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Joseph N. Sacca
Litigation Partner
Skadden, Arps, Slate, Meagher & Flom LLP

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

Collective Scienter

A key question directors are asking themselves these days is, “When can a corporation have the intent to commit securities fraud?” Finding an answer to this is critical as the definition of “intent” seems to be a moving target.

Assume the CFO of ACME Corporation tells a securities analyst ACME expects revenue growth of 10 percent in the next quarter. It has long been understood that both the CFO and ACME itself can face a lawsuit for securities fraud if the CFO knew the statement lacked a reasonable basis when she made it. Now assume the CFO honestly believed the statement when she made it, but was unaware of a recent problem in ACME's production facility that made the projection of 10 percent revenue growth utterly unrealistic. In this case, the CFO would lack the intent necessary to have committed securities fraud. But could ACME still be required to defend itself against a claim of securities fraud because – even though the CFO who spoke on its behalf had no intent to commit fraud – someone at the company's production facility with no responsibility for or knowledge of the projection itself obviously knew facts that made the projection unrealistic. The outcome of a crucial case before a federal appellate court could well settle this vexing question of whether the knowledge of employees who do not speak on behalf of a corporation will be imputed to the corporation for purposes of assessing the corporation's intent in making a statement that proves to be false.

What is this case and when do you expect it to be argued?

The United States Court of Appeals for the Second Circuit has scheduled oral arguments in the case for March. If it rules that corporations can be forced to defend these claims, the result could be a substantial increase in securities litigation and a whole new level of internal monitoring of communications from employees and directors.

To get a full picture of what has led to this critical judicial juncture, it is important to review several milestones in the evolution of securities law. It has long been settled that any intentionally false statement made by a corporate officer or director about the corporation's operations, financial results, or prospects can lead to a securities fraud claim – and not just against the officer or director individually, but also against the corporation itself. That is because the officer's or director's intent is imputed to the corporation under agency principles. Yet what remains unclear is whether a corporation can be forced to defend a securities fraud claim if an officer or director makes a false statement without knowing it to be false, but others within the corporation have knowledge of facts that make the statement false, even if they are unaware the statement was made. Resolving that question will have a significant impact on the burdens, expense, and potential liability corporations could face from securities fraud litigation.

Doesn’t this strike you as an impossible Catch-22? Can additional or enlightened regulation make a real difference?

Congress tried to rein in excessive securities litigation more than a decade ago. In 1995, it passed the Private Securities Litigation Reform Act, which among other things requires a plaintiff to allege specific facts giving rise to a "strong inference" that a defendant acted with fraudulent intent before a securities fraud lawsuit will be permitted to proceed to the discovery stage. Not surprisingly, the statute itself didn't close the book on this issue.

Appellate courts across the country have split on the question of how a plaintiff can properly allege that a corporate defendant acted with fraudulent intent. The United States Courts of Appeals for the Fifth and Ninth Circuits have concluded that, because a corporation can act only through its agents, it cannot be said to have the requisite intent to commit securities fraud unless those who actually acted on its behalf in making the false statement did so with fraudulent intent. That would appear to absolve a corporation from defending claims based on false statements made innocently by its officers or directors. This rule was expressed most clearly by the Fifth Circuit in its 2004 decision in Southland Securities Corporation v. Inspire Insurance Solutions. The court held "[a] defendant corporation is deemed to have the requisite scienter for fraud only if the individual corporate officer making the statement has the requisite level of scienter, i.e., knows that the statement is false, or is at least deliberately reckless as to its falsity…."

Can it be this easy? What about the “collective scienter” theory?

Other court rulings have muddied the waters. In 2004, the United States Court of Appeals for the Sixth Circuit adopted what has come to be known as the "collective scienter" theory. In City of Monroe Employees Retirement System v. Bridgestone Corporation, the Sixth Circuit held that the plaintiff had adequately alleged fraudulent intent on the part of the corporate defendant even though it had failed properly to allege that the officers responsible for making the purportedly fraudulent statements did so with intent. The court based its decision on the plaintiff's allegations that some employees within the corporation knew facts that rendered the statements false, holding that the knowledge of those employees could be imputed to the corporation for purposes of assessing the corporation's intent, even though the employees had no role in making the statements.

This collective scienter theory has attracted some judicial support. In the case now before the Second Circuit, In re Dynex Capital, a federal trial court in New York applied the collective scienter theory in declining to dismiss a securities fraud complaint against a corporation while at the same time dismissing claims against the individual officers who had made the challenged statements because the plaintiff failed to plead adequately that the officers had acted with fraudulent intent. Recognizing that the propriety of the collective scienter theory is the subject of substantial dispute among the courts of appeals, however, the trial court certified its decision for immediate appeal to the Second Circuit.

The ruling will be carefully scrutinized because the Second Circuit is widely considered to have particular expertise in securities law. So its upcoming decision in the Dynex case may go a long way towards settling the issue of whether the collective scienter theory is consistent with the requirements of the Private Securities Litigation Reform Act. It is also possible that this issue ultimately will be decided by the United States Supreme Court, which has demonstrated an increasing interest in securities litigation in recent years.

What happens then?

If the collective scienter theory gains traction, there may well be an increase in the number of securities claims against corporate defendants that survive motions to dismiss and proceed to the intrusive and expensive discovery stage, where the pressure to settle even weak claims is substantial. In addition to the unhappy consequence of increased litigation, acceptance of the collective scienter theory will present corporations and their boards with difficult management issues. If the knowledge of all of a corporation's employees – not just those who speak on its behalf – are to be considered in determining whether any corporate statement was made with fraudulent intent, the process of vetting the accuracy of disclosures will become enormously complex, and will require heightened vigilance by both officers and directors. That is why boardrooms across America would be well served to pay careful attention to the Second Circuit this spring.

Joseph N. Sacca is a partner with Skadden, Arps, Slate, Meagher & Flom LLP and represents a broad spectrum of domestic and foreign clients in complex corporate, commercial and securities litigation in federal and state courts and in arbitration proceedings.

He has represented public corporations and accounting firms in some of the most significant securities litigations in recent years, including class actions against DaimlerChrysler AG and Cendant Corporation. He successfully defended DaimlerChrysler in the trial of a multi billion dollar securities fraud action brought by Kirk Kerkorian's Tracinda Corporation, a victory the National Law Journal named the "Top Defense Win of 2005."

He holds a BA from the University of Pennsylvania and a JD from Temple University School of Law.