Doshi v. Gen. Cable Corp.: Creating an Inference of Scienter Requires Particularized Facts in Failure to Discover Complex Theft Scheme

In Doshi v. Gen. Cable Corp., No. 2:14-cv-22 (WOB-CJS), 2015 BL 19141 (E.D. Ky. Jan. 27, 2015), the United States District Court for the Eastern District of Kentucky held that City of Livonia Employees’ Retirement System and others similarly situated (“Plaintiffs”) failed to state a claim for failing to allege a strong inference of scienter.

According to the allegations in the complaint, Plaintiffs bought stock in General Cable Corporation over a three-year period. During the period, an inventory theft scheme occurred in an international subsidiary.  General Cable eventually issued two restatements in order to correct the accounting errors resulting from the scheme. Following the corrections, General Cable’s stock price declined. Plaintiffs filed suit, alleging General Cable’s senior executives (“Defendants”) “knew or recklessly disregarded that adverse facts had not been disclosed.” 

To prevail on a claim under Section 10(b) of the Exchange Act or Rule 10b-5 thereunder, a plaintiff must prove that the misstatement or omission was made with scienter. Scienter is a mental state that entails an “intent to deceive, manipulate, or defraud.” An inference of recklessness can arise from “multiple, obvious red flags.” Federal Rule of Civil Procedure 9(b) requires a fraud allegation to be stated with particularity, and the Private Securities Litigation Reform Act (“PSLRA”) requires a plaintiff to “state with particularity facts giving rise to a strong inference” the defendant acted with scienter. The inference of scienter must be as compelling as any other opposing inference drawn from the same set of facts. 

The existence of restatements can create an inference of scienter. Those restatements, however, must demonstrate clear accounting errors that are “‘drastic,’ ‘pervasive,’ and ‘egregious.’” The mere existence of a restatement, without any further evidence, does not create an inference of the necessary intent. Where the fraud occurs in a subsidiary, “courts should not ‘presume recklessness or intentional misconduct from a parent corporation's reliance on its subsidiary's internal controls.’” Corporate scienter can be imputed from “lower-level employees” who contribute to the misstatement but the complaint must nonetheless allege adequate facts “that give rise to a strong inference of fraudulent intent” by those individuals.     

In this case, the complaint failed to allege any particularized facts that would create an inference of scienter. Among other things, the magnitude of the restatements did not constitute sufficient evidence of scienter. The financial impact of the corrections involved only 0.3% of the company’s sales.

In discounting the duration of the errors as evidence of the necessary intent, the court reasoned that “the duration of the errors speaks less to Defendants' states of mind and more to the thieves' sophistication.” The court also found insufficient to establish scienter the allegations that Defendants had access to information that would allow for discovery of the scheme; Defendants had to make multiple restatements; and Defendants’ internal controls were insufficient. Plaintiffs did not “specify any instance where Defendants gained relevant knowledge . . . and disregarded it.”

Nor was the reliance by the parent on the financial and internal control systems of the subsidiary sufficient to show scienter.   The court stated “that courts should not ‘presume recklessness or intentional misconduct from a parent corporation’s reliance on its subsidiary’s internal controls.’” Furthermore, a mistake that is evident in hindsight does not provide evidence of scienter. It is also common for a parent company not to manage a seemingly successful subsidiary. Lastly, Plaintiffs did not allege any facts related to the purpose of concealing fraud.

The United States District Court for the Eastern District of Kentucky held Plaintiffs’ complaint failed to support a strong inference of scienter. Accordingly, the court granted General Cable’s motion to dismiss, dismissing Plaintiffs’ claims with prejudice.

The primary materials for this post can be found on the DU Corporate Governance website.