Deconstructing Scienter

In a typical securities fraud class action (SFCA) against a publicly traded company under SEC Rule 10b-5, the claim arises from an alleged cover-up of bad news by company agents. When the truth comes out, stock price drops, and fraud-period buyers sue to recover their losses. In most such cases, the merits of the claim turn on whether the plaintiff can plead (and ultimately prove) scienter – a wrongful state of mind – on the part of those who spoke falsely for the corporation. Moreover, the scienter of the speaker must be imputed to the corporation if the corporation is to be held liable. But the definition of scienter is nebulous at best – and especially so because securities fraud of the sort just described typically does not involve any gain for the corporation-defendant. If nothing is to be gained by the corporation-defendant, the alleged deception may be merely accidental or careless. So how do we separate the meritorious wheat from the dismissible chaff? What does it take to plead scienter in a situation in which the speaker is not obviously motivated by the prospect of gain?

The definition of scienter has evolved significantly since 1976 when it was first held by SCOTUS to be a required element of any claim under Rule 10b-5. At first, the Court defined scienter simply as a mental state embracing intent to deceive, manipulate, or defraud. The Court also acknowledged at the time that recklessness might suffice to show scienter. But so to define scienter is merely to kick the can down the road. What exactly does it mean to say that recklessness will suffice to prove scienter? The Court has repeatedly declined to require that any motive be pleaded, while itself freely discussing motive when it seems relevant. Thus, lower courts (and plaintiffs) are left to explain why a defendant corporation (or its agents acting on its behalf) would want to mislead the market when the truth is bound to come out anyway. The idea that a corporate agent might lie to the market for no reason at all would seem to suggest that negligence will suffice – which is contrary to the rationale for the scienter requirement – or that the defendant bears the burden of proof that the statement in question was made without scienter – which is contrary to the heightened pleading standard applicable to scienter.

Cleverly, SCOTUS has alluded to a possible alternative standard in a series of securities cases not involving Rule 10b-5. The genuine belief test asks whether the corporate spokesperson could or should reasonably believe their own words given known or knowable facts. This is essentially the same standard as the reasonable basis test, which has been applied in the context of actions against broker-dealers and investment advisers since the 1940s. In contrast to the traditional approach to scienter, the genuine-belief reasonable-basis (GBRB) test is an objective one that does not require any reference to motive. It does not rely on any explanation of why a corporate agent might want to deceive the market.

The question remains whether the scienter of a corporate agent in connection with a voluntary statement can be imputed to the corporation. As the few courts that have considered it have ruled, the answer to this question is a matter of agency law. But most courts have stopped short of providing a complete answer by relying on the doctrines of vicarious liability or apparent authority. Both answers are problematic. The former imposes strict or absolute liability and is thus inconsistent with the scienter requirement. The latter leaves open the possibility that the corporate agent who speaks to the market may have gone rogue in which case the principal corporation would have a claim against its own agent for any harm it suffers. But the imputation issue does not arise in cases in which the speaker acts with actual authority – rather than merely apparent authority – or where the corporation ratifies deception by failing promptly to correct.

This article traces the evolution of scienter as applied under Rule 10b-5 primarily by analysis of SCOTUS decisions addressing the concept. It contributes to the law and literature by demonstrating the relevance of agency law doctrine, which has been almost entirely ignored by other scholarship on the subject of scienter.