In 1995, public companies and their directors and officers received one of the greatest statutory gifts in the history of American corporate law: the Private Securities Litigation Reform Act. The Reform Act established heightened standards for pleading falsity and scienter, among other protections, to allow for dismissal before discovery in a fair percentage of cases. That was a tremendous change from the pre-Reform Act world, in which dismissals were infrequent and expensive discovery was the norm.
The provisions of the Reform Act make motions to dismiss in securities cases different from those in any other area of law, and guide our strategy in every case that we litigate. As a full-time securities litigation defense lawyer, I feel a responsibility to understand the Reform Act and the cases applying it with as much sophistication as possible. I have a sense of pride in my Reform Act analysis. It may sound hokey, but I consider myself a craftsman, and I know that some of the most effective full-time securities litigators tend to feel the same.
I was recently asked about the biggest threats to the Reform Act’s protections, and have since been giving that question a lot of thought. To be blunt, the biggest threat is the failure by many defense firms to make rigorous arguments on motions to dismiss that hold plaintiffs to the strict pleading standards of the Reform Act, allowing for court decisions that likewise lack rigor and fail to enforce the Act’s high pleading burdens.
This lack of technical rigor has many causes. One factor is the dwindling number of securities litigation defense specialists, caused by the downturn in classic securities litigation cases calling for straightforward Reform Act motions to dismiss. Beginning in 2006, securities litigation defense has mostly consisted of stock-option backdating derivative cases, large credit-crisis cases, and merger objection cases. Through these waves, very few securities litigators remained dedicated to studying Reform Act developments and devising better arguments that take advantage of its provisions. As a result, today there are relatively few practitioners whose practices are devoted to securities litigation defense – defense lawyers who sweat over subtleties in the law that in isolation may seem trivial, but which collectively make a big difference in the development of the law.
Another factor is the biglaw approach to writing motions to dismiss “by committee.” Biglaw firms tend to write motions with large teams composed of new associates, mid-level associates, senior associates, and partners. Writing by committee doesn’t work. It is not only expensive, it is ultimately far less effective. If the first draft of a motion is written without sufficient intellectual rigor and sophisticated understanding of the law and practice of securities litigation, it is difficult to reach an end result that will compensate for these deficiencies. To draft the best motion to dismiss possible, Reform Act “craftsmen” should be involved in the process from the beginning, the entire drafting team needs to coordinate closely on the strategic objectives of the motion, and all the attorneys need to be well trained to appreciate the subtleties of the law.
Whatever the cause, the declining quality of many motions to dismiss is leading to a deterioration of the law that is eroding the Reform Act’s protections. The rate of dismissals remains relatively high, but I predict that the dismissal rate will decrease, perhaps dramatically, over time as the law becomes more lax.
Below, I discuss the building blocks of a strong motion to dismiss and then address flaws found in many that I have seen filed lately – both by practitioners who do not specialize in the field, and by some “go to” biglaw firms with departments that specialize in securities litigation.
Constructing a Strong Motion to Dismiss
The Reform Act erected high hurdles for plaintiffs to clear before requiring a company to be put through the burdens of discovery:
- To plead the falsity of a challenged statement of fact, plaintiffs must plead inconsistent contemporaneous facts.
- To plead a false statement of opinion, in most circuits plaintiffs must plead that the statement was both objectively false and subjectively false, meaning they must show the speaker did not genuinely believe the opinion expressed.
- To plead that the defendant made a false statement with intent to defraud, plaintiffs must plead facts demonstrating a strong inference that the defendant either knew the statement was false or was extremely and deliberately reckless in choosing not to find out whether it was true or false.
- Even if plaintiffs plead facts demonstrating it was false, a forward-looking statement is not actionable under the Safe Harbor provisions of the Reform Act if either: (1) the statement was accompanied by meaningful cautionary statements, or (2) plaintiffs fail to plead that the speaker had actual knowledge of the statement’s falsity.
A rigorous motion to dismiss uses the Reform Act’s pleading tools in the most advantageous way possible, by really understanding them and maximizing their usefulness. These tools give defense lawyers the opportunity to delve into factual issues in a manner that is unusual in motion -to-dismiss practice, and which may feel unnatural to attorneys who are not securities litigation specialists or who didn’t become securities litigation specialists during the Reform Act era. An effective motion to dismiss not only dismantles the complaint with these tools, but capitalizes upon them to tell the judge a compelling story of an honest company that did its best to make straightforward disclosures to the market.
The Reform Act’s standards give judges enormous discretion; they can dismiss most complaints, or not, with very little room to challenge their decisions upon appeal. Winning motions recognize the human element to this discretion. Even if a complaint is technically deficient, judges are less likely to dismiss it (certainly less likely to dismiss it with prejudice) if they nevertheless get the feeling that the defendants committed fraud. Effective motions use the leeway given to defendants by the Reform Act to give judges a sense of comfort that they are not only following the law, but that by strictly applying the Reform Act’s protections, they are also serving justice. On the other hand, one of the most common flaws in ineffective motions to dismiss is the use of formulaic and hyper-technical arguments, which fail to take advantage of the Reform Act to dig into the facts of the individual case, expose the flaws of each complaint in detail, and tell the judge a compelling story of the case that negates the inference of scienter.
Flaws Found in Many Motions to Dismiss
Flaws in Arguments against Falsity
The first element of a claim under Rule 10b-5(b) – the classic securities claim – is a false or misleading statement. As we recently wrote, it is an incorrect statement of law to characterize this element as requiring a “materially false statement or omission.” An omission is only actionable if it made what the defendant said materially misleading (or he or she otherwise had a duty to disclose it, which is a rare assertion as the main claim in a securities class action).
Yet if I had a dollar for every motion to dismiss that contained this misstatement of law, I would be writing this blog from a vacation home in Hawaii. This is not a semantic issue; the difference between an “omission” and a “misleading statement” is enormous. Every disclosure problem involves dozens or even hundreds of omitted facts that seem “material” in the sense that an investor would want to know them, but far fewer involve statements that were materially misleading (it is the statement that must be material, not the omitted fact) as a result of the omission. I realize that many courts, including the U.S. Supreme Court, use this incorrect terminology. But that doesn’t mean we need to parrot it – and every time that we do, we weaken the standard that is an explicit part of the Reform Act statute.
Defense lawyers’ loose language is a symptom of a bigger problem: a lack of focus on falsity. The allegedly false statements frame the entire case; other defense arguments are derived from the attack on plaintiffs’ falsity claims. Foremost among the arguments derived from a strong falsity argument is the argument against scienter. Scienter requires plaintiffs to show that a speaker knew what he or she said was false. Falsity thus sets the stage for the scienter analysis – if there was no false statement to begin with, there can be no knowledge of that falsity. On the other hand, the more egregiously false plaintiffs can make a statement appear, the easier it will be for them to show knowledge of falsity. A strong scienter argument has as its North Star, “scienter as to what?” That “what” must be a false statement, and a good motion to dismiss will enforce that structure from the beginning. I cringe when I read a motion to dismiss that addresses scienter before falsity. That is simply backwards.
The lack of focus on falsity infects the way defense firms tend to argue against falsity. The Reform Act falsity standard generally requires the plaintiffs to allege contemporaneous facts that are inconsistent with each challenged statement. That is a high hurdle.
To be sure, it isn’t easy to make a fact-specific argument against falsity; it requires a great command of the complaint and judicially noticeable documents, which isn’t the forte of most litigators. And it can seem “too factual” to general litigators, or to many senior securities litigators who became securities litigation specialists under the pre-Reform Act regime, where motions to dismiss had to be simple and safe to have any chance of success under lenient pleading standards. Perhaps for these reasons, in addition to those discussed above, a large number of motions to dismiss bypass this advantageous and fundamental argument, or fail to emphasize it, and instead opt for arguments that lump statements together by type and argue against them as a group in a boilerplate fashion. In my view, one of the worst arguments of this type is the “puffery” defense – which basically concedes that a statement was false, but contends it was too immaterial to be actionable. The subtext is cavalier, and unlikely to reassure a dubious judge: “sure the defendant lied, but it doesn’t matter because no one cared.” Although courts do sometimes accept this argument, whether to do so or not amounts to an unprincipled coin-flip, and it is often made at the expense of better and more definite arguments. For example, statements constituting “puffery” also generally qualify as statements of opinion, which have a standard for falsity that is protective and can be analyzed specifically.
The Reform Act called out forward-looking statements for special analysis and protection. As we have previously written, the Safe Harbor is not as safe as Congress intended. Because they think it goes too far, and can give companies a “license to lie,” many judges go to great lengths to avoid the statute’s plain language. Many defense lawyers’ arguments not only fail to address this judicial skepticism, but actually reinforce it. They do this by relying solely on the Safe Harbor’s technical elements, while failing to simultaneously contend that the forward-looking statements in question also had a reasonable basis, and the company’s cautionary language was a good-faith effort to describe specific risks the company faced. Such arguments based only on the letter of the Safe Harbor ring of “caveat emptor,” which the law has been trying to shake for centuries.
Flaws in Arguments against Scienter
Scienter allegations are of two types: allegations pleading facts about what the defendant knew, to attempt to plead that he or she knew the challenged statements were false; and, far more prevalent, allegations that the defendant “must have” meant to lie, based on circumstantial considerations such as a defendants’ stock sales, corporate transactions, the temporal proximity of the challenged statement to the disclosure of the “truth,” and the relationship of the subject of the challenged statements to the company’s “core operations.” As with falsity, the primary flaw in most defense arguments against scienter is with their failure to engage in a fact-specific analysis of the complaint’s allegations about what the defendants knew in regard to each specific challenged statement. All too often, defendants allow themselves to be drawn to the plaintiffs’ preferred ground of battle, focusing just on arguing about the sufficiency of the circumstantial evidence that plaintiffs use to create the impression that the defendants must have done something wrong.
Circumstantial scienter allegations are only ways to try to make an educated guess about what the speaker knew or intended. But he Reform Act’s scienter standard requires particularized pleading yielding a “strong inference” that the defendant lied on purpose – a very high standard. So it makes no sense for defense counsel not to approach the issue directly, by making it clear that the speaker did not lie, and holding plaintiffs to the strict standard of showing specific scienter as to each challenged statement.
For this reason, all effective motions to dismiss start by testing the complaint’s allegations that the defendants actually knew, or were intentionally reckless about not knowing, the facts establishing falsity. This means that, for each statement and each defendant, the motion to dismiss needs to isolate the statement and the reasons that the complaint alleges it was false, and analyze what the complaint alleges each defendant knew about those facts at the time he or she made each challenged statement. Without this focus on each specific challenged statement, the scienter inquiry is vague, and becomes more about whether the defendant seems bad, or had generally bad motives, than whether he lied on purpose. A good motion to dismiss does not let plaintiffs get away with these kinds of generalized allegations.
The problem is made worse if defense counsel approaches falsity categorically, without careful scrutiny of the reasons the complaint alleges the challenged statements were false. Without this focus, defense counsel can’t meaningfully answer the central question in the Reform Act analysis – “scienter as to what?” – because there isn’t a sufficient nexus between the challenged statements and contemporaneous facts that made the statements false. The scienter inquiry thus becomes unmoored from knowledge that specific statements were false. The result is a lower burden for plaintiffs: if they are able to plead falsity, and the defendants seemed to know something about the general subject matter, scienter is almost a foregone conclusion.
This problem is even worse under the “core operations” inference of scienter, and the “corporate scienter” doctrine. Each of these theories allows a plaintiff to avoid pleading specific facts establishing the speaker’s scienter. For example, the core operations inference posits that scienter can be inferred where it would be “absurd to suggest” that a senior executive doesn’t know facts about the company’s “core operations.” Many motions to dismiss set up some formulation of this statement as a legal rule and make a simplistic syllogistic argument from it. Such arguments devolve into “did not, did so” debates, and thus play into plaintiffs’ hands because they are detached from knowledge of falsity.
Instead, the right approach to the core operations inference is to understand that it requires a falsity so blatant that we can strongly infer that the executive had knowledge of the exact facts that made the statement false – not just the subject matter of the facts. The most effective defense against the core operations inference thus focuses on falsity first, to show that even if a statement is false, it is at least a close call – making it hard for plaintiffs to contend that defendants must have known of this falsity. This can’t be done effectively, of course, if the argument against falsity is categorical (i.e., embraces arguments such as “puffery,” rather than discussing the specific statements), or otherwise fails to address the falsity allegations in detail. Of course, it is impossible to make this argument effectively if the scienter section precedes the falsity section of the brief.