Pleading Scienter in a Private Securities Fraud Litigation
by Harry Frischer

In Ottmann v. Hanger Orthopedic Group,¹ decided at the end of 2003, the Fourth Circuit articulated a new standard for pleading scienter in an action governed by the Private Securities Litigation Reform Act of 1995 (the “PSLRA”). Enacted to deter private plaintiffs from bringing meritless securities claims, the PSLRA raised the pleading standard by requiring plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” ² Although Congress intended the statute to create a uniform pleading standard,³ there is substantial disagreement among the circuits as to how the standard should be applied and what facts must be pleaded to support a strong inference of scienter.

In Ottmann, the Fourth Circuit rejected a relatively lenient standard applied by the Second Circuit and the strict formulation adopted by the Ninth Circuit. Instead, the Fourth Circuit adopted a case-specific approach that examines the particular allegations “in their entirety,” without regard to whether such allegations “fall into defined formulistic categories.”⁴

In this article, we examine the Fourth Circuit’s we-know-it-when-we-see-it standard, compare it with the pleading standards applied in other circuits, and discuss the type of facts that may constitute sufficient allegations of scienter under these differing standards.

The Elements of Securities Fraud

The basic elements of a claim for securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 are well established. To state a claim, the plaintiff must demonstrate that the defendant made a false statement or an omission of material fact, that the defendant acted with the required state of mind or scienter, and that the plaintiff justifiably relied on such statement or omission, which proximately caused the plaintiff ’s damages.⁵ For a statement or omission to be material, there must be a substantial likelihood that a reasonable investor would have considered the fact important in deciding whether to buy or sell the security, or that the investor would have viewed the total mix of available information to be significantly altered by disclosure of the omitted fact.⁶

Allegations of securities fraud may arise in a number of contexts. Most commonly, an investor will claim that he or she was defrauded by a company’s allegedly false financial statements. Investors also may assert fraud claims based on statements made in company press releases, or statements made by company officials to securities analysts, that influence the market price of the security. Statements made by underwriters or other broker/dealers also may be the basis for litigation.

Pleading Scienter

The term “scienter” refers to a defendant’s mental state. The scienter requirement is satisfied if the plaintiff can demonstrate that the defendant intended to deceive, manipulate, or defraud, such as where the defendant knew that the statements on which plaintiff relied were untrue.⁷ Although the Supreme Court has not definitively ruled on the issue, every circuit that has considered the matter has held that scienter also may be established by recklessness. Recklessness is often defined as conduct that is “highly unreasonable” and that represents such an extreme departure from the standard of ordinary care that the danger of misleading investors was either known to the defendant or so obvious that the defendant must have been aware of it.⁸

[T]he Fourth Circuit articulated a new standard for pleading scienter in an action governed by the Private Securities Litigation Reform Act of 1995.

Before the PSLRA was enacted, the Second Circuit adopted a heightened standard of pleading with respect to scienter in securities fraud litigation, requiring a plaintiff to plead facts that gave rise to a “strong inference” that the defendant acted with the required state of mind.⁹ Without the specific factual allegations on which the claim was based, conclusory or rote claims that defendants acted “intentionally” or “recklessly” were deemed insufficient.

A plaintiff could meet the Second Circuit’s pre-PSLRA pleading requirement in one of two ways. First, the plaintiff could allege facts constituting strong circumstantial evidence of conscious misbehavior or recklessness. For example, the plaintiff could point to the defendants’ knowledge of facts or access to information contradicting their public statements. Alternatively, a plaintiff could meet the Second Circuit’s pre-PSLRA scienter requirement by showing that the defendants had the “motive and opportunity” to commit fraud.

To adequately plead scienter under the “motive and opportunity” standard, the plaintiff was required to allege that the defendants would realize concrete benefits by false statements or wrongful disclosures, and that the defendants had the means and likely prospects of achieving those benefits. Often, the motive and opportunity standard was satisfied when corporate insiders were alleged to have misrepresented material facts about the corporation’s performance or prospects in order to keep the stock price artificially high while they sold their own shares at a profit.

[A] split has developed in the circuits as to whether the pleading requirement under the PSLRA can be satisfied by alleging facts demonstrating motive and opportunity.

In enacting the PSLRA, Congress codified the Second Circuit’s “strong inference” language as the standard for proving a defendant’s state of mind.¹⁰ However, Congress neither adopted nor rejected the Second Circuit’s rule permitting a plaintiff to satisfy the strong inference requirement by showing motive and opportunity.

In the absence of a clear expression of Congressional intent, a split has developed in the circuits as to whether the pleading requirement under the PSLRA can be satisfied by alleging facts demonstrating motive and opportunity. The Second Circuit has expressly reaffirmed its prior standard;¹¹ other circuits have held that factual allegations of motive and opportunity, standing alone, cannot satisfy the scienter pleading requirement.¹² In addition, as discussed below, there also is a difference among the circuits as to what facts, apart from motive and opportunity, would be sufficient to demonstrate a strong inference of scienter.

The Ottmann Decision

It is against this backdrop that the Fourth Circuit decided Ottmann. In that case, the plaintiff asserted securities fraud claims against Hanger Orthopedic Group and two of its senior officers based on a number of allegedly false statements concerning Hanger’s financial affairs. The district court dismissed the complaint on summary judgment, and plaintiff appealed to the Fourth Circuit.

Hanger provided services to patients who required orthotic and prosthetic devices, such as artificial limbs. It managed more than 600 patient care facilities, employing more than 900 certified practitioners in 42 states.

In 1999, Hanger acquired NovaCare, a large competitor that accounted for approximately 60% of the business of the combined entity. In November 1999, Hanger released earnings figures for the third quarter and made a number of public statements that described the integration of NovaCare’s business on mostly favorable terms.

Two months later, Hanger announced that it expected revenues and earnings for the fourth quarter to fall substantially below analysts’ expectations. As a result of this announcement, the price of Hanger common stock dropped from the previous day’s closing price of $9.375 per share to $3.75 per share, a decline of 60 percent.

In a conference call with analysts and investors, Hanger executives attributed the disappointing results to three factors relating to the NovaCare acquisition. First, revenue was reduced because more NovaCare practitioners terminated their relationship with the company following the acquisition than had been previously disclosed. Second, in December 1999, Hanger discovered that NovaCare’s revenue recognition practices were more aggressive than Hanger’s practices, and Hanger conformed NovaCare’s accounting to its own more conservative methods. Third, referral business to Hanger from rehabilitation clinics declined as a result of the acquisition.

Following these disclosures, the plaintiffs commenced a proposed class action on behalf of investors who purchased Hanger stock at relatively high prices following the optimistic statements made in November, but before the January disclosures caused the stock price to drop. Plaintiffs alleged that the statements made by the defendants in November were false because they misrepresented the number of NovaCare practitioners that departed after the acquisition and the reason for their departure, misrepresented the basis for recognizing revenue on the company’s financial statements, and omitted to disclose the decline in referral business.

The Fourth Circuit held that plaintiffs adequately alleged that the challenged statements were materially false and misleading. Nevertheless, the court ruled that the plaintiffs had not alleged facts showing a strong inference of scienter, and affirmed the dismissal of the complaint.

A Flexible, Case-Specific Standard

In a matter of first impression in the Fourth Circuit, the Ottmann court first addressed the appropriate standard to be applied under the PSLRA, and considered whether to adopt the Second Circuit’s “motive and opportunity” rule. In the absence of explicit statutory language, and in light of the inconclusive legislative history, the court found that Congress did not intend to specify any particular types of facts as necessary to show a strong inference of scienter.

The Fourth Circuit chose a middle ground among the standards applied by the various circuits, holding that the sufficiency of the complaint would be decided on a flexible caseby- case basis. Specifically, the court concluded that the scienter inquiry should not be restricted by focusing on specific categories of fact (such as those relating to motive and opportunity). Rather, a court should examine all of the allegations in a case to determine whether they collectively establish a strong inference of scienter. While facts demonstrating a motive and opportunity to commit fraud might be relevant to scienter, the court held that the weight accorded those facts should depend on the circumstances of each case.¹³

[T]he [Fourth Circuit] found that Congress did not intend to specify any particular types of facts as necessary to show a strong inference of scienter.

The court applied this case-specific standard to the allegations in the Ottmann complaint, starting with the allegation that the defendants’ November statements materially misrepresented the number of NovaCare practitioners who left the company following the acquisition. In support of their scienter claim, plaintiffs alleged facts showing that defendants viewed the retention of practitioners as the most important factor in revenue growth, that defendants had been monitoring the departure numbers on a monthly basis, and that defendants had recognized early on that the departures reflected a negative trend. From this evidence, plaintiffs argued that a strong inference could be drawn that defendants knew the numbers reported in November were false, or that defendants had acted recklessly.

The court agreed that such allegations provided some indication that defendants acted recklessly, but held that, on balance, other factors diminished an inference of scienter. In particular, the court observed that defendants’ November statements only gave a rough approximation of the number of departures, not a precise number, and that the absolute number of undisclosed departures was small in comparison to the overall number of practitioners employed by Hanger. Because Hanger was in the midst of a complex nationwide integration of NovaCare, the court also found a “distinct possibility” that defendants had simply “undercounted” the number of practitioners who departed, without acting intentionally or recklessly. The court also noted that there were no allegations showing a motive for defendants to commit fraud, and found the allegations generally to be more consistent with negligence than recklessness, and thus insufficient to show scienter.¹⁴

The court similarly rejected the allegations of scienter with respect to the claim that defendants’ November statements materially misstated the reason these practitioners departed. Plaintiffs alleged that defendants falsely stated that some of the former NovaCare practitioners were terminated because they were not producing sufficient business, suggesting that the loss of those employees would help Hanger’s performance. The court found such statements material because a reasonable investor might have found it important that Hanger was losing practitioners involuntarily rather than by its own strategic decisions. Nevertheless, the court found that the complaint did not allege facts establishing a strong inference that defendants knowingly or recklessly misstated the reason for these departures. On the contrary, the court found that any errors in the language used to describe the departures was just as likely the result of an overgeneralization as it was the product of an intentional deception or recklessness.¹⁵

The court likewise found no strong inference of scienter with respect to the alleged misrepresentations concerning Hanger’s method of revenue recognition.¹⁶ Plaintiffs alleged that various NovaCare executives were employed by Hanger after the acquisition, that Hanger had access to NovaCare documents, that NovaCare accounted for over half of the facilities and revenue of the combined company, and that the same outside auditing firm performed audits for both Hanger and NovaCare. From these allegations, plaintiffs argued that they had shown a strong inference that defendants either knew or recklessly disregarded that NovaCare and Hanger had different methods for recognizing revenue, and that the third quarter financial statements therefore were false.

In rejecting these allegations as insufficient, the court observed that defendants conformed NovaCare’s revenue recognition practice to Hanger’s as soon as they learned of the discrepancy. The court also found that plaintiffs had not alleged facts sufficient to demonstrate the defendants knew of the problem any sooner, or that the particular NovaCare documents possessed by Hanger revealed the inconsistency to defendants. The court also found that the difference in revenue recognition practices was relatively subtle and not so obvious that defendants must have been aware of it, especially in the complex nationwide integration of the two businesses, and there were no “red flags” that would have revealed the errors.¹⁷

Finally, with respect to defendants’ alleged failure to disclose that referral business had declined as a result of the merger, the court again found that the allegations did not establish a strong inference of scienter. The factual allegations indicating that defendants knew about the decline in referrals was, at best, ambiguous, and suggested that the information was not concealed, but was disclosed to analysts.18

On each of the significant scienter claims in the Ottmann case, the court rejected plaintiffs’ contention that a strong inference of scienter could be drawn from the pleadings, finding instead that the facts alleged could be explained by negligence or innocent mistake. In the absence of facts precluding such alternate inferences, the claim for securities fraud was not permitted to stand.

The Approach in Other Circuits

The Fourth Circuit’s decision in Ottmann should be contrasted with an opinion in which the Second Circuit found that the district court committed error when it assumed there was an innocent explanation for the facts alleged and rejected an inference of fraud.

In Novak v. Kasaks,¹⁹ plaintiffs were investors in Ann Taylor Stores, a specialty retailer of women’s clothing and accessories. Plaintiffs alleged that the corporation and various insiders made false statements concerning Ann Taylor’s financial performance, primarily by failing to properly account for millions of dollars of inventory. In particular, the complaint alleged defendants overstated the company’s financial condition by improperly accounting for inventory that defendants knew to be obsolete and nearly worthless and by failing to adhere to the company’s publicly stated markdown policy.

In an effort to meet the scienter requirement, plaintiffs alleged facts concerning a “box and hold” inventory practice, under which a substantial and growing quantity of out-of-date inventory was identified by company management and stored separately from the regular inventory. Plaintiffs alleged that internal company documents periodically distributed to the individual defendants distinguished between regular inventory and the “box and hold” inventory, and that such memoranda demonstrated that much of the “box and hold” was several years old and unlikely to be sold at full price or at all. From these facts, plaintiffs argued that a strong inference could be drawn that the defendants knew that the published financial statements, which incorporated the “box and hold” inventory at full value, were false, or that defendants were reckless in failing to make proper disclosure.

The district court rejected these allegations as insufficient, finding that such facts merely supported an inference that managers of Ann Taylor disagreed over matters of business judgment, such as the valuation of inventory and the timing of markdowns. The district court did not agree that the defendants acted intentionally or recklessly to defraud.²⁰

After reviewing the pleadings de novo, the Second Circuit reversed the dismissal of the complaint, finding that the district court had erred as a matter of law in determining what inferences could be drawn from these allegations. The court found that the facts set forth in the complaint could support an inference that defendants deliberately made material false statements concerning inventory with the intent to deceive the investment community.²¹

A Stricter Approach

The Fifth Circuit’s recent application of a strict pleading standard in Goldstein v. MCI WorldCom,²² further illustrates the differences among the circuits. The MCI WorldCom litigation involved one aspect of the highly publicized WorldCom bankruptcy.

In this particular litigation, plaintiffs alleged that the former chief executive officer and chief financial officer of MCI WorldCom knowingly or recklessly failed to direct the company to write off millions of dollars’ worth of uncollectible accounts receivable, resulting in material misrepresentations and omissions in WorldCom’s financial statements. In support of their claim of scienter, plaintiffs argued that defendants had a “monumental” motive and opportunity to delay recording necessary write-downs so as to increase the chief executive officer’s individual compensation. The court found that these allegations of motive and opportunity were sufficiently particularized, but that, in the Fifth Circuit, allegations of motive and opportunity alone were insufficient to establish scienter.

[T]he differences among the circuits … may lead to inconsistent results on similar facts.

Plaintiffs had alleged other circumstantial evidence of scienter, such as defendants’ positions and close involvement in the day-to-day operations and management of WorldCom, including their decision-making role in writing off uncollectible accounts. In rejecting these allegations, however, the court found that the complaint suggested only an inference of mismanagement with respect to WorldCom’s accounts receivable—not severe recklessness on behalf of the individual defendants.²³

Following the initial dismissal of the complaint, plaintiffs sought to introduce newly discovered evidence (arising from the widening criminal investigation into WorldCom) to bolster their allegations of scienter. The new evidence included the defendants’ invocation of their Fifth Amendment rights against self-incrimination during Congressional hearings; the guilty plea of a WorldCom executive who reported directly to the defendants and who, as part of his plea, stated that he was instructed by senior management to falsify WorldCom’s financial results; and numerous internal memoranda and e-mails from WorldCom, in which employees identify the defendants as the decision makers regarding certain improper accounting entries.

The court rejected this new evidence as inadequate to reopen the judgment dismissing the complaint, finding that the plaintiffs failed to make a sufficient connection between the bad acts described in the new material and their specific allegations of wrongdoing. In particular, the court noted that most of the new evidence related to the improper capitalization of certain items that should have been treated as regular operating expenses—not the uncollectible accounts receivable that were the sole issue addressed in the complaint.²⁴ The court did not consider whether the new evidence of defendants’ wrongdoing with respect to one aspect of WorldCom’s financial reporting might be sufficient to draw a strong inference of scienter with respect to other financial matters.

Conclusion

The cases discussed in this article demonstrate differences among the circuits with respect to both the formulation of the standard for pleading scienter, and how the standard is applied to particular facts. As to the formulation of the standard, the Supreme Court ultimately may decide to what extent allegations of “motive and opportunity” are sufficient. In the meantime, the differences among the circuits with respect to such allegations may lead to inconsistent results on similar facts. The Second Circuit, for example, may have found the motive and opportunity pleading in MCI WorldCom sufficient. The Fourth Circuit, in balancing the facts, also may have found the pleading sufficient under its flexible, case-specific approach.

The Supreme Court also may resolve the differences among the circuits as to what circumstantial evidence is sufficient to support a pleading of scienter, and what inferences may be drawn in reviewing the pleadings at an initial stage of the litigation. In Ottmann and MCI WorldCom, the courts rejected the inferences that plaintiffs urged, while the Second Circuit and the Fourth Circuit may well have permitted a jury to make such inferences.

These issues arise in virtually every private securities litigation claim that is filed, and clarification is sorely needed.

Notes

1. Ottmann v. Hanger Orthopedic Group, No. 02-2283 (4th Cir. Dec. 22, 2003).

2. 15 U.S.C.A. § 78u-4(b)(2).

3. H.R. Conf. Rep. No. 104-369 at 41 (1995), reprinted in 1995 U.S.C.C.A.N. 730-740.

4. Ottmann, supra note 1, slip op. at 8.

5. See Phillips v. LCI Int’l Inc., 190 F.3d 609, 613 (4th Cir. 1999).

6. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

7. Ernst & Ernst Hochfelder, 425 U.S. 185, 194 (1976).

8. Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir.), cert denied, 531 U.S. 1012 (2000). See, e.g., In re Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1244 (3d Cir. 1989) (where the defendant’s conduct is merely negligent, the scienter requirement will not be satisfied).

9. Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994).

10. 15 U.S.C.A. § 78u-4(b)(2).

11. Press v. Chem. Inv. Servs. Corp., 166 F.3d 529 537-38 (2d Cir. 1999); see also In re Advanta Corp. Sec. Litig., 180 F.3d 525 (3d Cir. 1999) (analyzing and accepting the Second Circuit’s standard).

12. In re Comshare Sec. Litig., 183 F.3d 542, 551 (6th Cir. 1999); see also In re Silicon Graphics, Inc. Sec. Litig., 183 F.3d 970, 977-79 (9th Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1285-86 (11th Cir. 1999).

13. Ottmann, supra note 1, slip op. at 8-9.

14. Id. at 20.

15. Id. at 13-14.

16. Id. at 17.

17. Id. at 18.

18. Id. at 19.

19. 216 F.3d 300 (2d Cir.), cert. denied, 531 U.S. 1012 (2000).

20. Id. at 303.

21. Id. at 315. The Second Circuit also reversed the district court’s finding that plaintiffs failed to meet the requirement to plead scienter with particularity because they did not reveal the names of the confidential sources for some of the facts on which their allegations were based. Id. at 314.

22. 340 F.3d 238 (5th Cir. 2003).

23. Id. at 254.

24. Id. at 255.

About the Author

© 2004 Harry Frischer. Mr. Frischer (hfrischer@proskauer.com) is a partner at Proskauer Rose LLP. The author gratefully acknowledges the assistance of Simone R. Coley, an associate at the firm, in preparing this article.