PREVIOUS      NEXT  

Hypothetical 3 -- Background

HOME
OnLine

Hypothetical 3
Factual basis
Class Discussion

TOC_CH1
TOC_CH2
TOC_CH3
TOC_CH4
TOC_CH5
TOC_CH6
TOC_EN
TOC_SOA
About Securities Litigation
Search

Regulations

Statutes
Sarbanes-Oxley Act

SECTION 4
Title 1
Title 2
Title 3
Title 4
Title 5
Title 6

   The PSLRA pleading provisions are Section 21D(b) of the Exchange Act[1] (comparable provisions are not included in the Securities Act) and are in two subsections as follows:

(1)   Misleading statements and omissions. — In any private action arising under this title in which the plaintiff alleges that the defendant —

(A)  made an untrue statement of a material fact; or

(B)  omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances in which they were made, not misleading; the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.

(2) Required state of mind. — In any private action arising under this title in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this title, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

   For convenience of exposition we will refer to the provisions as (b)(1) and (b)(2). The proviso requiring the pleading to state with particularity “all facts on which that belief is formed” as to any allegation based on “information and belief” is part of (b)(1)(B) relating to the making of misleading statements and the reasons the statements are misleading. The courts that have referenced it, however, with the exception of the Eighth Circuit (see § 3.14) have treated it as a third standard applicable to all of the allegations of the complaint. Pleading motive and opportunity plays a big and somewhat controversial role, but in terms of pleading the facts relevant to motive they are generally a matter of public record (e.g. insider stock trading) and easy to come by. See § 3.06. On the other hand, except when financial statements have been restated for prior period, pleading facts that establish the representations were false at the time made, and, in all situations, that defendants knew the statements were false or misleading are difficult to come by. Underlying much of the PSLRA controversy is how facts establishing the representations were false when made and/or the defendants were aware of the facts that made the representation false or misleading must be pled. The controversy may be framed in terms of the information and belief proviso (see § 3.10), and/or the particularity required to plead state of mind (see § 3.07), and/or the particularity required by Rule 9(b) (see § 3.01). Satisfying the pleading provisions are critical in a Rule 10b-5 case, since in the event of a motion dismiss, which is inevitably the case, discovery is stayed until the motion to dismiss is ruled upon. See § 4.01. In short, plaintiff generally must meet the pleading standard without the benefit of discovery.

Rule 9(b) of the Federal Rules of Civil Procedure has been in effect since the adoption of the Rules in 1938. Rule 9(b) requires plaintiff to plead “with particularity” the circumstances of the fraud, which means specifying the time, place and manner of the alleged fraudulent misrepresentations. The Seventh Circuit has said that Rule 9(b) requires pleading “the who, what, when, where, and how: the first paragraph of any newspaper story,”  an oft-repeated characterization. Rule 9(b) also states that “malice, intent, knowledge, and other condition of mind of a person may be averred generally.” The Ninth Circuit in GlenFed pre-PSLRA held that “[p]laintiffs may aver scienter generally, just as the rule states — that is, simply by saying that scienter existed.” Some circuit courts of appeals pre-PSLRA, particularly the Second Circuit, required that the complaint allege facts that give rise to a strong inference of fraudulent intent. No one questions that (b)(2) of the PSLRA rejected the  GlenFed view of pleading scienter and adopted the Second Circuit concept of requiring the facts alleged to create a strong inference of a culpable state of mind and that such facts be alleged with particularity. What is in controversy is whether the PSLRA also adopted Second Circuit pre-PSLRA precedent that a “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.” The hardliners being of the view that the legislative history suggests that more is required. On Rule 9(b), see § 3.01. On the legislative history and the debate in the Senate over the strong inference standard, see § 3.02.

   The prototypical securities fraud class action (here we go again) involves a company acknowledging an unfavorable development, which plaintiffs allege existed long before the announcement and made false a number of representations made by the company during a preceding several month period (the class action period). The company’s principal officers allegedly knew of the unfavorable developments because they received internal reports daily (weekly or monthly) and held periodic meeting at which the problem was discussed. On occasion there may be tidbits of detail; such as the CEO who said “our engineers are a bunch of incompetents” when informed of the problem. Of late, the complaint may even allege as the source of that statement an unnamed former employee who was in the room at the time. Defendants, of course, contend this is fraud by hindsight, the allegations relating to internal reports should not be taken seriously as they are included in substantially all complaints filed by counsel, and the CEO’s statement should not be taken into account unless the source of the information is named. Although nine circuit courts of appeals have spoken at length as to the PSLRA pleading standards, they often have done so in abstract and general terms that provide considerable latitude for district courts. See § 3.03 for summary.

   Although not in the forefront of current judicial scriptures on the subject, Glenfed[2], a pre-PSLRA Ninth Circuit en banc decision applying Rule 9(b), can teach us much about the underlying pleading issues. The case intepreted Rule 9(b) in terms of the pleading the reasons were false at the time made as at the time the Ninth Circuit interpreted Rule 9(b) as permitting scienter to be pled generally. As the court pointed out, however, what it regarded as necessary to plead the representations were false at the time made, coincidentally in the case before it and often would also tend to establish scienter.  GlenFed was a real estate and financial services holding company. The alleged misrepresentations included a failure to disclose inadequate loan reserves and the failure to consolidate a subsidiary that it was planning to dispose of, which was premised on the assumption that the disposition would not result in a loss. The decision was 7-4, with four members of the court filing a concurring opinion that on the principal pleading issue in reality was a dissenting opnion. What Judge Norris said in concurring framed that issue as follows: “Rule 9(b) must be read together with Rule 8(a), which requires “a short and plain statement of the claim and defense.”[3] Citing Walling[4] which in turn quoted Moore:[5] “Rule 9(b) does not require or legitimate the pleading of detailed evidentiary matter.”[6] Relying on Walling Judge Norris concluded: “A complaint satisfies 9(b) if it provides sufficient notice to the defendant of the particular acts that are alleged to be fraudulent so that the defendant can prepare an adequate answer. This notice requirement is satisfied by allegations of the time, place and specific content of the allegedly fraudulent statement, along with an identification of what in particular was false or misleading about the statement.”[7] Judge Fletcher for the majority responded to the Rule 8(a) argument, stating: “Rule 9(b) would clearly be superfluous if its only function were to ensure that defendants are provided with that degree of notice which is already required by Rule 8(a).”[8] As to pleading “evidentiary matter,” she said: ““‘Evidentiary facts’ as defined in Black’s Law Dictionary are facts necessary for determination of ultimate facts. Rule 9(b) requires particularity as to the circumstances of the fraud — this requires pleading facts that by any definition are ‘evidentiary’: time, place, persons, statements made, explanation of why or how such statements are false or misleading.”[9] The remainder of the opinion is an essay as to the type of facts that have to be pled to satisfy this standard. There are limited situations in which present inconsistent facts are sufficient to establish that the representation was false at the time it was made. Thus, alleging that a house is on a landfill is sufficient to establish the falsity of a representation that the house was “in perfect shape” at the time the representation was made because if the house is on a landfill now, it has always been on a landfill.[10] At the other end of the spectrum are cases that involve “some more or less catastrophic event occurring between the time the complained-of statement was made and the time a more sobering truth is revealed.”[11] In this situation, alleging facts at a specified subsequent date inconsistent with the representation is not adequate to establish that the representation was false at the time made because they may be inconsistent as the result of intervening events. The court alluded to an in-between category involving “an event internal to the company, such as the revaluation of assets, or the recalculation of loan loss reserves.” The internal event from a pleading standpoint also may require more than alleging inconsistent statements made at two different times (before and after announcement of the bad news) since the internal event may have been in response to an external event.[12] Similarly, the internal event acknowledged in the subsequent statement does not establish the falsity of the earlier statement if the difference in treatment (e.g., loan reserves or reevaluation of assets) reflects “the difference between two permissible judgments.”[13]

   The court refers to three principal ways, other than the self-evident landfill situation, in which the allegation of evidentiary facts may be sufficient to meet the Rule 9(b) particularity requirements as to the reasons a statement was false or misleading at the time made (author’s comments in brackets):

1.      [Ruling out possible intervening external events] “This can be done most directly by pointing to inconsistent contemporaneous statements or information (such as internal reports) which were made by or available to the defendants.”[14]

2.      A subsequent admission that the defendant knew the statement was false at the time made.[15]

3.      [Alluding to internal events and permissible judgments] “Here too, plaintiff may need to draw on contemporaneous statements or conditions to make that demonstration [of falsity].”[16]

4.      [Illustrating allegations of contemporaneous conditions taken from another case] “[I]n addition to alleging that defendants failed to disclose the need for a dramatic increase in loan loss reserves, they point to specific loans which were in jeopardy throughout the class period.”[17]

   The court did not indicate except by the manner in which it applied the above the specific level of abstraction that the evidentiary facts had to meet. Consider the difference in alleging (1) internal reports and board minutes disclosed XYZ without details; (2) An internal report dated [specific date] and board minutes dated [specific date] disclosed XYZ with details such as what was said by whom; (3) same as (2) by the report and/or copy of board minutes attached as an exhibit; (4) same as (2) but information based on statement concerning same the CEO made to an analyst in a telephone conversation. One of the few allegations the court regarded as sufficient related to an internal report as of a specific date and concurrent board minutes strongly suggesting that the subsidiary could not be sold and may have to be liquidated at a $17 million loss, which will create problems with the accountants and the SEC. This appears to be in category (2) above as no reference is made to allegations that authenticate its existence. The court noted there was some statements that appeared to contradict the above, but “we do not test the evidence at this stage.”[18]

The other allegations regarded as adequate pertained to a representation relating to its “superior asset quality” the falsity of which was supported by an internal report and auditor’s report questioning adequacy of internal controls and allegations of the specific appraisals of assets underlying loans that had not updated for over two years. The court compared these allegations with those it regarded as sufficient in Wells Fargo, in which plaintiffs in alleging inadequate loan reserves as a basis for falsity, referred to specific problem loans for which reserves had not been provided.[19] This, presumably, is an illustration of contemporaneous conditions making the representations false, and circumstantial but not necessarily conclusive evidence that defendants knew the representation was false. Further the allegations are specific as to the alleged nature of the undisclosed problem, but offer no evidentiary support for the allegation.

The court rejected as inadequate a number of what it characterized as “broad ranging allegations.” regarding them as conclusory and based on fraud by hindsight. Included in this category was the allegation that the company failed to increase its loan reserves for its outstanding Florida real estate loans. The allegation was based in part on the fact that during the referenced period of time the real estate market in Flordia was in the doldrums, which might have put it in the contemporaneous conditions category. The court remarked as to these specific allegations, “the plaintiffs fail to identify or quantify the number of non-per­form­ing assets (NPA). Plaintiffs simply state that the level of NPA was rising.”[20]

The First Circuit pre-PSLRA also put some emphasis on Rule 9(b) of pleading the reasons representations were false or misleading. The court in Greebel v. FTP Software, Inc., Inc., 194 F.3d 185, 197 (1st Cir.1999) summarized its pre-PSLRA Rule 9(b) requirements as follows:

• Rule 9(b) provides that "[i]n all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally." Fed.R.Civ.P. 9(b). This circuit has interpreted Rule 9(b) to require "specification of the time, place, and content of an alleged false representation." McGinty v. Beranger Volkswagen, Inc., 633 F.2d 226, 228 (1st Cir.1980). [FN7] "Even where allegations are based on information and belief, supporting facts on which the belief is founded must be set forth in the complaint. And this holds true even when the fraud relates to matters peculiarly within the knowledge of the opposing party." Hayduk v. Lanna, 775 F.2d 441, 444 (1st Cir.1985) (internal quotation marks and citations omitted).

• The PSLRA's pleading standard is congruent and consistent with the pre- existing standards of this circuit. This circuit has been notably strict and rigorous in applying the Rule 9(b) standard in securities fraud actions. See Maldonado v. Dominguez, 137 F.3d 1, 9 (1st Cir.1998) ("This court has been especially rigorous in applying Rule 9(b) in securities fraud actions ....") (quotation marks omitted); Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1223 (1st Cir.1996) (similar); Romani v. Shearson Lehman Hutton, 929 F.2d 875, 878 (1st Cir.1991) ("We have been especially rigorous in demanding ... factual support in the securities context....").

• The requirements of the PSLRA's new pleading standard in § 78u-4(b)(1) were largely imposed under First Circuit law, although this court has not used the same precise terminology. First, this court had already required a fraud plaintiff to specify each allegedly misleading statement or omission. See, e.g., Romani, 929 F.2d at 878 (plaintiffs' isolation of the offering materials as the source of the alleged fraud was "sufficient to identify the time and place of the alleged misrepresentations"); New England Data Servs., 829 F.2d at 292 (rejecting plaintiffs' claims as merely "conclusory allegations of mail and wire fraud ... with no description of any time, place or content of the communication").

• Second, this court has required a securities fraud plaintiff to explain why the challenged statement or omission is misleading by requiring that "the complaint ... provide some factual support for the allegations of fraud." Romani, 929 F.2d at 878 (citation omitted). This means that the plaintiff must not only allege the time, place, and content of the alleged misrepresentations with specificity, but also the "factual allegations that would support a reasonable inference that adverse circumstances existed at the time of the offering, and were known and deliberately or recklessly disregarded by defendants." Id.

• Finally, this court has required plaintiffs who bring their claims on information and belief to "set forth the source of the information and the reasons for the belief." Romani, 929 F.2d at 878; see also New England Data Servs., 829 F.2d at 288; Hayduk, 775 F.2d at 444-45; Wayne Inv., Inc. v. Gulf Oil Corp., 739 F.2d 11, 13 (1st Cir.1984).

 We suggest a mathematical formula approach that takes into account what combination motive and opportunity (MT), general but not specific factual allegations (GNS), specific factual allegations (SFA), inconsistent contemporaneous conditions (ICC), are necessary to create a strong inference of scienter (X). We can also divide specific factual allegations into three or more different categories (SFA-1, SFA-2, etc.) depending upon the level of abstraction as discussed above (with SFA-1 the most specific). Similarly, with respect to motive, we have to ask what kind of motive is alleged and how strong are the allegations. Thus, the question might be posed, can MT alone = X; is general but not specific factual allegations (GNS) plus allegations of motive (MT) sufficient to = X; does only specific factual allegations (SFA) and/or inconsistent contemporaneous conditions (ICC) = X; does motive (MT) plus inconsistent contemporaneous conditions (ICC) = X? Courts for the most part, unfortunately, tend to talk only about motive, which they have refined to a large degree and circumstantial evidence, which they have not refined. In the last analysis, much will depend upon the specific allegations and, perhaps, the court’s view of whether enough has been alleged to convince the court that the allegations are more than pleading fraud by hindsight and to allow discovery proceed. This lacks mathematical precision, but may be where the PSLRA has left us and, perhaps, is the best we can do in any event.