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.  

A Sad end to the Pequot investigation 

The Senate Finance Committee issued a lengthy report on the SEC’s now closed investigation into Pequot Capital Management which hopefully is the final chapter in this sad saga.  The report details one misstep after another by the SEC enforcement staff in handling this matter leading many to conclude, as Gretchen Morgenson and Walt Bogdanich wrote in the New York Times that the SEC “bungled a promising investigation … .”  Gretchen Morgenson and Walt Bogdanich, Report Says SEC Erred on Pequot, N.Y. Times, Aug. 4, 2007.  Among the more disturbing aspects of the report are repeated suggestions that senior Enforcement staff acted improperly in narrowing and eventually closing the inquiry. 

Perhaps the most inexplicable element of this entire matter is the SEC’s handling of it, once allegations of impropriety were raised.  The SEC supposedly conducted an internal inquiry which found nothing wrong.  In that inquiry, the investigators found it unnecessary to talk to the primary whistleblower, former staff member Gary Aguirre.  This conduct is inexplicable for an agency that regularly reviews the completeness of internal investigations conducted by public companies.  Indeed, it is hard to imagine any company under SEC scrutiny trying to convince the Enforcement staff that there was no impropriety based on an internal investigation that failed to interview key witnesses.  

Equally disturbing is the suggestion in the Senate report that senior staff may not have been candid with Congress.  For an agency that regularly conducts investigations and which emphasizes the fact that its processes rely on the integrity of those who appear before it, anything less than full and complete candor, no matter how distasteful is inexcusable.  No doubt the SEC should take a page from its own book:  when there is an alleged impropriety, conduct a full and complete investigation and let the chips fall where they should, not where you would like them to fall.

Finally, the Senate report recommends that the SEC recraft some of its internal procedures.  Included is a recommendation that it standardize employee evaluation procedures, prepare a manual of procedures for conducting investigations and allocate additional resources to the Enforcement division.  Sounds like the SEC should apply the SOX internal controls requirements to itself. 

Option backdating 

As mentioned in the August 7, 2007 entry in this blog, the jury in U.S. v. Reyes returned the first verdict in an options backdating enforcement case: Mr. Reyes, the former CEO of Brocade Communications was found guilty on all counts.  Defense lawyers reportedly were stunned, as many commentators suggested that the verdict would signal full steam ahead on the dozens of other options backdating investigations being conducted by the SEC and criminal prosecutors.  

While Mr. Reyes is awaiting sentencing, former Take-Two Interactive General Counsel Kenneth I. Selterman was sentenced to three years of probation for falsifying a letter to regulators.  This occurred in the context of an options backdating investigation.  

Options backdating civil cases seem to be having less success, however.  Last week, Judge Fogel dismissed a class action complaint against Mercury Interactive Corporation based on options backdating.  In re Mercury Interactive Corp. Sec. Litig., Case No. C 05-3395 JF (N.D. Cal. July 30, 2007).  A derivative suit against the company based on the same conduct had previously been dismissed.  Mercury had previously settled with the SEC with a consent decree in which it agreed to pay a civil fine.  An SEC suit against the former general counsel of the company is still pending.  

There is more than a bit of irony in the fact that individuals are being criminally convicted of defrauding shareholders by engaging in option backdating, while civil shareholder suits for similar actions are being dismissed.  

Financial Fraud Cases 

The SEC filed a settled fraud complaint against First BanCorp for aiding and abetting financial fraud by Doral Financial Corp.  According to the complaint, First BanCorp purportedly purchased non-conforming mortgages from Doral, which improperly recognized revenue on the transactions, when in fact there was no true sale.  Stated differently, First BanCorp engaged in sham transactions with Doral, which permitted the latter to inflate its earnings.  Doral settled with the SEC earlier.  First BanCorp consented to the entry of a statutory injunction prohibiting future violations of the antifraud and reporting provisions of the securities laws and to an order requiring the payment of an $8.5 million civil penalty.  SEC v. First BanCorp, 07-CV-7039 (Crotty, J.) (S.D.N.Y. filed August 7, 2007).   

This case is a good illustration of what is at stake in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, the private damage case which will be argued in the Supreme Court in October and which has been discussed in the occasional series now in progress in this blog.  In Stoneridge, the question is whether Section 10(b) covers third-party vendors who were alleged to have participated in transactions the issuer used to cook the books.  The same question has been raised in Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-13), the Enron litigation in which certiorari is pending (and which has been the subject of much debate because of the request of the SEC to file a brief which was declined by the Solicitor General).  The SEC, which had its authority to bring aiding and abetting charges restored in the 1995 amendments to the Exchange Act following the Supreme Court’s decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, 511 U.S. 164 (1994), could bring Section 10(b) fraud charges against the vendors in Stoneridge or Merrill Lynch, as First BanCorp highlights.  In private actions, however, where Congress declined to restore aiding and abetting liability, there is a significant question as to whether Section 10(b) liability can be imposed on the same third parties.  Stoneridge will resolve that question this fall. 

Insider trading

Earlier this year, the SEC was very aggressive in bringing insider trading cases.  Indeed, the pace and scope at which these cases were being brought seemed to eclipse the days of Boesky, Levine and others in the late 1980s.  While the pace of bringing cases in this area has slowed, the SEC did charge Taher Suterwalla of London with insider trading as part of its action regarding trading in the call options of Petco Animal Supplies.  That action was filed earlier last year.  SEC v. One or More Unknown Purchasers of Call Options for the Common Stock of Petco Animal Supplies, Inc., Case No. 06-CV-1446 DMS (S.D. Ca.).  The amended complaint claims that in a seventeen day period Mr. Suterwalla engaged in a series of highly leveraged trades using inside information about the pending acquisition of Petco to yield over $3 million in illegal trading profits. 

At the same time, Congress called for the SEC to allocate more resources to insider trading.  This comes at a time when insider trading is allegedly on the increase, not only on U.S. markets, but in other markets around the world.