Section 21D(b)(2) of PSLR of 1995: Pleading Securities Fraud

PLEADING SECURITIES FRAUD

Elliott J. Weiss^* This article is dated September 1, 2000. Some of the cases discussed herein were pending as of that date.

I. INTRODUCTION

Seven years 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. . . .”^[1] 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.’”^[2]

Two years later, Congress attempted to reverse the notice pleading system’s pro-plaintiff bias by enacting the Private Securities Litigation Reform Act^[3] 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.^[4] Congress observed that “investors always are the ultimate losers when extortionate ‘settlements’ are extracted from issuers.”^[5] 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.^[6]

The Reform Act’s legislative 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”^[7] and, with respect to every allegation made on information and belief, to “state with particularity all facts on which that belief is formed.”^[8] 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].”^[9] Section 21D(b)(3)(A) directs courts to dismiss any complaint that does not meet the requirements of sections (b)(1) and (b)(2).^[10] 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”.^[11] Viewed as a whole, these provisions clearly reflect an effort by Congress to reverse the litigation dynamic Judge Newman described^[12] by precluding a plaintiff from “conduct[ing] discovery of those [she] reasonably suspect[s] of having perpetrated a fraud”^[13] 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).

Most commentary to date has focused on two questions relating to those requirements:^[14]

Are facts that suggest a defendant acted recklessly sufficient to create a strong inference of scienter?

Are 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 scienter?

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.^[15]

Issues 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.^[16] The Ninth Circuit’s decision in In re Silicon Graphics Inc. Securities Litigation^[17] 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”^[18] while Judge Browning, dissenting, argued that facts sufficient to support a strong inference of simple recklessness should suffice.^[19]

The 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.^[20] 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 proceedings.”^[21] Moreover, Judge Browning pointed out, if the court treated as true plaintiff’s allegations concerning the Stop Ship and other internal reports,^[22] 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.”^[23]

Note the 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.^[24] 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.

Silicon 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.^[25] that interpret the Basis Requirement and analyze its relationship to the Strong Inference Requirement of section (b)(2).^[26] 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 pursue.

II. WHY THE BASIS REQUIREMENT IS CRITICAL

To 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.^[27] 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.^[28] In virtually every such situation, the issuer also will have issued “earlier, cheerier”^[29] 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.

The 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.”^[30] 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.^[31] 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).

The complaint in Silicon Graphics^[32] represents just such an exercise in creative drafting.^[33] 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.^[34] Within a few weeks after that announcement, SGI stock reached an all-time high.^[35]

Throughout the remainder of 1995, SGI continued to issue positive statements regarding the Indigo2 and denied negative rumors about its performance.^[36] Then, on January 2, 1996, SGI unexpectedly announced “disappointing second quarter results and acknowledged that revenue growth for the year would be much lower than expected.”^[37] 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.”^[38] As might be expected, SGI’s stock price declined following these announcements.

Plaintiffs’ 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.

More specifically, the key portions of plaintiffs’ First Amended Consolidated Compliant assert:

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 IMPACT^TM Workstations due to the ASIC chip performance problems as it attempted to assemble and ship the Indigo2 IMPACT^TM Workstations in Sept. 1995, SGI’s internal corporate procedures required that the managers of the Indigo2 IMPACT^TM 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 IMPACT^TM 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 IMPACT^TM Workstations were discovered in mid_Sept. 1995, McCracken, Baskett, Burgess, Kelly, Ramsey and Sekimoto were immediately advised of the problems by the Indigo2 IMPACT^TM project managers. . . . After they were advised of this problem in late Sept. 1995 by the Indigo2 IMPACT^TM 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 IMPACT^TM 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 IMPACT^TM 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 IMPACT^TM Workstations ordered was the extraordinary demand for the product which SGI simply could not meet.

39. Internally at SGI, the problems with Indigo2 IMPACT^TM 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 IMPACT^TM 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 IMPACT^TM 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 IMPACT^TM 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 when made.^[39]

Plaintiffs said 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. . . .”^[40] Plaintiffs added that they believed “that substantial evidentiary support will exist for the[se] allegations . . . after a reasonable opportunity for discovery.”^[41]

The Silicon 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.

Consider, first, 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.

Plaintiffs 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 so in 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.

In 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.

Paragraphs 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.^[42]

As noted 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).^[43] Had the majority agreed with him, the court would have left open the door^[44] to claims of “fraud by hindsight” masquerading as claims of disclosure fraud.^[45] The complaint in Silicon Graphics would then have provided plaintiffs’ attorneys with a template for the conversion of hindsight suspicions of fraud into what at least in Ninth Circuit would consider to be an adequately particularized claim of securities fraud.^[46]

However, a 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.”^[47] 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.”^[48] 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.^[49]

Then the court made the following, critical observation:

In 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.

Brody 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 recklessness.^[50]

The court’s 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.^[51] 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.^[52]

Consider, 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.^[53] 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 made).

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.”^[54] Relying on the Basis Requirement, the court correctly held that a complaint that includes no such details must be dismissed.^[55]

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^[56] 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.

Six Courts of Appeal that have addressed those questions.^[57] 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 recklessness”^[58] and that evidence of motive and the opportunity, standing alone, never is sufficient to create a strong inference of scienter.^[59] 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 & Ernst v. Hochfelder^[60] 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.”^[61] The Court also reserved the question of “whether, in certain circumstances, reckless behavior” is the equivalent of scienter^[62] and has twice subsequently reserved that question.^[63]

Every Court of Appeals to address the issue has held that proof of recklessness can suffice.^[64] The Courts of Appeals also uniformly have adopted what is often referred to as the Sunstrand definition of recklessness:

Reckless 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.^[65]

Prior to the passage of the Reform Act, though, courts rarely referred to Sunstrand when considering motions to dismiss.^[66] 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.^[67] 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.”^[68] 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.^[69]

Close 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^[70] — 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 by Sunstrand.^[71]

Time 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.^[72] 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 existed.”^[73]

Note the 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 make the 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.”^[74] 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”.^[75] 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.

Silicon 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.”^[76] 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.’”^[77] 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.”^[78]

Comshare 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 the Sunstrand definition of recklessness.^[79] Comshare then holds:

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.^[80]

The Sixth 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.”

Comshare’s discussion of motive and opportunity also closely tracks Silicon Graphics’ discussion of that issue. The Sixth Circuit states:

[E]vidence 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.^[81]

At most, 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.

But such 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.^[82]

Greebel and Avado endorse Comshare’s interpretation of section (b)(2).^[83] 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.

IV. GREEBEL GIVES CONTENT TO THE STRONG INFERENCE REQUIREMENT

Greebel 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.

Greebel 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:

During 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.^[84]

Primarily on the basis of this “white out” allegation, the district court denied defendants’ motion to dismiss.^[85]

Following 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.^[86] 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.”^[87]

The 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.”^[88] 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.^[89]

Plaintiffs 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 employees.^[90] Plaintiffs, however, were unable to make Ms. Nichols available for a deposition; she either was unavailable or unwilling to testify.^[91]

That led 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^[92] 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.^[93] Plaintiffs appealed all three rulings to the First Circuit.

Greebel first holds that the Basis Requirement in section (b)(1) “is congruent and consistent with the pre-existing standards of this circuit.”^[94] 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.”^[95] These “strict pleading requirements under Rule 9(b),” the court continues, “are, in our view, consistent with the PSLRA.”^[96]

Turning to 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 evidence.”^[97] Second, “the words of the Act neither mandate nor prohibit the use of any particular method to establish an inference of scienter.”^[98]

Third, and 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.^[99]

Then it observes:

In 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.^[100]

Finally, the court reiterates:

The 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 dismiss.^[101]

Having 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.^[102] 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].”^[103]

The terms 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.”

Greebel’s 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.

If one assumes that plaintiffs would then have disclosed that the “white out” allegations were based entirely on the hearsay statement of a former FTP employee,^[104] 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 -- supports this conclusion.^[105] As with the “white out” allegations, the court suggests that these allegations, if true, “are very serious.”^[106] 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 scienter,”^[107]

The court’s 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.^[108] 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.

Greebel’s 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.^[109]

The court quickly dispenses with the “channel stuffing” allegations.^[110] It treats them as adequately corroborated and notes that evidence of channel stuffing “has some probative value.”^[111] 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.^[112]

The court 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.”^[113]

Greebel’s 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.^[114]

Greebel 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 scienter.”^[115] 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.”^[116]

Finally,^[117] 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.^[118]

V. TWO IMPORTANT PENDING CASES

Two cases 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,^[119] 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.^[120]

In re Cell Pathways, Inc., Sec. Litig.^[121] wrongly denies defendants’ motion to dismiss. The district court’s opinion, written after defendants petitioned the Third Circuit for a writ of mandamus,^[122] 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

Novak 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,^[123] the date on which AnnTaylor unexpectedly announced reduced same store sales and sharply lower earnings for the first quarter of FY 1995.^[124] AnnTaylor blamed its problems on a weak retail environment and merchandising problems with its Spring line of clothing.^[125] 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.^[126]

1. The District Court’s Decisions

Plaintiffs’ original complaint, filed almost one year later,^[127] consisted largely of uncorroborated allegations to the effect that AnnTaylor and certain of its executives had engaged in “an elaborate ‘Box & Hold’ scheme”^[128]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 policy.”^[129]

The district court dismissed plaintiffs’ original complaint, holding that it “fails to allege with sufficient specificity that at the time the AnnTaylor defendants^[130] 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.”^[131] 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 complaint”.^[132] 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’ ). . . .^[133]

Finally, the court addressed plaintiffs failure to satisfy the Basis Requirement. It noted that plaintiffs’ umbrella description of the basis for their claims^[134] “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”;^[135] that the district court in Silicon Graphics rejected an identical paragraph as insufficiently specific; ^[136] 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.’”^[137]

Plaintiffs thereafter filed an amended complaint.^[138] They added to their listing of the categories of information on which their claims were based^[139] “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 independent consultants.”^[140] In addition, plaintiffs made additional, arguably significant, substantive allegations, apparently based on these newly-listed sources.

Plaintiffs 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”.^[141] 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.”