The case originally involved securities fraud claims against Dynex, Merit and two individual officers arising from the sale of bonds issued by Dynex and secured by loans that Merit made to people seeking to buy mobile homes. According to the Complaint, the defendants failed to disclose that the loans had been made to “uncreditworthy borrowers.” The Complaint further alleges that the underlying collateral eventually began to perform poorly as default rates steadily increased, leading to a restatement of Merit’s loan loss reserves. According to the Complaint, the defendants “misrepresented the cause of the bond collateral’s poor performance; misrepresented the reasons for restating its loan loss reserves; and concealed the loans’ faulty underwriting.”
The trial court dismissed the action with respect to the two individual defendants, ruling that the plaintiff “ha[d] failed to adequately plead scienter” with respect to those individuals. However, the court ruled that the plaintiff had sufficiently pled scienter with respect to the two corporate defendants, and allowed the action to proceed against them. The corporate defendants appealed the decision, arguing that the plaintiff’s failure to plead a strong inference of scienter with respect to the individual defendants precluded the court “as a matter of law” from finding such an inference with regard to the corporate defendants.
The Second Circuit disagreed. The Court acknowledged that allegations against a corporate entity must “create a strong inference that someone whose intent could be imputed to the corporation acted with the requisite scienter.” However, the Second Circuit held that such person need not be specifically named in the complaint. According to the court, “it is possible to raise the required inference with regard to a corporate defendant without doing so with regard to a specific individual defendant.” The Second Circuit, therefore, rejected the corporate defendants’ contention that the plaintiff had failed “as a matter of law” to plead scienter against Dynex and Merit simply because it had not sufficiently pled scienter with respect to the two individual defendants named in the Complaint.
The Second Circuit next looked at the specific allegations of scienter against Dynex and Merit and ruled that the plaintiff had nevertheless failed to plead the requisite scienter with respect to the two corporate defendants. In doing so, the Second Circuit analyzed each of the three allegations of scienter against Dynex and Merit separately.
First, the Second Circuit rejected the plaintiff’s assertion that the two corporate defendants should have known that the public statements were false because senior executives had access to raw data that conflicted with those statements. The Second Circuit held that there were no allegations in the Complaint that any raw data was presented to the defendants in a way that would have alerted them to the fact that certain statements might be false.
Second, the Second Circuit was equally critical of the plaintiff’s contention that the defendants’ failure to review or check information they had a duty to monitor raised a strong inference of scienter. According to the Second Circuit, the plaintiff failed to specifically identify any reports or statements that the defendants would have discovered during any such due diligence that would have demonstrated that the public statements were false.
Finally, the Second Circuit rejected the plaintiff’s contention that it had alleged scienter by showing motive and opportunity on the part of those defendants. The motive, according to the plaintiff, was to avoid making accurate disclosures to give the appearance of financial success and profitability. According to the Second Circuit, however, if scienter could be pled on that basis alone, the pleading requirement would be essentially meaningless.
Having determined that each of the allegations of scienter with respect to the corporate defendants were insufficient to satisfy the requisite pleading standards, the Second Circuit remanded the case with instructions to dismiss and with leave to replead. A complete copy of the decision is available here.
