In one of the most closely watched securities cases of the year, the Hunton & Williams Corporate and Securities Litigation team is pursuing an interlocutory appeal in the Second Circuit that poses the following question: If a corporate officer makes a statement that he reasonably believes to be true but a former, low-level sales employee believes is false, has the corporation acted with an intent to defraud investors?
Every federal Court of Appeals that has expressly considered this question has answered it in the negative. These courts have recognized that a corporation has no collective “mind.” Accordingly, while a corporation can be responsible for an officer’s fraudulent statement, the requisite fraudulent intent must actually exist in the mind of that individual officer.
Despite this precedent, the Southern District of New York held recently that a securities plaintiff can plead fraudulent intent on the part of a corporation by coupling the innocent misstatement of one employee with the alleged belief of another employee. In re Dynex Capital, Inc. Sec. Litig., 2006 WL 314524 (S.D.N.Y. Feb. 10, 2006). At the urging of the defendants, represented by Hunton & Williams, the Second Circuit has agreed to hear an interlocutory appeal of this decision. The U.S. Chamber of Commerce, the Business Roundtable, and the Securities Industry and Financial Markets Association have weighed in as amici curiae in support of the defendants’ effort to overturn the district court’s decision.
Why is corporate America so focused on this issue? The short answer is that the doctrine of collective scienter imposes strict liability on corporations so long as any employee, at any level of the corporation, believes an executive’s statement to be mistaken. This is a dramatic expansion of liability at a time when most observers think securities litigation is already too costly.
Congress sought to curb these costs when it passed the Private Securities Litigation Reform Act in 1995. Under this statute, securities plaintiffs must plead facts giving rise to a strong inference that each defendant acted with scienter. If a plaintiff cannot ground his allegations in fact, his suit must be dismissed.
Under the doctrine of collective scienter, however, a plaintiff need not plead facts giving rise to a strong inference that any defendant acted with scienter. Rather, a plaintiff need only allege that one individual made a statement on behalf of the company that another individual believed to be false. There need be no allegation that this alleged belief was ever communicated to or adopted by the individual who actually made the challenged statement.
This prospect is especially troubling as U.S. markets have already lost business to foreign markets due to concerns over litigation. Indeed, as the bipartisan Committee on Capital Markets Regulation recently noted, foreign companies often cite the U.S. class action enforcement system as the most important reason why they do not want to list in U.S. markets. The doctrine of collective scienter has been rejected for sound legal and practical reasons by every federal Court of Appeals to expressly consider it. It ought to be rejected expressly by the Second Circuit as well.