In posts in this space, and in my articles, I’ve criticized the idea that statements may be deemed immaterial or otherwise of little importance to reasonable investors merely because they are generic or stated at a particular level of generality.  Lots of really important statements are technically “generic,” I would say.  Consider fairness opinions!  Or representations that financial statements are in compliance with GAAP!

Well, joke’s on me because in New England Carpenters’ Guaranteed Annuity and Pension Funds v. DeCarlo, 2023 WL 5419147 (2d Cir. Aug. 23, 2023), the Second Circuit held that the general phrasing in a clean audit opinion may, in fact, render the statements immaterial to investors.  The court affirmed the dismissal of a securities fraud complaint on the ground that – even though the plaintiffs had shown the audit was shoddy and violated auditing standards (and the underlying financials were false) – the plaintiffs had not included specific allegations that the audit statements were material.

As the District Court concluded, the Complaint fails to allege any link between BDO’s misstatements in the 2013 Auditor Opinion and the material errors contained in AmTrust’s 2013 Form 10-K. The audit statements to which the Appellants point were so general in this case that a reasonable investor would not depend on them as a guarantee. Appellants’ claim that these statements were knowingly and verifiably false when made does not cure their generality, which is what prevents them from rising to the level of materiality required to form the basis for assessing a potential investment. We do not mean to suggest that audit opinions will always fail the materiality test because the statements they contain are too general for investors to rely on. Rather, in this case, as the District Court held, Appellants have failed “to allege any facts relevant to the way or ways in which BDO’s failure to supervise, review, document, and perform in good faith the 2013 audit would have been significant to a reasonable investor in making investment decisions.” We might have come to a different conclusion had such facts been alleged.

(citations and alterations omitted)

I … do not even know what to do with this.

First of all, audit opinion language is fairly standardized; in this case, the false statements were that the audit was conducted in accordance with PCAOB standards and provided a reasonable basis for the audit opinion.

If you assume that audits matter to investors, then it has to matter that an audit was not performed appropriately; what’s the point of even having an audit, then?  And as I keep beating this lonely drum, let’s imagine what would have happened if there was no audit opinion, or if there had been one that told the truth – that the audit was shoddy.  (According to the Second Circuit, those are exactly the counterfactuals we should be considering).  I think it’s fairly obvious that investors would have considered it significant if a publicly traded company suddenly couldn’t offer up audited financials.

Yet the Second Circuit, taking the whole “generalness” thing to the point of parody, held without further comment that audit opinions may not be material if sufficiently nonspecific – which is all of them, because they all say the same thing – and therefore materiality must be explained.

To some extent, the dispute below – and that the Second Circuit hints at – was not exactly about whether the opinion was material, but about whether the precise audit failures were in fact tied to the underlying false financials.  But, rather than really say that, the Second Circuit goes much farther, treating the generalized language of the opinion as a reason to doubt its materiality.

And, frankly, even if it turned out the underlying financials were completely accurate, I still don’t think it would make the audit opinion immaterial; the purpose of the opinion is to give investors confidence in the financials.  The financials don’t have to be discounted out of fear of inaccuracy, is what the audit opinion tells you. 

So, going forward, either every securities fraud complaint will have to include some standardized language about the importance of audit opinions – and these complaints are already well over 100-pages long, which judges complain about all the time – or somehow, each plaintiff will have to find some reason why this audit in specific was really important to investors in X company.  And also, every motion to dismiss will have to include that briefing.

In 1999, Chief Judge Young lamented the “Byzantine pleading code established in recent years by Congress and the courts for securities actions.”  In re Number Nine Visual Tech. Corp., 51 F. Supp. 2d 1 (D. Mass. 1999). Twenty four years later, I’d say code pleading is looking at securities fraud complaints and wondering how things got so technical.

I’ve previously blogged about difficulties that courts have when determining the scienter of a “corporation” in Section 10(b) cases.  The summary judgment decision Roofer’s Pension Fund v. Papa, 2023 WL 5287783 (D.N.J. Aug. 17, 2023), is another example of the genre.

There, the defendants were alleged to have concealed Perrigo’s collusion with other generic drug makers.  By the time the case got to summary judgment, however, the court concluded that the only individual defendants and named speakers had not acted with scienter.  The plaintiffs maintained that scienter could be shown against the corporate entity by virtue of the knowledge of two non-speaking executives, who were alleged to have been complicit in the collusive scheme.  The question, then, was the legal standard the court would use to determine corporate scienter.  I.e., would the non-speaking executives’ scienter be imputed to the corporate entity?

At that point, the court identified a purported difference among circuit approaches, which – the court lamented – was particularly difficult to examine in the summary judgment context because most of the prior decisions were reached on a motion to dismiss:

The narrow approach, applicable in the Fifth and Eleventh Circuits, requires a plaintiff to identify a corporate official responsible for the challenged statement who also possessed scienter…. Judge Walls rejected this narrow approach, finding it would allow corporations to escape “liability through tacit encouragement and willful ignorance,” and because it “fails to address instances where widespread corporate fraud cannot be connected to individual defendants at the pleading stage.”….

The intermediate approach taken by the Sixth Circuit looks to the state(s) of minds of certain employees to determine whether to impute scienter to the corporation. …Under this approach, courts may look to:

1. The individual agent who uttered or issued the misrepresentation;
2. Any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion therein or omission therefrom), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance;
3. Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance.

The broad approach, applicable in the Second and Seventh Circuits, allows a plaintiff to establish scienter against a corporation without specifically identifying an individual in a pleading. … Under this approach, scienter can be imputed to a corporation in two ways: (1) from an individual defendant, director, or officer who either made the challenged statement, or who was “involved in the dissemination of the fraud” even if not the speaker; or (2) from the statement itself in those “exceedingly rare instances” where the statement is “so dramatic that collective corporate scienter may be inferred.” …If a plaintiff seeks to impute scienter to a corporation from a person who was “not the actual speaker” of the challenged statement, the plaintiff must establish “connective tissue between those employees and the alleged misstatements.”…

To infer scienter from the statement itself, the statement must be “so dramatic” or extreme to permit an inference that knowledgeable corporate officials approved the statement. In Makor Issues & Rights, Ltd. v. Tellabs Inc., 513 F.3d 702 (7th Cir. 2008), the Seventh Circuit gave an example of such a statement:

        Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate                   scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the                    announcement was false.

…Setting aside these varying approaches, “at the summary judgment stage, ‘[t]o prove liability against a corporation, … a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation.’ ”

Plaintiffs seem to believe that Boothe’s and Wesolowski’s state of minds can be imputed to Perrigo, but they offer no explanation on how. They do not show any connection between Boothe’s and Wesolowski’s alleged misdeeds and their knowledge of the price-fixing scheme to the challenged statements at issue. Plaintiffs have left this Court clueless because they have not shown, for example, whether Boothe or Wesolowski furnished any information to Papa and Brown, or drafted, reviewed, or approved the challenged statements. … It is truly unfortunate that Plaintiffs have not adequately addressed this theory at this late stage of the case. Nonetheless, as an exercise of caution, and acutely aware that further delay will result, the Court will require additional briefing on the corporate scienter doctrine and the evidence (if any) Plaintiffs rely on to support its corporate scienter argument.

Now, first, the issue of procedural posture is something I highlighted in one of my earlier posts on the subject.  Because the question of corporate scienter comes up a lot in the motion to dismiss context, it’s often hard to tell from the rhetoric what courts are treating as the definition of corporate scienter – what does it mean, substantively, for a corporation to act with intent – versus what kind of facts are sufficient to show it, which, presumably, will vary to some extent on a motion to dismiss vs summary judgment (or trial).

Second, the court faults the plaintiffs for failing to show how these two particular executives may have been involved with any of the allegedly false statements.  And I agree with the court that under prevailing standards in all circuits, if you want to show that a non-speaking individual’s state of mind should be imputed to the corporation, you need to show some kind of connection that individual had to the allegedly false statement. 

My problem with the court’s analysis (and, to be fair, I think it’s taken from earlier decisions) is that it fails to recognize that all of these approaches are the same.  Or at the very least, we do not have enough information about them to determine where they differ.

Substantively, every single one of these approaches requires that there be someone in the corporation who was in some sense “responsible” for the false statement, and who acted with scienter.  The difference between the Second/Seventh Circuit and the others has to do with evidence.  Namely, the Second and Seventh Circuits have explicitly allowed for the possibility that under some circumstances, the plaintiff may be able to create an inference that there was such a person without in fact naming them.  I.e., if a dramatically false statement was approved by the board, you can infer that at least someone on the board knew the statement was false, because there’s no way that kind of information wouldn’t have made it to the board, even if you don’t know which board member(s) it was.

It’s the same substantive standard for defining what it means for a corporation to act intentionally as prevails in the other circuits – there was a human being who had scienter and was responsible for the statement – it’s just, the Second and Seventh Circuits have been explicit that the type of proof they require does not necessarily include naming the human.  Of course, since these were motions to dismiss, one might say you need a different proof at the summary judgment stage – but the facts you’re trying to prove remain the same.

Where the circuits might differ has to do with what it means to be “responsible” for a false statement.  Almost certainly, approval by a board level official counts.  Almost certainly, drafting by a high level official, but leaving their name off of it, counts.  But the circuits get very squirrely about what other kinds of internal actions would be sufficient, and whether the responsible person has to have a certain level of authority within the entity.  That’s a potential substantive difference as to what it means for a corporation to act with intent, but it’s not reflected in the court’s opinion or the quotes the court uses.