Ninth Circuit Applies Dual Part Test for Pleading Scienter, Implies Tellabs Standard is Less Strict Than Previous Standard

The Ninth Circuit issued its first analysis of Tellabs in Zucco Partners, LLC v. Digimarc Corporations, 2009 WL 57081 (9th Cir. Jan. 12, 2009).

The case was dismissed based primarily on the confidential witnesses' lack of personal knowledge but the interesting part was that the Ninth Circuit seemed to imply that the new Tellabs standard is less strict than the Court's previous standard (or, at least confirmed that Tellabs didn't raise the standard).

They applied a dual part test for pleading scienter: first, a segmented evaluation of each allegation, then a "holistic" evaluation under Tellabs.

Examples of the Court's perspective on the new Tellabs standard compared to the Ninth Circuit's previous standard:

"Tellabs did not materially alter the particularity requirements for scienter claims established in the court's previous decisions, but instead only added an additional "holistic" component to those requirements."

and

"The plaintiffs in this case assume that compiling a large quantity of otherwise questionable allegations will create a strong inference of scienter through the complaint's emergent properties. Although Tellabs instructs us to view such compilations holistically, even such a comprehensive perspective of Zucco's complaint cannot transform a series of inadequate allegations into a viable inference of scienter."

In Zucco Partners, LLC v. Digimarc Corporations, 2009 WL 57081 (9th Cir. Jan. 12, 2009) the court affirmed the district court’s ruling and dismissed, with prejudice, plaintiffs’ complaint for failure to allege scienter with the requisite particularity under the PSLRA’s heightened pleading standard. The 9th Circuit held that the confidential witnesses’ testimony introduced to establish scienter was not described with sufficient particularity to establish personal knowledge.

Zucco addressed the impact that Tellabs had on the Ninth Circuit’s standard for the pleading a strong inference of scienter and the level of particularity that will suffice to establish confidential witness’ reliability and personal knowledge.

The Plaintiff alleged that defendants incorrectly capitalized expenses in order to manipulate the company’s bottom-line. The improper capitalization, among other questionable accounting practices, resulted in a restatement of the company’s financial statements. The district court dismissed the Second Amended Complaint with prejudice and the circuit court affirmed.

Interpreting Tellabs, the Court conducted a dual inquiry: first, determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter; and second, if no individual allegations are sufficient, conduct a “holistic” review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.

The Second Amended Complaint (SAC) relied on several types of factual allegations to plead the requisite intentional or deliberately reckless conduct, including (1) statements of six confidential witnesses, (2) Digimarc’s April 5, 2005 restatement of earnings, (3) the resignations of Ranjit, two members of the accounting department, and the corporation’s auditing firm during the class period, (4) statements made in filing the corporation’s Sarbanes-Oxley certifications, (5) the compensation packages of the individual defendants, (6) the stock sales of the individual defendants occurring during the class period, and (7) a private placement by the corporation during the class period. We address each of these allegations in turn, and then, as Tellabs instructs, consider the allegations collectively to determine whether the complaint as a whole raises a strong inference of scienter.

Without “other factual information,” such as documentary evidence, the court’s analysis of the CW’s statements hinged on the particularity provided to support the probability that a person in the position of the CWs would possess the information alleged.

“We conclude that the SAC fails to allege with particularity facts supporting its assumptions that the confidential witnesses were in a position to be personally knowledgeable of the information.”

As a whole, the SAC’s plethora of confidential witness statements failed to create an “inference of scienter more cogent or compelling than an alternative innocent inference.”

“Although the allegations in this case are legion, even together they are not as cogent or compelling as a plausible alternative inference-namely, that although Digimarc was experiencing problems controlling and updating its accounting and inventory tracking practices, there was no specific intent to fabricate the accounting misstatements at issue here. Instead, the facts alleged by Zucco point towards the conclusion that Digimarc was simply overwhelmed with integrating a large new division into its existing business.”

The allegations of scienter in the SAC, though voluminous, were not pled with the particularity required to survive a Federal Rule of Civil Procedure 12(b)(6) dismissal under the standards enumerated in Federal Rule of Civil Procedure 9(b) and the PSLRA. Instead, the plaintiffs in the case assumed that compiling a large quantity of otherwise questionable allegations would create a strong inference of scienter through the complaint’s emergent properties. Although Tellabs instructed us to view such compilations holistically, even such a comprehensive perspective of Zucco’s complaint cannot transform a series of inadequate allegations into a viable inference of scienter. 2009 WL 57081 (9th Cir. Jan. 12, 2009)

Thus, the Court affirmed the district court’s dismissal of the Second Amended Complaint.