Ever since the passage of the Private Securities Litigation Reform Act ("Reform Act"), Courts have wrestled with the issue of what fact must be plead to create the requisite "strong inference" of scienter. The debate has centered on whether Congress, in adopting the Second Circuit’s "strong inference" requirement, also intended to adopt its caselaw holding that the allegations that the defendant had both the motive and opportunity to commit securities fraud would be sufficient to create the inference.
In Press v. Chemical Investment Services Corp., 1 without any analysis of the Reform Act or its legislative history, the Second Circuit applied the identical pleading requirement it had in place before the Reform Act was adopted. The Second Circuit stated that the Reform Act "heightened the requirement for pleading scienter to the level used by the Second Circuit," and therefore held that "[a]s a pleading requirement, a plaintiff must either (a) allege facts to show that ‘defendants had both motive and opportunity to commit fraud’ or (b) allege facts that ‘constitute strong circumstantial evidence of conscious misbehavior or recklessness.’"
After Press, the Third Circuit adopted the Second Circuit’s motive and opportunity test with which the SEC agrees 2 . The First 3 , Sixth 4 ,Ninth 5 and Eleventh 6 Circuits rejected the Second Circuit standard and each invoked its own more stringent standard. Now, the Second Circuit has revisited the issue in Novak v. Kasaks 7 , and has itself rejected the motive and opportunity test in favor of a more flexible standard with no bright lines and no catchy name.
The Novak court noted that courts that have weighed in on the issue have generally fallen into two camps and have held that either (1) the "statute effectively adopts the Second Circuit’s pleading standard for scienter wholesale," or (2) the "statute strengthens the Second Circuit’s standard by rejecting the simple pleading of motive and opportunity." As between the two camps, the Novaks court settled upon what it referred to as a "middle ground" approach.
The Novak court confirmed that the Reform Act adopted the Second Circuit’s strong inference standard," and as such it "effectively raised the nationwide pleading standard to that [which] previously exist[ed] in this circuit and no higher." As to whether the Reform Act also adopted its motive and opportunity test, the Second Circuit stated, "[W]e believe Congress’s failure to include language about motive and opportunity suggests that we need not be wedded to these concepts in articulating the prevailing standard."
After Novak, it appears that pleading motive and opportunity alone, without any other facts demonstrating scienter, will not be sufficient to meet the "strong inference" pleading standard. As for the "other facts" that would support the "strong inference," the Novak court directed district courts to the Second Circuit’s prior case law which suggests that "the [strong] inference may arise where the complaint sufficiently alleges that the defendants: (1) benefited in a concrete and personal way from the purported fraud; (2) deliberately engaged in illegal behavior; (3) knew facts or had access to information suggesting that their public statements were not accurate; or (4) failed to check information they had a duty to monitor."
As for the substantive nature of scienter after the Reform Act, the Novak court expressly pointed out that "[t]his case pertains not to the scienter requirement itself, but rather the pleading requirement for scienter in the securities fraud context." Therefore, in order for liability for securities fraud to follow, a showing of recklessness will continue to be a sufficient basis for establishing that the defendant acted with the requisite scienter.
Robert A. Horowitz and Karen Y. Bitar are shareholders in the New York Office of Greenberg Traurig and are members of the firm’s Securities Litigation Practice Group. They regularly defend corporations and individuals in securities actions nationally.
Footnotes
1 Press v. Chemical Investment Services Corp., 166 F.3d 529 (2d. Cir. 1999).
2 In re Advanta Corp. Securities Litigation, No. 98-1846, 1999 WL 395997 (3d Cir. 1999).
3 Greebel v. FTP Software, Inc., 194 F.2d 185 (1st Cir. 1999).
4 In re Comshare Incorporated Securities Litigation, No. 97-2098, 1999 WL 46017 (6th Cir. 1999).
5 In re Silicon Graphics, Inc. Securities Litigation, No. 97-16204, 97-16240 1999.
6 Bryant v. Avado Brands, Inc., No. 98-9253, 1999 WL 688050 (11th Cir. 1999).
7 Novak v. Kasaks, 2000 WL 796300 (2d Cir. 2000).
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