On July 20, 2021, a panel of the United States Court of Appeals
for the Ninth Circuit unanimously affirmed a decision of the United
States District Court for the Western District of Washington
dismissing with prejudice a putative class action lawsuit asserting
claims under Section 10(b) of the Securities Exchange Act of 1934
(the "Exchange Act") against a wholesale retailer (the
"Company") and certain of its executives, as well as
Section 20(a) claims against those individual defendants.
Davoli, et al. v. Costco Wholesale Corp., et
al., No. 20-35821 (9th Cir. July 20, 2021). Plaintiff
alleges that defendants made false statements regarding the
strength of the Company's internal controls over financial
reporting. The district court dismissed plaintiff's
Second Consolidated Amended Complaint (the "SAC") for
failure to adequately plead scienter and the Ninth Circuit
affirmed. The Panel's unpublished opinion cannot be cited
as precedent except as provided by Ninth Circuit rules.
According to the SAC, defendants made false and misleading
statements about the Company's financial controls.
Specifically, the SAC alleges that statements in the
Company's June 2018 Form 10-Q and the accompanying
Sarbanes-Oxley certifications failed to disclose material
weaknesses in the Company's internal controls regarding the
Company's information technology (IT) systems related to its
financial reporting. According to the confidential witness
cited in the SAC, defendants allegedly knew of "a strategy on
authentication and authorization that would have remediated user
administration and access control issues." Although this
strategy was approved by an IT officer who allegedly reported up to
one of the individual defendants, the confidential witnesses
maintained that the Company ultimately failed to implement this
strategy because "there was no budget" and "there
were more important things to work on." The SAC also
contained allegations from unidentified former Company employees
that one of the individual defendants sent a series of internal
emails in 2017 allegedly stating the need to "button up
internal controls and prioritize [Sarbanes-Oxley] compliance
issues," but later "gave up." According to
plaintiff, defendants knew in 2017 that the Company's IT Risk
Management Department was disorganized but failed to improve it,
allegedly considering internal controls to be an
"afterthought."
The Ninth Circuit first turned to the district court's ruling
that plaintiffs failed to adequately plead scienter with respect to
statements made by the Company in its June 2018 Form 10-Q.
The Court found that the SAC "failed to raise a strong
inference that any senior controlling officer of [the Company] . .
. had the requisite scienter of deliberate recklessness" that
could be imputed to the Company. In particular, the Court
held that the confidential witnesses "failed to make
sufficiently particularized allegations" that defendants, in
spite of knowing the material weaknesses in the Company's
internal controls, "made assurances regarding effective
internal control with deliberate recklessness" in signing the
Company's June 2018 Form 10-Q. Finding that the
confidential witnesses' roles at the Company did not provide
them with "personal knowledge" as to what information
defendants possessed, the Court affirmed that "the
witnesses' allegations were insufficient" to demonstrate
that defendants knew about the Company's "weaknesses in
the internal control over financial reporting." The
Court also affirmed that the confidential witnesses'
allegations failed to sufficiently plead that the IT officer or
other IT employees were aware that the Company's internal
controls were ineffective in June 2018 or that they were
"sufficiently involved with the making of the June 2018 10-Q
statement so that . . . their failure to act could support a strong
inference of deliberate recklessness." The Court
observed that the individual defendants' SOX certifications
"themselves add nothing substantial to the scienter
calculus."
Further, the Ninth Circuit found that the inferences raised in the
SAC were "not as compelling as the opposing innocent
inference" that defendants did not know that the Company's
"internal control was ineffective until the more rigorous
internal review performed in advance of the October 2018 Form
10-K." The Court affirmed the district court's
dismissal, holding that plaintiff failed to adequately allege that
defendants made the alleged statements with deliberate recklessness
and holding that such allegations failed to satisfy the heightened
pleading standards of the PSLRA. Notably, the Court rejected
plaintiff's argument that the Ninth Circuit's decision
in In re Oracle Corp. Securities Litigation, 627 F.3d
376 (9th Cir. 2010) permits scienter to be pled by alleging
"red flags" regarding a possible misstatement and
"access" to underlying facts, observing that such a
standard "is effectively a negligence standard" which the
Ninth Circuit consistently has rejected.
Having affirmed the dismissal of the Section 10(b) claim, the Court
similarly affirmed the dismissal of plaintiff's
control-personal liability claims under Section 20(a), finding no
predicate violations of the Exchange Act under which such claims
could be established.
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