In In re VeriFone Holdings, Inc. Securities Litigation, 2012 WL 6634351 (9th Cir. Dec. 21, 2012), the United States Court of Appeals for the Ninth Circuit reversed the dismissal of a securities fraud class action. Invoking the old adage that “the sum is greater than the parts,” the Court held that plaintiffs’ allegations of defendants’ scienter gave rise to a sufficiently strong inference of deliberate recklessness when considered “holistically.” In so holding, the panel seems to suggest that the long-standing “dual analysis” approach applied by courts in the Ninth Circuit when analyzing allegations of scienter under the heightened pleading requirements imposed by the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4 (“Reform Act”), should be applied less rigorously in light of the United States Supreme Court’s decision in Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1324 (2011) [blog article here].
VeriFone designs, markets and services transaction automation systems that enable secure electronic payments among consumers, merchants and financial institutions. In November 2006, VeriFone acquired Lipman Electronic Engineering Ltd. (“Lipman”) and began integrating the two companies. VeriFone touted the merger as likely to improve its financial condition.
In the three quarters following the merger, VeriFone reported relatively high gross margins, allowing it to claim the merger was an immediate success. It was undisputed, however, that VeriFone’s reports were false. In three consecutive quarters, VeriFone’s preliminary internal reports showed it had fallen short of its earnings and gross margins projections. VeriFone’s CEO and CFO allegedly supervised accounting staff as they made baseless multimillion-dollar adjustments that brought reported results in line with expectations. Each time, the CEO and CFO allegedly accepted the adjustments without question, representing publicly that the Lipman merger was driving VeriFone’s success even as the adjustments grew in size and negatively impacted key metrics. Eventually, VeriFone was required to restate its financial statements. In response, VeriFone’s stock price fell.
Investors filed suit alleging that VeriFone, the CEO and the CFO violated Sections 10(b), 20(a) and 20A of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78t(a) and 78t-1, and Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5. To state a securities fraud claim under Section 10(b) and Rule 10b-5, plaintiffs are required by the Reform Act and prevailing Supreme Court authority to plead particularized facts giving rise to a strong inference that defendants acted with scienter, i.e., a mental state embracing intentional fraud or deliberate recklessness. A complaint adequately pleads scienter under the Reform Act “only if a reasonable person would deem the inference of scienter” from the complaint’s allegations “cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” Tellabs Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007) [blog article here].
Here, plaintiffs alleged that the CEO and CFO were aware through internal reports of the falsity of positive statements about the merger and VeriFone’s financial results. They characterized the alleged misconduct of the CEO and CFO as either intentionally directing a subordinate to make false adjustments or being deliberately reckless in failing to question and account for unsupported accounting entries. Defendants moved to dismiss, arguing that plaintiffs’ allegations of scienter gave rise only to an inference that VeriFone and its management were “victim[s] of a difficult acquisition complicated by incompatible [accounting] systems.”
The United States District Court for the Northern District of California agreed, holding that plaintiffs’ allegations failed to give rise to a strong inference of scienter. In reaching its decision, the district court followed the longstanding practice of courts in the Ninth Circuit of applying a two-step “dual analysis” to allegations of scienter. See, e.g., In Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981, 992 (9th Cir.2009) [blog article here]. The district court first analyzed the individual allegations of scienter separately by topic. After determining that the allegations associated with each grouping were insufficient on their own to give rise to a strong inference of defendants’ scienter, the district court then considered the allegations “holistically.” The district court concluded summarily that “[t]here are many allegations in this case, but they fare no better when read in combination than when read independently.” Plaintiffs appealed.
The Ninth Circuit reached a different conclusion. It held that even though when viewed in isolation any one allegation may not give rise to a strong inference of scienter, the court must consider the allegations “holistically” as the Supreme Court directed in Matrixx. Other than the general directive to “review all the allegations holistically,” however, the Supreme Court in Matrixx did not prescribe a particular method of analysis a court must undertake. Although Matrixx did not preclude a “dual analysis” approach, the Ninth Circuit observed that the risk from this long-standing approach is “that a piecemeal analysis will obscure a holistic view” and that “reviewing each allegation before reviewing them holistically ‘risks losing the forest for the trees’ and that such a method is unnecessarily inefficient.”
To avoid these “potential pitfalls,” the Ninth Circuit decided to analyze the allegations of scienter primarily through a “holistic review” to determine whether the they combined to create a sufficiently strong inference of intentional conduct or deliberate recklessness. The Court noted that in three consecutive quarters, the CEO and CFO allegedly received accurate reports at quarter-end indicating that VeriFone had not met its financial targets. Each time, they allegedly addressed these “unacceptable” results by providing VeriFone’s supply chain controller with accounting adjustments necessary to conform results to expectations — without allegedly asking the controller whether “whether the adjustments were based in fact or even why changes of that magnitude were necessary in the first place.” Thus, the Ninth Circuit held, “the logical inference” from these allegations was that VeriFone’s priority was meeting projections even at the expense of accuracy. The Ninth Circuit held that in the face of such repeated adjustments, the management “cannot simply close its eyes with a sigh of relief.” When viewed “holistically,” the Ninth Circuit concluded, plaintiffs’ allegations gave rise to a strong inference of scienter.
The Court’s decision could be viewed as relaxing the Ninth Circuit’s analytically rigorous two-step “dual analysis” approach to scienter. However, the Court was quick to confirm that the district court did not err as a matter of law by engaging in that approach. Rather, the panel held, district court’s error lied in its what it considered to be undue discounting of certain of the allegations and inferences to be drawn therefrom. In short, this decision turns less on differences in the analytical approach, and more on the simple fact that the Ninth Circuit panel drew inferences of scienter different from those drawn by the district court based upon the same allegations in the complaint.