On July 20, 2021, a panel of the United States Court of Appeals for the Ninth Circuit unanimously affirmed a decision of the United States District Court for the Western District of Washington dismissing with prejudice a putative class action lawsuit asserting claims under Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") against a wholesale retailer (the "Company") and certain of its executives, as well as Section 20(a) claims against those individual defendants.   Davoli, et al. v. Costco Wholesale Corp., et al., No. 20-35821 (9th Cir. July 20, 2021).  Plaintiff alleges that defendants made false statements regarding the strength of the Company's internal controls over financial reporting.  The district court dismissed plaintiff's Second Consolidated Amended Complaint (the "SAC") for failure to adequately plead scienter and the Ninth Circuit affirmed.  The Panel's unpublished opinion cannot be cited as precedent except as provided by Ninth Circuit rules.

According to the SAC, defendants made false and misleading statements about the Company's financial controls.  Specifically, the SAC alleges that statements in the Company's June 2018 Form 10-Q and the accompanying Sarbanes-Oxley certifications failed to disclose material weaknesses in the Company's internal controls regarding the Company's information technology (IT) systems related to its financial reporting.  According to the confidential witness cited in the SAC, defendants allegedly knew of "a strategy on authentication and authorization that would have remediated user administration and access control issues."  Although this strategy was approved by an IT officer who allegedly reported up to one of the individual defendants, the confidential witnesses maintained that the Company ultimately failed to implement this strategy because "there was no budget" and "there were more important things to work on."  The SAC also contained allegations from unidentified former Company employees that one of the individual defendants sent a series of internal emails in 2017 allegedly stating the need to "button up internal controls and prioritize [Sarbanes-Oxley] compliance issues," but later "gave up."  According to plaintiff, defendants knew in 2017 that the Company's IT Risk Management Department was disorganized but failed to improve it, allegedly considering internal controls to be an "afterthought."

The Ninth Circuit first turned to the district court's ruling that plaintiffs failed to adequately plead scienter with respect to statements made by the Company in its June 2018 Form 10-Q.  The Court found that the SAC "failed to raise a strong inference that any senior controlling officer of [the Company] . . . had the requisite scienter of deliberate recklessness" that could be imputed to the Company.  In particular, the Court held that the confidential witnesses "failed to make sufficiently particularized allegations" that defendants, in spite of knowing the material weaknesses in the Company's internal controls, "made assurances regarding effective internal control with deliberate recklessness" in signing the Company's June 2018 Form 10-Q.  Finding that the confidential witnesses' roles at the Company did not provide them with "personal knowledge" as to what information defendants possessed, the Court affirmed that "the witnesses' allegations were insufficient" to demonstrate that defendants knew about the Company's "weaknesses in the internal control over financial reporting."  The Court also affirmed that the confidential witnesses' allegations failed to sufficiently plead that the IT officer or other IT employees were aware that the Company's internal controls were ineffective in June 2018 or that they were "sufficiently involved with the making of the June 2018 10-Q statement so that . . . their failure to act could support a strong inference of deliberate recklessness."  The Court observed that the individual defendants' SOX certifications "themselves add nothing substantial to the scienter calculus."

Further, the Ninth Circuit found that the inferences raised in the SAC were "not as compelling as the opposing innocent inference" that defendants did not know that the Company's "internal control was ineffective until the more rigorous internal review performed in advance of the October 2018 Form 10-K."  The Court affirmed the district court's dismissal, holding that plaintiff failed to adequately allege that defendants made the alleged statements with deliberate recklessness and holding that such allegations failed to satisfy the heightened pleading standards of the PSLRA.  Notably, the Court rejected plaintiff's argument that the Ninth Circuit's decision in In re Oracle Corp. Securities Litigation, 627 F.3d 376 (9th Cir. 2010) permits scienter to be pled by alleging "red flags" regarding a possible misstatement and "access" to underlying facts, observing that such a standard "is effectively a negligence standard" which the Ninth Circuit consistently has rejected.

Having affirmed the dismissal of the Section 10(b) claim, the Court similarly affirmed the dismissal of plaintiff's control-personal liability claims under Section 20(a), finding no predicate violations of the Exchange Act under which such claims could be established.

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