Section 21D(b)(2) of PSLR of 1995: Pleading Securities Fraud
This section sustains that a complaint alleging securities fraud must "state with particularity
facts giving rise to a strong inference that the defendant acted with the required state of mind."
Analysis and presentation of the argument by Elliott J. Weiss, Charles E. Ares and James E.
In the roughly five years since the Private Securities Litigation Reform Act of
1995 became law, courts and commentators have devoted considerable attention to
two questions associated relating to the requirement, set forth in section
21D(b)(2), that a complaint alleging securities fraud must “state with
particularity facts giving rise to a strong inference that the defendant acted
with the required state of mind.” Those questions concern: (1) What constitutes
“the required state of mind” in suits under section 10(b) and Rule 10b-5? And
(2) Are facts indicating a defendant had a motive and the opportunity to engage
in fraud, standing alone, sufficient to create a strong inference that that
defendant acted with the required state of mind?
commentators have devoted far less attention to what I call the Basis
Requirement -- the portion of section 21D(b)(1) that requires a plaintiff to
specifying not only “each statement alleged to have been misleading” and “the
reason or reasons why the statement is misleading,” but also, with respect to
every allegation made on information and belief, “all facts on which that
belief is formed.” This article argues that issues relating to the Basis
Requirement in the long run will prove to be far more significant than the
issues relating to motive, opportunity and degrees of recklessness that have
preoccupied courts and commentators to date.
question is the amount and quality of corroborating information a plaintiff
must include in her complaint. The article explains why, in order to implement
Congress’ goal of discouraging the filing and prosecution of speculative claims
of securities fraud, courts must adopt an interpretation of the Basis
Requirement similar to that adopted by the Ninth and first Circuits in In re
Silicon Graphics Securities Litigation and Greebel v. FTP Software,
respectively. Only by doing so will courts prevent plaintiffs from continuing
to make speculative allegations of fraud and then relying on the discovery
process to seek evidence to support their claims.
next highlights two additional holdings in Greebel: (1) A court must
consider the nature of the corroborating information plaintiff has provided
when evaluating plaintiff has pled facts sufficient to create a strong
inference of scienter. (2) The Reform Act effectively rejects the notice
pleading philosophy reflected in Conley v. Gibson by requiring
plaintiffs in securities fraud actions to plead facts that give rise to a strong,
rather than merely a reasonable, inference of scienter.
analytic framework created by Greebel and Silicon Graphics, the
article then considers two cases currently pending in courts in the Second and
Third Circuits. The first is Novak v. Kasaks, in which the Second
Circuit reversed and remanded a district court decision granting a motion to
dismiss. The article points out that the Second Circuit’s opinion is rather
muddled, but can be reconciled with Silicon Graphics and Greebel
and notes that whether the Second Circuit so interprets Novak will
provide an important indication of whether the inferior federal courts are
going to adopt a uniform or a fragmented approach to interpreting the Reform
Act’s pleading requirements. (The article also notes that a petition for a writ
of certiorari was filed in Novak after the article was completed.)
case is In re Cell Pathways, Inc. Securities Litigation, in which
defendants have petitioned the Third Circuit for a writ of mandamus to reverse
a clearly incorrect district court decision denying their motion to dismiss. As
is the case with Novak, how the Third Circuit deals with this petition
will provide an important indication of the approach inferior federal courts
are going to take to interpreting and enforcing the pleading requirements of
the Reform Act.
concludes by discussing some potential policy consequences of imposing on
plaintiffs in securities class actions the stringent pleading requirements. The
article observes that evaluating the impact of the Reform Act is largely an
empirical question and that, because the first appellate decisions interpreting
the Act’s pleading requirement were issued relatively recently and the legal
landscape in several circuits remains unclear, it will be several more years
before sufficient data is available to support any informed conclusions as to
whether the Act’s pleading requirements -- assuming they are interpreted
uniformly -- make it too difficult for victims of securities frauds to secure
Elliott J. Weiss*This article is dated September 1, 2000. Some
of the cases discussed herein were pending as of that date.
ago, Chief Judge Jon O. Newman highlighted the “inevitable tension” in
securities class actions between society’s “interest in deterring fraud in the
securities markets and remedying it when it occurs[, which] is served by
recognizing that the victims of fraud often are unable to detail their
allegations until they have had some opportunity to conduct discovery of those
reasonably suspected of having perpetrated a fraud” and society’s “interest in
deterring the use of the litigation process as a device for extracting
undeserved settlements as the price of avoiding the extensive discovery costs
that frequently ensue once a complaint survives dismissal. . . .”
Judge Newman also recognized that notice pleading rules then in force favored
the first of these interests when he held that complaints alleging securities
fraud should not be dismissed — and plaintiffs thus should not be precluded
from using the discovery process to search for evidence of fraud —“unless, in the familiar phrase from [Conley
v. Gibson], ‘it appears beyond doubt that the plaintiff can prove no set of
facts in support of his claim which would entitle him to relief.’”
later, Congress attempted to reverse the notice pleading system’s pro-plaintiff
bias by enacting the Private Securities Litigation Reform Act
over President Clinton’s veto. Congress took this step after finding that (i)
securities class actions generally were initiated and controlled by plaintiffs’
attorneys; (ii) those attorneys routinely filed class actions alleging
securities fraud “without regard to any underlying culpability of the issuer,
and with only faint hope that the discovery process might lead eventually to
some plausible cause of action”; and (iii) plaintiffs’ attorneys’ “abuse of the
discovery process to impose [burdensome] costs” on defendants often led “the
victimized part[ies] to settle” claims that had no merit. Congress
observed that “investors always are the ultimate losers when extortionate
‘settlements’ are extracted from issuers.” and that “the
reluctance of many judges to impose sanctions under Federal Rule of Civil
Procedure 11, except in cases involving truly outrageous conduct,” exacerbated
the problems posed by abusive securities class actions.
TheReform Act’slegislative history contains no explicit discussion of either
Conley v. Gibson or the notice pleading philosophy that has governed civil
actions in federal courts since 1938. However, the pleading and discovery
requirements promulgated in the Reform Act cannot be reconciled with Conley v.
Gibson and clearly reflect Congressional rejection, in private securities fraud
litigation, of the philosophy of notice pleading. Section 21D(b)(1) requires
every plaintiff alleging securities fraud to identify in her complaint each
statement she believes was misleading, to “specify . . . the reason or reasons
why the statement [was] misleading”
and, with respect to every allegation made on information and belief, to “state
with particularity all facts on which that belief is formed.”
Section 21D(b)(2) requires every plaintiff, with respect to each statement or omission
that she alleges constitutes a violation of section 10(b) and Rule 10(b)-5, to
“state with particularity facts giving rise to a strong inference that
the defendant acted with [scienter].” Section
21D(b)(3)(A) directs courts to dismiss any complaint that does not meet the
requirements of sections (b)(1) and (b)(2). Section
21D(b)(3)(B) effectively precludes a plaintiff from relying on discovery
process to uncover evidence of fraud by directing courts to stay all discovery
“during the pendency of any a motion to dismiss”. Viewed as a
whole, these provisions clearly reflect an effort by Congress to reverse the
litigation dynamic Judge Newman described by
precludinga plaintiff from
“conduct[ing] discovery of those [she] reasonably suspect[s] of having
perpetrated a fraud”
unless she first, without the benefits of discovery, is able to file a
complaint that satisfies the stringent pleading requirements set forth in
sections (b)(1) and (b)(2).
commentary to date has focused on two questions relating to those requirements:
facts that suggest a defendant acted recklessly sufficient to create a strong
inference of scienter?
facts that suggest a defendant had a motive and the opportunity to engage in
securities fraud, standing alone, sufficient to create a strong inference of
This Article focuses elsewhere. It deals primarily with what
I call the “Basis Requirement” --the
statement in section (b)(1) that, with respect to every allegation made on
information and belief, plaintiff must “state with particularity all facts on
which that belief is formed” —, with on how the Basis Requirement relates to
the “Strong Inference Requirement” set forth in section (b)(2), and with what
it means to create a strong inference of scienter.
associated with the Basis Requirement and its relationship to the Strong
Inference Requirement are far more significant than the issues concerning
degrees of recklessness and motive and opportunity that have preoccupied
commentators to date.
The Ninth Circuit’s decision in In re Silicon Graphics Inc. Securities
illustrates this point. The panel there divided, 2-1, on two questions. The
first concerned how to define when recklessness constitutes scienter. The
majority held a plaintiff must plead facts sufficient to give rise to a strong
inference that a defendant acted with “deliberate recklessness”
while Judge Browning, dissenting, argued that facts sufficient to support a
strong inference of simple recklessness should suffice.
dispositive question, though, concerned the proper interpretation of the Basis
Requirement. Central to plaintiffs’ claim were their allegations that certain
internal reports, including an alleged “Stop Ship” report, had placed the
senior management of Silicon Graphics, Inc. (“SGI”) on notice of problems that
SGI was experiencing with the Toshiba ASIC chip,a primary component of the “Indigo2 Impact Workstation”
(“Indigo2”) that SGI had claimed it was about to bring to market. The majority
held that in the absence of specifics such as the dates of the alleged reports
and the names of the authors and addressees, it would not credit those
allegations because it could not determine whether plaintiffs’ claim that SGI
knew its statements about the Indigo2 were false reflected anything more than
their speculative belief that a fraud must have occurred. Judge
Browning disagreed; he argued that “precise details” of the kind demanded by
the majority were “neither expected nor required at the pleading stage of the
Moreover, Judge Browning pointed out, if the court treated as true plaintiff’s
allegations concerning the Stop Ship and other internal reports,
those allegations clearly were sufficient to “form the basis for a strong
inference that SGI’s officers knew the representations they were making
to the public were false when made.”
import of the last quoted statement. It was the majority’s conclusion that
plaintiff had not satisfied the Basis Requirement that determined the outcome
in Silicon Graphics, not its conclusion regarding “deliberate
recklessness.” Put differently, had the majority agreed with Judge Browning
that it should treat as true, for purposes of deciding defendants’ motion to
dismiss, plaintiff’s allegations concerning the Stop Ship reports, the majority
would have had no choice but to agree with Judge Browning that plaintiffs had
pled facts sufficient to support a strong inference that SGI had made public
statements pertaining to the Indigo2 with actual knowledge that those
statements were false. That, in turn, would have rendered irrelevant the debate
between the majority and Judge Browning over whether simple recklessness or
“deliberate recklessness” is the equivalent of scienter.It is useful, in this regard, to consider the
finding of Professors Johnson, Nelson and Pritchard that there was a
statistically significant, positive stock market reaction to SGI. See
Johnson, et al., cited in note 14. The authors attribute the reaction to
the court’s holding that the Reform Act requires evidence of deliberate
recklessness. It seems more likely to me that the markets’ reaction was to the
court’s insistence that plaintiffs plead the basis for claims made on
information and belief.
Graphics’ interpretation of the Basis Requirement, in my view, is correct
and, more importantly, is critical to implementing Congress’ purpose in
enacting the pleading and discovery stay provisions of the Reform Act. Section
II of this Article explains why that is the case. Section III comments briefly
on Silicon Graphics’ holding concerning “deliberate recklessness” and
argues that it does not differ significantly from scienter standards most other
Circuit Courts of Appeal have adopted. Section IV describes and analyzes the
portions of the First Circuit’s decision in Greebel v. FTP Software, Inc.
that interpret the Basis Requirement and analyze its relationship to the Strong
Inference Requirement of section (b)(2). Section V discusses
two pending cases that raise important interpretative issues relating to
sections (b)(1) and (b)(2). How the courts resolve those issues will provide
important clues as to whether the inferior federal courts are following a
unified or a fragmented approach to interpreting the Reform Act’s pleading
requirements. Section VI, the conclusion, highlights the policy consequences of
the approach to interpreting sections (b)(1) and (b)(2) that this Article
argues courts should adopt and outlines alternative strategies courts could
II. WHY THE BASIS
REQUIREMENT IS CRITICAL
appreciate the critical importance of the Basis Requirement, one first must
understand the fundamental pleading problem faced by an investor who suspects
or believes she is the victim of a disclosure fraud. An issuer
will have disclosed some unexpected bad news, such as a decline in sales and
earnings, a problem in bringing a product to market, or discovery of fraudulent
practices at a division or subsidiary. The issuer’s announcement will have
precipitated a sharp decline in the price of its stock. In virtually
every such situation, the issuer also will have issued “earlier, cheerier”
statements relating to the subject discussed in the “bad news” release.
However, without conducting a costly investigation or obtaining access to the
issuer’s files and personnel, the investor and her attorney will find it difficult
to ascertain whether the issuer just became aware of the bad news or whether
the issuer knew the bad news, or facts suggesting it was likely to occur, at
the time the issuer made the “earlier, cheerier” statements.
investors’ attorney, if she is experienced, will be acutely aware that a
complaint alleging simply that the issuer “must have known” the bad news at the
time it made the “earlier, cheerier” statements will be dismissed on the ground
that it impermissibly pleads no more than “fraud by hindsight.”
But if the investor’s attorney is skilled as well as experienced, she also will
appreciate that, with relative ease, she can draw on the information in the bad
news release and other publicly available information to cobble together a
complaint alleging that, at the time the issuer made the “earlier, cheerier”
statements, either the issuer and its senior managers had learned from internal
reports the negative information later disclosed in the “bad news” release or
that “red flags” had placed the issuer and its senior managers on notice that
those negative developments were highly likely to occur. Finally, the
investors’ attorney will know that if the court can be persuaded to treat
plaintiff’s allegations as true, those allegations also will support a strong
inference that the issuer and its senior managers made the “earlier, cheerier”
statements either with actual knowledge that they were false or in reckless disregard
of that possibility.My awareness of these and similar
practices has made me unsympathetic to arguments in favor of allowing
plaintiffs to prosecute “long shot” securities claims. See Charles M.
Yablon, A Dangerous Supplement? Longshot Claims and Private Securities
Litigation, 94 NW. U. L. REV. 567 (2000).
in Silicon Graphics
represents just such an exercise in creative drafting. In July
1995, SGI had announced that it planned to produce the Indigo2, a new line of
graphic design computers that would compete with a new line of Hewlett Packard
workstations. SGI said it expected to ship the Indigo2 in volume by September
30, 1995, and to ship an upgraded version of the Indigo2 by January 1, 1996.
SGI also claimed that the Indigo2 would help it sustain a 40% growth rate.
Within a few weeks after that announcement, SGI stock reached an all-time high.
the remainder of 1995, SGI continued to issue positive statements regarding the
Indigo2 and denied negative rumors about its performance. Then, on
January 2, 1996, SGI unexpectedly announced “disappointing second quarter
results and acknowledged that revenue growth for the year would be much lower
This was followed, on January 17, 1996, by SGI senior management’s admission to
securities analysts “that SGI had been unable to fill Indigo2 orders because of
a shortage of [Toshiba] ASIC chips and other primary components.”
As might be expected, SGI’s stock price declined following these announcements.
attorneys, in addition to learning of these problems in January 1996, also
either learned from current or former SGI employees or simply assumed that SGI,
like most major corporations, had an elaborate management information system
capable of generating reports about major operational problems as soon as they
occurred. Drawing on that information (or that combination of information and
assumptions) they drafted a complaint alleging securities fraud. Their key
assertion was that SGI’s senior management knew, not later than mid-September
1995, that SGI was experiencing problems with the Toshiba ASIC chip, a primary
component of the Indigo2, which made it impossible for SGI to implement the
Indigo2 program on the schedule it had announced. As a consequence, plaintiffs
alleged, all the positive statements SGI and its senior managers made about the
Indigo2 program between mid-September and the end of November 1995 were false
and were made with actual knowledge that they were false.
specifically, the key portions of plaintiffs’ First Amended Consolidated
34.. . . SGI’s management information system
was capable of generating reports on a daily basis showing orders received (by
product), shipments (by product), inventories (by product), as well as overall
corporate revenue, cash balances, inventories, etc. As a result of this system,
SGI’s top management, such as [CEO Edward R.] McCracken, [Sr. V.P. Forest]
Baskett, [Sr. V.P. Robert K.] Burgess, [Sr. V.P. Michael] Ramsey, [Sr. V.P.
William M.] Kelly and [Sr. V.P. Terusayu] Sekimoto, were aware of the
corporation’s performance on a daily basis and were thus aware, virtually
immediately, of any significant problems with orders product production,
shipment delays or inventories, etc.
37.When SGI encountered serious quality and
performance problems with the Indigo2 IMPACTTM Workstations due to
the ASIC chip performance problems as it attempted to assemble and ship the
Indigo2 IMPACTTM Workstations in Sept. 1995, SGI’s internal
corporate procedures required that the managers of the Indigo2 IMPACTTM
project immediately advise top management of this problem in mid-Sept. 1995 via
a “Stop Ship” report. Such a report was issued and contained the following:
(1)identified the problem; (2) notified top management of the impact on volume
shipments and revenue; and (3) requested input on satisfying customer demands
in light of the available volume. Subsequently, within three weeks the
marketing, engineering and manufacturing managers prepared a report with the
Indigo2 IMPACTTM Program Director detailing the nature of the
problem, its cause, revenue impact, how the problem would be solved, how long
the solution would take, and what impact the problem and solution would have on
that project’s ability to meet its previously forecasted or budgeted sales.
38.Thus, when the serious deficiencies with the
ASIC chips being used in the Indigo2 IMPACTTM Workstations were
discovered in mid_Sept. 1995, McCracken, Baskett, Burgess, Kelly, Ramsey and
Sekimoto were immediately advised of the problems by the Indigo2 IMPACTTM
project managers. . . .After they were
advised of this problem in late Sept. 1995 by the Indigo2 IMPACTTM
project team, there immediately occurred a series of meetings among these top
managers, including the Individual Defendants, to evaluate the seriousness of
the problem, what could be done to attempt to fix it, as well as which customer
orders would be filled and to what extent.At this time, in what was known inside SGI as the “conspiracy of
silence,” the top officers of SGI, including the Individual Defendants, agreed
that in order to conceal the problem from the marketplace __ disclosure of
which would result in severely negative impact on sales of the Indigo2 IMPACTTM
products, a further loss of SGI’s competitive position to Hewlett Packard and
the collapse of SGI’s stock __ that the problems with the ASIC chips would be
kept secret and that SGI would falsely tell it [sic] customers, the marketplace
and securities analysts that it had achieved “volume” shipments of the Indigo2
IMPACTTM Workstations, that it was not encountering any production
or component part problems with the product and that the reason customers were
not receiving the full amounts of Indigo2 IMPACTTM Workstations
ordered was the extraordinary demand for the product which SGI simply could not
39.Internally at SGI, the problems with Indigo2
IMPACTTM Workstation production due to ASIC chip yield problems from
Toshiba continued to be encountered throughout Oct. 1995, and were so serious
that shipments of the Indigo2 IMPACTTM Workstations remained well
below the levels previously forecast. . . . This information was provided to
each of the defendants in the Oct. 1995 “Flash” financial report . . .
distributed to them no later than Nov. 3 or 6 . . . .
40.Internally at SGI, the problems with Indigo2
IMPACTTM Workstation production due to ASIC chip yield problems
continued to be encountered throughout Nov. 1995.The problems with ramping up of manufacturing of the R10000 ASIC
chip also continued and SGI knew that there was no possibility of shipping its
upgraded, high_end Indigo2 IMPACT Workstations in the volume necessary to
achieve announced goals in the third quarter of FY96. . . . This information
was provided to each of the defendants in the Nov. 1995 “Flash” financial
report . . . distributed to them no later than Dec. 4 or 5 . . . .
41.Because of the foregoing, each of the
Individual Defendants was aware of SGI’s FY96 forecast and budget and of the
internal reports detailing the ASIC chip problems (Stop Ship and Recovery
Report), and the financial reports comparing SGI’s actual results to those
budgeted and/or forecasted.Based on
the negative internal reports specified earlier about the Indigo2 IMPACTTM
Workstation and reports of the Company’s actual performance compared to that
budgeted and forecasted, the Individual Defendants each knew SGI’s business was
not performing as well as publicly represented, that SGI was plagued by an
inability to ship necessary volume due to an inadequate supply of suitable ASIC
chips from Toshiba, that problems with ramping up manufacturing with the R10000
would impact future volume, that serious and persistent problems with SGI’s
North American direct sales force were resulting in reduced productivity, i.e.,
revenue shortfalls, weak OEM sales and weak sales in Germany and France, and
thus, SGI could not possibly achieve near to 40% growth in the second quarter
of FY96 or FY96 as a whole.Thus,
defendants each actually knew that the forward_looking public statements
issued during the Class Period about SGI were false and misleading when made
and actually knew or recklessly disregarded that the non_forward_looking
statements issued during the Class Period about SGI were false and misleading
they based these allegations “upon the investigation of their counsel, which
included a review of SGI’s SEC filings, securities analysts reports and
advisories about the Company, press releases issued by the Company, media
reports about the Company and discussions with consultants. . . .”Plaintiffs added that they believed “that
substantial evidentiary support will exist for the[se] allegations . . . after
a reasonable opportunity for discovery.”
Graphics complaint undoubtedly was drafted with great care. At first
glance, it appears to set forth a detailed claim that SGI knew in September
1995 about problems with the Indigo2 program and the ASIC chip that it did not
disclose until January 1996. Close analysis, however, makes clear that
plaintiffs’ allegations represent no more than a skillfully disguised claim of
“fraud by hindsight” — a claim that, in September 1995, SGI must have been
aware of the problems it disclosed in January 1996.
the first clause of the first sentence of paragraph 37, which makes what
appears to be an unqualified statement of a historic fact — that “SGI
encountered serious quality and performance problems with the Indigo2 . . . due
to the ASIC chip performance problems . . . in Sept. 1995”. Note, though, that
nowhere in paragraph 37 (or anywhere else in their complaint), do plaintiffs
provide any corroborating details (apart from the information SGI disclosed in
January 1996) to support this conclusory assertion.
might contend that the second and third sentences of paragraph 37, which
describe an alleged Stop Ship report and an alleged report to the Indigo2
project manager, should be construed to provide adequate corroboration for the
assertion made in the first sentence. Observe, however, that while those
sentence purport to describe the content of the alleged reports, they do
soin general terms and neither quote
from those reports or provide any indication of plaintiffs’ basis for their
claim that such reports were issued. Rather, plaintiffs simply pile additional
assumptions — that the reports describing the problems with the ASIC chip were
was issued — on top of their initial assumption that SGI was aware of those
problems in September 1995.
paragraph 38, plaintiffs make additional allegations that build on these
assumptions: that McCracken and the other individual defendants were
immediately advised on the alleged problems with the ASIC chip; that those
defendants held a series of meetings to discuss those problems and entered into
a “conspiracy of silence” to conceal those problems from the marketplace; and
that those defendants agreed to falsely represent to customers and analysts
that SGI had achieved volume production of the Indigo2. Again, based on the
information plaintiffs included in their complaint, it is impossible to
determine whether plaintiffs had a reasonable evidentiary basis for these
claims or whether they were simply speculating that, given SGI’s disclosure in
January 1996 that it had experienced problems with the Indigo2 program and the
ASIC chip, this probably is what occurred.
39 and 40 are more of the same. As for paragraph 41, it simply sets forth the
conclusions that would follow logically from the four paragraphs that precede
it if, but only if, one accepted as true the allegations in paragraphs
37-40. That is, if SGI began to experience problems with the ASIC chip
in September 1995, if the Stop Ship and program manager’s reports were
issued and brought those problems to the attention of SGI’s senior managers, if
those managers thereafter conspired to keep the problems with the ASIC chip
secret and to misrepresent the Indigo2 program to SGI’s customers and to
securities analysts, and if those managers continued to misrepresent
material information about the ASIC chip and the Indigo2 program during October
and November 1995, then it would follow that SGI and the individual
defendants had actual knowledge that both the forward-looking and the
non-forward-looking statements that SGI and the individual defendants made
about the Indigo2 program between mid-September and the end of November 1995
were false at the time they were made.
above, Judge Browning took the position that plaintiffs alleged the “facts” set
forth in paragraphs 37-41 with sufficient particularity to meet the
requirements of sections (b)(1) and (b)(2). Had the
majority agreed with him, the court would have left open the door
to claims of “fraud by hindsight” masquerading as claims of disclosure fraud.
The complaint in Silicon Graphics would then have provided plaintiffs’
attorneys with a template for the conversion ofhindsight suspicions of fraud into what at least in Ninth Circuit
would consider to be an adequately particularized claim of securities fraud.
majority of the court rejected Judge Browning’s argument and held that the
complaint “neither states facts with sufficient particularity nor raises a
strong inference of deliberate recklessness.” More
specifically, the court refused to credit plaintiffs’ allegations concerning
the alleged internal reports and the alleged “conspiracy of silence” because
her “complaint does not include adequate corroborating details.”
The court continued:
She does not mention, for instance,
the sources of her information with respect to the reports, how she learned of
the reports, who drafted them, or which officers received them.Nor does she include an adequate description
of their contents which we believe — if they did exist — would include
countless specifics regarding ASIC chip shortages, volume shortages, negative
financial projections, and so on.We would
expect that a proper complaint which purports to rely on the existence of
internal reports would contain at least some specifics from those reports as
well as such facts as may indicate their reliability.
court made the following, critical observation:
the absence of such specifics, we cannot ascertain whether there is any basis
for the allegations that the officers had actual or constructive knowledge of
SGI’s problems that would cause their optimistic representations to the
contrary to be consciously misleading.In other words, in the absence of such specifics, we cannot determine
whether there is any basis for alleging that the officers knew that their
statements were false at the time they were made-a required element in pleading
fraud. Brody would have us speculate as to the basis for the allegations about
the reports, the severity of the problems, and the knowledge of the
officers.We decline to do so.
is required to state facts giving rise to a strong inference of deliberate
recklessness or intent.It is not
enough for her to state facts giving rise to a mere speculative inference of
deliberate recklessness, or even a reasonable inference of deliberate
reasoning is sound. A plaintiff must base her allegations of securities fraud
on some combination of testimonial and documentary sources. Where the source is
a document that plaintiff possesses or has seen, one would, as Silicon
Graphics suggests, expect plaintiff to quote the relevant portions of that
document in her complaint.
If plaintiff purports to do so, the court should treat those allegations as
adequately corroborated for two reasons. First, section (b)(1) requires a
plaintiff to plead only “facts,” not evidence. Second, plaintiff and her
attorney clearly would violate Fed. R. Civ. P.11(b), and would run the risk of incurring substantial sanctions, were
they, without qualification, to purport to quote in a securities fraud complaint
a document that they did not possess and had never seen.
next, a complaint that does not include direct quotations from a purported
document. In the absence of such quotations, a court reasonably can assume that
plaintiff does not possess and has not seen the purported document. That, of
course, does not mean the document does not exist. Plaintiff may have learned
of the document and its contents from a person who represented that she had
seen the document or had learned of its contents from another.
If that is the case, Silicon Graphics holds, plaintiff must set forth
sufficient specifics, of the kind the court mentions, to allow the court to
assess the credibility of her allegations.
The same is
true with respect to allegations concerning oral statements purportedly made to
or by named individuals. That is, if the court is to assess (a) whether
plaintiff has a reasonable basis for each such allegation and (b) whether that
allegation, in combination with plaintiff’s other allegations, give rise to a
strong inference that a defendant acted with scienter, plaintiff must tell the
court how she learned of those oral statements, from whom, and how her sources
learned of those statements (e.g., did the source hear the statement
personally or was she told by some third person that the alleged statement was
In short, Silicon
Graphics reflects the court’s appreciation of the necessity of requiring
plaintiffs to disclose corroborating details in order to allow them to
distinguish arguably meritorious claims of fraud from cleverly disguised
allegations of “fraud by hindsight.” Relying on
the Basis Requirement, the court correctly held that a complaint that includes
no such details must be dismissed.
III. DEFINING “THE
REQUIRED STATE OF MIND”
As noted in
Section I, the focus of this Article is not on the question of what degree of
recklessness is the equivalent of scienter or whether
evidence of motive and the opportunity, standing alone, is sufficient to create
a strong inference of scienter. However, courts’ holdings on those issues
provide the substantive context to which the Basis Requirement relates. They
also are relevant to the question of when a plaintiff’s allegations should be
deemed to give rise to a strong inference of scienter.
of Appeal that have addressed those questions. Only one,
the Ninth Circuit in Silicon Graphics, has held that, at a minimum,
plaintiff must plead facts sufficient to give rise to a strong inference
of“deliberate or conscious
and that evidence of motive and the opportunity, standing alone, never is
sufficient to create a strong inference of scienter. This Section
argues that Silicon Graphics’ holdings on these issues do not differ
significantly from the holdings of the First, Sixth and Eleventh Circuits’ in Greebel,
Comshare and Avado, respectively. I defer to Section V discussion
of the Second and Third Circuits’ holdings on these issues.
& Ernst v. Hochfelder
establishes the framework for discussion of what constitutes “the required
state of mind” in actions under section 10(b) and Rule 10b-5. The Court there
interpreted section 10(b) to require proof of “scienter,” which it defined as
“a mental state embracing intent to deceive, manipulate or defraud.”
The Court also reserved the question of
“whether, in certain circumstances, reckless behavior” is the equivalent of
and has twice subsequently reserved that question.
Every Court of Appeals to address the issue has held that
proof of recklessness can suffice. The Courts
of Appeals also uniformly have adopted what is often referred to as the Sunstrand
definition of recklessness:
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
and sellers that is either known to the defendant or is so obvious that the
actor must have been aware of it.
the passage of the Reform Act, though, courts rarely referred to Sunstrand
when considering motions to dismiss. In some
circuits, including the Ninth, the issue did not arise because a plaintiff was
allowed to plead state of mind generally, so long as she pled with
particularity the circumstances constituting the alleged fraud.
In other circuits, the situation was different. In the Second Circuit — on
whose case law the language of section (b)(2) is based — a plaintiff alleging
securities fraud was required to plead facts that “give rise to a ‘strong
inference’ that the defendants possessed the requisite fraudulent intent.”
However, the Second Circuit allowed a plaintiff to satisfy this requirement by
alleging facts that either established defendant had a motive and the
opportunity to commit fraud or constituted strong circumstantial evidence of
reckless or conscious misbehavior.
examination of individual Second Circuit decisions makes clear that — perhaps
in deference to the statement in Fed. R. Civ. P.9(b) that state of mind can be alleged generally
— while the Second Circuit may have “talked the talk,” it did not consistently
“walk the walk.” That is, there are numerous cases in which the Second Circuit
allowed plaintiffs to survive motions to dismiss on the basis of allegations
that by no stretch of the imagination gave rise to a strong inference
that defendants had acted intentionally or with the degree of recklessness required
Warner provides a good illustration. Plaintiffs
there argued that Time Warner had delayed disclosing its plan to raise needed
capital through a rights offering in the hope that the delay would allow Time
Warner to increase the price at which it could sell the stock for which the
rights would be issued.
Defendants ridiculed plaintiffs’ claim. They pointed out
that no matter when Time Warner announced the rights offering, SEC rules would
require it to wait several weeks before it could begin to sell stock. During
that period, investors surely would incorporate all material information
concerning the rights offering into their valuation of Time Warner stock.
Consequently, defendants maintained, Time Warner could not reasonably have
expected to be able to realize some financial benefit by delaying announcement
of its decision to raise capital by means of a rights offering.
The Second Circuit acknowledged that defendants’ argument
had merit, but nonetheless reversed
the district court’s decision dismissing plaintiffs’ complaint.
The appellate court observed that because “the laws of economics have
not yet achieved the status of the law of gravity, we cannot say, on a motion to dismiss, that plaintiffs cannot prove that a motive
striking disparity between the language of Hochfelder, Sunstrand
and the Second Circuit’s “strong inference” test on the one hand and the
court’s holding in Time Warner on the other. Even one who agreed that,
with all reasonable inferences drawn in their favor, plaintiffs arguably had
pled facts that suggested Time Warner may have hoped that delaying disclosure
of its intent to makethe rights
offering would provide it with some financial benefit would be forced to
concede that the facts pled by plaintiffs were not sufficient to support a strong
inference that Time Warner was motivated by an intent to deceive or defraud or
that Time Warner’s actions involved an “extreme
departure from the standards of ordinary care  which presents a danger of
misleading buyers and sellers that is either known to the defendant or is so
obvious that [defendants] must have been aware of it.” The
latter point is borne out by the Time Warner court‘s holding that, with
respect defendants’ alleged nondisclosure of the rights offering, “the
complaint cannot be said to adequately plead scienter under the circumstantial
evidence of conscious or reckless behavior approach”. In other
words, the court allowed plaintiffs’ complaint to survive a motion to dismiss
because it included a relatively weak and implausible claim that Time Warner
may have been seeking some financial gain.
Graphics can best be understood as reflecting a rejection of decisions like
Time Warner.The Ninth Circuit
concluded that it had an obligation to give content to both Hochfelder
and Sunstrand when interpreting section (b)(2). Hochfelder and Sunstrand
make clear that recklessness is the equivalent of scienter only when it “reflects
some degree of intentional or conscious misconduct.” It follows, Silicon
Graphics continued, that to meet the requirements of section (b)(2)
plaintiffs must plead with particularity facts that “create a strong inference
of, at a minimum, ‘deliberate recklessness.’” It also
“follows that plaintiffs proceeding under the PSLRA can no longer aver intent
in general terms of mere ‘motive and opportunity’ or ‘recklessness,’ but
rather, must state specific facts indicating no less than a degree of
recklessness that strongly suggests actual intent.”
adopts a slightly approach to interpreting section (b)(2). The Sixth Circuit,
as does the Ninth Circuit in Silicon Graphics, first reviews Hochfelder
and its earlier endorsement of theSunstrand definition of recklessness.Comshare
Because it is clear that
recklessness, understood as a mental state apart from negligence and akin to
conscious disregard, may constitute scienter, we conclude that under the PSLRA,
a plaintiff may survive a motion to dismiss by pleading facts that give rise to
a ‘strong inference’ of recklessness.
Circuit does not use the term “deliberate recklessness,” but its holding that a
plaintiff must plead facts sufficient to give rise to a strong inference of
recklessness “akin to conscious disregard,” in my opinion, amounts to much the
same thing. It is hard to conceive of a set of facts that a the Sixth Circuit
would view as sufficient to give rise to a strong inference of recklessness
“akin to conscious disregard” but that the the Ninth Circuit would hold were
not sufficient to give rise to a strong inference of“deliberate recklessness.”
discussion of motive and opportunity also closely tracks Silicon Graphics’
discussion of that issue. The Sixth Circuit states:
of a defendant's motive and opportunity to commit securities fraud does not
constitute ‘scienter’ for the purposes of § 10b or Rule 10b-5 liability. . . .
While facts regarding motive and opportunity may be ‘relevant to pleading
circumstances from which a strong inference of fraudulent scienter may be
inferred,’ and may, on occasion, rise to the level of creating a strong
inference of reckless or knowing conduct, the bare pleading of motive and
opportunity does not, standing alone, constitute the pleading of a strong
inference of scienter.
this statement reflects a scintilla of difference from Silicon Graphics.
Both courts hold that facts suggesting motive and opportunity may provide
circumstantial evidence of scienter. Silicon Graphics appears to rule
out the possibility that such facts, standing alone, can ever give rise to a
strong inference of reckless or knowing misconduct, while Comshare
suggests that, “on occasion,” facts relating to motive and opportunity may
support such an inference.
facts will rarely arise. One conceivable example is a situation in which (a) a
corporation’s top executives held substantial amounts of stock, (b) those
executives sold all or most of their stock shortly after the corporation
disclosed “good news” about some aspect of its business,and (c) the corporation shortly thereafter
issued “bad news” about the same aspect of its business. The Sixth Circuit
might well be prepared to treat these facts, which strongly suggest motive and
opportunity as sufficient, standing alone, to create a strong inference of
scienter. Silicon Graphics holds that more is required. However, relying
on the same facts, the Ninth Circuit might well treat the inconsistency between
the corporation’s two statements, together with their temporal proximity, as
circumstantial evidence that the corporation knew or recklessly disregarded
that the first statement was false when it was made. Thus, it might well hold,
as would the Sixth Circuit, that the facts plus those suggesting motive and
opportunity were sufficient to support a strong inference of scienter.
and Avado endorse Comshare’s interpretation of section (b)(2).
Thus, despite minor semantic differences, the substantive definition of
scienter adopted by the First, Sixth and Eleventh Circuits appears to be
essentially the same as that adopted by the Ninth.
GIVES CONTENT TO THE STRONG INFERENCE REQUIREMENT
is more significant for other reasons. First, it interprets the Basis
Requirement in much the same fashion as does Silicon Graphics. Second,
it attributes considerable importance to Congress’ use of the term “strong
inference” in section (b)(2), which leads it to hold that adequately
corroborated allegations of fraud -- which may well have survived a motion to
dismiss in pre-Reform Act days --were
properly dismissed because they did not create a strong inference of scienter.
has a somewhat unusual procedural history. Plaintiffs claimed that FTP and
several of its officers and directors deliberately misrepresented FTP’s
financial performance. Their strongest claim was as follows:
the third quarter of 1995, the defendants became aware that sales were
drastically below internal forecasts and performance goals and instructed FTP’s
sales force to induce distributors to accept additional FTP product with the
promise that the distributors had the right to return any product that they
failed to sell. Distributors sent in their orders to FTP noting that they were
entitled to return any unsold product. Aware that recognizing revenue where the
right of return existed was improper, the defendants instructed FTP’s sales
force to “white out” this notation on the distributors’ order forms in order to
prevent FTP’s auditors from discovering the contingent nature of the sales. A
material percentage of these purported sales were either returned to the
Company or remain with distributors, but have not been paid for.
Primarily on the basis of this “white out” allegation, the
district court denied defendants’ motion to dismiss.
the district court’s decision, defendants and plaintiffs made disclosures
pursuant to Fed. R. Civ. P.26.
Defendants demanded that plaintiffs produce document(s) or witness(es) to
support this “white out” allegation. Plaintiffs
countered by asking the court to allow them to conduct discovery of FTP
customers who they believed had submitted the purchase orders on which
notations of a right to return allegedly had been “whited out.”
district court rejected plaintiffs’ request. Although it had allowed plaintiffs
to survive defendants’ motion to dismiss on the basis of their uncorroborated
“white out” allegations, the court now told plaintiffs: “You have to know what
your case is about before you bring it.” Following a
colloquy in which plaintiffs’ attorney indicated that the “white out”
allegation may have been based entirely on the hearsay testimony of one
witness, the court ordered plaintiffs to advise defendants of the name of that
and any other percipient witnesses and the substance of their testimony.
thereafter acknowledged that the “white out” allegation was based on the
testimony of Trudy Nichols, a former FTP employee who plaintiffs’ attorney
advised the court had been told about the alleged “whiting out” by current FTP
Plaintiffs, however, were unable to make Ms. Nichols available for a
deposition; she either was unavailable or unwilling to testify.
defendants to move for partial summary judgment on plaintiffs’ “white out”
claim and to renew their motion to dismiss the balance of the complaint. The
district court granted both motions and also
denied plaintiffs’ request that it consider evidence plaintiffs had obtained
from files FTP had disclosed, reasoning, in effect, that such evidence
constituted fruit from a poisoned tree. Plaintiffs
appealed all three rulings to the First Circuit.
first holds that the Basis Requirement in section (b)(1) “is congruent and
consistent with the pre-existing standards of this circuit.”
The court notes, in particular, that under Rule 9(b) “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.” These
“strict pleading requirements under Rule 9(b),” the court continues, “are, in
our view, consistent with the PSLRA.”
section (b)(2), Greebel holds that the language of the Act supports
three conclusions. First, “Congress plainly contemplated that scienter could be
proven by inference, thus acknowledging the role of indirect and circumstantial
Second, “the words of the Act neither mandate nor prohibit the use of any
particular method to establish an inference of scienter.”
most significantly, Greebel holds that section (b)(2) effectively
overrides Conley v. Gibson. The court states:
Congress has effectively mandated
a special standard for measuring whether allegations of scienter survive a
motion to dismiss. While under Rule 12(b)(6) all inferences must be drawn in
plaintiffs’ favor, inferences of scienter do not survive if they are merely
reasonable, as is true when pleadings for other causes of action are tested by motion
to dismiss under Rule 12(b)(6). Rather, inferences of scienter survive a motion
to dismiss only if they are both reasonable and ‘strong’ inferences.
the guise of tinkering with procedural requirements, Congress has effectively,
for policy reasons, made it substantively harder for plaintiffs to bring
securities fraud cases, through the ‘strong inference’ of scienter requirement.
the court reiterates:
most salient feature of the PSLRA is that whatever the characteristic pattern
of the facts alleged, those facts must now present a strong inference of
scienter. A mere reasonable inference is insufficient to survive a motion to
established a framework for analysis, Greebel then states that “[i]f
adequately supported, claims that management deliberately altered company
records to hide material information from company auditors could well create” a
strong inference of scienter.
This provides a concrete example of the kind of allegation that the court
believes may create a strong inference of scienter. But in the case before it,
because “plaintiffs could not produce admissible evidence to support the
white-out allegations, [the court] disregard[s] [them].”
the court uses to state its holding raise an important question: Does the court
mean to suggest that only “admissible evidence” can constitute “adequate
support” for allegations of securities fraud? In my view, that is not how Greebel
should be interpreted. The question the court was addressing was whether the
district court had properly granted defendants’ motion for partial summary
judgment on the “white out” claim. To survive that motion, plaintiffs had to
produce evidence that supported every essential element of the claim. The
court’s reference to “admissible evidence” thus makes sense in the context of a
motion for summary judgment, but does not imply that a plaintiff must support
every essential allegation in her complaint with “admissible evidence.”
does make clear that the district court should have focused on whether
plaintiffs had described the source of information on which they based their
“white out” allegations when it ruled on defendants’ first motion to dismiss.
Had the district court done so, it presumably would have granted defendants’
motion because plaintiffs did not describe in their complaint the facts on
which those allegations were based.
assumes that plaintiffs would then have disclosed that the “white out”
allegations were based entirely on the hearsay statement of a former FTP
employee,Greebel establishes that the district court still should have dismissed
the complaint on the ground that those allegations, considered in light of the
facts on which they were based, do not have sufficient probative value to give
rise to a strong inference of scienter. Greebel’s treatment of
plaintiffs’ “warehousing allegations” – their claim that, during the class
period, FTP recorded as “sales” shipments it made to a warehouse, rather than
to customers, and later accepted back as returned goods -- supportsthis conclusion. As with the
“white out” allegations, the court suggests that these allegations, if true,
“are very serious.”
But the court then dismisses these allegations because, considering the facts
on which they are based, they “are not enough support a strong inference of
discussion of the “white out” and “warehousing” allegations highlights a key
aspect of the relationship of section (b)(1) to section (b)(2). Under section
(b)(1), a plaintiff must disclose the basis for each allegation made on
information and belief. The nature and quality of the factual basis for each
such allegation then becomes relevant to the court’s determination as to
whether plaintiff has pled facts sufficient to give rise to a strong inference
of scienter. A hearsay statement by a person with no first hand information as
to the relevant facts, standing alone, generally will not suffice. Neither will
facts suggesting a corporation engaged in some improper practice before the
start of the class period. Other claims, based on other facts, no doubt will
give rise to more difficult questions.Does Barrons’ publication of
this information make plaintiffs’ allegation credible? What weight should be
given to the fact that Barrons does not name its sources? As to the
blankets: (a) Is a $10 million transaction material? (b) Did the alleged
transaction affect Sunbeam’s second quarter results? Finally, given the lack of
specifics in the Barrons article, what significance should be attributed
to the remaining transactions described? Of course, a court asking these
questions also would need to take account of plaintiffs’ other allegations
relating to Sunbeam’s alleged fraud.
analysis of plaintiffs’ other allegations, concerning “channel stuffing” and
contingent sales, illustrates the importance of the court’s holding that to
satisfy section (b)(2), a plaintiff must plead facts that give rise to a strong
inference of scienter. The court avoids the sticky question of whether the
district court should have considered the arguably “tainted” evidence
plaintiffs obtained through discovery by holding that, even had plaintiffs
incorporated that additional evidence into their complaint, they still failed
to plead facts sufficient to create a strong inference of scienter.
quickly dispenses with the “channel stuffing” allegations. It treats
them as adequately corroborated and notes that evidence of channel stuffing
“has some probative value.”
But, the court continues,
that value is weak. Unlike
altering company documents, there may be any number of legitimate reasons for
attempting to achieve sales earlier. Thus, [plaintiffs’ channel stuffing
evidence] does not support a strong inference of scienter.
underlines the significance of the “strong inference” requirement in section
(b)(2) by noting that “[b]efore the PSLRA, a number of courts gave weight to
channel stuffing allegations in refusing to grant stays of discovery or motions
for dismissal or summary judgment.”
treatment of plaintiffs’ claims concerning FTP’s contingent sales is to like
effect. Plaintiffs produced evidence of one transaction that FTP booked as a
sale even though the customer had an unqualified right to return the product
within 60 days. The court points out that under GAAP, a seller is permitted to
treat such a transaction as a sale if it establishes a reasonable reserve for
returns. Plaintiffs pled no facts indicating FTP failed to establish an
adequate reserve. That leads the court to conclude:
Without any information on FTP’s
experience with past return rates, the size of its reserve for returns, or how
the reserve changed over time, it is difficult to infer that FTP’s revenue
recognition decisions were unreasonable enough to violate GAAP, or that they
give rise to a strong inference of scienter.
acknowledges that in September 1995, FTP probably should not have booked as a
sale an $1.14 million order, placed on September 28, for software that
documents discovered by plaintiffs indicate FTP was not yet fully developed. But,
the court argues, “[i]t is a leap from there to a strong inference of
Even when considered together with another clearly contingent order for
$416,325 that FTP also booked as a sale in September, the court points out,
plaintiffs’ additional evidence indicates only that FTP improperly recognized
between $416,000 and $1.55 million in revenue in a quarter in which its total
revenues were $37.1 million. This, Greebel holds, “does not support a
strong inference of scienter. It is equally possible to conclude that FTP made
some incorrect accounting decisions regarding a limited number of transactions.
Seeing fraud . . . requires too great of an inferential leap.”
the court acknowledges that the Reform Act’s new pleading requirements dictated
the result it reached. It states:
The difficult and different
balance the [Reform] Act now requires — testing allegations before little or no
discovery, but holding plaintiffs to a strong inference of scienter standard —
has been honored in this case. Plaintiffs did not have enough weight on their
side of the balance to meet the requirements of the Act, and so we affirm the dismissal.
V. TWO IMPORTANT
currently pending in a different procedural posture in the Second and Third
Circuits should provide important clues as to whether those courts will
similarly honor Congress’ intent and adopt a consistent approach to
interpreting the Reform Act’s pleading requirements. In Novak v. Kasaks,
the Second Circuit vacated and remanded a district court decision dismissing a
securities fraud complaint.Novak’s
significance is unclear. It could reflect the Second Circuit’s resolve to
interpret sections (b)(1) and (b)(2) in a considerably more relaxed fashion
than do Silicon Graphics and Greebel
or it could represent no more than a holding that plaintiffs are not required
to include in their complaints the names of the individuals who were the
sources of the information on which plaintiffs based their allegations.
Cell Pathways, Inc., Sec. Litig. wrongly
denies defendants’ motion to dismiss. The district court’s opinion, written
after defendants petitioned the Third Circuit for a writ of mandamus,
which calls attention to that petition, and also increases Cell Pathways’
potential significance. A decision by the Third Circuit not to consider defendants’
mandamus petition could signal that court’s willingness to tolerate district
court decisions denying motions to dismiss that flout the pleading standards
the Reform Act establishes. A decision by the Third Circuit granting the
requested writ would clearly signal that district courts have an obligation to
demand that plaintiffs to meet the Reform Act’s pleading standards. A decision
on the merits of defendants’ petition also is likely to clarify and expand upon
the Third Circuit’s decision in Advanta, the only case in which that
court has discussed those pleading standards.
A. Novak v. Kasaks
involves an amalgam of issues similar to those addressed by Silicon Graphics
and Greebel. Suit was brought on behalf of all persons who purchased
AnnTaylor Stores Corporation (“AnnTaylor”) stock between February 3, 1994 — the
date on which AnnTaylor announced its FY 1994 results — and May 4, 1995,
the date on which AnnTaylor unexpectedly announced reduced same store sales and
sharply lower earnings for the first quarter of FY 1995. AnnTaylor
blamed its problems on a weak retail environment and merchandising problems
with its Spring line of clothing. The market
reacted quickly; the price of AnnTaylor stock, which had declined substantially
during the previous month, dropped an additional 25% on May 5, 1995.
The District Court’s Decisions
original complaint, filed almost one year later, consisted
largely of uncorroborated allegations to the effect that AnnTaylor and certain
of its executives had engaged in “an elaborate ‘Box & Hold’ scheme”Id.,
¶¶ 31-32. in which it “knowingly and intentionally issued financial statements
that overstated AnnTaylor’s financial condition by accounting for inventory that
they knew to be obsolete and nearly worthless at inflated values and by
deliberately failing to adhere to the Company’s publicly stated markdown
district court dismissed plaintiffs’ original complaint, holding that it “fails
to allege with sufficient specificity that at the time the AnnTaylor defendants
made favorable statements to securities analysts, they were aware that much of
their inventory was worthless or seriously overvalued, or were reckless as to
whether that was the case.”
The court also pointed out that while plaintiffs’ claims focused on the alleged
“Box & Hold” scheme, “[t]he term ‘box-and-hold’ is nowhere defined in the
The court continued:
The implication is that inventory
was placed in containers and stored for some period of time or held for sale in
later seasons.That action, even if it
were a fact, is one essentially of business judgment.If there is more than business judgment involved, i.e., something
wrongful, then plaintiffs were required under Rule 9(b) to set forth, in detail,
the particulars of that wrongfulness.Plaintiffs have, instead, relied virtually exclusively on conclusory
language (e.g., ‘inventories had exploded to dangerously bloated levels ‘ and
hot words (e.g., ‘plunged into a liquidity crisis’ ). . . .
the court addressed plaintiffs failure to satisfy the Basis Requirement. It
noted that plaintiffs’ umbrella description of the basis for their claims
“provides none of the required facts underlying the complaint's allegations as
to the information that was available to the individual defendants, nor does it
direct the Court to where those facts might be found”; that the
district court in Silicon Graphics rejected an identical paragraph as
insufficiently specific; 
and that plaintiffs “also provide no basis for their allegation that
‘[t]hroughout the Class Period, AnnTaylor was falsifying and artificially
inflating its reported net income and earnings per share via its ‘box-and-hold’
scheme to hide excess, slow-moving and/or unsalable inventory and avoid writing
off that inventory.’”
thereafter filed an amended complaint. They added
to their listing of the categories of information on which their claims were
“internal AnnTaylor documents obtained through plaintiffs’ investigation; and
documents produced by various non-parties to this litigation, as well as
confidential communications with certain former AnnTaylor employees and
In addition, plaintiffs made additional, arguably significant, substantive
allegations, apparently based on these newly-listed sources.
alleged that an AnnTaylor internal document,a “Weekly Report” dated January 22, 1996, “demonstrates that . . . over
six months after the end of the Class period,” AnnTaylor’s Box and Hold inventory
(a) contained 13% of the “apparel units” in AnnTaylor’s inventory and 20% of
the “shoe units”; (b) had a reported value of $14 million, equal to 14% of the
publicly-reported value of AnnTaylor’s inventory as of January 28, 1996; and
(c) “consists primarily of 1993 and 1994 Class Period merchandise”.
To this they added the assertion — which they did not attribute to this or any
other source — that the “actual value” of the January 22, 1996 Box and Hold
inventory “was nearly zero.”
also alleged that similar “Weekly Reports,” in the same format as the January
22, 1996 Report, were distributed to AnnTaylor’s senior management every Monday
during the class period.
plaintiffs alleged, in paragraph 35 of their amended complaint, that there were
numerous discussions, involving three senior AnnTaylor executives named as
individual defendants and other AnnTaylor executives, in which “many AnnTaylor
executives demanded that [these individual defendants] end the Box & Hold
practice as it made no sense and was growing out of control.”
The three individual defendants’ response, plaintiffs further asserted, “was
that AnnTaylor could not ‘afford’ to eliminate or write-down the Box & Hold
inventory because doing so would ‘kill’ the Company’s reported financial
results and/or profit margins and damage the Company on ‘Wall Street’. . . [and
that each individual defendant] knew, at all relevant times, that this
inventory due to its age and condition was nearly worthless and could not and
would not be sold at its stated value.”
renewed their motion to dismiss, which the district court again granted.
The court held that plaintiffs’ additions failed to correct the deficiencies in
the original complaint, “or even to address them in any meaningful way.”
The court recognized that plaintiffs’ new allegations “appear to be directed at
demonstrating that the AnnTaylor defendants knew that the box-and-hold
inventory ‘was nearly worthless and could not and would not be sold at its
The court accepted arguendo plaintiffs’ claim that each Monday
AnnTaylor’s top managers received a report detailing AnnTaylor’s inventory,
including “Box and Hold” inventory “subdivided into seasonal lines (e.g., ‘Fall
But, the court pointed out, “these documents, if they exist, do nothing more
than confirm a fact already acknowledged by AnnTaylor — that AnnTaylor held
merchandise in warehouses and ultimately marked down this merchandise.”
the district court concluded that plaintiffs’ allegations concerning the
January 22, 1996 Weekly Report did not advance their cause. First, the Court
questioned the relevance of “a document describing the situation which existed,
as plaintiffs emphatically put it, over six months after the
end of the Class Period.”
The court then noted that, ‘[b]y plaintiffs' own count, there were 460,230
units of warehoused inventory.Dividing
this number into $14 million results in an average value of $30 per unit.Plaintiffs offer no explanation as to why
that number is an excessive average valuation for upscale clothing and shoes.”
Finally, and “perhaps most importantly,” the court highlighted the fact that
“plaintiffs offer no support for the allegation that the value of the box and
hold inventory was ‘nearly zero,’ nor do they attempt to demonstrate why $14
million was not a proper value to assign to the inventory.” In sum, the
court seemed to suggest that, even if plaintiffs had been able to show that at
some time during the class period AnnTaylor held “Box and Hold” inventory in
amounts identical to those it allegedly held on January 22, 1996, the court
would not, without more, find those facts sufficient to create a strong
inference of scienter. In this respect, the district court’s approach is much
the same as that the First Circuit subsequently took in Greebel.
the allegations in paragraph 35, which the district court caustically described
as “an excellent example of the improper pleading which leads the Court once
again to dismiss the complaint.” But the
court’s reasoning here, while fundamentally sound, may not have been
first faulted plaintiffs for not identifying the individual “former employees”
on whose reports it assumed paragraph 35 was based, a failure that it said
“ignores the clear mandate of the Court in our earlier opinion, and is contrary
to the particularity requirements of [section (b)(1)].” The court
was correct insofar as its holding was that plaintiffs did not satisfy the
Basis Requirement with respect to paragraph 35, because nowhere in the amended
complaint did plaintiffs identify the facts on which they based the allegations
in paragraph 35.
But the court was on shakier ground to the extent that its refusal to credit
the allegations in paragraph 35 was based on plaintiffs’ failure toname the former employees on whom
they relied. It was not clear then, and is not clear now, whether a plaintiff
must name all of her testimonial sources to satisfy the Basis Requirement.
also found that the allegations in paragraph 35, if credited, still would
reflect “nothing more than disagreement by certain AnnTaylor executives with
business decisions made by the AnnTaylor defendants.” But close
reading suggests that the import of those allegations is ambiguous. Plaintiffs
could contend that paragraph 35 reasonably can be interpreted as suggesting
that the three individual defendants rejected demands they write down the Box
and Hold inventory solely because they were concerned that such action would negatively
affect the price of AnnTaylor stock. If so interpreted, plaintiffs could argue,
the allegations in paragraph 35 are analogous to the “white out” claim that Greebel
held could create a strong inference of scienter.
the premise of this argument arguably is correct, the conclusion is flawed.
Even if plaintiffs could argue that the allegations in paragraph 35 support a reasonable
inference that the individual defendants acted with scienter, those allegations
fall far short of compelling such an inference. They can be distinguished from
the “white out” allegations in Greebel because whiting out notations on
purchase orders to deceive a company’s auditors can serve no legitimate
purpose. In contrast, even were the court to assume that the conversations
described in paragraph 35 actually occurred, it still could read that paragraph
to suggest no more than that the individual defendants expressed botha concern about the impact writing down the value of Box and Hold inventory
would have on the price of AnnTaylor stock and a good faith belief that writing
down that inventory would be premature.
That may be
what the court intended to suggest when it stated that “plaintiffs offer
absolutely no support for the conclusory, unsupported and inflammatory
allegation that the AnnTaylor defendants knew the box and hold inventory to be
Plaintiffs might respond that a reasonable implication to be drawn from the
“facts” alleged in paragraph 35 is that certain non-defendant AnnTaylor
executives expressed their concern that Box and Hold inventory had grown so
large that AnnTaylor would have difficulty selling it at a profit. But even
were that true, it does not necessarily follow that the defendant executives
shared (or recklessly disregarded the basis for) the other executives’ opinion.
Thus, even if construed to support plaintiffs’ claim, plaintiffs’ allegations
still do not support a strong inference that the defendant executives
acted with scienter.
the district court could have rejected the allegations in paragraph 35 in a
manner consistent with the principles subsequently articulated by Silicon
Graphics and Greebel. However,
the court advanced reasons for rejecting those allegations that rendered its
decision vulnerable to criticism. Plaintiffs predictably focused on those
reasons when they appealed to the Second Circuit.
The Second Circuit’s Decision
confine itself to a discussion of whether sources must be named, the Second
Circuit used Novak as a vehicle for discussion of wide range of pleading
issues under sections (b)(1) and (b)(2), as well as additional issues that Novak
Unfortunately, the court’s discussion of both sets of issues is confusing and
Pleading standards under the Reform Act
observes that “[t]he landscape of securities fraud litigation has been
transformed in recent years by the passage of the PSLRA.” After
reviewing briefly the history of the Reform Act and quoting sections (b)(1) and
(b)(2), Novakpurports to describe
the Second Circuit’s pre-Reform Act pleading requirements. The court notes that
a simple restatement of its oft-quoted, two-part strong inference test
“conceals the complexity and uncertainty that often surround its application”
and acknowledges that “different courts applying the pleading standard to
differing factual circumstances may reach seemingly disparate results.”
However, the court continues, “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.”
summary of the law concerning motive and intentional misconduct is
straightforward and unobjectionable. Its
discussion of recklessness, however, is mystifying.
reiterating that the Second Circuit long ago adopted a definition of
recklessness based on Sunstrand, the court
observes that its pre-PSLRA cases upheld claims of recklessness where
plaintiffs alleged that “defendants knew or, more importantly, should have
known that they were misrepresenting material facts related to the
The court seemingly does not recognize that the emphasized portion of this
statement sets forth a negligence standard that is far less demanding than the
“extreme departure from the standards of ordinary care” that Sunstrandrequires.Novak
then compounds the confusion by citing as illustrative of its application of
this recklessness standard two cases that do not rely upon it.
again uses language suggesting negligence when it states: “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.”
Moreover, while the court points out that it has refused to allow plaintiffs to
proceed on the basis of allegations of “fraud by hindsight” and that “there are
limits to the scope of liability for failure adequately to monitor the
allegedly fraudulent behavior of others”, it provides
no other indication of the principle on which its cases rely to set those
portion of Novak represented only a recounting of pre-Reform Act
authority, one might dismiss as unimportant the court’s errors and omissions.
But the court perpetuates the possibility that a plaintiff can create a strong
inference of scienter by pleading facts that suggest only negligence by
concluding its discussion of section (b)(2) as follows:
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. . . . [I]n applying this standard, district courts should
look to the cases and factors [described] 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;(2)
engaged in deliberately illegal behavior;(3) knew facts or had access to information suggesting that their
public statements were not accurate;or (4) failed to check information they had a duty to monitor.
introductory discussion of pleading standards under the Reform Act largely
ignores the Basis Requirement. The court mentions only its pre-Reform Act requirement
that a plaintiff who contend defendants had access to facts contrary to their
public statements “must specifically identify the reports or statements
containing this information.”
However, here again the court’s discussion is incomplete and therefore
potentially confusing in that Novak fails to mention that the Second
Circuit decision it cites
expressly relies on First and Seventh Circuit decisions that require a
plaintiff, in addition, “to ‘specifically identify the internal reports and
public statements underlying their claims, providing names and dates’”, and to
“indicate such matters as ‘who prepared the projected figures, when they were
prepared, how firm the numbers were, or which [company] officers reviewed
Thus, the court leaves unclear (until it discusses the complaint in the instant
case) the extent to which it believes section (b)(1) or “the words ‘with
particularity’ in section (b)(2)incorporate these additional pleading requirements.
Analysis of the AnnTaylor complaint
discussion of the AnnTaylor complaint and the district court’s decision is even
more baffling. The court opens this discussion by summarizing plaintiffs’
claims that the AnnTaylor defendants “engaged in conscious misstatements with
the intent to deceive” and then states: “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.”
In addition, the court identifies as “documentary sources that support the
plaintiffs’ belief that serious inventory problems existed during the Class
Period itself” statements AnnTaylor allegedly made at the end of the first and
second quarters of FY 1995 — i.e., after the end of the class period —
and data in the January 22, 1996 Weekly Report. Moreover,
the court ignores completely both the district court’s careful explanation of
its reasons for concluding the January 22, 1996 data has almost no probative
value and the district court’s description of AnnTaylor’s business as
vulnerable to sharp fluctuations due to changing consumer tastes and purchasing
court’s disposition of plaintiffs’ appeal appears flatly inconsistent with
these statements. The court first declares: “We express no view as to whether
the plaintiffs’ allegations in this case were sufficiently particularized.”The court then remands the case “with
instructions to: (1) allow the plaintiffs to replead in light of our discussion
above; and (2) reconsider the particularity of the plaintiffs’ pleadings in
light of the proper standards.”
This disposition makes no sense whatsoever if, as the court earlier states, the
complaint “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” and if
plaintiffs have adequately identified “documentary sources that support [their]
belief that serious inventory problems existed during the Class Period itself.”Time Warner, the governing
authority on this issue, holds that Rule 9(b) requires, “at a minimum, that the
plaintiff identify the speaker of the allegedly fraudulent statements.”
9 F.3d at 265 (emphasis added). Plaintiffs’ amended complaint claims only that
two individual defendants spoke to analysts and does not attribute specific,
allegedly false or misleading statements to either of them. See Novak
Amended Complaint, ¶¶ 70-74, 78-81.
way to make sense of Novak, I believe, is to focus not on these
conflicting statements but on the court’s conclusion that a plaintiff can
comply with the Basis Requirement without naming confidential sources. On this
issue, Novak states:
. . [O]ur reading of the PSLRA rejects any notion that confidential sources
must be named as a general matter.In
our view, notwithstanding the use of the word ‘all,’ paragraph (b)(1) does not
require that plaintiffs plead with particularity every single fact upon which
their beliefs concerning false or misleading statements are based.Rather, plaintiffs need only plead with
particularity sufficient facts to support those beliefs. Accordingly, where
plaintiffs rely on confidential personal sources but also on other facts, they
need not name their sources as long as the latter facts provide an adequate
basis for believing that the defendants’ statements were false.Moreover, even if personal sources must be
identified, there is no requirement that they be named, provided they are
described in the complaint with sufficient particularity to support the
probability that a person in the position occupied by the source would possess
the information alleged.We previously made a similar argument, to
the effect that plaintiffs should be free to decide what information to reveal
about their sources and that courts should take account of the basis for
plaintiffs’ allegations when deciding whether they give rise to a strong
inference of scienter. See Yossarian, cited in note 31, at 471, n. 71.
then explains that plaintiffs can satisfy the Basis Requirement “by providing
documentary evidence and/or a sufficient general description of the personal
sources of the plaintiffs’ beliefs.” Either kind
of information serves the underlying purpose of section (b)(1), which is to
ensure that plaintiffs “supply sufficient specific facts to support their
The court’s instruction on remand are consistent with this explanation.
The Issue on Remand
Novak is confusing in numerous respects, it is possible to set forth a
reasonably coherent interpretation of the court’s decision that also can be
reconciled with Silicon Graphics and Greebel. That
interpretation is as follows:
•The district court cannot
dismiss plaintiffs’ claim on business judgment grounds because plaintiffs’
claim that the AnnTaylor defendants made public statements that they knew or
recklessly disregarded were false or misleading could satisfy the scienter
requirement established by Hochfelder and section (b)(2). However,
whether plaintiffs have pled their claim with the particularity required by the
Reform Act remains an open question.
are not required to name their confidential sources, but to satisfy sections (b)(1)
and (b)(2) they must describe the documentary and/or personal sources on which
they rely. Moreover, their allegations, considered in light of the sources on
which they are based, must support a strong inference that the AnnTaylor
defendants acted with scienter.
that we have clarified what plaintiffs must do to satisfy the Basis
Requirement, the district court should give plaintiffs a chance to replead
their claims in light of our ruling.
district court then should reconsider plaintiffs’ complaint, including any
additional allegations plaintiffs make, and decide whether the plaintiffs’ well
pled allegations give rise to a strong inference that the AnnTaylor defendants
deliberately or recklessly misrepresented material facts.
assume, for purposes of discussion, that the Novak plaintiffs either
will not seek to amend their complaint or will add to it only some additional
facts describing the source(s) of the allegations in paragraph 35.
If this assumption is correct, the district court — as the above discussion of
its opinion suggests — will be free to again dismiss the complaint. More
specifically, the district court could reiterate that (1) the January 22, 1996
Weekly Report (and the AnnTaylor defendants’ other post-class period statements)
provide little support for plaintiffs’ claims that AnnTaylor held large amounts
of virtually worthless Box and Hold inventory during the class period; and (2)
in any event, plaintiffs have provided insufficient facts to support their
assertions concerning the amounts and value of AnnTaylor’s Box and Hold
inventory during the class period. As concerns paragraph 35, if plaintiffs do
not attribute the allegations therein to some person who was in a position to
have first hand knowledge of the facts alleged, the court should refuse to
credit those allegations. Moreover, even if plaintiffs do attribute those
allegations to a credible source, the district court still reasonably could
conclude that the facts alleged therein do not support a strong inference
the district court reach that conclusion and should plaintiffs again appeal,
the Second Circuit might take that opportunity to clarify some of the
ambiguities in Novak. More importantly, an appeal of such a decision
also would force the Second Circuit to clarify whether it interprets sections
(b)(1) and (b)(2) in much the same fashion as do Silicon Graphics and Greebel
or whether the Second Circuit, once generally credited with having the most
stringent pleading standards for claims of securities fraud, now is inclined to
uphold complaints that the First and Ninth Circuits would dismiss.After Silicon Graphics was handed
down, district courts in the Ninth Circuit have consistently dismissed
complaints when plaintiffs have not specified the basis for factual claims made
on information and belief. CompareIn re CBT Group PLC Sec.
Litig., 1999 WL 1249287 (N.D. Cal. 7/21/99); Dalarne Partners, Ltd. v. Synch
Research, Inc., 103 F.Supp 2d 1209 (C.D.Cal. 2000); In re FVC.Com Sec.
Litig., 2000 WL 1202065 (N.D. Cal. 2/14/00) (dismissing complaints) with
Imperial Credit Indus., Inc. Sec. Litig., Fed. Sec. L. Rep. ¶ 91, 024 [CCH]
(C.D. Cal. 2/23/00) (upholding complaint based on identified e-mails and
internal reports). See alsoIn re Segue Software, Inc. Sec.
Litig., 2000 WL 1059543 (D. Mass. 7/26/00) (post-Greebel decision
dismissing complaint quite similar to Novak Amended Complaint).
In re Cell pathways, Inc. securities
facts of Cell Pathways are relatively straightforward. Cell Pathways,
Inc. (“CPI”) is a bio-pharmaceutical company engaged in developing products to
prevent and treat cancer. In 1991, CPI discovered a compound called exisulind,
subsequently given the trade name “Prevatac,” that CPI believed would be useful
in the treatment of colonic polyps and the prevention of colon cancer.
Thereafter, CPI began clinical trials of Prevatac to test its efficacy on
patients with adenomatous polyposis coli (“APC”), a rare condition in which
patients form intestinal polyps that progress to colon cancer if not treated.
July 1998, the Food and Drug Administration (“FDA”) granted CPI “Fast Track”
authority to begin a Phase II/III clinical study of Prevatac.
On October 7, 1998, CPI announced that it had filled its enrollment of the
A month later, CPI issued a press release predicting it would complete the
Phase II/III clinical study in January 1999 and stating that, if the results
were favorable, it would seek FDA approval, during the first half of 1999, to
begin marketing Prevatac to patients with APC.
February 1, 1999, CPI announced that the clinical trial had not produced “a
statistically significant clinical response.” The
following day, plaintiffs allege that in an interview with Bloomberg Forum,
CPI’s CEO “noted the possibility that design flaws, particularly in patient
selection, could have accounted for the drug’s apparent lack of statistically
significant efficacy, and indicated his intention to review the findings of the
CPI conducted such a review and discussed the results on June 15-16, 1999. It
disclosed that (i) only 34 of the 65 patients who had completed the clinical
trial in fact met its selection criteria, (ii) unqualified patients had been
admitted to the study by referring physicianswith “little experience” with APC, (iii) Prevatac had demonstrated
statistically significant benefits for the subgroup of eligible patients, and
(iv) because of the small size of the subgroup of eligible patients, the FDA
would require further testing.
brought suit on behalf of all persons who purchased CPI stock between October
8, 1998 and February 2, 1999, inclusive. Plaintiffs’
central claim, which they based entirely on the statements by defendants
was that CPI acted recklessly in designing the Phase II/III clinical trial as
What is clear from the disclosures made by
defendants in June, 1999, is that in selecting physicians to identify
patients who would fall within the target population defendants knowingly or
recklessly disregarded, in their rush to complete the Fast Track approval
process, the great difficulty of identifying the target population in light of
the rare nature of APC and most physicians lack of familiarity with its
symptoms. Notwithstanding that knowledge, defendants knowingly or recklessly
failed to take steps to ensure that the physicians identifying patients for the
study had the special experience, knowledge, qualifications, and expertise to
perform their task properly.
a consequence, plaintiffs further alleged, CPI’s public statements about the
Phase II/III clinical trial were materially false and misleading (because they
did not describe the alleged flaws in the design of that clinical trial) and
were made with scienter “because at the time of their publications, defendants
knew, or recklessly disregarded, that [CPI] had failed to [properly] design
[that] clinical trial”.
Plaintiffs also asserted that “defendants were motivated to conceal the true
nature of CPI’s clinical trials in order to maintain the market’s perception
that CPI would be the first company with an FDA-approved . . . novel
investigational drug . . . for APC.”
facts alleged clearly do not support plaintiffs’ conclusory allegation that
defendants acted “knowingly or recklessly.” Those facts suggest, at most, that
CPI may have been negligent in designing the Phase II/III study or in
recruiting the physicians who participated in it. Of more significance, as
concerns the issue of scienter, other facts alleged by plaintiffs make clear it
would not have served CPI’s interests to badly design the clinical trial.
Prevatac was a unique drug that CPI thought might effectively treat a rare
condition — APC. Plaintiffs’ description of CPI, its business and Prevatac all
suggest CPI had no reason to believe Prevatac would produce beneficial results
in patients who did not suffer from APC. Thus,
including in the clinical trial patients who did not have APC would jeopardize
the prospect that the trial would produce statistically significant positive
results. Consequently, the facts alleged do not support either plaintiffs’
claim that defendants acted recklessly when they designed the Phase II/III
clinical trial or their claim that CPI acted with scienter when it made public
statements about the clinical trail that did not disclose the problems CPI
subsequently discovered in the design of clinical trial.
district court ignored these glaring weaknesses in the complaint and denied
defendants’ motion to dismiss. The district court also denied defendants’
subsequent motion seeking reconsideration or certification of the case for
Only after defendants filed a petition seeking a writ of mandamus did the
district court issue an opinion explaining its decisions.
district court acknowledged that the Reform Act requires plaintiffs to meet
more demanding pleading standards but then flouted those requirements. Its
discussion of the Basis Requirement may best reflect its attitude. The court
noted that section (b)(1) requires plaintiffs to plead with particularity all
facts on which their claims are based, but then indicated that it intended to
rely on the following statements, drawn from pre-Reform Act cases, when it
applied that requirement:
need not, however, plead the ‘date, place or time’ of the fraud, so long as
they use an ‘alternative means of injecting precision and some measure of
substantiation into their allegations of fraud.’”
‘the Third Circuit has cautioned that courts should “apply the rule with some
flexibility and should not require plaintiffs to plead issues that may have
been concealed by the defendants.”’ 
court’s central finding — that plaintiff “have adequately alleged that CPI
acted with deliberate recklessness in pushing forward with a clinical trial
which they knew was flawed” — cannot be squared with section (b)(1) because no facts
pled by plaintiffs demonstrate that defendants knew the clinical trial was
flawed at the time CPI issued the statements plaintiffs challenge. More
generally, the court’s reasoning is flawed because it treats as true allegations
made by plaintiffs
even though plaintiffs pled no facts to support those allegations.
second problem is that the court appears insensitive to limited nature of some
of plaintiffs’ claims. For example, facts pled by plaintiffs arguably support
their claim, on which the court heavily relies, that CPI officials “had
knowledge of the potential flaws in the enrollment process” at the time
CPI made the challenged statements about the Phase II/III clinical trial.
But plaintiffs’ use of the phrase “knowledge of the potential flaws” makes
clear that they are asserting no more than that senior CPI officials presumably
were familiar with the protocols governing clinical studies and therefore
should have been aware of potential problems with the enrollment process
they employed. Such allegations fall far short of the claim the court holds
plaintiffs have adequately alleged: that, as of February 1, 1999, CPI actually
knew or recklessly disregarded the fact that there were flaws in the
enrollment process and actually knew or recklessly disregarded that those flaws
were highly likely to jeopardize the statistical integrity of the Phase
II/III clinical trial.
This deficit is not remedied by the court’s finding that plaintiffs identified
“the sources for their beliefs that the trial was flawed.”
That plaintiffs believe the trial was flawed is unimportant; the
relevant question is whether defendants knew or recklessly disregarded, at the
time they made the challenged statements, that the trial was flawed.
most substantial defect in the court’s reasoning, though, is the absence of any
reasoned explanation of how — even if one assumes that plaintiffs alleged some
facts that suggest defendants’ actions in designing the clinical trial may have
been reckless — defendants’ alleged failure to take note of and disclose the
potential problems with the clinical trial conceivably could be viewed as
reflecting “an extreme departure from the standards of ordinary care . . .
which presents a danger of misleading buyers or sellers that [was] either known
to the defendant[s] or [was] so obvious that the[y] must have been aware of
In other words, even if the Cell Pathways complaint somehow could be
deemed to satisfy the requirements of section (b)(1), there is no way in which
any court reasonably could find it gives rise to a strong inference that
defendants acted with scienter when they issued the statements plaintiffs claim
were materially false and misleading.
might dismiss the district court’s decision as simply wrong, had the court not
noted defendants’ petition for a writ of mandamus. That give Cell Pathways added
importance. Should the Third Circuit refuse to hear defendants’ petition,
district courts might well interpret the appellate court’s action as a signal
that it is prepared to tolerate even clearly wrong decisions denying motions to
the other hand, should the Third Circuit grant the requested writ, it will make
clear to district courts that they must require plaintiffs in securities class
actions to meet the stringent pleading standards of the Reform Act.
Third Circuit was the first appellate court to consider those pleading
standards at length. Plaintiffs allegations in Advanta, the case in
which that court did so, were extremely weak. As a
consequence, it is difficult to tell from Advanta to what extent, if
any, the Third Circuit’s interpretation of the Reform Act differ from the
interpretations set forth in Silicon Graphics and Greebel.
concludes that section (b)(2) “was intended to modify procedural requirements
while leaving substantive law undisturbed.” As a matter
of substantive law, Advanta holds, “it remains sufficient for plaintiffs
plead scienter by alleging facts ‘establishing a motive and an opportunity to
commit fraud, or by setting forth facts that constitute circumstantial evidence
of either reckless or conscious behavior.’” But, Advanta
opportunity, like all other allegations of scienter (intentional, conscious, or
reckless behavior), must now be supported by facts stated ‘with particularity’
and must give rise to a ‘strong inference’ of scienter. These heightened
pleading requirements address the previous ease of alleging motive and
opportunity on the part of corporate officers to commit securities fraud. . . .
After the Reform Act, catch-all allegations that defendants stood to benefit
from wrongdoing and had the opportunity to implement a fraudulent scheme are no
longer sufficient, because they do not state facts with particularity or give
rise to a strong inference of scienter.
concerns recklessness, Advanta reiterates the Third Circuit’s “previous
holding that it remains a sufficient basis for liability” and also reiterates
that the relevant definition of recklessness is that set forth in Sunstrand.
statements suggest the Third Circuit intends to interpret the Reform Act in
much the same fashion as have the First, Sixth Ninth and Eleventh Circuits,
except insofar as Advanta’s discussion of motive and opportunity may
suggest a slightly lower pleading threshold than those courts have adopted.
Plaintiffs in Cell Pathways did not allege, and the district court did
not find, motive and opportunity, so a decision by the Third Circuit in Cell
Pathways is not likely to clarify whether that court takes a different view
of those factors than do the other circuits. But Cell Pathways could
provide the Third Circuit with a useful vehicle to elaborate on how plaintiffs
can satisfy the Basis Requirement of section (b)(1), which Advanta notes
but does not discuss.
Article applauds the manner in which the First and Ninth Circuits have
interpreted the Reform Act’s pleading requirements and urges other courts to
adopt similarly stringent interpretations of sections (b)(1) and (b)(2). It
take that position because the author has become convinced that plaintiffs’
attorneys, prior to the passage of the Reform Act, regularly used “the
litigation process as a device for extracting undeserved settlements as the
price of avoiding the extensive discovery costs that frequently ensue once a
complaint survives dismissal.”
Requiring plaintiffs to meet more stringent pleading standards, I believe, is a
viable — and perhaps the best — strategy for dealing with that problem.
surely will argue that the Reform Act, as interpreted in Silicon Graphics
and Greebel, shortchanges society’s “interest in deterring fraud in the
securities markets and remedying it when it occurs,” which can be protected
only by providing investors who believe they are the victims of fraud an
opportunity to conduct discovery of those they suspect of having perpetrated
Viewed in a void, this argument no doubt has merit. Cases surely will arise in
which, as a consequence of the Reform Act’s pleading standards, frauds may go
that is beside the point. As Judge Newman recognized years ago, any pleading
standard, no matter how drafted, will result in some frauds going unremedied
and some undeserved settlements being extracted. The
relevant inquiry, at least from a policy point of view, is whether
the Reform Act, as interpreted in Silicon Graphics and Greebel,
gets the balance right.
short answer to that question is that it is far too early to tell. Little more
than a year has passed since the first group of appellate decisions
interpreting sections (b)(1) and (b)(2) were handed down. Prior to that time,
district courts had adopted a variety of different interpretations ofthe Basis and Strong Inference Requirements.
Many plaintiffs’ attorneys no doubt followed what they viewed as an
economically rational strategy: where publicly available information suggested
a fraud may have occurred, they incurred as little in the way of investigation
costs as possible in the hope that the court would deny defendants’ motion to
dismiss and they could then use discovery to search for evidence of fraud.
Moreover, uncertainty remains as to whether a number of circuits — including,
most notably, the Second — will interpret the Basis and Strong Inference
Requirements as do Silicon Graphics and Greebel.
a consequence, it probably will be many years before researchers will have
enough data to to determine with any degree of confidence whether the costs
generated by the Reform Act, measured in terms of unremedied frauds, outweigh
One possibility is that, if courts uniformly begin to demand more of
plaintiffs, plaintiffs’ attorneys will become more skillful at ferreting out
evidence of fraud or explaining how available facts support a strong inference
be sure, situations will arise where the facts available to potential
plaintiffs will stimulate strong suspicions that a fraud has occurred but will
not be sufficient to support the filing of a complaint that meets the
requirements of sections (b)(1) and (b)(2). We have
argued elsewhere that courts could allow a plaintiff to rely on the “undue
prejudice” exception to the Reform Act’s discovery stay to take limited
discovery in such situations, provided she is
able to show that
defendants control information critical to her claim and also [can] (i)
plead particularized facts sufficient to make out most elements of a claim of
securities fraud; (ii) show that she has made a diligent effort to obtain the
remaining information necessary to flesh out her claim; and (iii) convince the
court that she has reasonable grounds to believe that particularized discovery
will produce that information.
SG Cowen Sec. Corp. v. U.S. District Court, the Ninth
Circuit issued a writ of mandamus reversing a district court decision allowing
a plaintiff to take limited discovery where the district court found she had
met somewhat similar conditions. The appellate court reasoned that to allow a
plaintiff to take discovery in such circumstances would contravene Congress’
clear intent “that complaints in these securities actions should stand or fall
based on the actual knowledge of the plaintiffs rather than information
produced by the defendants after the action has been filed.”
Ninth Circuit’s reasoning seems flawed. Congress expressly provided that a
plaintiff should be allowed to conduct discovery where she could show “undue
and never discussed what it meant by that term. In
addition, the case on which the Ninth Circuit relied dealt with quite a different
issue: whether, in a district whose rules provide for “disclosure,” plaintiffs
in cases involving allegations of securities fraud routinely should be allowed
to compel defendants to make disclosure before courts ruled on defendants’
motion to dismiss.
SG Cowen court, however, may well have been influenced by more pragmatic
concerns. In proposing that plaintiffs be allowed, in carefully defined
circumstances, to rely on the undue prejudice exception to the discovery stay,
we recognized the danger that, were courts to begin to allow discovery in such
circumstances, every plaintiff who found she could not develop facts sufficient
to allow her to draft a complaint that would survive a motion to dismiss would
then claim “undue prejudice.”
Given the persistence with which some plaintiffs’ attorneys have continued to
base claims of securities fraud on “boilerplate allegations,”
the Ninth Circuit might well have feared that a decision that allowed
plaintiffs, even in sharply defined circumstances, to plead “undue prejudice”
would result in claims of undue prejudice being made in virtually every case in
which a district court granted defendants’ motion to dismiss.
any event, with or without the possibility of limited discovery, it will be
many years before anyone knows with any degree of certainty whether the Reform
Act’s pleading provisions serve society’s interests better than did the notice
pleading regime that preceded them.
noted in the text, an attorney experienced in prosecuting class actions
alleging securities fraud will appreciate that plaintiffs must show not only
that they incurred losses, but that (i) some earlier statement or statements
made by or on behalf of the potential defendant (“Defendant”) were materially
false or misleading at the time they were made —i.e., falsity —,
(ii) that Defendant or one or more of its senior officials issued the earlier
statements with an intent to deceive or defraud — i.e., scienter — and
(iii) that the earlier statements inflated the market price of Defendant’s
stock and thus contributed to or caused the losses investors have incurred — i.e.,
satisfy the falsity requirement, plaintiff must specify why Defendant’s
“earlier, cheerier” statements were false or misleading at the time they were
made. Under the Reform Act, plaintiff also must plead with particularity facts
sufficient to give rise to a strong inference that the “earlier, cheerier”
statements were issued with an intent to deceive or defraud.
most such situations, plaintiffs’ attorney will not know precisely what
information, if any, relating to the subsequently announced bad news was
available to Defendant and its senior officers at the time the earlier
statements were made, nor will it be easy for plaintiffs’ attorney to ascertain
whether Defendant or its senior officers were aware of or deliberately ignored
any such information. However, plaintiffs’ attorney generally will find it easy
to identify some earlier statements by Defendant or its senior officers that
discuss the subject to which the unanticipated “bad news” relates. Using facts
disclosed in “bad news” statements, together with facts available from other
public sources, plaintiffs’ attorney usually have become skilled at cobbling
together complaints that, on their face, alleges “facts” that virtually compel
the conclusion Defendant and its senior officers knew the “earlier, cheerier”
statements were materially false or misleading at the time they were made.
Corporation (“Acme”), a manufacturer of electronic widgets,has reportedquarter-to-quarter increases in sales and profits for 30
consecutive quarters. Following the third quarter of the current year, Acme
announces unexpected news: its sales for the quarter were flat, as compared to
the previous quarter, and its profits declined.c The price of Acme’s
stock drops by more than 50% following this announcement. Plaintiff’s attorney
L does a quick analysis of Acme’s business and history and concludes there are
reasonable grounds to believe that Acme’s sales and earnings began to flatten
out prior to the third quarter. L also estimates how much Acme’s sales and
earnings would have been in each of the prior two quarters had their declined
followed what L considers to be a more normal trajectory. Finally, L ascertains
from Acme’s filing with the SEC and other public sources that Acme’s four
largest customers are WW, XX, YY and ZZ.
this information in hand, L (after having been retained by one or more recent
purchasers of Acme stock) files a class action, on behalf of all persons who
purchased Acme stock subsequent to Acme’s announcement of its earnings for the
first quarter, alleging that Acme’s management has been aware for at least six
months of a decline in Acme’s sales and that, in an effort to mislead investors,
Acme knowingly issued financial statements for the first and second quarters
that included materially inflated statements of Acme’s revenues and income. L
supports these claims by including in the complaint the following
In each of the first and second quarters, Acme
deliberately shipped excessive amounts of widgets to its largest customers. In
many instances, Acme promised these customers that they would not have to pay
for the widgets unless and until they re-sold them. In other instances, Acme
actually shipped merchandise that had not been ordered by the customer.These customers included WW, XX, YY and ZZ.
Generally accepted accounting principles
required Acme to defer revenue recognition of income with respect to these
shipments until payment was received, but Acme instead reported these shipments
as sales in order to overstate its revenues and net income. This resulted in
Acme overstating its revenues, net income, and earnings per share for the first
and second quarters in [material dollar amounts that L derives by estimating,
in consultation with an expert accountant, what Acme’s revenues, net income,
and earnings per share would have been had Acme’s sales declined in accord with
Corporation (“Baker”) announces on April 2 that its earnings declined in the
first quarter from first quarter earnings for the previous year — the first
year-to-year decline in Baker’s history. Baker also states that the decline was
due, in large part, to disappointing sales, and resultant losses, at several
stores that Baker recently had opened. Following this announcement, the price
of Baker stock declines by 30%. Attorney L ascertains that during the past nine
months Baker had made several positive statements about its expansion program.
The most recent of these was issued on January 16: a Baker press release stated
that Baker’s expansion program “was going well” and that most of Baker’s
recently opened stores were “quite successful.” L also finds, in Baker’s most
recent Form 10-K, that during the previous 18 months Baker opened new stores in
WW, XX, YY and ZZ. Finally, in early June, L learns from a Baker press release
that Baker has decided in close its stores in YY and ZZ.
concludes that Baker must have been aware of problems at some of its new stores
before it issued the January 16 statement, given that problems probably were
evident at the end of the fourth quarter, in which Baker’s storestypically generate more than 50% of their
sales, and that Baker probably was aware of problems at some of those stores by
July 15 of the previous year, when Baker also issues positive comments about
its expansion program. Based on these beliefs, L (after having been retained by
an investor who purchased Baker stock between July 15 of the previous year and
April 2) files a class action, on behalf of all persons who purchased Baker
stock between July 15 and April 2, alleging that as of or prior to July 15,
Baker’s management was aware of developing problems at its four new stores and
that, in an effort to mislead investors, Baker deliberately issued materially
false and misleading statements concerning its expansion program. To support
this claim, L includes in the complaint an allegation that five senior mangers
of Baker, all of whom L names as defendants, received weekly, monthly and
quarterly reports that included information on the sales and profitability of
each of Baker’s stores and the following “particularized” allegations:
During the period [beginning 18 months before
April 2 and ending the previous April 2], Baker opened new stores in WW, XX, YY
and ZZ. Initial sales volumes of these newly opened stores were below levels
usually experienced by Baker at newly opened stores and below levels necessary
for the stores to achieve profitable operations. Recent store openings in WW,
XX, YY and ZZ were proceeding poorly and most of these units were losing money.
At least for the near term, Baker faced a major threat of eroding profits and
declining margins because of the size of the losses being suffered at Baker’s
newly opened stores, especially in YY and ZZ. Baker’s new stores in YY and ZZ
were performing very poorly and suffering significant losses that were
adversely affecting Price Company's overall results.
Prior to the beginning of the Class Period,
and throughout the Class Period, the defendant senior managers of Baker
received weekly, monthly and quarterly reports advising each of them of the
disappointing sales and losses incurred at the stores in WW, XX, YY and ZZ..
Prior to January 16, those managers also knew, or recklessly disregarded the fact,
that the losses Baker was incurring at its stores in YY and ZZ were so large
that it was apparent Baker would have to close those stores.
Corporation (“Charlie”) licences software. For a number of years, it has
reported steadily rising revenues and earnings. On August 6, Charlie issues a press release disclosing that it
is delaying release of its results for the year ended June 30 pending
completing of its year-end audit. Charlie further discloses that it has
expanded its audit to include a detailed review of orders generated by its
United Kingdom (“UK”) subsidiary in the UK and other foreign countries after
discovering letters setting forth conditions to approximately $4 million in
orders that Charlie was not aware of when it recognized revenues from those
orders. Following this disclosure, the price of Charlie stock dropped from
$18.50 to $11.875.
month later, Charlie issues its Form 10-K for the fiscal year, in which it
discloses that in the course of the year-end audit it discovered side letters
issued by personnel at Charlie’s UK subsidiary that “set forth conditions to
certain foreign orders in violation of the Company’s revenue recognition
policies.” These letters related to approximately $6.9 million in revenues that
Charlie improperly recognized, some of which had been recognized in “prior
quarters and years.” The Form 10-K also reports that Charlie’s fourth quarter
revenue, as reported, was about 7% below that in the previous year, that
Charlie’s total revenue for the year increased 9.8%, but that Charlie incurred
a pre-tax loss of $13.7 million or the year, as compared to a pre-tax profit of
$2.1 million in the prior year. The Form 10-K further states that Charlie was
not restating any prior period results, that Charlie found no violations of its
revenue recognition policies in connection with U.S orders, and that Charlie
has taken “corrective actions . . . including management changes, personnel
terminations and other disciplinary actions and the establishment of new orders
L checks Charlie’s filings with the SEC and ascertains that Charlie’s chief
executive officer sold about $2.5 million in Charlie stock during the year
prior to the August 6 announcement and that three other Charlie executives sold
a total of about $1.8 million in Charlie stock during the same period. The last
of these sales, however, occurred almost two months before the August 6
announcement. Charlie also meets with an accounting expert and is advised that,
when contingent sales occur, a company’s accounts receivable usually build up
somewhat more rapidly than will its revenues because no payments will be
received with respect to the contingent sales until the contingencies have been
satisfied. A variety of financial reports usually will reflect this build up in
on this information, L (after having been retained by an investor who recently
purchased Charlie stock) files a class action on behalf of all persons who
purchased Charlie stock between the date Charlie issued its financial results
for the prior year and August 6. The complaint names as defendants Charlie and
the four executives who sold Charlie stock, details the sales of Charlie stock
by those defendants and alleges that Charlie and those defendants were parties
to a scheme to falsify Charlie’s revenues and profits during the class period .
The complaint further alleges:
Throughout the Class Period, defendants
entered into and were parties to a scheme to falsely inflate Charlie’s reported
annual and quarterly revenues and profits by agreeing that certain conditions
would be included in side letters with certain customers who had ordered
software licences from Charlie. In furtherance of this scheme, Defendants
reported the revenues, and hence the profits, from these licences despite that
fact that, because of the conditions in the side letters, recognizing those
revenues was a violation of both Charlie’s revenue recognition policies and
Generally Accepted Accounting Principles.
Charlie and the individual defendants were
aware of the side letters or were recklessly indifferent to “red flags”
indicating that the side letters had been issued and that revenues from
substantial amounts of contingent sales had improperly been recognized. In
and the individual defendants received monthly and quarterly reports that
disclosed increasing accounts receivable resulting from the phony sales over
and the individual defendants received and monitored payment schedules from
Charlie’s accounts receivable so that they could estimate the amount and timing
of cash collections and also received accounts receivable aging schedules to
assess the necessary level of reserves for uncollectible accounts. These reports
disclosed that the accounts receivable from the phony sales were delinquent for
extended periods of time and were not being collected.
Exchange Act of 1934, §21D(b)(1), 15 U.S.C. § 78u-4(b)(1) (2000) (hereinafter
referred to as “section (b)(1)”). This portion of section (b)(1) essentially
duplicates Fed. R. Civ. P.9(b)’s
requirement that a plaintiff plead with particularity the circumstances
Exchange Act of 1934, §21D(b)(2), 15 U.S.C. § 78u-4(b)(2) (2000) (hereinafter
referred to as “section (b)(2)”). The statute uses the term “the required state
of mind” but, in the case of an action brought under section 10(b) and Rule
10b-5, the required state of mind is “scienter.” See Ernst & Ernst v.
Hochfelder, 425 U.S. 185, 199, 96 S.Ct. 1375, 1383 (1976).
Exchange Act of 1934, §21D(b)(3)(B), 15 U.S.C. § 78u-4(b)(3)(B) (2000)
(hereinafter the “discovery stay”). The discovery stay provision provides for
an exception if “the court finds upon motion of any party that particularized
discovery is necessary to preserve evidence or to prevent undue prejudice to
that party.” Id. Apart from this exception, discussed in text at notes
233-238, below, courts uniformly have interpreted section 21D(b)(3)(B) to
preclude plaintiff from conducting discovery prior to the time a motion to dismiss
is filed. See id .
Robert Giuffra, Jr., Pleading Scienter Under the PSLRA, N.Y.L.J. 5
(7/22/99) (Mr. Giuffra is identified as “a principal drafter of the PSLRA.”);
Matthew Roskoski, A Case-By-Case Approach to Pleading Scienter Under the
Private Securities Litigation Reform Act of 1995, 97 Mich. L.Rev. 2265 (1999); Marilyn F.
Johnson, Karen K. Nelson & Adam C. Pritchard, In re Silicon Graphics
Inc.: Shareholder Wealth Effects Resulting from the Interpretation of the
Private Securities Litigation Reform Act's Pleading Standard, 73 So. Cal. L. Rev. 276 (2000). The
principal prior exception to this trend is Miranda S. Schiller & Haron W.
Murage, “Information and Belief” Pleading Under the Reform Act, 8 Sec. Reform Act Litig. Rep. 8 (Oct.
1999); see alsoSymposium: Securities Fraud Litigation After Silicon
Graphics, 7 Sec. Reform Act Litig. Rep.
798, 807-811 (Aug.-Sept. 1999) (discussion of the Basis Requirement, including
remark of Bruce G. Vanyo, Esq., counsel for defendants in Silicon Graphics,
to the effect that court’s ruling on that requirement “is the more significant
part” of its decision).
 I exclude
from this list the question of whether the PSLRA should be interpreted to
preclude liability based on recklessness in all suits brought under section
10(b) and Rule 10b-5.As a number of
courts have held, the language of the PSLRA clearly is directed at establishing
a pleading standard, not changing the substantive definition of “scienter.”
Thus, although the question of whether recklessness can constitute scienter
remains unresolved at the Supreme Court level, see Ernst & Ernst v.
Hochfelder, 425 U.S. at 194 n.12, it has always seemed clear to me that the
PSLRA could not reasonably be interpreted to abolish liability for reckless
conduct. See Elliott J. Weiss & Janet E. Moser, Enter Yossarian: An
Approach to the Procedural Catch-22 that the Private Securities Litigation
Reform Act Creates, 76 Wash. U. L.Q.
457, 466 n.47 (1998) (hereinafter “Yossarian”). In fact, Congress’s
adoption of an actual intent standard in certain circumstances, see, e.g.,
§ 21E of the Securities Exchange Act of 1934, as amended, 15 U.S.C. §78u-5
(1999), can be read as an implicit Congressional endorsement of the uniform
holdings of the courts of appeals that a high degree of recklessness qualifies
as scienter. See Greebel v. FTP Software, Inc., 194 F.3d 185, 200-201 (1st
 In an
earlier article, I suggested that the First Circuit’s pre-Reform Act
jurisprudence concerning pleading securities fraud could serve as a model for
other Circuits when applying the Reform Act’s new pleading requirements. See
Elliott J. Weiss, The New Securities
Fraud Pleading Requirement: Speed Bump or Road Block?, 38 Ariz.
L. Rev. 675, 695-699 (1996) (hereinafter “Speedbump”).
 I have
previously discussed this issue in Speedbump, supra note 26, and Yossarian,
supra note 16. Ongoing study has enhanced my understanding of the
pleading issues involved in securities fraud litigation and has led me to
modify (or, more charitably, to improve and refine) my thinking about these
 Although a
few such cases involve claims relating to positive corporate developments, see,
e.g., Basic Inc. v. Levinson, cite, the vast majority involve claims that
corporations have misrepresented or failed to disclose bad news.
re Glenfed, Inc. Securities Litig., 42 F.3d 1541, 1549 (9th
Cir. 1994) (en banc).
 The courts
have uniformly rejected complaints that allege no more than “fraud by
hindsight.” See Denny v. Barber, 576 F.2d 465, 469-70 (2d Cir.1978)
(Friendly, J.); DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir.), cert.
denied, 498 U.S. 941 (1990); Greenstone v. Cambex Corp., supra, at
25-26; Glenfed, supra, 42 F.3d at 1549.
 In my
experience, persons unfamiliar with securities fraud litigation often find it
difficult to appreciate the relative ease with which a skilled and experienced
plaintiff’s attorney can draft such a seemingly particularized complaint.
Consequently, in Appendix A I set forth three illustrative examples, two based
in pre-PSLRA Ninth Circuit decisions holding that such complaints should not be
dismissed and one based on a post-PSLRA decision dismissing such a complaint.
article in Fortune illustrates how
the most prominent plaintiffs’ firm specializing in prosecuting securities clas
actions has used such complaints to secure lucrative settlements.
Lerach is explaining what he needs to file one of his infamous shareholder
class_action lawsuits: ‘Stock drops. Insiders trading. A revelation of bad
news. You're not going to have that and come up dry. It's not going to happen.’
. . . His rationale is that his long experience has given him an unerring
instinct for corporate wrongdoing. ‘It's almost like having X_ray vision,’ he
boasts. ‘I'm almost always right. I'm seldom wrong.’ Then, once Lerach is
allowed to begin discovery__and search for damning internal documents__well, at
that point, the game is pretty much over. ‘You can always find a document to
incriminate them,’ he says.
Peter Elkind, The King of Pain is Hurting, Fortune, Sept. 4, 2000, at 190.
discussion that follows relates to the First Amended Consolidated Complaint
(10/17/96), In re Silicon Graphics, Inc. Sec. Litig., Lead Case No.
C-96-0393-FMS (N.D. Cal.) (hereinafter “SGI FAC”), avail. <http://securities.stanford.edu/complaints/sgi/96cv00393/068.html>.
complaint was drafted by the San Diego office of Milberg Weiss Bershad Hynes
& Lerach LLP, which clearly ranks among the most skilled and experienced
offices of plaintiffs’ attorneys in the United States.
 But if SGI
did become aware of the nature and magnitude of the problems with the ASIC chip
until shortly before its January 1996 announcements, this entire house of cards
text at notes 21-23, supra;183
F.3d at 997-1001 (Browning, J., dissenting).
 I say “left
open the door” because two pre-Reform Act Ninth Circuit decisions, Fecht v.
Price Co., 70 F.3d 1978 (9th Cir. 1995), and Cooper v. Prickett, 122
F.3d 1186 (9th Cir. 1997), held that complaints based on unsupported
allegations similar to those made by plaintiffs in Silicon Graphics
satisfied the particularity requirement of Fed. R. Civ. P.9(b). We have previously argued that those
cases were wrongly decided. See Yossarian, cited in note __, at __, n.–.
Yourish v. California Amplifier, 193 F.3d 983, 992-998 (9th Cir. 1999),
a post-Reform Act case that was decided after (but does not cite) Silicon
Graphics, appears to reverse Fecht and Cooper’s
interpretation of Rule 9(b) without explicitly stating that it is doing so.
 These were
just the kind of speculative claims Congress sought to discourage when it
passed the Reform Act. See text at notes 4-5, above.
 The approach
to pleading fraud followed by plaintiffs’ attorneys in Silicon Graphics
is alsoeconomically attractive, in
that it allows those attorneys to draft a complaints on the basis of readily
available information. See, generally, John C. Coffee, Jr., Understanding
the Plaintiff’s Attorney: The Implications of Economic Theory for Private
Enforcement of Law Through Class and Derivative Actions, 86 Colum. L.Rev. 669 (1986).In this
regard, it is notable that the Silicon Graphics plaintiffs’ description
of the basis for their allegations includes no mention of interviews with
current or former SGI employees or other, similar, investigatory activity. See
SGI FAC ¶96, discussed in text at notes 39-42, above.
 183 F.3d at
985. Although the compliant before the court was filed on behalf of several
named plaintiffs, see SGI FAC ¶25, the court discussed it as if it had
been filed only by Deanna Brody, who filed the first complaint against SGI. See
183 F.3d at 979 et seq.
(Citation omitted.) Note that the court relies on an amalgam of sections (b)(1)
and (b)(2). The last quoted statement suggests that the complaint should be
dismissed because it fails to give rise to a strong inference of scienter, but
the reason the complaint fails to do so lies in plaintiffs’ failure to meet the
e.g., Ruskin v. TIG Holdings, Inc., 2000 WL 1154278 at *2-*3 (S.D. N.Y.
8/14/00) (citing plaintiffs’ quotation of memoranda prepared by officers of
 Under Reform
Act § 21D(c), 15 U.S.C.A. §78u-4(c), a plaintiff and her attorney who quoted a
non-existent document in a complaint, in violation of Rule 11(b), could be held
liable for all defendants’ reasonable attorneys’ fees and other expenses.
 Who, in turn
may claim have seen the document or to have been told of its contents by
 The court
also seemed to appreciate that this problem is pervasive. It noted that the
district court had taken “judicial notice of five securities class action
complaints filed in United States District Courts that contain the same
boilerplate allegations of ‘negative internal reports’”. Silicon Graphics,
183 F.3d at 984, n.13.
Heliotrope General, Inc. v. Ford Motor Co., 189 F.3d 971, 979 (9th
Cir. 1999) (relying on Silicon Graphics’ interpretation of the Basis
Requirement to grant defendants’ motion for judgment on the pleadings with
respect to a complaint that the trial court, in a pre-Silicon Graphics
decision, had refused to dismiss).
(b)(2) requires plaintiff in a private action for money damages to “state with particularity
facts giving rise to a strong inference that the defendant acted with the
required state of mind.” (Emphasis added).
 The six
decisions, all of which consider this issue in relation to actions under
section 10(b) and Rule 10b-5, are (in the order in which they were decided) In
re Advanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999) (hereinafter “Advanta”);
In re Comshare, Inc. Sec. Litig. 183 F.3d 542 (6th Cir. 1999)
Graphics; Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir.
1999) (hereinafter “Avado”); Greebel; and Novak v. Kasaks,216
F.3d 300 (2d Cir. 2000).
Aaron v. Securities & Exchange Comm’n., 446 U.S. 680, 686 n.5 (1980);
Herman & MacLean v. Huddleston, 459 U.S. 375, 378 n.4 (1983).
Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568 n.6 (9th Cir. 1990), cert.
denied, 499 U.S. 976 (1991) (citing cases from 11 circuits).
Sunstrand Corp. v. Sun Chemicals Corp.,
553 F.2d 1033, 1044-45 (7th Cir.), cert. denied, 434 U.S. 875 (1977),
was the first appellate decision to adopt this definition.The Seventh
Circuit squared its holding with Hochfelder by describing such
recklessness as “the functional equivalent of intent.” Id. at 1045. The
Ninth Circuit recently adopted the Sunstrand definition in Hollinger,
914 F.2d at 1569.Other Circuits adopted it in Hackbart v. Holmes, 675
F.2d 1114, 1118 (10th Cir.1982);SEC v.
Carriba Air, Inc., 681 F.2d 1318, 1324 (11th Cir.1982);Broad v. Rockwell Int'l Corp., 642 F.2d 929,
961_62 (5th Cir.), cert. denied, 454 U.S.965 (1981);McLean v. Alexander, 599 F.2d 1190, 1197_98
(3d Cir.1979);Mansbach v. Prescott,
Ball & Turben, 598 F.2d 1017, 1025 (6th Cir.1979);Cook v. Avien, Inc., 573 F.2d 685, 692 (1st
Cir.1978); and Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 46_47 (2d
Cir.), cert. denied, 439 U.S. 1039 (1978).
involved an appeal from a judgment entered after trial. Hollinger, the
case in which the Ninth Circuit adopted the Sunstrand standard, involved
an appeal of a decision granting a motion for summary judgment.
Glenfed, Inc. Sec. Litig., 42 F.3d 1541, 1547 (9th Cir. 1994) (en banc) (holding
that a plaintiff may aver scienter
“simply by saying that scienter existed.”)
 Beck v.
Manufacturers Hanover Trust Co., 820 F.2d
46, 50 (2d Cir. 1987, cert. denied, 484 U.S. 1005 (1988), first
set forth this requirement.
Shields v. Citytrust Bancorp, 25 F.3d 1124, 1128 (2d Cir. 1994) (referring to
Rule 9(b)’s relaxed specificity requirement for scienter).
187 F.3d at 1286; In re Baesa Sec. Litig., 969 F.Supp. 238, 242, n.3
(S.D.N.Y. 1997) (both recognizing inconsistencies in the
Second Circuit’s application of its “strong inference” test). See also
Roskoski, cited in note 14, above, 97 Mich.
L. Rev. at 2273 (distinguishing between the pleading “standard” used by
the Second Circuit and the two “tests” that court employed to determine whether
a plaintiff had met that standard).
 Judge Ralph
Winter wrote a spirited dissent supporting defendants’ claim.See
Time Warner, 9 F.3d at 272 (Winter, J., dissenting).
 This is
especially so because whether Time Warner had a duty to update its prior
statements concerning its plans to raise additional capital itself posed a
close question. See San Leandro Emergency Med. Plan v. Phillip Morris
Cos., Inc., 75 F.3d 801, 810 (2d Cir. 1996) (hereinafter “San Leandro”)
(“Time Warner went nearly to the outer limit of the line that separates
disclosable plans from plans that need not be disclosed”); Kalnit v. Eichler,
85 F.Supp.2d 232 (S.D.N.Y. 1999) (holding complaint did not create a strong
inference of scienter because facts defendants allegedly failed to disclose
were, at best, of marginal materiality); Speedbump, supra note
26, at 688-90 (arguing that whether an issuer clearly has a duty to disclose
facts is relevant to inference of scienter).
 Note, too,
that Comshare and Silicon Graphics adopt the same approach to
evaluating claims that sales by insiders support an inference of scienter. Both
place on plaintiff the burden of pleading facts that demonstrate not simply
that insiders sold stock at prices influenced by the alleged fraud, but that
the insiders’ sales, viewed in context, were unusual and suspicious. See
Comshare, 183 F.3d at ___; Silicon Graphics, 183 F.3d at 986 (“Among
the relevant factors to consider are:(1) the amount and percentage of shares sold by insiders;(2) the timing of the sales;and (3) whether the sales were consistent
with the insider’s prior trading history.”)
Greebel, 194 F.3d at 197 (“Our view of [section (b)(2)] is thus close to
that articulated by the Sixth Circuit.”); Avado, 187 F.3d at 1283 (“[W]e
are in basic agreement with the Sixth Circuit;we hold that the Reform Act does not prohibit the practice of alleging
scienter by pleading facts that denote severe recklessness, the standard
previously approved of by this Circuit, . . . but we also hold that the Reform
Act does not codify the ‘motive and opportunity’ test formulated by the Second
Circuit.”) Greebel also takes essentially the same approach to
allegations of insider trading. See Greebel, 194 F.3d at 206-207; note
82 above. Avado does not explicitly address insider trading.
Second Amended Complaint, ¶ 45 , received as an attachment to a facsimile dated
Aug. 2, 1999, from Sanford Dumain, Esq., counsel for plaintiffs, to Elliott
Weiss, in which Mr. Dumain identified paragraph 45 as “the only specific
reference to ‘white out’” in the Second Amended Complaint.
at 372. The court did not issue an opinion explaining its decision. At a
subsequent hearing, it stated that it was the white out allegation “that saves
[plaintiffs] from the Motion to Dismiss.” Greebel v. FTP Software, Inc., No.
98-2194 (1st Cir.), Appendix, Vol. 5 (hereinafter (“Greebel
Appendix”), 1190 (Transcript of hearing, Apr. 29, 1997). See, also,
182 F.R.D. at 373. At the hearing on defendants’ motion to dismiss, defendants’
counsel pressed the court to dismiss the complaint on grounds other than plaintiffs’
failure to specify the basis for their “white out” allegation. See Greebel
Appendix at 1147-48 (Transcript of hearing, Feb. 4, 1997).
Appendix” at 1187 (Transcript of hearing, Apr. 29, 1997).
at 1191. The court added: “I mean, filing a lawsuit should be the last thing
you do, not the first thing you do.” Id.
at 1196. At a hearing held six weeks later, the court reiterated this
instruction after plaintiffs produced a list of seven witnesses, six of whom
were defendants. Id. at 1200 (Transcript of hearing, June 19, 1997).
at 1210-11 (Transcript of hearing, July 31, 1997).
quoting Romani v. Shearson Lehman Hutton, 929 F.2d 875, 878 (1st Cir.1991). The
court also included in its opinion the following statement from Hayduk v.
Lanna, 775 F.2d 441, 444 (1st Cir. 1985):
‘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.’
See Greebel, 194 F.3d at 193.
at 194.Two other circuits, in
decisions involving claims of securities fraud filed before the Reform Act
became effective, also had interpreted Rule 9(b) to require plaintiffs to
specify the basis for allegations made on information and belief. See In
re Healthcare Compare Corp. Sec. Litig., 75 F.3d 276, 281-82 (7th
Cir. 1996); Parnes v. Gateway 2000, Inc., 122 F.3d 539, 550 (8th
at 195-96 (emphasis added; citation to Conley v. Gibson omitted).
at 196, n.9. The court also discusses the fact that “[t]he device of effecting
policy-based change through adjustments in procedural or evidentiary rules is
not new, nor is it unique to Congress.” Id.
counsel, Mr. Dumain, first told the court: “I will tell you that she will
testify that she was told it happened, and she will identify the persons.”Greebel Transcript at 1209
(Transcript of hearing, April 29, 1997). Mr. Dumain later suggested that “every
time we have asked her to tell us who at the company” spoke to her, Ms. Nichols
was unwilling to do so. Id. at 1214.
The courtpoints out that the only
relevant fact plaintiffs have adequately alleged is that FTP fired, some time
before the class period, an employee who refused to sign for the “returned”
goods. That fact alone, the court holds, may be relevant to but does not
sufficiently support for plaintiffs’ claim, made on information and belief,
that the “warehousing” continued into the class period. See id.
for example, these issues in relation to the following paragraph in the
Consolidated Amended Class Action Complaint in In re Sunbeam Securities
Litigation, 89 F.Supp.2d 1326 (S.D.Fla. 1999):
138.An article in Barrons stated:
engaged in bill-and-hold transactions in other product lines, too, according to
a number of people in the appliance industry. In the second quarter, for example,
Sunbeam booked a sale and ‘shipped’ some $10 million of blankets to a warehouse
it had rented in Mississippi near its Hattiesburg distribution center. They
were held there for some weeks for Wal-mart. The Company also pumped millions
of dollars of goods into several national small-appliance distributors on such
easy payment terms as to call into question whether a sale ever took place.
Some with knowledge of Sunbeam’s business practices say the appliance maker in
some instances transferred title for the goods to distributors but then agreed
to not only delay payment but actually pay the distributors what amounted to a
storage for taking the goods. These sources also said that in some cases
distributors also had the right to return the items to Sunbeam without
suffering any loss.
at 204.I term the question “sticky”
because the court had no easy way to answer it.If Greebel had held that the district court should have
considered that evidence, plaintiffs who knew they could not satisfy the Basis
Requirement might have been tempted to “manufacture” bogus sources for critical
allegations they made on information and belief, in the hope that, that through
discovery, they would be able to find evidence of fraud (and thus avoid the
sanctions under Rule 11). On the other hand, if Greebel had concluded
that district court properly refused to consider evidence plaintiffs had
discovered and that that evidence created or might have created) a strong
inference of scienter, the court effectively would have acknowledged that the
Reform Act may shield from prosecution likely instances of securities fraud. CompareIn re Southern Pac. Funding Corp. Sec. Litig., 83 F.Supp.2d 1172 (D.
Ore. 1999) (denying renewed motion to dismiss and allowing plaintiffs to rely
on fruits of discovery, obtained after court’s original decision denying motion
to dismiss, which was inconsistent with Silicon Graphics but issued
prior to time Silicon Graphics handed down).
stuffing’ means inducing purchasers to increase substantially their purchases
before they would, in the normal course, otherwise purchase products from the
company. It has the result of shifting earnings into earlier quarters, quite
likely to the detriment of earnings in later quarters.” Id. at 202.
at 203, n.16 (citing cases). Greebel contrasts these with a post-PSLRA
district court decision, Lirette v. Shiva Corp., 27 F.Supp.2d 268, 282-83
(D.Mass.1998), that holds allegations of channel stuffing are not sufficient to
create a strong inference of scienter.
at 205. As concerns another set of transactions, where plaintiffs’ submitted
documents indicating FTP improperly booked a $138,078 transaction was as a sale
and booked as sales in September two transactions, totaling $548,192, that
remained largely unpaid as of December 31, 1995, Greebel appears to
disregard the first as inconsequential and holds, as to the others: “The mere
existence of an overdue receivable does not support an inference that the
original transaction was booked as a sale in violation of GAAP.” Id. at
at 206 (footnote omitted). The court contrasts this with a case on which
plaintiff produced evidence of a questionable sale that accounted for $5
million of a corporation’s $9 million in quarterly revenues. Id., n.18.
holding that plaintiffs’ allegations relating to insider trading also do not
support a strong inference of scienter. See id. at 206-07.
to the time this Article was written, defendants in Novak petitioned the
Supreme Court for a writ of certiorari. See Kasaks v. Novak, Petition
for Writ of Certiorari, No. 00-432 (Sept. 15, 2000).
Pathways at *1; Petition of Cell Pathways, Inc., Bob Towarnicki and Rifat
Pamukcu for Writ of Mandamus, In re: Cell Pathways, Inc. Sec. Litig.,
Master File No. 99-752 (E.D. Pa. 5/24/00) (hereinafter “CPI Petition”).
Complaint for Violation of the Securities Exchange Act of 1934, Novack v.
Kasaks, 96 Civ. 3073 (AGS) (S.D.N.Y. Apr. 9, 1998) (hereinafter “Novak
Amended Complaint”) ¶ 1.
fiscal year ended on the Saturday closest to January 31 of the following
calendar year. Thus, FY 1994 ended on January 28, 1995, Novak Amended
Complaint, ¶ 9(d), and FY 1995 started January 29 1995.
Jennifer L. Brady & Thomas J. Ryan, First quarter slump for The Limited,
Nordstrom, Ann Taylor, WWD 1,
1995 WL 8304453 (5/10/95). AnnTaylor, which had turned in a standout
performance in the highly competitive women’s fashion industry in FY 1994. Id.
 Novak v.
Kasaks, Complaint for Violation of the Securities Exchange Act of 1934, 96 CIV.
3073 (S.D.N.Y. 4/24/96) (hereinafter “Novak Original Complaint), avail.
Amended Complaint, ¶31. Paragraphs 31-32 of plaintiffs’ Amended Complaint
describes the alleged “‘Box & Hold’ scheme” as follows:
31.Prior to and throughout the Class Period,
AnnTaylor had accumulated huge amounts of excessive merchandise inventories
beyond the levels internally budgeted or planned for by defendants which had
not been marked-down and disposed of through the Company’s stated markdown and
Factory store clearance process.To
hide this serious problem from the marketplace and the investing public and to
avoid large write-downs and liquidation of the excessive inventories and
thereby artificially inflate AnnTaylor’s reported profits and margins and
future earnings estimates, defendants engaged in an elaborate “Box & Hold”
scheme, whereby millions of dollars of excessive and nearly worthless
inventories were stored in two secret warehouse locations throughout the Class
Period.Rather than write-down and
liquidate these excessive inventories which had not been sold (and which
AnnTaylor’s Factory stores would not accept for sale due to their own excess
inventory problems), prior to the start of the Class Period, defendants set up
a procedure whereby the inventory would be “Boxed” in cartons and removed from
AnnTaylor stores and shipped to two secret warehouses to “Hold” for later
disposition.As part of this scheme,
“Box and Hold” labels were sent to each AnnTaylor store which were affixed to
the outside of the cartons that were shipped to the warehouses on a regular basis.This procedure also alleviated the pressure
on the individual AnnTaylor stores which were overburdened with inventories and
did not have the space to store out of season and outdated merchandise.
32.Initially, and before the start of the Class
Period, AnnTaylor’s insiders hoped that the Company would be able to dispose of
and sell such excess inventory later, through reduced prices at AnnTaylor
Factory (clearance) stores.However,
this never happened.Box and
Hold inventories grew out of control by the start of the Class Period, with
AnnTaylor having accumulated, approximately $6 million of excessive and nearly
worthless Box & Hold inventory by February 2, 1994, including out-of-season
goods from as far back as 1992!This
Box & Hold inventory (which continued to grow at an alarming rate) remained
inside of the Box and Hold warehouses throughout the Class Period, without
write-down or disposition, in part because the AnnTaylor Loft and Factory
stores . . . had their own serious problems with excess inventories and refused
to accept excess AnnTaylor stores inventory for clearance sales.
sued both AnnTaylor and individuals associated with it (the “AnnTaylor
defendants”) and Merrill Lynch and individuals associated with it (“Merrill Lynch
defendants”). The latter group eventually settled with plaintiffs for $3
million, which represents a very small percentage of the damages claimed. SeeSecurities Class Action Alert
(Nov. 1999) at 28.
 Novak v.
Kasaks, 997 F.Supp.2d 425, 431 (S.D.N.Y. 1998) (“Novak I”). The court
This deficiency is particularly striking
where the target of the allegations is conceded to be ‘a specialty retailer of
women's apparel, shoes, and accessories’;a company engaged in a business that is affected by considerations of
fashion and taste. In effect, AnnTaylor was necessarily involved in the
generation of inventory based upon predictions as to product that was expected
to sell at a particular time or season
(citations to original complaint omitted). The court also observed that
“counsel for the AnnTaylor defendants stated at oral argument that AnnTaylor
does, in fact, transfer merchandise to warehouses on a seasonal basis, that
some of this merchandise is ultimately sold at less than full price, and that
the value of this inventory is written down on the books as markdowns are
taken.”Id. at 432.
asserted that the allegations in the original complaint were “based upon the
investigation of their counsel, which included a review of AnnTaylor's SEC
filings, securities analysts reports and advisories about the Company, press
releases issued by the Company, media reports about the Company and discussions
with consultants. . . .” Novak Original Complaint, ¶ 138. I call this an
“umbrella description” because plaintiffs made no effort to tie specific
allegations to specific sources.
¶ 34. I say seemingly on the basis of the January 22, 1996 report for two
reasons. First, plaintiffs do not state the basis for paragraph 34. Second, the
categories of information in the alleged “Weekly Reports” described in that
paragraph closely tracks the categories of information plaintiffs allege are
found in the January 22, 1996 report.
at 662 (footnote added). The court’s statement that this information has “no
relevance” may go too far. It seems more accurate to say (as did Greebel)
that, especially in light of the seasonality of AnnTaylor’s business and its
sensitivity to fashion trends, the fact that AnnTaylor had this amount of Box
and Hold inventory eight months after the end of the class period might have
some probative value, “[b]ut that value is weak.” See text at note ___,
The court also observed that it “is unable to ascertain the meaning” of
plaintiffs’ claim that the January 22, 1996 Box and Hold inventory consists
“primarily” of 1993 and 1994 class period merchandise.Id.
 The court
might also criticize paragraph 35 on the ground that plaintiffs do not
attribute specific statements to identified defendants. See [cite cases
requiring such identification].
Plaintiffs do not expressly allege that any participant in the alleged
discussions stated or admitted that the Box and Hold inventory “was nearly
also makes clear that had plaintiffs disclosed they based paragraph 35 on
hearsay statements by a former AnnTaylor employee, or similarly unreliable
“facts,” the court would have been justified in granting defendants’ motion to
 In Press v.
Chemical Invest. Servs. Corp., 166 F.3d 529, 538 (2d Cir.1999), the Second
Circuit characterized the Reform Act’s pleading requirement, without
discussion, as embodying that court’s pre-Reform Act case law. Novak
characterizes Press’s statement as dicta. Novak, 216 F.3d at 310.
 As concerns
motive, the court states that “in the ordinary case, adequate motive arose from
the desire to profit from extensive insider sales.” Id. at 308. It
describes intentional misconduct as “encompass[ing] deliberate illegal
behavior, such as securities trading by insiders privy to undisclosed and
material information or knowing sale of a company’s stock at an unwarranted
discount.” Id. (citations omitted).
 Although it
does not attribute that standard to Sunstrand. See id.
 As does
Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 47 (2d Cir. 1978)
(hereinafter “Rolf”). See Novak, 216 F.3d at 308.
Novak, 216 F.3d at 308. The first, Cosmas v. Hassett, 886 F.2d 8, 12 (2d
Cir.1989), does not discuss scienter on the page Novak cites. When
Cosmas does address scienter, it upholds the complaint at least in part
because plaintiffs’ allegations “do establish a motive.” Id. at 13. The
second, Goldman v. Belden, 754 F.2d 1059, 1070 (2d Cir.1985), held that “Rule
9(b) allows intent and knowledge to be alleged generally. . . .”
216 F.3d at 309 (emphasis added). The first part of the quoted statement
obviously uses the language of negligence; the second part is ambiguous. Moreover,
the first case Novak cites in support of this statement, Rolf,
570 F.2d at 47-48, also found that plaintiff adequately alleged defendants had
a motive to ignore material facts.
311 (emphasis added; internal cross-citations omitted). In the first part of
the quoted paragraph, the court may have been referring to the distinction
Roskoski notes between its pre-PSLRA “standard” and the “tests” is used to
determine whether a plaintiff had met that standard. See note 71, above.
An additional indication of the sloppiness of the court’s opinion is that the
statements it purports to relating to AnnTaylor’s first quarter FY 1995 report,
see id., in fact represent plaintiffs’ unattributed allegations
concerning statements some unidentified speaker (“AnnTaylor”) made to analysts.
See Novak Amended Complaint, ¶ 92.
Jennifer L. Brady, April sales brought letdown for stores; Easter didn’t
help, WWD 2 (May 5, 1995),
1995 WL 8304420 (reporting that several major women’s clothing retailers
reported “disheartening” Easter results).
additional flaw in Novak is its conclusion that plaintiffs’ allegations
concerning statements allegedly made to analysts by the AnnTaylor defendants
“were sufficiently detailed to meet the pleading threshold because generally
the circumstances of the statements-- including dates and participants--were
particularized.” Id. at 314. The court cites Acito v. Imcera Group,
Inc., 47 F.3d 47, 51 (2d Cir 1995), in support of this proposition. But that
case does not address the issue of when statements allegedly made to analysts
can be attributed to an issuer.
216 F.3d at 313-14 (footnote omitted). In a footnote, the court astutely
(b)(1) is strangely drafted. Reading ‘all’ literally would produce illogical
results that Congress cannot have intended. Contrary to the clearly expressed
purpose of the PSLRA, it would allow complaints to survive dismissal where
‘all’ the facts supporting the plaintiff’s information and belief were pled,
but those facts were patently insufficient to support that belief. Equally
peculiarly, it would require dismissal where the complaint pled facts fully
sufficient to support a convincing inference if any known facts were omitted.
Our reading of the provision focuses on whether the facts alleged are
sufficient to support a reasonable belief as to the misleading nature of the
statement or omission.
interpretation that follows is influenced by the organization of Novak.
Several of the court’s statements therein make more sense when viewed in
relation to the headings of the sections of the opinion in which they appear,
then they do when compared to seemingly inconsistent statements in other
sections of the opinion.
Admittedly, the court states, as part of this holding, that plaintiffs’
allegations satisfy “the requirement of the PSLRA that plaintiffs state facts
with particularity that give rise to a strong inference of the required state
of mind.” See text at note ___, above. However, that statement conflicts
with the court’s disposition of plaintiffs’ appeal. In addition, this statement
is made in the section of Novak that addresses only the substantive
standard established by that § 21D(b)(2). Thus, the best reading of Novak,
in my view, is that the court did mean the quoted statement to represent a holding
that plaintiffs had pled recklessness with the particularity required by
sections (b)(1) and (b)(2).
assumption seems reasonable because plaintiffs probably either believe that
they have already set forth a valid claim or no additional facts that will
support the allegations they have already made.
district court might choose to contrast plaintiffs claim with the claims upheld
in Rothman v. Gregor, ___ F.3d ___, 2000 WL 959484 (2d Cir. 7/11/00).
Plaintiffs there provided a well reasoned explanation, grounded in data drawn
from the defendant corporations’ financial statements, to support their claim
that that corporation had recklessly failed to write off royalty payments it
had capitalized. 2000 WL at *6-*7. They also relied on litigation documents
that corporation had filed to support their claim that it had no reasonable
expectation of recovering the capitalized royalties. Id. at *8-*9. In
fact, the only puzzling aspect of the court’s opinion in Rothman is its
statement that “[t]he facts of the pending case are not quite as strong as in Novak”.
Id. at *8. The Rothman plaintiffs’ allegations may not
have been as strong, but the facts they pled, as described in the
court’s opinion, seem to me to be considerably stronger.
recent decisions by district courts in the Second Circuit dismiss complaints
because plaintiffs have failed to detail the basis for their allegations. See
Ruskin v. TIG Holdings, Inc., 1999 WL 756466 (S.D.N.Y. 9/24/99) at *4; Sabratek
Corp. v. Keyser, 2000 WL 423529 (S.D.N.Y. 4/19/00) at *3-*4; Feasby v.
Industri-Matemik Int’l Corp., 2000 WL 977673 (7/17/00) at *4-*6. But seeIn re MCI Worldcom, Inc. Sec. Litig., 2000 WL 381966 (E.D.N.Y. 4/13/00)
(applying a lax scienter standard to a misrepresentation of marginal
materiality). Cf. Ruskin v. TIG Holdings, Inc., 2000 WL 1154278
(S.D.N.Y. 8/14/00) (refusing to dismiss amended complaint identifying, as basis
for plaintiffs’ allegations, internal memoranda written by senior officers of
Consolidated Amended Complaint, In re Cell Pathways, Inc. Sec. Litig.,
Master File 99-752 (E.D. Pa. 6/28/99) (hereinafter “CPI Complaint”) ¶ 45. Phase
III is the final stage of clinical study of a new pharmaceutical product.See id., ¶¶ 40-42.
mention no other sources in their brief in opposition to defendants’ motion to
dismiss. See Plaintiffs Memorandum of Law in Opposition to Defendants’
Motion to Dismiss, In re Cell Pathways, Inc. Sec. Litig., Master File
No. 99-752 (E.D. Pa. 1/12/99) at 12-14, 30-32. See, also CPI Complaint,
¶ 63, quoted in text at note 203, below.
example, the court says that paragraph 62 of the complaint supports plaintiffs’
assertion that“in a conference call to stock market analysts on June 16, 1999,
[a CPI official] stated that the medical records needed to identify persons who
would fall within the patient target population, those forming ten to forty
polyps per year, were not obtained and analyzed until after the Phase III trial
was concluded.” Id. at *4, n.2. But paragraph 62 contains only one
identified statement by a CPI official, to the effect that the “trial data
revealed a higher degree of variability in polyp formation by [the patients
included in the study] than had previously been thought by experts in this
disease.” CPI Complaint, ¶ 62. Note that the official’s statement is to the
effect that CPI was surprised by the variability in polyp formation revealed by
the trial data, not that CPI did not obtain patient records “until after the
Phase III trial was concluded.” If the court was relying on the added assertion
in paragraph 62 that a CPI executive “would later suggest that other factors,
like an ‘insufficient degree of scrutiny,’ of patient medical records had led
to inclusion of enough ineligible patients to cripple the trial”, id.,
it should have noticed that plaintiffs did not identify any documentary or
other source for that assertion. Thus, it should not have been credited.
 The court
does state that “in a conference call to stock market analysts on June 16,
1999, [a CPI official] stated that the medical records needed to identify
persons who would fall within the patient target population, those forming ten
to forty polyps per year, were not obtained and analyzed until after the Phase
III trial was concluded. Id. at *4. However, ¶62 of the amended
complaint, where the court says this “allegation can be found,” Id.,
n.2, does not contain such a statement. See note 211, above.
Another problem with plaintiffs’ claim is that they probably did not have a
duty to disclose “potential problems” with the clinical study until they knew
that those problems would, in fact, jeopardize the integrity of the study. SeeIn re Carter-Wallace Inc. Sec. Litig., 220 F.3d 36 (2d Cir. 2000), at 40
(“statements ‘did not become materially misleading until Carter-Wallace had
information that Felbatol had caused a statistically significant number of
aplastic-anemia deaths and therefore had reason to believe that the commercial
viability of Felbatol was threatened.’”)
Advanta, 180 F.3d at 535 (quoting McLean v. Alexander, 599 F.2d 1190, 1197
(3d Cir.1979), quoting Sunstrand).
at 540 (noting that allegation defendants disregarded “negative trends,” “even
if true, would not demonstrate [the] ‘extreme departure’ from the standards of
ordinary care” that is necessary to show scienter).
 Which, as
of Sept. 1, 2000, had been pending before a motions panel of that court for
more than two months.
 I will
assume, without discussion, that the Third Circuit has the authority to issue
an wirt of mandamus in this case, circumstances, should it choose to do so.
Defendants’ cite ample authority to that effect. See, generally, CPI
 The court
held that plaintiffs’ factual allegations did not support plaintiffs’ claim that
defendants’ challenged statements were either false or misleading. See
Advanta, 180 F.3d at 537-539. As concerned scienter, the court found that
plaintiffs offered only “conclusory assertions that the defendants acted
‘knowingly,’ [and] blanket statements that defendants must have been aware of
the impending losses by virtue of their positions within the company.” Id.
 The court
assumes, arguendo, that plaintiffs’ allegations are true and holds:
“Even if the positive portrayals were materially misleading, we believe the
complaint suffers a more fundamental defect in that it fails to satisfy the
Reform Act's requirements for pleading scienter.” Id. at 539.
Green Tree Finan. Corp. Stock Litig., 61 F.Supp.2d 860 (D. Minn. 1999),
currently on appeal to the Eighth Circuit (No. 99-3536), may be such a case. Cf.Yossarian, cited in note 31.
text at note 1, above. See also Lynn A. Stout, Type I Error, Type II
Error, and the Private Securities Litigation Reform Act, 38 Ariz. L.Rev. 711 (1996).
language and, to the extent it is relevant, the legislative history of sections
(b)(1) and (b)(2), it seems clear to me, provides substantial support for the
manner in which Silicon Graphics, Greebel, Comshare and Avado
interpret those provisions. And, “[i]f Congress erred, . . . it is for that
body, and not [the courts], to correct its mistake.”Reves v. Ernst & Young,
494 U.S. 56, 63 n.2 (1990).
 In Cell
Pathways, for example, after the court denied defendants’ motion to
dismiss, plaintiffs made 92 document requests that, taken together, called for
“the production of virtually every document in Defendants’ possession.” CPI
Petition at 8.
Seligman correctly suggests that an evaluation of costs and benefits also should
include assessments of the impact of the lead plaintiff provisions of the
Reform Act and of the quality of disclosure by issuers. See Joel
Seligman, The Nontrial Adversarial Model, __ L. & Contemp. Prob. ___, ___ (2000).
e.g., Rothman v. Gregor, cited in note 192 above.
Yossarian, cited in note 16, at 460, noting that three important categories
of cases are largely unaffected by the Reform Act’s pleading requirements:
(i) cases where the ‘bad
news’ statement that precipitates a claim also makes it clear that some earlier
statement made by defendants was false or misleading, as is often the case when
a corporation restates its earnings for some earlier period; (ii) cases where,
in connection with the ‘bad news’ statement, some third party discloses
information that indicates that one or more of a corporation’s earlier
statements were false or misleading; and (iii) cases where the temporal
proximity between the ‘bad news’ statement and the ‘earlier, cheerier’
statement, combined with the magnitude of the changes between the two, strongly
suggests that a corporation was aware of the bad news at the time it made the
Defendant Corporation’s stock is traded in an efficient market, such as the New
York Stock Exchange or NASDAQ, a court will presume that a materially false or
misleading public statement made by or on behalf of Defendant Corporation
influenced the price of its stock. Basic, Inc. v. Levinson, [cite].
illustration is based in large part on the court’s discussion of plaintiff’s
complaint in Cooper v. Pickett, 137 F.3d 616, 626 (9th Cir. 1998).
c A similar
scenario arises where a company announces that it sales failed to increase as
rapidly as the market had anticipated the would.
illustration is based in large part on the court’s discussion of plaintiff’s
complaint in Fecht v. the Price Co.,70 F.3d 1078,1083 nn. 5,6
(9th Cir. 1995), cert. denied, 517 U.S. 1136 (1996).
illustration is based in part on plaintiffs’ Consolidated Amended Class Action
Complaint in In re Comshare Inc. Sec. Litig., No. 96-73711 (E.D. Mich.
12/13/96), and in part on allegations that plaintiffs’ asserted they would make
if they were granted leave to amend that complaint. See Appellants
Petition for Rehearing and Rehearing en Banc, No. 97-2098 (6th Cir.
7/21/99). That complaint and those allegations were the focus of the court’s
decision in Comshare.