In Metzler Investment GMBH v. Corinthian Colleges, Inc., 2008 WL 2853402 (9th Cir. July 25, 2008), the United States Court of Appeals for the Ninth Circuit affirmed the dismissal with prejudice of a securities fraud class action, holding that plaintiffs had failed to plead the essential elements of loss causation, scienter and falsity consistent with the requirements of prevailing Supreme Court and Ninth Circuit authority. Corinthian Colleges is the most recent in a long line of Ninth Circuit decisions since 1999 that apply strictly the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).

Corinthian Colleges is an operator of private for profit vocational colleges. According to plaintiffs, senior management of Corinthian Colleges manipulated student rolls to make it seem as if more students were enrolled than actually were, and, as a result, improperly received federal funding which it reported as income, allegedly in violation of generally accepted accounting principles. Plaintiffs alleged that the result of this was that “at numerous Corinthian campuses, as many as 50% to 60% of the people defendants represented to the U.S. government as being qualified attending ‘students’ were either ‘no shows’ in class or unqualified for admission and federal funds from the outset.” Plaintiffs supported their allegations through several confidential witnesses.

The district court dismissed plaintiffs’ initial complaint with leave to amend. After plaintiffs amended their complaint, the district court dismissed the action with prejudice. Plaintiffs appealed. Although the district court’s decisions were summary in nature, it was clear on appeal that the main areas of contention were in respect to the elements of loss causation, scienter and falsity.

Loss Causation 

The court first considered the element of loss causation. According to plaintiffs, a newspaper story detailing a Department of Education investigation of enrollment irregularities at one of Corinthian Colleges’ campuses and a subsequent announcement adjusting the revenue forecast together were public admissions of wrongdoing that were directly responsible for the company’s decline in value. The court disagreed. It held that the alleged improprieties revealed in the newspaper article did not reveal company-wide fraudulent practices, but only the potential for such risk. In fact, the newspaper story only revealed enrollment irregularities at one of Corinthian Colleges’ 88 campuses. Similarly, Corinthian Colleges’ adjustment of its revenue forecast led to a decline in share price, not because it was a “revelation of Corinthian’s systematic manipulation of student enrollment,” but because “the company failed to hit prior earnings estimates.” Consequently, the court held that plaintiffs had failed to plead loss causation.

Scienter

Plaintiffs argued that a strong inference defendants’ scienter was supported by three independent sets of alleged facts: (1) unusual insider trading by defendant officers during the class period, (2) Corinthian Colleges had a “sophisticated information management system” which should have allowed management to understand each campuses enrollment and (3) one of the officers had a role in setting the revenue recognition policy.

The court held that these allegations were insufficient to show scienter. While noting that insider stock sales could trigger a “strong inference” of scienter, the court noted that many of the sales took place before the Department of Education investigation. Similarly, the court considered the sale of 37% of one defendant’s shares insufficiently large to trigger an adverse inference, noting that the Ninth Circuit “typically require[s] larger sales amounts . . . to allow insider trading to support scienter.” Finally, the court observed that the trades were consistent with an innocent explanation — defendant officers were trading their shares as they vested. The court held that these trades were not “dramatically out of line with prior trading practices.”

The court also rejected plaintiffs’ assertions that the capacity to observe company wide data supported a strong inference that the officers “must have had knowledge of the alleged fraudulent practices.” The court disagreed with this proposition, reaffirming the long-standing rule in the Ninth Circuit that “corporate management’s general awareness of the day-to-day workings of the company’s business does not establish scienter.”

Finally, the court addressed plaintiffs’ argument that one of Corinthian Colleges’ officers manipulated student enrollment figures and induced college admissions officers to admit unqualified students by telling them that they were the “gray area” in admissions. The court held that these allegations fell short. Plaintiffs, the court held, had failed to show that the officer knew or was reckless in recognizing this revenue because doing so required “demonstrating intent,” which plaintiff had failed to so. Moreover, the allegation that the defendant officer induced admissions officers to admit unqualified students was equally susceptible to an innocent interpretation; that the defendant officer “was simply making a broader exhortation to improve business.”

Falsity

Plaintiffs alleged that “virtually every statement made by Corinthian during the Class Period” was “by definition” false, because Corinthian’s admissions process necessarily overstated revenue. The court disagreed, finding that plaintiffs complaint was conclusory. The court held that falsity must be plead with particularity; a plaintiff must “connect the non-disclosure with any statement by [the defendants] regarding its financial health.”

In sum, the court concluded that, plaintiffs had failed to plead loss causation, scienter and falsity, and thus failed for the second time to state a securities fraud claim. As a result, the Ninth Circuit affirmed the district court’s dismissal with prejudice.

As noted above, Corinthian Colleges reaffirmed many prior decisions of the Ninth Circuit that strictly apply the Reform Act’s heightened pleading requirements and the law of loss causation to affirm dismissals of securities fraud complaints. The court went out of its way to explain how those prior decisions should be viewed as consistent with recent Supreme Court rulings, such as Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), and Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). Practitioners are likely to view Corinthian Colleges as the latest in a nearly decade long line of Ninth Circuit decisions that raise the bar for plaintiffs to plead a securities fraud complaint.

stands as an important development for securities fraud defendants in the Ninth Circuit. The court’s holding reasserts long-standing Ninth Circuit case law, in particular its finding that scienter cannot be plead merely by showing general awareness of day to day transactions. Moreover, the court’s close examination of the pleading standard for showing loss causation and falsity demonstrates the high bar set by the Reform Act. As such, Corinthian may ultimately serve to limit the number of securities fraud claims that survive the motion to dismiss stage.