District Court Properly Dismissed Securities Fraud Class Action Against JP Morgan Chase because Misrepresentations Underlying Class Action were not Material and Class Action Failed to Adequately Allege Scienter under Heightened Pleading Requirements Established by Private Securities Litigation Reform Act (PSLRA) Second Circuit Holds
Plaintiffs filed a class action against JP Morgan Chase (JPMC) and two of its officers alleging violations of federal securities laws; the class action complaint asserted that defendants “defrauded JPMC shareholders by making deliberate misrepresentations that artificially inflated the price of JPMC stock and ultimately led to a collapse of JPMC’s share price.” ECA v. JP Morgan Chase Co., ___ F.3d ___ (2d Cir. January 21, 2009) [Slip Opn., at 4]. More specifically, the class action alleged that JPMC “created disguised loans for Enron and concealed the nature of these transactions by making false statements or omissions of material fact in its accounting and Securities and Exchange Commission (SEC) filings.” Id. “JPMC created ‘Special Purpose Entities,’ among them an entity called Mahonia Ltd., to facilitate disguised loan transactions with Enron Corporation.” Id. “Following the collapse of Enron, however, the Senate investigated JPMC’s role in Enron’s fraudulent practices and concluded that JPMC had knowingly engaged in and actively assisted Enron in its sham transactions; the resulting disclosures caused JPMC’s stock to suffer significant losses.” Id., at 5. Defense attorneys moved to dismiss the class action for failure to meet the heightened pleadings requirements established by the Private Securities Litigation Reform Act (PSLRA); the district court dismissed the class action because it found that the class action complaint “failed to plead with the requisite particularity that JPMC made a materially false statement or omitted a material fact, with scienter.” Id., at 6. In particular, the district court found that plaintiffs adequately pleaded scienter only as to the “alleged improper accounting of the Mahonia transactions as trades rather than loans,” but found further that “the allegedly improper accounting of the Mahonia transactions as trades rather than loans was not material.” Id., at 6. Plaintiffs filed an amended class action complaint that included new allegations concerning “(1) JPMC’s alleged downplaying of its Enron-related exposure, (2) JPMC’s alleged misrepresentation of its integrity and risk management, and (3) the allegedly faulty reporting of the Mahonia transactions.” Id., at 7. Defense attorneys again moved to dismiss the class action, and the district court again granted the motion. See id., at 7-9. The Second Circuit affirmed.
The Second Circuit’s opinion provides a detailed discussion of the applicable law. See ECA, at -11-16. With respect to JPMC’s allegedly false financial reports, plaintiffs argued that defendants’ GAAP violations created a presumption that the financial statements were misleading, id., at 16-17. The Second Circuit agreed with plaintiffs that they had adequately alleged that JPMC and Mahonia were “related” and that they adequately alleged false or misleading statements by defendants, id., at 17, but the Court found the class action complaint failed to adequately allege scienter, id., at 17-25. The Circuit Court agreed with the district court’s finding that the class action “fail[s] to allege facts explaining why, if it was aware of Enron’s problems, [JPMC] would have continued to lend Enron billions of dollars,” id., at 25 (citation omitted), explaining at page 25 that “Even if JPMC was actively engaged in duping other institutions for the purposes of gaining at the expense of those institutions, it would not constitute a motive for JPMC to defraud its own investors.” The Court further rejected plaintiffs’ claim that JPMC disguised its loans to Enron as “trading activities,” id., at 25-30, agreeing with the district court that even assuming JPMC should have treated the prepaid transactions as trades rather than as loans was immaterial, id., at 25-26. Accordingly, “Because Plaintiffs have failed to adequately plead that JPMC made a materially false statement or omitted a material fact with scienter,” the district court properly dismissed the class action complaint. Id., at 33.
NOTE: The Second Circuit also rejected as mere “puffery” JPMC’s representations regarding its integrity and “highly disciplined” risk management. See ECA, at 30-32.