Opinion ID: 1448459
Heading Depth: 2
Heading Rank: 2

Heading: The Securities Fraud Claims

Text: To state a claim on which relief can be granted under § 10(b) and Rule 10b-5, a plaintiff must plead, inter alia, that in connection with the purchase or sale of securities, the defendant made a false representation as to a material fact, or omitted material information, and acted with scienter. See, e.g., Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 318, 321, 127 S.Ct. 2499, 168 L.Ed.2d 179 (2007); Chill v. General Electric Co., 101 F.3d 263, 265 (2d Cir.1996) ( Chill ); In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 264 (2d Cir.1993), cert. denied, 511 U.S. 1017, 114 S.Ct. 1397, 128 L.Ed.2d 70 (1994). The Supreme Court has defined scienter as `a mental state embracing intent to deceive, manipulate, or defraud.' Tellabs, 551 U.S. at 319, 127 S.Ct. 2499 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976)). Prior to the enactment of the PSLRA, this Court had held that in order to plead an intent to deceive, the complaint must allege facts giving rise to a strong inference of fraudulent intent, Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir. 1995); see, e.g., Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994); In re Time Warner Inc. Securities Litigation, 9 F.3d at 268, and that such an inference could be drawn from allegations of facts showing that the defendant had both motive and opportunity to commit fraud, see, e.g., Acito v. IMCERA Group, Inc., 47 F.3d at 52; Shields v. Citytrust Bancorp, Inc., 25 F.3d at 1128. Motive, we observed, could be shown by pointing to the concrete benefits that could be realized from one or more of the allegedly misleading statements or nondisclosures; opportunity could be shown by alleging the means used and the likely prospect of achieving concrete benefits by the means alleged. Id. at 1130. This test is generally met when corporate insiders [a]re alleged to have 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. Novak, 216 F.3d at 308. But in attempting to show that a defendant had fraudulent intent, it is not sufficient to allege goals that are possessed by virtually all corporate insiders, such as the desire to maintain a high credit rating for the corporation or otherwise sustain the appearance of corporate profitability or the success of an investment, or the desire to maintain a high stock price in order to increase executive compensation. Id.; see, e.g., San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 814 (2d Cir.1996); Chill, 101 F.3d at 268; Acito v. IMCERA Group, Inc., 47 F.3d at 54. This Court has also long held that the scienter element can be satisfied by a strong showing of reckless disregard for the truth. See, e.g., Lanza v. Drexel & Co., 479 F.2d 1277, 1301 (2d Cir.1973) (en banc); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.) ( Rolf ), cert. denied, 439 U.S. 1039, 99 S.Ct. 642, 58 L.Ed.2d 698 (1978); SEC v. McNulty, 137 F.3d 732, 741 (2d Cir.), cert, denied, 525 U.S. 931, 119 S.Ct. 340, 142 L.Ed.2d 281 (1998); Novak, 216 F.3d at 306, 308; ATSI Communications, Inc. v. Shaar Fund Ltd., 493 F.3d 87, 99 n. 3 (2d Cir.2007). See also Tellabs, 551 U.S. at 319 n. 3, 127 S.Ct. 2499 (Every Court of Appeals that has considered the issue has held that a plaintiff may meet the scienter requirement for civil liability under § 10(b) and Rule 10b-5 by showing that the defendant acted [either] intentionally or recklessly; the Supreme Court itself has not yet decided whether [a showing of] reckless behavior is sufficient.). By reckless disregard for the truth, we mean conscious recklessness  i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence,  Novak, 216 F.3d at 312 (internal quotation marks omitted) (emphases ours). In elaborating as to what may constitute recklessness in the context of a private securities fraud action, we have referred to conduct that `at the least ... is highly unreasonable and which represents an extreme departure from the standards of ordinary care to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it, ' In re Carter-Wallace, Inc. Securities Litigation, 220 F.3d 36, 39 (2d Cir.2000) (quoting Rolf, 570 F.2d at 47 (emphasis ours)); or to evidence that the defendants failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud, and hence should have known that they were misrepresenting material facts, Novak, 216 F.3d at 308 (emphases added). An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of ... recklessness. Chill, 101 F.3d at 269 (internal quotation marks omitted) (emphases added); see, e.g., SEC v. McNulty, 137 F.3d at 741 (defendant corporate officer who prepared and proceeded to file documents with the SEC containing statements whose veracity he himself had questioned, had had an obvious duty to verify the suspicious information). In passing the PSLRA, Congress adopted a substantive `standard modeled upon the pleading standard of the Second Circuit,' Novak, 216 F.3d at 311 (quoting legislative history), insofar as we had applied a strong inference test ( see Part II.B.2. below), although it did not adopt our motive-and-opportunity gloss for the pleading of intent or our alternative standard of recklessness, see Novak, 216 F.3d at 311. Thus, we reasoned that, under the PSLRA, litigants and courts need not and should not employ or rely on magic words such as `motive and opportunity' with respect to intent; but that, in accordance with our prior cases, a strong inference of the requisite state of mind may arise where the complaint sufficiently alleges that the defendants: (1) benefitted in a concrete and personal way from the purported fraud ...; (2) engaged in deliberately illegal behavior...; (3) knew facts or had access to information suggesting that their public statements were not accurate ...; or (4) failed to check information they had a duty to monitor.... Id.; see also id. at 307-09. In Novak, we also noted that there are limits to the scope of liability for failure adequately to monitor the allegedly fraudulent behavior of others. Id. at 309. In Chill, for example, we held that the allegation that a parent company had failed to interpret its subsidiary's unprecedented and dramatically increasing profitability in a particular form of trading as a sign of problems, and thus had failed to investigate further, did not adequately plead recklessness amounting to scienter. See 101 F.3d at 269-70. In Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120-21 (2d Cir.1982), we held that the allegation of a non-fiduciary accountant's failure to identify problems in a company's internal controls and accounting practices was not sufficient. For recklessness on the part of a non-fiduciary accountant [to] satisfy Ernst & Ernst 's requirement of scienter, it must approximate an actual intent to aid in the fraud being perpetrated by the audited company. Id.
As a general matter, [t]o survive a motion to dismiss, a complaint must contain sufficient factual matter, accepted as true, to `state a claim to relief that is plausible on its face. ' Iqbal, 129 S.Ct. at 1949 (quoting Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 570, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007) ( Twombly ) (emphasis ours)); see also Iqbal, 129 S.Ct. at 1953 (the [ Twombly ] pleading standard [applies to] all civil actions (internal quotation marks omitted)). Determining whether a complaint states a plausible claim for relief will ... be a context-specific task that requires the reviewing court to draw on its judicial experience and common sense. Iqbal, 129 S.Ct. at 1950. Generally [a] claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged. Id. at 1949; see Twombly, 550 U.S. at 556, 127 S.Ct. 1955. In a private securities fraud action, however, [u]nder the PSLRA's heightened pleading instructions, enacted in 1995 [a]s a check against abusive litigation by private parties, Tellabs, 551 U.S. at 313, 321, 127 S.Ct. 2499, the plaintiff must do more. See, e.g., Teamsters Local 445 Freight Division Pension Fund v. Dynex Capital Inc., 531 F.3d 190, 194 (2d Cir.2008) ( Teamsters Local 445 ). Section 21D(b)(2) of the PSLRA, codified at 15 U.S.C. § 78u-4(b)(2), provides that [i]n any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. 15 U.S.C. § 78u-4(b)(2) (emphases added). To meet the strong inference standard, it is not sufficient to set out facts from which, if true, a reasonable person could infer that the defendant acted with the required intent, for that gauge does not capture the stricter demand Congress sought to convey in § 21D(b)(2). Tellabs, 551 U.S. at 314, 127 S.Ct. 2499 (internal quotation marks omitted) (emphasis ours). Rather,  [t]o qualify as `strong' within the intendment of § 21D(b)(2), ... an inference of scienter must be more than merely plausible or reasonable  it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.  Tellabs, 551 U.S. at 314, 127 S.Ct. 2499 (emphases added). Thus, to determine whether a complaint's scienter allegations can survive threshold inspection for sufficiency, a court governed by § 21D(b)(2) must engage in a comparative evaluation; it must consider, not only inferences urged by the plaintiff, ... but also competing inferences rationally drawn from the facts alleged. An inference of fraudulent intent may be plausible, yet less cogent than other, nonculpable explanations for the defendant's conduct. Tellabs, 551 U.S. at 314, 127 S.Ct. 2499 (emphases added). In sum, [a] plaintiff alleging fraud in a § 10(b) action ... must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference. Tellabs, 551 U.S. at 328, 127 S.Ct. 2499 (emphasis in original). And in determining whether this standard has been met, the court must consider whether  all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard. Id. at 323, 127 S.Ct. 2499 (emphasis in original). Applying these principles in Teamsters Local 445, in which the complaint alleged that false and misleading statements were made recklessly but did not allege that the defendants had any compelling motive to mislead their bondholders, we concluded that there were a number of permissible competing inferences, including an inference that the statements were the result of merely careless mistakes by the defendants based on false information fed to them by others. 531 F.3d at 197 (internal quotation marks omitted). Given that this inference was `at least as compelling' as the conscious-recklessness inference advocated by the plaintiff, we concluded that the PSLRA required dismissal of the complaint. Id.
Within the above legal framework, South Cherry's challenge to the dismissal of its securities fraud claims presents two overarching questions: (1) whether the Complaint alleged facts sufficient to create a strong inference of scienter, and (2) whether an inference of scienter is at least as compelling as any opposing inference of nonfraudulent and nonreckless intent. To warrant reversal, both questions need to be answered in the affirmative. We conclude that both must be answered in the negative. The district court viewed South Cherry's Complaint as asserting that Hennessee Group's conduct was reckless in recommending Bayou Accredited for investment. South Cherry, in challenging that decision, reiterates some of the allegations in the Complaint that led the court to that interpretation. ( See, e.g., South Cherry brief on appeal at 25 (South Cherry clearly alleged that HG failed to do basic due diligence, with the result that its `representations and opinions were given without basis and in reckless disregard of their truth or falsity' as to the suitability of Bayou Accredited as an investment for South Cherry. (quoting Rolf, 570 F.2d at 48)).) But South Cherry also argues that [its] allegation is that HG, perpetrating its own fraud (and not merely advancing Bayou's), made intentional misrepresentations of fact to South Cherry when it represented, among other things, the performance history, investment strategy, principals' track record and auditors' identity for Bayou Accredited and its predecessor fund on the basis of thorough due diligence HG claimed to have performed, but did not. (South Cherry brief on appeal at 20 (emphases added).) This somewhat convoluted sentence is perhaps subject to various interpretations; but we conclude that whichever way it was intended, the Complaint lacks sufficient factual allegations to give rise to a strong inference of either fraudulent intent or conscious recklessness. To the extent that the quoted passage was intended to argue that Hennessee Group made intentional misrepresentations as to the performance and record of the Bayou funds and their principals, it does not carry the day because we see no such factual allegations in the Complaint. Despite the Complaint's conclusory allegation that Hennessee Group  knowingly or recklessly (a) made untrue statements of material fact and omitted to state material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, and (b) engaged in acts, practices, and/or a course of business that operated or would operate as a fraud or deceit upon South Cherry (Complaint ¶ 55 (emphasis added)), nowhere in the Complaint is there any allegation that Hennessee Group had knowledge that any representation it made as to the records or circumstances of Bayou Accredited, or its predecessor Bayou Fund, was untrue. Instead, the Complaint is replete with allegations that HG would have learned the truth as to those aspects of the Bayou funds if HG had performed the due diligence it promised. ( E.g., Complaint ¶¶ 7, 18, 26, 27, 28, 30.) Nor, to the extent that South Cherry sought to allege recklessness, does the Complaint contain an allegation of any fact relating to Bayou Accredited that (a) was known to Hennessee Group and (b) created a strong inference that HG had a state of mind approximating an actual intent either to relay false or misleading information about Bayou Accredited or to aid in the fraud being perpetrated by the Bayou Accredited principals. Although the Complaint alleged that, [i]n breach of its agreement with South Cherry, Hennessee Group failed to take obvious investigative steps and ignored clear red flags ( id. ¶ 30), it did not allege that Hennessee Group did not believe that the various Bayou funds' representations, including their records and financial statements, were accurate. It did not allege any fact known to Hennessee Group prior to the summer of 2005, i.e., during the period in which HG was recommending Bayou Accredited, that either made the falsity of any of the Bayou funds' representations obvious or that should have alerted HG that the Bayou funds' representations were dubious. According to the Complaint, federal and state officials did not focus on the Bayou funds until the summer of 2005, following Israel's announcement to investors that the funds would be liquidated. ( See Complaint ¶¶ 36, 37.) There is no factual allegation in the Complaint that, prior to that announcement in July 2005, there were obvious signs of fraud, or that the danger of fraud was so obvious that HG must have been aware of it. Rather, the Complaint alleged that [i]f Hennessee Group had asked various questions earlier, it would have further questioned the Bayou Accredited financial records or recognized the need to ask further questions. (Complaint ¶¶ 18, 24; see also id. ¶¶ 7, 26, 27, 28, 30, 35.) The closest the Complaint came to identifying any fact that supposedly should have put HG on fraud alert was the allegation that Bayou Accredited's purported auditor was named Richmond Fairfield, because Richmond [and] Fairfield [are] names that a diligent investigator might have recognized as names of counties and not accountants ( id. ¶ 27). But even leaving aside the Complaint's flawed premise, inter alia, that no person would have the same name as a place, the Complaint did not in fact allege that HG knew the Bayou funds' financials were purportedly audited by Richmond Fairfield; rather, it alleged that [i]f HG had taken steps to `verify' Bayou's auditors, as it promised South Cherry, HG would ... have discovered the existence of Richmond-Fairfield. (Complaint ¶ 24 (emphasis added).) To the extent that the above-quoted passage from page 20 of South Cherry's brief was meant to argue that HG intended to defraud South Cherry as to HG's own performance, i.e., that HG represented that it had performed due diligence when in fact it had not done so, the factual allegations in the Complaint do not give rise to a strong inference that the alleged failure to conduct due diligence was indicative of an intent to defraud. The only fact cited  in South Cherry's brief on appeal  as to a possible motive for such an intent is that HG receives a fee when a client invests in a recommended fund, and South Cherry suggests that HG wanted to receive its fee without incurring the expense of performing the promised due diligence ( see South Cherry brief on appeal at 22, 23). This is hardly a cogent or compelling suggestion. According to the Complaint, Hennessee Group proclaimed itself the industry leader, boasted that its principals testify before Congress, repeatedly emphasized the thoroughness of its hedge fund evaluations, and prided itself on its credibility with investors and other participants in the hedge fund industry. ( See, e.g., Complaint ¶¶ 13, 14.) The Complaint also alleged that HG represented that it evaluated 550 hedge funds each month ( see id. ¶ 13), a representation that South Cherry does not claim was false, and alleged that HG recommended the Bayou Family Funds to a large number of investors who proceeded to invest tens of millions of dollars in those funds ( see id. ¶ 10). Given the disclosures after the summer of 2005 as to the Bayou Family Funds principals' fraudulent conduct, it would be plausible to infer that Hennessee Group had been negligent in failing to discover the truth. It is far less plausible to infer that an industry leader that prides itself on having expertise that is called on by Congress, that emphasizes its thorough due diligence process, that values and advertises its credibility in the industry  and that evaluates 550 funds  would deliberately jeopardize its standing and reliability, and the viability of its business, by recommending to a large segment of its clientele a fund as to which it had made, according to South Cherry, little or no inquiry at all. On appeal, South Cherry suggests that the combination of Hennessee Group's wide recommendation of Bayou-related funds and its apparent failure to conduct much or any of the requisite due diligence or to learn easily discovered facts ... lends itself to the inference that HG was receiving some undisclosed payment from the Bayou funds for steering additional investors toward them. (South Cherry brief on appeal at 23-24 & n.7.) This suggestion that Hennessee Group may have deliberately engaged in illegal behavior, see 15 U.S.C. § 77q(b) (requiring disclosure of existence and amount of payments made for promotion of securities), appears nowhere in the complaint, and South Cherry essentially concedes that this proffered inference is speculative. It argues that because such facts would be peculiarly within the knowledge of the defendants, it had no obligation to include such an allegation in the Complaint ( see South Cherry brief on appeal at 23 n.7), intimating that it might hope to develop some such evidence in discovery. To be sure, South Cherry should not include such an allegation in its pleading without having a factual basis or justification, Fed.R.Civ.P. 11 Advisory Committee Note (1993). But before proceeding to discovery, a complaint must allege facts suggestive of illegal conduct, Twombly, 550 U.S. at 564 n. 8, 127 S.Ct. 1955; and a plaintiff whose complaint is deficient under Rule 8 ... is not entitled to discovery, Iqbal, 129 S.Ct. at 1954. South Cherry's confessed inability to offer more than speculation that there may have been such unlawful conduct underscores, rather than cures, the deficiency in the Complaint. The prior decisions of this Court on which South Cherry principally relies  Novak and Rolf ( see South Cherry brief on appeal, passim )  do not require a conclusion that the requisite state of mind has been adequately pleaded here, for they dealt with duties and actions different from those alleged here. Novak dealt with shareholder claims against one group of company officials who allegedly issued fraudulently inflated financial statements and another group of defendants who owned a dominant percentage of the company's shares, a significant number of which they sold during the period in which the financials were inflated. The relationship between South Cherry and Hennessee Group, a consultant, does not parallel either of the relationships that existed in Novak; and indeed, in our Novak opinion, the only claims at issue were those against the company officials who issued the financial statements. See 216 F.3d at 305. Nor does Rolf provide support for South Cherry's claim that dismissal of its complaint pursuant to Rule 12(b)(6) was error, for Rolf is significantly different from this case both procedurally and substantively. Our opinion in Rolf reviewed a decision after trial; thus, we were dealing with actual evidence and findings of fact, not assessing the adequacy of a pleading or the plausibility of inferences that could be drawn from factual allegations. And the pertinent facts, as sufficiently established at the Rolf trial, were that the defendants, a brokerage house and two of its account managers, had a fiduciary relationship with the plaintiff; that one of the individual defendants had engaged in fraudulent stock manipulations; and that the other individual defendant had aided and abetted the frauds on the plaintiff. Thus, the trial court concluded that the individuals and their firm had breached their fiduciary duty to the plaintiff. See 570 F.2d at 43, 47-48. Here, South Cherry has not sued the perpetrators of the Bayou funds' frauds, and the Complaint contains no allegation that Hennessee Group and its principals aided and abetted those frauds. Further, the present appeal involves no claim that Hennessee Group or its principals owed South Cherry a fiduciary duty. The Complaint contained a claim for breach of such a duty; but the district court dismissed that claim, and South Cherry has not pursued that claim on appeal. In sum, we conclude (a) that the factual allegations in the Complaint do not give rise to a strong inference of either fraudulent intent or conscious recklessness, and (b) that the inferences advocated by South Cherry are not as compelling as an inference of negligence. Accordingly, on either ground, South Cherry's efforts to plead a claim under § 10(b) and Rule 10b-5 were properly found wanting for lack of plausible and cogent allegations of scienter. At bottom, this was a contract case. The obligation to conduct the five-step due diligence [wa]s one imposed by contract on HG. (South Cherry brief on appeal at 27 (emphasis in original); see, e.g., id. at 21 (the ongoing Ponzi scheme would have been obvious if Hennessee Group had conduct[ed] any substantial portion of the due diligence it promised  (emphasis added; other emphasis omitted)); id. at 29-30 (HG would have discovered the Bayou fraud had it performed even a modicum of the due diligence for which South Cherry bargained  (emphasis added)).) But the alleged contract was not in writing and hence was unenforceable under the Statute of Frauds; and we cannot conclude, given the factual allegations of the Complaint, that these non-fiduciary defendants' failure to learn the truth constitutes the scienter needed to state a claim under § 10(b) and Rule 10b-5 where the supposed obligation to learn was imposed only by an agreement that is void.