Bell Atlantic Corp. v. Twombly, discussed in the last segment of this series here, imposes one pleading standard for securities class actions. The PSLRA adds three other key pleading requirements: 1) the complaint must specify each statement alleged to be misleading; 2) each statement made on information and belief must specify all facts on which it is based; and 3) as to state of mind, Section 21D(b)(2) requires that a “strong inference” be pled.

To craft the PSLRA pleading requirements, Congress borrowed from existing law. The particularity standards were taken from Federal Civil Rule 9(b), which requires that fraud be pled with particularity. That Rule did not however impose a heightened pleading standard for state of mind, requiring only general allegations. Nevertheless, some circuit courts crafted specific pleading standards regarding scienter.

The Second Circuit was viewed as having the most stringent standard in 1995 when the PSLRA was adopted. That standard required that a strong inference of scienter be pled. Under Second Circuit case law this requirement could be met by pleading either: 1) facts establishing motive and opportunity to commit fraud; or 2) facts constituting circumstantial evidence of either reckless or conscious behavior. See, e.g. In re Time Warner, Inc., Sec. Litig., 9 F.3d 1049 (2nd Cir 1993); but see In re GlenFed, Inc, Sec. Litig., 42 F.3d 1541 (9th Cir. 1994) (en banc) (holding that notice pleading was sufficient to plead scienter).

In writing Section 21D(b)(2), Congress adopted the “strong inference” test, but not the Second Circuit case law. The legislative reports however note that the Second Circuit case law should be considered as “instructive.” H.R. Conf. Rep. No. 104-369, at 15 (1995).

Following the passage of the PSLRA, the circuits split as to what constitutes a strong inference of scienter. The Second and Third Circuits followed the Second Circuit’s pre-PSLRA case law. See, e.g., Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 92nd Cir. 1999). The Ninth Circuit adopted what it called the “deliberate recklessness test,” which was a more stringent pleading standard than that used by the Second and Third Circuits. In re Silicon Graphics, Inc., Sec. Litig., 183 F.3d 970 (9th Cir. 1999). The First, Fourth, Sixth, Eighth and Tenth circuits adopted various intermediate positions. See, e.g., Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999); Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc); City of Philadelphia v. Fleming Co., Inc., 265 F.3d 1245 (10th Cir. 2001); Florida State Bd. Of Admin. v. Green Tree Fin. Corp., 270 F.3d 646 (8th Cir. 2001).

The circuit courts also split over how to deal with competing inferences. Traditionally, under Federal Civil Rule 12(b)(6) on a motion to dismiss all inferences were drawn in favor of the plaintiff. Since Section 21D(b)(2) required that a “strong inference” be pled, a key question became how to consider the various inferences raised by the allegations in the complaint. Again the circuits split. The First Circuit concluded there was no change to existing Rule 12(B)(6) practice. See, e.g., Aldridge v. A.T. Cross Corp., 284 F.3d 72 (1st Cir. 2002). The Ninth Circuit took a similar position, but noted that there was a “tension” between the Rule and the Section. See, e.g., Gompper v. VISX, Inc., 298 F.3d 893 (9th Cir. 2002). The Tenth Circuit, in contrast, concluded that all inferences had to be considered. See, e.g., Pirraglia v. Novell Inc., 339 F.3d 1182 (10th Cir. 2003).

The Supreme Court resolved the interpretation of Section 21D(b)(2) in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 761 (2007). There, the Court essentially held that the Section rewrites Rule 12(b)(6) procedure, requiring facts must be pled rendering an inference of scienter is at least as likely as any plausible opposing inference. While the Court noted that the inference must be “cogent,” the test is one of equipoise.

To assess the competing inferences, the Court held that the district court must: 1) accept all the facts in the complaint to be true as under existing Rule 12(b)(6) procedures; 2) consider the entire complaint; and 3) assess plausible opposing inferences.

Many commentators concluded that Tellabs is another pro-business decision by the Roberts Court. A review of the Circuit Court decisions applying the Tellabs decision however suggests that the impact of the case may be more difficult to assess. Clearly, the decision vests significant discretion in the district court to assess the various inferences. In many ways this may in fact mean that what constitutes a “strong inference” is in the eye of the reader or more appropriately the district court judge.

Next: The impact of Tellabs

This week, a private action based on a proxy fight raised a key question regarding the innovation of Wall Street, the application of disclosure rules under the securities laws and the position of the SEC. At the same time, the government continued to emphasize FCPA enforcement, while the option backdating scandal continued to trudge to conclusion. A final note of interest comes from a Canadian regulator in an insider trading case which was settled in a very different manner from what is typically seen in U.S. enforcement actions.

Disclosure obligations

CSX v. Children’s Investment Fund, (S.D.N.Y.) raises a key question concerning the continual creation of new products on Wall Street and the application of government regulations. In CSX, Judge Lewis Kaplan concluded that two hedge funds engaged in a bitter proxy contest violated Exchange Act Section 13(d). While the court entered an injunction prohibiting future violations of the Section, Judge Kaplan concluded that he could not enjoin the two hedge fund defendants from voting the shares at issue in the proxy contest under existing Second Circuit precedent.

The suit was brought by rail company CSX against two off-shore hedge funds, the Children’s Investment Fund and 3G Capital Partners. The complaint alleges that the hedge funds violated Section 13(d) by failing to disclose their ownership of CSX shares. Generally, Section 13(d) requires the filing of a Schedule 13D disclosing when a person or group of persons acting together owns 5% or more of a class of equity securities. The purpose is to alert the marketplace of the holdings and the intent the beneficial owner of the securities.

CSX claimed, since that the funds were acting as a group, they should have filed a Schedule 13D disclosing this fact. In view of their failure to do so, CSX requested that the funds be precluded from voting the shares in the coming proxy contest. The hedge fund defendants denied that they constituted a Section 13(d) group. At issue are potentially five seats on the CSX board, a minority, but substantial position.

The controversy centers on a Wall Street innovation called equity swaps. In essence, these swaps permit the separation of legal ownership and voting rights from the financial benefits. In the swaps at issue here, the two funds held the right to the financial benefits of CSX shares which were owned by brokerage firms that retained the voting rights.

CSX contended that the since the brokerage firms had no real economic interest in the shares, effectively the two funds controlled the voting. The funds, which are coordinating closely in the proxy contest, contended that since the voting rights legally remained with the brokerage firms, they were not a group for 13D purposes.

Judge Kaplan held that two hedge funds violated Section 13(d), noting that there was persuasive evidence establishing that the funds beneficially owned at least some, if not all, of the shares. In his lengthy opinion, Judge Kaplan stated that “some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formalistic legal arguments even when it is apparent that they have defeated the purpose of the law. This is such a case.”

Although Judge Kaplan asked the SEC to file an amicus brief, its General Counsel informed the court that there was not sufficient time to seek the views of the Commission and prepare such a brief. However, the Deputy Director of the Division of Corporation Finance submitted a letter generally supporting the position of the Funds.

Perhaps the real question going forward – absent an appeal – is how equity swaps and other esoteric creations of Wall Street will mesh with disclosure rules such as Section 13(d). Another key question is whether the SEC will adopt the position of the staff in view of Judge Kaplan’s ruling.

FCPA

The SEC and DOJ continued to bring cases in this key area enforcement area. As previously discussed here, the SEC brought an action against Faro Technologies, Inc. The complaint in hat case claimed Faro violated the anti-bribery provisions of the FCPA by paying bribes in China. According to the SEC, employees in the China sub requested authority to do business “the Chinese way” – that is, pay bribes. After securing a local legal opinion suggesting that such payments would probably violate Chinese anti-bribery laws, the parent company told its sub employees not to make the payments. Nevertheless, the payments were made.

The key to the SEC case seems to have been the fact that the company did not have an FCPA compliance program. Likewise, the company did not have an FCPA education program for its employees, despite doing business in what is clear a high risk area of the world. The SEC case was settled when the company consented to an injunction and the adoption of a compliance program.

DOJ also brought an action against Faro, who settled that case by entering into a non-prosecution agreement. The company agreed to pay a $1.1 million fine and consented to the appointment of a monitor.

Option backdating

The option scandal at Broadcom continued last week with the indictment of founder and former CEO Henry Nicholas and former senior company executive William Ruehle. The indictment is based on claims that between 1999 and 2005 the company backdated options resulting in a $2 billion restatement. U.S. v. Nicholas, Case No. 8:08-cr-00139 (C.D.Ca. June 4, 2008).

Previously, the company settled an option backdating option with the SEC. Also, former HR chief Nancy Tullos pled guilty to obstruction of justice charges (here).

A second indictment was brought against Mr. Nicholas alleging illegal drug use.

Marvel Technologies reached a tentative settlement last week in a derivative suit which was also based on option backdating. The settlement provides for certain corporate governance changes and the payment of legal fees and expenses. The company also has a class action pending against it based on backdating. Previously, Marvel settled similar claims with the SEC.

Insider trading

While the SEC clearly has emphasized insider trading enforcement, last week it was securities regulators in Alberta, Canada which settled an insider trading case. The action was against Paul Norman Oliver, a former CV Technologies executive who traded in the shares of his company to avoid a potential loss of about $250,000. The case was resolved with the payment of $375,000 and an additional $25,000 toward expenses.

A noteworthy feature of the settlement is its basis. SEC settlements are on the basis of neither admitting nor denying the claims. But here, Mr. Norman admitted in the settlement that he traded based on inside information.