In a recent decision, the Ninth Circuit Court of Appeals considered the following question: whether allegations that the defendants had knowledge of a company’s “core operations” could be used to satisfy the requirement of pleading fraudulent intent or “scienter” under the Private Securities Litigation Reform Act (the “Reform Act”). See South Ferry LP v. Killinger, et al., No. 06-35511, 2008 WL 4138237 (9th Cir. Sept. 9, 2008). Plaintiffs routinely argue in securities cases that knowledge of adverse undisclosed facts should be presumed because “[i]t may be inferred that the facts critical to a business’s core operations or important transaction are known to a company’s key officers.” Id. at *2.
In South Ferry, plaintiffs alleged that defendant Washington Mutual, Inc. and the individual defendant officers made materially false or misleading statements concerning the company’s ability to manage the risk present in its mortgage lending business. See id. According to plaintiffs, Washington Mutual was unprepared for interest rate volatility and had “failed to integrate its information systems to permit it to keep a close watch on the [risk] hedges it maintains.” Id. The lower court held that the plaintiffs had pled scienter by inferring that defendants knew of the difficulties with their information systems because these systems were deemed to be “core operations.” See id.
In ruling on this question, the Ninth Circuit acknowledged that a compelling and cogent inference of scienter is required under the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues and Rights, Ltd., 127 S. Ct. 2499 (2007). See id. at *3. The Ninth Circuit further held that allegations of management’s knowledge of core operations may be considered by the court, but standing alone would most likely fail to meet the scienter pleading requirement. See id. at *5. “Where a complaint relies on allegations that management had an important role in the company but does not contain additional detailed allegations about the defendants’ actual exposure to information, it will usually fall short of the [Reform Act’s] standard.” Id. This is so because “the inference that defendants had knowledge of the relevant facts will not be much stronger, if at all, than the inference that defendants remained unaware.” Id. Moreover, it had long been the rule in the Ninth Circuit that management’s general awareness of the day-to-day workings of the company does not establish scienter. See id. (citing Metzler Inv. GmbH v. Corinthian Coll., Inc., 534 F.3d 1068, 1087 (9th Cir. 2008) (concluding that the bare core operations inference fell short of the Tellabs standard)). For allegations of knowledge of “core operations” to satisfy independently the scienter pleading requirement, they must be “particular and suggest that [the] defendant had actual access to the disputed [company] information.” Id. at *6.
After it set forth the standard for consideration of such allegations, the Court of Appeals observed that the lower court’s order certifying this issue for appeal was not clear as to whether the District Court believed that alternative grounds existed for pleading scienter in addition to these core operations allegations. See id. at *6-*7. Accordingly, the Ninth Circuit vacated the District Court’s order on scienter and remanded the case to the lower court for further consideration in light of Tellabs and its opinion on the certified question. See id. at *7.