The Second Circuit Court of Appeals recently held that it was reversible error for the District Court for the Southern District of New York to deny the corporate defendants’ motion to dismiss on scienter grounds where plaintiff had not pled the requisite fraudulent intent or “scienter” as to any of the individual employee defendants. See Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital, Inc., --- F.3d ----, No. 06-2902, 2008 WL 2521676 (2d Cir. Jun. 26, 2008). On interlocutory appeal of an order denying Dynex Capital, Inc.’s (“Dynex”) and Merit Securities Corp.’s (“Merit”) (collectively, “the corporate defendants”) motion to dismiss, the corporate defendants argued that the lower court erred when it held that plaintiff successfully pled scienter against Dynex and Merit, despite the fact that plaintiff had failed to plead scienter against any specific individual defendant associated with either company. Id. at *1.
Dynex invests in bonds secured by mortgages on mobile homes. Merit, a subsidiary of Dynex, issued the mortgages that were pooled into two sets of asset-backed securities secured by the loans (“bonds”), with the income generated by the loans serving as collateral (“bond collateral”). Id. Plaintiff brought claims for violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that the defendants misrepresented the cause of the bond collateral’s poor performance, misrepresented the reasons for restating loan loss reserves, and concealed the loans’ faulty underwriting. Id. at *2. The defendants moved to dismiss. Although the District Court agreed that plaintiff had failed to plead scienter as to any of the individual defendants, it nevertheless found that plaintiff had pled scienter as to other unnamed “officers” of the companies and, thus, scienter had been sufficiently pled as to the corporate defendants. Id. at *4.
The Second Circuit explained that, where the defendant is a corporate entity, the Private Securities Litigation Reform Act (the “Reform Act”) requires that the plaintiff must plead facts that create a strong inference that “someone whose intent could be imputed to the corporation acted with the requisite scienter.” Id. Plaintiff argued that it satisfied this pleading requirement by alleging that (1) Dynex knew facts or had access to information suggesting that their public statements were not accurate, (2) unspecified employees or officers of Dynex and Merit benefited from the alleged fraud, and (3) those unspecified employees or officers were motivated to and had the opportunity to avoid disclosing the impaired quality of the bond collateral. Id. at *5. The Second Circuit rejected these arguments. Id.
The Court explained that, where it is contended that defendants had access to contrary facts, a plaintiff “must specifically identify the reports or statements containing this information.” Id. In the present case, the plaintiff’s “broad reference to raw data lacks even an allegation that th[e] data had been collected into reports that demonstrated that loan origination practices were undermining the collateral’s performance.” Id. Further, plaintiff’s alleged motive was insufficient because virtually all corporate insiders have a desire to sustain the appearance of corporate success or profitability. Id. Thus, the allegations here were no different from those that had been rejected in countless other cases over the years. See id.
Moreover, plaintiff’s allegations failed to show that the primary cause of the bonds’ poor performance was the purportedly undisclosed facts and not a general weakness in the mobile homes market. Plaintiff
would have us infer that someone whose scienter is imputable to the corporate defendants and who was responsible for the statements made was at least reckless toward the alleged falsity of those statements, [but] [w]e cannot say, based on the allegations in the complaint, that this inference is “at least as compelling” as the competing inference . . . that the statements either were not misleading or “were the result of merely careless mistakes at the management level based on false information fed it from below.”
Id. at *6 (citations omitted and emphasis in original). Accordingly, the Second Circuit held that the Reform Act required dismissal of all the claims against the corporate defendants for failure to plead the required element of scienter. Id.