Second Circuit Addresses Collective Scienter

The Second Circuit recently issued an important decision in Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190 (2d Cir. 2008) (“Dynex“), which has significant implications for securities class action litigation and the continuing fallout from the crisis in the credit markets. The decision addressed the issue of collective scienter, or whether a corporation can commit securities fraud when none of its individual agents acted with fraudulent intent.

The court rejected the expansive doctrine of collective scienter urged by the plaintiff and held that the plaintiff had failed to satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act (“Reform Act”). In particular, the court held that the inference of fraud urged by the plaintiff was weaker than the competing inference that the poor performance of certain asset-backed securities was the result of general market malaise. The opinion should prove significant in the many subprime mortgage and other lawsuits that have been filed in the wake of the ongoing credit crisis.

Background

Dynex is a financial services company that invests in loans and securities consisting principally of single-family residential and commercial mortgage loans. In 1999, Merit, an indirect subsidiary of Dynex, issued two series of bonds backed by manufactured housing loans. When the market for manufactured housing took a turn for the worse, these loans lost value. In 2004, credit rating agencies downgraded the bonds.

The plaintiff in Dynex had purchased these bonds prior to the downgrades. Unhappy with their decline in value, the plaintiff filed a class action complaint against Dynex, Merit and two of Dynex's individual officers. According to the plaintiff, these four defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by, among other things, misleading investors about both the quality of the bonds and the reasons behind the bonds' performance.

The defendants moved to dismiss. The district court granted the defendants' motion with respect to the two individual officers. See In re Dynex Capital, Inc., Sec. Litig., 2006 WL 314524 (S.D.N.Y. Feb. 10, 2006). It noted that the claims against these officers were based solely on generic allegations that the officers “must have” known of the alleged fraud given their “position in the corporate hierarchy.” Accordingly, the court concluded that “plaintiff's complaint fail[ed] the 'where's the beef' test” by failing to plead scienter with respect to the two officers.

The district court denied the motion to dismiss, however, with respect to the corporate defendants, Dynex and Merit. It held that a “plaintiff may, and in this case has, alleged scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation.”

Dynex and Merit sought permission to take an interlocutory appeal, arguing that by relying on the doctrine of collective scienter, the district court had run afoul of settled principles of corporate and securities law. They argued that the doctrine of collective scienter allowed plaintiffs to pursue securities fraud claims against a corporation despite the fact that no individual agent of that corporation made a statement or omission with fraudulent intent. This free-floating concept of corporate scienter, the defendants argued, converted Section 10(b) of the Exchange Act into a strict liability statute, as plaintiffs would no longer have to plead and prove anything resembling the requisite fraudulent intent.

The district court granted permission to take, and the Second Circuit agreed to hear, an interlocutory appeal.

The Second Circuit's Decision and Its Implications

The Second Circuit reversed the district court's ruling and rejected the district court's expansive theory of collective scienter. It held that “[t]o prove liability against a corporation ' a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation.” It held further that to state a claim against a corporation, “the pleaded facts must create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter.” Although “the most straightforward way to raise such an inference ' will be to plead it for an individual defendant,” the court noted that a plaintiff need not do so in certain rare and extreme cases. For example, if “General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero,” a court might be justified in finding a strong inference of scienter at the pleading stage even if the allegations failed to establish that any particular officer-defendant of General Motors knowingly uttered this misstatement. Although the hypothetical plaintiff in this case would not have tied a particular named defendant to an intentional misstatement, it would, the Second Circuit concluded, have established that some corporate employee responsible for making the challenged statement did so with fraudulent intent.

The court's GM example, which it borrowed from the Seventh Circuit, suggests that in the Second Circuit collective scienter can be used only in rare and unusual cases, and even in those cases the acceptable form of the collective scienter theory is narrowly circumscribed. Specifically, even in the extreme cases in which a court might appropriately invoke collective scienter, a plaintiff purporting to rely on the collective scienter theory must plead particular facts giving rise to a strong inference that “someone” whose intent “could be imputed to the corporation” acted ' i.e., made a misstatement or omission ' “with the requisite scienter.”

This is an onerous standard that should prevent plaintiffs from using the Exchange Act to police misstatements that were merely accidental or negligent. Rather, even in the limited circumstances in which an invocation of corporate scienter may be appropriate, plaintiffs still have to plead that someone responsible for making a misstatement did so with fraudulent intent, even if they cannot name that person at the pleading stage.

More importantly for the wave of litigation following the recent credit market collapse, however, the court held that the plaintiff in Dynex had not come close to satisfying this standard. Rather, it found that the more likely inference based on the facts alleged was that plaintiff's investment losses were caused by deteriorating market conditions, not fraud. Indeed, the court held that the plaintiff had “fail[ed] to allege the existence of information that would demonstrate that the statements made to investors were [even] misleading, e.g., information showing that the primary cause of the bonds' poor performance was not the general weakness in the mobile homes market.”

As an example, the plaintiff claimed that Dynex officers had access to unspecified “collection data” concerning the loans, but failed to allege that “these data had been collected into reports that demonstrated that loan origination practices were undermining the collateral's performance.” The court noted further that the plaintiff “failed to allege that anyone at Dynex or Merit had a compelling motive to mislead investors regarding the bonds.”

In sum, the court held that the inference of fraud urged by the plaintiff was not “at least as compelling” as the inference that “no one at Dynex or Merit found the statements misleading because the identified the cause of the bonds' performance as accurately as possible.”

This aspect of the Second Circuit's ruling is likely to be significant in the recent wave of subprime mortgage litigation. It is an acknowledgement by a prominent appellate court that market forces, not fraud, likely caused the investment losses in asset-backed securities that gave rise to a securities fraud claim. This should offer strong support to officers, directors and corporate participants in the mortgage industry facing accusations of securities fraud stemming from an unprecedented crisis in their industry. Together with the tight restrictions it imposed on the collective scienter doctrine, the Second Circuit's decision in Dynex is a significant win for securities class action defendants.

Conclusion

Dynex is an important decision from the influential Second Circuit. The court's rejection of the expansive collective scienter theory urged by the plaintiff should curtail the ability of future plaintiffs to bypass the Reform Act's strict pleading requirements. It should also prevent lower courts from converting Section 10(b) of the Exchange Act, which was enacted to police intentional deception, into a weapon for attacking misstatements that were negligent at worst.

The Dynex court's focus on market conditions in the mortgage industry is equally significant. The court found that the plaintiff's allegations of fraud failed to overcome the competing, non-culpable inference that the bonds lost value due to general market conditions. Given the continuing ripple effects of the credit crisis on corporate America and the substantial amount of related litigation already in the judicial pipeline, the court's express recognition of market forces should prove helpful to corporate defendants.

Edward J. Fuhr, a litigation partner at Hunton & Williams LLP, heads the firm's securities litigation practice and served as lead counsel to Dynex. He can be reached at [email protected] or 804-788-8201. Terence J. Rasmussen and Steven M. Haas are associates in the Litigation & Intellectual Property Practice and Business Practice Group, respectively.

The Second Circuit recently issued an important decision in Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc. , 531 F.3d 190 (2d Cir. 2008) (“ Dynex “), which has significant implications for securities class action litigation and the continuing fallout from the crisis in the credit markets. The decision addressed the issue of collective scienter, or whether a corporation can commit securities fraud when none of its individual agents acted with fraudulent intent.

The court rejected the expansive doctrine of collective scienter urged by the plaintiff and held that the plaintiff had failed to satisfy the heightened pleading requirements of the Private Securities Litigation Reform Act (“Reform Act”). In particular, the court held that the inference of fraud urged by the plaintiff was weaker than the competing inference that the poor performance of certain asset-backed securities was the result of general market malaise. The opinion should prove significant in the many subprime mortgage and other lawsuits that have been filed in the wake of the ongoing credit crisis.

Background

Dynex is a financial services company that invests in loans and securities consisting principally of single-family residential and commercial mortgage loans. In 1999, Merit, an indirect subsidiary of Dynex, issued two series of bonds backed by manufactured housing loans. When the market for manufactured housing took a turn for the worse, these loans lost value. In 2004, credit rating agencies downgraded the bonds.

The plaintiff in Dynex had purchased these bonds prior to the downgrades. Unhappy with their decline in value, the plaintiff filed a class action complaint against Dynex, Merit and two of Dynex's individual officers. According to the plaintiff, these four defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by, among other things, misleading investors about both the quality of the bonds and the reasons behind the bonds' performance.

The defendants moved to dismiss. The district court granted the defendants' motion with respect to the two individual officers. See In re Dynex Capital, Inc., Sec. Litig., 2006 WL 314524 (S.D.N.Y. Feb. 10, 2006). It noted that the claims against these officers were based solely on generic allegations that the officers “must have” known of the alleged fraud given their “position in the corporate hierarchy.” Accordingly, the court concluded that “plaintiff's complaint fail[ed] the 'where's the beef' test” by failing to plead scienter with respect to the two officers.

The district court denied the motion to dismiss, however, with respect to the corporate defendants, Dynex and Merit. It held that a “plaintiff may, and in this case has, alleged scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation.”

Dynex and Merit sought permission to take an interlocutory appeal, arguing that by relying on the doctrine of collective scienter, the district court had run afoul of settled principles of corporate and securities law. They argued that the doctrine of collective scienter allowed plaintiffs to pursue securities fraud claims against a corporation despite the fact that no individual agent of that corporation made a statement or omission with fraudulent intent. This free-floating concept of corporate scienter, the defendants argued, converted Section 10(b) of the Exchange Act into a strict liability statute, as plaintiffs would no longer have to plead and prove anything resembling the requisite fraudulent intent.

The district court granted permission to take, and the Second Circuit agreed to hear, an interlocutory appeal.

The Second Circuit's Decision and Its Implications

The Second Circuit reversed the district court's ruling and rejected the district court's expansive theory of collective scienter. It held that “[t]o prove liability against a corporation ' a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation.” It held further that to state a claim against a corporation, “the pleaded facts must create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter.” Although “the most straightforward way to raise such an inference ' will be to plead it for an individual defendant,” the court noted that a plaintiff need not do so in certain rare and extreme cases. For example, if “General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero,” a court might be justified in finding a strong inference of scienter at the pleading stage even if the allegations failed to establish that any particular officer-defendant of General Motors knowingly uttered this misstatement. Although the hypothetical plaintiff in this case would not have tied a particular named defendant to an intentional misstatement, it would, the Second Circuit concluded, have established that some corporate employee responsible for making the challenged statement did so with fraudulent intent.

The court's GM example, which it borrowed from the Seventh Circuit, suggests that in the Second Circuit collective scienter can be used only in rare and unusual cases, and even in those cases the acceptable form of the collective scienter theory is narrowly circumscribed. Specifically, even in the extreme cases in which a court might appropriately invoke collective scienter, a plaintiff purporting to rely on the collective scienter theory must plead particular facts giving rise to a strong inference that “someone” whose intent “could be imputed to the corporation” acted ' i.e., made a misstatement or omission ' “with the requisite scienter.”

This is an onerous standard that should prevent plaintiffs from using the Exchange Act to police misstatements that were merely accidental or negligent. Rather, even in the limited circumstances in which an invocation of corporate scienter may be appropriate, plaintiffs still have to plead that someone responsible for making a misstatement did so with fraudulent intent, even if they cannot name that person at the pleading stage.

More importantly for the wave of litigation following the recent credit market collapse, however, the court held that the plaintiff in Dynex had not come close to satisfying this standard. Rather, it found that the more likely inference based on the facts alleged was that plaintiff's investment losses were caused by deteriorating market conditions, not fraud. Indeed, the court held that the plaintiff had “fail[ed] to allege the existence of information that would demonstrate that the statements made to investors were [even] misleading, e.g., information showing that the primary cause of the bonds' poor performance was not the general weakness in the mobile homes market.”

As an example, the plaintiff claimed that Dynex officers had access to unspecified “collection data” concerning the loans, but failed to allege that “these data had been collected into reports that demonstrated that loan origination practices were undermining the collateral's performance.” The court noted further that the plaintiff “failed to allege that anyone at Dynex or Merit had a compelling motive to mislead investors regarding the bonds.”

In sum, the court held that the inference of fraud urged by the plaintiff was not “at least as compelling” as the inference that “no one at Dynex or Merit found the statements misleading because the identified the cause of the bonds' performance as accurately as possible.”

This aspect of the Second Circuit's ruling is likely to be significant in the recent wave of subprime mortgage litigation. It is an acknowledgement by a prominent appellate court that market forces, not fraud, likely caused the investment losses in asset-backed securities that gave rise to a securities fraud claim. This should offer strong support to officers, directors and corporate participants in the mortgage industry facing accusations of securities fraud stemming from an unprecedented crisis in their industry. Together with the tight restrictions it imposed on the collective scienter doctrine, the Second Circuit's decision in Dynex is a significant win for securities class action defendants.

Conclusion

Dynex is an important decision from the influential Second Circuit. The court's rejection of the expansive collective scienter theory urged by the plaintiff should curtail the ability of future plaintiffs to bypass the Reform Act's strict pleading requirements. It should also prevent lower courts from converting Section 10(b) of the Exchange Act, which was enacted to police intentional deception, into a weapon for attacking misstatements that were negligent at worst.

The Dynex court's focus on market conditions in the mortgage industry is equally significant. The court found that the plaintiff's allegations of fraud failed to overcome the competing, non-culpable inference that the bonds lost value due to general market conditions. Given the continuing ripple effects of the credit crisis on corporate America and the substantial amount of related litigation already in the judicial pipeline, the court's express recognition of market forces should prove helpful to corporate defendants.

Edward J. Fuhr, a litigation partner at Hunton & Williams LLP, heads the firm's securities litigation practice and served as lead counsel to Dynex. He can be reached at [email protected] or 804-788-8201. Terence J. Rasmussen and Steven M. Haas are associates in the Litigation & Intellectual Property Practice and Business Practice Group, respectively.