In fraud-on-the-market cases brought under the general antifraud provisions in Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, corporations face potential liability to a class of open market investors who purchased or sold their stock at prices allegedly made artificial by the company’s dissemination of materially false or misleading information. Among the requisite elements of such claims, class action representatives must sufficiently allege that the corporation acted with scienter -- a mental state embracing intent to deceive, manipulate or defraud. Scienter is a requisite element in pleading and proving a claim against any defendant alleged to have made materially false or misleading statements in connection with the purchase or sale of securities. When the defendant in a case is a corporation, however, alleging scienter is complicated because of the question: Whose knowledge and state of mind matters? For market fraud liability to attach to the corporation, must the person misrepresenting a material fact in the name of the corporation have also done so with scienter, or is it enough that some person in the corporate structure had the requisite state of mind? If the latter is correct, how high in the hierarchy of the corporation must the person with scienter be, and what must her relationship be to the statement?
On October 10, 2014, a three-judge panel of the United States Court of Appeals for the Sixth Circuit addressed these specific questions. The Sixth Circuit Court of Appeals sets mandatory legal rules for the U.S. District Courts and other lower federal courts in Ohio, Michigan, Kentucky and Tennessee, and in Ansfield v. KBC Asset Management, N.V., part of the complex Omnicare, Inc. Securities Litigation,the court acknowledged that its prior pronouncements on the matter of corporate scienter have been less than precise. The Court set out to clear away confusion, starting with a 2005 pronouncement in which the Court stated that knowledge of a corporate officer or agent acting within the scope of his or her authority is attributable to the corporation for purposes of pleading and proving scienter of the corporation in market fraud actions. In Ansfield, the Court expressed concern that if scienter of any agent can be imputed to the corporation, it would be possible for the corporation to be liable to an investor class so long as a “low-level employee, perhaps in another country, knew something to the contrary.” Such a result, said the Court, runs contrary to heightened scienter pleading requirements that are imposed by a federal law aimed at preventing so-called “strike suits.”
It was necessary, therefore, that the basis for corporate scienter be clarified going forward, and in particular that some of the overly broad language of the Court’s earlier pronouncement be qualified. Doing so, in Ansfield, the Court concluded that the state(s) of mind of any of the following persons will be probative for purposes of determining whether a misrepresentation made by a corporation was made by it with requisite scienter:
- The individual agent who uttered or issued the misrepresentation;
- Any individual agent who authorized, requested, commanded, furnished information for, prepared (including suggesting or contributing language for inclusion or omission), reviewed, or approved the statement in which the misrepresentation was made before its utterance or issuance; or
- Any high managerial agent or member of the board of directors who ratified, recklessly disregarded, or tolerated the misrepresentation after its utterance or issuance.
Importantly, the state of mind of any individual identified by the Court among these categories is unrelated to the scienter of any individual named as a defendant in a market fraud action. Such actions often name corporate officers and others directly as alleged violators of Section 10(b) and Rule 10b-5, and assessing the sufficiency of allegations against them individually proceeds without regard to assessments of “corporate” scienter. On that, the Court was satisfied that its announced formulation qualified previously broad language, while also preventing a corporation from evading liability through tacit encouragement and willful ignorance. A corporation, said the Court, “is not insulated if lower-level employees, contributing to the misstatement, knowingly provide false information to their superiors with the intent to defraud the public.” On the other hand, the Court was also satisfied that its approach protects corporations from liability, or strike suits, when one individual unknowingly makes a false statement that another individual, unrelated to the preparation or issuance of the statement, knew to be false or misleading.
Uncertainty over corporate scienter continues to the extent that approaches in other federal appeals courts are different. In Ansfield, however, the Sixth Circuit offered that its formulation solves perceived flaws in other approaches taken, and in that sense may point the way to broader clarification. Perhaps. In some other Circuits, however, courts have kept open the door to finding sufficient corporate scienter allegations without the necessity of pleading it as to an expressly identified person. The Seventh Circuit U.S. Court of Appeals has recognized, for example, that it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. With its October 10, 2014, decision in Ansfield, however, the Sixth Circuit has unquestionably dealt with what was hazy and muddled in its own position, and greater precision in pleading, and challenging, market fraud claims will result.