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(Article from Securities Law Alert, September 2017) 

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On August 15, 2017, the Central District of California dismissed with prejudice a securities fraud action against a Chinese solar energy company for failure to meet the “demanding standard” for pleading scienter based on the “absurd to suggest” exception to the core operations theory. Knox v. Yingli Green Energy Holding Co., 2017 WL 3503358 (C.D. Cal. 2017) (Wright, II, J.). [1] The court further held plaintiffs failed to establish loss causation because there were no allegations that the market ever learned of any alleged accounting misstatement.

Plaintiffs Must Provide Detailed Allegations to Plead Scienter Based on the “Absurd to Suggest” Exception to the Core Operations Theory  

“The core operations theory posits that facts critical to a business’s core operations or an important transaction generally are so apparent that their knowledge may be attributed to the company and its key officers.” The court explained that in the Ninth Circuit, “a securities fraud plaintiff cannot ‘rely[ ] exclusively on the core operations inference to plead scienter under the [Private Securities Litigation Reform Act].’” Id. (quoting S. Ferry LP No. 2 v. Killinger, 542 F.3d 776 (9th Cir. 2008)). “The only exception is the ‘rare’ instance where ‘the nature of the relevant fact is of such prominence that it would be ‘absurd’ to suggest that management was without knowledge of the matter.’” Id. (quoting Killinger, 542 F.3d 776).

In the case at hand, plaintiffs contended that the company’s “executives intended to defraud [the company’s] investors by touting” a Chinese government subsidy program for solar energy projects without “disclosing the risk that the government might terminate the program” due to allegedly “widespread” fraud. Plaintiffs alleged that companies in the industry had a “general ‘policy’ to delay construction after receiving subsidies” for solar energy projects. However, plaintiffs did not provide “facts such as how many companies had this purported policy and how many projects this policy affected.”

The court found plaintiffs’ reliance on “vague quantifiers and generalities” insufficient to satisfy the “absurd to suggest” exception to the core operations theory. “Without concrete numbers,” the court explained that it could not “conclude that the fraud was so pervasive throughout the entire solar industry that [the company’s] upper management could not possibly have been ignorant of it and its potential to shutter” the subsidy program.

Plaintiffs Must Plead Particularized Allegations Concerning the Market’s Awareness of the Alleged Fraudulent Practice to Satisfy the Loss Causation Requirement 

The court explained that “[l]oss causation requires that the market learn of, and react to, the company practice that the plaintiff alleges is fraudulent (although the market need not have learned that the practice was in fact fraudulent).” Here, plaintiffs alleged that the company engaged in accounting fraud by failing to write down one of its accounts. However, the two allegedly corrective disclosures neither identified the debtor by name nor indicated that the company’s “problems collecting the . . . debt should have been disclosed sooner.”

Because “the two reports [containing the alleged corrective disclosures] did not identify [the debt at issue] and did not include any facts from which one [could] infer that the  . . . debt should have been disclosed [as doubtful] earlier (if they even accounted for the debt [as doubtful] at all),” the court held plaintiffs could not “show that [the company’s] accounting for that debt had any causal connection to the drops in stock price that followed the release of the reports.” The court reasoned that “the market could not have reacted to a fact that it did not know.”