“In the end, plaintiffs’ allegations do not raise a strong inference that Ernst & Young acted with scienter in affirming Accredo’s allegedly fraudulent accounting. Conclusory allegations about what Ernst & Young must or should have known while auditing Accredo do not amount to specific allegations that show material misstatements or omissions committed with recklessness. Plaintiffs thus fails to adequately allege all of the elements of their Section 10(b) and Rule 10b-5 claim.” So the Sixth Circuit concluded in its recent decision, Louisiana School Employees’ Retirement Sys. v. Ernst & Young, LLP (Case No.08-6194, Sept. 22, 2010) (PDF).
In an important ruling applying the U.S. Supreme Court’s recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) (PDF), the Sixth Circuit explores the threshold showings necessary to demonstrate scienter in the context of a securities fraud class action. In Ernst & Young, the plaintiffs filed against Ernst & Young a class action on behalf of all persons and entities who purchased the publicly traded securities of the pharmaceutical distribution company Accredo Health, Inc. For the time period relevant to the class action, Ernst & Young had served as Accredo’s outside accountant, and the plaintiffs alleged that Ernst & Young conspired with Accredo to hide Accredo’s accounts receivable problems from investors — problems, which when later revealed, caused Accredo’s stock price to plummet 44% in a single day. The district court dismissed the action under Rules 9(b) and 12(b)(6) of the Federal Rules of Civil Procedure, finding, among other things, that the complaint did not, as required by the Private Securities Litigation Reform Act of 1995 (“PSLRA”), plead with sufficient particularity facts giving rise to a strong inference of scienter.
Writing for a unanimous panel that included Judges Boggs and Moore, Judge Gibson of the Eighth Circuit (sitting by designation) emphasized that the Tellabs standard governed the inquiry, though he also confirmed the continuing vitality of the Sixth Circuit’s longstanding holding that liability can be premised on reckless behavior. Applying these standards, the Court found that the complaint fell well short and that dismissal was warranted. Specifically, the Court rejected the argument that scienter was established even where the plaintiffs could show that Ernst & Young was in possession of certain data: “even if Ernst & Young should have included the appropriate data in its audit, its failure to do so does not create an inference that it acted with the requisite scienter.” Likewise, the Court rejected the assertion that the so-called “red flags” alleged by the plaintiffs — including the refusal of an investment banking firm to consummate a purchase — were sufficient to create an inference of scienter “because plaintiffs’ red flags rest on conclusory allegations and are devoid of facts.” Refusing to consider the magnitude of the $58.8 million error in its determination of scienter, the Sixth Circuit confirmed the vitality of its earlier ruling in Fidel v. Farley, 392 F.3d 220 (6th Cir. 2004), where the Court “decline[d] to follow the cases that hold that the magnitude of the financial fraud contributes to an inference of scienter on the part of the defendant.” Finally, the Sixth Circuit also rejected the contention that communications internal to Ernst & Young showing awareness of “‘a problem'” with Accredo’s accounting created an inference of scienter because “[a] statement such as ‘there was a problem’ does not tell us whether Ernst & Young fraudulently refused to see the obvious.”
The Sixth Circuit thus continues its trend of insisting on specific, material factual allegations for a securities fraud complaint to survive dismissal.