Pleading Securities Fraud

Abstract

In roughly five years since Private Securities Litigation Reform Act of 1995 became law, courts and commentators have devoted considerable attention to two questions relating to requirement, set forth in section 21D(b)(2), that a complaint alleging securities fraud must with particularity facts giving rise to a strong inference that defendant acted with 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 opportunity to engage in fraud, standing alone, sufficient to create a strong inference that that defendant acted with required state of mind? Courts and commentators have devoted far less attention to what I call Basis Requirement - 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 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 Basis Requirement in long run will prove to be far more significant than issues relating to motive, opportunity and degrees of recklessness that have preoccupied courts and commentators to date. A threshold question is 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 filing and prosecution of speculative claims of securities fraud, courts must adopt an interpretation of Basis Requirement similar to that adopted by 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 discovery process to seek evidence to support their claims. The article next highlights two additional holdings in Greebel: (1) A court must consider nature of 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 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 analytic framework created by Greebel and Silicon Graphics, article then considers two cases currently pending in courts in Second and Third Circuits. The first is Novak v. Kasaks, in which Second Circuit reversed and remanded a district court decision granting a motion to dismiss. The article points out that Second Circuit's opinion is rather muddled, but can be reconciled with Silicon Graphics and Greebel, and notes that whether Second Circuit so interprets Novak will provide an important indication of whether inferior federal courts are going to adopt a uniform or a fragmented approach to interpreting Reform Act's pleading requirements. (The article also notes that a petition for a writ of certiorari was filed in Novak after article was completed.) The second case is In re Cell Pathways, Inc. Securities Litigation, in which defendants have petitioned Third Circuit for a writ of mandamus to reverse a clearly incorrect district court decision denying their motion to dismiss. As is case with Novak, how Third Circuit deals with this petition will provide an important indication of approach inferior federal courts are going to take to interpreting and enforcing pleading requirements of 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 impact of Reform Act is largely an empirical question and that, because first appellate decisions interpreting Act's pleading requirement were issued relatively recently and 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 Act's pleading requirements - assuming they are interpreted uniformly - make it too difficult for victims of securities frauds to secure appropriate relief.