United States: New Jersey District Court Dismisses Securities Class Action For Failure To Adequately Allege Scienter

On August 1, 2018, Judge Kevin McNulty of the United States District Court for the District of New Jersey dismissed without prejudice a putative securities class action asserting claims under Section 10(b) of the Securities Exchange Act against the telecommunications company BT Group PLC and certain of its officers.  Plaintiffs, who purchased BT Group American Depository Receipts (“ADRs”), based their claims on allegations that defendants made a series of misstatements between 2013 and 2017 relating to control problems at a BT Group subsidiary in Italy.  Christian v. BT Group plc, No. 17-cv-497 (KM-JBC) (D.N.J. Aug. 1, 2018).  The Court held that plaintiffs failed to adequately allege scienter and therefore dismissed the action.

In October 2016, BT Group (formerly known as British Telecom) announced that it would take a write-down of £145 million due to “certain historical accounting errors” at its BT Italy division which were identified through an internal investigation following “allegations of inappropriate management behavior.”  Slip op. at 3-4.  In January 2017, BT Group announced that the write-down was being increased to £530 million.  Id. at 4.  BT Group explained at that time that the “extent and complexity of inappropriate behavior” was greater than previously identified, and revealed “improper accounting practices and a complex set of improper sales, purchase, factoring, and leasing transactions” resulting in the overstatement of earnings at BT Italy over a number of years.  Id.

Plaintiffs attempted to establish scienter with respect to the individual defendants by arguing that they knew, or were reckless in ignoring, significant concerns that were raised in the BT Group Audit Committee’s annual reports.  Id. at 10.  For example, each annual report from 2013 to 2016 noted that monitoring BT’s operations in Italy had been a particular focus, and several of those reports also stated that “progress has been made to improve the control environment.”  Id. at 10-11.  Plaintiffs argued that BT Group was put on notice of fraud at BT Italy through the Audit Committee’s monitoring and that the individual defendants were reckless in failing to discover and disclose the fraud.  The Court, however, found that the “more reasonable inference” was that the individual defendants were unaware of the fraud or other problems at BT Italy, given that BT Italy was one of 300 BT Group subsidiaries and the reports in question merely noted “potential control issues” and in themselves “did not reveal fraud or point out problems with the company’s core operations or products.”  Id. at 12-13.  The Court also rejected plaintiffs’ argument that the individual defendants should have inquired about the situation at BT Italy sooner, characterizing that argument as merely alleging mismanagement.

In addition, the Court rejected plaintiffs’ argument that “corporate scienter” could be imputed to BT Group.  The Court noted that the Third Circuit had neither accepted nor rejected the doctrine, but had suggested that a plaintiff might invoke the doctrine in “unique and extraordinary circumstances.”  Id. at 14 (citing City of Roseville Emps. Ret. Sys. v. Horizon Lines, LLC, 442 F. App’x 672, 676 (3d Cir. 2011)).  The Court further explained that courts outside the Third Circuit that had permitted plaintiffs to plead “corporate scienter” without successfully pleading scienter against any individual defendant still required a strong inference that someone in the corporation—whether or not that person was named as an individual defendant—acted with scienter.  Id. at 13.  The Court thus held that, even if “corporate scienter” were to be permitted within the Third Circuit, plaintiffs’ allegations would be insufficient.  Id. at 5.  For example, the Court found that (i) various allegations about the knowledge and actions of individuals at BT Group’s subsidiaries could not be imputed to the officers of the BT Group parent company, and (ii) a reduction in pay to BT Group executives merely reflected actual financial results after taking account of the write-downs necessitated by the fraud, as opposed to an indication that those executives had participated in the fraud.  Id. at 15-17 Citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 323 (2007), the Court found that, “taken collectively,” the allegations were not “so fundamental and pervasive as to support an inference of corporate scienter,” and in fact an opposing inference was “at least as likely.”  Slip op. at 17.  The Court therefore granted defendants’ motion to dismiss, while permitting plaintiffs to file an amended complaint within 30 days.

This decision is a reminder that, in the parent-subsidiary context, the relative scale of control issues at a subsidiary will affect whether an inference of scienter is reasonable as to individual defendants at the parent, and also that corporate scienter will not be lightly inferred at the parent level without a compelling inference of scienter on the part of officers of the parent company itself.

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