Retroactive legislative history: scienter under the Uniform Security Litigation Standards Act of 1998.

• Author: Caiola, Eugene P.

1. INTRODUCTION

   The Private Securities Litigation Reform Act of 1995 (PSLRA)(1) established a new heightened pleading standard for securities fraud violations, based primarily upon the Second Circuit pleading standard. As illustrated, however, both in the text and in the legislative history of the PSLRA and the Securities Litigation Uniform Standards Act (Uniform Act),(2) the PSLRA did not change either the substantive scienter requirement or proscribe the manner in which the scienter requirement could be demonstrated.

   As Zeus gave to Pandora, Congress has handed the courts two potentially disastrous Acts, the PSLRA and the Uniform Act. However, unlike Pandora, the instructions given the circuits are less than explicit. As a result of the textual shortcomings of the PSLRA and the Uniform Act, the circuits will have no choice but to "open up" other avenues of statutory construction. However, the usual method of interpretation, intention as derived from legislative history, is not dispositive on the issue. The Uniform Act, despite some attempts to the contrary, fails miserably to clear up the pleading standards problems created by the PSLRA. Even if the courts wanted to rely on the retroactive legislative history given by the Uniform Act, the history provided is woefully convoluted. With no clear legislative intent demonstrated, the courts are left with the unhappy responsibility of interpreting an unclear statute without the benefit of definitive legislative instruction. Moreover, the precedent created by the circuits' interpretation of the PSLRA has, to date, largely ignored the history given by the Uniform Act, leaving future courts little in the way of helpful interpretive analysis. In resolving the issue of congressional intent, the courts must look to the historical context and textual clues within which the PSLRA and the Uniform Act were written.

   Part Two of this comment presents an overview of the 1933 and 1934 Securities Exchange Acts and the development of scienter as a requirement for securities fraud.(3) Part Three examines the flaws in the 1934 Act, and the congressional response to these problems, namely the adoption of the PSLRA.(4) Part Three also examines the relevant provisions of the PSLRA by tracing its development through Congress.(5) Part Four examines the difficulties wrought by the PSLRA, focusing on its failure to resolve the split in the circuits regarding the pleading standard.(6) The split is divided into three basic groups, with the Ninth Circuit alone in its analysis, the Second Circuit coupled with the Third Circuit representing another group, and the Sixth and Eleventh Circuits standing in between these two extremes.(7) Part Five of this comment examines the latest failure of Congress to fix this schism via the adoption of the Uniform Act.(8) Part Five also follows the legislative history of the Uniform Act through Congress.(9) Part Six of this comment analyzes the circuit split in light of both the PSLRA and the Uniform Act and proposes a solution to the split via both judicial oversight and corrective legislative action.(10) Part Six also sets forth the author's thesis: the legislative history and text of both the PSLRA and the Uniform Act and the normative goals of these Acts demand an adoption of recklessness as the scienter standard, and facts showing motive and opportunity to commit fraud satisfy the pleading standard so long as they are demonstrative of a strong inference of scienter.(11) Part Seven concludes this comment.(12)

2. 1933 AND 1934 SECURITIES ACTS

   The Securities Exchange Acts of 1933 and 1934 were written in response to the mistrust of the securities markets occasioned by the collapse of the stock market in 1929.(13) "The Securities Act of 1933 (1933 Act), 48 Stat. 74, as amended, 15 U. S. C. [sections] 77a et seq., was designed to provide investors ... protect[ion] ... against fraud [through the full disclosure of material information concerning the sale of particular securities,] and, through the imposition of specified civil liabilities, to promote ethical standards of honesty and fair dealing."(14) The 1934 Act was intended to prevent manipulation of stock prices through regulation of the securities exchanges and over-the-counter markets.(15) The 1934 Act also created the Securities and Exchange Commission (the SEC), which was given a full compliment of enforcement powers.(16) Acting in accordance with the regulatory authority conferred by [sections] 10(b) of the 1934 Act, the SEC promulgated Rule 10b-5 in 1942.(17) "Although [sections] 10(b) does not by its terms create an express civil remedy for its violation, ... the existence of a private cause of action for violations of the statute and the Rule is now well established."(18) As the Supreme Court noted in 1976, "since a private cause of action was first implied under [sections] 10(b) and Rule 10b-5, a substantial body of case law and commentary has developed as to its elements."(19)

   The Supreme Court, in Ernst & Ernst v. Hochfelder,(20) considered whether scienter is a necessary element of securities fraud violations, or whether negligent conduct alone is sufficient.(21) Hochfelder established that scienter must be demonstrated for liability to attach to a defendant's actions(22) but did not decide if a showing of recklessness would satisfy the scienter requirement(23) In the time, however, between Hochfelder and the adoption of the PSLRA, the circuits that considered the issue uniformly adopted recklessness as fulfilling the scienter requirement.(24) The Seventh Circuit, in Sundstrand Corp. v. Sun Chemical Corp.,(25) defined recklessness for the purposes of securities fraud.(26) In this opinion, largely concurred with by the other circuits,(27) the court stated:

   "[R]eckless conduct may be defined as a highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it.(28) Under the Sundstrand definition, the risk of misleading buyers "must be actually known" or sufficiently obvious that the reasonable man would know of it,(29) and "the omission must derive from something more egregious than even `white heart/empty head' good faith.(30) It is in this context of universal acceptance of both liability for recklessness and the Sundstrand definition of recklessness that the PSLRA was adopted.(31)

3. PRIVATE SECURITIES LITIGATION REFORM ACT (PSLRA)

   Part one of this section outlines the developments in securities litigation that originally necessitated the enactment of the PSLRA.(32) Part two looks at the complimentary provisions of the PSLRA that are responsive to the individual phenomena that led to its enactment and shows why these provisions are important in interpreting the heightened pleading requirement contained in the PSLRA.(33) Part three examines the legislative history behind the heightened pleading requirement imposed by the PSLRA.(34) Parts two and three of this section, along with the discussion in Part Four of this comment, form the crux of the author's argument; i.e., that the PSLRA and the Uniform Act demand the adoption of the Second Circuit's pleading standard, and, in some instances, its "motive and opportunity" test.(35)

   A. Flaws in the 1933 and 1934 Exchange Acts

   Although germane to the issues that existed contemporaneous to the adoption of the 1933 and 1934 Securities Exchange Acts, the Acts were not responsive to issues that had not, and would not, manifest themselves until decades after enactment. The original Exchange Acts were written within the context of protecting the individual investor from predatory corporate insiders.(36) By the time of the PSLRA, however, this emphasis had shifted, and it was the corporation that was perceived as in need of protection from overly litigious investors.(37)

   The rise of the professional plaintiff, abusive discovery practices, imposition of joint and several liability upon largely innocent parties, and windfall damages had all impacted negatively upon the corporate world.(38) By the 1990s it had become clear (at least to Congress) that the 1933 and 1934 Exchange Acts needed to be revised.(39) Professional plaintiffs were not only contributing to the filing of frivolous lawsuits, but also were harming other potential plaintiffs by not adequately representing these investors' interests as lead plaintiffs in class action suits.(40) Abuses of the discover process by securities litigation attorneys had become epidemic.(41) These costs of discovery combined with the threat of retaining key corporate personnel in prolonged litigation processes were being used to force coercive settlements.(42) The threat of joint and several liability upon directors was having a severe chilling effect upon the recruitment of qualified individuals to join corporate boards.(43) The potential for irrational windfall damages in lawsuits, both frivolous and otherwise,(44) combined with the courts' unwillingness to enforce sanctions, had made securities issuers easy targets for unscrupulous attorneys.(45) Moreover, the circuit courts had split in their interpretation of the pleading standard of the 1934 Act, exacerbating the damage.(46) In response to all of these issues, Congress enacted the Private Securities Litigation Reform Act of 1995.(47) The PSLRA responded to each one of the above issues through a series of complimentary provisions.(48) Additionally, the PSLRA attempted to impose a heightened pleading requirement upon those plaintiffs attempting to bring securities fraud claims.(49) It is this heightened pleading requirement that is the focus of this comment.

   B. Complimentary Provisions of the PSLRA

   The Conference Committee ("the Committee"), attempting to create a bill palatable to both the Senate and the House...