The Judicial Access Barriers to Remedies for Securities Fraud

Article excerpt

I

INTRODUCTION

Congress has created a mechanism through which victims of securities fraud may pursue remedies for their losses against perpetrators. That mechanism includes the substantive prohibitions of the federal securities laws as well as the procedural pathways established by the Private Securities Litigation Reform Act of 1995 (PSLRA) and the Federal Rules of Civil Procedure and Evidence. Some federal courts have modified this mechanism by creating access barriers to remedies for securities fraud victims at the pleading, class-certification, and summary-judgment stages. In this article, we delineate those access barriers and question both their constitutionality and wisdom.

II

REWRITING RULES AND STATUTES TO CRAFT PRE-TRIAL ACCESS BARRIERS

In some federal jurisdictions, the requirements of the PSLRA and the Federal Rules of Civil Procedure and Evidence have been rewritten by the courts to erect merits barriers at three key pre-trial litigation stages that force plaintiffs to prove their case to a judge, often without the benefit of discovery, before they can reach a jury.

A. Pleading Scienter to Survive a Motion to Dismiss

Some federal courts have redesigned the pleading standard under the PSLRA and the federal rules to steeply discount allegations of scienter that are based on circumstantial evidence. Under the PSLRA, plaintiffs must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." (1) The required state of mind is scienter--that is, "intent to deceive, manipulate, or defraud." (2) Federal courts have also determined that recklessness is sufficient to establish scienter in actions for securities fraud. (3) In Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court interpreted "strong inference" to mean that a securities fraud complaint will survive dismissal only if "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged." (4) The Court later reaffirmed that the scienter standard "requires courts to take into account plausible opposing inferences." (5) Although Tellabs's weighing process may have reasonably interpreted the PSLRA, the Court's standard leaves room for courts considering a motion to dismiss to discount the kind of circumstantial evidence of scienter that would otherwise be sufficient to meet the plaintiff's burden of proof at trial.

Circumstantial evidence gives rise to two equally plausible inferences. In contrast, direct evidence is evidence from which there is only one plausible inference. Direct evidence of a defendant's mental state is rare because it is usually limited to an actual admission by the defendant under oath or the testimony of a witness based upon personal knowledge. Thus, before Tellabs, circumstantial evidence of scienter was commonly pleaded and accepted by alleging that the defendant had a motive and an opportunity to engage in fraud, and had access to information that discussed the fraud or concerned the company's core operations. (6) Tellabs did not eliminate the use of circumstantial evidence in pleading, but rather held that when two inferences are equally plausible, the tie goes to the plaintiff. (7) And circumstantial evidence is still accepted both explicitly and in application by several federal courts. (8)

Nonetheless, since Tellabs, some federal courts have erroneously steeply discounted circumstantial evidence of scienter. (9) Even though the federal courts have said that allegations of circumstantial evidence are sufficient to create a "strong inference" of scienter and even reiterated that mere recklessness is enough to satisfy the pleading standard, some courts in their application have found that the inference of scienter is less likely than virtually any other non-culpable mental state, even including negligence, (10) ignorance, (11) motive to improve the business, (12) and belief that undisclosed information was not material. …