A key pleading requirement under the PSLRA is the Section 21D(b)(2) mandate that a plaintiff plead facts which establish a strong inference of the requisite state of mind. The Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) considered what constitutes a strong inference without defining the term scienter as discussed here. The strong inference test was crafted by the second circuit and adopted by Congress in the PSLRA. Congress did not however, incorporate the “motive and opportunity” part of the test used by the Second Circuit to determine if there was a strong inference, the court continued to employ the test following the passage of the Act and the decision in Tellabs. While some circuits have consistently used the second circuit’s test, others have not. Indeed, from its inception, the motive and opportunity part of the test has caused a split in the circuits which persists today discussed here.

In South Cherry Street, LLC v. Hennessee Group, LLC, Case No. 07-3658 (2nd Cir. Decided July 14, 2009) the Second Circuit court retraced the origins of its motive and opportunity test and its evolution over time. In fact, while the evidentiary prong of the circuit’s long standing test has always been identified by the motive and opportunity label, it has evolved over time. Hennessee defines the court’s current approach to the question.

Hennessee Group is a securities fraud suit brought by South Cherry, an investor in Sam Israel’s Bayou Accredited Fund, LLC, now known to be a huge Ponzi scheme. South Cherry, according to the complaint, was inexperienced in investing in hedge funds. Hennessee Group, on the other hand, held itself out as an “industry leader” in making such investments. Based on Hennessee’s advice, South Cherry invested $2.9 million in Bayou Accredited from March 2003 through June 2003. The firm then withdrew $1.75 million in the spring of 2004, but later that year put another $900,000 into the fund.

Prior to making the recommendations, Hennessee told South Cherry about its proprietary data base and analytics regarding hedge funds. Hennessee also told South Cherry about its unique due diligence process and the care taken in investigating and selecting funds for investor clients, detailing an extensive, multiple-step investigative process.

With respect to Bayou Accredited, Hennessee provided South Cherry with a Biography of Sam Israel showing that he had been the head trader for Omega Advisors, where he was very successful. South Cherry was also provided with materials regarding the history of the fund and its track record of success.

A 2005 SEC report however, revealed that Bayou Accredited is nothing more than a Ponzi scheme. The fund had been founded in the late 1990s. Trading resulted in loss after loss. By 2003 according to the SEC, Mr. Israel and his partner essentially stopped trading and began diverting funds to their own use. The biography Hennessee furnished South Cherry on Sam Israel was false. In July 2005, Mr. Israel informed investors that the fund would be liquidated and that each investor would receive a distribution in August. No distributions were made. South Cherry lost its entire remaining investment of $1.15 million. Eventually the principals of Bayou Accredited pleaded guilty to criminal charges.

South Cherry’s securities fraud suit was dismissed by the district court in part for a failure to adequately plead scienter under the PSLRA. The Second Circuit affirmed. The court’s opinion begins by tracing the origins of its pleading standards from before the passage of the PSLRA. At that time, the circuit crafted the now well known requirement that a securities law plaintiff allege facts which give rise to “a strong inference of fraudulent intent.” That inference could be established from facts showing both a motive an opportunity to commit fraud. Motive could not however, be demonstrated by simply showing that the defendants had goals which virtually all corporate insiders have such as a desire to have a good credit rating. Rather, the pleader was required to point to “concrete benefits that could be realized” from the false statements or nondisclosure. Thus, the test could be met where corporate insiders made false statements about the performance of the company to keep the stock price up while they sold their shares.

Alternatively, the scienter element could be established by “a strong showing of reckless disregard for the truth.” In this regard, the facts must establish a conscious recklessness which is a state of mind “approximating actual intent, and not merely a heightened form of negligence,” the court noted.

The PSLRA incorporated the strong inference test, but did not adopt the motive and opportunity approach to pleading scienter. As a result the circuit concluded that pleaders should not “employ or rely on magic words” such as motive and opportunity. Rather, the court held that under the PSLRA a strong inference of scienter can arise where: 1) the defendants benefited in a concrete and personal way from the fraud; 2) the defendants engaged in deliberately illegal behavior; 3) the defendants knew facts or had access to information suggesting that their public statements were not accurate; or 4) that they failed to check information when they had a duty to monitor, although this doctrine has limits — essentially the facts must suggest conduct approaching actual intent.

The Supreme Court in Tellabs interpreted the Section 21D(b)(2) strong inference test of the PSLRA to mean that it is not sufficient for the inference to be merely plausible or reasonable. Rather, it must be cogent and at least as compelling as any opposing inference of non-fraudulent intent. In assessing whether this standard is met, all of the facts taken collectively must be considered. Under this approach if there is not a “compelling motive to mislead,” but rather other contrary inferences which can be drawn from the facts in the complaint, the plaintiff fails to plead a strong inference of scienter, the court noted.

Here, the complaint fails to plead facts which support a strong inference of scienter. Plaintiff also fail to demonstrate that the inference of scienter is at least as compelling as any opposing inference as required by Tellabs. The complaint in this case focused on the failure of the defendant to conduct the promised due diligence. These allegations center on what defendant might have discovered if it had properly investigated. The complaint does not specify any facts known to the defendant prior to 2005 which demonstrate an obvious sign of fraud or a red flag. The complaint also fails to allege facts suggesting a motive or intent to deceive. The court rejected plaintiff’s claim that the desire to receive a fee constitutes such a motive. On appeal, plaintiff also suggested that there must have been kickbacks between Hennessee and Bayou, but admits that this is simply speculation it would like to test in discovery. Such speculation is not sufficient to meet the plausibility test of Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007) under Rule 8(a), the court held.

The court concluded, noting that “the factual allegations in the Complaint do not give rise to a strong inference of either fraudulent intent or conscious recklessness, and . . . that the inferences advocated by South Cherry are not as compelling as an inference of negligence.” While the court’s analysis here will not harmonize its approach with that of circuits which reject the motive and opportunity test such as the ninth circuit, discussed here, it does provide good guidance on the current approach to the court’s long used and clearly evolved “motive and opportunity” evidentiary test.