Securities Fraud

ScienterState of mind: awareness or recklessness

Pleading: “particularized facts creating strong inference”

Weighing evidence in motion to dismiss

(last updated 18 Apr 12)

Securities Fraud Action

Rule 10b-5• Transaction (“in connection with

purchase or sale of securities”)• Plaintiff (“purchasers or sellers” /

except SEC)• Defendant (“primary violator” /

including company)• Elements

– Material misrepresentation or omission

– Scienter– Reliance– Causation– Damages

• Procedure – Jurisdictional nexus (federal court)– Statute of limitations / repose– Special rules for class actions

Ernst & Ernst v. Hochfelder (US 1976)

What was Nay’s “mail rule”?

Why didn’t the accountants discover it? Lack of “quality”?

What was plaintiffs’ theory under Rule 10b-5?

Rule 10b-5 It shall be unlawful for any

person, directly or indirectly,

(1)To employ any device, scheme, or artifice to defraud,

(2)To make any untrue statement of a material fact … or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(3)To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

Section 10 (‘34 Act) It shall be unlawful for any person, directly or indirectly …-

(b) To use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of [SEC] rules …

Section 11 (’33 Act)(a) In case any part of the registration statement, …

contained an untrue statement of a material fact … any person acquiring such security … may … sue --

(4) every accountant … who certified part of the registration statement …

(b) no person … shall be liable … who shall sustain the burden of proof

… as regards any part of the registration statement purporting to be made upon his authority as an expert … he had, after reasonable investigation, reasonable ground to believe and did believe… that the statements therein were true

Ernst & Ernst v. Hochfelder (US 1976)

Lewis F. Powell(corporate lawyer)

The argument [effect on investors same whether intentional or negligent] simply ignores … “manipulative, device an contrivance.”

[Legislative history gives] no indication that § 10(b) was intended to proscribe conduct not involving scienter [mental state embracing intent to deceive, manipulate or defraud]

[When] Congress created express civil liability … it clearly sp[ecifed whether recovery was to be premised on knowing or intential conduct, beligence or entirely innocent mistake. [See § 11, 12(2)]

Pleading scienter …

RecklessnessMotive and opportunity

Strong circumstantial evidence

Exchange Act 21D(b)(2)

In any private action arising under this title in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this title, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

Exchange Act 21D(b)(2)

In any private action arising under this title in which the plaintiff alleges the defendant made [materially false statement or omission] the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading

2d and 3d Circuits -• Motive and opportunity• Concrete personal benefit• Insider trading

1st, 5th, 6th, 10th, 11th Circuits• Strong inference of scienter• M&O is external marker• Unusual insider trading

9th Circuit • “Deliberate recklessness”• Intentional misconduct

Sup Ct resolves split …

(kinda)

• What were plaintiffs’ allegations? How might shareholders know whether executives knew product demand was weak and there was “channel stuffing”?

• What did 7th Circuit decide? Can reasonable person “infer” intent? What about defendants’ explanations of innocence?

• What was issue as the Supreme Court saw it? What was difference between justices?

Tellabs, Inc. v. Makor Issues & Rights, Ltd.(US 2007)

Ruth Bader Ginsburg(civil rights lawyer)

… PSLRA strong inference of state of mind (scienter) means … “a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference.”

… allegations must also be considered “holistically” [isolated insider sales not enough, must have unusual, broad sales]

“omissions and ambiguities [in the plaintiffs’ allegations] count against inferring scienter” [discount confidential witnesses]

Tellabs, Inc. v. Makor Issues & Rights, Ltd.(US 2007)

Antonin Scalia(law professor)

If a jade falcon were stolen from room to which only A and B had access, could it possibly be said there was a “strong inference” B was the thief?

Inconceivable PSLRA manifests the purpose of giving plaintiffs the edge in close cases

Justice Alito: Scalia’s interpretation would align the pleading test with the test used at summary judgment and judgment as matter of law.

The end

Green Tree Financial (8th Cir. 2001)

The issue?

Securitization

7.2%Pool

(diversifies risk)

Bonds(P&I)

11.5%

Home mortgages(P&I)

7.2%7.2%

7.2%7.2%

11.5%11.5%

11.5%11.5%

Securitization

7.2%Pool

(diversifies risk)

Bonds(P&I)

11.5%

Home mortgages(P&I)

7.2%7.2%

7.2%7.2%

11.5%11.5%

11.5%11.5%

• What is “gain on sale” revenue recognition?•Valuation

• Discount rate• Loan default rate• Loan prepayment rate

Green Tree Financial (8th 2001)

Eighth Circuit:

recklessness is limited to those highly unreasonable omissions or misrepresentations that involve … an extreme departure from the standards of ordinary care, and that present a danger of misleading buyers or sellers which is … so obvious that the defendant must have been aware of it.

Green Tree Financial (8th 2001)

Eighth Circuit:

Coss’s extraordinary compensation package [2.5% of pre-tax income minus other execs bonuses], on the eve of expiring, created a powerful incentive to see to it that Green Tree made plenty of money before his contract expired. ….

… they issued financials that did not take account of the disparity between the assumptions and actual experience… the sheer size of the $390 million write-down adds to the inference that the defendants must have been aware the problem was brewing.

Lawrence Coss(Green Tree CEO)