The core issue in Mizzaro v. Home Depot, Inc., No. 07-13812, 2008 WL 4498940 (11th Cir. Oct. 8, 2008), was whether the complaint against Home Depot and certain of its officers and directors raised a “strong inference” of scienter as required to state a claim under Section 10(b) of the Securities Exchange Act of 1934. Both the District Court and the Eleventh Circuit Court of Appeals decided the issue in the negative and dismissed the complaint. The Eleventh Circuit also denied the lead plaintiff’s motion for leave to further amend the complaint.
The complaint in Mizzaro alleged that Home Depot obtained excessive rebates from its vendors and violated the securities laws by not informing investors that its reported financial results were inflated by these purportedly excessive rebates. The complaint asserted violations of Section 10(b) and Rule 10b-5 based on alleged material misrepresentations and omissions in the company’s press releases and financial statements. Section 20(a) claims were asserted against certain officers and directors on the basis that they were “control persons.”
Many of the allegations in the complaint were allegedly the result of conversations that plaintiffs’ counsel had with confidential witnesses. Mizzaro, 2008 WL 4498940, at *5. Defendants argued that such statements should be “‘heavily discounted’ in all cases.” Id. Plaintiffs countered that the statements made by confidential witnesses should not be discounted simply because the witnesses were unnamed, and in this case, their statements should be given “great weight.” Id. The court set out to resolve these conflicting arguments in light of the heightened pleading requirements for securities fraud cases.
Under the Private Securities Litigation Reform Act (“Reform Act”), plaintiffs must allege facts that give rise to a strong inference of “scienter” or fraudulent intent. Id. at *4. The U.S. Supreme Court recently held that a strong inference of scienter is an inference that is “cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2510 (2007).
As to the proper standard for assessing confidential informant allegations, the Eleventh Circuit reasoned that, just as the tips of anonymous informants have served as the basis for the probable cause needed to issue search warrants in criminal cases, confidential witnesses could provide the basis for securities fraud complaints, so long as the complaint divulged the specific basis for the witness’s knowledge. Id. Nevertheless, because informants who lie to the police could face harsher consequences than witnesses who lie to plaintiffs’ attorneys, courts are entitled to be more skeptical of confidential witnesses in the securities fraud context. Id. at *6. On this basis, the Eleventh Circuit summarized its approach to confidential witnesses as follows:
We conclude that the weight to be afforded to allegations based on statements proffered by a confidential source depends on the particularity of the allegations made in each case, and confidentiality is one factor that courts may consider. Confidentiality, however should not eviscerate the weight given if the complaint otherwise fully describes the foundation or basis of the confidential witness’s knowledge, including the position(s) held, the proximity to the offending conduct, and the relevant time frame.
Id. at *6.
With the above-quoted language as the standard, the court proceeded to analyze whether the allegations attributed to the confidential witnesses in Mizzaro created a cogent and compelling inference that the individual defendants acted with the requisite scienter as required under Tellabs. The Eleventh Circuit found these allegations to be insufficient.
The court acknowledged that the positions of the confidential informants, the time periods covered by their allegations, and the similarity of the fraudulent schemes described by each informant supported the claim that Home Depot stores processed improper rebates. Id. at *14. However, these facts were insufficient to establish scienter on the part of the individual defendants. Id. To establish scienter on the part of those defendants, the facts would need to raise an inference that was “at least as likely as not that the individual high-ranking defendants either orchestrated the alleged fraud (and thus always knew about it), or learned about the alleged fraud sometime before the [end of the class period], or were otherwise severely reckless in not learning of the claimed fraud.” Id. at *14.
The Eleventh Circuit concluded that the facts alleged by the confidential informants were insufficient to raise a strong inference of scienter for several reasons. First, the court noted that there were no e-mails or letters from the individual defendants expressly ordering or even suggesting the scheme. Id. at *14. Second, the court considered the fact that none of the confidential witnesses said that any of the individual defendants discussed the alleged fraud or knew about it. Id. at *14, *16. Although one confidential witness, a former employee, interpreted his store manger’s comments to encourage wrongful rebates, there were no facts to link the manager’s comments with the individual defendants’ knowledge of wrongdoing. Id. at *15. Simply put, it was not enough to demonstrate the allegedly widespread nature of the fraud. To plead scienter, the facts would have to create an inference that the individual defendants were knowledgeable or otherwise involved in the fraud.
The Eleventh Circuit also generally discounted the idea that the fraud was so widespread that high-ranking officials in the company had to know about it. Id. at *14. The court reasoned that, in this case, the fraud was relatively straightforward and simple for even low-level employees to understand and effectuate. In such situations, the fact that many people may have committed the same fraud does not create a strong inference that upper management participated in the fraud. Id. at *16. If the fraudulent scheme had been more complex, it would be unlikely for numerous people to fall into the scheme without the coordinated effort or involvement of high-ranking company officials. Id. at *16. Moreover, the fact that confidential witnesses—even those in managerial positions—did not report that senior Home Depot officials directed them to engage in fraud undermined any assertion that the individual defendants must have known about the fraud. Id. at *16-*17. Therefore, the supposedly widespread nature of the fraud was insufficient to raise a strong inference of scienter on the part of the individual defendants.
On these grounds and others, the Eleventh Circuit affirmed the District Court’s dismissal of the complaint.