The Restricted Application of Rule 10b-5

By Michael A. Collora 
Send Email to: mcollora@dwyercollora.com   
  
This article first appeared in the July 28, 1997 edition of Massachusetts Lawyers Weekly. 
 

Securities fraud regarding publicly held companies is alive and well - witness the recent Rule 10b-5 indictment in this district of the President of Centennial Technologies Inc. U.S. v. Pinez, Cr. No. 97-10064 JLT (D.Mass.), the plea of an officer of Cambridge Biotech to one count of causing improper revenue recognition, U.S. v. Hartman, 97-40022 NMG (D.Mass.), and convictions and jail terms of officers of Kurtzweil Applied Intelligence, U.S. v. Bradstreet, No. 95-10228-RGS. However, despite a recent Supreme Court victory by the federal government on a criminal charge of insider trading, U.S. v. O'Hagan, No. 96-842, WL 345229 (U.S. June 25, 1977), it has become increasingly difficult for stock investors to win damages in federal court. Recent rulings, including those in this circuit, and legislation by Congress, have restricted the ability of plaintiffs to use Rule 10b-5 to recover losses. This article reviews that trend.

Rule 10b-5

Since it conception in 1942, and after approval of its use in private securities litigation in 1947, Rule 10b-5, 17 C.F.R. §240.10b-5, promulgated under §10 of the 1934 Securities Exchange Act, has been used frequently as authority to bring claims in federal court for recovery of losses sustained from the sale of securities. Rule 10b-5 is comprised of a number of elements, many of which are now under close scrutiny by the courts. To succeed under Rule 10b-5, a plaintiff must allege and prove that the defendant:

(a) either employed a device, scheme or artifice to defraud, or made a material false statement or omission

(b) relied upon by the plaintiff

(c) in connection with the purchase or sale

(d) of a security

(e) with intent to defraud

(f) causing damage

See generally Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1216-17 (1st Cir. 1996).

It has never been easy in this circuit to prevail in class action securities litigation. This circuit's very strict construction of Federal Rule of Civil Procedure 9(b), requiring that fraud be pled with particularity, makes it very difficult to allege the specific fraudulent intent necessary to defeat a motion to dismiss. In a number of decisions dating back at least as early as 1984, in Wayne Investment, Inc. v. Gulf Oil Corp., 739 F.2d 11, 15 (1st Cir. 1984), and continuing until the present, with Suna v. Bailey Corp., 107 F.3d 64, 74 (1st Cir. 1977) this circuit has used Rule 9(b) to permit district courts to dismiss complaints alleging securities fraud.

The Supreme Court itself has in recent years made it more difficult for plaintiffs to succeed in 10b-5 claims. In 1991, in Lampf, Pleva, Lipkind, Prupis & Peligrow v. Gilbertson, 501 U.S. 350 (1991), the Court restricted the statute of limitations to an outside limit of three years from the date of the fraud and one year from the date the plaintiff knew or should have known of the existence of the scheme. In 1994, it further restricted the use of 10b-5 by holding that it applied against principals directly involved in the fraudulent scheme and not to those secondarily liable under theories of aiding and abetting. See Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A, 511 U.S. 164 (1994). In that same term, the Court also excluded use of the more friendly provisions of the 1933 Securities Act as a remedy for non-public sales involving a prospectus containing allegedly material misstatements requiring plaintiffs to resort to the 1934 Exchange Act's Rule 10b-5. See Gustafson v. Alloyd Co., Inc., 513 U.S. 561 (1995).

However, on June 27, 1997, the Supreme Court granted a rare victory to a plaintiff in a 10b-5 case although notably it was the federal government, when it affirmed convictions under 10b-5 on the misappropriation theory in U.S. v. O'Hagan. In so doing, it held that the SEC and the United States Attorney's Offices may use Rule 10b-5 against any individual who knowingly misappropriates and uses material non-public information to trade on a security. However, because of the limited nature of the ruling, it will be of little assistance to most securities plaintiffs in the future.

O'Hagan had been a partner in a major Minneapolis firm, involved in a takeover representing the acquiring corporation. He purchased stock of the target based upon this material/non-public information. He was indicted and convicted of security fraud, based primarily upon the "misappropriation theory" first suggested by Chief Justice Berger in Chiarella v. U.S., 445 U.S. 222 (1980) as a possible interpretation of the prohibition against the use of any device, scheme, or artifice to defraud in the sale of securities under rule 10b-5. Upon appeal, the Eighth Circuit sided with the Fourth Circuit in U.S. v. Bryan, 58 F.3d 933 (4th Cir. 1995) and against several other circuits including the Second Circuit in U.S. v. Chestman, 947 F.2d 551 (2nd Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992), and reversed the district court. See U.S. v. O'Hagan, 92 F.3d 612 (8th Cir. 1996).

In O'Hagan, the Eighth Circuit concluded that Rule 10b-5 did not reach the use of inside information by a non-insider, so long as that person did not deceive a participant in the trade. It also ruled that since there was no breach of fiduciary duty by the defendant to either the company whose stock was the subject of the trade, or to the participants in the securities transaction, there was insufficient connection between the misappropriation and the purchase or sale to permit the use of Rule 10b-5. Almost as an afterthought, it held that SEC Rule 14e-3(a), designed to prohibit trading by those with access to confidential information while a tender offer was underway, exceeded the SEC's authority under § 14e of the Securities Exchange Act, 15 U.S.C. § 78n(e) and overturned convictions under that rule. The Circuit Court said the SEC could not define fraud to include the misuse of inside information where there was no breach of fiduciary duty. In so ruling, it conflicted with three other circuits on the validity of that rule and set the stage for the Supreme Court ruling.

In reversing the Eighth Circuit, the Supreme Court in O'Hagan held that 10b-5's prohibition against the use of a deceptive device or contrivance in connection with a purchase or sale of securities is violated when an outsider breaches a duty to someone in possession of inside or confidential information, and trades based upon that information. It said misappropriation of inside information is deception in this context, and the breach of duty need not be solely to the other party to the transaction to satisfy the "in connection with" requirement of 10b-5. The Court also upheld the validity of the SEC's tender offer restriction set forth in Rule 14e-3(a) as a proper exercise of the SEC's authority. Accordingly, O'Hagan's conviction was reinstated. 

Effect in First Circuit

First, O'Hagan merely stands for the unremarkable proposition that outsiders who misappropriate material financial information from anyone trade at their peril, unless they disclose such information prior to a trade. Thus, the O'Hagan decision will have immediate but only limited effect in this district. There is only one pending insider trading criminal case in this District, U.S. v. Sargent, Cr. No. 96-10134 (JLT) (D. Mass) in which the government relies upon the misappropriation theory, alleging a criminal violation of 10b-5 in connection with stock purchases of Puralator prior to a tender offer. In addition, there is at least one pending SEC civil case on similar grounds, SEC v. Larrabee, Civ. No. 97-10652 (PBS) (D. Mass), involving purchases of BayBank stock prior to its acquisition by BankBoston. As a result of O'Hagan, both cases will now go forward with the Government in the driver's seat. As to the use of Rule 10b-5 in more traditional contexts, such as that of the former Centennial President in U.S. v. Pinez, where the charge rests upon his role as an insider and fiduciary to his own shareholders, the O'Hagan opinion of course will not affect the prosecution which was never challenged on that basis.

O'Hagan will also have little effect on class action 10b-5 cases, because its application will be confined to frauds difficult to detect and usually discovered only by the federal government. Class action plaintiff's rarely have access to this kind of secret information and it would not bolster their fraud allegations in any event. They need inside trading of a more traditional variety, that of true insiders who must file a report of their activity on SEC forms at the end of a quarter. This is so because the primary problem for plaintiffs facing a stock loss in a publicly held company is whether their counsel can allege with particularity why past promises of performance were false when made and these allegations must be proved without help from cooperating witnesses or a federal investigative agency. In drafting a class action complaint, plaintiffs counsel puts together every public document available as well as comments from financial analysts that are intertwined with company comments, and tries to allege that the corporate defendant and its officers knowingly misled the marketplace.

Inside trading by corporate officials helps. This is because without more than the above public record, the federal courts often hold that the fraud allegations in the complaint are simply too conclusory, that the plaintiff must particularize the circumstances of the concealment or misleading events even if peculiarly within the knowledge of the opposing party. See Greenstone v. Cambex Corp., 975 F.2d 22, 25 (1st Cir. 1992) (an allegation that the defendants "knew" of the concealed facts was not "particular" enough).

Since evidence of intent is often lacking, plaintiffs must resort to circumstantial evidence to persuade the court that fraud has been sufficiently pled. Allegations of insider trading during the relevant period can be helpful in showing specific fraudulent intent at least as to the individual defendants and, combined with other factors, may help the plaintiffs offset motions to dismiss filed under Rule 9(b) of the Federal Rules of Civil Procedure by the company.

Normally, a corporation is not required to disclose non-public information, even if material, but it must do so if it is trading in its own securities. Roeder v. Alpha Industries, Inc., 814 F.2d 22, 26 (1st Cir. 1987). But absent a public offering, a company trading in its own securities is unusual. Thus, the plaintiff must allege more than a failure to disclose material facts.

In Shaw v. Digital Equipment Corp, the defendants claimed that plaintiffs had not alleged sufficient facts to show that defendants knew and then failed to reveal that a certain quarter's financial results were going poorly. The Shaw court agreed with defendants that plaintiffs could not simply plead fraud by hindsight nor could they contrast a poor performance in one financial period with past incorrect projections and hope the court would infer fraud. See 82 F.3d at 1223-24. But in sustaining part of the Shaw complaint, the Circuit focused on allegations of selling of a suspicious nature by two corporate insiders, and noted:

allegations of insider trading in suspicious amounts or at suspicious times may permit an inference that the trader - and by further inference, the company - possessed material nonpublic information at the time.

Id. at 1224. See also Greenstone v. Cambex Corp., 975 F.2d 22, 26 (1st Cir. 1992) ("Insider trading in suspicious amounts or at suspicious times of course could help the [plaintiff]").

Still, sales by officers may not be enough. In a recent case involving such allegations, a Rhode Island federal court resisted attributing allegations of insider trading of the officers to the corporation saying the company was not required to disclose material non-public information just because its officers were selling. See Simon v. American Power Conversion Corp., 945 F.Supp. 416, 425 (D. R.I. 1996). However, these allegations kept the individual defendant in the case under § 20A of the 1934 Securities Exchange Act. Id.

This scraping for evidence is necessitated by how these class action cases arise. The plaintiff, usually a small shareholder in a large company, hires counsel, who takes the company's public documents, and statements by a financial analyst if intertwined with company comment, and attempts to contrast them with a later disappointing quarter or year, which has caused a drop in stock prices. Rarely in these cases is there a cooperating insider or an agency investigation to help the plaintiff in obtaining statements or documents. Indeed, after the complaint is filed, discovery is usually stayed while the defendants try to halt the case on the pleadings alone.

Without extremely suspicious circumstances, it is hard to get past the First Circuit's standards. In class actions, where the stock market is the group relying upon the statements, the courts often decide that a statement cannot reasonably have misled the market and thus is not actionable. In Shaw for example, Circuit Judge Lynch made an almost painful review of each allegation made by plaintiffs, deciding whether one or another of these was actionable, that is, was it materially false and attributable to the company. Only a small part of the complaint and a much more narrowed class survived this vigorous analysis.

As another example, the plaintiff in Serabian v. Amoskeag Bank Shares, Inc., 24 F.3d 357 (1st Cir. 1994), who had benefited from some discovery, nonetheless had a third amended complaint dismissed by the district court. On appeal, in virtually a line by line dissection of the allegations, the Court of Appeals permitted some allegations within the complaint to stand. It said that the bank's claims, that the loan reserves were adequate, made when auditors were advising the bank of serious deficiencies, could survive, although the court did say that it was the better practice to make reference to specific loans rather than to generalized reports made by auditors and consultants. Id. at 364. Left unsaid was how plaintiffs could normally draft a specific enough complaint without discovery when all they normally have access to is the positive report of one period followed by a poor performance; that by itself is insufficient under 10b-5. Id. at 367.

Without insider trading or other clearly fraudulent circumstances, these strict requirements have had the effect of killing many securities fraud cases at a very early stage. For example, while the Serabian claims barely survived, other claims against failed banks in the early 90's usually did not. Plaintiffs had little success suing the collapsed banks and their directors for poor loan policies, mismanagement and failure to take adequate reserves at an earlier date despite allegations that these failures inflated the value of the stock. See e.g., Boyle v. Merrimack Bancorp Inc., 756 F.Supp. 55, 56 (D.Mass. 1991) and cases cited therein. Indeed, even in situations where there was criminal activity by the officers, the plaintiffs might be unaware of the criminal activity. In one of the rare cases to succeed for a bank plaintiff, Hurley v. First Service Bank, 719 F.Supp. 27 (D.Mass. 1989), the trial court appears to have acted generously toward the plaintiff when it permitted the allegations to go forward. The criminal allegations about the officers in First Service Bank only surfaced much later and could not at that late date have helped the plaintiff. See U.S. v. Wester, 90 F.3d 592, 600 (1st Cir. 1996) (affirming conviction of First Service president). 

Congress

If it was not already difficult for plaintiffs to survive this heightened surveillance, Congress also has strengthened the pleading requirement. In late 1995, it passed the Private Securities Litigation Reform Act (PSLRA) Pub. L. No. 104-67, 109 Stat. 26, (codified as amended in scattered section of 15 U.S.C.) part of which in effect amended Rule 9(b) for securities cases by requiring that for each allegedly false statement or omission the plaintiff must demonstrate why it is false and if, on information and belief, all facts supporting that belief. Plaintiffs also must plead with particularity the defendant's required state of mind. See 15 U.S.C. § 78u-4(b)(2). The drafters intended that the courts adopt the strictest court interpretation of Rule 9(b) and referred to opinions in the Second Circuit, giving Shields v. Citytrust Bancorp, 25 F.3d 1124, 1128 (2d Cir. 1994) as an example.

In one of the earliest opinions interpreting the PSLRA, In Silicon Graphics Inc. Litigation, No. 96-0393 FMS, WL 285057 (N.D. Cal. May 23, 1997), the Court reviewed a lengthy complaint alleging violations of 10b-5 in connection with Silicon Graphic's third quarter 1995 financial statements. Apparently, the quarter turned out badly, despite optimistic projections. During the same quarter certain insiders were selling stock. The court noted that the plaintiffs had to allege and prove intentional misconduct, and noted that now recklessness as the standard for scienter may not be enough, despite holdings by most circuit courts that it was sufficient.

After a review of the legislative history of the PSLRA and circuit law, none of which is crystal clear as to what standard of intent must be pled and proven, the district court held that securities plaintiffs must in their complaint create a strong inference of knowing or intentional misconduct. The alleged recklessness must be deliberate. "Motive, opportunity and non-deliberative recklessness may provide some evidence of intentional wrongdoing but are not alone sufficient to support scienter." Id. at 10.

To try to reach that heightened standard of scienter and without the benefit of discovery, the plaintiffs in Silicon Graphics claimed that negative internal reports conflicted with external statements; intent was shown by inside stock trading during the quarter. The court found the plaintiffs' allegations too general. It said references to the internal reports should have named titles and dates of documents, as well as who prepared and who received them. The court then reviewed the "insider" stock sales and found in large part they were not suspicious, although some of the trades when considered with other factors, might bolster the fraud claims. Nonetheless, the court found the complaint wanting and dismissed it.

Previous First Circuit law regarding scienter does not seem as strict as that adopted by the district court in the Silicon Graphics case. In discussing the level of scienter that the plaintiffs are required to prove, the First Circuit has labeled it as "carelessness approaching indifference." Hoffman v. Esterbrook & Co., 587 F.2d 509, 516 (1st Cir. 1978). Only one court in this circuit has discussed the new standard of intent which the PSLRA may have imposed. In Friedberg v. Discreet Logic Inc., 959 F.Supp. 42 (D. Mass. 1997), in denying a motion to dismiss the complaint, Judge Harrington wrote that the PSLRA raised the standards beyond even that of the Second Circuit (which required either facts establishing a motive to commit fraud and an opportunity to do so, or circumstantial evidence of either reckless or conscious behavior permitting scienter to be inferred); the court adopted a conscious behavior standard which it considered a higher level of intent than either recklessness or motive and opportunity. Id. at 49. While this ruling is similar to that of Silicon Graphics, such a standard is not uniform across the country, see In re Baesa Securities Litigation, Nos. 96 Civ. 7435 (JSR), 96 Civ. 8141 (JSR), 1997 WL 379690 (S.D.N.Y. July 9, 1997) (recklessness sufficient), and circuit rulings will have to clarify the standard.  Top

Conclusion

The heightened pleading requirements imposed by Congress, combined with this Circuit's already strict pleading requirements, will continue to make it more difficult for plaintiffs to prevail in opposing motions to dismiss, absent the more egregious circumstances such as are present in the Centennial situation. A mere drop in the value of a company's stock, even if it "surprises" the Street, will now be less likely to result in litigation in federal court. Stock trading by corporate insiders may help to provide motive and opportunity but such trading cannot by itself alone overcome the Circuit's distaste for these kinds of suits. However, the state courts offer an alternative and may become the venue of choice for certain types of class actions, which face a hostile federal forum.