US Supreme Court Declines to Resolve Pleading Requirements for Securities Fraud Claims

Overview

In an unexpected turn of events, the U.S. Supreme Court recently dismissed without explanation two securities fraud class action cases out of the U.S. Court of Appeals for the 9th Circuit—Facebook, Inc. v. Amalgamated Bank [No. 23-980] and NVIDIA Corp. v. E. Ohman J:or Fonder AB [No. 23-970]—that many were anticipating would clarify the exacting pleading requirements civil plaintiffs must satisfy in securities fraud class actions brought under the Securities Exchange Act of 1934 (the “Exchange Act”). Specifically, the three key questions before the Court were: (1) whether plaintiffs seeking to allege a strong inference of scienter under the Private Securities Litigation Reform Act (PSLRA)—a rigorous and formidable burden—based on allegations about internal company documents must plead the contents of those documents with particularity; (2) whether plaintiffs can satisfy the PSLRA’s particularized falsity requirement by relying on an expert opinion as a substitute for specific allegations of fact in a complaint; and (3) whether a risk disclosure is false or misleading when it does not disclose that a risk has materialized in the past, even if that past event raises no known present or future risk to the harm of the business.

Background

Both securities class actions were originally brought in the Northern District of California, where investors sued Facebook, NVIDIA and three of each company’s officers, alleging that they knowingly or recklessly made materially false or misleading statements to shareholders. Both cases were brought under Rule 10b-5 and Section 10(b) of the Exchange Act.

In Facebook, the putative class of shareholders contended that Facebook made materially misleading statements and omissions regarding Cambridge Analytica’s improper use of millions of Facebook users’ data. Specifically, the plaintiffs alleged that Facebook’s statements on the Cambridge Analytica data breach were inaccurate because Facebook painted the negative risk of data misuse by third parties as hypothetical in its Form 10-K filings, despite the fact that Cambridge Analytica had already committed the misuse.  

In NVIDIA, the putative class advanced similar claims, asserting that NVIDIA’s chief officers minimized the company’s sales of GeForce graphics processing units (GPUs) to crypto miners and instead attributed its revenue success to video game purchase partners, which are less susceptible to market swings. To show scienter, the plaintiffs alleged that NVIDIA’s officers had access to purported internal sources of information indicating a relatively high demand for GPUs from cryptocurrency miners.

District Court’s Rulings

The district court dismissed both complaints. In Facebook, the court did not find Facebook’s risk factor disclosure regarding the improper use of data by a third party misleading. This was because Cambridge Analytica’s data harvesting efforts of Facebook’s user data were already public knowledge when Facebook publicized the risks. For its part, the NVIDIA court concluded that the plaintiffs’ reliance on references to internal records fell short of the requirement to plead scienter, rejecting the plaintiffs’ claim at the pleadings stage. The court reasoned that the plaintiffs failed to “adequately tie the specific contents of any of these data sources to particular statements so as to plausibly show that the Defendant who made each specified statement knowingly or recklessly spoke falsely.”

9th Circuit’s Holdings

Two equally divided 9th Circuit panels reversed the district courts’ decisions in Facebook and NVIDIA in relevant part.

As to the district court’s holding in Facebook, the appeals court concluded that the full scope of the Cambridge Analytica scandal was not yet public when Facebook filed its Form 10-K and that the plaintiffs had adequately alleged that the company’s risk disclosure was misleading because the disclosure “represented the risk of improper access to or disclosure of Facebook user data as purely hypothetical when that exact risk had already transpired.” In the panel’s view, Cambridge Analytica’s breach—not the anticipation of impending reputational or financial harm stemming from it—rendered Facebook’s risk disclosure misleading.

With respect to the district court’s decision in NVIDIA, the 9th Circuit held that the plaintiffs adequately alleged a claim under Section 10(b) and Rule 10b-5 against NVIDIA and its officers. The court found that the plaintiffs satisfied the scienter requirement, reasoning that NVIDIA’s CEO’s “detail-oriented management style would have led him to become aware of the source of more than a billion dollars in company revenue during a fifteen- or eighteen-month period.” On falsity, which the district court did not reach, the 9th Circuit concluded that the plaintiffs had sufficiently alleged that NVIDIA’s statements about GeForce GPU revenue from cryptocurrency miners were false, considering the true revenue the company earned from those miners. While the plaintiffs did not have access to the actual GeForce revenue attributable to cryptocurrency miners, they relied on an expert consulting firm’s analysis of publicly available data to derive the figure. The expert opinion was deemed reliable by the 9th Circuit, partly because it was supported by public analyses, witness statements and corroborating market events.

Supreme Court’s Dismissals

Facebook and NVIDIA filed writs of certiorari before the U.S. Supreme Court following the respective 9th Circuit decisions. In its petition, Facebook asked the Court to resolve whether risk disclosures are false or misleading “when they do not disclose that a risk has materialized in the past, even if that past event presents no known risk of ongoing future business harm.” NVIDIA asked the Court to decide (1) whether scienter requires plaintiffs to plead with particularity the contents of internal company documents when bringing claims based on those documents, and (2) whether the falsity requirement can be met by relying upon an expert opinion as a substitute for particularized facts. After hearing arguments on whether to permit the lawsuits to move forward, however, the Court dismissed both cases as “improvidently granted” within weeks of one another, leaving the 9th Circuit’s rulings intact.

Takeaways

While the Supreme Court’s dismissal orders are short on paper, in practice, the decision to dismiss Facebook and NVIDIA means that both companies will now have to face protracted and costly merits and class discovery. Indeed, the heightened pleading standard required by the PSLRA is designed to stave off meritless claims brought by plaintiffs, safeguarding defendants from discovery pursuant to the PSLRA’s discovery stay until plaintiffs prevail at the pleadings stage.

The Supreme Court’s dismissals also may have implications for companies facing the threat of securities litigation. In securities class actions, defendants bring motions to dismiss to challenge the adequacy of allegations on the elements of scienter and falsity. Plaintiffs often seek to prove these elements by alleging that internal company documents contradict company executives’ public statements. The 9th Circuit appears to have adopted a more relaxed standard for the particularity with which plaintiffs must plead the contents of these documents, sanctioning the practice of retaining expert witnesses to support what may be otherwise unsupported allegations of falsity. As a result, plaintiffs’ reliance on expert testimony will likely rise. Further, companies disclosing risk will likely move towards greater disclosure, necessitating a more onerous compliance process for companies.

It remains to be seen whether the 9th Circuit’s acceptance of these methods to defeat a motion to dismiss will spread to other circuit courts. What remains certain, however, is that circuit courts will continue to grapple with pleading requirements in securities fraud class actions in light of the Supreme Court’s dismissals in Facebook and NVIDIA. The Court’s dismissals thus are not decisions reached, but decisions deferred.