Rule 10b-5 Archives - Columbia Law Review

Introduction Securities fraud class actions are big business. More than fifty percent of federal class actions filed are securities class actions,[footnote]James C. Spindler, Optimal Deterrence When Shareholders Desire Fraud 4 (Univ. of Tex. Sch. of L., Law & Econ. Rsch. Paper No. 595, 2021) [hereinafter Spindler, Optimal Deterrence].[/footnote] and over $114 billion has changed hands through securities class action settlements since 1996.[footnote]Stanford L. Sch. & Cornerstone Rsch., Box Scores or Key Statistics From 1996 to YTD, Sec. Class Action Clearinghouse, https://securities.stanford.edu/stats.html [https://perma.cc/28XY-DMZ7] (last visited Feb. 14, 2024).[/footnote] While the total number of filings has decreased significantly since 2017,[footnote]See Stanford L. Sch. & Cornerstone Rsch., Filings by Year, Sec. Class Action Clearinghouse, https://securities.stanford.edu/charts.html [https://perma.cc/SQX6-2T36] (last visited Feb. 14, 2024).[/footnote] the magnitude of potential losses to be claimed continues to increase.[footnote]Two measures of market capitalization losses, “disclosure dollar loss” (DDL) and “maximum dollar loss” (MDL), reached “historically high levels” in the first six months of 2022. Cornerstone Rsch., Securities Class Action Filings: 2022 Midyear Assessment 1 (2022), https://securities.stanford.edu/research-reports/1996-2022/Securities-Class-Action-Filings-2022-Midyear-Assessment.pdf [https://perma.cc/LXK7-2F3H]. In 2023, DDL decreased to pre-pandemic levels while MDL again increased. Cornerstone Rsch., Securities Class Action Filings: 2023 Year in Review 1 (2024), https://www.cornerstone.com/wp-content/uploads/2024/01/Securities-Class-Action-Filings-2023-Year-in-Review.pdf [https://perma.cc/6VXN-UYCB].[/footnote] And there is little reason to believe this trend will slow down: Many have predicted that a recession is on the horizon,[footnote]See, e.g., Aruni Soni, No Soft Landing: The US Economy Is Going to Fall Into Recession in the Middle of 2024, Citi’s Chief Economist Says, Bus. Insider (Feb. 15, 2024), https://www.businessinsider.com/recession-outlook-us-economy-job-market-unemployment-soft-landing-citi-2024-2 (on file with the Columbia Law Review ) (quoting Andrew Hollenhorst, chief U.S. economist for Citi, and other economists predicting a possible recession in 2024 despite rosy economic indicators).[/footnote] and recessions are often correlated with fraud in financial markets.[footnote]See Jean Eaglesham, SEC Accountant Warns of Heightened Fraud Risk Amid Recession Fears, Market Selloff, Wall St. J. (Nov. 3, 2022), https://www.wsj.com/articles/sec-accountant-warns-of-heightened-fraud-risk-amid-recession-fears-market-selloff-11667427464 (on file with the Columbia Law Review ).[/footnote] By the numbers, legal standards in securities fraud litigation have a significant impact on corporations and the millions of Americans whose wealth is invested in the stock market.[footnote]See Katie Kolchin, SIFMA, SIFMA Insights: Q: Who Owns Stock in America? A: Individual Investors 14–15 (2019), https://www.sifma.org/wp-content/uploads/2019/10/SIFMA-Insights-Who-Owns-Stocks-in-America.pdf [https://perma.cc/3WEK-73XD] (noting that fifty-two percent of U.S. households own stocks and that households own a plurality of all equities in the United States).[/footnote] And they may become even more salient in the coming years. One of the most-argued elements in section 10(b) securities fraud class actions is the defendant’s scienter. Scienter refers to fraudulent intent; it is what separates fraud from negligent or accidental misstatements.[footnote]See Scienter, Black’s Law Dictionary (11th ed. 2019).[/footnote] The concept of scienter is straightforward as applied to natural persons: What it means for an individual to intend or know something is clear, notwithstanding that intent and knowledge can be difficult to prove.[footnote]See PAMCAH-UA Loc. 675 Pension Fund v. BT Grp. PLC, No. 20-2106, 2021 WL 3415060, at *1 (3d Cir. Aug. 5, 2021) (explaining that securities fraud, including scienter, “is not easy to allege”); see also Steven Shavell, Liability and the Incentive to Obtain Information About Risk, 21 J. Legal Stud. 259, 269 (1992) (“[E]xactly what a defendant knew about risk may be hard to establish even when what he should have known and his level of care can be fairly well determined.”).[/footnote] For corporate defendants, however, an additional layer of conceptual difficulty emerges. A corporation is a fictional person, by definition distinct from the natural persons who are its owners and take actions on its behalf.[footnote]See 15 U.S.C. § 7 (2018) (defining “person” to include corporations); Adolf A. Berle, Jr. & Gardiner C. Means, The Modern Corporation and Private Property 3–9 (1933) (discussing the implications of separation of ownership from control in the modern corporation); Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 310–11 & n.12 (1976) (explaining the concept of legal fiction as applied to organizations and defining “corporation”).[/footnote] This feature of the corporate form means that to determine whether a corporation has scienter, courts must first develop a theory of the corporate mind that accommodates this separation. Even though corporations are regularly defendants in securities fraud class actions, and plaintiffs must plead scienter to establish claims against them,[footnote]See Cent. Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 175–78, 191 (1994) (holding there is no aiding and abetting liability under section 10(b)); infra note 35.[/footnote] organizational scienter remains “one of the greatly under-theorized subjects in all of securities litigation.”[footnote]Donald C. Langevoort, Lies Without Liars? Janus Capital and Conservative Securities Jurisprudence, 90 Wash. U. L. Rev. 933, 959 (2013).[/footnote] This theoretical gap could be explained by the fact that imputation of intent through respondeat superior is deeply ingrained as a method for ascribing intent to corporations in the tort context.[footnote]See infra notes 64–67 and accompanying text.[/footnote] But securities fraud is unlike other torts in its singular focus on deterrence[footnote]See Stuart M. Speiser, Charles F. Krause & Alfred W. Gans, 1 American Law of Torts § 1.3 & n.1, Westlaw (Monique C.M. Leahy, ed., database updated Feb. 2024) (“The fundamental policy purposes of the tort compensation system are compensation of innocent parties, shifting the loss to responsible parties or distributing it among appropriate entities, and deterrence of wrongful conduct.”); infra notes 42–46 and accompanying text.[/footnote]—specifically, this Note argues, optimal deterrence.[footnote]See Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5, 108 Colum. L. Rev. 1301, 1322 (2008) [hereinafter Rose, Reforming Securities Litigation Reform] (defining optimal deterrence as being achieved when defendants internalize the social costs of their behavior); infra section I.B.[/footnote] Respondeat superior liability is not suited to this goal.[footnote]See infra section II.C.1.[/footnote] Most circuits recognize the shortcomings of respondeat superior and deviate from it, sometimes without acknowledging the deviation.[footnote]Professor Ann Lipton has argued that courts already deviate from respondeat superior in section 10(b) cases even while they claim to apply it. See Ann M. Lipton, Slouching Towards Monell : The Disappearance of Vicarious Liability Under Section 10(b), 92 Wash. U. L. Rev. 1261, 1276–80 (2015). She argues courts surreptitiously apply principles of organizational fault in section 10(b) cases. See id.[/footnote] Circuit court approaches to corporate scienter[footnote]Some courts have used “corporate scienter” to refer only to scienter that cannot be established by imputation. See, e.g., Rahman v. Kid Brands, Inc., 736 F.3d 237, 246 (3d Cir. 2013) (indicating that “corporate scienter” and “collective scienter” are synonymous). This Note uses the phrase “corporate scienter” to refer generally to scienter attributed to corporations, whether by imputation or otherwise.[/footnote] can be sorted into three major groups: adherence to respondeat superior and variations,[footnote]The Fourth, Fifth, Seventh, and Eleventh Circuits fall into this group. See infra section II.B.1.[/footnote] collective scienter,[footnote]The Second and Ninth Circuits have each indicated openness to collective scienter, although neither has relied on it in denying a motion to dismiss. See infra section II.B.2.[/footnote] and the high managerial agent approach.[footnote]The Sixth Circuit is associated with this approach, although its popularity in other circuits is growing. See infra section II.B.3.[/footnote] But analyzed under the framework of optimal deterrence, these alternative approaches each fall short.[footnote]See infra sections II.C.2–.3.[/footnote] This Note argues that courts should consider corporate institutional features in the definition of corporate scienter to better meet the ideal of optimal fraud deterrence. The concept of optimal deterrence is well adapted to the securities fraud context, where maintaining market efficiency is a primary goal.[footnote]See Frank H. Easterbrook & Daniel R. Fischel, Optimal Damages in Securities Cases, 52 U. Chi. L. Rev. 611, 613 (1985); see also H.R. Rep. No. 104-369, at 31 (1995) (Conf. Rep.) (indicating one of the purposes of securities law is to “maintain confidence in the securities markets”).[/footnote] Moreover, since optimal deterrence reflects a balancing of the arguments for and against private section 10(b) litigation against corporations, it is the key goal that should orient corporate scienter analysis. The optimal deterrence framework suggests that courts are right to move away from the pure application of respondeat superior, but they should consider adding a category of corporate scienter that looks to corporate structure and compliance efforts as proxies for organizational “intent” to defraud. The U.S. Sentencing Commission incorporates similar considerations in its Organizational Sentencing Guidelines,[footnote]See U.S. Sent’g Guidelines Manual § 8A1.1–.2 (U.S. Sent’g Comm’n 2023) (considering an organization’s “compliance and ethics program” to calculate a “culpability score”); Paula Desio, Deputy General Counsel, U.S. Sent’g Comm’n, An Overview of the Organizational Guidelines, https://www.ussc.gov/sites/default/files/pdf/training/ organizational-guidelines/ORGOVERVIEW.pdf [https://perma.cc/CLQ4-WGHA] (last visited Feb. 10, 2024).[/footnote] and these guidelines provide helpful examples of corporate actions that could be factored in to the scienter analysis. Injecting these principles into the corporate scienter analysis in securities fraud cases will better calibrate corporations’ deterrence-related incentives. Corporate structure may determine who becomes aware of what information and when, and structures that prevent or inhibit the flow of information both prevent scienter from attaching to any corporate speaker and encourage fraud.[footnote]See Shavell, supra note 9, at 261, 268–69.[/footnote] Consequently, structure and compliance measures reflect both the corporation’s intention and ability to prevent fraud, or not. Part I summarizes the law of federal securities fraud class actions and explores the building blocks of corporate scienter. It also introduces the optimal deterrence goal that guides the remainder of the argument. Part II explains the ongoing circuit split and argues that each of the currently prevailing approaches is systematically either over- or underdeterrent. Part III proposes a new category of corporate scienter oriented to the idea of organizational fault. Inspired in part by the Organizational Sentencing Guidelines, this new category would allow courts to consider corporate structure and compliance alongside the traditional imputation analysis. Part III concludes by reviewing two hypothetical case studies that show how the proposed scienter concept is better equipped than predecessors to handle certain sets of facts that can arise in securities class actions.