Supreme Court in Central Bank does little to crystalize the amorphous status of scienter in § 10(b) civil litigation. See Leslie Fay I, 835 F. Supp. at 172 & n.1.
On the other hand, the Second Circuit has specifically addressed the scienter issue. As Judge Wood recounted in In re Fischbach Corporation Securities Litigation, No. 89 Civ. 5826 (KMW), 1992 WL 8715, at *2 (S.D.N.Y. Jan. 15), prior to the Supreme Court's rejection of negligent (as opposed to reckless or intentional) conduct as a basis for securities fraud in Hochfelder, the Second Circuit held that "proof of wilful or reckless disregard for the truth is necessary to establish liability under Rule 10b-5." Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc). Then, in Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38 (2d Cir.), cert. denied, 439 U.S. 1039, 58 L. Ed. 2d 698, 99 S. Ct. 642 (1978), the court stated that "Hochfelder left intact our rule that recklessness is a form of scienter in appropriate circumstances." Id. at 46. Since that time, the court has repeatedly held that recklessness, at least in some form, may support a claim of fraud under § 10(b). Possibly most important, however, even after Central Bank the court in Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994), indicated that allegations of "facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness " may be sufficient to overcome a motion to dismiss. Id. at 1128 (emphasis added).
Notwithstanding Shields ' endorsement of the recklessness standard, at different times since Hochfelder, the Second Circuit has approached § 10(b) scienter in at least three distinct ways.
First, consistent with the Shields holding, the Lanza line of cases indicates that unqualified allegations of recklessness are sufficient to satisfy the scienter requirement of § 10(b) and Rule 10b-5. See, e.g., In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 268-69 (2d Cir. 1993), cert. denied sub nom., Ross v. ZVI Trading Corp., 128 L. Ed. 2d 70, 114 S. Ct. 1397 (1994) ("We have recognized two distinct ways in which a plaintiff may plead scienter without direct knowledge of the defendant's state of mind . . . . The second approach is to allege facts constituting circumstantial evidence of either recklessness or conscious behavior."); Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 144 (2d Cir. 1991) ("'Allegations of scienter are sufficient if supported by facts giving rise to a 'strong inference' of fraudulent intent.' For Rule 10(b)(5) [sic] purposes, scienter includes recklessness." (citations omitted)); Oleck v. Fischer, 623 F.2d 791, 794 (2d Cir. 1980) ("To establish liability after Hochfelder,. . . this court has adhered to the proposition earlier announced in Lanza v. Drexel & Co., 479 F.2d 1277, 1306 (2d Cir. 1973) (en banc) that 'reckless conduct will generally satisfy the scienter requirement.'")
In the Rolf line of cases that developed under the now defunct aiding and abetting theory, the court allowed allegations of recklessness to satisfy the scienter requirement only if the aider and abettor had a fiduciary relationship with the plaintiff. Absent such a relationship, the requisite level of intent was proportional to the remoteness of the actor from the fraudulent transaction. See Sirota v. Solitron Devices, Inc., 673 F.2d 566, 575 (2d Cir. 1982), cert. denied, 459 U.S. 838, 74 L. Ed. 2d 80, 103 S. Ct. 86 (1992) ("This court has held that proof of reckless conduct meets the requirement of scienter in a section 10(b) claim . . . . For the imposition of aider and abettor liability under section 10(b), however, we have held that recklessness satisfies the scienter requirement where 'the alleged aider and abettor owes a fiduciary duty to the defrauded party.' (citations omitted)); Decker v. Massey Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir. 1982) ("Assuming for the argument that recklessness on the part of a non-fiduciary accountant will satisfy Ernst & Ernst's requirement of scienter, such recklessness must be conduct that is 'highly unreasonable,' representing 'an extreme departure from the standards of ordinary care. It must, in fact, approximate an actual intent to aid in the fraud being perpetrated by the audited company." (citations omitted)); IIT, An International Investment Trust v. Cornfeld, 619 F.2d 909, 923 (2d Cir. 1980) ("Reckless conduct will generally satisfy the scienter requirement. However, . . . in applying this general principle to aiders and abettors . . . 'the scienter requirement scales upward when activity is more remote; therefore, the assistance rendered should be both substantial and knowing.'" (citations omitted)); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 44 (2d Cir. 1978) ("At least where, as here, the alleged aider and abettor owes a fiduciary duty to the defrauded party, recklessness satisfies the scienter requirement." (note omitted)).
Finally, in the Wechsler line of cases the court has indicated that § 10(b) scienter requires either allegations of actual intent or circumstances implying a strong inference of actual intent. See Healey v. Chelsea Resources, Ltd., 947 F.2d 611, 618 (2d Cir. 1991) ("With regard to his claims under § 10(b) and Rule 10b-5, Healey was also required to prove defendants' scienter . . . or such recklessness to amount to scienter . . . ." (citations omitted)); Mayer v. Oil Field Systems Corp., 803 F.2d 749, 756 (2d Cir. 1986) ("Scienter requires at least knowing misconduct, which may, of course, be proven as a matter of inference from circumstantial evidence."); Wechsler v. Steinberg, 733 F.2d 1054, 1058 (2d Cir. 1984) ("To prove scienter in a § 10(b) case, a plaintiff must demonstrate 'knowing or intentional misconduct' on the part of the defendant, . . . or an 'intent to deceive, manipulate, or defraud' investors. Proof of scienter need not be direct, but may be 'a matter of inference from circumstantial evidence.'" (citations omitted)); cf. Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1031 (2d Cir. 1993) ("Scienter may be inferred by finding that the defendant knew or reasonably believed that the securities were unsuited to the investor's needs, misrepresented or failed to disclose the unsuitability of the securities, and proceeded to recommend or purchase the securities anyway."); Reiss v. Pan American World Airways, Inc., 711 F.2d 11, 14 (2d Cir. 1983) ("To prove scienter. . . there must be proof that the non-disclosure was intended to mislead.").
Possibly due to the wide variety of factual situations that may give rise to a securities fraud action, the Second Circuit's treatment of the scienter requirement is far from uniform. Moreover, the extent to which factual claims support allegations of scienter likewise eludes precise articulation. Faced with such incongruity, in our prior opinion assessing the plaintiffs' allegations of scienter we adopted the reasoning of the Wechsler line of cases as articulated in In re Fischbach,4 holding that at least as to outside auditors, "[Rule] 10b-5 proscribes only behavior which is either deliberate or so reckless that an inference of fraudulent intent might be drawn by a reasonable finder of fact." Leslie Fay I, 835 F. Supp. at 173. Although we noted that the complaint failed to allege facts indicating that BDO acted deliberately, we found that the plaintiffs alleged sufficient reckless conduct from which a fact finder might reasonably infer fraudulent intent. We did not, however, hold that mere allegations of recklessness were sufficient to satisfy the scienter requirement.
In this motion, BDO does not argue that the Second Circuit has rejected a scienter standard encompassing some form of reckless conduct. Nor does it maintain that we erroneously interpreted Second Circuit law in adopting the scienter standard articulated in the Wechsler cases. Instead, it asserts that the Supreme Court's adherence to strict statutory interpretation in rejecting aiding and abetting liability also requires a rejection of recklessness as a basis for establishing "manipulative or deceptive" conduct, overruling any Second Circuit precedent to the contrary. Citing Hochfelder, BDO contends that § 10(b) precludes only "knowing or intentional misconduct." Hochfelder, 425 U.S. at 197-98. Since reckless conduct is not by itself "knowing or intentional," BDO argues that the strict reading of § 10(b) called for in Central Bank precludes reliance on reckless conduct in establishing liability. In addition, BDO argues that because the distinction between negligent and reckless conduct is so arbitrary, we should reject reliance on recklessness as a basis for liability altogether. Cf. Central Bank, 114 S. Ct. at 1454 (lamenting the ad hoc nature of aiding and abetting liability).
At first blush, it seems BDO has misunderstood our previous ruling in Leslie Fay I. As noted above, our prior decision upholding plaintiffs' claims against BDO was not based on allegations in the complaint that supported a finding of recklessness. We held that plaintiffs alleged sufficient reckless conduct from which a reasonable fact finder could infer fraudulent intent. In light of this ruling, BDO's contentions can be read in either one of two ways.
First, BDO might be arguing that Central Bank prevents relying solely on allegations supporting an inference of recklessness to sustain a § 10(b) cause of action--effectively overruling the Lanza line of cases. However, since Leslie Fay I and Part III of this opinion do not rest on naked allegations of recklessness, but instead on allegations sufficient to support an inference of intent, we have no occasion to address this contention.
Whether or not Central Bank precludes maintaining a § 10(b) action based solely on reckless conduct, our prior ruling would be unaffected.
On the other hand, BDO might be arguing that Central Bank also precludes inferring actual intent from reckless conduct--overruling the Wechsler line of cases. While such a reading might indeed undermine our previous opinion and Part III herein, we find it untenable. Even granting BDO's broad interpretation of Central Bank, the Court's strict statutory construction approach and criticism of ad hoc liability standards implicit in aiding and abetting claims does not affect our prior holding in this case for the following reasons.
First, in a securities action, as in any other case, a plaintiff may establish a defendant's intent by either direct or circumstantial evidence. See United States Postal Service Board of Governors v. Aikens, 460 U.S. 711, 714 n.3, 75 L. Ed. 2d 403, 103 S. Ct. 1478 (1983). Therefore, plaintiffs' allegations of reckless conduct, which we previously held provide sufficient circumstantial evidence of intent, satisfy even BDO's contention that Central Bank requires pleading actual intent. In re Columbia Securities Litigation, 155 F.R.D. 466, 479 (S.D.N.Y. 1994); Enzo Biochem Inc. v. Johnson & Johnson, No. 87-6125 (KMW), 1992 WL 309613, at *11 (S.D.N.Y. Oct. 15, 1992); Cosmas v. Hassett, 886 F.2d 8, 12-13 (2d Cir. 1989). On a motion to dismiss, a court must read the complaint generously, and draw all reasonable inferences in favor of the pleader. Id. at 11.
Second, although what constitutes sufficient recklessness from which a jury can infer intent may often be an "ad hoc" determination, judges are forced to wrestle with these types of questions every time a defendant makes a motion for judgment as a matter of law. Hathaway v. Coughlin, 37 F.3d 63, 66 (2d Cir. 1994) (drawing all reasonable inferences against the moving party). While in a perfect world liability would be color-coded in black and white, shades of gray are an inherent incident of our legal system. Moreover, to hold that Central Bank forecloses a jury's traditional province of drawing reasonable inferences from the facts by dismissing inferentially based claims at the pleading stage would be a radical departure from centuries of jurisprudence. Indeed, such a holding would put a higher standard on securities plaintiffs at the pleading stage than on a motion for summary judgment, where all reasonable inferences are drawn against the non-moving party. Anderson v. Liberty Lobby, 477 U.S. 242, 255, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986). Whether or not Central Bank has affected the scienter standard of § 10(b), we are not prepared to conclude it has changed the fact finder's traditional role in securities cases. We merely reiterate the unremarkable tenet of our judicial system that juries are entitled to draw reasonable inferences from the facts and that judges must protect that right at the pleading stage. See Cosmas, 886 F.2d at 11.
Therefore, we hold that Central Bank does not affect the scienter standard we adopted in Leslie Fay I.
C. Central Bank and "In Connection With"
Next, BDO argues that Central Bank also demands a reexamination of the Second Circuit's interpretation of the "in connection with" requirement of § 10(b). BDO contends that since its false statements were contained only in SEC filings not readily available to the investing public,
they were not made in connection with the purchase or sale of any securities.
The Second Circuit in In re Ames Dep't Stores Inc. Stock Litig., 991 F.2d 953 (2d Cir. 1993) construed the "in connection with" requirement broadly to include all "dissemination[s] into the marketplace of false or misleading information." Id. at 962. The court based its reading in part on the Supreme Court's admonition in Superintendent of Insurance the State of New York v. Bankers Life & Casualty Co., 404 U.S. 6, 12, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971), that "section 10(b) must be read flexibly, not technically and restrictively." Analyzing Second Circuit law since Superintendent of Insurance, and in light of the Supreme Court's endorsement of fraud-on-the-market theory in Basic v. Levinson, 485 U.S. 224, 247, 99 L. Ed. 2d 194, 108 S. Ct. 978 (1988), the court reasoned:
Because the fraud on the market may taint each purchase of the affected stock, each purchaser who is thereby defrauded . . . is defrauded by reason of the publicly disseminated statement. If such a straightforward cause and effect is not a connection, then [Rule 10b-5] would not punish a particularly effective means of reducing the integrity of, and public confidence in, the securities markets. The 'in connection with' language was chosen in an effort to broaden the reach of the Rule to achieve precisely these aims, see, e.g., SEC v. Texas Gulf Sulphur, 401 F.2d at 860-62; it should not be used to defeat them.
Ames, 991 F.2d at 967-68.
Based solely on this broad reading of the requirement, we would have little trouble in holding that BDO's misleading financial statements contained in Form 10-K filings and company annual reports were made "in connection with" the sale or purchase of securities. According to the amended complaint, BDO's certifications of Leslie Fay's alleged false financial statements directly affected the market price of Leslie Fay stock. Under Ames, such allegations satisfy the "in connection with" requirement. However, BDO argues that Central Bank has abrogated such a loose interpretation of the statute and that the Seventh Circuit's analysis in Frymire-Brinati v. KPMG Peat Marwick, 2 F.3d 183 (7th Cir. 1993), while predating Central Bank, correctly characterizes the phrase's proper connotation. We are not persuaded.
Central Bank mandates that in assessing the scope of conduct prohibited by § 10(b), we must first look to the language of the statute. Central Bank, 114 S. Ct. at 1446. Although the statute makes no reference to aiding and abetting liability, it does prohibit using or employing manipulative or deceptive devices in connection with the purchase or sale of any security. While BDO apparently asserts that this phrase has an unambiguous meaning, courts and commentators do not share in its view. See Barbara Black, Commentary: The Second Circuit's Approach to the 'In Connection With' Requirement of Rule 10b-5', 53 Brook. L. Rev. 539, 540 (1987) ("What 'in connection with' requires remains a source of uncertainty."). For instance, as BDO argues, in one sense the statute seems to proscribe only fraud acting as a catalyst in a specific purchase or sale of a security. On the other hand, as Justice Douglas arguably indicated, the phrase should be interpreted to encompass any fraud that "touches" the purchase or sale of securities, whether or not directly associated with the transaction in question. Superintendent of Insurance, 404 U.S. at 12-13.
Recognizing the ambiguity of this "touch" test, still others assert that the phase's meaning can be fleshed out only on a case by case approach. See Natowitz on Behalf of Lexington/56th Associates v. Mehlman, 567 F. Supp. 942, 946 (S.D.N.Y. 1983). Judge Friendly possibly best characterized the phrase's ambiguity by noting that, "the 'in connection with' phrase 'is not the least difficult aspect of the 10b-5 complex to tie down.'" Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 942 (2d Cir.), cert. denied, 469 U.S. 884, 83 L. Ed. 2d 190, 105 S. Ct. 253 (1984) (quoting Loss, Fundamentals of Securities Regulation 903 (1983)).
Interestingly, BDO itself never offers a precise definition of the phrase. It merely argues that the requirement was not meant to encompass non-public filings with the SEC. However, the complaint alleges BDO's opinion was also included Leslie Fay's 1990 and 1991 Annual Reports. In light of the historical ambiguity surrounding the phrase, and the fact that plaintiffs allege that BDO's misstatements were included in annual reports distributed to shareholders in addition to 10-K filings, we are not prepared to hold that the statute, on its face, unambiguously forecloses liability in this situation. Nor does Central Bank compel such a holding. Unlike the phrase "manipulative or deceptive device," which clearly suggests scienter, see Hochfelder, 425 U.S. at 197, and the complete absence of language prohibiting the aiding and abetting of securities fraud, the "in connection with" phrase by itself does not indicate a Congressional intent to foreclose liability for falsely indicating a company's financial viability, and thereby directly affecting the price of the company's stock. Such a determination could come only from a more probing analysis of the statute.
Given the statute's inherent ambiguity, Central Bank requires us to examine the historical and legislative context of § 10(b) to uncover its probable legislative meaning. Central Bank, 114 S. Ct. at 1448 ("When the text of § 10(b) does not resolve a particular issue, we attempt to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision in the 1934 Act." (citation omitted)). Since that is precisely the process the Second Circuit utilized in Ames Department Stores to develop its broad interpretation, we do not think Central Bank compels a different result. Nevertheless, we will address each of BDO's contentions.
BDO refers to the language of provisions of the Securities Act of 1933 (the "1933 Act") as evidence of Congressional intent to attach a narrow reading to the "in connection with" requirement. For instance, § 7 of the 1933 Act requires an accountant's consent to use its statements "in connection with" a registration statement. 15 U.S.C. § 77g. Section 11(a)(4) allows private suits against accountants only for misstatements made "in connection with" a registration statement. 15 U.S.C. § 77k(a)(4). Finally, while not using the phrase "in connection with," § 12 of the 1933 Act places liability only on "offerors or sellers" who violate that section. 15 U.S.C. § 771. Since the "in connection with" requirements in §§ 7 and 11 both refer to a direct link between the auditor's report and a selling document, and the Supreme Court has interpreted § 12 to apply only to persons actually soliciting the purchase of a security, see Pinter v. Dahl, 486 U.S. 622, 647, 100 L. Ed. 2d 658, 108 S. Ct. 2063 (1988), BDO argues that a similar narrow interpretation applies to § 10(b)'s use of the "in connection with" phrase.
BDO's reasoning fails to acknowledge a fundamental difference between the 1933 and 1934 Acts. While the 1933 Act primarily regulates initial distributions of securities, the 1934 Act governs post-distribution trading. Central Bank, 114 S. Ct. at 1445. More specifically, as Judge Friendly stated:
the purpose of § 10(b) and Rule 10b-5 is to protect persons who are deceived in securities transactions--to make sure that buyers of securities get what they think they are getting and that sellers of securities are not tricked into parting with something for a price known to the buyer to be inadequate or for a consideration known to the buyer not to be what it purports to be.
Chemical Bank, 726 F.2d at 943. Similarly, the court stated in SEC v. Texas Gulf Sulphur, 401 F.2d 833, 860 (2d Cir. 1968) (en banc), cert. denied, 394 U.S. 976 (1969) that:
there is no indication that Congress intended that corporations or persons responsible for the issuance of a misleading statement would not violate the section unless they engaged in related securities transactions or otherwise acted with wrongful motives; indeed, the obvious purposes of the Act to protect the investing public and to secure fair dealing in the securities markets would be seriously undermined by applying such a gloss onto the legislative language.