In Zucco Partners, LLC v. Digimarc Corp., 2009 WL 311070 (9th Cir. Feb. 10, 2009), the United States Court of Appeals for the Ninth Circuit reaffirmed that when pleading a claim for securities fraud under the Private Securities Litigation Reform Act of 1995 (the “Reform Act”), plaintiffs are bound by prior Ninth Circuit authority that requires them to plead particularized facts giving rise to a strong inference that defendants knew, or were deliberately reckless in not knowing, that their statements were false when made. The viability of the Ninth Circuit’s particularity requirement has been the subject of much debate since the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). In Tellabs, the Court held that, in order to survive dismissal, plaintiffs must plead an inference of scienter that is “cogent and at least as compelling as any opposing inference of nonfraudulent intent.” [See blog article on Tellabs.] In South Ferry LP, No. 2 v. Killinger, 542 F.3d 776 (9th Cir. 2008), a panel of the Ninth Circuit suggested in dicta that Tellabs’ holistic analysis may have superseded the Ninth Circuit’s particularity requirement. [See blog article on South Ferry.] That same term, however, two other panels confirmed that the earlier cases governing scienter were controlling. See Metzler Inv. GMBH v. Corinthian Colleges, Inc., 540 F.3d 1049 (9th Cir. 2008) [blog article on Metzler]; Glazer Capital Management, LP v. Magistri, 549 F.3d 736 (9th Cir. 2008) [blog article on Glazer]. Now, with its most thorough decision to date on this issue, the Zucco court appears to have definitively resolved this question in favor of particularity, holding clearly that “Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions.”
Zucco arose out of an announcement by the defendant corporation, Digimarc Corp. (“Digimarc”), that it was restating its financials to properly account for expenses associated with its internal software development. Following this announcement, plaintiffs brought suit for securities fraud, alleging that Digimarc and its former chief executive and chief financial officers knew, or were reckless in not knowing, that the company had improperly capitalized software development costs that should have been treated as operating expenses. The district court granted defendants’ motions to dismiss with prejudice on the grounds that plaintiffs had failed to plead scienter with particularity. Plaintiffs appealed, arguing that under Tellabs the Reform Act imposes no particularity requirement. The Ninth Circuit disagreed, explaining “[b]ecause we hold that the Court’s decision in Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions, but instead only adds an additional ‘holistic’ component to those requirements, we affirm the district court’s dismissal of the complaint with prejudice and hold that Zucco has failed to adequately plead a strong inference of scienter.”
The court in Zucco then went on to set forth a two pronged test for determining whether the inference of scienter pled by plaintiffs is sufficient to survive a motion to dismiss. The court held following Tellabs, we will conduct a dual inquiry: first, we will determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will 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 Ninth Circuit further explained that the first prong of this test — which the court dubbed “segmented” — itself involved a dual inquiry, considering first whether the allegation of scienter was particularized, and second, whether the allegation was at least as strong as any opposite, competing inference.
Applying this test to allegations from certain “confidential witnesses,” the court analyzed each allegation in turn and then held that the majority of the allegations failed to contribute to a strong inference of scienter because the complaint did not “provide the requisite particularity to establish that certain statements of these confidential witnesses are based on the witness’ personal knowledge.” The court then considered the sole remaining confidential witness allegation, which it found was both pled with adequate particularity and was sufficient, standing alone, to demonstrate scienter. This allegation, however, the court rejected because it was contradicted by other allegations in the complaint.
After considering each allegation individually, the court then went on to analyze the complaint as a whole. Significantly, when engaging in this holistic analysis, the court did not consider allegations that, on segmented analysis, it deemed lacking in particularity or contradicted by the other allegations in the complaint. Instead, it focused its analysis solely on allegations like Digimarc’s public disclosures which, though insufficient individually to sustain a strong inference of scienter, were pled with adequate particularity. Even when viewed together, however, plaintiffs found these disclosures were insufficient to support the required strong inference of scienter.
In short, then, Zucco appears to resolve any ambiguity regarding Tellabs’ effect on existing Ninth Circuit case law. Following this decision, it appears well settled that plaintiffs who seek to plead a claim for securities fraud first must comply with existing Ninth Circuit precedent requiring that scienter be pled with particularity. It is only after plaintiffs meet this threshold burden of pleading particularized facts that the courts will move on to holistic review and weigh the inference supported by plaintiffs’ particularized allegations against any competing, non culpable, inference that they may support.