For more than thirty years, plaintiffs in a federal securities lawsuit under Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act") have been required to allege and prove that the defendants committed the securities law violation with "scienter", which the U.S. Supreme Court defines as "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Although the Supreme Court has not directly decided whether scienter includes recklessness for this purpose, virtually all Federal District Courts and all Federal Courts of Appeal that have addressed this issue over the last three decades have concluded that recklessness constitutes scienter.
Federal courts, though, historically disagreed regarding the specificity by which a plaintiff must allege the existence of scienter in order to properly plead a securities fraud case. Some courts, following a rule established in the Ninth Circuit, held that plaintiffs may generally plead scienter by simply alleging that defendants acted with scienter. Other courts followed a rule established by the Second Circuit, which required plaintiffs to plead specific facts giving rise to a strong inference of scienter.
The Private Securities Litigation Reform Act of 1995 ("Reform Act") established a uniform scienter pleading standard which was intended to preclude frivolous securities litigation. Under the Reform Act, a complaint alleging securities fraud must "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all the facts on which the belief is formed." In order to sufficiently allege scienter, the complaint must now "state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind." If the complaint fails to satisfy these pleading requirements, the lawsuit must be dismissed at the early pleading stage of the litigation before plaintiffs can conduct discovery.
The most litigated issue under the Reform Act to date has been what does this uniform pleading standard for scienter mean and how should it be applied. The debate centers around whether this new pleading requirement simply adopts the pre-existing Second Circuit scienter pleading requirement or whether a new, more demanding pleading requirement now exists. Within the last several months, five different Federal Courts of Appeal addressed this issue for the first time, reaching significantly different conclusions. As explained below, these new decisions are already having an important impact on the prosecution and defense of federal securities litigation and may warrant changes in the structure and terms of a company's D&O insurance program.
Recent Court Decisions
Second Circuit/Third Circuit
The Third Circuit (which includes New Jersey, Pennsylvania and Delaware) and the Second Circuit (which includes New York) basically adopted the historical Second Circuit scienter pleading requirement. In re Advanta Corp., Sec. Lit., 180 F.3d 525 (3d Cir. 1999); Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 538 (2d Cir. 1999). Under that standard, plaintiffs may plead scienter by alleging facts which give rise to a strong inference that defendant's had a motive and an opportunity to commit fraud, or by setting forth facts that constitute circumstantial evidence of either reckless or conscious behavior.Although the Second Circuit opinion in Press failed to explain how it arrived at this conclusion, the Third Circuit decision determined that Congress implicitly adopted the pre-existing Second Circuit standard and simply added an additional requirement that plaintiffs must allege the requisite facts with particularity. Thus, catch-all allegations that defendants stood to benefit from wrongdoing and had the opportunity to implement a fraudulent scheme are no longer sufficient to allege scienter. However, plaintiffs may be able to satisfy this scienter pleading standard by alleging in circumstantial fashion a combination of stock sales for profit by insiders during the class period (i.e. a "motive" for securities fraud) and the roles those individuals had as officers or directors of the Company (i.e. the "opportunity" to commit securities fraud).
Ninth Circuit
The Ninth Circuit adopted a diametrically opposed analysis to that of the Second and Third Circuits. In a highly publicized case, the Court found that the plain language of the Reform Act failed to specify what would establish a "strong inference" of intent, and therefore the Court looked to the legislative history of the Act. The Court concluded that the Reform Act created a new heightened pleading standard requiring the plaintiff, at a minimum, to plead in great detail particular facts demonstrating "a strong inference of deliberate or conscious recklessness", specifically rejecting the use of the Second Circuit's "motive and opportunity" test. In re Silicon Graphics, Inc., Sec. Lit., 183 F.3d 970 (9th Cir. 1999). The Court did not define "deliberate or conscious recklessness," although the Court stated that this phrase, at least for purposes of Section 10(b) of the 1934 Act, refers to "a form of intent rather than a greater degree of negligence."If applied literally, this new heightened pleading standard would likely result in dismissal of a significant number of securities class action lawsuits which previously survived motions to dismiss. Presumably, pleading "ordinary" recklessness is no longer sufficient but instead plaintiffs must allege facts establishing a strong inference of "deliberate" recklessness. Rarely can plaintiffs allege specific facts showing actual fraudulent intent, especially at the beginning of a case before any formal discovery. Insider trading by defendant D&Os does not establish that strong inference since in the Silicon Graphics case, two of the insider defendants sold over 95% of their stock during the class period yet their dismissal was affirmed by the Ninth Circuit. Also, the Ninth Circuit affirmed the District Court's granting of summary judgment in favor of the individual defendants based upon the D&O defendants' "uncontested" affidavits denying any wrongdoing, despite the fact that the plaintiffs were prevented from deposing those defendants because of the Reform Act's discovery stay while the motion to dismiss was pending. Not surprisingly, plaintiffs have sought review of this opinion by the entire Ninth Circuit en banc.
Sixth Circuit/Eleventh Circuit
The Sixth Circuit (including Ohio, Michigan, Kentucky and Tennessee) and Eleventh Circuit (including Florida and Georgia) appear to have adopted yet a third pleading standard under the Reform Act, charting a middle course between the historical Second Circuit standard and the very difficulty Silicon Graphics standard. These Courts concluded that the Reform Act did not change the substantive meaning of scienter, only the standard for pleading scienter. Because courts have historically and consistently recognized that recklessness suffices to establish scienter, these Courts concluded that pleading recklessness is sufficient if pled with facts that give rise to a strong inference of recklessness. However, the Courts rejected the pre-existing Second Circuit pleading requirement of motive and opportunity because the Courts concluded that bare pleading of motive and opportunity does not, standing alone, constitute the pleading of a strong inference of scienter. Thus, the Sixth Circuit held that "plaintiffs may meet [the Reform Act] pleading requirements by alleging facts that give rise to a strong inference of reckless behavior but not by alleging facts that illustrate nothing more than a defendant's motive and opportunity to commit fraud." In dicta, the Sixth Circuit stated that recklessness is "understood as a mental state apart from negligence and akin to conscious disregard," thereby suggesting the Sixth Circuit may accept a definition of recklessness similar to the Ninth Circuit. The Eleventh Circuit similarly held that plaintiffs must allege facts that give rise to a strong inference of "severe recklessness," apparently requiring something more than "ordinary recklessness." In re Comshare, Inc., Sec. Lit., 183 F.3d 542 (6th Cir. 1999); Bryant v. Abado Brands, Inc., 1999 U.S. App. LEXIS 21051 (11th Cir. Sept. 3, 1999).
Impact of Recent Decisions
Although it is still too early to accurately predict all of the important ramifications of these recent Federal Court of Appeals decisions, an initial analysis suggests that one cannot understate the potential importance of these decisions with respect to future D&O liability exposure in securities litigation and D&O insurance coverage for that exposure.
The following summarizes some of those important actual and potential liability and insurance ramifications:
Supreme Court Review
Because the Federal Courts of Appeal have interpreted the Reform Act pleading requirement differently in several material respects, it appears likely that the U.S. Supreme Court will eventually agree to resolve this conflict. One of the express goals of Congress in enacting the Reform Act was to adopt a uniform pleading standard which would be applied consistently in all federal securities lawsuits regardless where the lawsuit was pending. Ironically, the opposite result now exists and therefore it is incumbent upon the Supreme Court to resolve these conflicting statutory interpretations.In ruling on this issue, the Supreme Court can be expected to answer two basic questions. First, is some form of reckless behavior sufficient to impose liability under Section 10(b) of the 1934 Act, or must plaintiffs prove intentional misconduct? If recklessness is sufficient, must it be "ordinary," "severe" or "deliberate and conscious" recklessness? Although the Supreme Court has historically refused to address this issue, all Federal Courts of Appeal have consistently ruled that recklessness is sufficient to establish a Section 10(b) violation. However, in light of (i) the Supreme Court's current composition, (ii) language in the Supreme Court's 1976 Hochfelder decision, and (iii) certain legislative history to the Reform Act, some legal scholars believe there is a reasonable possibility that the Supreme Court may disallow the use of recklessness as a basis for Section 10(b) liability. Second, what facts must plaintiffs specifically allege in their complaint in order to properly plead a violation of Section 10(b) (i.e. what does the Reform Act's uniform pleading standard mean)?
Pending Securities Class Actions
As an initial response to the heightened pleading requirements recognized by the Ninth Circuit in the Silicon Graphics case, plaintiffs' counsel in the last several months have attempted to stay virtually every pending securities class action in district courts within the Ninth Circuit where a motion to dismiss is pending or will soon be filed. Plaintiffs' counsel apparently recognized that under the harsh pleading requirements set forth in the Silicon Graphics case, most securities cases will be dismissed. By seeking a stay of those cases, plaintiffs are hoping that they will obtain some relief from that harsh pleading standard either through the requested en banc review of that decision by the entire Ninth Circuit or by the U.S. Supreme Court. However, a ruling by the entire Ninth Circuit, even if the en banc review is granted, will likely not occur until mid-2000 and a ruling by the Supreme Court, even if the Court decides to hear this issue, would likely not occur until at least 2001. Thus, the number of motions to dismiss which are granted within the Ninth Circuit will likely increase materially unless and until the en banc Ninth Circuit or the Supreme Court modifies the "deliberate or conscious recklessness" pleading standard adopted by the Silicon Graphics decision. Only a modest increase in dismissals is likely in cases outside the Ninth Circuit.
New Securities Class Actions
Because of the Ninth Circuit's harsh pleading standard, few securities class action lawsuits will likely be filed in the future in the Ninth Circuit. Instead, plaintiffs will more likely file in the Second or Third Circuits (i.e., New York and the surrounding region) where possible, since those Circuits have adopted the most liberal pleading standard. It is currently unclear whether such a development will be beneficial or detrimental to defendants.
Dishonesty/Fraud Exclusion
To the extent the Ninth Circuit's "deliberate or conscious recklessness" standard applies, the dishonesty/fraud exclusion in at least some D&O insurance policies will become much more important. Section 10(b) has been consistently recognized by courts to prohibit securities "fraud." If some type of "deliberate" wrongdoing is required to impose liability, an exclusion in a D&O insurance policy applicable to "deliberate fraud" or other comparable conduct presumably would now apply to a Section 10(b) lawsuit. Under prior law, such an exclusion would not have applied to most Section 10(b) lawsuits because those suits were usually based upon simple recklessness. Thus, at least for cases in the Ninth Circuit, this exclusion may now eliminate coverage for any Section 10(b) lawsuit unless the exclusion applies only upon a final adjudication of liability. Even if the exclusion contains final adjudication language, there presumably would now be no coverage for any judgment in such a lawsuit in the Ninth Circuit since plaintiffs must prove deliberate fraud to obtain that judgment.
Uninsurable
Even if the dishonesty/fraud exclusion does not apply to the securities claim, no coverage may be afforded for a securities claim that requires deliberate or conscious wrongdoing since such coverage may be viewed as contrary to public policy. For example, California Ins. Code ' 533 prohibits an insurer from indemnifying an insured for willful acts:
An insurer is not liable for a loss caused by the willful act of the insured;.Other states have similar statutory or case law public policy limitations on insurance coverage for intentional or willful wrongdoing. Although the insurability of securities claims historically has not been a significant issue because liability for Section 10(b) violations could be premised upon simple recklessness rather than intentional wrongdoing, this issue may become much more important under the Ninth Circuit's "deliberate or conscious recklessness" standard, thereby potentially jeopardizing coverage for judgments and perhaps settlements in Section 10(b) cases.
Incentive to Settle
For more than 30 years, the SEC has taken the position that it is against public policy for a corporation to indemnify its directors and officers for violations of the federal securities laws and most courts that have examined that issue have agreed. However, the SEC and the courts have permitted corporations to indemnify D&Os for settlement amounts incurred in securities litigation. The risk of incurring a non-indemnifiable judgment in a securities lawsuit historically has been one of the principle reasons why corporations purchase D&O insurance.If as a result of the Silicon Graphics decision there is now no insurance coverage for non-indemnifiable judgments in securities litigation, D&Os face an enormous potential gap in insurance coverage and potentially subject their personal assets to catastrophic risk. As a result, D&Os will likely have an even greater incentive to settle any securities lawsuit as quickly as possible in order to avoid the risk of incurring a non-indemnifiable and uninsured judgment. Plaintiffs' lawyers will quickly recognize that strong settlement motivation and can be expected to insist upon larger and larger settlements in response to defendants' strong settlement desire. Thus, the ironic effect of the very pro-defendant Silicon Graphics decision may be much larger settlement amounts in securities lawsuits that survive a motion to dismiss.
Insurance Policy Amendments
In response to these concerns, insureds should examine the adequacy of their current D&O insurance protection. For example, the dishonesty/fraud exclusion should require a final adjudication and could further provide that the exclusion applies only if the final adjudication establishes that the defendant D&Os acted with the actual purpose and intent to defraud or that the D&Os committed the fraudulent wrongful act "with actual knowledge of its wrongful nature or with intent to cause damage". Such language arguably may preserve coverage for some judgments based on "deliberate recklessness." If uninsurability is a concern, the insureds should consider purchasing the desired coverage offshore where public policy coverage restrictions may be less. To accomplish that goal, insureds could either purchase their entire D&O insurance program offshore or could simply purchase a "wrap-around" offshore policy for uninsurable securities judgments, similar to wrap-around punitive damage policies.
Summary
In summary, particularly the recent Silicon Graphics Court of Appeals decision raises a host of potentially significant liability and insurance issues. Many of those issues may evaporate if the decision is subsequently reversed or significantly amended. Similarly, many of those issues currently do not apply to securities lawsuits filed in courts outside the Ninth Circuit. Nonetheless, a careful consideration of those issues and possible responses thereto appears appropriate at this time given the potentially severe consequences to D&Os which may result if that ruling or future comparable rulings apply. This proactive planning is particularly appropriate from an insurance standpoint since D&Os may not learn what scienter standard applies until after the securities lawsuit is filed and after the terms of the D&O insurance coverage for that lawsuit are agreed upon.