In the Private Securities Litigation Reform Act of 1995, Congress imposed heightened pleading standards on securities fraud claims in order to discourage the filing of unmeritorious litigation.[1]  Key among these standards are the dual requirements that a complaint “state with particularity”:  (i) “all facts” on which allegations based on information and belief are formed; and (ii) facts giving rise to a “strong inference that the defendant acted with the required state of mind.”[2]  Notwithstanding these heightened pleading standards, a small number of courts within the Second Circuit have continued to apply pre-PSLRA case law finding scienter to be adequately pleaded through the so-called “core operations” doctrine, under which a defendant’s intent to deceive can be assumed (even in the absence of particularized facts) based solely on the assertion that the underlying issue was so important that the defendants must have known about it.  Emboldened by these decisions, plaintiffs in securities class actions have increasingly invoked the doctrine and have also sought to extend it to issues that fall well outside the “core” of a company’s operations.  These aggressive applications of the core operations doctrine demonstrate its potential for abuse and further highlight the doctrine’s inconsistency with the pleading standards imposed by the PSLRA.  Though the Second Circuit has recently confirmed that the core operations doctrine is not an independent basis for pleading scienter, the doctrine remains inconsistent with the PSLRA and should be rejected entirely.

The Origins of the Core Operations Doctrine

Although it is difficult to find the specific origins of the core operations doctrine, courts  generally consider the Second Circuit’s pre-PSLRA decision in Cosmas v. Hassett, 886 F.2d 8 (2d Cir. 1989), to be the seminal “core operations” case.[3]  In Cosmas, the defendant corporation was a provider of projection and video equipment and services.[4]  The Second Circuit found that the plaintiffs adequately pled scienter where the complaint alleged that the company’s CEO made statements indicating that sales to the People’s Republic of China were an “important new source of revenue” for Inflight, even though the company was subsequently forced to “write down” a substantial amount of inventory because Chinese regulations that existed at the same time prevented sales to that country.[5]  The Second Circuit reasoned that the “complaint alleges facts from which one can reasonably infer that sales to [China] were to represent a significant part of Inflight’s business.  These facts give rise to a strong inference that the defendants, who the . . . complaint alleges were directors of Inflight, had knowledge of the PRC restrictions, since the restrictions apparently eliminated a potentially significant source of income for the company.”[6]

Over time, this limited holding was expanded into the broader core operations doctrine, which “permits an inference that a company and its senior executives have knowledge of information concerning the ‘core operations’ of a business.”[7]  The doctrine has been described as a “variant” on scienter arguments rooted in corporate position,[8] though courts have long held that “boilerplate allegations” that a defendant knew or should have known of fraudulent conduct based solely on their executive positions are insufficient, standing alone, to plead scienter.[9]  Courts considering the doctrine have generally stated that a company’s core operations “include matters critical to the long term viability of the company and events affecting a significant source of income.”[10]  In other words, if “a plaintiff can plead that a defendant made false or misleading statements when contradictory facts of critical importance to the company either were apparent, or should have been apparent, an inference arises that high-level officers and directors had knowledge of those facts by virtue of their positions with the company.”[11]

Questions Concerning The Doctrine’s Viability Following the PSLRA

Whether the core operations doctrine remains a valid theory to plead scienter in light of the PSLRA’s heightened pleading standards has not yet been explicitly decided by the Second Circuit.  Other Courts of Appeals that have addressed the question, however, have found that the core operations doctrine is no longer viable in most situations.[12]

Moreover, many district courts within the Second Circuit have questioned the continued viability of the doctrine.  In one instance, Judge Sullivan critically stated that “[b]ased on the trajectory of ‘core operations’ law in this and other circuits, the Court ventures to suggest that the future of the doctrine may be tenuous.  Indeed, the plain language of the PSLRA . . . would seem to limit the force of general allegations about core company operations.”[13]  Judge Sullivan, before his appointment to the Second Circuit, repeated this criticism in a number of opinions.[14]  Other courts have noted that the doctrine cannot support an inference of scienter on its own because it does not dispose of the “general requirement that Plaintiffs allege facts available to Defendants that would have illuminated the falsities” of the allegedly fraudulent statements.[15]

In the absence of a Second Circuit decision explicitly overruling Cosmas, however, those courts (and others) have generally assumed that the doctrine remains valid but have nonetheless severely circumscribed it in several significant ways.  First, courts applying the doctrine typically require that the operation in question constitute “nearly all of a company’s business” and be “critical to the long term viability” of the company before finding scienter.[16]  Some courts have even gone as far to say that the core operation must be “essential” to the company’s survival.[17]  Second, the “core operations inference” may be considered as part of a court’s “holistic assessment of scienter allegations,” but, on its own, has generally not been considered “independently sufficient to raise a strong inference of scienter.”[18]  Finally, recent case law consistently suggests another potential requirement:  the magnitude of the alleged fraud must be “startling” in relation to the core operation.[19]

In a recent decision, the Second Circuit similarly criticized the core operations doctrine but stopped short of eliminating it entirely.  That decision admonished the plaintiffs for arguing that the relevant product was a “key product” for the defendant company, such that its senior officers must have known that challenged statements pertaining to the product were false.[20]  Jackson’s rejection of the “naked assertion, without more,” that the product was a “key product” affirms the holdings of those lower courts that have held the core operations doctrine is not an independently sufficient basis to plead scienter.[21] The ruling may also demonstrate the Second Circuit’s limited appetite to entertain arguments based on the core operations doctrine.  However, a subsequent case in the Southern District of New York noted Jackson’s holding, but still stated that allegations regarding core operations may factor into a court’s holistic assessment of scienter allegations.[22]

Recent Attempts to Expand the Doctrine

Although most district courts in the Second Circuit have either rejected the core operations doctrine or significantly narrowed it in light of the PSLRA, a small number have accepted the doctrine in certain cases before them.  For example, in Oklahoma Firefighters Pension & Retirement System v. Lexmark Int’l, Inc., the court denied the defendants’ motion to dismiss, holding that the plaintiffs’ core operations allegations “buttressed” their otherwise sufficient scienter allegations.[23]  There, the plaintiffs accused Lexmark of “channel stuffing” in their Europe, Middle East, and Africa (“EMEA”) supply channel, which accounted for 35% of revenue for the printer and cartridge division that comprised 83% of Lexmark’s business and was its primary profit engine.  Although the court appears to have concluded that the complaint also contained other specific factual allegations that satisfied the PSLRA’s heightened pleading standards, it also observed that the alleged importance of the EMEA channel further “move[d] the needle in Plaintiffs’ favor.”[24]

Possibly buoyed by this decision, and a small number of others like it,[25] plaintiffs have routinely invoked the doctrine – and its relaxed standard for pleading scienter – in many recent cases.  In fact, a review of complaints and motion to dismiss opposition briefs from the 53 securities fraud class actions filed in the Southern District of New York in 2019 reveals that the core operations doctrine was cited by the plaintiffs in almost half of those cases.

Moreover, plaintiffs have also increasingly invoked with doctrine with respect to issues that bear little relation to a company’s core operations, and that push the doctrine to its limits and beyond.  For example, in Das v. Rio Tinto PLC, the plaintiffs argued that “integrity” was a core operation of Rio Tinto’s, as well as a single mine development project (by claiming it was a “significant” project, without even providing “the comparative amount of resources that Rio Tinto exerted on other projects”).[26]  Other examples abound, including cases where it has been argued that internal accounting and management,[27] and commercialization efforts for a particular product[28] are core operations.

Conclusion

This recent flood of attempts to vastly expand the core operations doctrine further demonstrate that the doctrine is inappropriate under the PSLRA.  As an initial matter, the doctrine, which asks a court to assume scienter exists in the absence of particularized facts, defies the PSLRA’s heightened pleading standards.  But beyond that, the limitless way in which the doctrine has been advanced demonstrates that it presents the precise type of abuse that the PSLRA was intended to eliminate.  Therefore, as the PSLRA approaches its 25th anniversary, it is past time for the Second Circuit to put the core operations doctrine to rest, and the Second Circuit’s recent decision in Jackson demonstrates the Court may be well on its way to doing just that.

ENDNOTES

[1] See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 324 (2007).

[2] 15 U.S.C. § 78u–4 (b)(2).

[3] See Frederick v. Mechel OAO, 475 F. App’x 353, 356 (2d Cir. 2012); Epstein v. Itron, Inc., 993 F. Supp. 1314, 1326 (E.D. Wash. 1998), abrogated by In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970 (9th Cir. 1999).

[4] Cosmas, 886 F.2d at 10.

[5] Id. at 12.

[6] Id. at 13.

[7] In re Hi-Crush Partners L.P. Sec. Litig., No. 12 Civ. 8557(CM), 2013 WL 6233561, at *26 (S.D.N.Y. Dec. 2, 2013) (citations omitted).

[8] In re Rockwell Med., Inc. Sec. Litig., No. 16 Civ. 1691 (RJS), 2018 WL 1725553, at *14 (S.D.N.Y. Mar. 30, 2018).

[9] In re Sotheby’s Holdings, Inc., No. 00 Civ. 1041(DLC), 2000 WL 1234601, at *7 (S.D.N.Y. Aug. 31, 2000). 

[10] In re Hi-Crush Partners L.P. Sec. Litig., 2013 WL 6233561, at *26.

[11] City of Pontiac Gen. Employees’ Ret. Sys. v. Lockheed Martin Corp., 875 F. Supp. 2d 359, 371 (S.D.N.Y. 2012).

[12] See Yates v. Municipal Mortg. & Equity LLC, 744 F.3d 874, 890 (4th Cir. 2014) (stating that allegations regarding “core operation” and corporate position not sufficient under PSLRA); Police Retirement System of St. Louis v. Intuitive Surgical, Inc., 759 F.3d 1051, 1062 (9th Cir. 2014) (stating that allegations regarding “core operation” insufficient absent “specific admissions by . . . corporate executives of detailed involvement in the minutia of a company’s operations, such as data monitoring” or “witness accounts demonstrating that executives had actual involvement in creating false reports”); Hall v. Rent-A-Center, Inc., No. 4:16cv978, 2017 WL 6398742, at *32 (E.D. Tex. Oct. 19, 2017) (stating that the Fifth Circuit recognizes the core operations doctrine only as supplementary evidence that “might” demonstrate scienter when combined with any of four specific “considerations”) (citing Nathenson v. Zonagen Inc., 267 F.3d 400, 425 (5th Cir. 2001)).

[13] In re Wachovia Equity Sec. Litig., 753 F. Supp. 2d 326, 353 (S.D.N.Y. 2011) (noting that the future of the core operations doctrine may be “tenuous” and that “the plain language of the PSLRA, which requires facts supporting the scienter inference ‘state[d] with particularity,’ would seem to limit the force of general allegations about core company operations.”); see also In re Kandi Technologies Grp., Inc. Sec. Litig., No. 17 Civ. 1944 (ER), 2019 WL 4918649, at *7 (S.D.N.Y. Oct. 4, 2019) (“There also seems to be some tension between the doctrine and the plain requirement by PSLRA that scienter be pled with particularity.”)

[14] See In re Rockwell Med., Inc. Sec. Litig., 2018 WL 1725553, at *14–15.; In re Ferrellgas Partners, L.P., Sec. Litig., No. 16 Civ. 7840 (RJS), 2018 WL 2081859, at *19 (S.D.N.Y. Mar. 30, 2018), aff’d, 764 F. App’x 127 (2d Cir. 2019); Shemian v. Research In Motion Ltd., No. 11 Civ. 4068 (RJS), 2013 WL 1285779, at *17–18 (S.D.N.Y. Mar. 29, 2013), aff’d, 570 F. App’x 32 (2d Cir. 2014)

[15] Louisiana Mun. Police Employees’ Ret. Sys. v. Green Mountain Coffee Roasters, Inc., No. 2:11-CV-289, 2013 WL 6728869, at *16 (D. Vt. Dec. 20, 2013) (citing Warchol v. Green Mountain Coffee Roasters, Inc., No. 2:10-CV-227, 2012 WL 256099, at *11 (D. Vt. Jan. 27, 2012)).

[16] In re Rockwell Med., Inc. Sec. Litig., 2018 WL 1725553, at *14; In re Salix Pharmaceuticals, Ltd., No. 14-CV-8925 (KMW), 2016 WL 1629341, at *16 (S.D.N.Y. April 22, 2016) (the alleged fraud concerned several of the pharmaceutical company’s core drugs); In re Hi-Crush Partners L.P. Sec. Litig., 2013 WL 6233561, at *26; But see Hawaii Structural Ironworkers Pension Tr. Fund v. AMC Ent. Holdings, Inc., 422 F. Supp. 3d 821, 852–53 (S.D.N.Y. 2019) (items constituting a “significant source of income” may be considered “core operations”).

[17] Tyler v. Liz Claiborne, Inc., 814 F. Supp. 2d 323, 344 (S.D.N.Y. 2011).

[18] In re Rockwell Med., Inc. Sec. Litig., 2018 WL 1725553, at *15; New Orleans Employees Retirements System v. Celestica, Inc., 455 F. App’x. 10, 14 (2d Cir. 2011) (considering “core operations” evidence to potentially constitute supplementary, but not an independent, means to plead scienter) (internal citations omitted).

[19] In re The Hain Celestial Grp. Inc. Sec. Litig., No. 2:16-CV-04581 (ADS)(SIL), 2019 WL 1429560, at *19 (E.D.N.Y. Mar. 29, 2019) (“[C]ore business allegations are not evidence of scienter unless the ‘magnitude’ of fraud is ‘startling’ in relation to core products.”); see In re Salix Pharm., Ltd., No. 2016 WL 1629341, at *16 (“The magnitude of the alleged fraud, and the fact that it involved Salix’s key drugs and ‘critical’ wholesale inventory metric, all provide additional support for finding that Defendants acted with scienter.”).

[20] Jackson v. Abernathy, 960 F.3d 94, 99 (2d Cir. 2020).

[21] Id. The Second Circuit had previously acknowledged, but did not adopt, this limitation in dicta in an unpublished decision.  See New Orleans Employees Retirements System, 455 F. App’x. at 14 n.3 (noting that the Court “need not address defendants’ argument[] that plaintiffs’ allegation[] regarding Celestica’s core operations [is] insufficient by [itself] to establish scienter” but that this view “finds support in decisions by this court and district courts within this circuit”).

[22] See Bratusov v. Comscore, Inc., No. 19 Civ. 3210 (KPF), 2020 WL 3447989 at *14 (S.D.N.Y. June 4, 2020) (emphasis in original).

[23] Oklahoma Firefighters Pension & Ret. Sys. v. Lexmark Int’l, Inc.,367 F. Supp.3d 16, 38 (S.D.N.Y. 2019).

[24] Id. at 38.

[25] See, e.g., AMC Ent. Holdings, Inc. 422 F. Supp.3d at 852–53 (finding that (i) acquisition and renovation of certain theaters constituted a significant source of income; (ii) AMC’s loyalty program was a “significant source of income and a central focus of AMC’s” and (iii) seasonal trends in AMC’s international operations “would plausibly affect a significant source of income” such that these three items constituted core operations, but which, without more, did not independently support a strong inference of scienter).

[26] Das v. Rio Tinto PLC, 332 F. Supp. 3d 786 at 816­–17 (S.D.N.Y. 2018).

[27] Reilly v. U.S. Physical Therapy, Inc., No. 17 Civ. 2347 (NRB), 2018 WL 3559089 at *18 (S.D.N.Y. July 23, 2018).

[28] In re Rockwell Med., Inc. Sec. Litig., 2018 WL 1725553 at *14.

This post comers to us from Cleary Gottlieb Steen & Hamilton LLP. It is based on the firm’s memorandum, “Rotten to the Core: Why It Is Time for the Second Circuit to Abandon the “Core Operations” Doctrine,” dated September 15, 2020.