Securities Class Action Complaint Properly Dismissed for Failure to Meet Pleading Requirements Under Private Securities Litigation Reform Act (PSLRA) and for Failure to Adequately Allege Loss Causation Fourth Circuit Holds
Plaintiffs filed a putative securities class action against Cree, Inc., a high-technology business in Durham, North Carolina, for violations of Section 10(b) of the Securities Exchange Act of 1924 and Rule 10b-5 alleging it made misleading statements about its business transactions and that these misstatements were discovered when a former officer sued the company. Teachers’ Retirement Sys. of La. v. Hunter, 477 F.3d 162, 167 (4th Cir. February 20, 2007). Defense attorneys moved to dismiss the class action under Rule 12(b)(6) on the ground that the allegations in the class action complaint failed to satisfy the heightened pleadings requirements imposed by the Private Securities Litigation Reform Act of 1995 (PSLRA), id. The district court dismissed the class action, holding that “the complaint failed to allege facts sufficient to support the plaintiffs’ claims that Cree’s statements were misleading” and that “plaintiffs did not sufficiently allege that the statements were made with the requisite scienter or that plaintiffs’ losses were caused by the misrepresentations and omissions of which they complained.” Id. (italics in original). The Fourth Circuit affirmed, “concluding that plaintiffs are complaining only about market risks, not particularized securities fraud.” Id., at 168.
In June 2003, Cree’s co-founder Eric Hunter filed suit against Cree and various officers and directors, including his brother and co-founder F. Neal Hunter, for violations of state and federal securities laws, defamation and intentional infliction of emotional distress; the complaint additionally sought “a preliminary injunction against Cree and Neal Hunter to prevent alleged personal harassment that appeared to have attended an ongoing family fight.” Hunter, at 168. Eric had served as Cree’s CEO from 1987 to 1994, and news of his lawsuit caused Cree’s stock price to drop from $22.21 to $18.10 in a single day. Id. Eric’s lawsuit was resolved only two months later, but “the allegations in his complaint quickly spawned numerous class actions by purchasers of Cree stock who alleged securities fraud during a period beginning on August 12, 1999, when Cree filed an annual report on SEC Form 10-K, and ending on June 13, 2003, the day after Eric Hunter filed his suit, purportedly revealing the truth of Cree’s fraud during the previous years.” Id. Eventually the cases were consolidated in the Middle District of North Carolina, and the court named Teachers’ Retirement System of Louisiana as lead plaintiff. The first amended class action complaint alleged violations of § 10(b) and Rule 10b-5 (prohibiting false or misleading statements), § 20(a) (control person liability), § 18 (personal liability for making misleading statements), and Sarbanes-Oxley Act § 304 (reimbursement of accounting restatement costs due to misconduct). Id., at 168-69. The specific allegations of the complaint are set forth at page 169.
The Fourth Circuit summarized the district court order granting defendants’ Rule 12(b)(6) motion as follows: “The court concluded first that ‘plaintiffs adequately identif[ied] the statements [of Cree] they believe[d] to be false and the reasons why they believe[d] them to be false, but fail[ed] to state with particularity facts supporting a strong inference of fraud.’ Second, the district court concluded that plaintiffs did not adequately plead that the defendants acted with the requisite scienter because the complaint neither identified misleading statements or omissions nor alleged sufficient circumstantial evidence of scienter. Finally, the court found that ‘plaintiffs … failed to demonstrate a direct relationship between their losses and the alleged misrepresentations and have failed, therefore, to establish the required element of loss causation.’ [¶] Having dismissed the first count alleging a claim under § 10(b) and Rule 10b-5, the court also dismissed plaintiffs’ claims under §§ 20(a) and 20A . . . because these claims depended upon the liability alleged in the first count. Similarly, the court dismissed plaintiffs’ claim pursuant to § 18 . . . because plaintiffs failed to plead facts showing that Cree made false statements. Finally, the court dismissed plaintiffs’ claim under § 304 . . . because plaintiffs did not allege that Cree was required to issue any restatement of its financial reports.” Hunter, at 169-70.
The Circuit Court began its analysis with the purpose behind the PSLRA, noting that even though FRCP Rule 9(b) mandates a “heightened pleading standard in fraud cases,” it failed to prevent abusive securities fraud claims because it was applied and interpreted inconsistently. Hunter, at 171. The PSLRA was enacted to combat the “‘abusive practices committed in private securities litigation include … the routine filing of lawsuits against issuers of securities and others whenever there is a significant change in an issuer’s stock price, without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action.’” Id. (citation omitted). As the Fourth Circuit emphasized, the PSLRA requires that in order to plead a material misrepresentation or omission in violation of § 10(b) or Rule 10b-5 and the necessary scienter for such a misrepresentation or omission, “the plaintiff must plead facts”; specifically, “a complaint must include ‘each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed’” and, in order to adequately plead scienter, “the plaintiff must, ‘with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.’” Id., at 172 (citations omitted) (italics added by court).
The Fourth Circuit then embarked on a detailed analysis of the numerous claims asserted in the lengthy complaint, summarizing its conclusions at pages 174 and 175 as follows:
The complaint at issue here adequately specifies the statements alleged to have been misleading and the reasons why they were misleading. Indeed, it identifies no less than 48 statements publicly made over nearly four years regarding Cree’s transactions. But after each misleading statement, the complaint simply repeats a formulaic set of allegations why, upon “information and belief,” the statement was misleading. The facts alleged in support of these formulaic reasons fail to support a reasonable belief that the statements were in fact misleading, and therefore we conclude that the complaint fails to satisfy the PSLRA and Rule 12(b)(6)’s requirement that the complaint shall state with particularity sufficient facts on which a reasonable belief can be formed. This becomes clear when we consider the facts supporting the allegations about each transaction.
As to each allegedly misleading statement or omission, the Circuit Court held that the class action complaint failed to satisfy PSLRA’s heightened pleadings requirements, Hunter, at 175-83, and further failed to adequately plead under PSLRA the scienter necessary to support a securities fraud claim, id., at 183-85.
The Court of Appeals also considered the district court’s conclusion that the class action complaint failed to adequately allege loss causation. Hunter, 185. In the Fourth Circuit, “a plaintiff must allege and prove that the defendant’s misrepresentations proximately caused the plaintiff’s economic loss-in this case, the diminution of the value of their shares.” Id. (citation omitted). Based on the PSLRA and cases interpreting that statute, see id., at 185-86, the Circuit Court held that “a plaintiff purporting to allege a securities fraud claim must not only prove loss causation–the material misrepresentations or omissions alleged actually caused the loss for which the plaintiff seeks damages–but he must also plead it with sufficient specificity to enable the court to evaluate whether the necessary causal link exists.” Id., at 186 (citation omitted). The Fourth Circuit concluded that each of plaintiff’s damage claims failed to adequately allege loss causation. See id., at 186-88. It therefore affirmed the district court’s order granting defendants’ motion to dismiss.
NOTE: The Fourth Circuit noted, “As an epilogue, it appears that the market reached the same conclusion regarding plaintiffs’ allegations. The record shows that although Cree’s share price dropped from $22.21 to $18.10 the day after Eric Hunter filed his complaint on June 12, 2003, and then dropped to a low of $11.84 in August 2003, the price recovered quickly, trading above $18.00 by the end of 2003, and at $22.00 or higher for most of 2004.” Hunter, at 189.