Ninth Circuit Holds Former Employee Statements Can Be Probative of Scienter in 10b-5 Actions at the Pleading Stage Even Where the Former Employee Departed the Company Before the Class Period Began or Had No Direct Contact With a Defendant

Whether allegations in a complaint raise a strong inference of scienter is one of the most hotly contested questions in nearly every securities fraud action brought under Section 10(b) of the Exchange Act and its corollary, Rule 10b-5. In the recent Ninth Circuit decision, E. Ohman J v. Nvidia Corp., the majority opinion puts a finer texture on what type of allegations from former employees can be probative of scienter at the pleading stage. E. Ohman J v. NVIDIA Corp., 2023 U.S. App. LEXIS 22473 (9th Cir. Aug. 25, 2023). Additionally, comparing the majority opinion with the dissent can provide practitioners and courts with a better understanding of what type of allegations are not required to raise a strong inference of scienter under Ninth Circuit law. The following briefly summarizes the facts of NVIDIA and offers a few observations that can be useful in practice.

In NVIDIA, the plaintiffs alleged that Defendant Huang, NVIDIA’s CEO, materially understated the Company’s exposure to the volatility of the cryptocurrency market by understating the number of Gaming GPUs—NVIDIA’s primary product—the Company knew were being sold to end-users in the crypto industry. When asked by analysts what amount of NVIDIA’s GPU sales were related to the highly volatile crypto industry, Defendant Huang repeatedly minimized that amount, often misstating it by hundreds of millions of dollars, and assured investors that substantially none of the sales reported in NVIDIA’s “Gaming” segment were subject to crypto volatility. But when the crypto market pendulum returned to its nadir, NVIDIA Gaming GPU sales were substantially lower than expected. Investors were shocked when NVIDIA’s executives revealed that “Gaming was short of expectations as post crypto channel inventory took longer than expected to sell through,” leaving a “crypto hangover” from excess inventory buildup.

The District Court dismissed the amended complaint for failing to “plausibly show that the Defendant who made each specified statement knowingly or recklessly spoke falsely.” On appeal, the Ninth Circuit reversed, in part, holding that the plaintiffs adequately pleaded Defendant Huang made false and misleading statements with scienter.

In reversing the lower court’s decision, the Ninth Circuit relied heavily on statements from two former NVIDIA employees. Former Employee 1 (“FE 1”) was a Senior Account Manager in China employed at NVIDIA for nearly 10 years whose knowledge of the relevant facts was largely derived from FE 1’s discussions with superiors and not from direct contact with the defendants, themselves. Id. at *43-44. FE 1 reported that Nvidia kept meticulous records and collected sales data from all regions in a centralized global database, accessible by Defendant Huang. Former Employee 2 (“FE 2”) had more direct knowledge of Defendant Huang’s knowledge and behavior from personal interactions and regular meetings with Huang. But FE 2 departed from NVIDIA before the Class Period, limiting FE 2’s information about Defendant Huang’s knowledge, habits, and behaviors to a period before the alleged fraud. Id. at *45-47. FE 2 described Defendant Huang as a meticulous manager who closely monitored sales data.

Applying a “holistic” analysis, the Ninth Circuit held FE 1 and FE 2’s accounts were probative of scienter and Plaintiffs’ allegations raised a strong inference that Defendant Huang acted with scienter, stating:

A holistic review gives rise to such an inference in this case. To summarize Plaintiffs’ allegations, they allege that (1) Huang had detailed sale reports prepared for him; (2) Huang had access to detailed data on both crypto demand and usage of NVIDIA’s products; (3) Huang was a meticulous manager who closely monitored sales data; and (4) sales data at the time would have shown that a large portion of GPU sales were being used for crypto mining. Huang’s access and review of contemporaneous reports are the most direct way to prove scienter. See Oracle, 380 F.3d at 1230. Huang himself admitted to closely monitoring sales data. Taken together, these allegations support a strong inference that Huang reviewed sales data showing that a large share of NVIDIA’s GeForce GPUs sold during the Class Period were being used for crypto mining.

*          *          *

In their amended complaint, Plaintiffs provide a number of reasons supporting a conclusion that Huang, the CEO of NVIDIA, knew that more than a billion dollars in company revenues came from selling GeForce GPUs to crypto miners. We state the obvious. A CEO who does not know the source of $1.126 billion in company revenues during fifteen-month period, or $1.35 billion during an eighteen-month period, is unlikely to exist. Or if such a CEO does exist, he or she is not likely to remain CEO for very long. It is “reasonable to infer” that Huang’s “detail-oriented management style” would have led him “to become aware of” the source of more than a billion dollars in company revenue during a fifteen- or eighteen-month period. See Oracle, 380 F.3d at 1234 (“It is reasonable to infer that Oracle executives’ detail-oriented management style led them to become aware of the allegedly improper revenue recognition of such significant magnitude that the company would have missed its quarterly earnings projections but for the adjustments.”)

Id. at *50, *65-66.

In holding the plaintiffs adequately alleged a strong inference of scienter, the majority made two important points:

Former Employee Statements Can Be Relevant and Probative of Scienter Even when the Former Employee Was Not Employed by the Defendants During the Class Period

The majority opinion found that FE 2’s statements of Defendant Huang’s knowledge and behavior immediately before the class period allowed the court to infer what Defendant Huang “would have known” and how Defendant Huang “would have behaved” during the immediately following Class Period. Specifically, the majority observed:

FE 2 quit working at NVIDIA at the beginning of the Class Period. However, FE 2’s statements about Defendant Huang’s practices in the period immediately preceding the Class Period—in particular, his micromanaging and attention to detail—are relevant and probative, showing how Huang would have behaved and what he would have known during the immediately following Class Period. Critically, FE 2’s statements were not only about Huang’s general practices and knowledge. Instead, FE 2’s statements specifically concerned what Huang knew about the issue at the heart of this case—the large volume of sales of GeForce GPUs to crypto miners.

Id. at *47 (emphasis added).

Thus, while the dissent complained that FE 2’s knowledge was limited to a time period outside of the alleged fraud and refused to draw any inferences from FE 2’s statements alleged in the amended complaint, id. at *100, the majority credited FE 2’s knowledge of Defendant Huang prior to the Class Period, holding that it is appropriate for courts to draw reasonable inferences from the facts alleged by former employees, even if not employed during the Class Period.

Former Employee Statements Can Be Relevant and Probative of Scienter Even when the Former Employee Had No Direct Contact With A Defendant

The majority also credited statements from FE 1 that “NVIDIA kept meticulous track of who was buying its GPUs” and that “NVIDIA managers from all regions collected sales data and inputted it into NVIDIA’s centralized global database,” finding them probative of scienter. Id. at *43. Whereas the dissent complained that FE 1 “lacks personal knowledge of what the global database showed” and “was five levels removed from Huang and never interacted with him,” id. at *96, the majority held that such information from a junior-level employee is relevant and probative of scienter when considered together with the other allegations in the complaint, as part of a holistic analysis: “Taken together, these allegations support a strong inference that Huang reviewed sales data showing that a large share of NVIDIA’s GeForce GPUs sold during the Class Period were being used for crypto mining.” Id. at *50 (emphasis added). In other words, FE 1’s statements that the Company carefully tracked who was buying its GPUs combined with FE 2’s statements that Defendant Huang carefully reviewed the Company’s data, to raise a strong inference of scienter.

Putting NVIDIA into Practice

• When drafting a complaint for securities fraud, practitioners should consider including former employee statements, even when the employee had no direct contact with the defendants or departed before the alleged fraud, if the statements would add to the holistic analysis of scienter.
• In drafting complaints, practitioners should also consider including allegations regarding a defendant’s knowledge and behavior prior to the alleged fraud because a court may use that information to infer what the defendant would have known or how the defendant would have behaved during the Class Period. Specifically, allegations that a Defendant is meticulous, detail oriented, closely monitors data, or has specific reports prepared for her may be probative of scienter, especially when combined with other allegations.
• When briefing a motion to dismiss for failure to state a claim, plaintiffs should advocate for the court to consider the allegations in totality as part of a holistic review, rather than in isolation. When courts consider the allegations in isolation, they often conclude that because no single allegation, alone, raises a strong inference of scienter, taking them together could not add up to a strong inference of scienter. But when courts engage in a proper, holistic analysis, allegations that would have otherwise been insufficient can combine to raise a strong inference of scienter.