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(Article from Securities Law Alert, September/October 2018) 

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On September 20, 2018, the Third Circuit affirmed dismissal of a securities fraud class action against a car rental company brought on the heels of an acknowledgement in an SEC filing that a “sometimes inappropriate tone at the top . . . may have led to inappropriate accounting decisions.” In re Hertz Global Holdings, 2018 WL 4496352 (3d Cir. 2018) (Jordan, J.). The Third Circuit found the district court did not err in interpreting this statement as “an admission of ‘mismanagement,’ as opposed to an admission of ‘misconduct.’” The Third Circuit found the allegations did not “necessarily suggest” that defendants were “engaged in a systematic fraud.” The court determined that it was “[m]ore plausible . . . that the [i]ndividual [d]efendants were just bad leaders.”

The Third Circuit found plaintiffs’ other allegations equally insufficient to plead scienter. First, the court held that the “size and scope” of the company’s financial restatement did not support a strong inference of scienter because plaintiffs failed to “plead particularized allegations of fraudulent intent.” The court observed that “any inference of scienter was circumscribed by the fact that the accounting errors were spread across myriad accounting categories.” The court also noted that for each income category, the amount of the overstatement ranged from 9.97% to 32.12%. The Third Circuit explained that “[c]ourts that have looked to the magnitude of a financial restatement to strengthen the inference of scienter have been faced with restatements significantly more drastic” than those at issue here.

Second, the court found the allegation that the individual defendants certified the accuracy of the company’s SEC filings did not “add to the scienter puzzle in the absence of any allegation that [any] defendant knew he was signing a false SEC filing or recklessly disregarded inaccuracies contained” in that filing. Third, the court placed no weight on allegations that the individual defendants “each resigned in close proximity to the public release of bad news.” The court explained that “[c]hanges in leadership are only to be expected when leadership fails.” The court stated that in order “for corporate departures to strengthen an inference of scienter, there must be particularized allegations connecting the departures to the alleged fraud.”

Finally, the Third Circuit determined that the alleged insider trading activity did not support a strong inference of scienter because the individual defendants did not sell their holdings when the stock was trading at its peak. Moreover, plaintiffs alleged that only two of the five individual defendants engaged in insider trading. Although these two individual defendants allegedly sold a sizable percentage of their holdings, the court explained that “even large percentages of holdings sold at first blush appearing suspicious are not sufficient to infer scienter when other factors, such as the timing of the relevant sales, weigh against that inference.” The court found that the lengthy class period also mitigated any inference of scienter based on alleged insider trading because “it is not unusual for insiders to trade at some point during their tenure with a company.”