Grounding the Short Circuit: the Need for Supreme Court Intervention in Scienter Pleading Requirements for Private Securities Fraud Cases After the Second Circuit's Decision Inatsi Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007)

• Publication year: 2021

91 Nebraska L. Rev. 238. Grounding the Short Circuit: The Need for Supreme Court Intervention in Scienter Pleading Requirements for Private Securities Fraud Cases After the Second Circuit's Decision inATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007)

Grounding the Short Circuit: The Need for Supreme Court Intervention in Scienter Pleading Requirements for Private Securities Fraud Cases After the Second Circuit's Decision in ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2d Cir. 2007)

Joe Ehrich

TABLE OF CONTENTS

I. Introduction.......................................... 239

II. Background........................................... 242
A. The Private Securities Litigation Reform Act of 1995 (PSLRA) .......................................... 242
B. The Post-PSLRA Circuit Split..................... 246
C. The Supreme Court Weighs In: Tellabs, Inc. v. Makor Issues and Rights, Ltd........................ 251

III. The Post-Tellabs Second Circuit Response: ATSICommunications, Inc. v. Shaar Fund, Ltd.............. 253

IV. Analysis.............................................. 254
A. The ATSI standard conflicts with Tellabs by allowing plaintiffs to plead scienter through individual allegations.............................. 256
B. The ATSI standard prevents full use of the Tellabs review process .................................... 258
C. ATSI conflicts with the Supreme Court's intent to create a heightened, uniform scienter pleading standard capable of reducing frivolous litigation.... 260

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D. The ATSI decision ensured a circuit split and provided a guide for the renewal of the wide split over motive and opportunity allegations ........... 264
E. The Supreme Court should fortify the Tellabs standard.......................................... 268

V. Conclusion............................................ 270

I. INTRODUCTION

A securities litigation defense attorney is currently seated at his desk considering the possibility that a securities fraud class action lawsuit will be filed against his client, the Chief Financial Officer (CFO) of Doe Corporation, by a group of the company's shareholders. Doe's share price recently plummeted from $50 to $5 after the company announced that it had prematurely recognized revenue and would be forced to restate its revenue projections for the upcoming quarter. Shortly after the announcement, a group of shareholders learned that the CFO's compensation package is tied to the company's attainment of a $50 common stock share price. Although his client is innocent, the attorney believes the shareholders will view this as a case of securities fraud and file suit against the CFO, alleging that due to the large compensation, he stood to gain from reaching this share price, and with his ability to influence the company's revenue projections, he possessed the motive and opportunity to defraud Doe's investors. Such allegations may create a strong inference that the CFO acted with the required state of mind, or scienter,(fn1) which is a mental state that reflects a defendant's "intent to deceive, manipulate, or defraud."(fn2) Scienter is a required element of a private securities fraud claim.(fn3)

Of course, these kinds of allegations could be equally, if not more suggestive of innocent behavior,(fn4) and only constitute relevant, not dis-

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positive, factors that must be considered with the rest of the complaint's allegations in determining whether a plaintiff has adequately pleaded scienter.(fn5) If the plaintiffs file in a federal court in the Third Circuit, where Doe's corporate headquarters is located, they cannot rely only on individual allegations of motive and opportunity to plead scienter. Rather, they must use the complaint's entire allegations, which can include motive and opportunity, to demonstrate an inference of scienter that is at least as compelling as the inference of the CFO's innocent state of mind, which the allegations will also suggest.(fn6) The plaintiffs can also expect, after receiving the CFO's likely motion to dismiss,(fn7) that a court reviewing their complaint will consider its collective allegations, compare the competing inferences, and only allow it to advance if the scienter inference is at least as likely as the innocent inference.(fn8) In holding plaintiffs to these requirements, the Third Circuit applies the stringent scienter pleading standard created by the Supreme Court in Tellabs,(fn9) which will prompt dismissal of the meritless complaint(fn10) and spare the CFO from the untenable, albeit almost inevitable, task of settling an invalid claim.(fn11)

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However, if the plaintiffs choose to file in the neighboring Second Circuit, these individual allegations of motive and opportunity alone will be sufficient to plead scienter.(fn12) Further, because courts in the Second Circuit have shown a proclivity for basing their scienter pleading findings solely upon the presence or absence of such allegations, a court reviewing the complaint after a motion to dismiss may summarily find that scienter-and therefore an inference as compelling as the opposing, innocent inference-has been pleaded.(fn13) If the court follows this review process, as others in the Second Circuit have done, it will not study the collective allegations, examine and compare the competing inferences, or determine whether the plaintiffs actually pleaded an equally strong inference of scienter.(fn14) Under such permissive pleading and dismissal review procedures, it is unlikely the court will dismiss the shareholders' lawsuit, even if it is meritless,(fn15) meaning the CFO may end up paying for something that he did not do.

Why the disparity in pleading standards between these two circuits? Quite simply, the Second Circuit, in ATSI, disregarded the pleading and review instructions the Supreme Court established in Tellabs by stating that plaintiffs may plead a strong inference of scien-ter using only allegations of motive and opportunity or conscious misbehavior or recklessness.(fn16) This decision has allowed plaintiffs to plead scienter using only such individual allegations;(fn17) encouraged courts within the Second Circuit to conduct abbreviated reviews of complaints at the dismissal stage;(fn18) undermined the Court's intent for a heightened, uniform scienter pleading standard capable of reducing frivolous litigation and allowing the advancement of meritorious claims;(fn19) and contributed to the renewal of a wide circuit split over whether motive and opportunity allegations are sufficient to plead sci-enter.(fn20) In sharp contrast to the divergent policies and practices of the Second Circuit, the Third Circuit adopted the full Tellabs provi-sions.(fn21) It therefore utilizes the scienter pleading standard that the Supreme Court intended.

Given the serious consequences of this split, the Second Circuit standard merits further discussion. This Note begins by discussing

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the Private Securities Litigation Reform Act (PSLRA), which established the pleading requirements for private securities fraud claims. Part II details the post-PSLRA circuit split over motive and opportunity allegations, and the pleading provisions the Supreme Court established in Tellabs. Part III describes the pleading prescriptions created by the Second Circuit in ATSI. Part IV discusses how the ATSI standard diverges from Tellabs by allowing plaintiffs to plead scienter through individual allegations, which has led to only partial application of the Tellabs dismissal review process in the Second Circuit and has undermined the Supreme Court's intent for a heightened, uniform scienter pleading standard capable of reducing frivolous claims. This Part also details how ATSI contributed to the post-Tel-labs circuit split over motive and opportunity allegations, and argues that the Supreme Court must rectify this untenable situation by fortifying the Tellabs review test. If the Court does not, plaintiffs who sue in the Second Circuit, as the Doe shareholders may, will continue to receive more favorable treatment at the pleading stage and have a greater opportunity to receive undeserved settlements from innocent defendants such as the Doe CFO than those who sue in the Third Circuit.

II. BACKGROUND

A. The Private Securities Litigation Reform Act of 1995 (PSLRA)

In December 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA)(fn22) to eliminate abuses in the private securities fraud class action realm.(fn23) One abuse was frivolous lawsuits, which, due to the prospect of significant discovery expenses, defendants often settled.(fn24) Congress sought to eliminate frivolous lawsuits through the provisions of the PSLRA,(fn25) such as stronger Rule 11 sanc-

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tions,(fn26) a limit on damages,(fn27) and a pleading standard,(fn28) which requires the plaintiff, for each alleged violation, to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,"(fn29) or scienter.(fn30)

The "strong inference" condition was a prominent change because it affected the pleading requirements for and recovery abilities of plaintiffs who sought to bring private securities fraud class action lawsuits. Section 10(b) of the Securities Exchange Act of 1934 makes it illegal to "use or employ, in connection with the purchase or sale of any security . . . any manipulative or...