LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part XI: The Circuit Split Which Leads to Section 21D(b)(2) of the Reform Act

The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. 127 S. Ct. 2499 (2007) regarding Section 21D(b)(2) of the Reform Act is rooted in a split in the circuits over the pleading standards for the state of mind in securities fraud suits.  Prior to the Reform Act of 1995, Fed. R. Civ. P. 9(b) required that “fraud or mistake … shall be stated with particularity.  Malice, intent, knowledge, and other considerations of mind of a person may be averred generally.” 

The courts had no difficulty concluding that fraud had to be pled with “particularity.”  Under this standard, facts supporting the “who, what, when and where” of the allegation had to be included in the complaint. 

The courts had no difficulty in agreeing on what constitutes the required state of mind in a Section 10(b) claim.  Under the Supreme Court’s decision in Ernst & Ernst, 425 U.S. 185 (1976), a Section 10(b) claim required proof of scienter.  Although the Court reserved decision on the question of whether scienter included recklessness, the circuit courts quickly and uniformly answered the question in the affirmative. 

The circuit courts could not, however, agree on the requirements for pleading scienter, despite the plain language of Rule 9(b).  Indeed, a three way split developed.  The Second Circuit developed what became known as the strictest pleading standard, requiring a securities law plaintiff to plead a “strong inference” of scienter.  This standard could be met by demonstrating either a motive and opportunity to commit fraud or pleading facts constituting circumstantial evidence of either reckless or conscious behavior.  See, e.g., In Re Time Warner Sec. Litig., 9 F.3d 259 (2nd Cir. 1993). 

In contrast, the Ninth Circuit adopted the most liberal standard.  In In Re GlenFed Sec. Litig., 42, F.3d 1541 (9th Cir. 1994), the court concluded that under Rule 9(b), only notice pleading was required for scienter.  Under this test, only a general allegation was required.

Finally, several courts developed what was essentially a middle view.  In cases such as In Re HealthCare Compare Corp. Sec. Litig., 75 F.3d 276 (7th Cir. 1996), the courts required a plaintiff to plead facts demonstrating a basis for a claim of scienter. 

This split in the circuits over what was required to plead scienter became the key backdrop to Congress’ struggle in 1995 to craft pleading standards which would eliminate frivolous suits while permitting those with merit to proceed. 

Next, the passage of the 1995 Reform Act.