The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) is rooted in the language and history of Section 21D(b)(2) of the Reform Act.  That section adopted the “strong inference” language from the Second Circuit, effectively resolving a split among the circuits over the pleading requirements for state of mind in securities fraud actions.  While Congress sought to establish a uniform standard through the Reform Act, the circuits again split on the pleading standards afterwards.

Following the passage of the Reform Act, the circuit courts considered four key issues in interpreting Section 21D(b)(2).  Three of those issues are addressed in this segment of this series, while the fourth will be discussed in the next part. 

The first concerned the applicable state of mind.  Most courts quickly concluded that Congress did not disturb the well developed body of law following the Supreme Court’s decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), which held that a Section 10(b) cause of action requires proof of scienter.  Following that ruling, the circuit courts almost uniformly held that scienter includes reckless conduct.  See, e.g., Ottmann v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 343 n. 3 (4th Cir. 2003) (collecting cases).

The Ninth Circuit was the sole exception.  Based on the legislative history of Section 21D(b)(2), that court concluded that Congress intended to raise the standard.  Following this theory, the court held in In re Silicon Graphics Inc., Sec. Litig., 183 F.3d 970 (9th Cir. 1999) that the requisite mental state must be closer to actual intent – what the court called “deliberate recklessness.”

The circuits split again over a second issue, the meaning of the phrase “strong inference.”  The Second and Third Circuits concluded that Congress intended to adopt the pre-Reform Act Second Circuit case law interpreting the phrase.  Thus, for example, the Second Circuit in Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) held that to establish a “strong inference” of scienter, a securities law “plaintiff must either (a) allege facts to show that ‘defendants had both motive and opportunity to commit fraud’ or (b) allege facts that ‘constitute strong circumstantial evidence of conscious misbehavior or recklessness.’”  Press adopted the circuit’s pre-Reform Act case law.  Later, the SEC filed amicus briefs advocating this position before other circuits.

The Ninth Circuit, on the other hand, rejected the “motive and opportunity” prong of the Second Circuit test as inadequate.  In Silicon Graphics, the court concluded that a securities law plaintiff must plead “particular facts giving rise to a strong inference of deliberate recklessness, at a minimum … .”  Id. at 974. 

Other circuits adopted an intermediate position focused on the specific facts of the case.  For example, the First Circuit in Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999) held that the district court must analyze “the particular facts in each individual case to determine whether the allegations were sufficient to support scienter.”  See also City of Philadelphia v. Fleming Companies, Inc., 264 F.3d 1245 (10th Cir. 2001) (all allegations must be considered). Other circuits such as the Eleventh Circuit held that the motive and opportunity test was insufficient. Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283 (11th Cir. 1999).  Others such as the Sixth Circuit concluded that such evidence may be sufficient depending on the circumstances.  Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc); see also Ottmann, 353 F.3d 338 (4th Cir. 2003) (motive and opportunity may be sufficient depending on the case); Cf. In Re Green Tree Financial Corp. Options Litig., 270 F.3d 645 (8th Cir. 2001) (arguing that the Second Circuit constricted the motive and opportunity test over time).

A third key issue involved the group pleading doctrine.  Pre-Reform Act cases presumed that misrepresentations in filings were the collective action of officers.  See, e.g., Wool v. Tanden Computers, Inc., 818 F.2d 1433 (9th Cir. 1987).  Following the passage of the Reform Act, the courts split over the continued vitality of the doctrine based on the language of the Act which provided that “particularized” facts be pled as to each defendant.  Compare Southland Sec. Corp. v. Inspire Insurance Solutions, Inc., 365 F.3d 353 (5th Cir. 2004) (doctrine no longer applicable) with Schwartz v. Celestial Seasonings, Inc., 124 F.3d 1246 (10th Cir. 1997) (not inconsistent with Act). 

The final issue concerned the construction of competing inferences – not a traditional issue on a motion to dismiss under Fed. R. Civ. P. 12(b)(6).  The circuits also split over this key question, which is the issue decided by Tellabs against the backdrop of the other three. It will be analyzed in the next part of this series. 

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The Report by the Senate Finance Committee titled “The Firing of an SEC Attorney and the Investigation of Pequot Capital Management” is less than kind to the SEC and its Enforcement Division.  By all accounts, this is well deserved.  As the conclusion to the report notes:  “The investigation of Pequot Capital Management could have been an ideal opportunity for the SEC to develop expertise and visibility into the operations of a major hedge fund while deterring institutional insider trading and market manipulation through vigorous enforcement.  Instead, the SEC squandered this opportunity through a series of missteps … .”  Id. at 46. 

Regardless of the reasons, the Enforcement Staff dropped the ball on a major investigation.  The Office of the Inspector General, which conducted an internal investigation to determine what happened, did even worse.  No doubt any corporate counsel that came to the Enforcement Staff with an internal investigation of an issuer that had the difficulties of the SEC’s Pequot inquiry or that of the OIG would have received very rough treatment.  By its own standards, the Enforcement Staff deserved the same. 

The Pequot inquiry is past.  What remains are the detailed recommendations by the Senate Finance Committee for improving the Enforcement Staff.  These include standardizing investigative procedures, reallocating resources to significant and complex matters and other internal procedures designed to ensure that improper influences do not alter the course of enforcement inquiries.  As the SEC and its Enforcement Staff assess how to implement the recommendations in the Report, a key question of importance to many issuers, executives and market professionals is whether this will result in a renewed emphasis on insider trading.  After all, the Pequot inquiry was an insider trading investigation into a major hedge fund.  One result of all this could be marshalling of resources and a new emphasis on insider trading, hedge funds and market professionals. 

Last time Congress questioned the SEC about insider trading, within weeks the agency responded with a series of significant insider trading cases.  Last September for example, Congress held hearings on insider trading (see post of Sept. 27, 2006).  By early this year the SEC was bringing some of the most significant insider trading cases it had brought in years.  Coincidence?  Perhaps.  But then consider the fact that as those cases were being brought Enforcement Chief Linda Thomson noted that the once safe harbor of Rule 10b-5-1 plans used by many corporate executives might not be so safe.  The Enforcement Staff is scrutinizing the plans and the trading under them based on an academic study which suggested they were being abused.  This is, of course, precisely how the current option backdating scandal started. 

If past history is any indication, one immediate result of the Pequot debacle may be a new emphasis by the Enforcement Staff on insider trading.  A logical first target is hedge funds and other market professionals.  Next up, however, may well be corporate executives trading under the once safe harbor of a Rule 10b-5-1 plan and others with access to inside information.  This suggests that market professionals as well as corporate directors and officers should carefully examine compliance plans before trading to avoid what may well be intense scrutiny in a renewed insider trading program.  After all, the best defense is a good offense.  If the SEC did poorly in defending its investigation into insider trading at Pequot, a string of successes in insider trading investigations would be just the thing to deflect congressional critics. 

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