New Jersey District Court Dismisses Putative Securities Fraud Class Action For Failure To Plead Scienter
On January 31, 2019, Judge Madeline Cox Arleo of the United States District Court for the District of New Jersey granted with leave to amend defendants’ motion to dismiss a putative securities fraud class action against a digital printing company (the “Company”) and two of its officers. In Re: Electronics For Imaging, Inc. Securities Litigation, No. 17-5592 (D. N.J. Jan. 31, 2019). Plaintiffs alleged that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by intentionally misrepresenting the adequacy of the Company’s internal controls. The Court disagreed, finding that because the complaint did not allege facts sufficient to show that the deficiencies were “‘so obvious’ that defendants must have known about them . . . , or allegations that defendants ignored ‘red flags,’” it failed to plead scienter.
Plaintiffs alleged that the Company assured investors of the strength of its internal controls in its 2016 10-K and its first quarter 2017 10-Q. A few months later, the Company issued a press release announcing that its second quarter 2017 financial results would be delayed due to an internal investigation into the effectiveness of its internal controls. The next day the Company’s stock declined over 45%. The Company later amended its SEC filings and identified certain material weaknesses in internal controls over financial reporting.
In support of their scienter allegations, plaintiffs argued that by certifying the effectiveness of the Company’s internal controls, defendants “conceded that they actually assessed the effectiveness of those controls thoroughly.” Based on those representations, plaintiffs argued that two scenarios are possible: (i) if defendants lied about their thorough assessment, they are reckless in certifying those controls as effective; and (ii) if they assessed the effectiveness of the Company’s internal controls thoroughly, as they certified, then it defies credulity that they did not uncover the pervasive deficiencies.
The Court rejected plaintiffs’ first contention that defendants “lied about their thorough assessment,” finding the complaint alleged no corroborative facts—let alone “strong circumstantial evidence”—to support the inference that defendants lied about the performance or the depth of their review. According to the Court, plaintiffs’ allegations amounted to “nothing more than pure conjecture.”
The Court also rejected plaintiffs’ alternative argument (if they in fact conducted a thorough assessment, defendants must have noticed the deficiencies), finding that plaintiffs pointed to no evidence that any deficiency was “so obvious” that defendants must have been aware of it. Instead, plaintiffs cited only the consequences of internal control deficiencies (e.g., “the worst conversion rate of any quarter in recent memory, . . . due at least in part to the Company’s assessment of its controls”), rather than “red flags” that should have alerted defendants to the weakness of internal controls.
The Court also rejected plaintiffs’ other bases for alleging scienter. First, the Court found that the “core operations doctrine” did not support a finding of scienter because plaintiffs failed to allege specific information conveyed to management related to the fraud. Second, the Court found that the fact that executives signed certifications attesting to the accuracy of the SEC filings did not—in the absence of specific allegations—support the conclusion that defendants knew the information was false. Third, the Court rejected plaintiffs’ allegation that the Company’s auditor’s opinion in its 2016 10-K supported an inference of scienter, again finding that plaintiff failed to allege any particularized facts in support of the allegation. Fourth, because plaintiffs did not allege a “concrete and personal benefit” resulting from the fraud to the individual defendants, allegations regarding defendants’ motive did not support an inference of scienter. And fifth, because plaintiffs could not plead facts creating a strong inference that someone whose intent could be imputed to the Company acted with scienter, the theory under the “collective scienter” doctrine also failed.
Because the Court found no violation of Section 10(b), it also dismissed the derivative Section 20(a) claim for control person liability.