Opinion ID: 769157
Heading Depth: 4
Heading Rank: 1

Heading: The Second Circuit's Pre-PSLRA Pleading Standard

Text: 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