Opinion ID: 2807988
Heading Depth: 3
Heading Rank: 2

Heading: Allegations common to more than one defendant

Text: We now discuss the allegations that, according to plaintiffs, lead to a strong inference of scienter. First, we look at the various allegations that apply to more than one defendant and discuss the appropriate inference, if any, to be drawn from them. 4 Then we proceed, defendant by defendant, adding any allegations unique to that defendant, to comprehensively determine if plaintiffs have alleged facts that give rise to a strong inference of scienter as to any defendant. The SAC contains no direct allegations of fraudulent conduct; rather, plaintiffs rely on circumstantial allegations. See Shaw, 537 F.3d at 535.
One of plaintiffs’ primary allegations is that defendants had knowledge of Guaranty’s undercapitalization 5 and, as officers and directors, wanted to raise capital necessary for the continued operation of the business. This, plaintiffs say, created a motive for defendants to overstate the value of Guaranty’s MBS portfolio; if Guaranty appeared to be a healthy company, it could more easily attract much-needed capital. The SAC pleads with particularity that defendants Jastrow, Dubuque, and Murff—but not Gifford—knew of Guaranty’s undercapitalization. The SAC alleges that Dubuque met with Temple’s management before the spin-off and suggested that Guaranty needed $200 million in additional capital. 4 These allegations do not constitute group pleading because they are sufficiently particularized. However, because they apply to more than one defendant, they are most easily discussed together. 5 The SAC’s use of the term “undercapitalized” likely refers to the industry-specific definition of regulatory capital, see 12 C.F.R. § 325.103 (defining the risk-based capital ratios that constitute a bank’s undercapitalization), and not the colloquial definition, see Black’s Law Dictionary 251 (10th ed. 2014) (defining “undercapitalization” as “[t]he financial condition of a firm that does not have enough capital to carry on its business”). Regardless, this distinction is not significant for our discussion of scienter. 11 Case: 13-10928 Document: 00513076785 Page: 12 Date Filed: 06/12/2015 No. 13-10928 Dubuque is also alleged to have had discussions after the spin-off in which he expressed the desire for $100 million in additional capital. Dubuque and Murff are alleged to have led a meeting in the spring of 2008 concerning Guaranty’s capital position. The SAC also derives knowledge of undercapitalization—and motive—from the Tepper complaint. 6 The Tepper complaint alleged that Jastrow, Dubuque, and Murff knew of Guaranty’s undercapitalization before the spin-off. These allegations adequately state that Jastrow, Dubuque, and Murff were aware of Guaranty’s need for capital during the Class Period. 7 The resulting question is whether any inference of scienter should be drawn from defendants’ knowledge of Guaranty’s undercapitalization. The desire to raise capital in the normal course of business does not support a strong inference of scienter because virtually all corporate insiders share this goal. See Abrams, 292 F.3d at 434 (holding that a desire to raise capital, receive incentive compensation, and sell stock at inflated prices did not support a strong inference of scienter). Plaintiffs contend that the inference of scienter here is much greater because capital infusions were not merely desirable, but necessary for the ongoing operation of Guaranty. “[A]ppropriate allegations of motive and opportunity may meaningfully enhance the strength of the inference of scienter, but . . . allegations of motive and opportunity, without more, will not fulfill the pleading requirements of the PSLRA.” Goldstein v. MCI WorldCom, 340 F.3d 238, 246 (5th Cir. 2003). In 6The parties do not dispute that we should consider the Tepper complaint’s allegations regarding knowledge of undercapitalization because they were expressly incorporated by the SAC. See Stratte-McClure v. Morgan Stanley, 776 F.3d 94, 100 (2d Cir. 2015) (considering, in deciding a motion to dismiss, the complaint as well as “any statements or documents incorporated in [the complaint] by reference”). 7 Plaintiffs argue that the SAC alleges Gifford’s knowledge of undercapitalization because, due to his position as Guaranty’s Principal Accounting Officer, he “cannot credibly claim ignorance of [Guaranty’s] financial situation.” This allegation is not contained within the SAC and, in any event, is not pled with particularity. We therefore decline to infer that Gifford had knowledge of Guaranty’s undercapitalization. 12 Case: 13-10928 Document: 00513076785 Page: 13 Date Filed: 06/12/2015 No. 13-10928 Goldstein, WorldCom’s CEO was alleged to have avoided taking an accounting charge for delinquent receivables in order to artificially inflate results and ensure a merger was completed. See id. at 249–250. Plaintiffs alleged that the CEO’s motive contributed greatly to scienter, not only because the CEO would lose millions in compensation if the stock price dropped, but also because such a drop would accelerate payment on his personal loans. See id. at 250. We found that the merger was important and more than routine, and supported a “strong and unique incentive” for the CEO to commit fraud. Id. Yet even this strong motive evidence was insufficient, on its own, to raise a strong inference of scienter, and, after considering other allegations of scienter, we affirmed the district court’s dismissal of the complaint. See id. at 251–54. Plaintiffs maintain that this case is similar to Nathenson v. Zonagen Inc., 267 F.3d 400 (5th Cir. 2001). This court, in Nathenson, held that plaintiffs “barely” pled a strong inference of scienter as to a defendant who was President, CEO, and a director of a “one product company” and was alleged to have made misstatements regarding a patent’s applicability to that single product. See id. at 424–25. Nathenson suggested, in dicta, that the rare case might establish a strong inference of scienter solely from motive and opportunity allegations. See id. at 412 (“[I]t would seem to be a rare set of circumstances indeed where [motive and opportunity] allegations alone are both sufficiently persuasive to give rise to a scienter inference of the necessary strength and yet at the same time there is no basis for further allegations also supportive of that inference.”). This is not such a case, even if one could exist after Goldstein’s pronouncement seemingly foreclosing the possibility. Defendants’ alleged misstatement of the MBS portfolio valuation was not as crucial to the continuing operation of Guaranty as were the misstatements regarding the patent’s applicability in Nathenson. Although Guaranty’s nonagency MBS portfolio was undeniably a large and important business asset, it 13 Case: 13-10928 Document: 00513076785 Page: 14 Date Filed: 06/12/2015 No. 13-10928 is not alleged to have been Guaranty’s single product, instead comprising at all relevant times no more than 22% of Guaranty’s total assets. See Abrams, 292 F.3d at 438 (Parker, J., concurring) (concluding that defendants’ recklessness could not be inferred when the source of accounting irregularities accounted for 20% of the company’s revenues). The motive allegations contribute to a finding of scienter as to Jastrow, Dubuque, and Murff, but must be considered together with other allegations to determine if they rise to a strong inference of scienter. 8 See Nathenson, 267 F.3d at 412 (“Appropriate allegations of motive and opportunity may meaningfully enhance the strength of the inference of scienter.”). ii. Knowledge of red flags regarding MBS valuation Plaintiffs allege that Guaranty’s MBS valuation and its decision not to recognize losses as “other than temporary” violated GAAP. Because the question of whether the statements actually violated GAAP is fact-dependent, it is not properly addressed on a motion to dismiss. See Barrie v. IntervoiceBrite, Inc., 397 F.3d 249, 257 (5th Cir. 2005). The issue, for the scienter analysis, is whether, assuming the statements violated GAAP, the allegations give rise to a strong inference that individual defendants were severely reckless in valuing the securities. Plaintiffs contend that several “red flags” included in the SAC should have alerted each defendant that the MBS valuation was materially incorrect. The red flags include (1) a 250% increase in the average delinquency rate on Guaranty’s non-agency MBS portfolio in the nine-month period ending June 8We decline to draw additional inferences of scienter from the Tepper action. Because the Tepper complaint covers only events before the Class Period, it does not directly address the misstatements at the heart of this case. For this reason, and because the persuasive force of the Tepper action’s settlement is disputed, we limit the contribution to scienter of the Tepper complaint to Jastrow’s, Dubuque’s, and Murff’s knowledge of Guaranty’s undercapitalization. 14 Case: 13-10928 Document: 00513076785 Page: 15 Date Filed: 06/12/2015 No. 13-10928 30, 2008; (2) a decrease in the value of the non-agency MBS portfolio to 60% of its cost by June 30, 2008; and (3) the downgrading or placing on negative watch of ten securities in Guaranty’s portfolio in June and July 2008. The “red flags” add little inference of scienter. Each “red flag” is alleged to have become knowable only in June 2008, whereas many of the alleged misrepresentations occurred before June 2008. Even as to those alleged misstatements that occurred after the “red flags” were apparent, the red flags were disclosed to the public, which negates the inference that defendants acted with scienter. See Fire & Police Pension Ass’n of Colo. v. Simon, 778 F.3d 228, 244 (1st Cir. 2015) (holding that a company’s disclosures of red flags “undercut any inference of scienter”); Ziemba v. Cascade Int’l, Inc., 256 F.3d 1194, 1211 (11th Cir. 2001) (noting that various disclosures of red flags “undermine[d] any hint of fraud”). Plaintiffs dispute whether and to what extent the red flags were disclosed. However, documents referenced in the SAC and attached to defendants’ motion to dismiss confirm that the alleged red flags, or at least the inputs that would allow the public to easily calculate them, were disclosed promptly by Guaranty. See Tellabs, 551 U.S. at 322 (holding that, on a Rule 12(b)(6) motion, a court must consider “documents incorporated into the complaint by reference”). Additional transparency, not disputed by plaintiffs, further negates the inference of scienter. Defendants disclosed that Guaranty’s MBS valuation was based on internal models, not market prices, and Guaranty disclosed the inputs it used in its models. Guaranty provided investors with additional explanatory and cautionary information from which they could judge the accuracy of the models and Guaranty’s decision not to recognize losses as other than temporary. Guaranty’s filings further disclosed that valuation was “difficult,” and that the valuation estimates involved a “high degree of uncertainty” and might “prove to be materially incorrect.” As the Supreme 15 Case: 13-10928 Document: 00513076785 Page: 16 Date Filed: 06/12/2015 No. 13-10928 Court recently recognized, “an investor reads each statement within [an SEC document], whether of fact or of opinion, in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information.” Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S. Ct. 1318, 1330 (2015). We distinguish this case from Spitzberg v. Houston American Energy Corporation, 758 F.3d 676 (5th Cir. 2014). In Spitzberg, an energy company made public statements estimating billions of barrels of oil reserves even though the company had done no geological testing. Id. at 680, 684. We held that defendants were severely reckless because using the term “reserves”—an industry-specific term indicating that production or testing had occurred— would present an obvious danger of misleading investors as to the value of the company’s assets. Id. at 681, 684. Here, in contrast, defendants’ disclosures conveyed to investors that its MBS valuations were far from certain. Defendants’ disclosure of the “red flags” and candidness about the uncertainty underlying its models neutralize any scienter inference from “red flags.” iii. Magnitude of alleged misstatements Plaintiffs contend that the magnitude of the valuation errors contributes to a strong inference of scienter. The significance of a large accounting error depends on the circumstances. In Goldstein, we held that a $685 million writeoff did not create a strong inference of scienter because the company was large and frequently took similarly-sized write-offs. 340 F.3d at 251. Here, the magnitude was undoubtedly large; the OTS directed Guaranty to restate its March 31, 2009 Thrift Financial Report and recognize a $1.62 billion OTTI, representing an overvaluation of the MBS portfolio of 100%. But, as we discuss in Section II.C.i, infra, the magnitude’s contribution to an inference of scienter 16 Case: 13-10928 Document: 00513076785 Page: 17 Date Filed: 06/12/2015 No. 13-10928 is small, because the valuation involved subjective accounting concepts that can yield a wide range of reasonable results. See Shaw, 537 F.3d at 536. 9