5th Circuit rejects securities fraud class action

Public disclosures, pleading standards prove fatal

Publication January 2016

On January 13, 2016, the Fifth Circuit issued an opinion reiterating that securities class actions filed over disappointing earnings announcements, guidance reductions and statements of opinion remain highly susceptible to dismissal on the pleadings.  The opinion, which is styled Local 731 I.B. of T. Excavators and Pavers Pension Trust Fund v. Diodes, Inc., No. 14-41141, 2016 WL 157822 (5th Cir. 2016), is important because it addresses several common arguments plaintiffs make to end-run the legal protections afforded to opinions and forward-looking statements.  The decision also illustrates how companies can position themselves to defeat securities fraud claims over unfavorable quarterly results by making fulsome and specific disclosures, while reaffirming the Fifth Circuit’s rigorous approach to enforcing the requirement that securities complaints allege particularized facts supporting a “strong inference” of fraudulent intent or severe recklessness.

The plaintiffs were investors in Diodes, Inc., a semiconductor company that maintains manufacturing facilities in China.  In February 2011, the company alerted investors that its manufacturing output would be affected by labor shortages at its Chinese facilities but predicted that the problem would be resolved during the following quarter.  In its next two quarterly earnings releases, however, the company disclosed that it took longer to recover from the labor shortage problems than it expected, leading to a stock price drop after both announcements and a reduction in earnings guidance for the second quarter. 

Plaintiffs filed suit, claiming that the company’s executives concealed the extent of the labor problems.  As is often the case in missed-projections suits, the plaintiffs eschewed an “affirmative misstatement” theory (which would be difficult to maintain given the protections for forward-looking statements) in favor of an “omissions” or “half-truths” theory, asserting that the guidance was rendered misleading based on the alleged concealment of existing facts about the shortage.  The district court granted the company’s motion to dismiss, and the Fifth Circuit affirmed. 

The Fifth Circuit’s decision is noteworthy for several reasons.  First, the court emphasized that the company’s repeated warnings that a labor shortage existed weighed heavily against any inference that the alleged omissions were misleading or fraudulent.  While plaintiffs alleged that the company concealed both the extent and the alleged cause of the problems, the Fifth Circuit observed that “[m]ost reasonable investors would rather receive an accurate ‘bottom line’ assessment of a disclosed company problem than all of its assumptions and nuances.”  The plaintiffs failed to identify any particularized facts showing that the company omitted any details that would have rendered their affirmative disclosures misleading.

Second, the court rejected the plaintiffs’ efforts to water down the stringent requirement for pleading scienter.  The plaintiffs argued that the court should infer executive knowledge of the alleged problems based on their positions at the company.  The Fifth Circuit reaffirmed the traditional requirement that a securities fraud plaintiff cannot demonstrate an executive’s knowledge of alleged fraudulent conduct based solely on the executive’s position at the company.  In the “handful” of cases where an officer’s position was found to support a strong inference of scienter, there were “special circumstances” present that strengthened the inference of executive knowledge.  These “special circumstances” include: (i) the small size of the company (which makes it more likely that an executive will be familiar with day-to-day issues); (ii) a transaction that is critical to the company’s continued vitality; (iii) information that would be readily apparent to the speaker; or (iv) internal inconsistencies between the executives’ statements.  Because Diodes is a large company, the plaintiffs made no allegation that the labor shortage jeopardized the company’s existence, the purportedly omitted information “could not have been readily apparent” to the executives, and there were no internal inconsistencies in the executives’ statements, the court declined to infer scienter based on the officers’ positions at the company.  

Third, the district and appellate courts gave considerable weight to the economic theory behind the defendants’ conduct in concluding that innocent inferences overwhelmed any inference of fraud.  The plaintiffs alleged that the company was accelerating the delivery of its products so that it could recognize revenue more quickly.  The Fifth Circuit, however, observed that a company that accelerates delivery during a labor shortage would cause the shortage to worsen and become more apparent to investors, thus undercutting any inference that the company was trying to conceal the shortage.  The court also noted that shipping orders early is not inherently illegal and refused to credit an inference of illegality based on speculation. 

Fourth, the court refused to infer scienter even though the CEO sold a much larger amount of stock during the class period than in prior periods.  Even though “[v]iewed in isolation, [the CEO’s] sales during the class period might be considered suspicious,” the court noted that the CEO sold only 12 percent of his holdings and that “there are many innocent reasons why an individual will sell stock at a given time.” 

The Fifth Circuit’s opinion in Diodes should give companies further ammunition for obtaining dismissals of securities class actions.  Disappointing earnings announcements and reductions in guidance will no doubt continue to be a frequent target for shareholder plaintiffs.  Nonetheless, a company can maximize its prospects for dismissal by disclosing specific adverse trends that could cause earnings to be lower than expected (or for events to turn out differently in other respects than how the company predicted them).  Companies need not disclose every detail about a problem as long as the omitted details are consistent with (and do not contradict) the company’s affirmative disclosures.  Once a suit is filed, companies should also carefully evaluate the economic motivations behind the conduct alleged in the complaint and identify reasons why the company’s actions are inconsistent with an intent to defraud.  The securities litigation, investigations and SEC enforcement team at Norton Rose Fulbright has extensive experience advising companies how to minimize their disclosure risk and obtaining dismissals of securities class actions.

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