Opinion ID: 198674
Heading Depth: 2
Heading Rank: 3

Heading: Substantive Scienter Standards

Text: 69 The parties disagree about the effect, if any, of the PSLRA on the substantive standard for proving scienter. We start with the state of the law in this circuit before the enactment of the PSLRA. 70 The Supreme Court has defined scienter as a mental state embracing intent to deceive, manipulate, or defraud. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976). The Court explicitly reserved the issue of whether recklessness sufficed, saying [i]n certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act. Id. Before enactment of the PSLRA, most circuits had held that scienter in civil securities fraud actions could be shown by showing recklessness. 12 It is accepted that recklessness may establish intent to defraud in criminal prosecutions under § 17(a)(1) of the Exchange Act and under the mail and wire fraud statutes. See 8 L. Loss and J. Seligman, Securities Regulation 3656-57 (3d ed. 1991). The question became whether the standard for criminal liability should also apply to civil liability. That, in turn, raised the question of what was meant by recklessness. 71 We have used a definition of recklessness articulated by the Seventh Circuit: 72 [R]eckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable, negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious the actor must have been aware of it. 73 Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977) (quoting Franke v. Midwestern Okla. Dev. Auth., 428 F. Supp. 719, 725 (W.D. Okla. 1976)). Without at first explicitly adopting that standard, this court assumed that it applied and cited it with approval in Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978). In Hoffman v. Estabrook & Co., 587 F.2d 509, 515-16 (1st Cir. 1978), this court again assumed that recklessness could ground a Rule 10b-5 action and, again, quoted with approval a Seventh Circuit definition: 74 In view of the Supreme Court's analysis in Hochfelder of the statutory scheme of implied private remedies and express remedies, the definition of reckless behavior should not be a liberal one lest any discernible distinction between scienter and negligence be obliterated for these purposes. We believe reckless in these circumstances comes closer to being a lesser form of intent than merely a greater degree of ordinary negligence. We perceive it to be not just a difference in degree, but also in kind. 75 Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). This court explicitly rejected a formulation of recklessness as mere negligence, finding it had to come closer to being a lesser form of intent than merely a greater degree of ordinary negligence. See Hoffman, 587 F.2d at 516 & n.10. 76 In Serabian this court held that it was error to dismiss a securities fraud complaint that alleged sufficient facts to draw an inference that the [defendant] knew, or should have known, that its public statements were inconsistent with the actual conditions then being reported to [it]. Serabian, 24 F.3d at 365 (emphasis added and original emphasis omitted). We understand Serabian to have used should have known in the reckless disregard sense used in Cook and Hoffman. This court has explicitly tested factual allegations to see whether they supported an inference that defendants acted with reckless disregard. See Romani, 929 F.2d at 878. Since then, there have been encapsulated references to this rule in dicta in other cases. See, e.g., Maldonado, 137 F.3d at 9 n.4. The rule in this circuit has been to accept recklessness, as narrowly defined in the two Seventh Circuit cases (Sundstrand and Sanders), as a method of proving scienter. See Serabian, 24 F.3d at 365. That definition of recklessness does not encompass ordinary negligence and is closer to a lesser form of intent. 77 The effect of the PSLRA on the standard for scienter has been much disputed. The Act itself is silent on the general scienter requirements for 10b-5 actions, referring only to scienter as the required state of mind. 15 U.S.C. § 78u-4(b)(2). Plaintiffs and the SEC maintain that the PSLRA did not intend or purport to change whatever the preexisting standard was, and that standard included some form of recklessness. The defendants say that only the most heightened recklessness standard should be used, and that the SEC's views are not entitled to any weight. 78 The circuit courts have reached different results. A panel in the Ninth Circuit has held that the PSLRA elevated the standard to one of deliberate recklessness, In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999). One district court within this circuit has concluded that recklessness is insufficient and that only conscious conduct would suffice under the Act. See Friedberg v. Discreet Logic Inc., 959 F. Supp. 42, 48 (D. Mass. 1997). 79 In contrast, the Sixth Circuit has concluded that the PSLRA did not alter the state of mind requirement and thus a complaint pleading facts that give rise to a 'strong inference of recklessness' of the kind required for securities fraud liability suffices. In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 552-53 (6th Cir. 1999). The Sixth Circuit had previously adopted, as had this circuit, the Sundstrand definition of recklessness, see id. at 550, and concluded that same standard applied after the PSLRA was enacted. The Eleventh Circuit has expressed its basic agreement with the Sixth Circuit, Bryant v. Avado Brands, Inc., 187 F.3d 1271-1282-83 (11th Cir. 1999), holding that the PSLRA did not substantively change the actionable level of scienter, id. at 1284-85. The Third Circuit has concluded that [a]lthough the Reform Act established a uniform pleading standard, it did not purport to alter the substantive contours of scienter, In re Advanta Corp. Sec. Litig., 180 F.3d 525, 534 (3d Cir. 1999), and reiterated its prior law that recklessness, as defined in Sundstrand, suffices, see id. Without much discussion of the issue, the Second Circuit has adhered to its previous acceptance of recklessness. See Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 537-38 (2d Cir. 1999). The Fourth Circuit has also concluded that the PSLRA did not change the pre-existing scienter standard. See Phillips v. LCI Int'l, Inc., 190 F.3d 609,620 (4th Cir. 1999) ([T]o establish scienter, a plaintiff must still prove that the defendant acted intentionally, which may perhaps be shown by recklessness.). Two district courts in this circuit have reached the conclusion that some form of recklessness is available. See In re PLC Sys., Inc. Sec. Litig., 41 F.Supp.2d 106, 115 (D. Mass 1999); Lirette v. Shiva Corp., 27 F.Supp.2d 268, 282 (D. Mass. 1998). 80 We agree with those courts that hold that the PSLRA did not address the substantive definition of scienter. The legislative history shows no such intent and the language of the Act itself does not address the topic. See generally Dunn, Note, Pleading Scienter After the Private Securities Litigation Reform Act, 84 Cornell L. Rev. 193 (1998). The opinions of the Sixth and Third Circuits discuss these points ably and there is no reason to repeat the discussion here. 81 We add additional reasons that buttress this conclusion. The PSLRA does in fact discuss the role of knowing violations, and thus an aspect of scienter, in two different respects. The first concerns contribution; the second, safe harbors for defendants. As to contribution, 13 the Act, through a new § 21D(g), added a section to preserve joint and several liability for persons who knowingly commit securities fraud, but otherwise to proportionately limit liability to the 'portion of the judgment that corresponds to the percentage of responsibility of that covered person.' 10 Loss & Seligman, at 4687 (quoting 15 U.S.C. § 78u-4(f)(2)(B)(i)). The PSLRA specifies that: 82 [a]ny covered person against whom a final judgment is entered in a private action shall be liable for damages jointly and severally only if the trier of fact specifically determines that such covered person knowingly committed a violation of the securities laws. 83 15 U.S.C. § 78u-4(f)(2)(A). In turn knowingly commits a violation of the securities laws is defined (for 10b-5 purposes) as requiring actual knowledge that a representation is false or an omission renders a representation false. Id. § 78u-4(f)(10)(A). The definition specifically excludes reckless conduct as a basis for construing a knowing commission of a violation. Id. § 78-u(f)(10)(B). 84 These special contribution provisions lead to several conclusions. Congress, having explicitly eliminated recklessness as a basis for imposing joint and several liability, should not be taken as implicitly having eliminated recklessness as a basis for any liability. See In re Silicon Graphics, 183 F.3d at 995 (Browning, J., concurring in part and dissenting in part). Because joint and several liability is more onerous than individual liability, the exclusion of recklessness as the basis for imposing joint and several liability constitutes a recognition that some form of recklessness may suffice for individual liability. Furthermore, Congress took great care to insure that the actual knowledge requirement was restricted to the joint and several liability provisions of the Act. Section 78u-4(f)(1) provides that nothing in this subsection shall be construed to create, affect, or in any manner modify, the standard for liability associated with any action arising under the securities laws. 15 U.S.C. § 78-u(f)(1). Including this language would not make sense if Congress had altered the general scienter requirement to restrict it to actual knowledge. 85 The safe harbor provisions of the Act similarly buttress the conclusion that the Act did not alter pre-existing law defining scienter. The PSLRA adopted a statutory safe harbor by adding a new section 27A to the 1933 Act, 15 U.S.C. § 77z-2, and a new section 21E to the 1934 Act, 15 U.S.C. § 78u-5. The safe harbor has two alternative inlets: the first shelters forward-looking statements that are accompanied by meaningful cautionary statements. See 15 U.S.C. § 78u-5(c)(1)(A)(i). The second inlet is of importance here. It focuses on the state of mind of the defendant and precludes liability for a forward-looking statement unless the maker of the statement had actual knowledge it was false or misleading. See § 78u-5(c)(1)(B); H.R. Conf. Rep. No. 104-369 (1995), reprinted in 1995 U.S.C.C.A.N. 730, 743. Again, this new section 21E to the 1934 Act is explicit, in contrast with the lack of such language in the definition of scienter in § 21D(b)(2). See Bryant, 187 F.3d at 1284-85; In re Silicon Graphics, 183 F.3d at 995 (Browning, J., concurring in part and dissenting in part). 86 Concluding that the Act does not alter the pre-existing definition of scienter adopted by this circuit, we accordingly test the complaint against that definition.