- C.D. Cal. Greenlights SOX Claim, Analyzing Whether Scienter Must Be Shown Where Violation of Internal Controls Is Alleged
- May 9, 2013 | Authors: Noa M. Baddish; Harris Michael Mufson; Steven J. Pearlman
- Law Firm: Proskauer Rose LLP - New York Office
On April 24, 2013, the U.S. District Court for the Central District of California issued its final ruling that a SOX whistleblower complaint survived a Rule 12(b)(6) challenge. Zulfer v. Playboy Enterprises, Inc., No. 12-cv-08263 (C.D. Cal. April 24, 2013). The decision focused on Plaintiff Catherine A. Zulfer’s (Plaintiff) allegation that she ”reasonably believed” her disclosures regarding certain of Defendant Playboy Enterprises, Inc. (Company) executives’ alleged attempts to circumvent internal procedures concerning discretionary bonuses were related to a violation of SEC rules and regulations. Although the court allowed her to proceed with a claim under Section 806 of SOX, it dismissed her claims under California state law pursuant to Rule 12(b)(6) because she did not sufficiently allege that accruing the bonuses would have been illegal.
The Prior “Tentative” Ruling. As we reported in our February 15th post (which sets forth the pertinent factual allegations in greater detail), the court issued a “tentative” decision on February 11, 2013, finding Plaintiff’s SOX whistleblower claim survived the Company’s Rule 12(b)(6) challenge, but that her claims under California labor law should be dismissed. In that decision, the court found that Plaintiff adequately stated a claim under Section 806 of SOX by pleading that she had a reasonable belief that the Company violated internal controls regarding executive bonuses required by the Securities and Exchange Act, and also found that Plaintiff failed to state a claim for shareholder fraud, highlighting the absence of any allegation that the Defendants intended to communicate a misrepresentation to shareholders.
SOX Section 806 Claim. In the final decision, the court adhered to the rulings in its interim decision, but also engaged in a more comprehensive discussion of the scienter requirement for SOX whistleblower complainants, in light of Defendants’ argument “that a SOX plaintiff should be required to ‘prove some level of scienter’ on defendants’ part in order to allege that she had a reasonable belief there had been a violation falling within one of the six categories enumerated in § 1514A(a)(1).” Id. at 17, n.37. It acknowledged that the first, fourth and sixth categories in Section 1514A(1)(a) specifically pertain to fraud, noting that in most cases arising under SOX, “a plaintiff will be required to plead a belief that the defendants acted with scienter because the intent to decide will be an element of the underlying violation.” Id. But the court found that scienter is not required to show a violation of “any rule or regulation of the Securities and Exchange Commission” - the fifth category enumerated in §1514A(1)(a). Accordingly, it ruled that, “[b]ecause scienter is not a required element of a claim alleging an internal controls violation of the Exchange Act, see § 78m(b)(2), and because Zulfer has adequately alleged a reasonable belief that [the Company executives] attempted to circumvent internal controls in violation of that statute, her failure to allege that they acted with the intent to deceive shareholders is not entirely fatal to her SOX claim.” Id. at 18, n.37. The court ultimately ruled that Plaintiff adequately stated a claim based on the alleged disclosure of information covered by the fifth category of violations enumerated by Section 1514A(1)(a).
California Labor Code Section 1102.5(c) Claim. Section 1102.5(c) of the California Labor Code, upon which Plaintiff separately relied, provides that “[a]n employer may not retaliate against an employee for refusing to participate in an activity that would result in a violation of state or federal statute, or a violation or noncompliance with a state or federal rule or regulation.” Unlike Section 806 of SOX, 1102.5(c) requires a plaintiff to allege that the employer committed an illegal act. The court found that, although Plaintiff alleged that she had a reasonable belief that accruing the bonuses without Board of Director approval would have violated one of the laws listed in Section 1514A(a)(1), she did not allege sufficient facts to show that actually accruing the bonuses would have been illegal. Accordingly, the court dismissed this claim.
Implications. Though concerning with respect to its analysis of whether a plaintiff relying on alleged internal control failures or violations needs to prove scienter to state a claim under Section 806 of SOX, the Court’s final decision should prove useful to employers in tag-along state retaliation claims, such as those under Section 1102.5(c) of the California Labor Code. In fact, this decision serves the highlight how plaintiffs oftentimes face more lenient standards under SOX whistleblower claims than under state retaliation claims.