In Acticon AG v. China North East Petroleum Holdings Ltd., No. 15-172, 2015 U.S. App. LEXIS 15187 (2d Cir. N.Y. Aug. 28, 2015), the Second Circuit provided guidance on what allegations may be sufficient to plead scienter in a Section 10(b) claim.
China North East Petroleum was an oil exploration and production company based in the People’s Republic of China. Wang Hung Jun, the company’s chief executive officer, owned approximately one-third of the company’s outstanding stock. Mr. Jun’s mother and brother-in-law sat on the company’s board of directors. Between 2008 and 2010, the company and its executive management allegedly misled investors by inflating oil reserve estimates, accounting improperly for warrants, and transferring corporate funds to personal accounts. When the truth emerged in 2010, investors discovered that the company’s income had been inflated by almost 100 percent during certain reporting periods. Restatements followed along with revelations of material weaknesses over internal controls and abrupt resignations from senior management. China North’s stock declined by over 50 percent in connection with the company’s revelations, falling to $4.42 per share from $9.37 per share over the course of several months. The plaintiffs filed suit in the Southern District of New York shortly thereafter.
In January 2015, the district court dismissed the plaintiff’s claims against China North, Wang, and the remaining defendants. According to the district court, the plaintiff’s allegations concerning the company’s internal controls and illicit transfers of funds did not give rise to the requisite strong inference of scienter.
On August 28, 2015, the Second Circuit issued a summary order vacating the dismissal of the claims against China North and Wang and affirming the remainder of the decision. The court found that the Plaintiff had adequately pled Wang’s “motive and opportunity to commit fraud” by alleging that, “[a]s China North’s former CEO, Wang signed all of the relevant SEC filings attesting to the company’s internal controls, while allegedly simultaneously looting China North’s treasury and engaging in unauthorized transfers of company funds.” Further, because Wang was CEO, his scienter could be imputed to China North.
In affirming the dismissal of the claims against other defendants, the circuit noted that while defendant Ju Guizhi may have been involved in the transfers, the plaintiff failed to allege that she “reviewed or signed any of the allegedly false SEC filings, and thus [there was] no basis to conclude that she made a material misrepresentation.” Similarly, the Second Circuit held that the plaintiff had not adequately alleged scienter for the remaining defendants based on failure to identify defects in China North’s internal controls or GAAP violations, observing that generally “failure ‘to identify problems with [a] defendant-company’s internal controls . . . does not constitute reckless conduct sufficient for 10(b) liability.’”
The case has been remanded to the district court for further proceedings.