PLEADING SCIENTER IN SEC ENFORCMENT ACTIONS
Pleading standards in SEC enforcement actions are suppose to be uniform under the Federal Rules of Civil Procedure. Two rulings last week, however, highlight the different standards that apply in those actions when pleading the key element of scienter. In one, the SEC was only required to plead scienter generally. In the other, the court applied the same standard, but followed the pre-PSLRA Second Circuit case law by imposing a heightened two-part test, at least portions of which were written into the Reform Act by Congress. While the SEC met each standard, its complaint was dismissed in the first for other pleading violations. SEC v. Medical Capital Holdings, Inc., Case No. CV 00-818 (C.D. Cal. Filed July 20, 2009); SEC v. Reserve Management Company, Inc., Case No. 09 Civ. 4346 (S.D.N.Y. Filed May 5, 2009).
Medical Capital Holdings is an action against the company and its principals, alleging fraud in connection with the sale of notes issued by a special purpose entity controlled by the company. The SEC complaint claims that the defendants defrauded investors by misappropriating about $18.5 million of investor funds and by making misrepresentations in the offering materials.
In ruling on a motion to dismiss, the first amended complaint the court rejected claims that the SEC failed to adequately plead fraud with particularity. To the contrary, the court concluded that the Commission had specifically identified false statements in the offering materials. In reaching this conclusion, the court rejected a defense argument that the SEC should be required to identify specific individuals who were defrauded.
In ruling on the adequacy of the allegations regarding scienter, the court rejected a claim by the defendants that the Private Securities Litigation Reform Act requires the SEC to meet a heightened pleading standard. That statute on its face does not apply to the SEC. Rather, quoting Federal Civil Rule 9(b) regarding the pleading of fraud, the court held that the Commission need only plead “[m]alice, intent, knowledge, and other conditions of a persons mind . . . generally.” The SEC met this standard, but failed to adequately plead with particularity how the materials containing the false statements were used in the offering. Accordingly, the complaint was dismissed with leave to amend.
Reserve Management is the Commission’s enforcement action stemming from the collapse of The Reserve Primary Fund, the first fund to “break the buck,” as discussed here. In ruling on the adequacy of the SEC’s complaint, the court agreed that the PSLRA does not apply by its plain terms, rejecting a defense argument. Accordingly, it is beyond dispute that the more relaxed pleading standard of Federal Civil Rule 9(b) need only be met.
The Second Circuit, however, has long held that a securities law plaintiff alleging fraud must plead facts which give rise to a strong inference of fraudulent intent the court noted, citing Novak v. Kasaks, 216 F.3d 300 (2nd Cir. 2000). While the Second Circuit has yet to decide how, if at all, Tellabs, Inc., v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) may apply, it is clear under Novak that plaintiff must plead facts demonstrating a strong inference by either alleging facts that show the defendants had both motive and opportunity to commit fraud, or by pleading facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. In Reserve Management, the court found that the SEC had met the pleading standard. Accordingly, the motion to dismiss was denied.
While in the end each court agreed that the PSLRA standard does not apply to SEC enforcement actions and that Civil Rule 9(b) governs, the tests used are significantly different. The pleading “generally” standard of the Rule used in Medical Capital Holdings meant just that – a general allegation is sufficient. In contrast, in Reserve Management the same pleading “generally” standard means a strong inference of scienter as demonstrated by a two part test. Ironically, the Second Circuit uses that same two-part test to evaluate compliance with the heightened scienter pleading requirements of the PSLRA which both courts concluded do not apply here.