Riding the Fence on Collective Scienter: Allowing Plaintiffs to Clear the PSLRA Pleading Hurdle

• Author: Heather F. Crow
• Pages: 313-344

Riding the Fence on Collective Scienter: Allowing

Plaintiffs to Clear the PSLRA Pleading Hurdle

―Law school taught me one thing;

how to take two situations that are exactly the same

and show how they are different.‖

1

When federal circuits split on a point of law, two situations that

are exactly the same may, in fact, be different. A split in the courts

results in uncertainty in the law and encourages forum shopping.

2

This is the current situation for plaintiffs who plead securities fraud

in the federal courts. A securities fraud class action claim against a

publicly held corporation in the United States has historically

resulted in an expensive proposition for corporations and

shareholders, especially before 1995.

3

At that time, plaintiffs could

file a claim and hope to unearth ammunition through discovery.

4

Consequently, meritless claims were a serious problem.

5

In 1995, Congress passed the Private Securities Litigation

Reform Act (PSLRA) in order to stem the tide of frivolous

litigation.

6

One principal change that the PSLRA made to

securities law was to heighten the pleading standards that a

plaintiff must meet—stricter requirements meant that surviving a

defendant‘s motion for dismissal was more difficult.

7

To validly

plead securities fraud, plaintiffs are required to plead, among other

things, both a misstatement and scienter, or fraudulent intent, by

the defendant.

8

Plaintiffs may allege liability for securities fraud

against individual defendants, such as corporate officers, or the

corporation itself.

9

The PSLRA changed securities law so that the misstatement

and intent elements of a claim are pled with particularity, rather

Copyright 2010, by HEATHER F. CROW.

1

. Ha rt Pomerantz Quotes, FAMOUS QUOTES & AUTHORS, http://www.

famousquotesandauthors.com/authors/hart_pomerantz_quotes.html (last visited

Nov. 6, 2009). Hart Pomerantz is a lawyer and Canadian television comedian.

2

. Michael A. Perino, Did the Private Securities Litigation Reform Act

Work?, 2003 U. ILL. L. REV. 913, 947–48.

3

. H.R. REP. NO. 104-369, at 31–3 2 (1995) (Conf. Rep.), reprinted in 1 995

U.S.C.C.A.N. 730, 730–31.

4

. Id.

5

. Id.

6

. Id.

7

. Adam Pritchard, Should Congress Repeal Securities Class Action

Reform?, POL‘Y ANALYSIS (Cato Inst., Wash., D.C.), Feb. 27, 2003 , at 6–8,

availa ble at http://www.cato.org/pubs/pas/pa471.pdf.

8

. Dura Pharmaceuticals, Inc. v. B roudo, 544 U.S. 336, 341–42 (2005).

9

. Securities Exchange Act of 1934 § 3(a)(9), 15 U.S.C. § 78c(a)(9) (2006).

314 LOUISIANA LAW REVIEW [Vol. 71

than simply inferred.

10

In other words, before discovery ever

begins, a plaintiff must have sufficient factual detail to adequately

allege fraud.

11

As plaintiffs strive to meet the heightened pleading

requirements, varying pleading theories and doctrines have

developed.

12

One of the most controversial is the theory of

collective scienter.

13

Collective scienter permits the aggregation of one person‘s

misstatement with the intent of another in a single pleading in

order to attribute an allegation of scienter to the corporation, rather

than pinpoint a single actor who intentionally misspoke.

14

The

issue of whether to accept collective scienter as a pleading theory

resulted in a split among federal circuits.

15

Consequently, the same

set of facts may result in a different outcome in different circuits.

Consider three scenarios.

Scenario #1:

A publicly traded pharmaceutical company discovers a

revolutionary new drug. During the company‘s quarterly

conference call report, the CEO makes a statement about the

drug‘s positive results in clinical trials. Predictably, the company‘s

stock price receives an upward jolt. Unbeknownst to the CEO,

company scientists discover that the drug has a terrible side effect

that could render it unusable. However, the scientists operate in a

small lab in a foreign country and decide not to tell anyone.

Under a pure collective scienter theory, pleading fraud here is

viable by aggregating the unknowing false statement of the CEO

with the knowledge and intent of the scientists.

16

While this may

be the only option for a plaintiff to meet the pleading requirements,

this scenario illustrates the primary argument for rejection of the

theory of collective scienter. The liability claim is too broad,

impeaching those who made statements in good faith and

extending beyond what Congress intended with the passage of the

PSLRA.

17

10

. 15 U.S.C. § 78u-4(b)(1) (20 06).

11

. Id.

12

. Patricia S. Abril & Ann Morales Olazabal, The Locus of Corpora te

Scienter, 2006 COLUM. BUS. L. REV. 81, 86.

13

. Id.

14

. Id.

15

. See infra Part III.

16

. Kevin M. O‘Riordan, Clear Support or Cause for Suspicion? A Critique of

Collective Scienter in Securities Litigation, 91 MINN. L. REV. 1596, 1597 (2007).

17

. Id. at 1621.

2010] COMMENT 315

Scenario #2:

The CEO makes the same statements. Although the

information about the drug‘s side effect is not public, the CFO is

informed of these effects through lower level employees. He asks

them to sit on the information. Later, the information is leaked to

the press, and the company‘s stock price plummets. Again, there is

a potential claim of corporate fraud for the non-knowing

misleading statements made by the CEO while the CFO

intentionally withheld the information. Under a strict reading of the

PSLRA by federal circuit courts that reject the pleading theory of

collective scienter, the case faces dismissal because the person who

actually made the misleading statement, the CEO, had no

knowledge that the information was false and had no intent to lie.

18

On the other hand, a circuit court that has not rejected the theory

may allow aggregation of the misstatement of the CEO with the

intent of the CFO to allege corporate scienter,

19

which allows the

claim to survive under the theory of collective scienter.

20

Scenario #3:

The CEO knows that the drug is dangerous and a public

revelation of this information will cause the stock price to

plummet. He makes no public statements. The public relations

department issues statements that are eventually revealed to be

false. Although the CEO took no part in making these statements,

he deliberately failed to prevent them. Under a pure rejection of

collective scienter, the CEO‘s actions may enable the company to

skate on a dismissal because there is no intersection between the

individual, the misstatement itself, and the intent to defraud.

21

Under this rule, only when all three elements collide in one actor is

a corporate liability claim adequately pled.

22

This is the scenario that proponents of the collective scienter

theory warn against. A company may use its separate parts to avoid

liability by ensuring that the person with the knowledge and intent

is not the one who makes misleading statements.

23

After Congress

18

. Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353 (5th Cir.

2004); see also Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015 (11th Cir. 2004).

19

. Corporate scienter is co ncerned with attributing the intent element to the

corporation, rather than an individual actor.

20

. City of Monroe Emps. Ret. Sy s. v. Bridgestone Corp., 399 F.3d 651 (6th

Cir. 2004).

21

. Southland Sec., 365 F.3d at 366.

22

. Id.

23

. Charles W. Murdock, Sarbanes-Oxley, Corporate Corruption, and the

Complicity of Courts and Legislatures 43–46 (Sept. 7, 2006) ( unpublished

manuscript), availa ble at http://ssrn.com/abstract=1012970.