The Second Circuit reversed the dismissal of securities fraud violations under Section 10(b) of the Securities Exchange Act of 1934 in Indiana Public Retirement System v. SAIC, Inc., No. 14-4140-cv, 2016 U.S. App. LEXIS 5748 (2d Cir. N.Y. Mar. 29, 2016). In its opinion, the court clarified the pleading requirements for securities fraud claims premised upon violations of Item 303 of Regulation S-K. The court also addressed the standards applicable to GAAP violations under Financial Accounting Standard No. 5 relating to disclosure of loss contingencies.
The plaintiffs sued SAIC and certain of its executive officers for materially misstating the company’s liability to the City of New York for employee fraud in an illegal kickback scheme. The plaintiffs alleged, among other things, that SAIC failed to disclose appropriate loss contingencies in accordance with GAAP as well as known trends or uncertainties likely to have a negative impact on the company’s financial condition pursuant to Item 303.
The district court initially granted the defendants’ motions to dismiss, with the exception of the plaintiffs’ claims concerning the violations of GAAP and Item 303. The defendants moved for reconsideration and won. The plaintiffs then moved for relief from the district court’s order and sought leave to file a proposed amended complaint. The district court denied the motion.
On appeal, the Second Circuit vacated the district court’s decision and remanded for further proceedings. The Second Circuit held that the district court applied the wrong standard to the plaintiffs’ GAAP allegations. Pursuant to Financial Accounting Standard No. 5, issuers must disclose a loss contingency when a loss is a “‘reasonable possibility,’ meaning that it is ‘more than remote but less than likely.’” SAIC at *17. Contrary to the district court’s holding, the “reasonable possibility” standard is only replaced by a “probability” standard when a potential claimant has not “manifest[ed]” an “awareness of a possible claim.” Id. The plaintiffs’ allegations in the proposed amended complaint demonstrated that the City of New York had already evinced its intent to file a claim against SAIC. Accordingly, the Second Circuit applied the “reasonable possibility” standard and held that the plaintiffs adequately alleged that SAIC failed to properly disclose a loss contingency in its public filings.
With regard to liability under Item 303, the Second Circuit confirmed that disclosure of trends and uncertainties are required only when the issuer has “actual knowledge of the relevant trend or uncertainty.” Id. at *22. “It is not enough that it should have known of the existing trend, event, or uncertainty.” Id. With this in mind, the Second Circuit held that the plaintiffs’ proposed amended complaint “support[ed] a strong inference that SAIC actually knew” of the ongoing kickback scheme and that the Company could be implicated and held liable. Id. at *22–23. One fact the Second Circuit relied upon in rendering its decision was the importance of the project at issue to the Company and the likelihood that it would generate significant additional revenue. Id. The Second Circuit also relied on this fact in holding that the disclosures were not “‘so obviously unimportant’ either quantitatively or qualitatively that they could not be material.” Id. at *24–25.
Finally, the Second Circuit addressed the plaintiffs’ scienter allegations. The defendants argued that it was “simply implausible” that they “deliberately conceal[ed] the ‘misconduct of rogue employees for just over two months’” because such a “brief concealment” would have yielded little if any benefit. Id. at *26–27. The Second Circuit rejected the defendants’ argument as “confus[ing] expected with realized benefits”—if SAIC believed it had more time before being exposed, then “‘the benefits of concealment might [have] exceed[ed] the costs.’” Id. at *27 (quoting Makor Issues & Rights, Ltd. v. Tellabs Inc., 513F.3d 702, 710 (7th Cir. 2008)). This theory of scienter, according to the Second Circuit, was “hardly implausible.”