Two recent decisions by the largest federal circuit court in the country have some defense lawyers wondering if the pendulum is swinging against them in securities fraud suits.
Until recently, the 9th Circuit—which includes California and a number of other western states—was considered the friendliest jurisdiction in the country for companies being sued by shareholders under federal securities laws. That’s because the circuit had applied the toughest test for plaintiffs trying to meet the “heightened pleading standard” under the Private Securities Litigation Reform Act of 1995.
In enacting the PSLRA, Congress sought to reduce frivolous and costly securities class actions by requiring plaintiffs to “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, [a] complaint shall state with particularity all facts on which that belief is formed.” The law also requires plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”
Despite the law, some circuits—like the New York-based 2nd Circuit—have set the bar fairly low, letting securities suits go forward based on allegations that many defense lawyers felt were insufficiently specific and failed to make the required showing of intentional wrongdoing. The 9th Circuit, in contrast, had construed the statute strictly, generally dismissing lawsuits before they got to the costly discovery stage.
But two recent decisions—Nursing Home Pension Fund, et al. v. Oracle Corp. in September 2004 and In re: Daou Systems, Inc. Securities Litigation in February 2005—have caused defense lawyers to worry that the 9th Circuit may no longer be safe turf for corporate defendants. In both those cases, trial judges dismissed class actions under the PSLRA and the appellate court reinstated the lawsuits.
McClosky
Michael McCloskey of San Diego, who represents Daou Systems, told Compliance Week that defense lawyers have reason to be anxious. “Before the PSLRA, no one got a dismissal based on [the] pleading standard,” said McCloskey, who practices with Foley & Lardner. “After the PSLRA, other circuits have readily reversed dismissals based on [their interpretation of the act]. But the 9th Circuit has always been more inclined to dismiss based on heightened pleading standards. That’s why defendants have loved the 9th Circuit.”
McCloskey said he would ask the 9th Circuit to reconsider its ruling or, if that fails, for the full court to review the matter. An appeal to the U.S. Supreme Court is also a possibility. He expressed confidence that his client would prevail at trial if it came to that. “But no company needs [a trial like] this. My client has a business it wants to run,” he said.
A Step Back
The 9th Circuit’s tough stance began with a 1999 case, In re Silicon Graphics Inc. Securities Litigation, in which the court said that Congress “intended for the PSLRA to raise the pleading standard even beyond the most stringent existing standard.” As a result, the court said, “plaintiffs proceeding under the PSLRA can no longer aver intent in general terms of mere ‘motive and opportunity’ or ‘recklessness,’ but rather, must state specific facts indicating no less than a degree of recklessness that strongly suggests actual intent,” and, at minimum, must plead “particular facts giving rise to a strong inference of deliberate or conscious recklessness.”
The Silicon Graphics decision was embraced by defense lawyers, who successfully used it to get dozens of lawsuits dismissed before they proceeded to the discovery stage.
But then the 9th Circuit last fall did something that took many by surprise: It overturned a judge’s dismissal of a securities fraud suit against Oracle alleging that the company covered up losses by creating phony sales invoices and improperly recognizing customer overpayments as revenue. In its decision, the court ruled that “the total of plaintiffs' allegations, even though individually lacking, … [were] sufficient to create a strong inference that [Oracle] acted with deliberate or conscious recklessness."
McCloskey said the decision against Oracle caused concern among his colleagues in the defense bar, but that he had hoped the ruling—made by a panel of three of the court’s most liberal judges—was an aberration. “The facts were so unique and the panel so liberally populated that the decision was almost [expected],” McCloskey said.
But the more recent decision reinstating a lawsuit against Daou Systems, McCloskey’s client, was not at all anticipated and very troubling, the lawyer said.
In the suit, the plaintiffs allege that company officials “systematically and fraudulently” violated the generally accepted accounting principles in order to artificially inflate the price of the company’s stock. Many of the allegations are based on accounts from confidential witnesses, which courts have been suspicious of in the past. In the Daou case, the court said that relying on confidential witnesses was fine as long as the complaint described what positions they held in the company and was supported by “adequate corroborating details.”
The court also said that the plaintiffs had sufficiently alleged that Daou officials made false or misleading statements intentionally or with deliberate recklessness. This so-called “scienter” requirement was met, the court said, by demonstrating the “hands on” management style of corporate officers and “suspicious corporate acquisitions and insider stock sales.”
Smarter Plaintiffs’ Bar
Ohly
Although the Oracle and Daou rulings have prompted concern among defense attorneys, securities litigator D. Christopher Ohly of Blank Rome in Washington, D.C., told Compliance Week that these two outcomes are not inconsistent with the PSLRA’s goal of halting baseless suits at an early stage.
“Congress never meant to exclude cases completely or to provide immunity to people in corporations who engage in accounting fraud,” Ohly said. “It meant to weed out cases that were generalized and were not based on very specific information from those that were well-founded. If these allegations [in Oracle and Daou] are provable and these witnesses are credible, it’s hard to imagine anyone looking at this and saying these are not meritorious cases.”
The 9th Circuit, “overall is standing by its nominal standard [set forth in Silicon Graphics] but is applying it now in a way much more like other circuits,” Ohly said.
And the plaintiffs’ bar is getting smarter, Ohly noted. “What they’ve done is turn these complaints into very detailed storytelling, which is not like the typical notice pleading that you find in many cases,” he said.
We’ve made the relevant decisions available in the box above, right.
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