June 24, 2019

Tenth Circuit: Dismissal Appropriate Where Plaintiffs Failed to Show Scienter

The Tenth Circuit Court of Appeals issued its opinion in In re ZAGG, Inc. Securities Litigation: Swabb v. ZAGG, Inc. on Tuesday, August 18, 2015.

Robert Pedersen, former CEO and Chair of ZAGG, Inc., pledged nearly half of his shares in ZAGG, Inc., as collateral in a margin account. Pedersen’s pledged shares equaled nearly 9 percent of the company. ZAGG was required by SEC Rule S-K to disclose the amount of shares pledged as security “in a footnote or otherwise” in ZAGG’s Form 10-K, but Pedersen failed to make the required disclosure. In December 2011, ZAGG share prices fell, creating a deficiency in Pedersen’s account, and he was forced to sell 345,200 of his shares to meet the margin call. He mailed a Form 144 to the SEC disclosing the margin call on December 22, 2011, and electronically filed a Form 4 the next day. Pedersen’s account experienced a second margin deficiency in August 2012, and he was forced to sell an additional 515,000 shares. Pedersen filed a Form 4, stating the sale occurred “to meet margin calls.”

On August 17, 2012, ZAGG issued a press release announcing Pedersen was stepping down as Chair and CEO. ZAGG also filed a Form 8-K with the SEC, stating the company had implemented a policy prohibiting officers, directors, and 10 percent shareholders from pledging ZAGG securities on margin. A week later, after Pedersen’s resignation was final, a third margin call resulted in the forced sale of his remaining ZAGG shares. ZAGG held a conference call to reassure investors, and stated that Pedersen’s departure was entirely related to the margin call situation. Pedersen also spoke at the call, telling investors he had taken a step toward building investor confidence by completely deleveraging his ZAGG stock.

Plaintiffs filed a complaint against ZAGG and six individual officers and directors on behalf of a putative class of all people who purchased ZAGG stock during the relevant time period, alleging the company’s filings omitted material information regarding Pedersen’s pledged shares and also that ZAGG failed to disclose a secret succession plan that had been implemented after Pedersen’s first margin call in December 2011. Defendants filed two motions to dismiss, the first by Pedersen and the second by ZAGG and several individual officers and directors. After a hearing on the motions, the court dismissed the complaint with prejudice, finding the § 10(b) and § 14(a) claims failed because they did not allege with particularity facts giving rise to a strong inference Pedersen intended to violate securities laws. Plaintiffs appealed only the dismissal of their §10(b) and Rule 10b-5 claims and only as to Pedersen and ZAGG, and only as to Pedersen’s material omission of his margin account.

The Tenth Circuit agreed with the district court that plaintiffs failed to meet the heightened pleading requirements applicable to the scienter element in § 10(b) claims. The district court held that plaintiffs proved only one element of scienter—that Pedersen knew of the pledged securities in the margin account. The district court held, and the Tenth Circuit agreed, that the complaint failed to allege any facts showing that Pedersen knew failure to reveal the account would likely mislead investors. Plaintiffs listed five facts they claimed proved scienter: (1) Pedersen made inconsistent statements following the first margin call, (2) Pedersen selectively complied with the Item 403(b) disclosure requirement, (3) Pedersen knew that disclosing his margin account would jeopardize his position at ZAGG, (4) Pedersen was forced to resign because of his margin account, and (5) following Pedersen’s resignation, ZAGG adopted a policy prohibiting holding stock in margin accounts. The Tenth Circuit analyzed each claim.

First, the Tenth Circuit evaluated plaintiffs’ claim that Pedersen’s statements on the Forms 144 and 4 in December 2011 were inconsistent. Pedersen stated on the Form 4 that the sale was made “to meet an immediate financial obligation” and on the Form 144 that the sale was made “to meet margin calls.” The Tenth Circuit found no inconsistency in these two statements, as margin calls could certainly be characterized as immediate financial obligations. Plaintiffs also argued that it was deceptive of Pedersen to mail the Form 144 when he e-filed the Form 4, but the Tenth Circuit noted Pedersen was under no obligation to deliver the forms via the same method.

The Tenth Circuit next addressed plaintiffs’ argument that Pedersen’s failure to disclose his margin account amounted to scienter. Defendants argued that the violation of a rule is not enough to show scienter, and the Tenth Circuit agreed. Without some other facts evidencing Pedersen knowingly omitted the disclosure, the violation alone was not enough. Plaintiffs argued Pedersen failed to disclose the account because he knew it would jeopardize his position at ZAGG, but the Tenth Circuit again found that at most Pedersen’s execution of the certifications supported an inference of negligence.

The Tenth Circuit similarly found that neither Pedersen’s forced resignation nor ZAGG’s implementation of a new policy barring investors from pledging ZAGG shares on margin accounts established an intent to defraud. Rather, the Tenth Circuit found that both the resignation and new policy acknowledged that the company had found a better way to run its business moving forward. The district court found, and the Tenth Circuit agreed, that the complaint failed to allege any facts giving rise to an inference of scienter. Plaintiffs argued that even if the knowing element was not met, the facts showed that Pedersen acted with reckless disregard of a substantial likelihood of misleading investors. The Tenth Circuit disagreed, finding that plaintiffs failed to overcome the high standard necessary to show recklessness.

The Tenth Circuit affirmed the district court.

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