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5th Circuit Interprets Fraud Pleading Ruling

Interpreting the U.S. Supreme Court's recent ruling on scienter pleading in a securities fraud class action (Tellabs, Inc. v. Makor Issues & Rights, Ltd., ¶94,335), a 5th Circuit panel rejected a reading that would allow the drawing of a strong inference of scienter from the fact that the senior executive and financial officers signed a Sarbanes-Oxley Act Section 302 certification. Investors were unable to explain the link between the certification statement concerning internal controls and the actual accounting and reporting problems.

Investors filed a securities fraud class action against the company, its CEO and two CFOs who served at different times. They alleged that a number of false statements by the company regarding its financial condition caused an artificial inflation in the market price of the company's securities. Under Section 302, the senior executive and financial officers have to sign the certification.

In Tellabs, the Supreme Court held that investors in a private securities fraud action must state facts that the defendants acted with a strong inference of scienter. According to the high court, a fraud claim will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference.

The appeals court rejected a reading of Tellabs that would allow a strong inference of scienter from the Sarbanes-Oxley Act certification alone. If this interpretation were accepted, the court said that scienter would be established in every case where there was an accounting error or an auditing mistake made by a publicly traded company, which would eviscerate the pleading requirements for scienter set forth in the Private Securities Litigation Reform Act.

An inference of fraud might be proper in a Sarbanes-Oxley Act certification if the person signing the certification had reason to know, or should have suspected, due to the presence of glaring accounting irregularities or other red flags, that the financial statements contained material misstatements or omissions. This was not the case here, according to the court, so the certifications at issue did not allow an inference of scienter.

In addition, while confidential source statements are a permissible basis on which to make an inference of scienter, the court said the investors' confidential source statements lacked sufficient detail to credit them as a basis for a strong inference of scienter with respect to the particular allegations of fraud.

There were two specific allegations suggesting that the senior officers ignored the accounting problems at the company. First, a former technician claimed that he overheard comments at headquarters that the company lacked the internal controls it repeatedly lauded and embraced a culture of financial manipulation that favored hitting financial numbers rather than accurate accounting.

Second, a former senior officer stated that the CEO said that he did not want to know the details of a revenue issue so that he would not be liable. In the court's view, these confidential statements lacked sufficient detail to credit them as bases for a strong inference of scienter with respect to the particular allegations of fraud.

Central Laborers' Pension Fund v. Integrated Electrical Services, Inc. will be published in a forthcoming Report.