An ongoing issue in many securities cases concerns the precise state of mind necessary to satisfy the element of scienter in a Section 10(b) violation. The basic dispute is about whether the defendant must have intended to harm investors, or whether it is sufficient if the defendant simply intended to mislead them.
One would have thought this issue was settled by the Supreme Court’s decision in Basic Inc. v. Levinson, 485 U.S. 224 (1988). There, the defendants lied to investors by falsely claiming that they were not engaged in merger negotiations. The lie was not intended to harm anyone; if anything, the defendants intended to benefit investors by concealing the talks so as not to prejudice a beneficial deal. The Supreme Court did not weigh in on the definition of scienter per se, but it did emphasize that the defendants’ benign motives would not immunize them from liability. As the Court put it, “[W]e think that creating an exception to a regulatory scheme founded on a prodisclosure legislative philosophy, because complying with the regulation might be ‘bad for business,’ is a role for Congress, not this Court.”
Similarly, in Nakkhumpun v. Taylor, 2015 U.S. App. LEXIS 5547 (10th Cir. Apr. 7, 2015), the Tenth Circuit rejected a defendant’s argument that his false statements – in that case, false characterizations as to why a corporate asset sale had fallen through – were intended to benefit investors by attracting new deal partners. The Tenth Circuit held that whatever the defendant’s ultimate motive, Section 10(b) liability would be imposed if he intentionally or recklessly misled investors.
Nonetheless, courts continue to sporadically define Section 10(b) scienter in a more limited manner.
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For example, in ECA & Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co., 553 F.3d 187 (2d Cir. 2009), the plaintiff-stockholders of JP Morgan Chase claimed that the bank had assisted Enron’s fraud by falsely structuring loans as trades. The fraud was intended to allow Enron to falsify its own financial statements, but a necessary consequence was that JPMC itself falsely listed the loans as trades in its own SEC filings. When JPMC’s role in Enron’s fraud was disclosed, its stock price fell, harming its own shareholders. Nonetheless, the Second Circuit held that the plaintiffs failed to allege scienter against JPMC because they did not “show an intent to defraud JPMC’s shareholders rather than Enron’s shareholders….Indeed, Plaintiffs have argued that JPMC concealed its transactions with Enron in return for excessive fees … It seems implausible to have both an intent to earn excessive fees for the corporation and also an intent to defraud Plaintiffs by losing vast sums of money.”
Other decisions have followed a similar pattern. See, e.g., Pipefitters Local No. 636 Defined Benefit Plan v. Zale Corp., 499 Fed. Appx. 345 (5th Cir. 2012) (no scienter alleged against executive who falsified accounting entries because she “acted with the intent to maintain the good appearance of her department rather than to defraud investors”); Doshi v. Gen. Cable Corp., 2015 U.S. Dist. LEXIS 9306 (E.D. Ky. Jan. 27, 2015) (“Although Sandoval may have been aware of problems and failed to disclose them, there are no facts to support that he did so with intent to defraud. Instead, the allegations support an inference that his intent was one shared by most corporate executives: to be profitable and achieve business goals.”).
Looking at the cases, it’s hard to avoid the conclusion that courts are somewhat strategic about which definition of scienter they choose to adopt. In particular – as I posted previously – courts often struggle with the line between securities fraud under Section 10(b), and claims that seem more about corporate mismanagement, and they have a variety of strategies for drawing the distinction. One strategy, I suspect, is by defining scienter narrowly in cases that strike courts as being more properly framed as breaches of fiduciary duty (via lack of care, or via intentional violations of law to enhance profits – which under Delaware law counts as disloyalty).
In any event, the matter is now pending before the Second Circuit in the context of a criminal prosecution for securities fraud of an ex-Jeffries trader who misled clients about the margins he was earning on the RMBS bonds he bought and sold. One of the defendant’s arguments is that he did not intend to harm anyone, and therefore he did not harbor the requisite state of mind for a Section 10(b) violation. (Neither the defendant nor the government make any argument that the rules should be different in the criminal context.)
It will be interesting to see what the Second Circuit does – and how its decision will influence cases going forward.