Third Circuit in Rahman v. Kid Brands, Inc., Affirms Dismissal of Federal Securities Class Action Suit, Declines Opportunity to Decide Viability of “Corporate Scienter” Doctrine

In Rahman v. Kid Brands, Inc., No. 12-4257, 2013 U.S. App. LEXIS 23084 (3d Cir. Nov. 15, 2013), the Third Circuit issued a precedential opinion affirming dismissal of a federal securities class action suit alleging violations of Sections 10(b)(5) and 20 of the Securities Exchange Act of 1934. Specifically at issue on appeal was whether the district court had properly dismissed the plaintiff’s second amended complaint (“SAC”) under the Private Securities Litigation Reform Act (“PSLRA”) due to insufficient allegations of scienter, which is one of the elements of a claim under Section 10(b)(5) (and without which a claim under Section 20 similarly fails since Section 20 liability is derivative of a primary violation under Section 10(b)(5) or another securities law). The court agreed with the district court and the defendants that the allegations in the SAC fell short of the PSLRA’s heightened pleading requirements

The plaintiff in Rahman represented a putative class of investors who had purchased common stock in the defendant company. The allegations in the suit centered on the company’s alleged practice of misrepresenting the origins of imported products in order to pay reduced import duties and increase profits. In particular, the suit alleged that the company had failed to timely disclose that it was the target of a “Focused Assessment” from U.S. Customs and that it had undertaken an internal investigation into its importing practices in response to the review by U.S. Customs. Once it was eventually disclosed that the company had misidentified its products and would be subject to a fine, stock prices began to decline precipitously. This stock decline was only exacerbated several months later when the company disclosed additional customs violations and the imposition of fines in excess of $10 million. It was essentially the plaintiff’s position that the defendants had wrongfully withheld this information from investors. This allegation of wrongdoing was supported by several “confidential” witnesses, whose statements generally confirmed that the company had been aware of the importing issues.

In considering whether these statements were adequate to establish scienter, the court reiterated the threshold requirements for pleading a securities violation under Section 10(b)(5) under the PSLRA. The court specifically stated that it was necessary for the plaintiff not only to plead the existence of materially misleading statements, but also that the statements were made with “a mental state embracing intent to deceive, manipulate, or defraud.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322, 127 S.Ct. 2499, 2509, 168 L. Ed. 2d 179 (2007). In regard to the former, the court found that all of the information that the plaintiff alleged should have been disclosed could have been deemed materially misleading by a jury, notwithstanding the fact that the district court had found that the initial withholding of information relating to the company’s importing practices was not materially misleading given “practical considerations” and the ongoing nature of the investigation. Nonetheless, the appeals court said that it did not have to definitively resolve the “materiality” issue because the plaintiff had failed to plead scienter.

Citing its decision in Institutional Investors Grp. v. Avaya, Inc., 564 F.3d 242, 252 (3d Cir. 2009), the court held that, before the statements of confidential witnesses may be relied upon to establish scienter, their reliability must first be established. Considerations relevant to the reliability of confidential witness statements include the “detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corroborative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia.” Absent indicia of reliability, the court held that confidential witness statements should be discounted “steeply.” As the court recognized, discounting statements for lack of indicia of reliability upholds the particularized pleading requirements of the PSLRA, while recognizing that “anonymous” statements can be reliable if they are particularized.

Turning to the confidential witness statements at issue in the case, the court found they were lacking in corroborating details. For example, the statements of several confidential witnesses purportedly detailed management’s awareness of the importing practices, but one of the witnesses could not have possibly had personal knowledge of such meetings taking place within the period in question because he was not employed with the company at that time. Further, the statements of the witnesses were lacking as to specific details about the meetings that had taken place with management concerning the importing practices. On these bases, the statements had to be discounted and could not be viewed as giving rise to a strong inference of scienter as required by the PSLRA.

Separately, the court also noted that the allegations of scienter were lacking in other respects. The plaintiff, for instance, had not alleged any motive or opportunity to commit fraud, which, although not required, could have bolstered the allegations. Further, the court declined to address the possible application of the “corporate scienter” doctrine since there were no plausible allegations of fraud or cover-up on the part of the company. (AUTHOR’S NOTE: the doctrine of “corporate scienter” recognizes that, in narrow circumstances, the fraudulent activities of a company are so significant that the collective knowledge of the corporation’s employees suffices to meet the scienter requirement, even though an individual showing of scienter cannot necessarily be made with respect to those employees). Last, the court rejected the application of the “core operations” doctrine because there was no evidence that management was actively involved in the importing practices, and those practices in any event affected only a relatively small percentage of the company’s overall business.  As such, under the totality of the circumstances, the plaintiff did not carry his burden of alleging facts that, if proven, would establish an inference of scienter that is at least as likely as the “plausible opposing inferences” that could be drawn in favor of the defendants.

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