South Ferry Lp v. Killinger ( 2008 )

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
SOUTH FERRY LP, # 2, individually 
and on behalf of all others
similarly situated,
No. 06-35511
Plaintiff-Appellee,
v.  D.C. No.
CV-04-01599-JCC
KERRY K. KILLINGER; DEANNA W.
OPINION
OPPENHEIMER; WASHINGTON
MUTUAL, INC.,
Defendants-Appellants.

Appeal from the United States District Court
for the Western District of Washington
John C. Coughenour, District Judge, Presiding
Argued and Submitted
April 8, 2008—Seattle, Washington
Filed September 9, 2008
Before: Raymond C. Fisher, Ronald M. Gould, and
Sandra S. Ikuta, Circuit Judges.
Opinion by Judge Gould
12533
SOUTH FERRY LP v. KILLINGER 12537
COUNSEL
Stephen M. Rummage, Davis Wright Tremaine LLP, Seattle,
Washington, and Jay B. Kasner (argued), and Scott D. Mus-
off, Skadden, Arps, Slate, Meagher & Flom LLP, New York,
New York, for the appellants.
Melvyn I. Weiss, Lori G. Feldman, and John Rediker, Mil-
berg Weiss & Bershad LLP, New York, New York, and Stu-
art J. Guber and James Evangelista, Motley Rice LLC,
Atlanta, Georgia, and Professor Arthur R. Miller (argued),
New York University School of Law, for the appellee.
12538 SOUTH FERRY LP v. KILLINGER
OPINION
GOULD, Circuit Judge:
Defendants-Appellants Kerry Killinger (“Killinger”),
Thomas Casey (“Casey”), Deanna Oppenheimer
(“Oppenheimer”) and Washington Mutual, Inc. (“WAMU”,
collectively, “Defendants”) appeal the district court’s partial
denial of their motion to dismiss a securities fraud action
brought by Plaintiffs-Appellees South Ferry LP et al. (“South
Ferry”), who allege violations of Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b),
78t(a), and its underlying regulations, found at Rule 10b-5, 17
C.F.R. § 240.10b-5. Defendants argue that the district court
erred by inferring that Defendants had knowledge of “core
operations” at WAMU based on their management positions
and argue that such an inference does not satisfy the height-
ened pleading requirements of the Private Securities Litiga-
tion Reform Act of 1995, 15 U.S.C. § 78u-4(b)(2)
(“PSLRA”). The district court certified for interlocutory
appeal its order granting in part and denying in part defen-
dants’ motion to dismiss. We have jurisdiction pursuant to 28
U.S.C. § 1292(b), vacate the district court’s order, and
remand.
I
WAMU is a publicly-traded financial services company
that serves individuals and small businesses, offering con-
sumer banking, mortgage lending, commercial banking, and
other services. Defendants Killinger, Casey, and Oppenhei-
mer all served as officers of WAMU during the class period,
with Killinger serving as the Chairman of WAMU’s Board of
Directors, President, and CEO, Casey serving as Executive
Vice-President and CFO, and Oppenheimer as President of
WAMU’s consumer group. Thus, they held not merely nomi-
nal but rather key officer positions at relevant times.
SOUTH FERRY LP v. KILLINGER 12539
Plaintiffs are WAMU shareholders who seek to represent a
class of individuals who owned WAMU stock between April
15, 2003 and June 28, 2004. The complaint relates to several
related aspects of WAMU’s mortgage lending business. That
business involves originating home loans, buying and selling
home loans in the secondary markets, mortgage servicing, and
providing mortgage-insurance products.
When WAMU originates a home loan, it may later sell that
loan to another institution on the secondary market. However,
WAMU typically retains the mortgage servicing rights
(“MSRs”) for the loans that it sells. The holder of MSRs,
WAMU here, provides billing and other services to mortgage
customers for the life of the loans even though a different
entity may actually own them. MSRs have an independent
value to WAMU because WAMU is paid a portion of each
loan payment for the services it provides.
This case relates to two types of risk present in WAMU’s
mortgage lending business, both of which are exacerbated by
nationwide interest rate fluctuations. The first, “MSR-related
risk,” is the risk that WAMU will lose MSR-related revenue
due to the pre-payment of loans that it services. MSR-related
risk is greatest in an environment in which interest rates are
falling, because falling rates make it more likely that borrow-
ers will refinance their loans to take advantage of cheaper
financing. When they do so, the original mortgage loan is paid
in its entirety and replaced with a lower-interest loan, often
from a different lender. Because WAMU’s MSR-related reve-
nue from a given loan comes from the services that it provides
over the life of that loan, a loan that is fully repaid at an early
date due to refinancing causes WAMU to lose future MSR-
related revenue.
The second type of risk, “pipeline risk,” is the risk that
WAMU will commit to fund a loan at a certain interest rate
only to see market interest rates change by the time the loan
is finalized. This may occur whenever interest rates change.
12540 SOUTH FERRY LP v. KILLINGER
Borrowers typically “lock in” an interest rate on their home
mortgage loan several weeks before they actually close a
mortgage deal. A loan in this lock-in period is referred to as
a loan “in the pipeline.” When mortgage rates are falling, bor-
rowers may find that the rate that they have locked in is
higher than the prevailing rates at the time of their closing.
Those borrowers may abandon a lender with a loan in the
pipeline, such as WAMU, to take a mortgage from a different
lender at the lower then-current rate. Conversely, when rates
are rising, borrowers may lock in rates that turn out to be
below market by the time of their closing, leaving WAMU to
fund at below market rates all loans that were in the pipeline
at the time that rates rose.
To manage MSR-related and pipeline risk, WAMU hedges
its expected MSR and mortgage-origination revenues with
securities and derivative instruments. In a rising interest rate
environment, WAMU also relies on an important “natural
hedge” to protect its revenues. When rates are rising, WAMU
faces greater pipeline risk because market rates are more
likely to exceed the locked-in rates at the time mortgage deals
close. However, MSR revenues provide some protection from
this pipeline risk, because borrowers are less likely to refi-
nance and pre-pay their mortgages when the rates that would
apply to their refinancing loans are higher than the rates they
pay on their existing mortgage. Accordingly, WAMU
receives more stable MSR-related revenues when it suffers
increased pipeline risk. This natural hedge, in theory, allows
WAMU to have a more steady revenue stream despite volatil-
ity of interest rates.
South Ferry alleges that the individual defendants made
materially false or misleading statements concerning
WAMU’s ability to manage MSR-related and pipeline risk
during the class period. South Ferry also alleges that the indi-
vidual defendants repeatedly assured investors that the natural
hedge and additional securities and derivative hedges would
allow WAMU to thrive in an environment where interest rates
SOUTH FERRY LP v. KILLINGER 12541
were increasing, and that the individual defendants assured
investors that WAMU had fully integrated the information
systems that are central to WAMU’s ability to maintain and
update their various hedges in a timely fashion during periods
of interest rate volatility. According to South Ferry, WAMU
was unprepared for the interest rate volatility that occurred
later because it failed to integrate its information systems to
permit it to keep a close watch on the hedges that it maintains.
Defendants moved to dismiss South Ferry’s complaint on
May 17, 2005, and the district court granted the motion to dis-
miss as to defendants Chapman, Longbrake, and Vanesek, but
denied the motion as to the remaining defendants. South Ferry
LP No. 2 v. Killinger, 399 F. Supp. 2d 1121 (W.D. Wash.
2005). The district court found that South Ferry satisfied the
PSLRA’s heightened pleading standard1 by inferring that the
remaining defendants had knowledge of WAMU’s difficulties
with their information systems “because of the nature of the
statements they [Defendants] were making and the nature of
these specific alleged operational problems,” relying on In re
Northpoint Communications Group, Inc. Securities Litigation,
184 F. Supp. 2d 991, 998 (N.D. Cal. 2001), for the principle
that it may be inferred that facts critical to a business’s “core
operations” or important transactions are known to key com-
pany officers (sometimes referred to in this opinion as the
“core operations inference”). South Ferry, 399 F. Supp. 2d at
1141. Defendants moved for reconsideration or, alternatively,
for a certification from the district court that interlocutory
appeal was appropriate under 28 U.S.C. § 1292(b) to deter-
mine whether the district court properly imputed scienter in
the complaint’s allegations based on the inference that key
officers had knowledge of the “core operations” of the com-
pany.
1
The PSLRA requires, among other things, that a plaintiff “state with
particularity facts giving rise to a strong inference that the defendant acted
with the required state of mind.” 15 U.S.C. § 78u-4(b)(2).
12542 SOUTH FERRY LP v. KILLINGER
The district court denied the motion for reconsideration, but
granted the certification motion. In the order granting the cer-
tification motion, the district court recognized that “the com-
plaint does rely on circumstantial evidence and an inference
of knowledge arising from the connection between Defen-
dants’ job roles and the core operations of the business,” and
that “[s]hould the Ninth Circuit rule that the core operations
inference is improper, even Defendants’ specific statements
indicating first-hand knowledge of WAMU’s technological
and operational systems may be insufficient to support a
strong inference of scienter.” Defendants timely pursued this
interlocutory appeal.
II
The decisions of a district court on motions to dismiss are
reviewed de novo. In re Silicon Graphics Inc. Sec. Litig., 183
F.3d 970, 983 (9th Cir. 1999). We must accept as true all
well-pleaded allegations in the complaint. Id.III
[1] Under the PSLRA, South Ferry must “state with partic-
ularity facts giving rise to a strong inference that the defen-
dant acted with the required state of mind.” 15 U.S.C. § 78u-
4(b)(2). “Under this provision, the mental state required for
securities fraud liability is distinct from the level of pleading
required to infer that mental state.” Silicon Graphics, 183
F.3d at 975. In a securities fraud action like this one, there is
no dispute as to the required state of mind: the plaintiffs must
show that defendants engaged in “knowing” or “intentional”
conduct. Id. We have held that reckless conduct can also meet
this standard “to the extent that it reflects some degree of
intentional or conscious misconduct,” or what we have called
“deliberate recklessness.” Id. at 977 (internal quotation marks
omitted).
[2] The United States Supreme Court has recently dis-
cussed this scienter requirement, holding in Tellabs, Inc. v.
SOUTH FERRY LP v. KILLINGER 12543
Makor Issues and Rights, Ltd., 127 S.Ct. 2499, 2510 (2007),
that a strong inference “must be cogent and compelling, thus
strong in light of other explanations.” According to the Court,
“[t]he reviewing court must ask: When the allegations are
accepted as true and taken collectively, would a reasonable
person deem the inference of scienter at least as strong as any
opposing inference?” Id. at 2511.
[3] Before the Tellabs decision, we construed this pleading
standard in light of the applicable substantive legal standard,
explaining that, “the PSLRA requires plaintiffs to plead, at a
minimum, particular facts giving rise to a strong inference of
deliberate recklessness,” Silicon Graphics, 183 F.3d at 979,
and specifying that “plaintiffs proceeding under the PSLRA
can no longer aver intent in general terms of mere ‘motive
and opportunity’ or ‘recklessness,’ but rather, must state spe-
cific facts indicating no less than a degree of recklessness that
strongly suggests actual intent.” Id.The district court concluded that the PSLRA scienter stan-
dard was satisfied in this case because of alleged public state-
ments by Defendants that WAMU’s information systems
were fully integrated and effective at a time when WAMU
was suffering technology problems that affected its ability to
control MSR related and pipeline risk and hedge effectively.
It concluded: “Defendants’ knowledge of this information can
be inferred because of the nature of the statements they were
making and the nature of the alleged operational problems”
because “[i]t may be inferred that the facts critical to a busi-
ness’s core operations or important transaction are known to
a company’s key officers.” South Ferry, 399 F. Supp. 2d at1141 (citing Northpoint, 184 F. Supp. 2d at 998). Defendants
argue that the district court’s reliance on the “core operations”
inference was erroneous in light of In re Read-Rite Corp.
Securities Litigation, 335 F.3d 843, 848-49 (9th Cir. 2003). In
Read-Rite, we held that while it might be a “reasonable infer-
ence” to conclude that high-ranking corporate officers have
knowledge of the core operations of their companies, it was
12544 SOUTH FERRY LP v. KILLINGER
not a “strong inference” as required by the PSLRA in that
case. Id. (internal quotation marks omitted).
To evaluate the district court’s judgment, we must consider
whether a scienter theory that infers that facts critical to a
business’s “core operations” or an important transaction are
known to a company’s key officers satisfies the PSLRA’s
heightened pleading standard.
We have visited these issues before in several cases, most
notably in Silicon Graphics, In re Vantive Securities Litiga-
tion, 283 F.3d 1079, 1087-88 (9th Cir. 2002), and Read-Rite.
Silicon Graphics does not specifically address whether the
core operations inference can satisfy the heightened PSLRA
pleading standard, but it sets a very high bar for securities
plaintiffs under the PSLRA. As we there explained, the
PSLRA requires that plaintiffs state with particularity all facts
on which their belief of scienter is formed. 15 U.S.C. § 78u-
4(b)(1); Silicon Graphics, 183 F.3d at 985. “This means that
a plaintiff must provide, in great detail, all the relevant facts
forming the basis of her belief. It is not sufficient for a plain-
tiff’s pleadings to set forth a belief that certain unspecified
sources will reveal, after appropriate discovery, facts that will
validate her claim.” Id. We held that the plaintiffs’ complaint
was deficient in Silicon Graphics because it did not contain
the requisite detail.2 Without those details, we held that we
could not conclude that the defendants had actual knowledge
of the facts they were alleged to have misstated and that we
2
See id. at 985 (“In this case, Brody’s complaint does not include ade-
quate corroborating details. She does not mention, for instance, the
sources of her information with respect to the reports, how she learned of
the reports, who drafted them, or which officers received them. Nor does
she include an adequate description of their contents which we believe—
if they did exist—would include countless specifics regarding ASIC chip
shortages, volume shortages, negative financial projections, and so on. We
would expect that a proper complaint which purports to rely on the exis-
tence of internal reports would contain at least some specifics from those
reports as well as such facts as may indicate their reliability.”)
SOUTH FERRY LP v. KILLINGER 12545
were forbidden by the PSLRA from finding a strong inference
from such general allegations. Id.Three years later, in Vantive, 283 F.3d at 1087-88, we elab-
orated on the Silicon Graphics standard, explaining that Sili-
con Graphics required “ ‘corroborating details’ ” to support
the allegations in the complaint. (quoting Silicon Graphics,
183 F.3d at 985). In Vantive, plaintiffs alleged that internal
company reports contained information contrary to the public
statements of company management, and that said manage-
ment would have known of the reports because of their
“hands-on managerial style.” Id. (internal quotation marks
omitted). We held that these allegations did not meet the
PSLRA requirements because plaintiffs did not offer details
that would bridge the gap between the existence of the reports
and actual knowledge on the part of the defendants. Id. We
concluded that we could not infer such knowledge from the
general allegation that management was informed about
important issues in the company.
Finally, in Read-Rite, we rejected the notion that “facts crit-
ical to a business’s core operations or an important transaction
generally are so apparent that their knowledge may be attri-
buted to the company and its key officers” under the PSLRA.
Read-Rite, 335 F.3d at 848. The Read-Rite plaintiffs argued
that defendants alleged false statements and high rank within
the company, viewed in conjunction with the importance of
the products that were the subject of the statements, created
a strong inference of scienter under Silicon Graphics. We
rejected that argument, holding that those facts presented only
a “reasonable inference,” but were not sufficiently detailed to
meet the PSLRA and Silicon Graphics standard. Read-Rite,
335 F.3d at 848-49. While such an inference may have suf-
ficed before the enactment of the PSLRA, it was not enough
under the PSLRA’s heightened pleading standard. See id.[4] Silicon Graphics, Vantive, and Read-Rite, read without
reference to Tellabs, will generally prevent a plaintiff from
12546 SOUTH FERRY LP v. KILLINGER
relying exclusively on the core operations inference to plead
scienter under the PSLRA. See Read-Rite, 335 F.3d at 848-49.
Plaintiffs recognize this. However, the Supreme Court’s
recent Tellabs decision also discusses the level of detail
required under the PSLRA, and with its controlling and per-
suasive weight, it suggests that perhaps Silicon Graphics,
Vantive, and Read-Rite are too demanding and focused too
narrowly in dismissing vague, ambiguous, or general allega-
tions outright. In Tellabs, the Court explained that “omissions
and ambiguities count against inferring scienter,” but held that
they were still properly considered. 127 S. Ct. at 2511. Tel-
labs suggests that while a high level of detail is required
under the PSLRA, a court should look to the complaint as a
whole, not to each individual scienter allegation as Silicon
Graphics suggests. Thus, Tellabs counsels us to consider the
totality of circumstances, rather than to develop separately
rules of thumb for each type of scienter allegation.
Consistent with this thematic idea, though without the ben-
efit of later-decided Tellabs, Plaintiffs argue that Read-Rite
prevents only total reliance on the core-operations inference
absent other particularized supporting allegations. In Plaintiffs
view, the core-operations inference can be one relevant part
of a complaint that raises a strong inference of scienter.
[5] We conclude that this position is correct in light of Tel-
labs. The Supreme Court’s reasoning in Tellabs permits a
series of less precise allegations to be read together to meet
the PSLRA requirement, the prior holdings of Silicon Graph-
ics, Vantive, and Read-Rite notwithstanding. Vague or ambig-
uous allegations are now properly considered as a part of a
holistic review when considering whether the complaint raises
a strong inference of scienter. See 127 S. Ct. at 2511 (“We
reiterate, however, that the court’s job is not to scrutinize each
allegation in isolation but to assess all the allegations holisti-
cally.”). Allegations that rely on the core-operations inference
are among the allegations that may be considered in the com-
plete PSLRA analysis. The allegations, read as a whole, must
SOUTH FERRY LP v. KILLINGER 12547
raise an inference of scienter that is “cogent and compelling,
thus strong in light of other explanations,” id. at 2510, to sat-
isfy the PSLRA standard. In assessing the allegations holisti-
cally as required by Tellabs, the federal courts certainly need
not close their eyes to circumstances that are probative of
scienter viewed with a practical and common-sense perspec-
tive.
[6] A question remains, however, about reliance on the
core-operations inference when it is the only basis for scienter
in the complaint. Where a complaint relies on allegations that
management had an important role in the company but does
not contain additional detailed allegations about the defen-
dants’ actual exposure to information, it will usually fall short
of the PSLRA standard. In such cases the inference that
defendants had knowledge of the relevant facts will not be
much stronger, if at all, than the inference that defendants
remained unaware. As a general matter, “corporate manage-
ment’s general awareness of the day-to-day workings of the
company’s business does not establish scienter—at least
absent some additional allegation of specific information con-
veyed to management and related to the fraud” or other alle-
gations supporting scienter. See Metzler Inv. GmbH v.
Corinthian Colleges, Inc., no. 06-55826, 2008 WL 2853402at *13 (9th Cir. July 25, 2008) (concluding that the bare core
operations inference fell short of the Tellabs standard). How-
ever, in some unusual circumstances, the core operations
inference, without more, may raise the strong inference
required by the PSLRA.3
3
In Berson v. Applied Signal Technology, Inc., 527 F.3d 982 (9th Cir.
2008), we permitted a securities plaintiff to rely on the core operations
inference without particularized allegations about defendants’ access to
the relevant information. In Applied Signal, the defendants allegedly failed
to disclose “stop-work orders” from its largest customers even though
those orders had “a devastating effect on the corporation’s revenue.” Id.
at 987. The first stop-work order “halted between $10 and $15 million of
work on the company’s largest contract with one of its most important
12548 SOUTH FERRY LP v. KILLINGER
[7] Allegations regarding management’s role in a corporate
structure and the importance of the corporate information
about which management made false or misleading state-
ments may also create a strong inference of scienter when
made in conjunction with detailed and specific allegations
about management’s exposure to factual information within
the company. For example, in In re Daou Systems, Inc., 411
F.3d 1006, 1022-23 (9th Cir. 2005), plaintiffs relied in part on
“specific admissions from top executives that they are
involved in every detail of the company and that they moni-
tored portions of the company’s database” to support a strong
inference of scienter. The complaint in Daou relied on spe-
cific and particular accusations about the role played by the
defendants in managing the company, including specific alle-
gations that defendants actually did monitor the data that were
the subject of the allegedly false statements. Id. That is suffi-
cient under the PSLRA. Similarly, in Nursing Home Pension
Fund, Local 144 v. Oracle Corp., 380 F.3d 1226, 1231 (9th
Cir. 2004), we held that the plaintiffs had pleaded facts show-
ing a strong inference of scienter because, among other
things, the CEO of the defendant company was quoted as say-
ing: “All of our information is on one database. We know
exactly how much we have sold in the last hour around the
world,” a specific and detailed statement about defendants’
actual knowledge. Id. (emphasis omitted); see also id.(“Plaintiffs here [also] have hard numbers and make specific
allegations regarding large portions of Oracle’s sales data.”).
The allegations at issue in Daou and Oracle go beyond a mere
inference of management knowledge of all “core operations,”
customers,” and the second halted $8 million. Id. at 988 n.5. The com-
plaint alleged that only two government agencies made up 80% of the
company’s revenue, making the loss of even one contract disastrous for
the entire company. Id. at 983. Moreover, the defendants admittedly knew
about the stop-work orders only two weeks after the alleged false state-
ments. Id. at 988 n.5. All of these factors put Applied Signal into the
exceedingly rare category of cases in which the core operations inference,
without more, is sufficient under the PLSRA.
SOUTH FERRY LP v. KILLINGER 12549
and were sufficient under the PSLRA because they included
details about the defendants’ access to information within the
company.
[8] In summary, allegations regarding management’s role
in a company may be relevant and help to satisfy the PSLRA
scienter requirement in three circumstances. First, the allega-
tions may be used in any form along with other allegations
that, when read together, raise an inference of scienter that is
“cogent and compelling, thus strong in light of other explana-
tions.” Tellabs, 127 S.Ct. at 2510. This view takes such alle-
gations into account when evaluating all circumstances
together. Second, such allegations may independently satisfy
the PSLRA where they are particular and suggest that defen-
dants had actual access to the disputed information, as in
Daou and Oracle. Finally, such allegations may conceivably
satisfy the PSLRA standard in a more bare form, without
accompanying particularized allegations, in rare circum-
stances where the nature of the relevant fact is of such promi-
nence that it would be “absurd” to suggest that management
was without knowledge of the matter. See Allied Signal, 527
F.3d at 988 (internal quotation marks omitted).
IV
We pause to consider again the district court’s order. South
Ferry contends that the district court had adequate alternative
bases for its decision even if the core operations inference was
improperly applied. However, the district court made clear in
its certification order that it had serious doubts about the via-
bility of the complaint unless South Ferry could rely on the
core operations inference:
“It is also apparent that the viability of the core oper-
ations inference is central to the outcome of this case
. . . . Should the Ninth Circuit rule that the core oper-
ations inference is improper, even Defendants’ spe-
cific statements indicating first-hand knowledge of
12550 SOUTH FERRY LP v. KILLINGER
WAMU’s technological and operational systems
may be insufficient to support a strong inference of
scienter.”
This also suggests that the district court was concerned
whether an alternative basis might exist for affirming the
complaint if the core operations inference was improper.
[9] Regardless of the district court’s uncertainty as to the
outcome under a different standard, the parties urge us to
resolve the entirety of the case in this interlocutory appeal.
South Ferry urges us to conclude that the complaint contained
an alternative basis for a strong showing of scienter, while
WAMU urges us to dismiss the entire action if the core opera-
tions inference is improper. Although we have jurisdiction to
reach the merits of the entire complaint because it was at issue
in the certified order, we decline to do so.
[10] The district court and the parties at the time of the cer-
tified order were without the benefit of much of the case law
underlying this opinion, including the Supreme Court’s guid-
ance on theory in Tellabs. We conclude that the district court
in the first instance, and with its detailed knowledge of the
facts, should have the opportunity to review Defendants’
motion to dismiss under the appropriate standard. See Tellabs,
127 S. Ct. at 2513; Bassiri v. Xerox Corp., 463 F.3d 927, 934
(9th Cir. 2006) (remanding to the district court for consider-
ation of alternative basis for its dismissal order after initial
basis was rejected on interlocutory appeal). Accordingly, we
VACATE the order of the district court with regard to the
PSLRA scienter requirement and REMAND the case to the
district court for further proceedings consistent with Tellabs
and consistent with this opinion. This opinion does not disturb
the other conclusions reached by the district court.
JUDGMENT VACATED, ORDER VACATED IN
PART AND REMANDED.