Revitalizing motive and opportunity pleading after Tellabs.

• Author: Lowenthal, Marvin

Congress passed the Private Securities Litigation Reform Act of 1995 ("PSLRA ") to prevent frivolous lawsuits that had been draining resources from businesses. This legislation included provisions for heightening the pleading requirements for the scienter, or state of mind, requirement for securities law violations. Many circuit courts debated whether the motive and opportunity test for scienter, applied initially by the Second and Third Circuits, survived the passage of the PSLRA. This Note argues that while the motive and opportunity test has been discounted by numerous circuits, it not only remains viable for pleading scienter under the PSLRA, but it accomplishes the PSLRA's goals better than any other standard presently available. Despite the concerns voiced by many circuit courts, the PSLRA was not passed to eliminate the motive and opportunity test, nor is the motive and opportunity test, as it is now applied by the Second Circuit, inconsistent with the PSLRA. In addition, while the recent Supreme Court decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. convinced the Third Circuit to abandon the motive and opportunity test, the language of Tellabs demonstrates that the decision did not eliminate the test. Not only is the motive and opportunity test still viable, but it serves the policy reasons behind enacting the PSLRA better than the holistic approach utilized by other circuit courts.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND II. THE PSLRA's PASSAGE DOES NOT PREVENT MOTIVE AND OPPORTUNITY PLEADING A. The PSLRA Does Not Eliminate Motive and Opportunity Pleading by Raising the National Pleading Standard B. A Strong Inference of Scienter Is Required C. The Specter Amendment 1. The Conference Committee Notes 2. The Congressional Override of President Clinton's Veto III. THE MOTIVE AND OPPORTUNITY TEST IS NOT PROHIBITED BY TELLABS A. Motive and Opportunity Can Still Be Sufficient Even Though a Lack of Motive Is Not Fatal to a Complaint. B. The Complaint Is Examined as a Whole C. Competing Inferences IV. THE PSLRA's POLICY GOALS FAVOR IMPLEMENTATION OF THE MOTIVE AND OPPORTUNITY TEST A. Balancing Stopping Meritless Lawsuits Against Allowing Meritorious Claims B. Providing Uniformity C. Practical Difficulties in the Intermediate Approach Are Not Present in the Motive and Opportunity Test CONCLUSION INTRODUCTION

In 1994, the U.S. securities industry earned $1 trillion. (1) However, our securities markets were also facing substantial litigation pressure. While private securities class actions are an important part of the Securities and Exchange Commission's ("SEC") enforcement strategy, they can also be a burden on corporations. A study in the early 1990s conducted by Janet Cooper Alexander analyzed settlements in securities class actions and determined that companies settled for a similar amount, roughly one-quarter the potential damages, regardless of the merits of the case. (2) Her analysis considered the incentives of both plaintiffs and defendants in securities class actions and concluded that defendants had a strong incentive to settle, as did plaintiffs. (3)

Taking advantage of the incentives to settle, plaintiffs' firms have been accused of "legal extortion," filing baseless lawsuits against corporations in order to extract settlements, which the corporation agrees to in order to save the expense of litigation. (4) For example, within days or even hours of a drop in stock price, firms initiate lawsuits, even when there is little or no evidence of wrongdoing. (5) Congress's report on the problems of meritless suits designed to provoke settlement--known as "strike suits"--was highlighted by James Kimsey's testimony, the co-founder, CEO, and first chairman of America Online: "Even when a company committed no fraud, indeed no negligence, there is still the remote possibility of huge jury verdicts, not to mention the costs of litigation. In the face of such exposure, defendant companies inevitably settle these suits rather than go to trial." (6) Even though companies may have done nothing wrong, litigation can be unpredictable, and with the massive potential harm, companies consider settlement the safer option. Thus, strike suits lead to a needless drain on the resources of law-abiding companies whenever any negative news is presented.

Not only are law-abiding companies damaged, but Congress felt that if left unchecked, the whole of the United States would suffer as a result of these strike suits. (7) Professor David Fischel testified on this issue using hypothetical pharmaceutical companies to illustrate:

[Once a similarly-situated company has been sued, other companies] have several options, none of which are socially desirable. Some companies may decide not to go public. In this way, they can avoid possible liability but only by incurring the costs associated with more expensive private financing. Other companies may decide not to experiment with risky drugs. By avoiding risky projects, firms can avoid adverse outcomes that result in dramatic stock price declines. This solution, too, is undesirable, because society does not get the benefit of products that are never developed. The drug in the above example, after all, should be introduced because it is beneficial even though its benefits were less than was initially anticipated. A third solution is to remain silent about the drug because the company cannot later be accused of "fraud" if it chose not to speak in the first place. These "solutions" are perverse because investors--the supposed beneficiaries of the existing law--are denied the opportunity to invest in and learn about attractive but risky ventures. (8) As Fischel explains, the public is harmed when corporations are forced to take action to protect themselves from strike suits. In exchange for the damage that could result from these strike suits, the lawyers initiating the suits recover significant fees, while each shareholder recovers mere pennies. (9) Under these circumstances, the securities laws fail to prevent fraud, because lawsuits are filed whether or not fraud existed. (10) A company's shareholders are the ones harmed by corporate fraud, because it is their money in the corporation being used improperly. Thus, an anti-fraud legal system could work either by preventing fraud from happening or by reimbursing the shareholders when fraud does happen. If there is no deterrent value, a recovery of fractions of a dollar for shareholders does not seem to counterbalance the harm from strike suits.

In response to this issue, Congress passed the Private Securities Litigation Reform Act of 1995 ("PSLRA") to reign in securities fraud suits. The PSLRA established certain requirements for pleading securities class actions, as well as other provisions designed to check abusive filings by attorneys. (11) The required state of mind, or "scienter," for securities law violations targeted by the PSLRA has been defined by the Supreme Court as "a mental state embracing intent to deceive, manipulate, or defraud." (12) The circuit courts have long split in interpreting how the scienter element of the PSLRA's pleading standard should be satisfied. After the passage of the PSLRA, there were three viewpoints: the Second and Third Circuits allowed allegations of motive and opportunity to deceive, manipulate, or defraud alone to satisfy the pleading requirement; (13) the Ninth Circuit did not consider allegations of motive and opportunity sufficient; (14) and the First, Fourth, Fifth, Sixth, Seventh, Eighth, Tenth, and Eleventh Circuits employed what is known as the "intermediate approach," allowing allegations of motive and opportunity to help show scienter, but not considering them sufficient in every case. (15)

The Supreme Court recently resolved a different but related circuit split in Tellabs, Inc. v. Makor Issues & Rights, Ltd. (16) The full effect of the decision is not yet clear. However, after Tellabs the Third Circuit declared that the motive and opportunity test is no longer viable, (17) while the Second Circuit continues to use it. (18)

This Note argues that not only does pleading motive and opportunity according to the Second Circuit's current standards still satisfy the PSLRA's scienter requirement, it also accomplishes the PSLRA's goals better than the tests used in other circuits. Part I supplies a brief background regarding the PSLRA and the divergent interpretations the circuits have adopted for the scienter pleading requirements. Part II shows that the motive and opportunity test utilized by the Second and Third Circuits was not eliminated by the PSLRA. Part III then focuses on the language of Tellabs and how different circuits have interpreted it, concluding that Tellabs did not eliminate the motive and opportunity test. Part IV argues that allowing scienter to be pied through motive and opportunity better serves the policy goals of the PSLRA: the intermediate approach does not appear to be any better at filtering out meritless suits, and the motive and opportunity test better promotes uniformity in application than the intermediate approach.

1. BACKGROUND

   The PSLRA establishes requirements for pleading securities class actions, which are typically filed under Section 10(b) of the Securities Exchange Act of 1934. (19) In these lawsuits, a class alleges that it was harmed by fraud or misrepresentation in connection with the sale or purchase of securities. (20) The legislative history of the PSLRA notes a concern that if corporations were threatened with class actions every time they announced bad news, they would stop making voluntary disclosures. (21) For example, the PSLRA regulates the calculation of damages and determination of attorney fees, settlements, discovery stays, and provides sanctions for attorneys who pursue unwarranted suits. (22)

   The PSLRA also seeks to block frivolous lawsuits while permitting meritorious claims by establishing a uniform, high pleading...