(Article from Securities Law Alert, April 2015)
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On March 25, 2015, the Eleventh Circuit affirmed dismissal of a securities fraud action against Jiango Pharmaceuticals’ CFO and auditor on scienter grounds. Brophy v. Jiangbo Pharm., 781 F.3d 1296 (11th Cir. 2015) (Pryor, J.). The court found that plaintiffs had “fail[ed] to allege a theory of fraud that [was] specific enough in its scope or [its] connection to [either the company’s CFO or its auditor] to support a strong inference of scienter.” Notably, the court rejected plaintiffs’ contention that the company’s former CFO “must have known” of the alleged fraud given her position at the company.
Background
In May 2011, less than a year after Jiango Pharmaceuticals became a publicly traded company, the company disclosed that the SEC had formally launched an investigation into the company’s reported cash balances, and also disclosed that it had defaulted on a debt payment. The company’s share price quickly plummeted in the days and months that followed. Plaintiffs subsequently brought a securities fraud action against Jiangbo, its principal officers, as well as its audit firm, Frazer LLP.
Plaintiffs alleged that Elsa Sung, Jiangbo’s former CFO, and Frazer, Jiangbo’s auditor, “misrepresented the company’s cash balances and failed to disclose a material related-party transaction.” The district court dismissed plaintiffs’ claims against both Ms. Sung and Frazer for failure to allege fraud with the specificity required under the Private Securities Litigation Reform Act (“PSLRA”). Plaintiffs appealed.
Eleventh Circuit Rejects Plaintiffs’ Contention That Jiangbo’s Former CFO “Must Have Known” About the Alleged Fraud Given Her Role at the Company
On appeal, the Eleventh Circuit rejected plaintiffs’ attempt to establish scienter by claiming that “the disparity between Jiangbo’s actual and reported cash balances” was so large “that it would have been difficult or impossible for Ms. Sung not to have known about it in her capacity as CFO.” The court noted that plaintiffs’ “fail[ure] to allege any particular amount or even a range” by which Jiangbo’s cash balances were overstated “weaken[ed] any inference of scienter to be drawn from the magnitude of the alleged overstatements.” The Eleventh Circuit also found meritless plaintiffs’ claim that “a number of red flags,” including the SEC investigation and the company’s allegedly “dysfunctional internal controls,” “should have put Ms. Sung on notice of the fraud.” The court explained that “the complaint provide[d] no explanation as to how these red flags should have alerted her to the fraud.” The court stated that since plaintiffs did not describe “how these vaguely defined problems would have affected financial reporting or how Ms. Sung would have known about them,” it could not “rely” on those allegations “to add much weight to an inference of scienter.”
The Eleventh Circuit found that plaintiffs essentially wanted the court to “rely solely on Ms. Sung’s position as CFO to overlook [the] omissions and ambiguities in the complaint.” In support of this argument, plaintiffs “cite[d] cases in which courts [have] recognized a strong inference of scienter based in part on a senior financial executive’s oversight of the processes that produce a company’s financial statements.” The Eleventh Circuit deemed those cases inapposite because they all “involve[d] particularized allegations that the executives knew or were severely reckless in disregarding how those processes were distorted by fraud.” Here, however, plaintiffs had “allege[d] no particularized facts that directly show[ed] [that] Ms. Sung intended to deceive shareholders or knew about or was severely reckless with respect to deficiencies in reporting.” For example, plaintiffs “offer[ed] no allegations describing Ms. Sung’s day-to-day practices as CFO or identifying any specific misconduct apart from confirming incorrect cash balances within filings and on conference calls.”
The Eleventh Circuit held that in the absence of “more particularized allegations,” plaintiffs’ “claim that Jiangbo’s fraud was too large for Ms. Sung not to have noticed [was] unpersuasive.” The court determined that “[t]he seriousness of Jiangbo’s errors and Ms. Sung’s proximity to those errors at most impl[ied] negligence, which is not enough to establish scienter.”
Eleventh Circuit Finds the Inference of Scienter as to Jiangbo’s Auditor Even Weaker Than the Inference as to Jiangbo’s Former CFO Because the Auditor Was “a Step More Removed” From the Alleged Indicators of Fraud
The Eleventh Circuit found that “[i]f the inference of scienter against Ms. Sung [was] tenuous, then the corresponding inference against Frazer [was] even more attenuated.” The court explained that “[a]s an external auditor, Frazer was a step more removed than Ms. Sung from any alleged indicators of the fraud.” Here, plaintiffs did not specify “in what ways Frazer’s audit was deficient,” nor was there any “allegation that Frazer had extensive involvement with the company beyond what was required to conduct a single audit.”
“Ultimately,” the court held that “the investors’ allegations against Frazer suffer[ed] from the same overarching deficiency as those against Ms. Sung: they fail[ed] to articulate a theory of the fraud with any particularity.” The court observed that “[a]lthough the allegations against Ms. Sung and Frazer might survive motions to dismiss under a less burdensome pleading standard, the PSLRA imposes a high bar.” The Eleventh Circuit therefore affirmed dismissal of the complaint as to both Ms. Sung and Frazer.