Opinion ID: 198674
Heading Depth: 2
Heading Rank: 2

Heading: Pleading Required State of Mind: Characteristic Fact Patterns

Text: 54 Where a plaintiff can recover money damages on proof that a defendant acted with a particular state of mind, the PSLRA now requires a complaint to 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). The required state of mind for liability under section 10(b) and Rule 10b-5 is referred to as scienter, which the Supreme Court has defined as a mental state embracing intent to deceive, manipulate, or defraud. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). 55 The debate between the plaintiffs and the defendants is largely over whether Congress intended to embody, as the SEC says, the prior Second Circuit methods for proving scienter (i.e., by showing motive and opportunity or evidence of reckless or conscious behavior sufficient to raise a strong inference) or, as the defendants say, to prohibit use of at least the motive and opportunity method. This focus of the parties is not surprising, as there was much debate in Congress on these points. 56 The plaintiffs and the SEC argue that the PSLRA does not prohibit use of the Second Circuit's methods for proving scienter. They refer to the bill reported out of the Senate Committee on Banking, Housing, and Urban Affairs, see S. 240, 104th Cong. § 104(b) (1995), reprinted in 141 Cong. Rec. S9222 (daily ed. June 28, 1995), and to the Senate Report, which states, in part, that: 57 The Committee does not adopt a new and untested pleading standard that would generate additional litigation. Instead, the Committee chose a uniform standard modeled upon the pleading standard of the Second Circuit. . . . [T]he Second Circuit requires that the plaintiff plead facts that give rise to a strong inference of defendant's fraudulent intent. The Committee does not intend to codify the Second Circuit's caselaw interpreting this pleading standard, although courts may find this body of law instructive. 58 S. Res. 98, 104th Cong., at 15 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 694 (footnotes omitted). They also rely on the comments of Senator Dodd, co-sponsor of the PSLRA, explaining that Congress intended to codify the Second Circuit's pleading standards. 141 Cong. Rec. S17960 (daily ed. Dec. 5, 1995). Finally, they argue that their position is bolstered by the Statement of Managers of the Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227, which declared that the managers again emphasize that the clear intent in 1995 and our continuing intent in this legislation is that neither the Reform Act nor [the Standards Act] in any way alters the scienter standard in Federal securities fraud suits. Joint Explanatory Statement of the Committee of Conference, Conference Report to Accompany S. 1260, H.R. Conf. Rep. No. 105-803 (1998 Conf. Rep.), at 15 (1998). 59 The defendants argue that allegations of the existence of motive and opportunity to commit fraud (or simple recklessness) do not satisfy the scienter requirement. To support their view, they note Congress' statement that [t]he Conference Committee language is based in part on the pleading standard of the Second Circuit, (emphasis added) and that [b]ecause the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit's case law interpreting this pleading standard. H.R. Conf. Rep. 104-369, at 41 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 740. Defendants also rely heavily on the footnote associated with this sentence, which states: For this reason, the Conference Report chose not to include in the pleading standard certain language relating to motive, opportunity, or recklessness. Id. at 41 n.23, reprinted in 1995 U.S.C.C.A.N. at 747. Further, the defendants emphasize that although the Senate Bill (S. 240) included an amendment that would codify Second Circuit law, the Conference Committee eliminated that amendment. See Amend. 1485, S. 240, 104th Cong., 1st Sess. (1995), 141 Cong. Rec. S9170 (daily ed. June 27, 1995). 60 Finally, the defendants place considerable weight on Congress' decision to override President Clinton's veto, in light of the President's statement that in the Act Congress intended to 'strengthen' the existing pleading requirements of the Second Circuit . . . [and] to erect a higher barrier to bringing suit than any now existing[.] H.R. Doc. No. 104-150, 104th Cong., 1st Sess. (1995), 141 Cong. Rec. H15214 (Dec. 20, 1995). 8 Counsel for defendant FTP candidly admitted before the district court that the legislative history standing alone could be read either way, but argued that the President's veto -- based on his reading of the Act as overruling the Second Circuit motive and opportunity test -- administered the coup de grace. While the President's view of what Congress meant has some informational value, we give that view little weight: the real issue is what the intent was of the Congress, not the President. 61 The legislative history is inconclusive on whether the Act was meant to either embody or to reject the Second Circuit's pleading standards. As the Third Circuit has noted, [t]he Reform Act's legislative history on this point is ambiguous and even contradictory. In re Advanta Corp. Sec. Litig., 180 F.3d 525, 531 (3d Cir. 1999). The history and text show no agreement to restrict the types of evidence which may be used to show a strong inference of scienter. Indeed, it would be unusual for Congress to legislate on what fact patterns could or could not prove fraud or scienter. At best, there appears to have been an agreement to disagree on the issue of Second Circuit standards (other than the strong inference standard), and perhaps, as is common, to leave such matters for courts to resolve. See, e.g., Burlington Indus., Inc. v. Ellerth, 118 S. Ct. 2257, 2264 (1998). 62 From the words of the Act, certain conclusions can be drawn. First, Congress plainly contemplated that scienter could be proven by inference, thus acknowledging the role of indirect and circumstantial evidence. See 15 U.S.C. § 78u-4(b)(2) (requiring that the complaint . . . state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind) (emphasis added). Second, the words of the Act neither mandate nor prohibit the use of any particular method to establish an inference of scienter. Third, Congress has effectively mandated a special standard for measuring whether allegations of scienter survive a motion to dismiss. While under Rule 12(b)(6) all inferences must be drawn in plaintiffs' favor, inferences of scienter do not survive if they are merely reasonable, as is true when pleadings for other causes of action are tested by motion to dismiss under Rule 12(b)(6). See Conley v. Gibson, 355 U.S. 41, 45-46 (1957). Rather, inferences of scienter survive a motion to dismiss only if they are both reasonable and strong inferences. 9 63 Indeed, the debate about adoption or rejection of prior Second Circuit standards strikes us as somewhat beside the point. The categorization of patterns of facts as acceptable or unacceptable to prove scienter or to prove fraud has never been the approach this circuit has taken to securities fraud. As stated in Maldonado, 137 F.3d at 10 n.6, this court has never adopted the Second Circuit test. Instead we have analyzed the particular facts alleged in each individual case to determine whether the allegations were sufficient to support scienter. See, e.g., Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1209 (1st Cir. 1996). In this, the approach of this circuit has been like that taken by the Supreme Court as to the issue of materiality in Basic Inc. v. Levinson, 485 U.S. 224 (1988). 64 This court has considered many different types of evidence as relevant to show scienter. Examples include: insider trading (discussed below); divergence between internal reports and external statements on the same subject (see Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 361 (1st Cir. 1994)); closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent information (see Shaw, 82 F.3d at 1224-25); evidence of bribery by a top company official (see Greenstone v. Cambex Corp., 975 F.2d 22, 26 (1st Cir. 1992)); existence of an ancillary lawsuit charging fraud by a company and the company's quick settlement of that suit (see id.); disregard of the most current factual information before making statements (see Glassman v. Computervision Corp., 90 F.3d 617, 627 (1st Cir. 1996)); disclosure of accrual basis information in a way which could only be understood by a sophisticated person with a high degree of accounting skill (see Holmes v. Bateson, 583 F.2d 542, 552 (1st Cir. 1978)); the personal interest of certain directors in not informing disinterested directors of impending sale of stock (see Estate of Soler v. Rodrguez, 63 F.3d 45, 54 (1st Cir. 1995)); and the self-interested motivation of defendants in the form of saving their salaries or jobs (see Serabian, 24 F.3d at 368). While a number of these cases could be thought of as falling into motive and opportunity patterns, this court continues to prefer a more fact-specific inquiry. See, e.g., Glassman, 90 F.3d at 624 (fact that lead underwriter may have had incentive to inflate the offering price was significant, but overall, complaint failed to state a claim on which relief could be granted). 65 The most salient feature of the PSLRA is that whatever the characteristic pattern of the facts alleged, those facts must now present a strong inference of scienter. A mere reasonable inference is insufficient to survive a motion to dismiss. Our pre-Act case law had used both the language of strong inference and of reasonable inference in various contexts. For example, strong inference is used in Maldonado, 137 F.3d at 9 and Suna v. Bailey Corp., 107 F.3d 64, 68 (1st Cir. 1997). Reasonable inference language was used in Gross v. Summa Four Inc., 93 F.3d 987, 996 (1st Cir. 1996); Shaw, 82 F.3d at 1224; Serabian, 24 F.3d at 368; Greenstone, 975 F.2d at 25; and Romani, 929 F.2d at 878. It is clear that scienter allegations now must be judged under the strong inference standard at the motion to dismiss stage. 66 Our view of the Act is thus close to that articulated by the Sixth Circuit. That court held that a plaintiff could survive a motion to dismiss by pleading facts that give rise to a strong inference of [scienter]. In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 550 (6th Cir. 1999) (internal quotation marks omitted). The Sixth Circuit found that evidence of motive and opportunity to commit fraud did not, of itself, constitute scienter for purposes of section 10(b) and Rule 10b-5. See id. at 551. Indeed, those courts addressing motive and opportunity in Securities Act cases have held only that facts showing a motive and opportunity may adequately allege scienter, not that the existence of motive and opportunity may support, as scienter itself, liability under § 10b or Rule 10b-5. Id. The court held that evidence of motive and opportunity was relevant to pleading facts that could establish scienter, and, on occasion, could rise to the level of creating a strong inference of reckless or knowing conduct. Id. Nevertheless, such evidence, standing alone, could not constitute the pleading of a strong inference of scienter. Id.; accord Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1282-83 (11th Cir. 1999). 67 Without adopting any pleading litany of motive and opportunity, we reject defendants' argument that facts showing motive and opportunity can never be enough to permit the drawing of a strong inference of scienter. But, as we cautioned in Maldonado, 137 F.3d at 10 n.6, merely pleading motive and opportunity, regardless of the strength of the inferences to be drawn of scienter, is not enough. Three circuits have interpreted the PSLRA as permitting use of motive and opportunity type pleading if it raises a strong inference. See In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534-35 (3d Cir. 1999); Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 537-38 (2d Cir. 1999); Williams v. WMX Techs., Inc., 112 F.3d 175, 178 (5th Cir. 1997) (dicta). Like the Third Circuit, we caution that catch-all allegations that defendants stood to benefit from wrongdoing and had the opportunity to implement a fraudulent scheme are [not] sufficient. In re Advanta Corp., 180 F.3d at 535. 68 Similarly, the PSLRA neither prohibits nor endorses the pleading of insider trading as evidence of scienter, but requires that the evidence meet the strong inference standard. 10 Unusual trading or trading at suspicious times or in suspicious amounts by corporate insiders has long been recognized as probative of scienter. See Shaw, 82 F.3d at 1204; Rubinstein v. Collins, 20 F.3d 160, 169-70 (5th Cir. 1994); Greenstone, 975 F.2d at 26. The vitality of the inference to be drawn depends on the facts, and can range from marginal, see Shaw, 82 F.3d at 1204, to strong, see Rubinstein, 20 F.3d at 169-70. This continues to be true in litigation after the effective date of the PSLRA. Indeed, in Greenstone we noted, and still think today, that allegations of unusual insider trading by a defendant with access to material non-public information can support a strong inference of scienter. See Greenstone, 975 F.2d at 26. We similarly caution that mere pleading of insider trading, without regard to either context or the strength of the inferences to be drawn, is not enough. See Maldonado, 137 F.3d at 9-10. At a minimum, the trading must be in a context where defendants have incentives to withhold material, non-public information, and it must be unusual, well beyond the normal patterns of trading by those defendants. 11