S.D.N.Y. Upholds Strict Scienter Pleading Requirements

In In re ShengdaTech, Inc. Sec. Litig., 2014 BL 222900 (S.D.N.Y. Aug. 12, 2014), the District Court for the Southern District of New York granted Defendants A. Carl Mudd and Sheldon B. Saidman’s (the “Defendants”) motion to dismiss a securities fraud complaint (“Complaint”).

According to the allegations in the Complaint, ShengdaTech, Inc. (ShengdaTech or Company) manufactured nano-precipitated calcium carbonate, an additive used in tires and other products. ShengdaTech went public in 2007 through a reverse merger with a shell company incorporated in Nevada. In 2008, the Company disclosed in SEC reports $824 million in net sales and $36.03 million in net income. For the same period, ShengdaTech disclosed in reports filed with the Chinese Administration of Industry and Commerce (“AIC”) only $9.5 million in net sales and a net loss of $2 million. In 2009, ShengdaTech reported $102.1 million in net sales and $23.1 million in net income to the SEC; $6.07 million in net sales and a net loss of $6.2 million to the AIC.         

The Complaint asserted that, in March 2011, KPMG HK, the outside accountant, informed the audit committee that there were “significant inconsistencies” in its findings and ShengdaTech’s records and that “management had misdirected, intercepted and/or otherwise interfered with [] confirmation requests and responses.” The board immediately formed a special committee (“Special Committee”), which included both Defendants, to investigate the issue. In April 2011, KMPG resigned as auditor. In resigning, the Auditor was alleged to have stated:

“[S]enior management of the Company had not taken, and the Company's Board of Directors had not caused senior management to take, timely and appropriate remedial actions with respect to discrepancies and/or issues relating to the Company's financial records that were identified during the course of the audit for the year ended December 31, 2010.”

In August 2011, counsel for the Special Committee presented an initial report that "confirmed material irregularities and/or inaccuracies in the financial records of the Company." The same day, the Special Committee authorized the filing of a petition for Chapter 11 bankruptcy.

A number of shareholders (the “Plaintiffs”) initiated suits against ShengdaTech and the Defendants, alleging, in part, that the Defendants violated Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 20(a) of the Exchange Act. The Defendants’ filed a motion to dismiss the Complaint as it dealt with them individually.

Securities fraud claims brought under § 10(b) of the Exchange Act and Rule 10b-5 have six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.”

Under the PSLRA, plaintiffs must plead a “strong inference” of scienter. Scienter in the Second Circuit may be established by showing the defendants had motive and opportunity to commit fraud or presenting “strong circumstantial evidence of conscious misbehavior or recklessness.” The inference of scienter must be “strong in light of other explanations.” Group pleading gives rise to a presumption that statements made in group-published information are “the collective work of those individuals with direct involvement in the everyday business of the company.”

The court found that the Complaint did not meet the strict pleading standard required to show scienter. A desire to sell ShengdaTech securities at inflated prices was a motive that could be applied to almost any corporate defendant and was, therefore, an insufficient motive to establish the required strong inference of scienter. The Complaint also, according to the court, lacked any specific allegation showing the Defendants had actual knowledge that the 2008 and 2009 filings were false.

The opinion further found that group pleading was inapplicable. Group pleading applied to individuals involved in the day-to-day management of an organization. By the very nature of their position as directors, however, the Defendants were not involved in day-to-day management. 

For the above reasons, the District Court for the Southern District of New York granted the Defendant’s motion to dismiss the claims against them. 

The primary materials for this post are available on the DU Corporate Governance website.