On September 20, 2018, the United States Court of Appeals for the Third Circuit affirmed dismissal of a putative securities fraud class action brought against Hertz Global Holdings Inc. (the “Company”) and several of its executives for failure to plead a strong inference of scienter. In Re Hertz Global Holdings Inc., No. 17-2200 (3d Cir. Sep’t 20, 2018). Plaintiffs alleged that defendants violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 by making materially false and misleading statements concerning the Company’s financial results, internal controls, and future earnings projections. The panel found that plaintiffs’ allegations more plausibly suggested defendants were “just bad leaders,” confirming that claims of mismanagement cannot be converted into a claim of securities fraud, and that the complaint failed to allege factual allegations sufficient to give rise to a strong inference of scienter.

Plaintiffs’ lawsuit followed a restatement by Hertz that revealed the Company’s financial statements from 2011 to 2013 cumulatively overstated its net income by $132 million (20.23%) and its pre-tax income by $215 million (17.58%). The restatement disclosed internal control deficiencies, including that “an inconsistent and sometimes inappropriate tone at the top” had existed under its former management and resulted in an environment that may have led to inappropriate accounting decisions. Several executives resigned after the restatement. Based on these announcements, plaintiffs alleged that defendants falsely touted the Company’s financial position. The United States District Court for the District of New Jersey dismissed the action, holding that plaintiffs failed to adequately plead facts giving rise to a strong inference of scienter.

The panel upheld the district court’s decision. Instructing that courts must analyze the issue of scienter “holistically,” the Third Circuit first held that the district court properly applied the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007). First, rejecting the argument that the district court failed to make inferences in plaintiffs’ favor, the Third Circuit held that Tellabs requires a comparative analysis that considers inferences favorable to plaintiffs as well as plausible, nonculpable explanations of the alleged misconduct. Second, the Third Circuit held that the district court was not requiring plaintiffs to submit “smoking gun” evidence, but instead was simply requiring plaintiffs to plead factual allegations to support a cogent inference of scienter. Finally, the Third Circuit held that the district court correctly considered plaintiffs’ scienter allegations holistically, even though the district court’s analysis was broken up into one-at-a-time assessments of individual categories of allegations.

After concluding Tellabs had been applied properly, the Third Circuit held that plaintiffs’ allegations failed to give rise to a strong inference of scienter. With respect to allegations based on the size and scope of the restatement, the Third Circuit found that the fact that the accounting errors were spread across several different accounting categories circumscribed any inference of scienter, and further found that the restatement’s size alone was not sufficiently large to create a strong inference absent particularized allegations of fraudulent intent. The panel noted that, when broken down by year, the income categories had been overstated by between 9.97% and 32.12%.

The Third Circuit also concluded that the restatement’s admissions of internal control weaknesses were more plausibly admissions of mismanagement and not affirmative misconduct. The panel observed in particular that the admission of an “inappropriate tone at the top” was linked to one executive’s management style. This, at most, meant defendants presided over a poorly managed corporation, which the Third Circuit reiterated is insufficient to support a securities fraud claim. In addition, the panel found that a strong inference of scienter did not arise from the executives’ resignations because plaintiffs did not allege that the resignations resulted from participation in a systemic fraud. For corporate departures to strengthen an inference of scienter, the panel noted there must be allegations suggesting “a compelling inference that the resignation was the result of something other than…the release of bad news.” Likewise, with respect to plaintiffs’ allegations regarding defendants signing SOX certifications that later turned out to be false, the panel held that such allegations cannot give rise to an inference of scienter absent allegations that defendants knowingly or recklessly signed a false certification.

Finally, the panel concluded that allegations concerning insider trading did not create a strong inference of scienter because the class period alleged was long (29 months), plaintiffs’ allegations did not plausibly suggest that trades were timed to improperly reap a benefit from any particular disclosure, and only two of the five named defendants allegedly engaged in trading activities. The panel noted that, even though some of the trading activity involved large percentages of certain executives’ holdings, that does not give rise to a strong inference of scienter when other factors, such as timing of the relevant sales, weigh against that inference.

The Third Circuit’s decision stands as a reminder that claims of mismanagement alone do not constitute securities fraud claims, and underscore that plaintiffs must meet a high bar to allege facts sufficient to give rise to a strong inference of scienter.

In Re Hertz Global Holdings Inc.