The 10b-5 Daily

The opinion in the Interpublic Group case (In re Interpublic Securities Litigation, 2003 WL 21250682, (S.D.N.Y. May 29, 2003)) is a must-read because it brings three strands of questionable law together to eviscerate the PSLRA’s scienter (i.e., fraudulent intent) pleading requirement. It has taken The 10b-5 Daily a while to get around to addressing the opinion, but only because there is so much to say!
A little background is in order. Interpublic (�IPG�) is a New York holding company that ranks as the second-largest owner of advertising agencies in the world. The case is the result of a restatement IPG announced last August for the five years from 1997 to 2001, which corrected inter-company charges that had been wrongly declared as income for the European offices of one of IPG’s agencies.
The three strands of questionable law are:
1) Section 20(a) liability has no scienter element– Section 20(a) of the ’34 Act creates a cause of action against defendants alleged to have been “control persons” of those who engaged in securities fraud. Good faith may be asserted as an affirmative defense. Six circuit courts have held that plaintiffs do not have to show that the control persons acted with scienter (the 5th, 7th, 8th, 9th, 10th, and 11th Circuits); two have held that such a showing is required (the 3rd and 4th Circuits). The Second Circuit has not definitively answered the question, but has stated that to prove a Section 20(a) claim a plaintiff must show, inter alia, “that the controlling person was in some meaningful sense a culpable participant.” Although some district courts in the Second Circuit have found that this creates a scienter pleading requirement, others have disagreed. The effect of no scienter requirement, however, is that the heightened pleading standards of the PSLRA do not apply. All plaintiffs need to show at the pleading stage is: (a) there was a primary violation by a controlled person; and (b) control of the primary violator by the defendant.
2) Corporate acquisitions for stock can be a motive for securities fraud – There is a line of cases, especially in the Second Circuit, which hold that a desire to acquire other companies through the use of stock as consideration may be a sufficient allegation that defendants had a motive to make misstatements for the purpose of artificially inflating the stock price. (Note that the question of whether the motive and opportunity to commit fraud is sufficient, on its own, to establish scienter for a Rule 10b-5 claim is a whole separate debate. The Second Circuit has held that it is, but other circuit courts have disagreed.) The relatively unexplored question is: motive for whom? The company may benefit from obtaining another entity at a cheap price, but the �concrete benefit� for the individual defendants (i.e., officers or directors) is in the value of their stock. So in the absence of stock sales by the individual defendants at an inflated price (with the acquisition presumably included), are corporate acquisitions really a motive for individual defendants to commit fraud?
3) Personifying the company – It is generally understood that a company acts through its officers and directors. As a result, courts uniformly hold that allegations of scienter as to the individual defendants in a securities fraud case can be used to plead a claim against the company. In other words, the scienter of the individual defendants is imputed to the company. But is the reverse true? Can a securities fraud case continue against a company if there are insufficient allegations of scienter as to the individual defendants? For some courts, the corporate acquisitions motive appears to be the answer to this question. In In re IPO Securities Litigation, 241 F.Supp.2d 281 (S.D.N.Y. 2003), for example, the court separately examined the motive allegations against the companies and the individual defendants that had been sued. For the companies, the court considered whether there had been stock-based acquisitions or add-on offerings during the class period. For the individual defendants, the court looked at stock sales during the class period. In other words, the motive of a company to commit fraud was evaluated without reference to the motive of the company’s officers or directors.
All of which leads to the holdings in the IPG opinion, the perfect storm that happens when these three strands of questionable law come together. As to the Rule 10b-5 claims in the case, the court made the following rulings: (a) the series of stock-for-stock acquisitions made by IPG during the class period created a strong inference that IPG had acted with scienter; and (b) there were insufficient allegations concerning the individual defendants’ stock sales and knowledge of the accounting problems to create a strong inference that the individual defendants had acted with scienter. As a result, the Rule 10b-5 claims were allowed to continue against IPG, but were dismissed against the individual defendants.
The individual defendants were not, however, free to go. Since they controlled IPG and the court had found that a Rule 10b-5 claim was adequately pled against IPG, the Section 20(a) claims for controlling person liability against the individual defendants still remain.
This is a troubling result on two levels. By analyzing the scienter of IPG separately, the court, in essence, ends up holding that IPG acted with fraudulent intent, but its officers and directors did not. How can a company do anything if not through its officers and directors? Moreover, the PSLRA was designed to protect individuals from unsubstantiated securities fraud claims. By applying Section 20(a) in this manner, the court allowed the plaintiffs to bypass the heightened pleading requirements for scienter in the PSLRA. Based on the IPG holding, plaintiffs merely have to establish that the company had a motive for fraud (or, one supposes, that some unnamed person at the company knew of the misstatements or was reckless with respect to them), and can then continue to bring their securities fraud claims against both the company and its officers and directors (in the form of Section 20(a) claims) without having to make any specific scienter allegations concerning the individual defendants. That does not comport with the PSLRA�s requirement that scienter be sufficiently alleged as to each defendant.
This post covers a lot of ground. Readers comments, as always, are welcome.