Pleading Securities Fraud

Abstract

In the roughly five years since the Private Securities Litigation Reform Act of 1995 became law, courts and commentators have devoted considerable attention to two questions relating to the requirement, set forth in section 21D(b)(2), that a complaint alleging securities fraud must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Those questions concern: (1) What constitutes "the required state of mind" in suits under section 10(b) and Rule 10b-5? And (2) Are facts indicating a defendant had a motive and the opportunity to engage in fraud, standing alone, sufficient to create a strong inference that that defendant acted with the required state of mind? Courts and commentators have devoted far less attention to what I call the Basis Requirement - the portion of section 21D(b)(1) that requires a plaintiff to specifying not only "each statement alleged to have been misleading" and "the reason or reasons why the statement is misleading," but also, with respect to every allegation made on information and belief, "all facts on which that belief is formed." This article argues that issues relating to the Basis Requirement in the long run will prove to be far more significant than the issues relating to motive, opportunity and degrees of recklessness that have preoccupied courts and commentators to date. A threshold question is the amount and quality of corroborating information a plaintiff must include in her complaint. The article explains why, in order to implement Congress' goal of discouraging the filing and prosecution of speculative claims of securities fraud, courts must adopt an interpretation of the Basis Requirement similar to that adopted by the Ninth and First Circuits in In re Silicon Graphics Securities Litigation and Greebel v. FTP Software, respectively. Only by doing so will courts prevent plaintiffs from continuing to make speculative allegations of fraud and then relying on the discovery process to seek evidence to support their claims. The article next highlights two additional holdings in Greebel: (1) A court must consider the nature of the corroborating information plaintiff has provided when evaluating whether plaintiff has pled facts sufficient to create a strong inference of scienter. (2) The Reform Act effectively rejects the notice pleading philosophy reflected in Conley v. Gibson by requiring plaintiffs in securities fraud actions to plead facts that give rise to a strong, rather than merely a reasonable, inference of scienter. Using the analytic framework created by Greebel and Silicon Graphics, the article then considers two cases currently pending in courts in the Second and Third Circuits. The first is Novak v. Kasaks, in which the Second Circuit reversed and remanded a district court decision granting a motion to dismiss. The article points out that the Second Circuit's opinion is rather muddled, but can be reconciled with Silicon Graphics and Greebel, and notes that whether the Second Circuit so interprets Novak will provide an important indication of whether the inferior federal courts are going to adopt a uniform or a fragmented approach to interpreting the Reform Act's pleading requirements. (The article also notes that a petition for a writ of certiorari was filed in Novak after the article was completed.) The second case is In re Cell Pathways, Inc. Securities Litigation, in which defendants have petitioned the Third Circuit for a writ of mandamus to reverse a clearly incorrect district court decision denying their motion to dismiss. As is the case with Novak, how the Third Circuit deals with this petition will provide an important indication of the approach inferior federal courts are going to take to interpreting and enforcing the pleading requirements of the Reform Act. The article concludes by discussing some potential policy consequences of imposing on plaintiffs in securities class actions these stringent pleading requirements. The article observes that evaluating the impact of the Reform Act is largely an empirical question and that, because the first appellate decisions interpreting the Act's pleading requirement were issued relatively recently and the legal landscape in several circuits remains unclear, it will be several more years before sufficient data are available to support any informed conclusions as to whether the Act's pleading requirements - assuming they are interpreted uniformly - make it too difficult for victims of securities frauds to secure appropriate relief.