To survive a motion to dismiss, the PSLRA requires plaintiffs bringing a securities fraud claim to plead facts establishing a “strong inference” that the defendants acted with scienter (i.e., fraudulent intent). There are two components to this analysis: (1) what is the substantive standard for scienter; and (2) what must a plaintiff allege to meet the “strong inference” pleading requirement. Until last week, the U.S. Court of Appeals for the Fourth Circuit had declined to take a position on either of these issues. Not anymore.
In Ottmann v. Hanger Orthopedic Group, 2003 WL 22992292 (4th Cir. Dec. 22, 2003), the court joined every other circuit in holding that scienter may be established by pleading not only intentional misconduct, but also recklessness (although it must be “severe recklessness [that] is, in essence, a slightly lesser species of intentional misconduct”). Having established the substantive standard, the court turned to what a plaintiff must plead to meet the PSLRA’s “strong inference” pleading requirement.
The court found that “Congress ultimately chose not to specify particular types of facts that would or would not show a strong inference of scienter [as part of the PSLRA].” As a result, the court concluded that a “flexible, case-specific analysis is appropriate in examining scienter pleadings.” Although facts establishing “motive and opportunity to commit fraud (or lack of such facts) may be relevant to the scienter inquiry, the weight accorded to those facts should depend on the circumstances of each case.”
In applying this flexible analysis to the instant case, the court found that there were insufficient facts demonstrating that any of the alleged misstatements were the product of reckless or intentional conduct (as opposed to negligence). Moreover, the court noted that the plaintiffs failed to allege that the individual defendants had any personal motive to make the alleged misstatements, “such as to facilitate personal sales of Hanger stock.” Instead, plaintiffs argued that the defendants were motivated to misrepresent Hanger’s financial situation so as to maintain the company’s positive relationships with its creditors, avoid additional interest payments, and promote future acquisitions. The court concluded that other courts “have repeatedly rejected these types of generalized motives — which are shared by all companies — as insufficient to plead scienter under the PSLRA.”
Holding: Affirm the dismissal of complaint.
Quote of note: “We therefore conclude that courts should not restrict their scienter inquiry by focusing on specific categories of facts, such as those relating to motive and opportunity, but instead should examine all of the allegations in each case to determine whether they collectively establish a strong inference of scienter.”
Addition: Note that the facts of the case do not allow the Fourth Circuit to address an important issue. Based on the analysis in the opinion, it appears clear that the court could have affirmed the dismissal of the complaint based on the lenient Second Circuit pleading standard, as it has in other cases. See Phillips v. LCI Int., Inc. 190 F.3d 609 (4th Cir. 1999). Instead, the court chose to adopt and apply a new pleading standard in a case where the plaintiffs did not allege any personal motive to commit securities fraud (e.g., stock sales by the individual defendants). District courts in the Fourth Circuit are left with no practical guidance on what “weight” the appellate court thinks should be given to those types of allegations in determining whether a strong inference of scienter has been plead.