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October 24, 2017 Top Story

Ninth Circuit Applies Heightened Pleading for Securities Fraud

Supreme Court’s Omnicare holding extended to Section 10(b) and Rule 10b-5 claims.

Erin Louise Palmer

The U.S. Court of Appeals for the Ninth Circuit extended the U.S. Supreme Court's standard for pleading falsity of opinion statements to securities fraud cases under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5.

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In City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., the Ninth Circuit required the plaintiffs to allege both objective and subjective falsity, overruling its prior standard requiring the plaintiffs to allege only objective falsity. ABA Section of Litigation leaders believe the Ninth Circuit's opinion is consistent with the heightened pleading requirements under Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act (PSLRA).

The Supreme Court's Omnicare Decision

In Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund, the Supreme Court considered the pleading standard for opinion statements under Section 11 of the Securities Act of 1933, which provides purchasers of securities a right of action against the issuer where a registration statement contains false statements. After the federal government filed suit against Omnicare (a pharmacy services company) for allegedly receiving kickbacks from pharmaceutical manufacturers, pension funds that had purchased Omnicare stock sued Omnicare under Section 11 for Omnicare's statements that it was in compliance with federal and state laws.

The Supreme Court rejected the U.S. Court of Appeals for the Sixth Circuit's holding that the pension funds only had to allege that the statements were "objectively false." Instead, the Court held that a plaintiff who asserts material misrepresentation under Section 11 must allege that the statement was objectively false and that "the speaker did not hold the belief that she professed."

The Ninth Circuit's Align Technology Decision

Align Technology, Inc. designs, manufactures, and markets the Invisalign system for treating misaligned teeth. In April 2011, Align acquired Cadent Holdings, Inc., which designs, manufactures, and markets 3-D digital services and intra-oral scanners, for $187.6 million. Align allocated $76.9 million of the purchase price to the "goodwill"—the amount of the purchase price exceeding fair value—of one of Cadent's units. In late 2011, after the acquisition, Align represented to investors that the goodwill valuation remained accurate. Between October 2012 and April 2013, however, Align represented a decline of the "goodwill" valuation between $52.6 million to $36.6 million to zero.

City of Dearborn Heights Act 345 Police & Fire Retirement System, a pension fund representing investors who purchased stock in Align, filed a complaint alleging that Align violated Section 10(b) and Rule 10b-5, which prohibit fraud in connection with the purchase or sale of any security, by deliberately overvaluing Cadent's goodwill. According to the pension fund, Align artificially inflated Cadent's revenue by "channel stuffing"—offering substantial discounts to customers to make the company appear more valuable—which masked a number of factors negatively impacting Cadent, including difficulties integrating Cadent with Align, increasing market competition, and deteriorating relationships with a distributor.

On December 9, 2013, the U.S. District Court for the Central District of California dismissed the pension fund's first amended complaint for failure to plead with specificity falsity and scienter, two of the required elements for Section 10(b) and Rule 10b-5 claim, and as required under Federal Rule of Civil Procedure 9(b) and the PSLRA. The district court similarly dismissed the pension fund's second amended complaint on August 22, 2014, for failure to remedy the deficiencies in the first amended complaint.

On May 5, 2017, the Ninth Circuit affirmed the district court's dismissal, holding that the Omnicare standard for pleading falsity of opinion statements applies to Section 10(b) and Rule 10b-5 claims. In so holding, the Ninth Circuit concluded its prior standard was "clearly irreconcilable" with Omnicare to the extent that it permitted plaintiffs to plead falsity by alleging that "there is no reasonable basis for the belief."

The Ninth Circuit concluded that the pension fund failed to sufficiently plead falsity and scienter under the Omnicare standard. According to the Ninth Circuit, the pension fund did not allege subjective falsity because it "fail[ed] to allege the actual assumptions that [Align] relied upon in conducting their goodwill analysis." Although the pension fund relied on confidential informants to substantiate its allegations channel stuffing, the pension fund failed to "link Cadent's channel stuffing to [Align], much less the set of assumptions that [Align] used to conduct its goodwill valuation."

The Ninth Circuit similarly concluded that the pension fund failed to adequately plead scienter, again relying on the pension fund's failure to allege sufficient facts to establish that Align had direct knowledge of Cadent's channel stuffing. According to the Ninth Circuit, neither the timing nor magnitude of the decrease in Align's goodwill valuation between October 2012 and April 2013 established a "strong inference of scienter." Ultimately, the pension fund "failed to establish an inference of scienter that is at least as compelling as the opposing inference that [Align] exhibited poor business judgement."

Align Technology Affirms Heightened Fraud Pleading Standard

Section leaders believe the Ninth Circuit's opinion is consistent with heightened pleading standards under Federal Rule of Civil Procedure 9(b) and the PSLRA. "The heightened pleading standard under the PSLRA requires a plaintiff to plead what was known, who knew it, when they knew it. That has not really changed," says Peter Safirstein, New York, NY, cochair of the Section of Litigation's Class Actions Subcommittee of the Securities Litigation Committee. "The Ninth Circuit's opinion is consistent with the PSLRA's exacting standards to plead falsity and scienter," affirms Howard S. Suskin, Chicago, IL, cochair of the Section's Class Actions Subcommittee of the Securities Litigation Committee. "For years, it has been very difficult to assert an opinion statement as the basis for a fraud claim," adds Safirstein.

Nor do Section leaders believe other courts are likely to reach a different conclusion. "The vast majority of Section 10(b) claims are filed in these circuits, and it is unlikely other courts would take different approach," states Suskin. "The Omnicare standard is becoming the standard in securities fraud cases in all the other Circuits to consider this question," notes Tiago Duarte-Silva, Boston, MA, cochair of the Class Actions Subcommittee of the Securities Litigation Committee.


Erin Louise Palmer is an associate editor for Litigation News.

Keywords: securities fraud, opinion statements, fraud pleading, goodwill valuation

Hashtags: #securitiesfraud, #opinionstatements, #fraudpleading, #goodwillvaluation

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