The approach to pleading scienter under the PSLRA in a securities damage action was resolved four years ago by the Supreme Court in Tellabs, Inc. v. Makor Issues & rights, Ltd., 551 U.S. 308, 324 (2007). The test has four key factors: 1) all the facts in the complaint are assumed to be true; 2) the facts must be viewed collectively and not in isolation; 3) the court must consider plausible contrary inferences as well as strong supporting inferences; and 4) omissions and ambiguities count against a strong inference. See, e.g., Flaherty & Crumrine Preferred Income Fund Inc. v. TXU Corp., Case No. 08-10414 (5th Cir. April 8, 2009).
Despite the adoption of a “holistic” approach by the Supreme Court many courts continued to examine each allegation and use the collective approach of Tellabs. See, e.g., Rubke, Trustee, v. Capitl Bankcorp LTD, Case No. 07-15083 (9th Cir. Jan. 13, 2009)(requiring that each allegation be examined and then the holistic Tellabls test be applied)(here). Now that may be about to change in view of Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011) where the Court actually applied its holistic approach in contrast to Tellabs where it did not.
In Plumbers & Pifefitters National Pension Fund v. Dana Corporation, Case No. 09-4233 (6th Cir. Decided May 25, 2011) the Circuit Court read Matrixx Initiatives as requiring that only the holistic approach be used. Its prior approach of first evaluating each allegation and then considering the all of the allegations is inference is incorrect the Circuit Court held.
Defendants Michael Burns and Robert Richter, respectively the CEO and CFO of Dana Corporation, engaged in fraud, according to the complaint, by making repeated false statements regarding the financial condition of the company. Between April 2004 and October 2005 defendants signed Dana’s SEC filings, announced the earnings of the company in conference calls and executed SOX Section 302 certifications. In each instance during the class period the company reported and projected positive earnings. In many instances the earnings improved over prior periods. The company told investors that it was able to continue these trends despite rapidly increasing prices for the steel it used because it had achieved “cost efficient efficiencies.”
While these positive statements were being made, some divisions of Dana were faltering. Fifty percent of the company’s drive shaft division was operating at a loss. Its light axle division was also suffering. The cost of steel, one of Dana’s largest supply costs, increased 75% to 120% in late 2004.
On September 15, 2005 the company announced that it would reduce earnings projections by 50% because of the rising cost of steel. The company also announced a likely restatement of its financial statements for the second quarter of 2005 and that it may write down tax-deferred assets. The stock price fell 20% the day of the announcement and continued to slide. By the end of December the company restated earnings for the first two quarters of 2005, reducing income by $44 million. The next month it reported a $1.27 billion loss for the third quarter of 2005 and significantly reduced its tax deferred assets. The next month the SEC began an investigation. By early March the company filed for bankruptcy. This Exchange Act Section 10(b) class action suit followed.
Plaintiffs claimed that they adequately pleaded a strong inference of scienter as to each defendant. To support this claim they pointed to a series of factors demonstrating that plaintiffs knew or were reckless in not knowing that their statements were false including: 1) internal reports; 2) statements regarding accounting systems; 3) the magnitude of the false statements; 4) the temporal proximity of Dana’s positive statements which continued up to September 15, 2005 when corrective statements were made; 4) their motivation to earn bonuses and make Dana appear healthy; 5) Mr. Richter’s retirement; 6) false SOX certifications; and 7) the SEC investigation.
The Sixth Circuit agreed. Previously the Court noted, it approached the question of scienter by reviewing each allegation individually before concluding with a collective approach. In view of Matrixx Initiatives the Court declined to follow that approach. In Matrixx Initiatives the Supreme Court demonstrated how the “holistic” approach of Tellabs works: “Writing for the Court, Justice Sotomayor expertly addressed the allegations collectively, did so quickly, and, importantly, did not parse out the allegations for individual analysis . . .this is the only proper approach following Tellabs’s mandate to review scienter pleadings based on the collective view of the facts, not the facts individually. . . Our former method of reviewing each allegation individually before reviewing them holistically risks losing the forest for the trees. Furthermore, after Tellabs, conducting an individual review of myriad allegations is an unnecessary inefficiency.”
Following this approach the Court briefly and quickly analyzed the allegations as a collective. Defendants Burns and Richter were the top executives of an auto parts manufacturer. They reported what the Court called “gangbuster earnings” while the industry was failing. They filed reports and made repeated statements to governmental authorities showing increasing earnings while multiple factories were failing to meet budget and the price of their major component was spiraling up. “It is difficult to grasp the thought that Burns and Richter really had no idea that Dana was on the road to bankruptcy” the Court concluded. Here the inference that they acted recklessly and disregarded the falsity of their extremely optimistic statements is at least as compelling as their claim that the fault stems from the operating systems. Accordingly the Tellabs test post Matrixx Initiatives has been met. The Court reversed the district court’s order of dismissal.
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