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Second Circuit Affirms Dismissal Of Putative Class Action Against Manufacturers Of Medical Equipment Because Of Failure To Adequately Plead Corporate Scienter
06/01/2020On May 27, 2020, the United States Court of Appeals for the Second Circuit dismissed a putative class action brought under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 against two manufacturers of medical equipment (the “Companies”). Jackson v. Abernathy, No. 19-1300-CV, 2020 WL 2755690 (2d Cir. May 27, 2020). Plaintiff claimed that the Companies (one of which was spun off from the other, and both of which manufactured the product at issue) intentionally misled shareholders about the protective qualities of their surgical gown product. The district court had dismissed the action with prejudice and subsequently denied plaintiff’s motion to set aside the judgment and for leave to file an amended complaint. The Court affirmed the district court’s denial, holding that the proposed amendments failed to adequately plead corporate scienter.
The Companies manufacture surgical gowns worn by healthcare providers when treating patients with highly infectious diseases. Plaintiff alleged that the Companies falsely represented that the surgical gown met the standard for the highest rating for protective qualities developed by the Association for the Advancement of Medical Instrumentation when, in fact, the gown had failed several quality control tests.
The district court dismissed the complaint for failure to allege scienter against the individual defendants or the Companies. Plaintiff subsequently moved to set aside the judgement and requested leave to file an amended complaint to include new allegations that three employees knew of problems with the surgical gowns and prepared documents detailing those problems to be presented to senior management. According to plaintiff, these allegations were sufficient to plead scienter as to the Companies. The district court denied the motion because, among other things, there were no allegations that the information was presented to senior management.
Reviewing the lower court’s decision de novo, the Court observed that “[a]scribing a state of mind to a corporate entity is a difficult and sometimes confusing task” because “‘the hierarchical and differentiated corporate structure’ often muddies the distinction between a deliberate fraud and an unfortunate (yet unintentional) error caused by mere mismanagement.’” Because of this, the Court noted that corporate scienter most straightforwardly can be pleaded based on an individual defendant who makes an alleged misstatement. However, in “exceedingly rare instances . . . a statement may be so ‘dramatic’ that collective corporate scienter may be inferred.” The Court then held that none of the allegations in plaintiff’s proposed amended complaint sufficed. First, the employees who were aware of the testing failures themselves took steps to raise concerns, which belied any inference of scienter as to those employees. Second, there were no particularized allegations that senior management ignored the employees’ warnings, and thus, “no connective tissue between [the] employees and the alleged misstatements.” Finally, the Court held that general assertions that the surgical gown was a “key product” of such importance that senior officers must have known about the problems were “naked assertions” insufficient to give rise to a strong inference of scienter on the part of the Companies.
While there are diverging views among Circuit Courts on how corporate scienter can be pled, which the Court’s decision acknowledges, the Court’s opinion confirms that pleading corporate scienter will always require a plaintiff to overcome an extremely high bar and will not be possible except in exceptional cases.
