Securities Fraud: Courts Set Different Scienter Pleading Standards

The Private Securities Litigation Reform Act of 1995 (PSLRA) requires a securities fraud plaintiff to "state with particularity facts giving rise to a strong inference" of defendant’s scienter. 15 U.S.C. §78u-4(b)(2). The nine circuits that have considered how a plaintiff can satisfy this pleading requirement have divided into three camps. In the Second and Third Circuits, a plaintiff can demonstrate scienter either with allegations of motive and opportunity or with allegations constituting strong circumstantial evidence of conscious misbehavior or recklessness. At the other end of the spectrum, the Ninth Circuit accepts only allegations raising a strong inference of intentional misconduct or deliberate recklessness. Thus, in addition to rejecting the motive and opportunity test, the Ninth Circuit sets a higher standard for pleading recklessness than any other circuit. In the middle, six circuits (the First, Fifth, Sixth, Eighth, Tenth, and Eleventh Circuits) have rejected motive and opportunity as a separate test but permit allegations of motive and opportunity to give rise to a strong inference of recklessness or intentional misconduct on a case-by-case basis. See generally Florida State Bd. of Admin. v. Green Tree Fin. Corp., 2001 U.S. App. LEXIS 22921 (8th Cir. Oct. 25, 2001) (discussing issue and citing cases from other circuits).

The Second Circuit’s motive and opportunity test is not satisfied by a generalized motive – one that could be imputed to any publicly owned for-profit endeavor, such as a corporation’s desire to appear profitable or a corporate officer’s desire to keep stock prices high to increase his or her compensation. Rather, a plaintiff must allege that the defendants benefited in a concrete and personal way from the fraud (e.g., by selling a large portion of their holdings at a substantial profit). Moreover, if no such motive is alleged, then the inference necessary to satisfy the alternative test (strong circumstantial evidence of conscious misbehavior or recklessness) must be stronger. A recent decision of the Second Circuit, Kalnit v. Eichler, 264 F.3d 131 (2d Cir. 2001), gives a good explanation of that court’s test.

In 1996, MediaOne Group, Inc. (MediaOne) acquired Continental Cablevision (Continental). As part of this acquisition, MediaOne entered into a publicly disclosed Shareholder’s Agreement with Amos Hostetter – Continental’s co-founder and an influential player in the telecommunications industry who became MediaOne’s largest shareholder as the result of the merger. The agreement included a "standstill" provision that limited Hostetter’s ability to propose mergers involving MediaOne.

On March 22, 1999, MediaOne announced that it had entered into a definitive merger agreement with Comcast Corporation (Comcast) whereby Comcast would acquire MediaOne for approximately $48 billion. The agreement gave MediaOne 45 days to accept a superior proposal, but prohibited MediaOne from directly or indirectly soliciting a superior offer – a so-called "no shop" provision.

On March 25, 1999, Hostetter sent defendants a letter expressing his dissatisfaction with the terms of the Comcast agreement and sought release from the 1996 standstill restriction to allow him to develop a superior proposal. On or about March 30, 1999, defendant Eichler (MediaOne’s Executive Vice President, General Counsel and Secretary) agreed to waive the standstill provision, and Hostetter agreed that he would not make any public announcement of his effort to solicit a superior offer. That same day, MediaOne filed its Annual Report, which did not disclose MediaOne’s March 30, 1999 waiver agreement with Hostetter.

On April 22, 1999, AT&T Corporation publicly proposed to acquire MediaOne in a transaction valued at $9 billion more than the value of the Comcast proposal. This offer was the result of Hostetter’s activities. Also on April 22, Hostetter filed a Schedule 13D with the SEC disclosing, for the first time, MediaOne’s March 30, 1999 agreement. On May 6, 1999, MediaOne officially terminated the Comcast agreement.

Plaintiff sued MediaOne and 11 of its officers and directors for alleged violations of §10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Plaintiff alleged that defendants fraudulently failed to disclose that Hostetter had been permitted to market MediaOne and keep that information from the public, thus deflating the value of MediaOne’s stock price between March 31 and April 21. The United States District Court for the Southern District of New York dismissed plaintiff’s amended complaint for failure to allege the element of scienter with adequate particularity. Plaintiff appealed the dismissal. The Second Circuit affirmed.

Since it was undisputed that the individual defendants had the opportunity to commit fraud, the issue was whether plaintiff had sufficiently alleged motive. Plaintiff claimed that defendants concealed Hostetter’s release from the 1996 standstill agreement (i) to protect themselves from liability for breaching the Comcast agreement’s "no shop" provision, (ii) to protect benefits that they would obtain under the Comcast agreement, and (iii) to ensure that Hostetter would be able to obtain a superior proposal. The Second Circuit agreed with the district court that the first two theories were "speculative and conclusory" and "too generalized," respectively. 264 F.3d at 139-40. Further, it termed plaintiff’s third motive theory "nonsensical" because all shareholders – not just the defendants – would benefit from a superior transaction. Id. at 140.

Where motive is not apparent, it is possible to plead scienter by demonstrating strong circumstantial evidence of defendant’s conscious misbehavior or recklessness. Reckless conduct is that which is highly unreasonable and represents an extreme departure from the standards of ordinary care. In Kalnit, plaintiff’s allegations of recklessness concerned MediaOne’s failure to disclose its waiver of a then three-year-old standstill provision. The public, moreover, was aware that MediaOne could accept a superior proposal within 45 days. The court found, given these facts, that there was no clear duty to disclose. Plaintiff’s claim of misrepresentation through non-disclosure therefore did not provide strong evidence of conscious misbehavior or recklessness.

Congress considered the Second Circuit’s pre-PSLRA test for pleading scienter to be the strictest in the country. See, e.g., 1995 U.S.C.C.A.N. 679, 694. Ironically, the Second Circuit (together with the Third) is now the most lenient. Generally, however, it has become more difficult for plaintiffs to plead securities fraud, as was Congress’ intent in enacting the PSLRA.