On June 28, 2017, Judge Charles R. Breyer of the United States District Court for the Northern District of California ruled, among other things, that allegations of knowledge of “defeat devices” did not equate to knowledge of the probability of exposure from the devices and granted in part a motion to dismiss a putative securities class action against Volkswagen Aktiengesellschaft and certain of its affiliates (“VW”) and officers and directors, asserting claims under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder, as well as additional “control person” claims against the officers and directors under Section 20(a) of the Exchange Act. In re Volkswagen “Clean Diesel” Marketing, Sales Practices, and Products Liability Litigation, MDL No. 2672 CRB (JSC), 2017 WL 2798525 (N.D. Cal. June 28, 2017). Plaintiffs alleged that VW’s financial statements and statements regarding its U.S. vehicles’ compliance with diesel emissions standards were misleading because VW had failed to disclose, in various manners, that it had been using “defeat device” software to manipulate emissions tests in vehicles sold in the United States. After plaintiffs were given leave to replead following an earlier motion to dismiss, the Court held that the amended complaint’s allegations supported claims regarding financial statements after May 2014, but dismissed claims regarding earlier alleged misstatements. In addition, the Court dismissed claims against one individual defendant for failure to sufficiently allege scienter and “control.”
First, despite holding that Plaintiffs had sufficiently alleged that VW knew of the use of “defeat device” software to manipulate emissions tests by February 2011, the Court dismissed claims that VW made intentional or reckless misstatements in its quarterly and annual financial statements between that time and May 2014 by failing to set forth either a provision or contingent liability for the emissions manipulation. The Court accepted that such disclosures are required by International Accounting Standard 37 if such losses are “probable” (the test for a provision) or “more than remote” (the test for a contingent liability), id. at *3, but held that alleged awareness of the defeat device did not satisfy the requirement that VW knew that losses were probable or more than remote at the time: “That [VW] may have deliberately employed an illegal defeat device does not mean the Company knew with reasonable certainty that it was going to get caught.” Id. at *4. The Court noted that there were no allegations that VW was at the time under investigation or regulatory scrutiny related to the emissions issue. Without such allegations, the Court noted, the federal securities laws do not require a company to “accuse itself of wrongdoing.” Id. The Court thus held that disclosure was not required “as soon as the fraud began,” but rather “at most . . . when an investigation into the conduct began.” Id. at *5.
In contrast, the Court upheld claims based on financial statements following May 2014, finding that specific factual allegations, taken together, supported a strong inference that by that date VW senior executives knew that regulators were investigating VW and that losses were probable. These allegations included that certain executives were aware of a university study asserting VW’s “clean diesel” vehicles had emissions levels many times higher than the legal limit, that there was no plausible explanation for the study results other than the defeat device, that regulators were likely to focus their investigation on the use of a defeat device, and that losses would result if regulators discovered such use. Moreover, given the size of the potential liability, the Court held that a fact finder could reasonably find that the misstatements were substantial and knowledge could plausibly be attributed to VW AG’s CEO.
Second, the Court also dismissed “control person” claims against one individual defendant but upheld claims against another individual defendant based on differing factual allegations as to the extent of involvement each individual was alleged to have had over VW’s day-to-day operations. And, third, the Court dismissed a direct claim against one individual on the basis that his alleged knowledge of an internal exposure estimate of $26 billion did not create a strong inference that he was intentionally or recklessly misleading by signing a financial statement reflecting “initial exception charges of €6.7 billion.” Id. at *8. To the contrary, the Court held that such an inference was countermanded by accompanying disclosures that this charge was merely “initial” and was subject to adjustment. Id.
This case demonstrates that knowledge of alleged wrongdoing is not always knowledge that it will cause a loss and that courts continue to carefully evaluate the extent of control necessary to support a control-person claim.