In a recent decision, Indiana Electrical Workers’ Pension Trust Fund IBEW v. Shaw Group, Inc., No. 06-30908, 2008 WL 2894793 (5th Cir. July 29, 2008), the Fifth Circuit Court of Appeals overturned the denial of the defendants’ motion to dismiss, holding that the plaintiffs had failed to adequately plead scienter under the standards set forth in the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights Ltd., 127 S. Ct. 2499 (2007). Among other defects that counseled in favor of dismissal, the Fifth Circuit recognized that Tellabs was fundamentally inconsistent with the plaintiffs’ attempted reliance on confidential sources to bolster their claims.

The Fifth Circuit relied on the three step approach set forth in Tellabs for determining whether scienter had been adequately alleged in Shaw: (1) the allegations must be taken as true; (2) the court may take judicial notice of appropriate matters, may consider documents incorporated in the complaint by reference, and must consider the facts collectively, not in isolation; and (3) the court must take into account plausible opposing inferences in determining if the inference of scienter is cogent and compelling. Id. at *2 (citing Tellabs, 127 S. Ct. at 2509 – 10). Under this framework, the Fifth Circuit concluded that plaintiffs’ allegations of purported actual knowledge or severe recklessness on the part of the defendants were deficient for several reasons.

As an initial matter, the Fifth Circuit, like other Circuit Courts in the wake of Tellabs, determined that it was necessary to discount plaintiffs’ use of confidential sources, ruling that such sources did not allow the court to weigh competing inferences as required by Tellabs. Id. at *4. Rather, to be of any use, the complaint must, at a minimum, describe the confidential source with sufficient particularity to support the probability that such a person would be in a position to possess the information alleged, a burden that the plaintiffs had failed to satisfy. Id. Specifically, the plaintiffs had failed to describe the confidential sources by title, employment location, or dates of employment, failed to set forth when or where supposed incidents took place, failed to assert when or how the defendants supposedly became aware of information of which the confidential sources were aware, and failed to sufficiently allege the substance of alleged conversations informing defendants of any irregularities or problems. Id. at *7 – *9, *11.

The Fifth Circuit then proceeded to identify numerous other problems with plaintiffs’ scienter allegations that also supported dismissal. For example, plaintiffs had argued that defendants “must have known” of the undisclosed, adverse facts based on their positions with the company, the magnitude of the alleged accounting irregularities, the defendants’ “hands-on” management style, and the supposed company-wide knowledge of these issues. The Fifth Circuit rejected all of these arguments. The court observed that the case law was clear that a defendant’s position with the company standing alone was insufficient to establish an inference of scienter. Id. at *4. Similarly, the magnitude of the accounting errors was insufficient because the plaintiffs had failed to estimate how much the earnings were supposedly inflated as a result of these errors. Id. at *5. Further, bald assertions of a hands-on management style, based on one defendant’s alleged boast that “there is nothing in this company that I don’t know,” could not prevail because such a statement lacked specificity as to what the defendant supposedly knew or should have known about the accounting practices at issue. Id. at *4. Finally, the Court of Appeals concluded that plaintiffs’ speculation that “everyone else” in the company knew of the accounting issues was simply too vague to support a strong inference of scienter as to any particular defendant. Id. at *9.

The Circuit Court also rejected the notion that knowledge by the individual defendants could be inferred because they supposedly pressured employees to inflate the completion figures on certain construction projects. Id. at *7 – *8. Plaintiffs relied on two statements by one defendant to support these allegations: a dinner conversation in which the defendant supposedly stated, “[w]e have got to show more progress” and a second conversation with an analyst during which the defendant allegedly stated that the analyst “needed to do something to fix” the company’s low revenue numbers. Id. at *7. In addition to discounting these allegations as coming from the confidential sources, the Court of Appeals concluded that they also did not give rise to a strong inference of scienter under Tellabs because they were “susceptible to many interpretations, including innocent ones.” Id. at *8 (internal citations omitted).

In reaching the ultimate conclusion that dismissal was warranted, the Fifth Circuit also rejected allegations concerning the defendants’ receipt of monthly progress reports due to the fact that plaintiffs had simultaneously argued that these same reports were generated by a faulty program and contained unreliable numbers. Id. at *9. Further, consistent with other Circuits, the Fifth Circuit rejected the notion that the mere fact that a defendant may have signed certain Sarbanes-Oxley certifications was probative of his or her scienter. Id. at *14.