Saturday, June 7, 2014

Amended Pleadings in Securities Cases

On Thursday, the First Circuit handed down its opinion in In re Genzyme Corp. Securities Litigation(.pdf), affirming the dismissal of the complaint.  The decision highlights an issue that’s particularly important in securities cases – although, full disclosure, I was very involved with the Genzyme case on the plaintiffs' side before I left practice to teach, so I’m not an unbiased observer.  Take that as you will.

[More after the jump]

The PSLRA significantly raised the pleading standards for complaints alleging claims under Section 10(b).  Plaintiffs have to “state with particularity all facts” that lead them to believe the defendant issued false statements, and “state with particularity facts giving rise to a strong inference that the defendant acted with” scienter.  To gauge whether scienter has been properly pled, the court must balance the culpable inferences against nonculpable inferences to determine whether the inference of fraud is at least as strong as the inference of innocent conduct.  See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007).  And because discovery is stayed until the resolution of the motion to dismiss, this standard must be met based solely on what the plaintiffs can gather on their own, without subpoena power.

This is a notoriously difficult and – more importantly, indeterminate – standard.  And over the years, the bar has (unofficially) gone up – if you go back and look at early cases under the PSLRA and compare them to today’s cases, it’s pretty clear that facts that were once considered sufficient to plead scienter are no longer good enough.  Hillary Sale actually documented how courts continually moved the bar when deciding whether plaintiffs sufficiently pled that the defendants had a “motive” to commit fraud.  See Hillary A. Sale, Judging Heuristics, 35 U.C. Davis L. Rev. 903 (2002).  As then-Chief Judge Young in the District of Massachusetts put it, under the PSLRA, “the gamesmanship required to plead a successful securities claim has taken on a dimension reminiscent of pre-Federal Rules pleading practice.” In re Number Nine Visual Tech. Corp. Sec. Litig., 51 F. Supp. 2d 1, 27 n.22 (D. Mass. 1999).

The standard has had a couple of consequences.  First, more and more, plaintiffs rely on confidential witnesses – basically, former employees – to provide information about what really went on at a company.  But plaintiffs almost never have access to higher level employees – most of them may still be employed at the company, they might count as part of the company control group such that it would be unethical to talk to them without their lawyer present, they may have confidentiality agreements, or they may be sufficiently implicated in the wrongdoing such that they have no interest in talking to plaintiffs.

So instead, plaintiffs talk to lower level employees.  But lower level employees usually don’t have direct knowledge of what went on in the CEO suite.  Instead, the lower level employees give information that kind of adds up, drip drip drip – collectively, piece by piece, the lower level employees demonstrate that the problems were so widespread that that the top corporate officials were recklessness if they didn’t know of them.

The second result of the high pleading standard is that it takes forever for a motion to dismiss to be resolved, during which time, of course, the discovery stay remains in place.  It takes 45 days to 60 days to draft a complaint, months to brief the motion to dismiss, and many more months, or years, before the district court issues a ruling.

So the question is – what happens when the complaint is dismissed, but the plaintiff believes the deficiencies identified by the district court can be cured?  Maybe the plaintiff can find more witnesses, for example, or even already has information that the district court felt was lacking, but was unaware that would be needed.  Does the plaintiff get a chance to replead?

In Genzyme, the original complaint had 5 confidential witnesses.  Over two years later – and over a year after oral argument – the district court dismissed the complaint with prejudice and closed the case.  The plaintiffs filed a motion under Rule 59(e) seeking to reopen the judgment with a proposed amended complaint, containing an additional 13 witnesses.  Many, though not all, of these witnesses had been identified at some point in the two year period between the time the complaint was filed and the district court's dismissal order.  Several had been identified in the year between oral argument and dismissal.

The district court rejected the proposed complaint without evaluating the sufficiency of the new allegations, on the ground that the plaintiffs could have proffered the witnesses much earlier.  The First Circuit affirmed, also without evaluating the new complaint, holding that the district court had not abused its discretion.  At the same time, it “pause[d] to note” its “discomfort with the district court’s choice to dismiss the complaint with prejudice.”

In fact, there’s a circuit split on this issue.  The Ninth Circuit, recognizing that PSLRA cases present particular pleading challenges for plaintiffs, has held that district courts should give plaintiffs an opportunity to replead as a matter of course.  See Eminence Capital, LLC v. Aspeon, Inc., 316 F.3d 1048 (9th Cir. 2003).  The Sixth Circuit has held that the high PSLRA pleading bar embodies a congressional policy in favor of giving plaintiffs only one bite at the apple.  See Miller v. Champion Enters., Inc., 346 F.3d 660 (6th Cir. 2003).

The First Circuit believes the PSLRA has had no effect on the federal rules, which contain a “liberal” approach to allowing amendments; in prior caselaw, it has suggested that if plaintiffs want a chance to replead, they should proffer additional evidence prior to dismissal.  See, e.g., ACA Fin. Guar. Corp. v. Advest, Inc., 512 F.3d 46 (1st Cir.  2008).

My own view is that it is manifestly unfair – and quite unrealistic – to expect plaintiffs to routinely offer new evidence during the pendency of a motion to dismiss in a PSLRA case.  It is very hard to tell, in advance, whether a complaint is sufficient on its own to meet the standard – the standard is just too fuzzy, and courts are quite idiosyncratic about what they will accept.  And it is very rare – though not unheard of – for plaintiffs to discover a “smoking gun” after the complaint is filed; most of the time, as in Genzyme, additional evidence comes in bits and pieces, a new statement from a new witness that they saw an additional incident of wrongdoing, or heard a rumor, and so forth.  Each one of these new facts does not necessarily mean much, standing alone – it’s only incrementally, over time, that their significance becomes clear, and even then, it may only be clear that these witnesses are helpful after the district court dismisses the case for failure to plead some particular fact or set of facts.  Repetitive statements from multiple witnesses may or may not be significant, for example, depending on whether the district court feels that existing witnesses are not credible, or do not offer sufficient evidence of common knowledge or a widespread problem.

Moreover, if plaintiffs are required to proffer new evidence in advance, there would be another round of briefing, and more delays – thus dragging out the time to resolve a motion to dismiss immeasurably – during which time, again, the discovery stay remains in place, and so the case remains entirely stalled.

So unless there’s a reason to think the plaintiff was sitting on something really explosive or that would dramatically change the nature of the allegations,  the liberal amendment policy of the federal rules should be interpreted to allow plaintiffs at least one additional opportunity to amend –  regardless of whether the plaintiff proffered the earlier evidence prior to the dismissal order.

http://lawprofessors.typepad.com/business_law/2014/06/amended-pleadings-in-securities-cases.html

Ann Lipton | Permalink

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