The opinion of the court was delivered by: RAKOFF
The first question raised by the pending motions to dismiss these consolidated class actions is whether the Private Securities Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (the "Reform Act") heightens the scienter requirement for liability in a private securities fraud action by requiring more than "recklessness." The answer is no. The second question is whether the Reform Act makes the pleading of "motive and opportunity" no longer automatically sufficient in this Circuit to raise the required "strong inference" of fraudulent scienter. The answer is yes. The third question is whether the pending complaint alleges particulars giving rise to a strong inference that the defendants acted with the required scienter. The answer is no. The final question is whether the plaintiffs should be given leave to re-plead to attempt to rectify this shortcoming. The answer is yes.
A few words of explanation may be in order.
This case began as two separate class action complaints filed, respectively, on September 30, 1996 and October 30, 1996. On December 16, 1996, the Court consolidated the actions and appointed lead counsel for each side. On January 23, 1997, a Consolidated Amended Class Action Complaint (the "Complaint") was filed, alleging primary claims against all defendants for violations of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and secondary claims against defendants Beach and Pepsico as "control persons" under 15 U.S.C. § 78t(a).
As set forth in the Complaint, defendant Buenos Aires Embotelladora S.A. ("Baesa") is an Argentinean bottling corporation, organized in 1989, with principal offices in Buenos Aires, Argentina, and Boca Raton, Florida. Its securities are traded on the New York Stock Exchange in the form of "American Depository Shares." At all relevant times, defendant Charles H. Beach was its President and "Principal Executive Officer." In November, 1993, Baesa entered into an agreement with defendant Pepsico, Inc., by which, among other things, Pepsico acquired nearly 24% of Baesa's common stock in exchange for $ 35 million, various Pepsi bottling and distribution rights in Argentina and certain other parts of South America, and the right to approve certain Baesa management decisions. Ultimately, in August, 1996, following Beach's resignation, Pepsico took total control of Baesa and, shortly thereafter, announced that Baesa had suffered substantial losses largely attributable to "accounting irregularities." The price of Baesa shares fell precipitously, and these lawsuits by Baesa shareholders followed.
The gist of plaintiffs' 70-page Complaint is that between November, 1995 and August, 1996, Baesa, in concert with Beach and Pepsico, issued numerous false and misleading public statements that materially overstated the company's assets and earnings and effectively concealed the company's deteriorating financial position. Careful inspection of the Complaint reveals, however, that the legally cognizable allegations of fraudulent conduct largely center on financial and other irregularities at Baesa's Brazilian subsidiary, a separate company known as "PCE," that is not a party to this case but the financial statements of which were included in Baesa's public reports. Furthermore, the Complaint is noticeably skimpy in setting forth particular facts from which one might strongly infer that Baesa, Beach (who worked at the Boca Raton office), or Pepsico had knowledge during the class period that the reported Brazilian results were fraudulent.
Accordingly, on March 26, 1997, defendants promptly moved to dismiss the Complaint, contending, inter alia, that plaintiffs' had failed to meet the requisite standards for pleading scienter in a securities fraud case.
Properly to determine what those standards are, one must first distinguish between the mental state required for securities fraud liability ("scienter") and the level of pleadings required to adequately allege that mental state at the outset of a lawsuit. The Reform Act speaks only to the latter. Specifically, subsection 21D(b)(2) of section 101(b) of the Reform Act, entitled "Required State of Mind," reads in its entirety as follows:
In any private action arising under [Title I of the Exchange Act] in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this title, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
Since the Reform Act nowhere defines what the "required state of mind" is for any of the kinds of actions that might be brought under this title, the definition must necessarily be found either elsewhere in the Exchange Act itself or (if the action is judicially implied) in the existing case law. Specifically, in the case of private securities fraud actions implied under section 10(b) of the Exchange Act (and Rule 10b-5 promulgated thereunder), the Supreme Court, in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976), determined that a mental state embracing an intent to deceive, manipulate or defraud was required for liability and that negligence would not suffice. Id. 425 U.S. at 193-94. The Court left open, however, whether "recklessness" -- in the sense, not of gross negligence, but of "a form of intentional conduct" -- could constitute such scienter. Id. at n.12.
Subsequently, virtually every Circuit Court to consider the issue, including the Second Circuit, held that recklessness suffices. See, e.g., Rolf v. Blyth Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir. 1978); Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1244 (3d Cir. 1989); Broad v. Rockwell Int'l Corp., 642 F.2d 929, 961-62 (5th Cir. 1981) (en banc), cert. denied, 454 U.S. 965, 70 L. Ed. 2d 380, 102 S. Ct. 506; Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 (6th Cir. 1979); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990), cert. denied, 499 U.S. 976, 111 S. Ct. 1621, 113 L. Ed. 2d 719.; Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989). This is hardly surprising, since "recklessness," in its classic formulations, describes a conscious state of mind that is inherently deceptive, i.e., a conscious and purposeful disregard of the truth about a known risk. See, e.g., Model Penal Code § 2.02(c) ("A person acts recklessly with respect to a material element of an offense when he consciously disregards a substantial and unjustifiable risk that the material element exists or will result from his conduct").
While in certain other contexts, the term may also denote a kind of negligence, see Black's Law Dictionary 1270 (6th Ed. 1990) ("According to circumstances it may mean desperately heedless, wanton or willful, or it may mean only careless, inattentive, or negligent."), this is not the usage the Supreme Court left open as a possibility in Hochfelder. Nor is it the usage adopted by the Circuit Courts in private securities fraud actions. Rather, in the standard formulation in these cases, "reckless conduct is, at the least, conduct which is highly unreasonable and which represents an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." Chill v. General Electric Co., 101 F.3d 263, 268 (quoting Rolf, 570 F.2d at 47) (emphasis added). See also Loss and Seligman, Fundamentals of Securities Litigation at 843 n.320 (1995) (collecting cases).
While this formulation may suffer from joining negligence-like concepts of conduct to awareness-like concepts of intent, still, on its face, it leaves no doubt that some form of conscious disregard is required. As the Seventh Circuit, which first adopted this definition in this context, noted: "We believe 'reckless' in these circumstances comes closer to being a lesser form of intent than merely a great degree of ordinary negligence. We perceive it to be not just a ...