In 1999, the Ninth Circuit issued an opinion related to unjustified securities lawsuits and the Private Securities Litigation Reform Act that Congress passed in 1995 (the "Reform Act"). The Reform Act requires that every complaint filed in a private securities lawsuit for damages "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The Silicon Graphics decision held that:
- the "required state of mind" is an intent to defraud;
- to plead a "strong inference" of such intent, plaintiffs must allege, at a minimum, particular facts demonstrating deliberate or conscious recklessness;
- simply pleading "motive" (through executive stock sales) and "opportunity" (through executives' control of public statements about a company) is not enough to satisfy this pleading standard;
- general allegations that management received "internal reports" at odds with public statements are insufficient unless plaintiffs also plead the details of those reports, such as authors, recipients and particular contents contradicting the public statements; and
- when plaintiffs allege that executive stock sales before a "bad news" announcement demonstrate intent, courts must evaluate those sales in the context of historical patterns of executive sales and all relevant share holdings, including vested options.
A three-judge panel decided Silicon Graphics. Other Courts of Appeal have interpreted the heightened pleading standard that the Reform Act imposes. These decisions conflict with each other and with Silicon Graphics.
The Silicon Graphics Decision: Disciplined Application of Reform Act Requirements
The two-to-one Silicon Graphics majority affirmed the district court's dismissal of a 10b-5 securities lawsuit brought by the Milberg Weiss law firm against Silicon Graphics. Silicon Graphics is the first Ninth Circuit decision to interpret the Reform Act. The Court noted that Congress passed the Reform Act to stop "abuse in private securities lawsuits," in particular "the routine filing of lawsuits against issuers of securities and others whenever there is a significant change in an issuer's stock price, without regard to any underlying culpability of the issuer, and with only faint hope that the discovery process might lead eventually to some plausible cause of action."
To stop this abuse, Pillsbury lawyers were among the leaders working with a coalition of more than 200 companies to press successfully for passage of the Reform Act in 1995. Among its many salutary changes, the Reform Act added a heightened pleading standard to the Securities Exchange Act that requires every complaint filed in a private 10b-5 lawsuit to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." The Reform Act also stops all discovery while defendants test a private 10b-5 complaint against this standard, by a motion to dismiss decided by a federal judge.
Lower courts have been deeply divided in interpreting the Reform Act's heightened pleading requirement. The controversy centers on whether Congress intended courts to employ the Second Circuit's pre-Reform Act pleading standard. The Second Circuit's standard permits plaintiffs to proceed beyond the complaint stage-and begin avalanche discovery-provided that the complaint alleges either "facts constituting circumstantial evidence of either reckless or conscious behavior" or "facts establishing a motive to commit fraud and an opportunity to do so." Silicon Graphics directly addresses the applicability of the Second Circuit test to private lawsuits governed by the Reform Act.
Recklessness is sufficient only if plaintiffs allege particular facts showing deliberate or conscious recklessness.
Harkening back to the Supreme Court's decision in Ernst & Ernst v. Hochfelder, the Silicon Graphics majority held squarely that, in a 10b-5 case, the defendant must intend to commit a fraud: the "'required state of mind' ... has always been and continues to be 'fraudulent intent.'" The majority recognized that the Supreme Court left open in Hochfelder "whether, in some circumstances, reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5" and that Ninth Circuit decisions written before the Reform Act had held that "recklessness" was sufficient to raise a reasonable inference of intent. The majority found, however, that the Reform Act-with its requirement that plaintiffs plead particular facts showing a "strong inference" of the "required state of mind"--raises the bar. Plaintiffs now "must state specific facts indicating no less than a degree of recklessness that strongly suggests actual intent." The Reform Act "requires plaintiffs to plead, at a minimum, particular facts demonstrating deliberate or conscious recklessness."
Pleading motive and opportunity is not enough.
The Second Circuit's alternative test-permitting plaintiffs to plead intent to defraud by "motive and opportunity"-opens the door to lawsuits that are based not on particular facts showing that the defendant committed fraud but on circumstances that are common to most public companies. Every company has an "opportunity" to commit fraud simply because the company, and the executives controlling public announcements, draft and publish statements that contain material information. This leaves only "motive," which plaintiffs attempt to satisfy by alleging that a number of the executives made money selling stock while the company made positive statements.
Silicon Graphics rejects this "motive and opportunity" test. Reviewing the legislative history, the majority focused on the Conference Committee report, which said that the Reform Act:
"is based in part on the pleading standard of the Second Circuit. . . . Regarded as the most stringent pleading standard, the Second Circuit requirement is that the plaintiff state facts with particularity, and that these facts, in turn, must give rise to a 'strong inference' of the defendant's fraudulent intent. Because the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit's case law interpreting this pleading standard."
In a footnote, the Conference Committee added that it "chose not to include in the pleading standard certain language relating to motive, opportunity, or recklessness."
The Ninth Circuit found this language to demonstrate a congressional intent to "strengthen" pleading requirements beyond the Second Circuit's standard. Congress had intended that "plaintiffs proceeding under the [Reform Act] can no longer aver intent in general terms of mere 'motive and opportunity.'"
Executive stock sales provide evidence of intent only if they are unusual when examined in context.
Most public companies compensate their executives in part by awarding stock options. The companies expect that the executives will exercise those options and sell the shares they so acquire, with the sale proceeds constituting an important component of overall compensation. Most public companies also restrict executive sales to "window" periods beginning after the publication of one quarter's financial results and ending significantly before the publication of the next quarter's results. Together, modern compensation schemes and trading "windows" normally produce significant sales by multiple executives, selling roughly at the same time. When financial results later turn south, the professional plaintiffs' bar points to those sales as evidence of fraud, arguing that the sales show that the executives "dumped" their holdings before the market realized the company was in trouble. Plaintiffs' lawyers even ask courts to ignore the options that the executives held but did not exercise and focus only on the circumstance that the executives sold a large percentage of the shares they held outright.
The Silicon Graphics majority quoted from the 1989 Ninth Circuit Apple decision and reaffirmed that insider trading is suspicious only when it is "dramatically out of line with prior trading practices at times calculated to maximize personal benefit from undisclosed inside information." Relevant factors include (1) the amount and percentage of shares sold by insiders; (2) the timing of the sales; and (3) whether the sales were consistent with the insider's prior trading history. The Ninth Circuit found that, when reviewing executive stock sales, a court should consider not only the shares that a defendant holds outright but vested stock options as well.
Taking account of this information, the Silicon Graphics majority found that the stock sales plaintiff alleged were not suspicious. All but two of the officers "sold a relatively small portion of their total holdings [when options were included] and traded in a manner consistent with prior practice." As to the two remaining officers, one sold 43.6% of his holdings, but his sales represented an insignificant portion of the total executive sales. Moreover, this executive had only been with the company for one year, and so had no established trading history for purposes of comparison. While the other executive sold what the court called "a vast quantity of shares"-250,588 shares constituting 75.3% of his holdings-he had acquired his stock when Silicon Graphics bought his company. He had been legally forbidden to trade until shortly before he sold.
Plaintiffs cannot rely generically on "internal reports" to allege that executives knew that company statements were wrong.
Post-Reform Act decisions raise an additional question, beyond whether the Second Circuit test should apply: When plaintiffs attempt to plead a defendant's state of mind in a 10b-5 case by reference to "internal reports" that supposedly contradict an issuer's public statements, how specifically must plaintiffs describe those reports? Some complaints have referred simply to "internal reports." Others have generically referenced "flash reports" or "monthly financial packages."
Virtually all companies have such reports. It is an easy task for a plaintiffs' lawyer to quote an SEC filing, or a company press release, and then allege that a contemporaneous, internal report contradicted the filing or release. The professional plaintiffs' bar has deftly crafted paragraphs-which they include with little or no variation in different complaints against different companies--that appear on first review to refer to specific company documents but which, after a hard look, provide virtually no details-such as the dates, authors, recipients or specific contents of the reports.
In Silicon Graphics, plaintiffs alleged that the company and six executives made false positive statements about the production and sale of a new Indigo 2 workstation when the company and the executives knew that a chip shortage was causing serious production delays. Plaintiffs also charged that the company and executives made false public statements about continued sales growth when they knew that slowing sales would prevent Silicon Graphics from increasing its revenue at publicly projected rates.
The majority rejected the complaint's vague reliance on "internal reports" to plead knowledge that the public statements were false:
"[Plaintiff] alleges that SGI's internal reports alerted the officers to serious production and sale problems. According to [plaintiff], the Flash reports, Financial Statements/Packages and Stop Ship reports announced that: (1) SGI was not shipping the Indigo 2 workstation in volume; (2) North American and European sales remained slow; and (3) SGI would not meet its revenue and growth targets for FY96."
The Ninth Circuit found that these allegations were not enough. The complaint:
"does not include adequate corroborating details. [Plaintiff] does not mention, for instance, how [plaintiff] learned of the reports, who drafted them, or which officers received them. Nor does [plaintiff] include an adequate description of their contents which we believe-if they did exist-would include countless specifics regarding ASIC chip shortages, volume shortages, negative financial projections, and so on. We would expect that a proper complaint which purports to rely on the existence of internal reports would contain at least some specifics from those reports."
The Significance of the Silicon Graphics Decision
The Reform Act has reduced abusive securities lawsuits. A higher percentage of securities complaints today allege "hard number" accounting fraud rather than simply over-optimistic projections. The percentage of cases dismissed by motions filed at the outset-before the crippling burdens of discovery-has increased.
But problems persist. Plaintiffs are filing more securities lawsuits today than before the Reform Act. The Reform Act included new procedures for selecting plaintiffs who will represent the stock purchaser classes-procedures designed to favor institutional investors, who have sufficient sophistication and a sufficient stake in the case to wrest control from professional plaintiffs' lawyers. Institutional investors, however, have typically declined to step forward as class representatives. Private 10b-5 lawsuits are still the creatures of the attorneys who specialize in filing them.
Silicon Graphics tackles one of the most significant post-Reform Act questions-what it means to plead particular facts raising a "strong inference" that the defendants acted with the required state of mind. If it is not overturned, the decision will greatly advance the purposes of the Reform Act.
The Silicon Graphics majority summed it up this way:
"[Plaintiff's] assertions in the complaint differ very little from the conjectures of many concerned and interested investors. At one time, an immensely successful company and its officers state publicly that the company will continue to succeed. The officers then sell a noticeable quantity of shares at a considerable profit. Shortly thereafter, the company takes a turn for the worse and suddenly, suspicion abounds. . . . In the absence of greater particularity and more incriminating facts, we have no way of distinguishing [this plaintiff's] allegations from the countless 'fishing expeditions' which the [Reform Act] was designed to deter. . . . Congress enacted the [Reform Act] to put an end to the practice of pleading 'fraud by hindsight.' . . . [W]e conclude that [this plaintiff's] general allegations regarding negative internal reports and stock sales do not give rise to a strong inference of fraudulent intent."
The Game Is Not Over
The panel of three Ninth Circuit judges making the July 2 decision split 2-1. The dissenting judge disagreed with virtually all of the helpful analysis that is in the majority opinion.
We expect the plaintiffs' lawyers to petition the Ninth Circuit for a hearing en banc. If the Ninth Circuit grants that petition, an 11-judge panel-consisting of the Chief Judge and 10 other judges randomly selected from the other 20 active Ninth Circuit judges-will hear the case again. Given the diversity of views and securities experience on the Ninth Circuit bench, we cannot predict how an en banc panel would rule.
Silicon Graphics could ultimately be headed to the United States Supreme Court. Both the majority and the dissenting judge recognized that the Circuits now interpret the Reform Act's pleading requirements differently. The Second Circuit has, without analysis, continued to employ the "motive and opportunity" test. The Third Circuit has reviewed the text and legislative history in detail and concluded that "the Reform Act establishes a pleading standard approximately equal in stringency to that of the Second Circuit." On July 8, the Sixth Circuit, also after a lengthy analysis, concluded that plaintiffs may still satisfy 10b-5 pleading requirements by alleging recklessness but cannot supply the "strong inference" required by the Reform Act merely by pleading motive and opportunity. Since the Circuit courts disagree and the issues are important, the United States Supreme Court might well grant a hearing on one or more of these cases.
Conclusion
The July 2 Silicon Graphics decision takes an important step towards fulfilling the promise of the Private Securities Litigation Reform Act. But plaintiffs' law firms have made a very comfortable living off securities litigation for many years. This new decision threatens to significantly curtail their business. They will not let it do so without a fight to the finish. Stay tuned.