(Article from Securities Law Alert, March 2015)
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On March 12, 2015, the Southern District of New York dismissed a securities fraud action against Molycorp Inc. for failure to allege scienter with respect to the progress of a mining project and the commercial potential of one of the company’s products. In re Molycorp, Inc. Sec. Litig., 2015 WL 1097355 (S.D.N.Y. 2015) (Crotty, J.). The court found that that the case was a “classic example of fraud by hindsight” in which plaintiffs attempted to plead scienter based on company statements that later turned out to be inaccurate.
Southern District of New York Determines That Defendants’ Alleged Misstatements Concerning the Progress of Project Phoenix Were at Most Erroneous, Rather Than Reckless
The court found that plaintiffs had failed to allege scienter with respect to defendants’ alleged misstatements concerning the progress and anticipated completion date of Phase 1 of Project Phoenix, an effort to modernize Molycorp’s rare earths mine.
Plaintiffs attempted to plead scienter by demonstrating “circumstantial evidence of conscious misbehavior or recklessness,” rather than “motive and opportunity to commit the alleged fraud.” The court explained that a “stricter standard” applies to scienter allegations based on “a conscious misbehavior or recklessness theory.” Although a plaintiff can “plead scienter by identifying conscious misbehavior by the defendant, . . . the strength of circumstantial allegations must be correspondingly greater” than the allegations sufficient to plead scienter under a motive and opportunity theory. “A finding of recklessness requires a showing of conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious the defendant must have been aware of it.” The court held that “[p]laintiffs’ allegations fail[ed] to meet this high burden” for a number of reasons.
First, the court found that “a close analysis of the allegations of confidential witnesses” relied on by plaintiffs “reveal[ed] that the [c]omplaint d[id] not actually come close to alleging [d]efendants’ knowledge of delays at the [Project Phoenix] mine until, at the earliest, June 2012.” The court determined that “this dearth of scienter allegations mean[t] that a large portion of the statements which [p]laintiffs allege[d] [were] actionable, made during February and May [2012], [were] patently not actionable.” The court found the remaining confidential witness allegations “devoid of facts demonstrating that [d]efendants knew they would fail to meet the announced schedule [for completing Phase 1 of Project Phoenix] when the statements were made.” At best, the allegations “may show that [ ] defendants should have been more alert and more skeptical, but nothing alleged indicates that management was promoting a fraud.”
Second, the court rejected plaintiffs’ efforts to allege scienter based on defendants’ knowledge of “serious problems in work performed by a [Project Phoenix] contractor, M & K Chemical Engineering.” Even though “poor work was done and . . . the damages were significant enough for Molycorp to sue M & K,” the court determined that this was not sufficient to establish “that Molycorp knew its proposed schedule [for completing Phase 1 of Project Phoenix] was no longer viable.” The court found it “equally as likely, and indeed more compelling, that Molycorp believed it could remedy this damage within the existing time frame.”
Third, the court determined that there was no basis for plaintiffs’ assertion that defendants “must have known of the delay in completion of Phase 1 [of Project Phoenix] prior to the company’s January 10, 2013 announcement that the project would take six months longer than expected. The court explained that “[m]anagers . . . are entitled to investigate for a reasonable time, until they have a full story to reveal.” Moreover, even if defendants had relied on timelines that “were not realistic,” the court emphasized that “recklessness and erroneousness are not equivalent” for purposes of alleging securities fraud. The court stated that “[j]ust because something is wrong or incorrect as a matter of fact does not mean it was reckless.”
Fourth, the court found that plaintiffs had not alleged scienter based on “the facts that the financials were SOX-certified; that Project Phoenix was a ‘core operation’ of Molycorp; and that certain [i]ndividual [d]efendants were ‘forced’ to resign during the class period.” The court explained that “in the absence of more particularized allegations of scienter,” the fact “that certain [d]efendants signed or certified SEC disclosures is insufficient to support a finding of scienter.” Moreover, “without factual allegations linking [d]efendants’ resignations to the alleged fraud, the mere fact of the resignations provides no support for a finding of scienter.” Finally, with respect to plaintiffs’ attempt to rely on the “core operations” theory, the court explained that “the majority approach” in the Second Circuit “has been to consider such allegations as a supplementary but not independently sufficient means to plead scienter.”
The court concluded that “[p]laintiffs’ allegations regarding Project Phoenix read as a classic example of ‘fraud by hindsight.’” Given that defendants “eventually disclosed the delay” in anticipated Phase 1 completion of Project Phoenix, the court found that permitting plaintiffs’ claims to go forward “would impose too high a burden of clairvoyance and continuous disclosure on corporate officials.”
Southern District of New York Holds Plaintiffs’ Scienter Allegations Concerning the Commercial Viability of SorbX Inadequate Under the Heightened Scienter Standard Applicable to Forward-Looking Statements
The court determined that plaintiffs had also failed to allege scienter with respect to alleged misstatements concerning “Molycorp’s progress in building commercial potential for SorbX, Molycorp’s proprietary water filtration product.” The court found that “[t]he majority of statements regarding SorbX identified in the complaint [were] classically forward-looking – they address[ed] what defendants expected to occur in the future.” The court explained that “[t]he scienter requirement for forward-looking statements – actual knowledge – is stricter than [the standard applicable to] statements of current fact.”
Here, the court found “[p]laintiffs’ allegations of [d]efendants’ knowledge . . . both speculative and conclusory.” For example, plaintiffs cited a confidential witness who stated that “if anyone in management was ‘paying attention,’ they would [have] know[n] by late 2012 that SorbX had no short term commercial potential.” The court explained that these types of allegations do “not meet th[e] [actual knowledge] standard” for forward-looking statements.
The court also found insufficient plaintiffs’ attempt to allege scienter based on Molycorp’s August 8, 2013 announcement that it would restate its financials for the first quarter of 2013, and therefore dismissed the complaint in its entirety.