Describing, Discouraging, and Disposing of Securities Fraud Claims

Hillary A. Sale
University of Iowa College of Law

 

  1. The initial shift in securities pleading occurred in the courts, through the application of Rule 9(b) to securities claims brought pursuant to Section 10(b), Rule 10b-5 of the Securites Exchange Act of 1934.

    1. To see how it worked, it is first necessary to understand the basics of these claims.

      1. The elements of a securities fraud claim are:

        1. a material misstatement or omission,

        2. made with scienter,

        3. in connection with the purchase or sale of securities,

        4. on which the plaintiff relied, and

        5. that caused the plaintiff's injury.

    2. Scienter in securities fraud generally refers to some kind of recklessness in the making of the misstatement.

      1. In the 1980's the Supreme Court held that because this cause of action is implied, not express, it could be limited to situations involving scienter, as opposed to recklessness.

      2. Courts have reviewed scienter in different ways, looking for some handling of the misstatement or omissions that makes it look intentional, though, again, the standard is recklessness.

    3. The scienter element is the one the courts have used to justify applying Rule 9(b) to these claims.

      1. Rule 9 sets the standard for "Pleading Special Matters."

      2. Clause (b) states:

        1. In all averments of fraud or misstate, the circumstances constituting fraud or mistake shall be state with particularity. Malice, intent, knowledge, and other conditions of mind of a person may be averred generally.

      3. Thus, Rule 9(b) arguably applies to these claims, but how the courts applied it was another matter entirely.

    4. Two key circuits for securities fraud applied 9(b) in two different ways.

      1. The Second Circuit used it to focus on the scienter element of the claim.

      2. The Ninth Circuit used it to focus on all other elements of the claim, reasoning that the text of 9(b) clearly stated that the state of mind element could be pleaded generally.

  2. Rule 9(b)'s use in securities fraud claims became universal, though its application differed across circuits and it became the stick used by those arguing for Congressional reform of these cases.

    1. The accountants began to push for reform of securities fraud cases in the early 1990's, arguing that they were being forced to pay as "deep pockets" even though liability properly attached to issuers.

      1. In part, their press for reform arose out of their liability resulting from the savings and loan scandals of the 1980's.

    2. Industry members soon joined them, including those from the high-tech industry in Silicon Valley.

    3. They argued that Congress should reform these claims, for several reasons:

      1. First, they argued that the filing of class actions was not based on actual fraud but on sudden drops in share prices that resulted in strike suits.

      2. Second, the transaction cost of filing the claims was minimal.

        1. The lawyers are experienced.

        2. The complaints were simplistic and required little information.

        3. Discovery would solve any problems.

      3. Third, the first attorney/law firm to file would gain control of the case, creating an incentive to rush to the courthouse.

      4. Fourth, given liberal discovery rules, plaintiffss would gain discovery quickly and use that discovery to replead their cases and to leverage a settlement.

      5. Fifth, settlements were arguably cost effective in cases lacking merit because the court process was lengthy and expensive.

        1. Multiple motions to dismiss on multiple complaints.

        2. The result was settlements of frivolous cases.

  3. And, they won when Congress adopted the Private Securities Litigation Reform Act as part of its Contract with America.

    1. The PSLRA included many wide-ranging reforms designed to cut back on the litigation of securities claims.

    2. Only three are relevant to today's discussion.

      1. The first is the heightened pleading standard for securities fraud claims brought pursuant to Section 10(b), Rule 10b-5 of the Securities Exchange Act of 1934.

        1. These are the claims I described previously.

        2. Although the complaint made to Congress was focused on class actions making these claims, the reform adopted applies to all claims, including those of individual parties.

      2. The second is the provision creating a safe harbor for certain kinds of statements, those that are forward-looking.

        1. These statements now require plaintiffs to prove actual knowledge of the inaccuracy of the alleged misstatement, not just some level of recklessness in the making of the misstatement.

      3. The third is the discovery stay - all securities claims, whether brought pursuant to the Securities Act, where the claims are either strict-liability or negligence-like claims, or the scienter-based claim under the Securities Exchange Act - are subject to a stay of discovery until the plaintiffs have survived a motion to dismiss.

  4. What has it meant in practice?

    1. Far more complaints are dismissed.

      1. Pre-PSLRA about 10-15% of complaints were dismissed in the 9th Circuit.

      2. Post, it's about 64%.

      3. Courts are more likely to dismiss with prejudice, even on the first complaint.

    2. The Circuits are still split as to what the standard is.

      1. The Second Circuit has a less defendant-friendly standard, but one which is still quite stringent, requiring the plaintiffs to plead recklessness/scienter.

      2. The Ninth Circuit has a more defendant-friendly standard, requiring pleading of something akin to conscious recklessness.

      3. The Circuits will remain split - the Supreme Court rejects securities cases and has denied cert on this issue several times already.

      4. The legislative history is a mess.

      5. The cases are fact specific, so a standard is less useful than the defendants seem to think.

      6. Post-Enron, it's hard to argue that there is no fraud.

    3. It has decreased the available supply of securities law:

      1. Judges are increasingly deploying heuristics/shortcuts to resolve cases at the motion to dismiss stage, resulting in fewer cases actually developing substantive law in this area.

  5. Results empirical study employing regression analysis to determine what types of allegations are most likely to survive motions to dismiss in the Second and Ninth Circuit.

  6. Results of study comparing these cases to Delaware cases, assessing the types of arguments made and the role of these cases in corporate governance.