Significant events last week in SEC securities litigation focused on the resolution of an old case and continued silence from the SEC on Stoneridge. 

First, the old case.  

On August 15, 2007, the SEC finally settled with former McKesson Corp. executive, Michael G. Smeraski.  Mr. Smeraski, a one time McKesson senior sales vice president, was alleged to have acted together with other senior executives and participated in a long-running financial fraud at the company.  The settlement came with a consent to a statutory injunction, baring future violations of the antifraud provisions, and an agreement to pay a civil penalty of $50,000.  While the underlying conduct here took place in 1999, this was not a case where the SEC dallied in filing suit.  Indeed, its complaint was filed in September 2001.   However, it took another six years to get the settlement, meaning that it was eight years after the events at issue before the case finally ended.  One can only wonder what took so long.  SEC v. Smeraski, Case No. C-01-3651 MJJ (N.D. Cal.).  The SEC’s Litigation Release is available at   

The most significant event in securities litigation last week took place – or perhaps did not take place – in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, the case pending before the Supreme Court which will be argued in early October.  As discussed previously in this blog, Stoneridge is perhaps the most significant case to come before the Court in years concerning the construction of the antifraud provisions of the federal securities laws and private damage actions.  The question to be decided is the scope of liability under antifraud provision Section 10(b) and Rule 10b-5 thereunder – that is, whether there is “scheme liability.”  Stated differently, the question is who can be held liable under this catch-all antifraud provision if an issuer engaged in fraudulent conduct:  auditors, attorneys, vendors or others?  The resolution of this case can have an impact on the potential liability of all who deal with public companies. 

Last week, the U.S. government filed its amicus brief.  The Solicitor General sided with the defendant third party vendors and against the shareholder plaintiffs.  This is a significant filing since it eschews the usual SEC position, which typically argues that private damage actions by shareholders are a necessary supplement to its enforcement program.  The brief does, at points, attempt to harmonize the positions advocated with those previously taken by the SEC on scheme liability. 

Two groups of former SEC Commissions also filed briefs.  Former Chairman Donaldson and Levitt joined with former commissioner Goldschmid in arguing in support of the petitioners.  In contrast former Chairmen Hills, Williams and Pitt joined with former Commissioners Cox, Fleischman, Friedman, Grundfest, Hunt, Karmel, Lochner, Peters, Roberts, Unger and Wallman, arguing in favor of the respondent defendants.  In addition, Representatives John Conyers, Jr. and Barney Frank filed a brief in support of petitioners. 

In sum, what the Court and the public have is views from the parties, the government, two congressmen, a number of former SEC Commissioners and a host of interested persons.  What the Court does not have is the views of the SEC, the agency charged by Congress with administering the statutes.  Yet, it has been widely reported that the SEC wants to file a brief in support of petitioners.  In the past, when the SEC’s views did not comport with those of the Solicitor General, the agency filed a separate brief.  As I have written in the past, regardless of whether one agrees with the view the SEC would espouse, on this most important issue, the Court, the parties and the public should have the benefit of the Commission’s view.  Stifling argument is no way to argue a court case.  

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.”