Securities Fraud
Scienter
State 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)
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]
Lewis F. Powell
(corporate lawyer)
[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 …
Recklessness
Motive and opportunity
Strong circumstantial evidence
Exchange
Exchange Act
Act 21D(b)(2)
21D(b)(2)
In
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made [materially
defendant
acted
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statement or
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have to
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misleading,
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with is
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particularity
misleading facts giving rise to
a strong inference that the
defendant acted with the
required state of mind.
9th Circuit
• “Deliberate recklessness”
• Intentional misconduct
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
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)
… 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]
Ruth Bader Ginsburg
(civil rights lawyer)
“omissions and ambiguities [in the
plaintiffs’ allegations] count against
inferring scienter” [discount
confidential witnesses]
Tellabs, Inc. v. Makor Issues & Rights, Ltd.
(US 2007)
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
Antonin Scalia
(law professor)
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
11.5%
11.5%
11.5%
11.5%
11.5%
Home mortgages
(P&I)
Pool
(diversifies risk)
7.2%
7.2%
7.2%
7.2%
7.2%
Bonds
(P&I)
Securitization
11.5%
11.5%
11.5%
11.5%
11.5%
Home mortgages
(P&I)
Pool
(diversifies risk)
• What is “gain on sale”
revenue recognition?
•Valuation
• Discount rate
• Loan default rate
• Loan prepayment rate
7.2%
7.2%
7.2%
7.2%
7.2%
Bonds
(P&I)
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)