Fourth Circuit Affirms Dismissal Of Putative Class Action For Failure To Adequately Allege Scienter
On December 1, 2021, the United States Court of Appeals for the Fourth Circuit affirmed the dismissal of a putative class action asserting claims under the Securities Exchange Act of 1934 against an information technology company and certain of its executives. KBC Asset Mgt. NV v. DXC Tech. Co., —F.4th—, 2021 WL 5626377 (4th Cir. 2021). Plaintiffs claimed that the company made misrepresentations regarding its financial health, which plaintiffs alleged were false because the company had undertaken cost-cutting measures that undermined its ability to meet its revenue projections. The district court dismissed the action and the Fourth Circuit affirmed, holding that plaintiffs failed to adequately allege scienter.
Plaintiffs relied on five types of allegations to demonstrate scienter: (1) allegations made by a former executive in a separate lawsuit; (2) statements of unnamed former employees; (3) stock sales by certain executives during the class period; (4) the core-operations theory; and (5) the temporal proximity between the company’s challenged revenue projections and its ultimate admission that those forecasts had been overly optimistic. Id. at *3. The Court concluded that none of these allegations, either on their own or viewed holistically, plausibly established that defendants acted with scienter.
The Court first determined that the allegations derived from the former executive’s lawsuit, including that the former executive had complained about the cost-cutting measures, supported only a weak inference of scienter that defendants knew they could not meet their revenue projections. Id. Given that the company had asserted that the former executive was terminated for performance reasons, including a failure to cut costs sufficiently, the Court concluded that the more persuasive inference was that the former executive, rather than his entire division, was “performing poorly.” Id. Moreover, the Court observed that the allegations from this lawsuit “suggest[ed] a mere business disagreement among the executives, which does not amount to securities fraud.” Id.
With respect to allegations based on alleged statements by unnamed former employees, the Court explained that confidential witness allegations will “only be afforded the weight they are due given their indicia of reliability” and, because the former employees did not claim that they informed defendants of their purported concerns or that defendants were otherwise aware of the problems alleged, the indicia were weak. Id. at *4. The Court further noted that the confidential witnesses’ lack of direct contact with defendants also “weaken[ed] the inference of scienter,” and that even in one instance where one defendant allegedly acknowledged “mistakes” with a particular client, that did not show that he knew those mistakes related to the cost-cutting measures. Id. The Court reasoned that the more plausible inference was that the company made a business decision to cut costs, which some employees disagreed with. Id.
With respect to the alleged stock sales, the Court agreed that plaintiffs’ allegations—that one executive sold 77% of his shares after the alleged misrepresentations and before unfavorable public reports emerged about the company, while the other executive sold 17% of his shares during the nine-month class period after selling none in the prior nine-month period—provided a strong motive to defendants to inflate the company’s stock price. Id. at *5. The Court concluded, however, that those sales did not establish a strong inference of scienter because (i) the sale of 17% of one executive’s holdings was not sufficiently large, and (ii) the other executive had sold more stock during the prior nine months when there was no allegation that alleged misrepresentations had inflated the stock price than he did during the nine-month class period. Id. at *5–6. The Court also noted that both executives had Rule 10b-5 trading plans in place, which could further diminish any inference of scienter, although the Court discounted this factor as the record did not establish whether those plans were put in place prior to the class period. Id. at *6.
The Court also rejected plaintiffs’ argument for an inference of scienter based on the core operations theory, under which plaintiffs contended that it was more likely that defendants knew their statements were false because they related to the company’s “core operations.” Id. The Court explained that, while core-operations allegations “are relevant to the court’s holistic analysis of scienter,” plaintiffs merely asserted that the alleged misstatements related to the company’s “move into the digital space and investment in its human capital,” which the company had stated were “key concerns.” Id. at *7. The Court determined that, “[e]ven if such broad corporate strategies can constitute core operations, no core-operations inference can be appropriately drawn from these allegations” because the complaint lacked particularized allegations regarding defendants’ knowledge of the company’s alleged shortcomings regarding those issues. Id.
Finally, the Court concluded that plaintiffs’ theory of scienter based on the temporal proximity between the alleged misstatements and subsequent disclosures was also insufficient. While noting that temporal proximity “is relevant to the scienter inquiry,” the Court declined to find “a strong inference of scienter” based solely on that factor. Id.