(Article from Securities Law Alert, August 2015)
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Under the “adverse interest” exception, a corporate executive’s scienter will not be imputed to the corporation if the executive acted purely self-interestedly and against the corporation's interests. On July 30, 2015, the Southern District of New York held that the adverse interest exception did not apply in a securities fraud action brought in connection with an alleged bribery and kickback scheme involving Petróleo Brasileiro S.A. (“Petrobras”). In re Petrobras Sec. Litig., 2015 WL 4557364 (S.D.N.Y. 2015) (Rakoff, J.).[1] The court found that the allegations did not “conclusively establish” that Petrobras had “received no benefit from the [c]orrupt [e]xecutives' actions, as required to render the adverse interest exception applicable.”
The court further held that it could not “conclude that . . . alleged misrepresentations in Petrobras’ financial statements were immaterial as a matter of law” even though the alleged misstatements did not necessarily "reach[ ] the five percent" threshold of presumptive materiality set forth in the SEC’s Staff Accounting Bulletin (“SAB”) No. 99. The court found that the qualitative factors discussed in SAB No. 99 “strongly favor[ed] a finding of materiality” because the alleged misstatements concerned the company’s core business and its corporate integrity.
Background
Plaintiffs contended that Petrobras, its subsidiaries, and certain former officers and directors of the company and its subsidiaries had “made two categories of false and misleading statements” in connection with an alleged “multi-year, multi-billion dollar bribery and kickback scheme.” First, plaintiffs alleged that “the corruption scheme rendered the [c]ompany’s financial statements materially false and misleading.” Specifically, plaintiffs claimed that the reported value of Petrobras’ property, plant, and equipment (“PP&E”) was “inflated by . . . bribe payments and overcharges from [a construction] cartel,” which were incorporated into the price of Petrobras’ construction contracts. Second, plaintiffs alleged that “Petrobras [had] made false and misleading statements regarding the integrity of its management and the effectiveness of its financial controls.” Plaintiffs asserted claims under Section 10(b) and Rule 10b-5, among other claims.
Court Finds the Adverse Interest Exception Inapplicable Because Petrobras Allegedly Benefited from the Corrupt Executives' Alleged Fraud
With respect to the complaint’s allegations, defendants did not dispute that plaintiffs had adequately pled scienter as to the company executives who had allegedly “carried out the bribery scheme” (the “Corrupt Executives”). However, defendants contended that “the adverse interest exception applie[d]” to shield the Petrobras entities from any imputation of corporate scienter based on the Corporate Executives’ knowledge “because the Corrupt Executives acted entirely to benefit themselves and their political patrons, at the [c]ompany's expense.”
The court explained that the “so-called ‘adverse interest’ exception to the general rule that a corporate executive’s scienter is attributable to the corporation . . . applies [only] where ‘an officer acts entirely in his own interests and adversely to the interests of the corporation’” (quoting Kirschner v. Grant Thornton LLP, 2009 WL 1286326 (S.D.N.Y. Apr. 14, 2009), aff'd sub nom. Kirschner v KPMG LLP, 626 F. 3d 673 (2d Cir. 2010)). The court underscored that a corporation's “agents cannot be said to have ‘totally abandoned’ the interests of the corporation” for purposes of the adverse interest exception if the “corporation benefit[ed] to any extent from the fraudulent acts of its agents.”
Here, the court found the complaint plausibly alleged that the bribery scheme caused the value of Petrobras’ PP&E to appear higher than it actually was, “which in turn inflated the value of Petrobras’ securities.” The court determined that “the inflation of the [c]ompany's PP & E operated as a fraud on the investing public, not on Petrobras itself.” The court further found that the Corrupt Executives’ alleged “failure to correct” the company's compliance and internal control-related statements “clearly benefited the [c]ompany, which was able to continue to attract investment and to complete its large-scale expansion plans.” Finally, the court found that Petrobras allegedly “benefited from” the corruption scheme by “remaining in favor with its political patrons.”
The court held that the allegations did “not conclusively establish that the [c]ompany received no benefit from the Corrupt Executives’ actions, as required to render the adverse interest exception applicable.” The court therefore determined that the Corrupt Executives’ alleged scienter could be imputed to the corporation.[2]
Court Applies the Qualitative Factors in SAB No. 99 to Find That Alleged Misstatements Concerning the Value of Petrobras’ Assets Were Not Presumptively Immaterial
With respect to alleged overstatements of the value of Petrobras’ assets, defendants claimed that the company [had] “paid only three percent more on the cartel contracts than it would have under an honest bidding system.” Defendants contended that “the three percent bribe payment built into the cartel contracts did not materially affect the accuracy of Petrobras’ financial statements" under SAB No. 99, which “establishes a ‘rule of thumb’ that changes of less than five percent to financial statements are presumptively immaterial.”
As an initial matter, the court found that the public documents on which the complaint relied “permit[ted] the inference that the contracts were inflated by much more than three percent.” The court determined that it was “not clear whether Petrobras’ alleged misstatement[s] reach[ed] the five percent ‘rule of thumb,’” but found that “there [was] a plausible possibility that [they] might.”
“In any event,” the court stated that this “quantitative analysis [was] not dispositive of materiality.” The court found that “[h]ere, the qualitative factors [set forth in SAB No. 99] strongly favor[ed] a finding of materiality.”[3] The court explained that “[t]he errors in Petrobras’ financial statements were directly related to its concealment of the unlawful bribery scheme, revelation of which would [have] ‘call[ed] into question the integrity of the company as a whole.’” The court also deemed it significant that the alleged “misstatements related to the value of Petrobras’ oil-producing infrastructure, which [was] the core of its business.” Finally, because Petrobras’ share price “dropped dramatically when news of the corruption scheme emerged,” the court found that investors did, in fact, consider the information material.
The court therefore determined that it could not “conclude that the alleged misrepresentations in Petrobras’ financial statements were immaterial as a matter of law.”
Court Finds Alleged Misstatements of Opinion Actionable Under the Supreme Court's Decision in Omnicare Because Defendants Allegedly Disbelieved the Statements at the Time They Were Made
Defendants contended that “many of their allegedly false and misleading statements were statements of opinion,” and claimed that plaintiffs had not “plausibly alleged that those opinions were not honestly held” as required under the Supreme Court's decision in Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015).[4]
The court explained that under Omnicare, “[a] statement of opinion is not materially false just because it is incorrect unless it is not ‘honestly held’ or omits facts about the speaker’s basis for holding that view, and those facts conflict with what a reasonable investor would understand from the statement itself.” Here, the court found that plaintiffs had adequately alleged that defendants did not believe their statements of opinion concerning the company’s business operations at the time those statements were made. For example, “plaintiffs allege[d] that at the time the [c]ompany's management was professing its opinion that the company's internal controls were effective, that same management was well aware of the extensive corruption in the [c]ompany’s procurement activities.” The court therfore determined that the alleged statements of opinion were actionable under Omnicare.
The court also found that the alleged misstatements were not inactionable puffery. “[W]hen, (as here alleged) the statements were made repeatedly in an effort to reassure the investing public about the [c]ompany’s integrity,” the court found that “a reasonable investor could rely on [those statements] as reflective of the true state of affairs at the [c]ompany.”
The court therefore denied defendants’ motion to dismiss plaintiffs’ Section 10(b) and Rule 10b-5 claims for failure to plead materiality and scienter.
[1] The court’s July 30, 2015 opinion explained the reasoning for its July 9, 2015 order granting in part and denying in part defendants’ motion to dismiss plaintiffs’ claims.
[2] The Southern District of New York recently reached the same conclusion with respect to the adverse interest exception in a different case that also involved an alleged bribery and kickback scheme. See In re PetroChina Co. Sec. Litig., 2015 WL 4619797 (S.D.N.Y. Aug. 3, 2015). In the PetroChina case, the court emphasized that the adverse interest exception is “narrow” and does not apply when “insiders defraud third parties for the corporation.” PetroChina, 2015 WL 4619797. The court found that the adverse interest exception did not apply in the PetroChina case because “[p]resumably, it was in PetroChina’s interest for any corruption occurring within the [c]ompany to remain undisclosed in order to preserve its shareholders’ confidence.” The court explained that cases applying the adverse interest exception have “involved corporate actors that were deemed to have acted to the company’s detriment,” and found that the PetroChina case “present[ed] no such scenario.”
[3] In SAB No. 99, the SEC stated that “[q]ualitative factors may cause misstatements of quantitatively small amounts to be material.” 1999 WL 1123073. Qualitative factors that the SEC may consider include “whether the misstatement concerns a segment or other portion of the registrant’s business that has been identified as playing a significant role in the registrant’s operations or profitability,” and “whether the misstatement involves concealment of an unlawful transaction.”
[4] Please click here to read our prior discussion of the Omnicare decision.