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Pleading Scienter in Securities Fraud Actions

By: Katya Long

The Texas Southern District Court’s decision in Caleb HO v. Flotek Industries, Inc. embodies the most up-to-date Texas law on the heightened pleading standards in securities fraud actions as mandated by the Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act (the “PSLRA”). Caleb HO, et al. v. Flotek Indus., Inc., et al., 2017 WL 1240111 (S.D. Tex. 2017).

Essentially, the standards compel securities fraud Plaintiffs to make such ‘cogent and compelling’ allegations as to elicit a strong inference of scienter—or the state of mind—on behalf of those individuals who made the allegedly misleading statements. Id. at *4-5.

The Court’s use of the terms ‘cogent and compelling’ is neither accidental nor original. Rather, these terms derive from one of the securities law’s seminal decisions in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 323 (2007).

In Tellabs, the United States Supreme Court has delineated the analytical framework for testing motions to dismiss the complaints based on allegations of securities violations of section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”).

The Flotek Court adhered to the Tellabs framework as much as a court possibly could when it is tasked with an interpretation of such amorphous terms as cogent and compelling.

To elaborate, in Flotek, Caleb HO and other investors alleged that the corporate representatives of a public chemical company Flotek Industries, Inc., violated sections 10(b) and 20(a) of the Exchange Act and the SEC Rule 10b-5 when they issued “false” or “misleading” statements about the accuracy and usefulness of its proprietary software application (“FracMax”) in marketing its drilling fluids technologies. Flotek, 2017 WL 2017 WL 1240111 at *2-3.  

According to the investors, Defendants made those statements while they were fully aware that the statements were “false” or “misleading” and that the chemical company “systematically” manipulated the FracMax’s data to enhance marketability of its nano-Fluid technologies that purportedly increased oil and gas wells profitability. Id. at *2.

Defendants responded that their statements about the enhanced production of those wells that used its nano-Fluid technologies were neither false nor misleading. Instead, in making their statements, Defendants merely relied on the FracMax’s data that contained errors of which Defendants were evidently unaware. As such, Defendants argued, Plaintiffs’ complaint failed to satisfy the heightened pleading requirements and must be dismissed. Id. at *5-6.

The Flotek Court agreed with Defendants, finding that Plaintiffs’ allegations failed to allege facts that gave rise to a ‘strong inference that the defendant[s] acted with the required state of mind’ in making their statements about FracMax. Id. at *4-6 (citing 15 U.S.C. § 78u-4(b)(2)(A)). To the contrary, the Court noted, there existed “a strong, plausible, nonculpable inference that Defendants mistakenly relied on the data produced by FracMax.” Id. at *9.

Plaintiffs failed to negate the non-culpable inference because they did not allege facts demonstrating Defendants’ actual or constructive knowledge of the errors in data. Id.

To the contrary, Plaintiffs’ allegations that Defendants used an algorithm to collect data into statistically significant results or that they used a third-party to collect the publicly available data, according to the Flotek Court, failed to equate with any actual or constructive knowledge on Defendants’ part concerning the errors in the data. Id. at *6.

Plaintiffs, the Court remarked, might have avoided the dismissal had they pleaded facts showing that Defendants should have known the data was inaccurate. Id.

For instance, had Plaintiffs alleged facts showing that Defendants had an expertise in developing data-driven software, a finding of a strong inference of scienter would have been more likely. Id. at *7.   

Further, the Flotek Court observed that Defendants’ failure to verify the accuracy of the data merely indicated Defendants’ poor business judgment that could not translate into a finding of a strong inference of scienter, but which instead was more consistent with a finding of negligence. Id. at *6.   

As to Defendants’ motive to present its nano-Fluid technologies in a favorable light, such a motive, standing alone, could not establish scienter. Id. at *7-8. Instead, Plaintiff should have pleaded facts showing that Defendants had reasons to doubt the accuracy of FracMax’s data and that they ignored those reasons. Id. at *9.

Based on Flotek, while such terms as compelling or cogent are admittedly amorphous, so long as Plaintiffs that file section 10(b) actions demonstrate particular facts that support Defendants’ actual or constructive knowledge of the false or misleading nature of the remarks made to investors, Plaintiffs should be in good shape to avoid a dismissal for failure to establish a strong inference of scienter.