Diodes derived four considerations that may suggest "special circumstances" sufficient to tip the scales in favor of an inference of scienter: (1) whether the company is small, thus making it more likely that executives are familiar with the intricacies of day-to-day operations; (2) whether the transaction at issue was critical to the company's existence; (3) whether the misrepresented or omitted information would have been readily apparent to the speaker; and (4) whether defendants' statements were internally inconsistent.

The court found none of the above four factors to be present in Diodes. Diodes was a large company with more than 4,000 employees. There was no indication that the labor shortages at issue threatened the company's continued vitality, nor was there any indication that defendants were aware that the company's policies were a significant contributor to the shortages. Finally, the defendants' statements were both consistent and accurate regarding the extent of the labor shortage, as well as its effects on the company's revenue.

Second, plaintiffs sought to draw a strong inference of scienter from Diodes' early shipments of orders without prior customer authorization. Plaintiffs argued that this practice was intended to conceal the true impact of the labor problems by artificially propping up earnings. The court did not find this argument persuasive, noting that early shipping is a legal practice that may be supported by any number of legitimate reasons. The court additionally reasoned that shipping orders early would actually deplete inventory and exacerbate any manufacturing issues caused by a labor shortage. Therefore, the practice did little to indicate defendants' intent to conceal the shortage from investors.

Third, plaintiffs argued that the timing and nature of certain stock transactions made by one of the defendant corporate officers created an inference of scienter. The court acknowledged that some of the stock sales pointed out by plaintiffs could be viewed as suspicious in isolation because they were out of line with the officer's typical trading behavior. However, the court declined to draw an inference of scienter from the sales because they represented a relatively small amount of the officer's total stock ownership (about 12 percent) and because there were no other corroborating factors sufficiently alleged.

Considering these factors individually and as a whole, the 5th Circuit held that the plaintiffs' allegations failed to satisfy the PSLRA's requirement to plead with particularity facts supporting a strong inference of scienter. Notably, in considering each of plaintiffs' allegations, the court repeatedly referenced the fact that the company had warned investors of a labor shortage during the class period on multiple occasions and even accurately predicted the labor shortage's impact on Diodes' financial results. Undoubtedly, these were important facts to the 5th Circuit, which appeared tempted to dismiss the case on those grounds alone. The court saw little need for requiring additional disclosure, observing that "[m]ost reasonable investors would rather receive an accurate 'bottom line' assessment of a disclosed company problem than all its assumptions and nuances."

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