In South Ferry LP, #2 v. Killinger, 2008 WL 4138237 (9th Cir. Sept. 9, 2008), the United States Court of Appeals for the Ninth Circuit held that inferring scienter based upon nothing more than defendants’ senior management positions in a company does not satisfy the heightened pleading standards of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). The interlocutory appeal in this case arose from a series of apparently conflicting case law within the Ninth Circuit with respect the so-called “core operations inference” in securities fraud actions, i.e., an inference that senior management must be aware of all matters, including wrongdoing, affecting a company’s core operations. This decision resolves that apparent conflict by reaffirming pre-existing law and distinguishing a handful of seemingly contrary Ninth Circuit decisions.
In South Ferry purchasers of Washington Mutual (“WAMU”) stock alleged that individual managers made materially false or misleading statements concerning WAMU’s ability to manage the various risks associated with volatile interest rate fluctuations in their mortgage lending business. Plaintiffs further alleged that the defendants had falsely assured investors that WAMU had a fully integrated information system for managing various hedges, securities and derivative instruments. The district court allowed the case to proceed against certain key managers of WAMU, relying heavily upon the core operations inference to sustain the Reform Act’s pleading standard that plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind” (emphasis added). The district court, however, granted defendants’ motion to for an interlocutory appeal to the Ninth Circuit to address the sufficiency of the core operations inference to support a strong inference of scienter.
The Ninth Circuit had previously addressed this issue in In re Read-Rite Corp. Securities Litigation, 335 F.3d 843 (9th Cir. 2003), where it held that although the core operations inference may be a “reasonable inference,” it nonetheless falls short, standing alone, of the “strong inference” threshold. The court in South Ferry revisited the central tenets of Read-Rite in light of the Supreme Court’s ruling in Tellabs, Inc. v. Makor Issues and Rights, Ltd., 127 S. Ct. 2499 (2007) [see blog article]. The Supreme Court in Tellabs held that the Reform Act’s heightened pleading standard requires courts to take a holistic approach and to look to the “totality of the circumstances” in assessing allegations of scienter. South Ferry reaffirmed Read-Rite and held that the Read-Rite rule, read in conjunction with Tellabs, would serve to prevent sole reliance on the core operations inference in supporting a strong inference of scienter.
South Ferry distinguished prior Ninth Circuit decisions, such as In re Daou Systems, Inc., 411 F.3d 1006 (9th Cir. 2005), and Nursing Home Pension Fund, Local 144 v. Oracle Corp., 380 F.3d 1226 (9th Cir. 2004), noting that in those cases the complaint invoked the core operations inference in addition to admissions and facts about the defendant’s level of access to information within the company. The Court also distinguished a more recent decision, Berson v. Applied Signal Technology, Inc., 527 F.3d 982 (9th Cir. 2008), as belonging to an “exceedingly rare category of cases” where the core operations inference would suffice to support a strong inference of scienter.
South Ferry has resolved any confusion in the Ninth Circuit surrounding the core operations inference. Except in very rare cases where, for example, management has bragged about its detailed knowledge of core operations or it would be “absurd” to believe otherwise, a plaintiff cannot satisfy the Reform Act’s heightened standard for pleading scienter by relying solely upon allegations that senior management must have known about all goings on in the core operations of the company.