The Case for Semi-Strong-Form Corporate Scienter in Securities Fraud Actions

Introduction

To establish liability under § 10(b) and Rule 10b-5,
a plaintiff must prove that the defendant acted with scienter, “a mental state
embracing intent to deceive, manipulate, or defraud.”[1] A plaintiff is required to allege at the pleading stage facts creating a
“strong inference” of scienter, which must then be proven by a “preponderance
of the evidence.”[2] This
endeavor is relatively straightforward when the defendant is an individual. The
analysis becomes more complicated when a corporate defendant is involved, however,
because a corporation, though a “person” under the law, can only act through
its agents. A corporation has no “single mind of its own,”[3] so “its scienter is necessarily derived from its employees.”[4] Reflecting this complexity, courts have evolved three different approaches to
address corporate scienter in the securities fraud context: strong-form
corporate scienter, weak-form corporate scienter, and semi-strong-form
corporate scienter.

The most rigorous of the three standards is strong-form corporate scienter, which requires plaintiffs to show that the
same agent who made a misrepresentation on a company’s behalf also possessed
the requisite scienter. At the other end of the spectrum lies weak-form corporate scienter. The
weak-form approach does not require the agent who made a misstatement on the
company’s behalf to have acted with scienter. Moreover, no individual agent is
required to possess scienter. Instead, courts may aggregate the knowledge of
multiple corporate agents, none of whom possesses scienter individually, to
establish collective corporate scienter. There is no requirement that any of
these agents be connected to the misstatement. Semi-strong-form corporate scienter occupies the middle ground. The
semi-strong-form standard requires proof that one agent committed a reprehensible
act with scienter in connection with a misrepresentation, but does not demand
that the agent possessing scienter be the maker of the misstatement.

This Essay argues that semi-strong-form corporate scienter
provides the best approach, because it strikes a balance between several
countervailing public policy concerns.

I. Strong-Form Corporate Scienter

The Northern District of California best articulated the
theory of strong-form corporate scienter in Apple
Computer.[5] The plaintiffs
brought claims against Apple and its CEO Steve Jobs, alleging that Jobs made
material misrepresentations regarding sales projections for a new product.
Apple was unable to meet the projections because of production problems. The
plaintiffs presented evidence establishing that other Apple agents were aware
of the problems. They did not, however, present sufficient evidence that Jobs
himself, the maker of the misstatements, had knowledge of the production
problems when he made the misrepresentations. Accordingly, the court held that
the plaintiffs’ allegations were insufficient to create an inference that Jobs
acted with scienter. In refusing to aggregate Jobs’ misstatements with the
knowledge of other Apple agents, the court further determined that Apple could
not have acted with scienter:

It is not enough to establish fraud on the part of a
corporation that one corporate officer makes a false statement that another
officer knows to be false. A defendant corporation is deemed to have the
requisite scienter for fraud only if the individual corporate officer making
the statement has the requisite level of scienter, i.e., knows that the statement is false, or is at least
deliberately reckless as to its falsity, at the time that he or she makes the
statement.

The Ninth Circuit affirmed the Northern District’s
dismissal of claims against Jobs and Apple, holding in regard to Apple: “A corporation
is deemed to have the requisite scienter for fraud only if the individual corporate
officer making the statement has the requisite level of scienter at the time
that he or she makes the statement.”[6]

Courts have also employed strong-form corporate scienter
at the summary judgment stage to extinguish claims against corporate
defendants. In Tyson Foods, the
plaintiffs asserted claims based on alleged misrepresentations in a press
release regarding Tyson’s termination of its plans to merge with another entity.[7] The trial court granted summary judgment in favor of the individual defendants
and Tyson, stating:

For a corporation to have primary liability under §
10(b) and Rule 10b-5, scienter must be present with respect to at least one of
the officers or agents who made a false or misleading statement. Having
concluded that each of the individual defendants is entitled to summary
judgment under § 10(b) and Rule 10b-5, as a matter of law, Tyson Foods can not
be primarily liable and is entitled to summary judgment.

The Third Circuit affirmed this decision: “Having
concluded that there is no primary liability on the part of any of the
individual officers, the District Court properly held that Tyson Foods could
not itself be primarily liable under the facts of this case.”[8]

At first glance, public policy appears to support the
theory of strong-form scienter, because its use curbs abusive litigation. Congress
enacted the Private Securities Litigation Reform Act to check perceived abuses
of private § 10(b) securities litigation, including “nuisance filings,
targeting of deep-pocket defendants, vexatious discovery requests and manipulation
by class action lawyers.”[9] Limiting private securities fraud actions to only those instances where
plaintiffs can show that an agent who made a misrepresentation on behalf of a
company possessed scienter would help to ensure that only the strongest claims
are brought.

Unfortunately, while furthering the goal of preventing
strike suits, the strong-form theory also allows malfeasant corporations to
skirt securities laws by simply compartmentalizing information, i.e., by separating the “mouth” of the
operation from the “brain.” Under this approach, a company wishing to commit
fraud could escape liability by shielding agents who speak on its behalf from
knowledge of facts contradicting their public statements. Such tactics could
result in a company clearly and intentionally misleading its investors, yet
allowing the investors no legal recourse because they are unable to tie
evidence of scienter to a specific agent who made a misstatement on its behalf.

II. Weak-Form Corporate Scienter

In Bridgestone,
the Sixth Circuit endorsed the use of weak-form corporate scienter at the
pleading stage.[10] The
plaintiffs brought claims under § 10(b) and Rule 10b-5 against Bridgestone, its
subsidiary Firestone, Bridgestone’s former CEO Yoichiro Kaizaki, and Masatoshi
Ono, Bridgestone’s former Executive VP and Firestone’s former CEO. Although the
court upheld the dismissal of claims against the individual defendants Kaizaki
and Ono, it allowed claims to proceed against the corporate defendants: “[W]e
conclude under the totality of the circumstances that the facts argued collectively
give rise to a strong inference of at least recklessness.” Thus, the
Bridgestone court held that scienter can be pled against a corporate defendant
by looking to its collective knowledge, regardless of whether scienter is
alleged against an individual agent.

Likewise, the Southern District of New York relied on
weak-form scienter to deny a corporate defendant’s motion for summary judgment
in WorldCom.[11] The defendant accounting firm Arthur Andersen argued that it was entitled to
summary judgment because the plaintiffs “failed to demonstrate that a
particular Andersen auditor acted with scienter.” The court disagreed: “To
carry their burden of showing that a corporate defendant acted with scienter,
plaintiffs in securities fraud cases need not prove that any one individual
employee of a corporate defendant also acted with scienter. Proof of a
corporation’s collective knowledge and intent is sufficient.” As such, the
court held that the plaintiffs were “entitled to show reckless misconduct
through a cumulative pattern of decisions and inaction by several Andersen
auditors,” i.e., that “Andersen as a
firm was reckless.” The court, relying on the First Circuit’s analysis in Bank of New England, reasoned that
modern corporate structure necessitated the use of this approach. As the First
Circuit aptly stated:

Corporations compartmentalize knowledge, subdividing
the elements of specific duties and operations into smaller components. The
aggregate of those components constitutes the corporation’s knowledge of a
particular operation. It is irrelevant whether employees administering one
component of an operation know the specific activities of employees
administering another aspect of the operation: A corporation cannot plead
innocence by asserting that the information obtained by several employees was
not acquired by any one individual who then would have comprehended its full
import. Rather the corporation is considered to have acquired the collective
knowledge of its employees and is held responsible for their failure to act
accordingly.[12]

Allowing claims founded on weak-form corporate scienter
does prevent delinquent companies from avoiding liability by compartmentalizing
knowledge. Yet any positive influence the use of weak-form scienter might have
on corporate policy is drastically overshadowed by its inconsistency with the
federal securities laws, the inefficient incentives it creates, and its
negative impact on the dissemination of information.

The weak-form approach, which pegs liability to a
corporate entity’s failure to parse together the knowledge of its agents, is
akin to a negligence standard.[13]  Moreover,
this theory is clearly at odds with Congress’ intention to discourage
unmeritorious litigation under the PSLRA. Weak-form scienter makes it
exceedingly easy for overzealous plaintiffs to advance past the motion to
dismiss stage, at which point they can use the leverage of discovery to extort
settlements from corporate defendants.

Reliance on
weak-form scienter would also cause the inefficient allocation of
corporate resources and stymie communications. Under this approach, a
risk-averse corporation would have to spend undue amounts of human and monetary
capital to determine that each piece of information communicated to investors
had been thoroughly vetted to ensure that none of the corporation’s agents
possesses any information which, in combination with information possessed by
other agents, could be construed as being inconsistent with the company’s
public statements. These costs would be substantial. It is doubtful that even
the most earnest companies could comply with this unduly burdensome
requirement, which would dampen communications between companies and their investors,
a primary objective of the Securities Exchange Act of 1934.[14]

III. Semi-Strong-Form Corporate Scienter

The Fifth Circuit discussed the standard of proof required
under semi-strong-form corporate scienter in Southland:

For purposes of determining whether a statement made by
the corporation was made by it with the requisite Rule 10(b) scienter we
believe it appropriate to look to the state of mind of the individual corporate
official or officials who make or issue the statement (or order or approve it or its making or issuance, or who furnish
information or language for inclusion therein, or the like) rather than
generally to the collective knowledge of all the corporation’s officers and
employees acquired in the course of their employment.[15]

Since the plaintiffs did not allege that any particular
employee other than the named executive defendants acted with scienter in
connection with any of the misstatements, the Southland court held that the plaintiffs were limited to this pool
of named individual defendants in pleading that the corporate defendant acted
with scienter. In other words, in order to prove that a corporate defendant
acted with scienter, a plaintiff must provide evidence showing that an
individual agent who is connected to-but not necessarily the maker of-the
misstatement at issue had scienter.

Judge Richard Posner applied the semi-strong-form standard
in Tellabs to reverse the lower court’s grant of a motion to dismiss: “That no member of
the company’s senior management who was involved in authorizing or making
public statements . . . knew that they were false is very hard to
credit, and no plausible story has yet been told by the defendants that might
dispel our incredulity.”[16]

Similarly, the District of Columbia utilized semi-strong-form scienter in Johnson, an action brought by the SEC.[17] The
defendant, Christopher Benyo, a former Senior Vice President for Marketing and
Network Development at PurchasePro.com, was found liable for aiding and
abetting PurchasePro’s violations of the securities laws. Benyo argued in his
motion for judgment as a matter of law or in the alternative for a new trial
that the SEC had not presented sufficient evidence to establish a primary
violation by PurchasePro, because the SEC did not show that PurchasePro’s
president (the party who acted on its behalf) possessed scienter. The court
disagreed and denied Benyo’s motions:

[M]ultiple PurchasePro officers, including Layne and
Boeth, could have provided the requisite scienter. Both Layne and Boeth
furnished information or language for inclusion in the earnings statement, and
each admitted that they knew claiming the AuctioNet revenue in the First
Quarter of 2001 was fraudulent at the time in question. Given the evidence
presented regarding Boeth and Layne’s role in the earnings announcement and
their scienter, the jury had sufficient probative evidence to find that
PurchasePro had engaged in a Section 10(b) or Rule 10b-5 violation.

Demanding that plaintiffs show scienter by an individual
management-level employee, who is concretely connected to but not necessarily
the maker of a misrepresentation, prevents corporate bad actors from avoiding
liability by compartmentalizing information. But it does so without heaping
unrealistic expectations on corporations making a good faith effort to comply
with the law. Rather than requiring a company to undertake the nearly
impossible task of synthesizing the knowledge of its agents prior to making a
public statement, semi-strong-form scienter simply requires those executives responsible for the statement to ensure the
statement does not contain information which contradicts what they know to be
true. This is a reasonable expectation.

Furthermore, semi-strong-form scienter discourages trivial
litigation without forcing wronged shareholders to comply with overly stringent
requirements on the types of claims they may bring. This theory requires
plaintiffs to show that a specific individual employee possessed scienter-which
ensures that plaintiffs cannot bring a claim lacking a fully-developed theory
of liability-but does not limit plaintiffs to only those individuals
responsible for making the alleged misstatements.

Conclusion

How to attribute the mental state of scienter to a
corporate entity has far-reaching implications. Strong-form scienter-limiting
the imputation of scienter to only those instances in which the maker of a
misstatement possessed intent-would stifle legitimate claims that do not
satisfy this narrow criterion. It also would prompt companies seeking to evade
the securities laws to erect barriers between those who speak on their behalf
from those possessing knowledge. Weak-form scienter-taking an aggregative approach
to corporate scienter-would result in unmeritorious claims, economic
inefficiency, and degraded corporate communications. The semi-strong-form
standard, on the other hand, provides the right blend of incentives. The
approach encourages companies to be thorough in their compliance with securities
laws without making unreasonable demands. It also sets the bar just high enough
to weed out shoddy claims while allowing valid claims to pass. Perhaps the
strongest evidence that semi-strong-form scienter is the right choice is that
it is the approach which most closely aligns the interests of corporations and
their shareholders by encouraging the most efficient allocation of corporate
resources while adequately protecting shareholder rights.

 

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[1]. Ernst & Ernst v. Hochfelder, 25 U.S.
185, 193 n.12 (1976).

[2]. Tellabs,
Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 328-329 (2007)
(“We emphasize, as well, that under our construction of the ‘strong inference’
standard, a plaintiff is not forced to plead more than she would be required to
prove at trial. A plaintiff alleging fraud in a § 10(b) action, we hold today,
must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference. At trial, she must then prove her case by a
‘preponderance of the evidence.’ Stated otherwise, she must demonstrate that it
is more likely than not that the defendant acted with scienter.”)
(emphasis in original; internal citation omitted).

[3]. In re
Monster Worldwide, Inc. Sec. Lit., 549 F.Supp.2d 578,
583 (S.D.N.Y. 2008) (citing Suez
Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 101 (2d
Cir. 2001)).

[4]. In re
Monster, 549 F. Supp. 2d at 583 (internal quotation omitted).

[5]. In
re Apple Computer, Inc., Sec. Litig.,
243 F. Supp. 2d 1012 (N.D. Cal. 2002).

[6]. In re
Apple Computer, Inc., 127 Fed. Appx. 296, 303 (9th Cir. 2005) (internal
citation omitted).

[7]. In re Tyson Foods, Inc. Sec. Litig.,
Civ. A. No. 01-425-SLR, 2004 U.S. Dist. LEXIS 11122 (D. Del. June 17, 2004).

[8]. In re Tyson Foods, Inc., 155 Fed.
Appx. 53, 57 (3d Cir. 2005).

[9]. Tellabs, 551 U.S. at 320.

[10]. City of Monroe Employees Ret. Sys. v.
Bridgestone Corp., 399 F.3d 651 (6th Cir. 2005).

[11]. In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472 (S.D.N.Y. 2005).

[12]. United States v. Bank of New England, N.A.,
821 F.2d 844, 856 (1st Cir. 1987) (internal quotation omitted).

[13]. See Ernst & Ernst, 425 U.S. at
193 (holding that a cause of action under § 10(b) and Rule 10b-5 does not lie
for mere negligence).

[14]. Randall
v. Loftsgaarden, 478 U.S. 647, 664 (1986).

[15]. Southland Sec. Corp v. INSpire Ins.
Solutions Inc., 365 F.3d 353, 366 (5th Cir. 2004) (emphasis added).

[16]. Makor Issues & Rights, Ltd. v. Tellabs,
Inc., 513 F.3d 702, 708-709 (7th Cir. 2008).

[17]. SEC v. Johnson, 565 F. Supp. 2d 82
(D.D.C. 2008).