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District Court For The Western District Of Texas Dismisses Securities Class Action For Failure To Adequately Plead Scienter, Rejecting Confidential Witness Allegations
10/24/2016On October 18, 2016, Judge Sam Sparks of the United States District Court for the Western District of Texas dismissed without prejudice a putative class action against EZCorp, Incorporated (“EZCorp”) for failure to adequately plead that defendants had acted with fraudulent intent. Wu Winfred Huang v. EZCorp, Inc., 15-CA-00608-SS, 2016 WL 6092717 (W.D. Tex. Oct. 18, 2016). Plaintiffs claimed that EZCorp and its CEO knew or recklessly disregarded the possibility that EZCorp’s reported financial results were materially false and misleading when made. The Court’s rejection of plaintiffs’ confidential witness allegations is an example of the rigor with which such allegations often are analyzed.
EZCorp, which provides “instant loans” such as payday loans and pawn loans, purchased a Mexican company which primarily provided payday loans to Mexican government employees. Plaintiffs alleged that due diligence during the acquisition of the Mexican company revealed significant accounting problems. After a restatement of EZCorp’s financial statements resulted in a drop in EZCorp’s stock price, plaintiffs brought suit, asserting violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (“Securities Act”) and Securities Exchange Commission Rule 10b-5. Plaintiffs’ scienter allegations were based on (1) the magnitude of the financial restatement, (2) the CEO’s Sarbanes-Oxley certifications, (3) the CEO’s incentive-based bonus, and (4) statements from confidential witnesses.
The Court explained that the Private Securities Litigation Reform Act requires plaintiffs to plead facts sufficient to show a “strong inference” of fraudulent intent. The Court found that the size of the company’s restatement, ranging from 29.4% to 52.9% of the company’s net income dating back to 2012, “provide[d] some basis from which to infer scienter.” However, the Court rejected allegations that management’s Sarbanes-Oxley certifications and incentive-based compensation provided support for an inference of scienter. While an officer’s Sarbanes-Oxley certification may provide support for an inference of scienter where the officer had reason to know or suspect the statements contained material inaccuracies due to “glaring accounting irregularities” or other “red flags,” the certification on its own could not do so. And “standing alone, the alleged desire to increase compensation does not support a strong inference of scienter.”
In considering plaintiffs’ confidential witness allegations, the Court observed that courts within the Fifth Circuit “view confidential witnesses with some level of skepticism.” The Court found one confidential witness’s statements unpersuasive because, among other things, he was not alleged to have had personal knowledge of the internal audit or resulting report that purportedly alerted the CEO to revenue and governance issues at the Mexican company. Plaintiffs’ allegations regarding another key confidential witness were deficient because they failed to specify “when and where” the alleged conversations took place that supposedly put the CEO on notice of financial reporting violations.
The decision demonstrates that the PSLRA’s pleading requirements can pose a substantial obstacle to securities fraud claims even where the claims are based on restatements that might be considered substantial. It also underscores the high burden plaintiffs encounter in the Fifth Circuit to the extent that their pleading relies on confidential witness allegations.
