Opinion ID: 769157
Heading Depth: 3
Heading Rank: 2

Heading: The Pleading Standard for Scienter

Text: 31
32 We can easily summarize the pleading standard for scienter that prevailed in this circuit prior to the PSLRA: 33 [P]laintiffs must allege facts that give rise to a strong inference of fraudulent intent. The requisite 'strong inference' of fraud may be established either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. 34 Acito, 47 F.3d at 52 (quoting Shields, 25 F.3d at 1128 (internal citations omitted). However, this statement of the standard conceals the complexity and uncertainty that often surround its application. This difficulty in application stems, at least in part, from the inevitable tension between the interests in deterring securities fraud and deterring strike suits. See In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 263 (2d Cir. 1993). As a result, different courts applying the pleading standard to differing factual circumstances may reach seemingly disparate results. See id. at 264. Nevertheless, we discern some basic patterns in our case law under § 10(b) and Rule 10b-5 that help to provide substance to the general language of the standard itself. 35 We described the type of motive and opportunity required to plead scienter under our pre-reform standard as follows: 36 Motive would entail concrete benefits that could be realized by one or more of the false statements and wrongful nondisclosures alleged. Opportunity would entail the means and likely prospect of achieving concrete benefits by the means alleged. 37 Shields, 25 F.3d at 1130. Plaintiffs could not proceed based on motives possessed by virtually all corporate insiders, including: (1) the desire to maintain a high corporate credit rating, see San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., Inc., 75 F.3d 801, 814 (2d Cir. 1996), or otherwise sustain the appearance of corporate profitability, or of the success of an investment, Chill, 101 F.3d at 268; and (2) the desire to maintain a high stock price in order to increase executive compensation, see Acito, 47 F.3d at 54, or prolong the benefits of holding corporate office, see Shields, 25 F.3d at 1130. Rather, plaintiffs had to allege that defendants benefitted in some concrete and personal way from the purported fraud. This requirement was generally met when corporate insiders were 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. See, e.g., Stevelman, 174 F.3d at 85; Goldman v. Belden, 754 F.2d 1059, 1070 (2d Cir. 1985). Accordingly, in the ordinary case, adequate motive arose from the desire to profit from extensive insider sales. 38 Plaintiffs could also meet the pre-PSLRA pleading standard by alleging facts that constituted strong circumstantial evidence of conscious misbehavior or recklessness on the part of defendants. Intentional misconduct is easily identified since it encompasses deliberate illegal behavior, such as securities trading by insiders privy to undisclosed and material information, see Simon DeBartolo Group, L.P. v. Richard E. Jacobs Group, Inc., 186 F.3d 157, 168-69 (2d Cir. 1999), or knowing sale of a company's stock at an unwarranted discount, see Schoenbaum v. Firstbrook, 405 F.2d 215, 219 (2d Cir. 1968) (in banc). 39 Recklessness is harder to identify with such precision and consistency. In 1978, when we first held that recklessness suffices to plead scienter under § 10(b) and Rule 10b-5, we defined reckless conduct as: 40 at the least, conduct which 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. 41 Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 47 (2d Cir. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)) (ellipsis in original). Similarly, we later noted that '[a]n 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 (quoting Goldman v. McMahan, Brafman, Morgan & Co., 706 F. Supp. 256, 259 (S.D.N.Y. 1989)) (ellipsis in original). 42 However, these general standards offer little insight into precisely what actions and behaviors constitute recklessness sufficient for § 10(b) liability. It is the actual facts of our securities fraud cases that provide the most concrete guidance as to the types of allegations required to meet the pre-PSLRA pleading standard in this circuit. 43 According to these cases, securities fraud claims typically have sufficed to state a claim based on recklessness when they have specifically alleged defendants' knowledge of facts or access to information contradicting their public statements. Under such circumstances, defendants knew or, more importantly, should have known that they were misrepresenting material facts related to the corporation. Thus, for example, the pleading standard was met where the plaintiffs alleged that the defendants made or authorized statements that sales to China would be an important new source of revenue when they knew or should have known that Chinese import restrictions in place at the time would severely limit such sales. See Cosmas v. Hassett, 886 F.2d 8, 12 (2d Cir. 1989). Similarly, the pleading standard was met where the plaintiffs alleged that the defendants released to the investing public several highly positive predictions about the marketing prospects of a computer system to record hotel guests' long-distance telephone calls when they knew or should have known several facts about the system and its consumers that revealed grave uncertainties and problems concerning future sales of the system. Goldman, 754 F.2d at 1063, 1070. 44 Under certain circumstances, we have found allegations of recklessness to be sufficient where plaintiffs alleged facts demonstrating that defendants failed to review or check information that they had a duty to monitor, or ignored obvious signs of fraud. Thus, the pleading standard was met where the plaintiff alleged that the defendant, his broker, consistently reassured the plaintiff that the investment advisor responsible for the plaintiff's portfolio knew what he was doing but never actually investigated the advisor's decisions to determine whether there was a basis for the [defendant's] assertions. Rolf, 570 F.2d at 47-48. Similarly, the pleading standard was met where the defendant allegedly included false statements in SEC filings despite the obviously evasive and suspicious statements made to him by the corporate officials upon whom he was relying for this information and despite outside counsel's recommendation that these statements not be included. SEC v. McNulty, 137 F.3d 732, 741 (2d Cir. 1998). 45 At the same time, however, we have identified several important limitations on the scope of liability for securities fraud based on reckless conduct. First, we have refused to allow plaintiffs to proceed with allegations of fraud by hindsight. See Stevelman, 174 F.3d at 85. Corporate officials need not be clairvoyant; they are only responsible for revealing those material facts reasonably available to them. See Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978). Thus, allegations that defendants should have anticipated future events and made certain disclosures earlier than they actually did do not suffice to make out a claim of securities fraud. See Acito, 47 F.3d at 53. 46 Second, as long as the public statements are consistent with reasonably available data, corporate officials need not present an overly gloomy or cautious picture of current performance and future prospects. See Stevelman, 174 F.3d at 85; Shields, 25 F.3d at 1129-30. Where plaintiffs contend defendants had access to contrary facts, they must specifically identify the reports or statements containing this information. See San Leandro, 75 F.3d at 812 (Plaintiffs' unsupported general claim of the existence of confidential company sales reports that revealed the larger decline in sales is insufficient to survive a motion to dismiss.). 47 Third, there are limits to the scope of liability for failure adequately to monitor the allegedly fraudulent behavior of others. Thus, the failure of a non-fiduciary accounting firm to identify problems with the defendant-company's internal controls and accounting practices does not constitute reckless conduct sufficient for § 10(b) liability. See Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir. 1982). Similarly, the failure of a parent company to interpret extraordinarily positive performance by its subsidiary -- specifically, the unprecedented and dramatically increasing profitability of a particular form of trading -- as a sign of problems and thus to investigate further does not amount to recklessness under the securities laws. See Chill, 101 F.3d at 269-70. 48 Finally, allegations of GAAP violations or accounting irregularities, standing alone, are insufficient to state a securities fraud claim. See Stevelman, 174 F.3d at 84; Chill, 101 F.3d at 270. Only where such allegations are coupled with evidence of corresponding fraudulent intent, Chill, 101 F.3d at 270, might they be sufficient. 49 We now examine to what extent these lessons from our prior case law have survived the recent reform of the securities laws. 50
51 Courts have disagreed on the proper interpretation of the new pleading requirement imposed by paragraph (b)(2) in light of the text of the PSLRA and its legislative history. They have generally come to one of two conclusions: 52 (1) The statute effectively adopts the Second Circuit's pleading standard for scienter wholesale, and thus plaintiffs may continue to state a claim by pleading either motive and opportunity or strong circumstantial evidence of recklessness or conscious misbehavior. See In re Advanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999); Press v. Chemical Invest. Servs. Corp., 166 F.3d 529, 538 (2d Cir. 1999) (dicta); Rubinstein v. Skyteller, Inc., 48 F. Supp. 2d 315, 320 (S.D.N.Y. 1999) (following Press). 53 (2) The statute strengthens the Second Circuit's standard by rejecting the simple pleading of motive and opportunity. See Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283 (11th Cir. 1999); In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 979 (9th Cir. 1999); In re Comshare, Inc. Sec. Litig., 183 F.3d 542, 550-51 (6th Cir. 1999); Novak I, 997 F. Supp. at 430; In re Glenayre Tech., Inc. Sec. Litig., 982 F. Supp. 294, 298 (S.D.N.Y. 1997); In re Baesa Sec. Litig., 969 F. Supp. 238, 241-42 (S.D.N.Y. 1997). 54 Our own review of the text and legislative history leads us to a middle ground. We conclude that the PSLRA effectively raised the nationwide pleading standard tothat previously existing in this circuit and no higher (with the exception of the with particularity requirement). At the same time, however, we believe that Congress's failure to include language about motive and opportunity suggests that we need not be wedded to these concepts in articulating the prevailing standard. We are led to these conclusions by the considerations that follow. 55 In order to gauge the implications of paragraph (b)(2), we apply familiar canons of statutory construction. We look first to the text of the statute. If that language is plain and its meaning sufficiently clear, we need look no further. See Connecticut Nat'l Bank v. Germain, 503 U.S. 249, 254 (1992). Only if the text of the statute is not unambiguous do we turn for guidance to legislative history and the purposes of the statute. See Dowling v. United States, 473 U.S. 207, 218 (1985). Applying these principles, we conclude that the enactment of paragraph (b)(2) did not change the basic pleading standard for scienter in this circuit. 56 In this case, our interpretive task begins and ends with the text of the statute. In drafting paragraph (b)(2), Congress specifically incorporated this circuit's strong inference language to define the pleading standard for securities fraud cases. Compare 15 U.S.C. § 78u-4(b)(2) (requiring plaintiffs to state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind), with Acito, 47 F.3d at 52 ([P]laintiffs must allege facts that give rise to a strong inference of fraudulent intent.). We agree with the Third Circuit that this use of the Second Circuit's language compels the conclusion that the Reform Act establishes a pleading standard approximately equal in stringency to that of the Second Circuit. In re Advanta Corp., 180 F.3d at 534. Cf. United States v. Johnson, 14 F.3d 766, 770 (2d Cir. 1994) (finding that Congress's use of substantially identical language to that of an earlier statute bespeaks an intention to import judicial interpretations of that language into the new statute). 57 Given the absence of ambiguity in the statutory text, no resort to legislative history or the purposes of the PSLRA is required. In any event, there is nothing in these sources that would alter our conclusion. As far as the general purposes of the PSLRA are concerned, Congress plainly sought to impose a stricter nationwide pleading standard and did so. But this purpose does not require raising the standard above that of this circuit, particularly in light of the explicit Congressional recognition that our pre-PSLRA standard was the most stringent in the nation. See H.R. Conf. Rep. No. 104-369, at 41. In many jurisdictions, adoption of a 'strong inference' standard will substantially heighten the barriers to pleading scienter, a result Congress expressly intended. Moreover, even in jurisdictions already employing the Second Circuit standard, the additional requirement that plaintiffs state facts 'with particularity' represents a heightening of the standard. In re Advanta Corp., 180 F.3d at 534. 58 Meanwhile, in our view, as is so often the case with legislative history generally, the legislative history of the PSLRA contains conflicting expressions of legislative intent with respect to the pleading requirement. Id. at 533. For example, while the Conference Committee rejected language from the Senate bill that would have adopted the Second Circuit rule wholesale, including language about motive and opportunity and recklessness, see H.R. Conf. Rep. No. 104-369, at 41 & 48 n.23, the Senate Committee reporting the bill stated that it was proposing not a new and untested pleading standard that would generate additional litigation, but rather a uniform standard modeled upon the pleading standard of the Second Circuit. S. Rep. No. 104-98, at 15 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 694 (noting that courts interpreting the proposed strong inference pleading standard might find Second Circuit case law instructive). 59 When all is said and done, we believe that the enactment of paragraph (b)(2) did not change the basic pleading standard for scienter in this circuit (except by the addition of the words with particularity). Accordingly, we hold that the PSLRA adopted our strong inference standard: In order to plead scienter, plaintiffs must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind, as required by the language of the Act itself. Although litigants and lower courts need and should not employ or rely on magic words such as motive and opportunity, we believe that our prior case law may be helpful in providing guidance as to how the strong inference standard may be met. Therefore, in applying this standard, district courts should look to the cases and factors discussed in Section I.B.1 above to determine whether plaintiffs have pleaded facts giving rise to the requisite strong inference. These cases suggest, in brief, that the inference may arise where the complaint sufficiently alleges that the defendants: (1) benefitted in a concrete and personal way from the purported fraud, see supra at [page 307]; (2) engaged in deliberately illegal behavior, see supra at [page 308]; (3) knew facts or had access to information suggesting that their public statements were not accurate, see supra at [page 308-09]; or (4) failed to check information they had a duty to monitor, see supra at [pages 308-09]. We now turn to the complaint in this case to determine whether the plaintiffs have met their burden to plead scienter. 60
61 The district court concluded that the plaintiffs had failed to plead facts giving rise to a strong inference of the defendants' fraudulent intent, as required to state a claim under § 10(b). We disagree. 62 According to the complaint, the AnnTaylor defendants knew at all relevant times that the Company had serious inventory problems that they sought to disguise by adopting the Box and Hold scheme. By refusing to mark down inventory they knew to be worthless, obsolete, and unsalable, the defendants acted intentionally and deliberately to artificially inflate AnnTaylor's reported financial results. They discussed the need to mark down inventory but refused to do so because that would damage the Company's financial prospects. Further, in approving the inventory management practices of Box and Hold, the defendants knowingly sanctioned procedures that violated the Company's own markdown policy, as stated in the Company's public filings. In doing so, they caused those filings to be materially misleading in that the disclosed policy no longer reflected actual practice. Lastly, despite knowledge of the true reasons for rising inventory levels, the defendants made repeated statements to the investment community either offering false reassurances that inventory was under control or giving false explanations for its growth. In short, the Complaint alleges that the defendants engaged in conscious misstatements with the intent to deceive. There is no doubt that this pleading satisfies the standard for scienter under Hochfelder, and the requirement of the PSLRA that plaintiffs state facts with particularity that give rise to a strong inference of the required state of mind. 63 In the end, we believe that the district court applied the correct standard but erroneously found that this standard was not met on these pleadings. According to the district court, the scienter requirement can be satisfied by pleading either conscious recklessness -- i.e., a state of mind approximating actual intent, and not merely a heightened form of negligence -- or actual intent. Novak I, 997 F. Supp. at 430. This was an accurate statement of the law. However, the district court believed that the facts pleaded by the plaintiffs supported nothing more than an inference that the managers of AnnTaylor disagreed over matters of business judgment, such as the valuation of inventory and the timing of markdowns. See Novak II, 26 F. Supp. 2d at 660. This was incorrect as a matter of law. When managers deliberately make materially false statements concerning inventory with the intent to deceive the investment community, they have engaged in conduct actionable under the securities laws.