Pleading Scienter Under the Federal Securities Laws: What Creates a Strong Inference of Fraudulent Intent?

Co-written by Margaret A. Jacobs & Karen E. Siciliano

One of the keys to curtailing litigation costs for public companies in any securities class action is dismissal at an early stage. Heightened standards for pleading defendants’ state of mind increase the chances of early dismissal and also enhance defendants’ likelihood of prevailing on the merits.

The Private Securities Litigation Reform Act of 1995 ("PSLRA") amended the Securities Act of 1933 and the Securities Exchange Act of 1934. Among other things, the PSLRA demanded greater particularity in pleading misleading statements and omissions in securities fraud class actions. Perhaps most significantly, it raised the bar for pleading "scienter" - defendants’ state of mind - in fraud cases by requiring plaintiffs to state with particularity facts giving rise to a strong inference that the defendants acted with the requisite state of mind.

The PSLRA was designed to discourage the filing of abusive "strike" suits brought on the heels of any significant change in the issuer’s stock price in the hope that discovery would uncover evidence of wrongful conduct. Adoption of the PSLRA in turn sparked debate over whether and to what degree the legislation required reconsideration of pre-PSLRA scienter pleading standards. On this question, litigants currently face a three-way split of authority among the federal circuit courts of appeals. This article discusses the views of the different circuits on scienter pleading requirements, focusing on current developments within the Second Circuit, which governs cases in New York and traditionally has been an influential court throughout the country on securities law matters.

Prior to the PSLRA, the Second Circuit had the most stringent pleading standard, requiring plaintiffs to "allege facts that give rise to a strong inference of fraudulent intent" by alleging "(1) facts that demonstrate defendants’ motive and opportunity to commit fraud; or (2) facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness." Sheilds v. City Trust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994). Other circuits did not require the pleading of particularized facts supporting an inference of scienter.

The PSLRA has not achieved uniformity in pleading standards. Currently, the Circuits are divided as to how the PSLRA has affected the scienter pleading requirement. The scienter debate has focused principally on two issues: whether plaintiffs can still satisfy their pleading obligations in fraud cases by alleging "motive and opportunity" to commit fraud; and satisfied by alleging traditional recklessness (i.e., an extreme departure from the standards of ordinary care), or whether deliberate recklessness or conscious misconduct is now required.

In the most dramatic heightening of the scienter pleading standard since passage of the PSLRA, the Court of Appeals for the Ninth Circuit has held that neither the traditional level of recklessness, nor motive and opportunity,

is sufficient to support the PSLRA pleading standard for the requisite state of mind. In In re Silicon Graphics Sec. Litig., Inc., 183 F.3d 970 (9^th Cir. 1999), the Ninth Circuit rejected the motive and opportunity prong of the Second Circuit’s scienter requirement, and further rejected a pleading of traditional recklessness, requiring plaintiffs instead to plead deliberately reckless or conscious misconduct. Since many complaints are based on allegations of motive, opportunity or traditional recklessness, as opposed to purposeful wrongdoing, the Ninth Circuit has erected a formidable barrier, arguably permitting survival of a complaint only if it pleads facts evincing intentional or conscious misconduct.

The Second Circuit considered the impact of the PSLRA on pleading standards in its decision in Novak v. Kasaks, 216 F.3d 300 (2d Cir. 2000). In Novak, a class of shareholders of Ann Taylor alleged, among other things, that the company and individual officers made fraudulent misstatements and omissions concerning the financial condition of the company. The Court of Appeals reversed the lower court’s dismissal of the complaint.

The Novakcourt stated that the PSLRA "did not change the basic pleading standard for scienter in this circuit." It then provided four categories of pleadings that would fulfill the requirements for scienter, and suggested reviewing the Second Circuit’s pre-PSLRA cases for successful examples of pleadings from each category. The Novakcourt described the categories as including situations where a plaintiff alleges that a defendant:

1) benefited in a concrete and personal way from the purported fraud (i.e., motive and opportunity), which could be established by alleging, for example, that corporate insiders misrepresented to the public material facts about the corporation’s performance or prospects in order to keep the stock price artificially high while they sold their own shares at a profit;

2) engaged in deliberately illegal behavior (i.e., conscious misbehavior), which could be established by alleging, for example, securities trading by an insider privy to undisclosed and material information, or a knowing sale of a company’s stock at an unwarranted discount;

3) knew facts or had access to information suggesting the inaccuracy of public statements (i.e.,reckless-ness), which could be established by alleging, for example, facts showing that defendants knew or should have known that they were misrepresenting material facts related to the corporation; or

It is noteworthy that the first category, which deals with motive and opportunity, requires that the alleged benefit be specified. Generalized allegations of motive and opportunity are not sufficient. As for the recklessness standard, while Novakdoes not require deliberate conduct, other courts have noted that its reference to defendants who "should have known" of a misrepresentation was not meant to change the recklessness standard to one of negligence. See In re Livent, Inc. Noteholders Sec. Litig., 151 F. Supp. 2d 371 (S.D.N.Y. 2001). Since Novak, there have been several securities fraud decisions by the Second Circuit that follow Novak even when not specifically citing it. An example is Rothman v. Gregor, 220 F.3d 81 (2d Cir. 2000), which emphasized the Novakcourt’s admonition that motive and opportunity cannot be satisfied through a "bare invocation of ‘magic words such as "motive and opportunity" ’ " and required greater specification of those circumstances previously recognized in this Circuit’s jurisprudence to justify a strong inference of scienter.

A series of District Court cases from the Southern and Eastern Districts of New York from July 2000 through November 2001 follow a similar pattern. All cite Novak or Rothman as authority for retention of the motive and opportunity prong, where such pleadings are particularized. Most engage in a detailed review of the factual allegations in order to determine whether they resemble prior fact patterns satisfying Novak’s four categories or pleadings previously held insufficient in the Second Circuit. For example, courts have held that generally pleading a desire to advance the appearance of corporate profitability or the success of the investment, to maintain a high credit rating, to maintain high stock prices, to increase executive compensation or to prolong benefits of corporate office will not suffice. See Faulkner v. Verizon Communications, Inc.,156 F. Supp. 2d 384 (S.D.N.Y. 2001).

Most of the foregoing cases resulted in dismissal of the complaint, some without leave to amend. Thus, courts in the Second Circuit generally have been exacting in requiring detailed allegations to satisfy the PSLRA scienter pleading standard.

In In re Avanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999), the Third Circuit held that the PSLRA intended to adopt the Second Circuit’s pre-PSLRA standards with respect to recklessness as well as motive and opportunity, and merely required that "[m]otive and opportunity, like all other allegations of scienter must now be supported by facts stated ‘with particularity’ and must give rise to a ‘strong inference’ of scienter." In Florida State Board of Administration v. Green Tree Financial Corp., 270 F.3d 645 (8th Cir. 2001), the Eighth Circuit similarly recognized the continuing validity of the Second Circuit’s motive and opportunity analysis, noting the limits articulated by Novakand post-NovakSecond Circuit decisions.

The First, Fifth, Sixth, Tenth and Eleventh Circuits all have taken positions on the scienter issue between those of the Second and Ninth Circuits, holding that allegations of traditional recklessness satisfy the scienter standard, while allegations of motive and opportunity alone do not.

For example, in In re Comshare, Inc. Sec. Litig., 183 F.3d 542 (6th Cir. 1999), the Court of Appeals for the Sixth Circuit held that plaintiffs may plead scienter "by alleging facts giving rise to a strong inference of recklessness but not by alleging facts merely establishing that a defendant had the motive and opportunity to commit securities fraud." Nonetheless, the court found that allegations of motive and opportunity alone "may, on occasion," create a strong inference of reckless or knowing conduct. The Sixth Circuit further explicated its position in Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001), which held, "[w]hile it is true that motive and opportunity are not substitutes for a showing of recklessness, they can be catalysts to fraud and so serve as external markers of the required state of mind."

Similarly, in Nathenson v. Zongen, 267 F.3d 400 (5th Cir. 2001), and City of Philadelphia v. Fleming Co., Inc., 264 F.3d 1245 (10th Cir. 2001), the Fifth and Tenth Circuitsexpressed skepticism as to the sufficiency of motive and opportunity allegations, but declined to conclude that such allegations, standing alone, nevercan create a strong inference of scienter.

In Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999), the Eleventh Circuit employed even stronger language with respect to motive and opportunity. Unlike the Sixth Circuit, which envisioned some situations in which motive and opportunity allegations could create a strong inference of scienter, the Eleventh Circuit considered such allegations, standing alone, inadequate to fulfill the scienter requirement. The First Circuit, in Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999), adopted a similar approach.

The current circuit court split presents opportunities and challenges for the securities practitioner. To the extent there is a choice of forum (probable with many class actions), plaintiffs most likely will file in the Second or Third Circuits, while defendants, where possible and barring other strategic concerns, will seek transfer to the Ninth Circuit.

Although the pleading bar effectively has been raised in all circuits, corporations and their management still have cause for concern. Even with motive and opportunity pleading being out of vogue, allegations such as false statements or wrongful nondisclosure resulting in concrete benefits to corporate officials, or a divergence between internal reports and public statements, still have been held to satisfy the scienter element. Moreover, in most circuits that have addressed the issue, traditional recklessness is sufficient to establish scienter. Scienter, therefore, retains an objective component, and allegations of securities fraud can withstand a motion to dismiss even when defendants do not act with deliberateness.