Pleading Scienter Under the Federal Securities Laws: What Creates a Strong Inference of Fraudulent Intent?

Co-written by Margaret A. Jacobs & Karen E. Siciliano

One of the keys to curtailing litigation costs for public companies in any securities class action is dismissal at an early stage. Heightened standards for pleading defendants' state of mind increase the chances of early dismissal and also enhance defendants' likelihood of prevailing on the merits.

The Private Securities Litigation Reform Act of 1995 ("PSLRA") amended the Securities Act of 1933 and the Securities Exchange Act of 1934. Among other things, the PSLRA demanded greater particularity in pleading misleading statements and omissions in securities fraud class actions. Perhaps most significantly, it raised the bar for pleading "scienter" - defendants' state of mind - in fraud cases by requiring plaintiffs to state with particularity facts giving rise to a strong inference that the defendants acted with the requisite state of mind.

The PSLRA was designed to discourage the filing of abusive "strike" suits brought on the heels of any significant change in the issuer's stock price in the hope that discovery would uncover evidence of wrongful conduct. Adoption of the PSLRA in turn sparked debate over whether and to what degree the legislation required reconsideration of pre-PSLRA scienter pleading standards. On this question, litigants currently face a three-way split of authority among the federal circuit courts of appeals. This article discusses the views of the different circuits on scienter pleading requirements, focusing on current developments within the Second Circuit, which governs cases in New York and traditionally has been an influential court throughout the country on securities law matters.

Prior to the PSLRA, the Second Circuit had the most stringent pleading standard, requiring plaintiffs to "allege facts that give rise to a strong inference of fraudulent intent" by alleging "(1) facts that demonstrate defendants' motive and opportunity to commit fraud; or (2) facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness." Sheilds v. City Trust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994). Other circuits did not require the pleading of particularized facts supporting an inference of scienter.

The PSLRA has not achieved uniformity in pleading standards. Currently, the Circuits are divided as to how the PSLRA has affected the scienter pleading requirement. The scienter debate has focused principally on two issues: whether plaintiffs can still satisfy their pleading obligations in fraud cases by alleging "motive and opportunity" to commit fraud; and satisfied by alleging traditional recklessness (i.e., an extreme departure from the standards of ordinary care), or whether deliberate recklessness or conscious misconduct is now required.

In the most...