Article by Lawrence E. Ritchie and Eric Morgan

A US appeals court has dismissed a proposed securities fraud class action, clarifying when a corporation will be deemed to make misstatements knowingly. The decision emphasizes the importance of compliance procedures for vetting procedures when making public statements and also demonstrates the strict approach US courts take when examining pleadings alleging securities fraud.

The Claim

The plaintiff shareholder in In Re: Omnicare, Inc. Securities Litigation brought a proposed class action against the defendant company, a pharmaceutical care provider, and several executives. The plaintiff alleged the defendants had committed securities fraud, making misrepresentations about the company's compliance with Medicare and Medicaid regulations. The plaintiff alleged the company knew these statements were false based on internal audits that revealed evidence of fraudulent billing practices.

The Decision

The US appeals court for the Sixth Circuit, based in Cincinnati, Ohio, dismissed the action. The decision found that the plaintiff had failed to plead adequate facts:

  • That the defendant executives had actual knowledge of the audit results when the misrepresentations were made; and
  • That there was an intent to defraud the public.

Corporate Knowledge Of Wrongdoing

The appeals court noted that courts have taken different approaches to determining when a corporation will be deemed to have knowledge of its wrongdoing.

The court drew a distinction between 'hard' information (typically historical information which is objectively verifiable) and 'soft' information (which includes predictions, opinions and beliefs).

The statements at issue in this case were 'soft' information because, in the words of the lower court, they "merely revealed errors from limited internal audits, not finding of irregularities by an agency."

The court set out its preferred approach that the knowledge of the following individuals are probative of corporate knowledge of wrongdoing:

  • The individual agent who made the misrepresentation
  • An individual agent who reviewed or authorized the relevant information before the misrepresentation was made
  • Any high level manager or board member who ratified or tolerated the misrepresentation after it was made

The court believed this formulation struck a balance between:

  • Preventing corporations from evading liability through tacit encouragement or wilful blindness; and
  • Protecting corporations from liability when one individual unknowingly makes a false statement that another unconnected individual knew to be false.

The court's approach emphasizes to companies the importance of vetting procedures when making public statements, but refuses to apply a rule of strict liability. The proposed class action class action was dismissed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.