Circuit Deals Blow to Stock Fraud Cases
By Paul Elias
The Recorder/Cal Law
July 6, 1999
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Handing technology companies and others a huge victory in their running battle with plaintiffs attorneys, the Ninth Circuit U.S. Court of Appeals on Friday made it much more difficult for disgruntled shareholders to sue corporations when their stock drops.
The divided court ruled that in order to sue for stock fraud, plaintiffs must show that corporate officers were "deliberately reckless" in making optimistic financial forecasts that turned out to be severely wrong. The opinion Friday was the most defense-friendly interpretation yet of the 1995 Private Securities Litigation Reform Act.
"We hold that a private securities plaintiff proceeding under the PSLRA must plead, in great detail, facts that constitute circumstantial evidence of deliberately reckless or conscious misconduct," Judge Joseph Sneed wrote for the majority. He was joined by L.A. District Judge John Rhoades, sitting be designation. Judge James Browning dissented, writing that the majority opinion "raises the pleading bar higher than that envisioned by Congress, and places the Ninth Circuit at odds with both the Second and Third Circuits."
Indeed, Sneed acknowledged that "not all courts share our view," seemingly making the issue ripe for U.S. Supreme Court review. The Second Circuit, for instance, has allowed suits to proceed by merely pleading that corporate officers had the "motive and opportunity" to commit fraud or by pleading simple recklessness.
But Sneed said that Congress intended the pleading standards to be even more stringent than the Second Circuit's holding.
"The legislative history supports our conclusion that the PSLRA pleading standard is higher than the standard of the Second Circuit," Sneed wrote. "Congress must have intended a standard that lies beyond mere recklessness."
In affirming a decision of recently retired Northern District Judge Fern Smith, Sneed held that the mere existence of insider trading does not, on its face, show fraudulent intent. Insider trading has long been the centerpiece of stock fraud class actions, with plaintiffs lawyers often showing that corporate officers have sold off considerable quantities of stock before its value fell, and otherwise filing boilerplate language alleging fraudulent intent.
The king of these cases, William Lerach of Milberg Weiss Bershad Hynes & Lerach, has called proof of insider trading "footpaths in the snow," and used it as exhibit one that corporate officers lied about a company's financial well being to artificially inflate the stock.
Sneed held that is not enough. "As the district court recognized, mere boilerplate pleadings will rarely, if ever, raise a strong inference of intent or otherwise satisfy the PSLRA's particularity requirement," Sneed wrote. "The district court also concluded that the sales of stock were not so suspicious as to create a strong inference of fraudulent intent."
Stanford Law professor Joseph Grundfest, who closely monitors securities litigation, said the insider trading issue is one of the most significant aspects of the opinion. Fully 60 percent of all securities class actions use insider trades as evidence of fraud.
With Sneed's opinion, "you now have to evaluate the insider's trading behavior in context" with trades made over longer periods of time, Grundfest said.
Judges have been sitting on hundreds of securities cases throughout the country while the pleading standards in the PSLRA are straightened out, and few such cases have settled. Of the 643 cases the Stanford University Law School Securities Clearinghouse tracks, fewer than 100 have been resolved.
"I think the courts have been waiting for this," said Sara Brody, a partner with Brobeck, Phleger & Harrison. "I would expect a number of district court judges, particularly in California, to start deciding motions to dismiss." Brody said a motion to dismiss in In re Oak Technology Inc. Securities Litigation, 96-20522, for instance, has been pending before San Jose Senior Judge Spencer Williams since December 1997.
There are also a number of similar cases on appeal that will probably now be decided in short order, predicted Brody. In re Silicon Graphics Inc. Securities Litigation, 97-16204, was filed by Milberg Weiss in 1996 after Silicon Graphics announced that its earnings had grown only 22 percent rather than the 40 percent previously projected. Lerach accused officers of knowing their projections were false in order to boost the stock price. As proof of their intent, Lerach pointed out that insiders sold 400,000 shares during the time of the alleged fraud.
But Bruce Vanyo of Wilson Sonsini Goodrich & Rosati successfully argued that the heightened pleading standard mandated by the Reform Act required the case to be thrown out, which the Ninth Circuit ordered on Friday. Both sides of the bar anticipate that either an en banc Ninth Circuit panel or the Supreme Court will weigh in on the issue.
The ruling comes the same week the Congress overwhelmingly passed a law that would greatly limit the number of class actions that could be filed because of anticipated computer failures due to the Year 2000 problem.
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