On May 27, the Second Circuit issued a decision affirming the dismissal of a putative federal securities class action for failure to plead corporate scienter.[1] In so doing, the Court dramatically increased the already high burden a plaintiff must meet under Dynex to adequately allege a strong inference of collective corporate scienter.

This decision will be a useful tool for corporate defendants moving to dismiss federal securities complaints brought under Section 10(b), particularly when the allegations are based on statements attributed to confidential employees who are not alleged to have communicated directly with the senior executives to whom allegedly false statements were attributed.

Background

Plaintiff Ronald Jackson asserted claims against Kimberly-Clark Corporation (“Kimberly-Clark”), Avanos Medical, Inc. (“Avanos,” together with Kimberly-Clark, the “Corporate Defendants”), and four senior executives of the Corporate Defendants (collectively, the “Individual Defendants”), for alleged violations of Sections 10(b) and 20(a) of the Exchange Act. Jackson’s claims arose out of statements by the Corporate Defendants relating to the quality and infection-prevention capabilities of the MicroCool Breathable High Performance Surgical Gown (the “MicroCool gown”), which is worn by healthcare providers when treating patients with highly infectious diseases to prevent the transfer of microorganisms, bodily fluids, and particulate matter.

In March 2018, the district court dismissed Jackson’s complaint in its entirety, finding that Jackson had failed to adequately allege scienter. Jackson subsequently moved for leave to amend his complaint. The proposed complaint added new allegations based on a recent California consumer fraud case, including testimony from three employees that the MicroCool gown’s compliance problems were well known at the companies.

The district court denied Jackson’s motion as futile, reasoning that the new allegations required the court to engage in several layers of speculation as to what the Individual Defendants actually knew.

The Second Circuit’s decision

In his appeal, Jackson raised two arguments as to why an inference of collective corporate scienter could be drawn. First, he claimed that knowledge on the part of three employees who testified in the California action could be imputed to the Corporate Defendants. Second, he argued that the MicroCool gown was a key product with which the companies’ senior management would have been expected to be familiar, such that scienter could be inferred. The Second Circuit rejected both arguments. 

The Court first reiterated the standard set forth in Dynex,[2] which held that, where a defendant is a corporation, a plaintiff must plead facts that give rise to “a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter.” In support of his argument that scienter could properly be imputed to the Corporate Defendants, Jackson cited testimony that the three employees took steps to raise concerns about the MicroCool gown’s testing failures, including holding meetings to discuss the failures, preparing documents that were “presented to senior management,” and the assertion from one employee that one senior executive “was informed” of noncompliance issues.

The Second Circuit rejected this, holding that “general allegations of warnings made to unidentified senior executives” are “not sufficiently particularized to raise a strong inference of scienter against any individual, much less one whose knowledge may be imputed to the Corporate Defendants.” The Court also found that the proposed amended complaint provided “no connective tissue” between those unidentified senior executives and the alleged misstatements, leaving the panel to “only guess what role those employees played in crafting or reviewing the challenged statements and whether it would otherwise be fair to charge the Corporate Defendants with their knowledge.”

As for Jackson’s second argument—that the MicroCool gown was of such core importance to the Corporate Defendants that their senior officers must have known that the challenged statements were false—the Court again rejected it, finding that Jackson’s “naked assertion” that the MicroCool gown was a “key product” for the Corporate Defendants was “plainly insufficient to raise a strong inference of collective corporate scienter.” The Court stressed that this allegation was not one of the “exceedingly rare instances” of a statement so “dramatic” that collective corporate scienter could be inferred.

Takeaways from the Jackson decision

The Jackson decision will be a valuable tool for defendants arguing that plaintiffs have failed to adequately plead corporate scienter. Securities class action plaintiffs frequently rely on allegations from low- and mid-level employees of the corporate defendant, and in particular from confidential witnesses, to plead corporate scienter. Going forward, the Second Circuit has made clear how difficult it is for plaintiffs to impute scienter to corporate defendants using these sorts of allegations. 

To survive a motion to dismiss, plaintiffs will now have to plead particularized facts alleging that an employee’s knowledge was shared with a senior executive who made or was otherwise involved in the dissemination of the challenged statement. In addition, plaintiffs will also have to show the non-speculative “connective tissue” between those senior employees and the challenged statement such that it would be fair to charge the corporation with those senior employees’ knowledge. An example of an allegation that could be sufficient, as suggested by the Second Circuit in Jackson, would be a particularized allegation that specific, identified senior officers received warnings from employees and ignored them.

As for what sort of allegation would qualify as a statement so “dramatic” that corporate scienter could be inferred, the Court did not offer any concrete examples but stressed that such examples are “exceedingly rare.” It is clear, however, that a mere “naked assertion,” without particularized facts, is insufficient.

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[1] Jackson v. Abernathy, No. 19-1300-cv, slip op. (2d Cir. May 27, 2020).

[2] Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 195 (2d Cir. 2008).