Securities Law Alert
In This Edition:• Fourth Circuit: Inference of Scienter “Exceptionally Weak” Where BDC’s Investment Strategy Appeared
Bad Only in Hindsight and BDC Disclosed That Investments Would Be Classified as Junk
• Eastern District of Pennsylvania: CEO’s Background and Industry Experience Supported an Inference of
Scienter at the Pleading Stage• Southern District of New York: No Duty to Disclose Risk of a “#MeToo Reckoning” Where Plaintiff Failed
to Allege Risk Was Concrete and Substantial• Southern District of New York: Accounting Firm Did Not Ignore “Red Flags” Where It Disclosed That Its
Audit Report Could No Longer Be Relied Upon
March 2021

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Fourth Circuit: Inference of
Scienter “Exceptionally Weak”
Where BDC’s Investment
Strategy Appeared Bad Only in
Hindsight and BDC Disclosed
That Investments Would Be
Classified as Junk
On February 22, 2021, the Fourth Circuit
affirmed the dismissal with prejudice ofa securities fraud class action against abusiness development company (“BDC”) as
well as director liability claims against three
directors/executives alleging that defendants
failed to disclose the risks of the BDC’s
investment strategy, which involved offering
mezzanine financing to lower middle market
companies. In re Triangle Capital Corp. Sec.
Litig., 988 F.3d 743 (4th Cir. 2021) (Agee, J.).
The court held that the heightened burden for
pleading scienter under the Private Securities
Litigation Reform Act (“PSLRA”) was notsatisfied. The court found that the inferenceof scienter rested on “statements andomissions of facts arising from the executionof legitimate, subjective business judgments

that, only when viewed in hindsight, allegedly
become misleading.”

Background
Plaintiff argued that defendants “knew in2014 and 2015 that the mezzanine lending
market was contracting, and that the
mezzanine deals that remained were ofinferior quality than what was available before
the rise of unitranche lending.” Plaintiffs
asserted that “this knowledge, coupled withthe ‘false’ representations about the qualityof those deals and the state of the mezzanine
market, give rise to a strong inferenceof scienter.”Specifically, plaintiff argued that certain
statements to investors equated to admissions
that defendants knew in 2014 and 2015 thatthey were investing in low-quality deals.
In a May 2017 investor call, one of the
defendant executives said, in reference tothe BDC’s 2014 and 2015 business activity,that “there was a period where [the BDC]
was chasing yield more than it should have.”
In a November 2017 investor call, anotherdefendant executive explained how theinvestment decisions from 2013 to 2015

contributed to some investments later goingon full non-accrual status. This executive
stated that the adherence to a mezzanine
investment strategy during a period ofmassive change in the market “was thewrong strategic call” when “other investment
strategies were available which provided abetter risk-reward equation.”

Inference of Scienter Is Weak inPart Due to Ambiguities and Lackof Motive
Focusing only on the element of scienter,the court determined that “to the extent that
we can make any inference of scienter from[plaintiff’s] allegations, it is exceptionally
weak.” With respect to plaintiff’s allegationthat the defendant executives (who largely
controlled the investment committee’s
decisions) were advised that the mezzanine
lending market was contracting and that itshould focus on unitranche lending, the court
stated that “two factors diminish the strengthof any scienter inference that could be
drawn.” First, plaintiff “never specifies when
this advice was given, how firm in theirconviction these investment advisors were inrecommending that [the BDC] should avoid
mezzanine deals moving forward, or what a
mix of mezzanine and unitranche investments
should look like.” Second, plaintiff failed toallege that defendants had some particularmotive to defraud investors. The court
concluded that these “ambiguities, and thelack of a motive to defraud, thus diminish thestrength of any scienter inference that can be
drawn from the allegation.”quantity of investments was incompatible
with quality.”
The court continued that “[f]or similarreasons, we cannot reasonably draw thatsame inference from [the] November 2017
conversation with investors.” The court notedthat “[o]f course, many bad investments will,in retrospect, look like the wrong strategic
call.” However, the court cautioned that
nothing said in the November 2017 investor
call “plausibly suggests that [the BDC] or
its C-level executives knew or recklessly
disregarded the fact that each of theirportfolio companies bore inherently more risk
than the typical ‘high yield’ or ‘junk’ securities
that constituted [the BDC’s] investment
portfolio.” The court stated that “[i]n fact,[the BDC] regularly disclosed to its investors
that ‘junk’ was how their investments would
be classified.” The court observed that
pleading fraud by hindsight is precisely what
Congress intended the PSLRA to eliminate.
The court concluded that “[c]onsidering
these allegations holistically and in theirproper context, we hold that [plaintiff]
has failed to allege a strong inference of
scienter.” The court then stated that “themuch stronger inference is that [d]efendants
had an honest debate about the merits ofa subjective business judgment, and inhindsight, simply made the wrong choice withsome investments.”

Retrospective Statements Do
Not Support a Strong Inferenceof Scienter
Plaintiff also alleged that an investmentbank’s report that compiled survey results
and commentary about lending market
trends concluded that the mezzanine market
was “rapidly shrinking.” However, the court
found that “the Report contains just as many
optimistic statements about the state of themezzanine lending market as it does thoseexpressing concern with the potential changes
in that market.” The court concluded that“[w]ithout more, we cannot reasonably inferfrom [the executive’s] retrospective statementin [the] May 2017 [investor call] that in 2014
and 2015, [] [d]efendants knew that the2Eastern District ofPennsylvania: CEO’s
Background and Industry
Experience Supported an
Inference of Scienter at the
Pleading StageOn February 16, 2021, the Eastern Districtof Pennsylvania largely denied a motion todismiss a securities fraud class action against
a drug company and certain of its executives
alleging that they made false or misleadingstatements about the company’s COVID19 vaccine development and its ability to
manufacture it. McDermid v. Inovio Pharms.,2021 WL 601159 (E.D. Pa. 2021) (Pappert, J.).
The court held that scienter was pled with therequisite particularity concerning the CEO’svarious statements that the company had
constructed, not merely designed, a vaccine
within hours based on the CEO’s backgroundand experience in the pharmaceuticalindustry and his consistent use of theterm “construct.”

Defendants’ Motion toDismiss Arguments
Defendants sought to dismiss plaintiffs’
claims based on the CEO’s “vaccine
construction statements because they failed
to state with particularity facts giving rise toa strong inference that the defendant actedwith the required state of mind.” Plaintiffs
alleged that there was a significant difference
between “constructing” and “designing” avaccine “because a vaccine construct is anactual vaccine, not a mere design of one.”
Defendants argued that plaintiffs failed toallege that the CEO “intended to deceive when
he said construct instead of design, and even
if they had, such a claim would be implausible
because the terms are synonymous.”

The Court Weighs the CEO’s
Specialized Background andExperience
The court held that plaintiffs “have pledscienter with the requisite particularity.”
The court noted that plaintiffs “detail[the CEO’s] background and experience inthe pharmaceutical industry, which strongly
suggest he would understand the difference
between constructing and designing avaccine (taking as true [p]laintiffs’ allegationthat these terms have distinct meanings
in this context).” The CEO’s “extensive”
experience included having worked in vaccine
development at a different well-known
pharmaceutical company, publishing morethan 100 scientific papers, holding numerous
patents, and sitting on editorial boards andscientific review panels. The court pointed
out that that plaintiffs also allege that “notonly did [the CEO] claim [the company]‘constructed’ its vaccine in three hours several
times during a televised interview, he took
the claim a step further when speaking with
then-President Trump on television, claiming[the company] had ‘fully constructed’ its
vaccine in three hours.” The court statedthat “[c]onsistent usage of ‘construct’ andthe heightened claim that the company
had ‘fully constructed’ the vaccine support
a strong inference of scienter.” The court
reasoned that “[e]ven if [d]efendants’ claimthat [the CEO] consistently used ‘construct’
because he thought it was synonymous with‘design’ raises a plausible inference that hedid not act with scienter, that inference is no
more plausible than the inference raised by[p]laintiffs’ allegations.”

Southern District of New York:No Duty to Disclose Risk of a“#MeToo Reckoning” Where
Plaintiff Failed to Allege Risk
Was Concrete and Substantial
On February 3, 2021, the Southern District of
New York dismissed a securities fraud classaction against a restaurant company and twoof its former executives, which alleged thatthey made misrepresentations and omissions
regarding the company’s culture where thedefendant executives and other non-party
executives allegedly sexually harassed thecompany’s employees and “cultivated a toxic
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workplace culture.” Okla. Law Enf’t Ret.
Sys. v. Papa John’s Int’l, 2021 WL 371401(S.D.N.Y. 2021) (Wood, J.). The court heldthat plaintiff failed to plausibly allege that the“positive assurances about the [c]ompany’s
culture exceeded the protected bounds ofgeneric puffery” or to plausibly allege that“the risk that [the company] would face a#MeToo reckoning was so concrete andsubstantial that there arose an affirmative
duty to disclose it.”

Background
One of the two executive defendants inthis case was the company’s founder who
held various high-level positions in thecompany over his tenure, including CEO. The
founder’s name and likeness were central
to the company’s brand, and he frequently
appeared in its advertisements. Beginning in
2017, defendants “faced a range of negative
publicity.” For example, in 2018 Forbes
published an article in which numerous
unnamed, former employees described“disturbing instances of workplace sexual
harassment and misconduct” by senior
executives.

Risks Had Not Already Materialized
Where Allegations Were “Generaland Conclusory”
The court held that the risk disclosures in thecompany’s SEC filings were not misleading.
Plaintiff alleged that when the company filed
its 2016 and 2017 annual reports on form
10-K, its “risk disclosures were misleading(i.e., the risks identified had alreadymaterialized) because the #MeToo movement
was well underway and because [d]efendants
had knowledge of their own misconduct andthe hostile and unlawful work environmentat [the company] at the time.” The court held
that, “even drawing all inferences in favorof [p]laintiff, its allegations still fail to showthat the risks described above had alreadymaterialized at the time the [c]ompany filed
its 2016 and 2017 10-K statements.” The court
explained that plaintiff “fail[ed]—again—to
specify when the [c]ompany failed to comply
with labor laws (and what these labor laws
were), when the [c]ompany’s executives
engaged in misconduct, and when theirharassing behavior became widely known(including to those individuals who had thepower to fire them).” The court described
plaintiff’s claims about the influence of the#MeToo movement and plaintiff’s claims thatthe defendant executives “were aware of andwere fueling an unlawful workplace culture”
as “general and conclusory.”

No Duty to Disclose Uncharged,
Unadjudicated Wrongdoing
Plaintiff also alleged that the founderengaged in “illegal and unethical sexual
behavior, resulting in at least two confidential
settlements.” Citing City of Pontiac
Policemen’s & Firemen’s Ret. Sys. v. UBS,
752 F.3d 173 (2d Cir. 2014), which stated that“companies do not have a duty to disclose
uncharged, unadjudicated wrongdoing,”
the court determined that “[t]his allegation
suffers from the same flaw as [p]laintiff’s
other general and conclusory allegations:
it does not amount to anything more thanuncharged, unadjudicated wrongdoing.”
Additionally, quoting from a recent casewhere a prominent media company executive
also faced #MeToo allegations, the court
stated that “[e]ven if the risk that [thecompany’s] executives would be disgraced or
fired increased with the expanding influenceof the #MeToo movement, ‘an increase in arisk does not mean the risk has already cometo pass, such that a disclosure that simply
identifies the risk would be misleading.’”
Quoting Constr. Laborers Pension Tr. v. CBS,433 F. Supp. 3d 515 (S.D.N.Y. 2020).

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Southern District of New
York: Accounting Firm Did
Not Ignore “Red Flags” Where
It Disclosed That Its Audit
Report Could No Longer Be
Relied Upon
On February 23, 2021, the Southern Districtof New York granted certain defendants’
motions to dismiss the third amended
complaint in a putative securities fraud classaction alleging that they made misstatements
arising out of a company’s initial public
offering materials and subsequent financial
statements. Xu v. Gridsum Holding, 2021 WL
773002 (S.D.N.Y. 2021) (Ramos, J.). With
respect to the company’s former accounting
firm, the court held that scienter was notadequately alleged because plaintiffs failed
to plead facts suggesting that the firm’s audit
was so deficient as to effectively be no audit
at all, or that it ignored “red flags” that wereso obvious that it must have been aware offraudulent behavior.

defendants had both motive and opportunity
to commit the fraud or (2) constituting
strong circumstantial evidence of conscious
misbehavior or recklessness.” Citing Second
Circuit precedent, the court explained that“to hold an auditor liable for fraud, suchcircumstantial allegations [of conscious
misbehavior or recklessness] must, in fact,
approximate an actual intent to aid in
the fraud, such as conducting an audit so
deficient as to amount to no audit at all, ordisregarding signs of fraud so obvious that thedefendant must have been aware of them.”
The court held that plaintiffs failed to meetthis standard and further, alleged no facts
showing that the auditor had any motive toperpetuate fraud.

Plaintiffs’ Fraud Allegations
The defendant auditor in this case preparedaudit opinions in connection with thecompany’s 2015 and 2016 financial
statements. With respect to the 2016 opinion,
plaintiffs alleged that the auditor was “liable
for fraud based on its statement that theaccompanying financial documents present
fairly, in all material respects, the financial
position of [the company],” and its statementthat it “conducted its audits of thesestatements in accordance with the standardsof the Public Company Accounting Oversight
Board.” Plaintiffs further argued that certain
audit procedures were not performed.

Applicable Standard for Holding an
Auditor Liable for Fraud
The court held that plaintiffs did notadequately allege scienter. The court
explained that “Section 10(b) and Rule10b–5 require plaintiffs to allege a state ofmind demonstrating an intent to deceive,
manipulate or defraud, also known as
scienter.” Further, “[u]nder Rule 9(b) and
the PSLRA, a plaintiff must allege facts
leading to a ‘strong inference’ of scienter.”
The court explained that a plaintiff can“either alleg[e] facts showing that the

Auditor Did Not Ignore Red Flags
Where It Identified and RaisedInternal Control Issues
On the issue of whether the auditor
ignored red flags, the court stated thatplaintiffs “allege facts suggesting that [theauditor] eventually did identify and raiseseveral internal control issues relevant tothis case.” The court ruled “[i]n light of this,[p]laintiffs do not plead facts supporting astrong inference that [the auditor] must havebeen aware of, and ignored, red flags.” Thecourt noted that plaintiffs “allege that [theauditor] informed [the company] that its
2016 Audit Report could no longer be relied
upon because, over the course of the following
year’s audit, [the auditor] identified issues
relating to certain revenue recognition, cash
flow, cost, expense items, and their underlying
documentation that [it] had previously raisedwith the Company.” The court continued
that the company “later revealed that [theauditor] had stated that these issues raisedquestions related to its ability to rely on the
representations of management.”5

Countervailing Facts Offset
Auditor’s Alleged Failure to
Perform an Auditing Procedure
Noting plaintiffs’ argument that “in the courseof the 2016 audit [the auditor] still failed toperform a basic audit cutoff procedure toreconcile vendor statements with [c]ompanyrecorded invoices, despite knowing of [thecompany’s] internal control weaknesses”, thecourt determined that “[w]hile this allegation,
in a vacuum, might constitute evidence that[the auditor] ignored a ‘red flag,’ it is notenough to offset the countervailing facts in
the record that undermine a strong inferenceof scienter.” The court determined that thesecountervailing facts distinguished this casefrom the “red flag” cases cited by plaintiffs.
For example, the court described the red flags
in Varghese v. China Shenghuo Pharm., 672
F. Supp. 2d 596 (S.D.N.Y. 2009), as “moresevere and voluminous, and not underminedby other alleged conduct by the auditor.” Thecourt concluded by stating “[o]n the whole,[p]laintiffs’ allegations support the inferencesthat [the] 2016 audit opinion was deficient,even negligent, and that [the auditor] likely
did not perform procedures that it shouldhave. But they do not support the inference
that these errors were done fraudulently.”

This edition of the
Securities Law Alert was edited by
Paul C. Gluckow
pgluckow@stblaw.com / +1-212-455-2653,
Lynn K. Neuner
lneuner@stblaw.com / +1-212-455-2696,
and Jonathan K. Youngwood
jyoungwood@stblaw.com /+1-212-455-3539

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