LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part XII: Section 21D(b)(2) Emerges From Hearings Detailing Abusive Litigation

The split among the circuits over how to plead scienter, coupled with the legislative hearings which detailed abuses in bringing private securities damage actions, spawned the requirement to plead a “strong inference” of scienter incorporated in Section 21D(b)(2) of the Reform Act. During the legislative hearings, Congress heard repeated testimony about the filing of suits which were lawyer-driven. Those suits, Congress was told, were frequently frivolous and contained few facts. Nevertheless, large settlements often resulted because of the burdens of discovery and the potential liability, rather than the merits of the claim. Based on this testimony, Congress concluded that a “complaint alleging violations of the federal securities laws is easy to craft and can be filed with little or no due diligence.” S. Rep. No. 98, 104th Cong. 1st Sess. 8 (1995). Congress concluded that Fed. R. Civ. P. 9(b) was largely ineffective.

In crafting Section 21D(b)(2), Congress borrowed the standard of “strong inference” from the Second Circuit case law, which was viewed as the highest pleading standard at the time. The purpose was to create a uniform pleading standard. See, e.g., H.R. Conf. Rep. 104-369 at 31, 41. At the same time, Congress chose not to adopt the Second Circuit case law which interpreted the strong inference standard.

As the bill containing what would become Section 21D(b)(2) moved through Congress, Senator Specter offered an amendment. That amendment sought to incorporate the Second Circuit case law into the bill which would become the Reform Act. The amendment was rejected, according to Senator Dodd because it contained an incomplete codification of the Second Circuit case law. 141 Cong. Rec. S 19067 (daily ed. Dec. 21, 1995).

The Joint Conference Committee Report stated that the “strong inference” standard was in fact taken from the Second Circuit case law and that the “particularity” requirements of the Reform Act were keyed to Rule 9(b). The Report went on to note that the bill was intended to strengthen pleading requirements. Accordingly, “it does not intend to codify Second Circuit’s case law interpreting [the] standard.” H.R. Conf. Rep. 104-369 at 41. The Report notes, however, that “courts may find this [the second circuit] body of law instructive.” Id. at 15.

Subsequently, President Clinton vetoed the bill, arguing that the standard exceeded that of the Second Circuit. At the same time, President Clinton made it clear that he would support a bill containing the Second Circuit standard. Congress overrode the veto. During the floor debates, supporters of the bill noted that it incorporated the Second Circuit standard. See, e.g., 141 Cong. Rec. S 1906 7 (daily ed. Dec. 21, 1995).

From this history, Section 21D(b)(2) of the Reform Act emerged, requiring that a securities fraud plaintiff plead a “strong inference” of the “required state of mind.” The undefined phrases in the section and the Section’s complex and at times seemingly contradictory history resulted in yet another split among the circuits over the proper pleading standards. That split ultimately resulted in the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. 127 S. Ct. 2499 (2007).

Next: The circuits split over the meaning of “strong inference” and the “required state of mind.”