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[2]  Rule 10b-5 and Scienter

Prior to 1976, the courts had struggled with the issue of the extent to which scienter is re­quired in order to establish a private claim based upon violations of Rule 10b‑5. In Ernst & Ernst v. Hochfelder,^[1] the Supreme Court held that plaintiffs, at least in an ac­tion for dam­ages, must prove “scienter” as distinguished from negligence, and that scien­ter for this purpose refers to a mental state, that is, an intent to deceive, manipulate, or defraud.^[2] The Court in Hochfelder left open the question as to the extent to which “reckless” conduct may subject one to liability in this context.^[3] The Seventh Circuit in Sundstrand equated “an extreme departure from the standards of ordinary care,” in hold­ing “reckless” conduct ac­tionable under Rule 10b‑5 and the Supreme Court declined to review.^[4] Another panel of the Seventh Circuit has cautioned in this context that in light of the emphasis of the Su­preme Court in Hochfelder on “mental state” that:

[T]he definition of “reckless behavior” should not be a liberal one lest any dis­cern­ing distinction between “scienter” and “negligence” be obliterated for these pur­poses. We believe “reck­less” in these circumstances comes close 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.^[5]

The debate relating to the adoption of the PSLRA may have some relevance in determining what constitutes recklessness. H.R. 1058 as passed by the House would have defined “reck­less­ness” as involving “highly unreasonable conduct” that is “not merely simple or even gross negligence, but an extreme departure from standards of ordinary care AND [that] presents a danger of misleading either known to the defendant or so obvious that defendant must have been aware of it.”[6] This is basically the standard adopted by the Seventh Circuit in Sundstrand. The proponents of the legislation also added on the floor a provision providing that a failure to investigate constitutes recklessness only if such failure is deliberate, claiming this is implicit in a Sundstrand footnote. Although the Act as adopted does not define recklessness, given the significant role of Sundstrand in the debate and its general acceptance by the appellate courts, it may be worthwhile to take an in-depth look at the decision in Sundstrand and the common law analog referred to in Sundstrand.

The Seventh Circuit, affirming the decision of the district court, held that the failure to disclose certain reports available to the defendant referring to deferred preproduction costs that would have to be written off eventually made the financial statements and projections misleading and that the failure to disclose such reports was reckless. The court, noting that the Supreme Court had only recently adopted the scienter requirement in Hochfelder and left the issue of recklessness open, alluded to the fact that “at common law reckless behavior” was sufficient to support a fraud claim and concluded that “it would be highly inappropriate to construe the Rule 10b-5 remedy to be more restrictive than its common law analogs.”[7] Although the court apparently thought it was following common law analogs, it did not examine them closely. The common law analogs can be found in Derry v. Peek,[8] which established scienter as an element of the action of deceit. Scienter under Derry v. Peek[9] could be established by any of the following:

1.   The defendant knew that the statement was false.

2.   The defendant made the statement knowing that s/he did not know whether it was true or false (“without belief in its truth”).

3.   The defendant believed the statement, but knew that s/he did not have sufficient basis for believing it to be true (“recklessly, careless whether it be true or false”).

None of the above emphasizes degree of care, but rather all are based on a state of mind — knowing that the statement is false, or representing it is true without knowing whether it is true or false, or believing that a statement is true, but indifferent to the evidence that it is false and the inadequacy of the basis for the belief. To the extent any of the above involves an element of care, it is a failure to investigate the truth when one knows that s/he does not have a sufficient basis for the statement. The criteria speak more to recklessness with the truth than recklessness in ascertaining the truth, although the latter obviously contributes to the former. All of the above places the risk on one making a representation either knowing that it is false or that s/he does not have an adequate basis for the statement.

There is no mystery to the fact that the above satisfied the scienter requirement at common law. Reckless for this purpose does not involve failing to follow certain steps to verify information that would be taken by a reasonable person, but rather representing something as a fact when knowing or being indifferent to the fact that one does not have an adequate basis for the representation. The fact that defendant had no reasonable ground for the belief is not scienter, but it may be some evidence that s/he knew that s/he did not have adequate grounds for the statement. Prosser and Keeton on Torts states the law as follows:[10]

[T]here is general agreement that it [scienter] is present when the representation is made without any belief as to its truth, or with reckless disregard whether it be true or false. Further than this, it appears that all courts have extended it to include representations made by one who is conscious that he has no sufficient basis of information to justify them. A defendant who asserts a fact as of his own knowledge, or so positively as to imply that he has knowledge, under circumstances where he is aware that he will be so understood when he knows that he does not in fact know whether what he says is true, is found to have intent to deceive, not so much as to the fact itself, but rather as to the extent of his information.

The line is drawn, according to these authors, between “an honest belief, however unreasonable, that the representation is true and the speaker has information to justify it,” which, under Derry v. Peek, is not a sufficient basis for scienter, and an honest belief but with knowledge that s/he does not have an adequate basis for the belief. “It is of course clear that the very unreasonableness of such a belief may be strong evidence that it does not in fact exist; and where this conclusion is reached as an inference of fact, or even through a presumption capable of being rebutted, there is nothing inconsistent with a basis of intent.”[11] The Restatement of Torts essentially is to the same effect.[12]

Sundstrand, influenced by the assumed necessity of distinguishing negligence from recklessness in terms of degree of care (“extreme departure from the standards of ordinary care”), adopted as an additional prerequisite to establish recklessness relating to omissions that the omission “presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.”[13] The court in explaining the standard referred to the “so obvious” part of the standard as “an objective test although the circumstances must be viewed in their contemporaneous configuration rather than in the blazing light of hindsight.”[14] It went on to say, however, that more than “‘white heart/empty head’ good faith” was required,[15] which is somewhat obscure but may or may not be consistent with the Derry v. Peek view noted above[16] that “an honest belief, however unreasonable, that the representation is true and the speaker has information to justify it” does not constitute scienter. If “empty head” means that belief is enough without any basis to justify it, then it is inconsistent with Peek, although as Prosser and Keeton have noted, “the court [in Peek] took an extremely charitable view of the evidence” as to the information necessary to justify a belief.[17] It is the footnote explanation referring to this as “a subjective test” and the illustrations used in the footnote that the proponents of the “deliberate failure to investigate” language used to contend that the equivalent of such language is part of Sundstrand.[18] The court said: “Thus if a trial judge found, for example, that a defendant genuinely forgot to disclose information or that it never came to his mind, this prong of the test . . . would defeat a finding of recklessness even though the proverbial ‘reasonable mind’ would never have forgotten.”[19] Based on this footnote the proponents of the H.R. 1058 definition of recklessness argued justified the proviso that the failure to investigate could be deemed recklessness only if such failure was deliberate. The Seventh Circuit “forgot to disclose” or “it never came to his mind” defense, it should be noted, is peculiarly applicable to omissions and requires the court in order to absolve the defendant to find that the defendant did not deliberately withhold information, which is significantly different from requiring plaintiff to prove that the information was deliberately withheld. This difference is critical given the enhanced pleading requirements under the securities litigation reform legislation. See § 3.02. Interestingly, in the concluding sentence re the standard being adopted, the court said: “While this definition might not be the conceptual equivalent of intent as a matter of general philosophy, it does serve as a proper legally functional equivalent for intent, because it measures conduct against an external standard which, under the circumstances of a given case, results in the conclusion that the reckless man should bear the risk of his omission.”[20]

Prior to Hochfelder, plaintiffs would ordinarily assert claims under Rule 10b‑5 rather than Section 18(a) in order to avoid the limitations of Section 18(a) including the re­quire­ment of reliance and the good faith defense. Since Hochfelder, the Rule 10b‑5 sci­enter requirement is, perhaps, more formidable than Section 18(a) since the plaintiff has the burden of proof. It, nonetheless, may be advantageous to pursue a claim under Rule 10b‑5 because of the strict re­liance requirements of Section 18(a). The “fraud on the market” theory discussed below re­spect to claims based on Rule 10b‑5 does not require proof of actual reliance if the misrepre­sentations are likely to have affected the market price of the security. The Second Circuit has held that Section 18(a) is not exclusive and that a claim can be asserted on the basis of Rule 10b‑5 with respect to documents filed under the Ex­change Act.^[21] The Court’s holding in Herman & MacLean that the express Section 11 and 12(2) remedies under the Securities Act do not preclude a Rule 10b-5 claim from being asserted by a defrauded purchaser^[22] probably is persuasive that a Rule 10b‑5 action is available in this context.

The Annual Report to shareholders is not a filed document for purposes of Section 18(a). Rule 14a‑3(c). The Commission excluded the Annual Report from Section 18(a) in order to encourage companies in preparing such reports to feel less constrained in pre­sent­ing informa­tion. It appears clear, therefore, that those portions of the Annual Report which are not incor­porated by reference into a Form 10‑K are subject to a possible Rule 10b‑5 claim.

See §§ 11.02-11.07 for discussion of the PSLRA and how, if at all, it affects the definition of fraud for Rule 10b-5 purposes.