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.”^[142]

Plaintiffs 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.^[143]

Finally, 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.”^[144] 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.”^[145]

Defendants renewed their motion to dismiss, which the district court again granted.^[146] The court held that plaintiffs’ additions failed to correct the deficiencies in the original complaint, “or even to address them in any meaningful way.”^[147] 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 stated value.’”^[148] 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 92').”^[149] 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.”^[150]

Similarly, 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^[151] after the end of the Class Period.”^[152] 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.”^[153] 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.”^[154] 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.

That leaves 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.”^[155] But the court’s reasoning here, while fundamentally sound, may not have been sufficiently nuanced.

The court 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)].”^[156] 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.^[157] 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 to name 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.^[158]

The court 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.”^[159] 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.^[160]

But while 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 both a 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.^[161]

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 ‘nearly worthless.’”^[162] 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.

In short, 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.^[163] 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.

2. The Second Circuit’s Decision

Rather than 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 involves.^[164] Unfortunately, the court’s discussion of both sets of issues is confusing and contradictory.

a. Pleading standards under the Reform Act

The court observes that “[t]he landscape of securities fraud litigation has been transformed in recent years by the passage of the PSLRA.”^[165] After reviewing briefly the history of the Reform Act and quoting sections (b)(1) and (b)(2), Novak purports 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”^[166] and acknowledges that “different courts applying the pleading standard to differing factual circumstances may reach seemingly disparate results.”^[167] 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.”^[168]

Novak’s summary of the law concerning motive and intentional misconduct is straightforward and unobjectionable.^[169] Its discussion of recklessness, however, is mystifying.

After reiterating that the Second Circuit long ago adopted a definition of recklessness based on Sunstrand,^[170] 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 corporation.”^[171] 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 Sunstrand requires.^[172] Novak then compounds the confusion by citing as illustrative of its application of this recklessness standard two cases that do not rely upon it.^[173]

Similarly, Novak 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.”^[174] 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”,^[175] it provides no other indication of the principle on which its cases rely to set those “limits.”

If this 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:

When 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.^[176]

Novak’s 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.”^[177] 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^[178] 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 them.’”^[179] 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.

b. Analysis of the AnnTaylor complaint

Novak’s 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.”^[180] 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.^[181] 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 patterns.^[182]

However, the 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.”^[183] 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.”^[184] 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.”^[185] 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.

The best 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.^[186] 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.

Novak 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.”^[187] 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 allegations.”^[188] The court’s instruction on remand are consistent with this explanation.^[189]

3. The Issue on Remand

Although 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.^[190] 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.^[191]

• Plaintiffs 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.

• Now 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.

• The 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.

I 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.^[192] 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 of scienter.^[193]

Should 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.^[194] 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. Compare In 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 also In 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).

B. In re Cell pathways, Inc. securities Litigation

The 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.^[195]

In July 1998, the Food and Drug Administration (“FDA”) granted CPI “Fast Track” authority to begin a Phase II/III clinical study of Prevatac.^[196] On October 7, 1998, CPI announced that it had filled its enrollment of the clinical study.^[197] 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.^[198]

On February 1, 1999, CPI announced that the clinical trial had not produced “a statistically significant clinical response.”^[199] 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 trial.”^[200] 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 physicians with “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.^[201]

Plaintiffs brought suit on behalf of all persons who purchased CPI stock between October 8, 1998 and February 2, 1999, inclusive.^[202] Plaintiffs’ central claim, which they based entirely on the statements by defendants described above,^[203] was that CPI acted recklessly in designing the Phase II/III clinical trial as it did.

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.^[204]

As 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”.^[205] 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.”^[206]

The 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.^[207] 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.

The 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 interlocutory review.^[208] Only after defendants filed a petition seeking a writ of mandamus did the district court issue an opinion explaining its decisions.^[209]

The 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:

• “Plaintiffs 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.’”

• Moreover, ‘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.”’ ^[210]

The 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^[211] even though plaintiffs pled no facts to support those allegations.^[212]

A 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.^[213] 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.^[214] This deficit is not remedied by the court’s finding that plaintiffs identified “the sources for their beliefs that the trial was flawed.”^[215] 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.^[216]

The 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 it.”^[217] 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.^[218]

One 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,^[219] 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 dismiss.^[220]On 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.

The 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.^[221] 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.

Advanta concludes that section (b)(2) “was intended to modify procedural requirements while leaving substantive law undisturbed.”^[222] 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.’”^[223] But, Advanta continues:

Motive and 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.^[224]

As 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.^[225]

These 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.^[226]

VI. CONCLUSION

This 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.”^[227] Requiring plaintiffs to meet more stringent pleading standards, I believe, is a viable — and perhaps the best — strategy for dealing with that problem.

Some 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 the fraud.^[228] 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 unremedied.^[229]

But 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.^[230] The relevant inquiry, at least from a policy point of view,^[231] is whether the Reform Act, as interpreted in Silicon Graphics and Greebel, gets the balance right.

The 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 of the 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.^[232] 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.

As 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 the benefits.^[233] 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 of scienter.^[234]

To 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).^[235] 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.^[236]

In SG Cowen Sec. Corp. v. U.S. District Court,^[237] 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.”^[238]

The Ninth Circuit’s reasoning seems flawed. Congress expressly provided that a plaintiff should be allowed to conduct discovery where she could show “undue prejudice”^[239] and never discussed what it meant by that term.^[240] 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.^[241]

The 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.”^[242] Given the persistence with which some plaintiffs’ attorneys have continued to base claims of securities fraud on “boilerplate allegations,”^[243] 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.

In 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.

^* Copyright © 2000 Elliott J. Weiss. Charles E. Ares Professor of Law, James E. Rogers College of Law, University of Arizona. The author thanks Charles Ares and Tom Mauet for helpful conversations and comments and Eric Magnuson, Paul Moore, Saami Zain, Kris Harman and Deborah Hansen for valuable research assistance.

^[1] In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 263 (2d Cir. 1993), cert. denied 511 U.S. 1017 (1994) (hereinafter “Time Warner”).

^[2] Id., citing Conley v. Gibson, 355 U.S. 41, 45-46 (1957).

^[3] Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (1995) (codified as scattered sections of 15 U.S.C.) (hereinafter “Reform Act” or “PSLRA”).

^[4] H.R. Conf. Rep. No. 104-369, at 31 (1995).

^[5] Id. at 32.

^[6] Id. at 31.

^[7] Securities 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 constituting fraud.

^[8] Section (b)(1) (emphasis added).

^[9] Securities 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).

^[10] Securities Exchange Act of 1934, §21D(b)(3)(A), 15 U.S.C. § 78u-4(b)(3)(A) (2000).

^[11] Securities 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 .

^[12] See text at note 1 above.

^[13] See id.

^[14] See, e.g., 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 also Symposium: 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).

^[15] See text at note __ above.

^[16] 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 (1^st Cir. 1999).

^[17] 183 F.3d 970 (9^th Cir. 1999) (hereinafter “Silicon Graphics”).

^[18] Id. at 974-979.

^[19] Id. at 991-996 (Browning, J., dissenting).

^[20] Id. at 984-985.

^[21] Id. at 999 (Browning, J., dissenting).

^[22] As would be the case under Conley v. Gibson.

^[23] Id. (Browning, J., dissenting).

^[24] In fact, given the majority’s holding that plaintiff had not met the basis requirement, it’s holding concerning “deliberate recklessness” could be considered dicta.

^[25] 194 F.3d 185 (1^st Cir. 1999) (hereinafter “Greebel”).

^[26] 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”).

^[27] 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 issues.

^[28] 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.

^[29] See In re Glenfed, Inc. Securities Litig., 42 F.3d 1541, 1549 (9^th Cir. 1994) (en banc).

^[30] 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.

^[31] 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.

An article in Fortune illustrates how the most prominent plaintiffs’ firm specializing in prosecuting securities clas actions has used such complaints to secure lucrative settlements.

Bill 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.

^[32] The 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>.

^[33] The 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.

^[34] Silicon Graphics, 183 F.3d at ___.

^[35] Id.

^[36] Id. at

^[37] Id. at

^[38] Id. at ___.

^[39] SGI FAC, ¶¶ 34, 37-41 (emphasis added).

^[40] Id., ¶ 96.

^[41] Id. (Emphasis added.)

^[42] 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 collapses.

^[43] See text at notes 21-23, supra; 183 F.3d at 997-1001 (Browning, J., dissenting).

^[44] I say “left open the door” because two pre-Reform Act Ninth Circuit decisions, Fecht v. Price Co., 70 F.3d 1978 (9^th Cir. 1995), and Cooper v. Prickett, 122 F.3d 1186 (9^th 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 (9^th 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.

^[45] 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.

^[46] The approach to pleading fraud followed by plaintiffs’ attorneys in Silicon Graphics is also economically 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.

^[47] 183 F.3d at 984.

^[48] 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.

^[49] Id. at 985.

^[50] Id. (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 Basis Requirement.

^[51] See, 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 defendant corporation).

^[52] 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.

^[53] Who, in turn may claim have seen the document or to have been told of its contents by another.

^[54] 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.

^[55] See also Heliotrope General, Inc. v. Ford Motor Co., 189 F.3d 971, 979 (9^th 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).

^[56] Section (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).

^[57] 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 (6^th Cir. 1999) (hereinafter “Comshare”); Silicon Graphics; Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11^th Cir. 1999) (hereinafter “Avado”); Greebel; and Novak v. Kasaks,216 F.3d 300 (2d Cir. 2000).

^[58] See Silicon Graphics, 183 F.3d at 979.

^[59] Id. at

^[60] Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199, 96 S.Ct. 1375, 1383 (1976).

^[61] Id. at 194, n.12.

^[62] Id.

^[63] See 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).

^[64] See 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).

^[65] 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).

^[66] Sunstrand 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.

^[67] In re 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.”)

^[68] 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.

^[69] See, e.g., Time Warner, 9 F.3d at 269.

^[70] See, e.g., Shields v. Citytrust Bancorp, 25 F.3d 1124, 1128 (2d Cir. 1994) (referring to Rule 9(b)’s relaxed specificity requirement for scienter).

^[71] See Avado, 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).

^[72] Judge Ralph Winter wrote a spirited dissent supporting defendants’ claim. See Time Warner, 9 F.3d at 272 (Winter, J., dissenting).

^[73] 901 F.3d at 271 (emphasis added).

^[74] 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).

^[75] Id. at 271.

^[76] Silicon Graphics, 183 F.3d at 977.

^[77] Id.

^[78] Id. at 979.

^[79] Mansbach v. Prescott, Ball & Turben, 598 F.2d at 1024.

^[80] Comshare, 183 F.3d at 550.

^[81] Id. at 551 (citation omitted).

^[82] 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.”)

^[83] See 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.

^[84] Plaintiffs’ 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.

^[85] See id. 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 (1^st 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).

^[86] Greebel Appendix” at 1187 (Transcript of hearing, Apr. 29, 1997).

^[87] Id. at 1193-94.

^[88] Id. at 1191. The court added: “I mean, filing a lawsuit should be the last thing you do, not the first thing you do.” Id.

^[89] 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).

^[90] Id. at 1210-11 (Transcript of hearing, July 31, 1997).

^[91] See 182 F.R.D. at 372.

^[92] Id. at 373, 376. It dismissed the complaint with prejudice. Id.

^[93] Id. (“Plaintiffs would not have discovered the additional evidence but for the inclusion of the white-out claim, which . . . has since turned out to be groundless.)

^[94] Greebel, 194 F.3d at 193.

^[95] Id., 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 (1^st 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.

^[96] Id. 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 (7^th Cir. 1996); Parnes v. Gateway 2000, Inc., 122 F.3d 539, 550 (8^th Cir. 1997).

^[97] Id. at 195.

^[98] Id.

^[99] Id. at 195-96 (emphasis added; citation to Conley v. Gibson omitted).

^[100] Id. 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.

^[101] Id. at 196-197. (Emphasis added.)

^[102] Id. at 201.

^[103] Id. at 202.

^[104] Plaintiffs’ 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.

^[105] Greebel, 194 F.3d at 202.

^[106] Id.

^[107] Id. The court points 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.

^[108] Consider, 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:

Sunbeam 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.

^[109] Id. 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. Compare In 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).

^[110] “‘Channel 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.

^[111] Id. at 203.

^[112] Id.

^[113] Id. 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.

^[114] Id. 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 204.

^[115] Id.

^[116] Id. 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.

^[117] After holding that plaintiffs’ allegations relating to insider trading also do not support a strong inference of scienter. See id. at 206-07.

^[118] Id. at 207.

^[119] 216 F.3d 300 (2d Cir. 2000) (hereinafter “Novak”).

^[120] Subsequent 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).

^[121] 2000 WL 805221 (E.D.Pa. 6/20/00) (hereinafter “Cell Pathways.”).

^[122] See Cell 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”).

^[123] Amended 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.

^[124] AnnTaylor’s 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.

^[125] See 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.

^[126] Novak Amended Complaint ¶ 92.

^[127] 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. <http://securities.stanford.edu/complaints/anntaylor/96cv03073/001.html>.

^[128] Novak 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.

^[129] Novak, 216 F.3d at 304.

^[130] Plaintiffs 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. See Securities Class Action Alert (Nov. 1999) at 28.

^[131] Novak v. Kasaks, 997 F.Supp.2d 425, 431 (S.D.N.Y. 1998) (“Novak I”). The court added:

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

Id.

^[132] Id.

^[133] Id. (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.

^[134] Plaintiffs 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.

^[135] Novak I, 997 F.Supp. at 431.

^[136] Id. The resemblance may not be coincidental. Plaintiffs in both cases are represented by Milberg Weiss Hynes Bershad & Lerach LLP.

^[137] Id.

^[138] The district court’ first decision granted them 30 days to re-plead their case. Novak I, 997 F.Supp. at ___.

^[139] See note 134.

^[140] Novak Amended Complaint, Introductory ¶ (numbers in listing omitted).

^[141] Id., ¶ 37 (emphasis in original).

^[142] Id.

^[143] Id., ¶ 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.

^[144] Id., ¶ 35.

^[145] Id.

^[146] Novak v. Kasaks, 26. F.Supp.2d 658 (S.D.N.Y. 1998) (“Novak II”).

^[147] Id. at 660.

^[148] Id. at 661 (citation to amended complaint omitted).

^[149] Id.

^[150] Id.

^[151] In fact, more than eight months.

^[152] Id. 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 ___, above.

^[153] Id. 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.

^[154] Id.

^[155] Novak II, 26 F.Supp. 2d at 661.

^[156] Id. at 661.

^[157] See Silicon Graphics, 183 F.3d at 985; Greebel, 194 F.3d at 193.

^[158] Neither Silicon Graphics or Greebel explicitly sets forth such a requirement.

^[159] Novak II, 997 F.Supp. at 661.

^[160] Greebel, 194 F.3d at 201.

^[161] 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].

^[162] Id. Plaintiffs do not expressly allege that any participant in the alleged discussions stated or admitted that the Box and Hold inventory “was nearly worthless.”

^[163] Greebel 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 dismiss.

^[164] 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.

^[165] Id. at 305.

^[166] Id. at 307.

^[167] Id.

^[168] Id.

^[169] 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).

^[170] Although it does not attribute that standard to Sunstrand. See id.

^[171] Id. (Emphasis added.)

^[172] 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.

^[173] See 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. . . .”

^[174] Novak, 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.

^[175] Id. at 309.

^[176] Id. at 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.

^[177] Id. at 309.

^[178] San Leandro, 75 F.3d at 812.

^[179] See id. at 812-13, quoting Serrabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357, 365 (1^st Cir. 1994); Arazie v. Mullane, 2 F.3d 1456, 1467 (7^th Cir. 1993) (bracketed material added by court).

^[180] Novak, 216 F.3d at 312.

^[181] Id. 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.

^[182] See also 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).

^[183] Novak, 216 F.3d at 314.

^[184] Id.

^[185] An 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.

^[186] Novak, 216 F.3d at 313-14 (footnote omitted). In a footnote, the court astutely observed:

Paragraph (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.

Id. at 314, n.1.

^[187] Novak at 314.

^[188] Id.

^[189] See text at note 183, above.

^[190] The 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.

^[191] 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).

^[192] This 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.

^[193] The 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.

^[194] Several 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 see In 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 defendant corporation).

^[195] Cell Pathways, 2000 WL at *1.

^[196] See 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.

^[197] CPI Complaint, ¶ 48.

^[198] Id., ¶ 49.

^[199] Id., ¶ 57. This announcement led to a sharp decline in the price of CPI stock. Id. However, plaintiffs make no claim that CPI ever misrepresented the potential of Prevatac.

^[200] Id., ¶ 59.

^[201] Id., ¶¶ 60-62.

^[202] Id., ¶ 2.

^[203] Plaintiffs 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.

^[204] Id., ¶ 63.

^[205] Id., ¶ 65(e).

^[206] Id., ¶ 68. Plaintiffs did not claim that CPI or any of its officers or directors sold CPI stock during the class period. See id.

^[207] See id., ¶¶ 29-32.

^[208] See CPI Petition at 7-8 (court denied both motions in one sentence orders).

^[209] See Cell Pathways at *1.

^[210] Id. at *5 (internal quotation marks and citations omitted).

^[211] Id. at *8.

^[212] For 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.

^[213] Cell Pathways at *7 (emphasis added).

^[214] 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.

^[215] Id. at *9 (emphasis added).

^[216] 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. See In 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.’”)

^[217] See Advanta, 180 F.3d at 535 (quoting McLean v. Alexander, 599 F.2d 1190, 1197 (3d Cir.1979), quoting Sunstrand).

^[218] See id. 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).

^[219] Which, as of Sept. 1, 2000, had been pending before a motions panel of that court for more than two months.

^[220] 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 Petition.

^[221] 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. (citation omitted).

^[222] Id. at 534.

^[223] Id. at 534-35, quoting Weiner v. Quaker Oats Co., 129 F.3d 310, 318 n. 8 (3d Cir.1997).

^[224] Id. at 535 (citation omitted; emphasis added).

^[225] Id.

^[226] 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.

^[227] See text at note 1, above; note 31, above.

^[228] See text at note 1, above.

^[229] In re 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.

^[230] See 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).

^[231] The 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).

^[232] 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.

^[233] Dean 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).

^[234] See, e.g., Rothman v. Gregor, cited in note 192 above.

^[235] But see 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 earlier statement.

(Footnotes omitted.)

^[236] See Yossarian, cited in note 31, at 506.

^[237] 189 F.3d 909 (9^th Cir. 1999).

^[238] Id. at 912, quoting Medhekar v. United States Dist. Court., 99 F.3d 325, 328 (9th Cir.1996).

^[239] Securities Exchange Act of 1934, §21D(b)(3)(B), 15 U.S.C. § 78u-4(b)(3)(B) (2000).

^[240] See Yossarian, cited in note 31, at 501.

^[241] See Medhekar v. United States Dist. Court., 99 F.3d 325 (9th Cir.1996).

^[242] See Yossarian, cited in note 31, at 506.

^[243] See note 54, above.

^a If 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].

^b This 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.

^d This 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).

^e This 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 (6^th Cir. 7/21/99). That complaint and those allegations were the focus of the court’s decision in Comshare.