By: Anna Currier
On September 24, 2014, a putative class action was filed by Plaintiff Amish Patel, a holder of Defendant Axesstel stock. Axesstel, Inc., a company that sells wireless and broadband products worldwide, has 35 full time employees, with 15 of those employees located in the United States. The Complaint alleged violations of Rule 10b-5, a rule promulgated by the Securities and Exchange Commission pursuant to Section 10(b) of the Securities and Exchange Act of 1934. Specifically, the Complaint alleged that Axesstel reported false revenue to the SEC from the purported sale of one of its wireless products for two quarterly reports, and that the company “misrepresented the collectability of the accounts receivable related to this revenue.”
Rule 10b–5 prohibits any untrue statement or omission in connection with the purchase or sale of securities. A violation of Rule 10b-5 requires not just a material misrepresentation or omission of a fact, but also scienter, a “mental state embracing intent to deceive, manipulate, or defraud.” Accordingly, the Ninth Circuit reviews all of the plaintiff’s allegations of misconduct to determine whether there is a “strong inference of intentional conduct or deliberate recklessness.” The issue the District Court faced in this case was whether the alleged misrepresentations were the result of carelessness or an actual intent to deceive. Although the Defendant argued that its CEO and CFO- both of whom made the alleged false statements- did not know the express terms of the purported sale they made the alleged false statements about, the Court held that the size of the company and the importance of the sale in question indicated that both officers should have known the terms of the sale. Further, the Court implemented the “Core Operations Theory”, a theory that allows the Court to “impute scienter based on the inference that key officers have knowledge of the ‘core operations’ of the company.” The statements alleged in the complaint, which indicated that both the CEO and CFO had detailed knowledge of the product sale, supported this theory. Most notably, the Court held that the significantly small size of Axesstel created an inference of scienter, mainly due to the fact that, with only 15 people total working in its United States office, the CEO and CFO would certainly be included in the specifics of major deals and contracts.
The Plaintiff was able to meet its burden of showing an inference of scienter through the false statement allegations. The Court therefore inferred the mental state of scienter primarily through the disposition of Axesstel; it would have been illogical to think that in such a small company, the CEO and CFO were unaware of the inner details of an important contract. The Court found that the Plaintiff’s allegations plead a strong inference of scienter without mentioning any allegations that purported to show that the CEO or CFO were directly aware of the status or specifics of the contract. Allowing the Court to use an inference to establish a manipulative and deceptive mental state could set a dangerous precedent; a company’s physical disposition could allow Plaintiffs to successfully plead an inference of scienter without presenting any allegations that show a specific intent to deceive. Furthermore, a Defendant could become liable solely because of his title; an officer who was expected to know certain information could be liable even though there are no allegations that purport to show that he actually knew of the alleged misconduct.
 Patel v. Axesstel, Inc., 2015 WL 631525, 1 (S.D. Cal. Feb. 13, 2015)
 Id. at 1.
 Id. at 6.
 Id. at 2.
 17 C.F.R. § 240.10b-5 (2015).
 Id. at 7.
 Id. at 8.
 Id. at 8.
 See id. at 9 (“Thus, while [the CEO] and [the CFO] did not have to review every detail of these contracts, it was deliberately and consciously reckless for them to fail to at least confirm that such contracts existed.”).
 Id. at 10.
 See id. (noting that the CEO had told investors the reception to the product was “fantastic” and the CFO indicated that the account had been “reviewed for collectability”, meaning it existed).
 Id. at 11 (stating that to suggest top management would not be aware of important details of big contracts would be “absurd.”).
 Id. at 13.
 See id. (explaining that it would be “exceedingly unlikely” that the CEO and CFO of such a small company would have no knowledge of expensive contracts, and it was more likely that not, based on a review of the allegations in this complaint, to infer scienter).
 Id. (“[G]iven the size of Axesstel, [the CEO and CFO’s] management roles in Axesstel and their alleged involvement in sales and the complete lack of contracts for the purported sales of Home Alert products in Africa at issue here . . . there is a logical, and strong, inference that Defendants were aware at the time the false statements were made that the revenue was being recognized improperly . . . [t]hus . . . the Court finds that the amended complaint pleads a strong inference of scienter for purposes of establishing a primary violation of Section 10(b).”).