On Securities

The Ninth Circuit’s decision in Silicon Graphics may have finally put some teeth in the Private Securities Litigation Reform Act (the “Reform Act”). Although other Circuits have articulated somewhat different versions of the new pleading standard, the emerging consensus should change what and how securities fraud cases are brought.


The Reform Act requires a securities fraud complaint to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”  Unfortunately, neither the statute nor its legislative history are clear about exactly what this means. Part of the new standard came from Second Circuit cases that required plaintiffs to establish a “strong inference of fraudulent intent” by alleging either (1) “facts constituting circumstantial evidence of either reckless or conscious behavior” or (2) “facts establishing a motive to commit fraud and an opportunity to do so.”  See In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 268-69 (2nd Cir. 1993).  The Conference Report, however, stated that Congress did “not intend to codify the Second Circuit’s case law” and “chose not to include in the pleading standard language relating to motive, opportunity or recklessness.”

The Reform Act’s reference to the “required state of mind” also invites judicial interpretation. 10(b)-5 liability has always required scienter – the “intent to deceive, manipulate or defraud.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976).  But the Supreme Court has left open “whether, in some circumstances, reckless behavior is sufficient.”  Id. at 194 n. 12.  Lower federal courts have imposed liability for “recklessness” that constitutes “an extreme departure from the standards of ordinary care” and “presents a danger of misleading buyers or sellers that is either known … or so obvious that the actor must have been aware of it.” See, e.g., Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569 (9th Cir. 1990). 


Judge Fern Smith had dismissed the complaint for failing to meet the new pleading standards.  In re Silicon Graphics, Inc., 970 F. Supp. 746. (N.D. Cal. 1997).  The Ninth Circuit has now affirmed, in a 2-1 decision written by Judge Sneed, holding that plaintiffs must “plead, in great detail, facts that constitute strong circumstantial evidence of deliberately reckless or conscious misconduct.”  Id., 183 F.3d 970 (9th Cir. 1999).

Relying on Hochfelder and Hollinger, the Ninth Circuit concluded that “recklessness” constitutes scienter only “to the extent that it reflects some degree of intentional or conscious misconduct.”  Id. at 977. Relying primarily on the Conference Report, the Court also concluded that plaintiffs cannot allege intent “in general terms of mere ‘motive and opportunity.’”  Id. at 979.

Plaintiffs’ allegations of negative internal reports that contradicted the defendants’ public statements did not raise the required “strong inference,” because they lacked “adequate corroborating details.”  The Reform Act requirement that plaintiffs “state with particularity all facts” supporting such allegations was interpreted to mean that plaintiffs must allege the author, recipients and sources of such reports.  Id. at 985.

The Ninth Circuit also found that the alleged insider trading ($13.8 million in proceeds over fifteen weeks) was not sufficiently “unusual” or “suspicious.” Viewed in the context of the defendants’ total holdings, including vested options, and their prior trading practices, these stock sales were not “suspicious enough to create a strong inference of the required deliberate recklessness.”  Id. at 987.

The Ninth Circuit’s decision is the strongest formulation yet of the new pleading requirements. The Second and Third Circuits have recently chosen to apply the Second Circuit test of “motive and opportunity” or “recklessness.”  See Stevelman v. Alias Research, Inc., 174 F.3d 79 (2nd Cir. 1999); In re Advanta Corp., 180 F.3d 525 (3rd Cir. 1999). The Sixth and Eleventh Circuits have tried to split the difference, concluding that allegations giving rise to “a strong inference of recklessness” are sufficient, but merely pleading “motive and opportunity” is not.  In re Comshare, Inc., 1999 WL 460917 (6th Cir. 1999); Bryant v. Avado Brands, Inc., 1999 WL 688050 (11th Cir. 1999) (requiring “severe” recklessness).

Although the formulations differ, the results appear to be converging. Both the Sixth and Third Circuits affirmed dismissals of complaints for failing to meet the Reform Act standard, however articulated.  In particular, these courts, like the Ninth Circuit, made realistic evaluations of alleged “insider trading” based on all the facts, including vested options and prior trading patterns.

Other appellate courts should also adopt the Ninth Circuit’s holding that plaintiffs have to allege “corroborating details” about “negative internal reports.”  Forcing plaintiffs’ counsel to do their investigative work before filing their complaints was one of the main goals of the Reform Act.