(Article from Securities Law Alert, October 2014)
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On October 10, 2014, the Sixth Circuit adopted a “middle ground” formulation for determining when the knowledge of a corporate officer may be imputed to the corporation for purposes of alleging corporate scienter. In re Omnicare, Inc. Sec. Litig. (Omnicare II), 2014 WL 5066826 (6th Cir. 2014) (Moore, J.). In so holding, the Sixth Circuit “qualifie[d] some of [the] overly broad language” on corporate scienter pleading requirements expressed in its earlier decision in City of Monroe Emps. Ret. Sys. v. Bridgestone Corp., 399 F.3d 651 (6th Cir. 2005).
Background
In 2012, plaintiffs brought suit under Section 10(b) and Rule 10b-5 alleging that Omnicare, Inc. and several of its current and former officers (the “Individual Defendants”) had made “various material misrepresentations and omissions … in public and SEC filings regarding Omnicare’s compliance with Medicare and Medicaid regulations.” The allegations focused on three internal audits that allegedly revealed problems with Omnicare’s Medicare and Medicaid reimbursement claims practices. These audits were conducted by John Stone, Omnicare’s former Vice President of Internal Audit, who eventually brought a qui tam action against Omnicare under the False Claims Act in connection with Omnicare’s reimbursement practices. Notably, plaintiffs did not name Stone as a defendant in the action.
On March 27, 2013, the Eastern District of Kentucky dismissed plaintiffs’ complaint. In re Omnicare, Inc. Sec. Litig. (Omnicare I), 2013 WL 1248243 (E.D. Ky. 2013) (Bunning, J.). The court found that plaintiffs had “failed to plead sufficient facts to establish that any of the Individual Defendants had actual knowledge of the audit results, or that any of the Defendants knew that the legal compliance statements were false when made.” Even if the court “impute[d] to Omnicare the knowledge of non-defendant employees” who were not alleged to be “in any way responsible for the compliance statements,” the court determined that plaintiffs had failed to “allege sufficient facts to support a finding that from this knowledge Omnicare knew its legal compliance statements were false.” Plaintiffs appealed.
Sixth Circuit Addresses the Elements of a Misrepresentation Claim Concerning “Soft Information”
The Sixth Circuit began its analysis by addressing the elements of a Section 10(b) and Rule 10b-5 claim based on an alleged misrepresentation of “soft information,” such as “predictions and matters of opinion.” Omnicare II, 2014 WL 5066826. The court explained that “[w]hen an alleged misrepresentation concerns ‘hard information’ — ‘typically historical information or other factual information that is objectively verifiable’ — it is actionable if a plaintiff pleads facts showing that the statement concerned a material fact and that it was objectively false or misleading.” But “[w]hen an alleged misrepresentation concerns ‘soft information,’ … a plaintiff must additionally plead facts showing that the statement was ‘made with knowledge of its falsity.’” The Sixth Circuit explained that the case at hand concerned “this latter type of alleged misrepresentation.”
The Sixth Circuit found that the test for an alleged misrepresentation of “soft information” has historically been problematic “because it adds a subjective inquiry to an otherwise objective element, thus conflating two elements of the six-element cause of action [under Section 10(b) and Rule 10b-5] — an actionable misrepresentation and scienter.” The court observed that “[u]ntil now,” courts in the Sixth Circuit “have muddled the analytical framework” by assessing “whether a defendant had actual knowledge under both [e]lements.”
The Sixth Circuit determined that it “must choose one way or the other to analyze a defendant’s actual knowledge” of an alleged misrepresentation of “soft information.” The court held that “it makes the most sense to … conceive of this additional requirement as raising the bar for alleging scienter.” The court explained that taking this approach “allow[s] courts to evaluate materiality and whether the statement was misleading or false ― two objective inquiries ― under the material-misrepresentation prong and then to save all subjective inquiries for the scienter analysis.” The Sixth Circuit reasoned that “whether someone made a statement with the knowledge that it was false is, at bottom, a question of someone’s state of mind —the general subject of a scienter inquiry.”
Sixth Circuit Adopts a “Middle Ground” Standard for Considering Allegations of Corporate Scienter
The Sixth Circuit next turned to the question of whether plaintiffs had adequately pled scienter in the case before it. The court explained that the scienter analysis “can become much more complicated when the defendant is a corporation because there is the additional question of whose knowledge and state of mind matters.” For example, “must the person misrepresenting a material fact in the name of the corporation have also done so with scienter, or is it enough that some person in the corporate structure had the requisite state of mind?” Assuming “the latter conception is correct, how high in the hierarchy of the corporation must the person with scienter be, and what must his relationship be to the statement?” The Sixth Circuit observed that it has “been less than precise in [its] prior pronouncements” on this issue, and therefore attempted to clarify “where [it] stand[s] on the doctrine of collective corporate scienter.”
After reviewing decisions from other circuits, the Sixth Circuit adopted what it deemed a “middle ground” approach. The Sixth Circuit held that for purposes of determining whether a corporation made a misrepresentation “with the requisite scienter under Section 10(b),” courts should consider “probative” the “state(s) of mind of any of the following” individuals:
a. The individual who uttered or issued the misrepresentation;
b. Any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance;
c. Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance.
The Sixth Circuit explained that this test “largely prevents corporations from evading liability through tacit encouragement and willful ignorance, as they potentially could under [the] strict respondeat superior approach” adopted by the Fifth and Eleventh Circuits in Southland Sec. Corp. v. Inspire Ins. Sol’ns, Inc., 365 F.3d 353 (5th Cir. 2004) and Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015 (11th Cir. 2004) respectively. The Sixth Circuit observed that the Fifth and Eleventh Circuits “‘look to the state of mind of the individual corporate official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like) rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment.’” In the Sixth Circuit’s view, this approach “risks running counter to the goals and purposes of the 1934 Act — which include fostering ‘an attitude of full disclosure by publicly traded corporations.’”
The Sixth Circuit underscored that its formulation for evaluating allegations of corporate scienter is “consistent with” but “qualifies some of [the] … overly broad language” in its earlier decision in City of Monroe, 399 F.3d 651. There, the Sixth Circuit stated that “knowledge of a corporate officer or agent acting within the scope of [his] authority is attributable to the corporation.” The City of Monroe court held that the knowledge of a company’s CEO could be imputed to the corporation, even though the CEO did not issue the alleged material misrepresentations at issue in the company’s annual report. Notably, the City of Monroe court dismissed the suit against the CEO in his personal capacity.
In Omnicare II, the Sixth Circuit found that “reading … City of Monroe too broadly could expose corporations to liability far beyond what Congress has authorized.” The court explained that “[i]f the scienter of any agent can be imputed to the corporation, then it is possible that a company could be liable for a statement made regarding a product, so long as a low-level employee, perhaps in another country, knew something to the contrary.” The court determined that “[s]uch a result runs contrary to the PSLRA, which increased the scienter pleading requirements to prevent strike suits.”
The Sixth Circuit reasoned that its new “middle ground” “formulation protects corporations from liability — or strike suits — when one individual unknowingly makes a false statement that another individual, unrelated to the preparation or issuance of the statement, knew to be false or misleading.” Under the Omnicare II test for evaluating allegations of corporate scienter, courts may “examine only the states of mind of lower-level employees connected to the statements” at issue.
Sixth Circuit Finds Plaintiffs Failed to Allege Omnicare’s Scienter
Turning to the allegations in the case before it, the Sixth Circuit “agree[d] with the district court” in finding “that the [c]omplaint does not sufficiently tie … any of the Individual Defendants” to the audits allegedly revealing problems with Omnicare’s Medicare and Medicaid reimbursement claims process. The Sixth Circuit found that plaintiffs had therefore “failed to plead sufficient facts showing that … [the] Individual Defendants had actual knowledge that [Omnicare’s statements of legal compliance] were false.” Since the statements of legal compliance at issue “concerned soft information,” the Sixth Circuit held that the Individual Defendants’ “lack of knowledge [was] fatal” to plaintiffs’ claims “against the Individual Defendants.
The court next considered “whether the [c]omplaint contains sufficient allegations to demonstrate that, collectively, Omnicare possessed actual knowledge that” its statements of legal compliance “were false and that Omnicare, nevertheless, made” those statements “(or failed to correct them) to defraud the public.” The Sixth Circuit found that under its “formulation of collective corporate scienter,” the knowledge of John Stone, Omnicare’s former Vice President of Internal Audit, could “be imputed to Omnicare … because [Stone] was both an ‘individual agent who … [allegedly] furnished information for, … [and] reviewed … the statement in which the misrepresentation was made before its utterance or issuance.’” Stone was also “potentially a ‘high managerial agent … who ratified … or tolerated the misrepresentation after its utterance or issuance.’”
Nevertheless, the Sixth Circuit found that plaintiffs had “fail[ed] to plead sufficient facts that would give rise to a strong inference that Omnicare [had] acted to defraud the public.” Among other grounds, the court pointed out that plaintiffs had “alleged no facts, other than the Individual Defendants’ general interest in being paid, that [led] to an inference that the Individual Defendants or Omnicare [had] fraudulently misled the public to save their jobs or salaries.” The Sixth Circuit affirmed dismissal of the complaint and observed that “[i]f a well-pleaded complaint can allege only that a corporation intended to defraud based on a desire to continue earning money, without showing a particular link between the actual statement and a specific payment, then the heightened pleading standard for scienter has no bite.”
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