Berson v. Applied Signal Technology, Inc.
2008 U.S. App. LEXIS 11982, 527 F.3d 982 (2008)
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Rule of Law:
Once a company voluntarily discloses a financial metric, it has a duty to do so in a manner that is not misleading by omitting material facts. For pleading scienter under the PSLRA, a strong inference of knowledge may be attributed to high-level corporate officers if the undisclosed facts concern the company's core operations and are of such significance that it would be absurd to suggest management was unaware of them.
Facts:
- Applied Signal Technology, Inc. ('Applied Signal') derived almost all of its revenue from contracts with U.S. government agencies.
- These government customers had the authority to issue 'stop-work orders,' which could halt work on a contract for up to 90 days and often led to contract cancellation.
- Applied Signal received four separate stop-work orders which halted tens of millions of dollars of work.
- While these stop-work orders were in effect, Applied Signal continued to count the dollar value of the halted work in its publicly reported 'backlog' figure, a metric representing work under contract but not yet performed.
- Plaintiffs purchased Applied Signal stock during the six-month period when the company was reporting this backlog figure.
- Applied Signal subsequently announced that its quarterly revenue had fallen by 25%.
- Immediately following the revenue disclosure, Applied Signal's stock price dropped by 16%.
Procedural Posture:
- Plaintiffs, investors in Applied Signal, filed a securities fraud lawsuit against the company and two of its officers in the United States District Court.
- The defendants filed a motion to dismiss the complaint for failure to state a claim.
- The district court granted the defendants' motion to dismiss the complaint.
- The plaintiffs appealed the district court's dismissal to the U.S. Court of Appeals for the Ninth Circuit.
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Issue:
Does a securities fraud complaint adequately plead that a company's 'backlog' reports were misleading and made with scienter when the company included the value of work halted by government stop-work orders in that figure, and when scienter is inferred from the top executives' positions and the operational importance of the halted work?
Opinions:
Majority - Kozinski, Chief Judge
Yes. A securities fraud complaint adequately pleads its claims where it alleges particular facts showing that a company's financial reports were misleading and that knowledge can be inferred for top executives based on the operational importance of concealed negative information. The court found that counting halted work in a 'backlog' figure without disclosing the stop-work orders could mislead a reasonable investor, as the generic disclaimer about potential cancellations did not alert investors to risks that had already materialized. The court held that scienter was adequately pled against the CEO and CFO under the 'core operations' theory; the stop-work orders were so significant to the company’s revenue that it is 'absurd to suggest' top management, responsible for day-to-day operations, would be unaware of them. This strong inference is permissible under the PSLRA. The court also found that the backlog reports were not protected 'forward-looking statements' because they described the company’s present contractual status, not a future projection. Finally, the complaint adequately pled loss causation by linking the concealed stop-work orders to the subsequent revenue shortfall and stock price drop.
Analysis:
This decision reinforces the viability of the 'core operations' inference for pleading scienter in the Ninth Circuit after the passage of the Private Securities Litigation Reform Act (PSLRA). It clarifies that plaintiffs can satisfy the PSLRA's heightened pleading standard by alleging that undisclosed negative information was so central to a company's business that top executives' knowledge can be strongly inferred from their positions, without needing a confidential source or document directly proving their knowledge. The ruling also underscores that facially accurate statements, like a backlog number, can be materially misleading if they omit critical context. This holding limits the scope of the PSLRA's 'safe harbor' by defining backlog as a statement of present fact rather than a forward-looking projection, thereby exposing such statements to greater scrutiny in securities fraud litigation.
