Inadequate pleading of scienter

Originally published by David Coale.

The plaintiffs in Owens v. Jastrow sued officers of Guaranty Bank for securities fraud, alleging that their SEC filings and public comments misstated the vulnerability of the bank’s mortgage-related holdings.  No. 13-10928 (June 12, 2015).  The Fifth Circuit affirmed dismissal in a detailed opinion, holding, procedurally, that:

• “A district court may best make sense of scienter allegations by first looking to the contribution of each individual allegation to a strong inference of scienter, especially in a complicated case such as this one.  Of course, the court must follow this initial step with a holistic look at all the scienter allegations”; and
• “Group pleaded” allegations were properly disregarded, although the Court declined to adopt “a strict rule requiring outright dismissal for any group or puzzle pleading[.]”

And on the merits:

• Knowledge of undercapitalization showed motive and opportunity, but does not by itself establish scienter;
• “Defendants’ disclosure of the ‘red flags’ [cited by Plainitiffs] and candidness about the uncertainly underlying its models neutralize any scienter inference from ‘red flags’”; and
• “An inference of severe recklessness is more likely when a statement violates an objective rule than when GAAP permits a range of acceptable outcomes.”

Therefore: “Considered holistically, plaintiffs’ allegations of knowledge of Guaranty’s undercapitalization, a large misstatement, red flags, and ignorance of internal warnings, do not raise a strong inference of severe recklessness that is equally as likely as the competing inference that [Defendants] negligently relief on the AAA ratings and believed that Guaranty’s internal models were accurate.”

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