Second Circuit Rejects Collective Scienter Theory

In a recent decision, the Second Circuit rejected a shareholder-plaintiff’s theory of collective scienter in a securities fraud suit brought against a financial services company. At issue in Teamsters Local 445 v. Dynex Capital, Inc., was a district court’s ruling that a plaintiff adequately pled scienter with respect to the corporate defendants even though it dismissed the claims brought against the defendants’ officers. The corporate defendants appealed the decision, challenging the district court’s expansive theory of “collective scienter.”

On appeal, the Second Circuit largely agreed with the defendants. It explained that “[t]o prove liability against a corporation… a plaintiff must prove that an agent of the corporation committed a culpable act with the requisite scienter, and that the act (and accompanying mental state) are attributable to the corporation.” The court stopped short of holding, as a matter of law, that a plaintiff must always plead scienter as to specific individuals in order to survive a motion to dismiss with respect to corporate defendants. But, except in highly unusual situations, the Second Circuit’s decision effectively means that securities fraud plaintiffs must plead scienter against specific corporate agents in order to recover from a corporate defendant.

Perhaps more importantly, the Second Circuit held that the plaintiff had failed to sufficiently allege any wrongful conduct by any of the defendants. Rather, the court suggested that any diminution in the value of the company’s asset-backed securities could have been caused by “the general weakness” in market conditions, particularly in the manufactured housing industry. Accordingly, the opinion is an important judicial recognition that market forces, not fraud, often cause investment losses that are the subject of securities fraud allegations. For that reason, we expect the Second Circuit’s decision to be quite significant in light of the wave of class actions that have been filed in connection with the subprime mortgage industry.

My colleagues Ed Fuhr and Terence Rasmussen represented the defendants and have prepared a case alert available here.