by T. GormanPosted on Posted in SECActions

Since most securities class actions are resolved shortly before or after the motion to dismiss, pleading standards are often critical. The PSLRA adopted the particularity requirement of Rule 9(b) in its specialized pleading standards.

Now however, a new pleading standard has emerged – Federal Civil Rule 8(a). Traditionally, the requirements of this Rule have been viewed as fairly easy to comply with and minimal. Last year however, in Bell Atlantic Corp. v. Twombly, 137 S.Ct. 1955 (2007), the Supreme Court reinvigorated the Rule. After reinterpreting its oft-cited Rule 8 holding in Conley v. Gibson, 355 U.S. 41 (1957), which many had viewed containing a very pro-plaintiff standard, the Court concluded that the Rule has a plausibility standard – a plaintiff must plead a cause of action which is plausible.

While Twombly is an antitrust case, in reaching its conclusion, the Court noted that “[w]e alluded to the practical significance of the Rule 8 entitlement requirement in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), when we explained that something beyond the mere possibility of loss causation must be alleged, lest a plaintiff with a ‘largely groundless claim’ be allowed to ‘take up the time of a number of other people, with the right to do so representing an in terrorem increment of the settlement value,’” quoting Blue Chip Stamps v. Manor Drug Stores, 411 U.S. 723 (1975).

The Court’s citation to Dura, a securities class action, as part of the origin of the “plausibility” standard, and Blue Chip Stamps, another securities damage action, for the abusive impact of discovery in meritless cases, clearly suggests that Twombly be applied in securities damage actions as a primary pleading standard.

Subsequently, Twombly has been followed in securities damage actions. In Atsi Communications, Inc. v. The Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007), the Second Circuit concluded that Twombly applies in securities damage actions. The court went on to affirm the dismissal of a securities damage complaint, concluding in part that the manipulation alleged in the complaint did not pass the “plausibility” test.

The First Circuit adopted a similar approach in ACA Financial Guaranty Corp. v. Advest, 512 F.3d 46, 58 (1st Cir. 2008). Although the court affirmed the dismissal of a securities damage complaint for failure to comply with the PSLRA pleading standards, the Court noted that the Twombly standard applies.

Finally, the Ninth Circuit reached a similar conclusion in Mississippi Public Employees Retirement System v. Boston Scientific Corp., 2008 WL 1735390 (9th Cir. April 16, 2008). See also Foster v. Wilson, 504 F.3d 1046, 1051 (9th Cir. 2007) (affirming the dismissal of a securities class action noting that ‘here the flaw in the federal fraud claim is not a failure to allege sufficient facts, but a failure to state a tenable theory upon which the claim could be established” without citing Twombly).

Next: PSLRA pleading standards – a strong inference of scienter

by T. GormanPosted on Posted in SECActions

Since antifraud Section 10(b) is the weapon of choice in many securities class actions, a key question is the reach of the statute – just who can be held liable under Section 10(b) and Rule 10b-5?

The Supreme Court’s decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (Jan. 15, 2008) earlier this year could have expanded the reach of the statute. It did not. Stoneridge rejected scheme liability theory under which business partners of defendant Charter Communications could have been held liable for allegedly participating in a fraud Charter perpetrated on its shareholders by falsifying its financial statements.

Stoneridge traces its roots to the Supreme Court’s 1994 decision in Central Bank of Denver N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In that case the Court concluded that there is no liability for aiding and abetting under Section 10(b). The decision is based largely on the literal language of the Section, which does not mention aiding and abetting.

Following Central Bank, the circuit courts struggled to determine who could be held liable under Section 10(b). Essentially two tests evolved, although there are variations. The Ninth Circuit created the “substantial participation” test. That test focused on the conduct of the potential defendant, keying on whether the person substantially contributed to the claimed fraud. Virtually no reference is made to the other elements of a Section 10(b) claim in the Ninth Circuit decisions discussing this test. In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1995); see also Howard v. Everex Systems, Inc., 228 F.3d 1057, 1061 (9th Cir. 2000).

In contrast, the Second and Tenth Circuits developed the “bright line” test. Under this test, the defendant must have made a misrepresentation which he or she knew or should have known would reach investors, essentially keyed to the fraudulent conduct and reliance elements of a claim. Shapiro v. Cantor, 123 F.3d 717 (2nd Cir. 1997); Anixter v. Home-Stake Production Co., 77 F.3d 1215 (1996). These circuits rejected the Ninth Circuit test.

The SEC crafted a different approach called “scheme liability.” Under this theory, a securities law plaintiff must prove three key elements to sustain a Section 10(b) claim: 1) the person must directly or indirectly engage in deceptive or manipulate conduct as part of a scheme; 2) there is a deceptive act whose principle purpose or effect is to create a false appearance; and 3) the plaintiff relies on a material deception flowing from defendant’s deceptive act. A variation of this theory was adopted by the Ninth Circuit in the Simpson/Homestore case, Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9th Cir. 2006). The Fifth and Eighth Circuits rejected it in, respectively the Enron and Charter Communications (later Stoneridge) cases. Regents of the Univ. of Calif. v. Credit Suisse First Boston (USA), 482 F.3d 372 (5th Cir. 2007), cert. denied, 128 S.Ct. 1120 (2008); In re Charter Communications, Inc., Sec. Litig., 443 F.3d 987 (8th Cir. 2006), reversed Stoneridge Investment Partners, LLC. V. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008).

Stoneridge considered the question of scheme liability under a fact pattern similar to those in Enron and Homestore. Each case, in essence, involved round trip barter transactions which allegedly were used by the issuer to falsify its financial statements and defraud its shareholders. Noting that scheme liability obviates the key element of reliance, the Stoneridge Court rejected the theory.

In support of its conclusion the Supreme Court cited five policy reasons: 1) the theory is too broad; 2) the acts of the defendants were too remote; 3) the transactions involving the third-party defendants were not securities transactions; 4) the deals plaintiffs sought to reach with their “scheme liability” theory were covered by state law; and 5) the cause of action for damages under Section 10(b) has been implied by the courts and not enacted by Congress, suggesting caution in expanding its reach. In many ways, the opinion is reminiscent of classic tort law foreseeability concepts.

The implications of Stoneridge are just beginning to emerge. The initial impact of the decision can be seen in Enron and Simpson. At the time Stoneridge was decided, petitions for certiorari had been filed in both cases. Following its decision in Stoneridge, the Supreme Court denied the petition in Enron, ending that litigation. The petition in Simpson was granted and the case was remanded to the Ninth Circuit which, in turn, sent the case back to the district court.

Another indication is the ruling in Grossman v. Merrill Lynch & Co., Civ. Action No. 2:03-cv-05336 (E.D. Pa. filed Sep. 23, 2003). There, claims against a law firm alleged to have participated in the fraud of a client company were dismissed based on Stoneridge. These early rulings clearly suggest that Stoneridge will in fact have a significant impact on the reach of Section 10(b).

Next: A new pleading standard