The Pleading Standard Of The Private Securities Litigation Reform Act of 1995 (excerpts)

Originally published in PLI Securities Law handbook September-October 1998 [and at 1070 PLI/Corp 285]



The Reform Act Aimplements needed procedural protections to discourage frivolous [securities] litigation. Conf. Rep. at 32. One such protection is the Reform Act's heightened pleading standard.

The Reform Act sets forth specific requirements for pleading the falsity of an alleged misrepresentation and the requisite mental state. Plaintiff must plead with particularity each statement alleged to be misleading and set forth in detail the Areasons why the statement is misleading. Securities Exchange Act of 1934 section 21D(b)(1), 15 U.S.C.section 78u-4(b)(1). To the extent that plaintiff is required to prove that a defendant acted with a particular state of mind, plaintiff must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. Id. section 21D(b)(2), 15 U.S.C.section 78u-4(b)(2) . If allegations are made on information and belief, plaintiff must state with particularity all facts on which that belief is formed. Id. section 21D(b)(1) (emphasis added).

In the Conference Report, Congress explained it had adopted this heightened pleading standard because Fed. R. Civ. P. 9(b), as interpreted by the federal courts of appeal, provided defendants with inadequate protection against frivolous fraud allegations. Congress found that naming a party in a civil suit for securities fraud is a serious matter because[unwarranted fraud claims can lead to serious injury to reputation for which our legal system effectively offers no redress. Conf. Rep. at 41. In particular, Congress concluded that Rule 9(b)'s requirement that allegations of fraud be pleaded with particularity Ahas not prevented abuse of the securities laws by private litigants@and has led to conflicting . . . distinctly different standards among the courts of appeal. Id. The Reform Act's pleading requirement was intended to rectify this problem by establishing "uniform and more stringent pleading requirements to curtail the filing of meritless lawsuits." Id.

The Reform Act's "strong inference" pleading standard was adapted from decisions in the Second Circuit:

  1. The Conference Committee language is based in part on the pleading standard of the Second Circuit. . . . Regarded as the most stringent pleading standard, the Second Circuit requirement is that the plaintiff state facts with particularity, and that these facts, in turn, must give rise to a "strong inference" of the defendant's fraudulent intent.

Conf. Rep. at 41. The application of this standard by courts in the Second Circuit before the Reform Act is discussed in Section II, infra. As the Conference Report makes clear, however, Congress specifically intended to strengthen even the existing Second Circuit standard. It therefore chose not to codify the entire Second Circuit case law. Instead, Congress expressly rejected portions of Second Circuit law that allowed scienter to be pleaded based on allegations of motive, opportunity, or recklessness:

  1. Because the Conference Committee intends to strengthen existing pleading requirements, it does not intend to codify the Second Circuit=s case law interpreting this pleading standard. FN 23/
  2. FN 23/ For this reason, the Conference Report chose not to include in the pleading standard certain language relating to motive, opportunity, or recklessness.

Conf. Rep. at 41 & n.23. This portion of the Conference Committee Report was directed to an amendment that had been proposed by Senator Arlen Specter. That amendment would have codified one line of Second Circuit cases, which held that a plaintiff may satisfy the strong inference standard by alleging that a defendant had a motive and opportunity to commit fraud, or by pleading facts constituting strong circumstantial evidence of conscious misbehavior or recklessness. Amend. 1485, S. 240, 104th Cong., 1st Sess. (1995). The conference committee eliminated the Specter Amendment from the final version of the bill, which Congress passed.

President Clinton vetoed the bill reported out of the Conference Committee. In his letter to Congress explaining his veto, President Clinton stated:

  1. I am prepared to support the high pleading standard of the [Second Circuit] -- the highest pleading standard of any Federal circuit court. But the conferees make crystal clear in the Statement of Managers their intent to raise the standard even beyond that level. . . . The conferees deleted an amendment offered by Senator Specter and adopted by the Senate that specifically incorporated Second Circuit case law with respect to pleading a claim of fraud. Then they specifically indicated that they were not adopting Second Circuit case law but instead intended to "strengthen" the existing pleading requirements of the Second Circuit. All this shows that the conferees meant to erect a higher barrier to bringing suit than any now existing.

H.R. Doc. No. 104-150, 104th Cong., 1st Sess. (1995). Notwithstanding the President's objections, Congress overrode his veto and passed the Conference Committee's bill.


Because the Reform Act's heightened pleading standard is based, in part, upon the Second Circuit's strong inference standard, Second Circuit jurisprudence provides an appropriate starting point for interpreting the Reform Act's pleading provisions. Accordingly, this section discusses the state of Second Circuit law before the Reform Act.

Mental State

Before the Reform Act, one line of Second Circuit cases permitted plaintiffs to plead scienter by alleging either: (1) facts showing that the defendant had both motive and opportunity to commit fraud; or (2) facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness by the defendant. This line of cases culminated in In re Time Warner Inc. Securities Litigation, 9 F.3d 259 (2d Cir. 1993), which set forth that standard and applied it to reverse the dismissal of a securities fraud complaint. Id. at 268-69. This standard is the same standard that was set forth in the rejected Specter Amendment. See Section II, supra.

As the court noted in In re Leslie Fay Companies, Inc. Sec. Litig., 871 F. Supp. 686 (S.D.N.Y. 1995), however, there is a second line of Second Circuit cases that did not endorse a recklessness standard. Rather, like Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), and (later) Central Bank v. First Interstate Bank, 511 U.S. 164 (1994), these decisions "indicated that Section 10(b) scienter requires either allegations of actual intent or circumstances implying a strong inference of actual intent." Id. at 692. For many years, district courts in the Second Circuit applied this higher standard at the pleading stage, drawing particularly on the standard for pleading fraud in civil RICO cases established by Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46 (2d Cir. 1987).

In part, the differences in Second Circuit approaches reflected the fact that among the courts recognizing liability for recklessness, there was considerable uncertainty whether such liability in the Second Circuit extended to all reckless conduct, or only to deliberate recklessness. Thus, for example, in Goldman v. McMahan, Brafman, Morgan & Co., 706 F. Supp. 256 (S.D.N.Y. 1989), rather than require a showing of bad faith, the court held that the plaintiff need only plead facts that "give rise to an inference of gross negligence which can be the functional equivalent of recklessness." Id. at 259. On the other hand, in In re Fischbach Corp. Securities Litigation, [1995 Tr. Binder] Fed. Sec. L. Rep. (CCH) & 98,665, at 92,091 (S.D.N.Y. Jan. 15, 1992), Judge Wood concluded that the Second Circuit had not "held that recklessness per se is sufficient," and viewed any such holding as inconsistent with Hochfelder. Judge Wood noted that "[t]he question left open by [Hochfelder] is not whether recklessness is always sufficient to meet the scienter requirements of Section 10(b)." Id. Rather, Hochfelder "leaves open the question of whether recklessness that is equivalent to intentional conduct is actionable." Id. Judge Wood held that liability for recklessness in the Second Circuit could not extend beyond the "willful blindness" considered to be the equivalent of knowledge in the common law, and to which Judge Friendly referred in Securities & Exch. Comm'n v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1969). Id. at 92,092.

The court in Time Warner also purported to rely on Beck, which requires the pleading of facts that would support a strong inference of "conscious behavior." At the same time, however, it added a new standard not present in Beck or the district court decisions that had applied Beck under Section 10(b): the pleading of mere recklessness. Although a recent trilogy of Second Circuit cases cited the Time Warner standard, these decisions paid only lip service to recklessness. For example, in Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir. 1995), a company expressed comfort with estimates of strong earnings and stated "that the company's overall growth would continue." Id. at 50. The next day, however, the company's Kansas City plant failed its third straight FDA inspection C its 85 violations were almost double the number of violations found in the first two inspections C and the company suspended operations there. One month later, the company announced a significant after-tax charge against earnings to correct the plant's problems and downgraded its earnings estimates. Id. at 51.

The Second Circuit rejected plaintiffs' allegation that the company "should have foreseen that the third FDA inspection would have negative consequences, given the deficiencies noted in the first two inspections," holding that "plaintiffs clearly have failed to allege facts constituting circumstantial evidence of reckless or conscious misbehavior." Id. at 51, 53. The court refused to infer that defendants should have known the plant would fail the third inspection just because it had failed the first two: "one cannot infer that it was a 'foregone conclusion' that the Kansas City plant would fail the inspection and adverse consequences would ensue. . . . [D]efendants' lack of clairvoyance simply does not constitute securities fraud." Id. at 53 (emphasis added). By this reasoning, the Court applied a test akin to an actual knowledge standard, and, notwithstanding reference to the word recklessness in the opinion, required plaintiff to plead facts indicating that defendants actually knew that the plant would fail an inspection and that the company's financial results would be negatively impacted as a result.

Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994), came even closer to explicitly rejecting a recklessness approach. In that case, a bank allegedly failed to disclose that it had eased its policy for real estate loans. Two months after announcing it expected a "12th consecutive year of record earnings," the bank disclosed that declining real estate values required it to record a $40 million charge for problem loans that would cause a loss for the year. Id. at 1126. The Second Circuit rejected plaintiff's allegation that the bank fraudulently failed to disclose that its collateral policy was "critically vulnerable" to declining real estate values, because the complaint did no more than "couple a factual statement with a conclusory allegation of fraudulent intent" and did not "adduce the kind of circumstantial evidence that would indicate conscious fraudulent behavior." Id. at 1129 (emphasis added). The court found that plaintiffs did not allege facts establishing that the bank knew, when it made its optimistic statements, that reserves were inadequate, or "that the company's disclosures were inconsistent with current data. The pleading strongly suggests that the defendants should have been more alert and more skeptical, but nothing alleged indicates that management was promoting a fraud." Id. In other words, the Court came very close to finding that a complaint alleging that the defendants were objectively reckless did not adequately plead scienter.

Finally, San Leandro Emergency Medical Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801 (2d Cir. 1996), also failed to credit recklessness allegations. In that case, plaintiffs alleged that the company had predicted favorable financial results, but failed to disclose flagging sales for Marlboro cigarettes and its intention to implement a radical new marketing strategy, drastically cutting Marlboro prices to increase market share at the expense of short term profitability, which would reduce annual earnings by $2 billion. Id. at 805. The Second Circuit rejected plaintiffs= allegation that Philip Morris had been aware of slower Marlboro sales and had actually been testing its new strategy months before announcing it, because plaintiffs failed to "offer anything but conclusory allegations to support their contention that defendants knew long before the . . . announcement that Marlboro was in trouble and that a change in strategy would be necessary." Id. at 810, 812. The Court rejected the conclusory allegation that "confidential company sales reports" revealed much earlier that Marlboro sales were in trouble, because plaintiffs had not specifically identified the reports, their authors, or the dates when written. Id. In sum, the Court pointed at an approach to pleading scienter that requires plaintiffs to plead specific reports that provided corporate executives with actual knowledge of the adverse conditions existing at the time of a company's optimistic statements.


In the year-and-a-half that has passed since the Reform Act's enactment, several district courts have considered the Act's heightened pleading standard. No Court of Appeal has yet to consider this standard.

Two principal lines of cases have emerged from the district courts. One line of cases has held that the Reform Act did nothing more than codify existing Second Circuit pleading standards, as reflected in the Time Warner line of cases--although, as we shall see, those courts have not examined the full scope of the Second Circuit precedents that were available to guide their interpretation of the Reform Act. These cases are discussed in Section IV(A), infra. A second line of cases has emphasized Congress' intent in the Reform Act to impose pleading standards stricter than the standards applied by prior Second Circuit law--although, ironically, the standard that has emerged also is supported by Second Circuit law. These cases are discussed in Section IV(B), infra.

Cases Adopting The "Second Circuit" Standard

Notwithstanding Congress' rejection of the Specter Amendment, several courts have held that the Reform Act did nothing more than codify existing Second Circuit pleading standards, and thus adopted Time Warner (or some variant thereof) as the standard for pleading scienter.

Marksman Partners

The first and most significant of the line of cases adopting a "Second Circuit" approach to pleading scienter is Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297 (C.D. Cal. 1996).

In Marksman Partners, Judge William Rea of the Central District of California found that Congress' rejection of the Specter Amendment did not signify an intent to abandon the Time Warner standard articulated therein. 927 F. Supp. at 1311. Rather, the Court found that "the new pleading standard is derivative of prior Second Circuit jurisprudence in securities fraud cases," especially the first, motive and opportunity prong of Time Warner. Id. at 1311-12. The principal basis for the Court's holding was statements to the effect that the Reform Act's pleading standard was derived from Second Circuit law. In particular, the Court quoted a long passage from a report of the Senate Banking, Housing, and Urban Affairs Committee, which concluded that "[t]he Committee does not intend to codify the Second Circuit's caselaw interpreting this pleading standard, although courts may find this body of law instructive." Id. at 1311. The Court also noted the Conference Committee's apparent assent to this proposition. Id. ("The Conference Committee language is based in part on the pleading standard of the Second Circuit").

It is important not to overstate the breadth of Marksman Partners. Notwithstanding its reliance on Second Circuit law, in three important respects, that case sets forth a more nuanced and limited approach to pleading scienter than is suggested by a simplistic application of the Time Warner standard.

First, although it adopted the motive and opportunity method of pleading scienter, Marksman Partners heeded subsequent Second Circuit pre-Reform Act decisions that explained the narrow scope of that pleading method. In Time Warner, the majority had strained to resolve the admittedly Aclose question@ posed by plaintiffs= convoluted motive theory in plaintiffs' favor, 9 F.3d at 269-70, while raising the possibility that "some focused preliminary discovery" would resolve the issue adversely to plaintiffs. Id. at 272 . The dissent vigorously contended that the theory was "inconsistent with assumptions underlying securities law, statements in the complaint, and any plausible understanding of the operation of capital markets." 9 F.3d at 273-75 (Winter, J., dissenting). Subsequent Second Circuit cases, in contrast, easily rejected motive and opportunity allegations, and dismissed securities fraud complaints. Shields v. Citytrust Bancorp, Inc., 25 F.3d 1124, 1130-31 (2d Cir. 1994); Acito v. IMCERA Group, 47 F.3d 47, 53-54 (2d Cir. 1995); San Leandro Emergency Med. Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 813-14 (2d Cir. 1996).

It is safe to say that these cases (Shields, Acito, and Philip Morris) more accurately reflected the Second Circuit standard than did Time Warner at the time the Reform Act was enacted. Marksman Partners recognized this fact by citing Shields, and not Time Warner, as the source of "Second Circuit" law. 927 F. Supp. at 1310. Marksman Partners also cited Acito in disallowing the pleading of motive based on bare allegations that the company's executives sought to enhance the value of their company's stock and maintain their executive positions. The Court found that such a "motive" could be applied to the executives of every public company and, therefore, concluded that these generic allegations were not sufficient. 927 F. Supp. at 1312 (citing Acito, 47 F.3d at 53-54); see also San Leandro Emergency Med. Profit Sharing Plan, 75 F.3d at 814 (allegation that executives were motivated to maintain a high bond or credit rating cannot suffice to plead scienter, as this would apply to every corporation). In this respect, Marksman Partners undoubtedly is correct. If such allegations sufficed to plead scienter, then the duty to plead a strong inference of scienter would be meaningless, because it could be met in literally every case. Certainly, Congress could not have intended to render meaningless the duty to plead a strong inference of scienter.

Second, the defendants in Marksman Partners did not argue that Reform Act disapproved of the second prong of Time Warner, i.e., that scienter may be pleaded by "alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness by the defendant." Id. at 1313. Therefore, that issue was not contested and resolved until the Silicon Graphics case, discussed in Section IV(B), infra.

Third, while the Marksman Partners Court found on its own initiative that the Reform Act allowed the second prong of the Time Warner standard, it was careful to incorporate the limitation on the use of that method set forth by Second Circuit case law: if the motive and opportunity prong does not apply, then the strength of the circumstantial evidence of conscious misbehavior or recklessness by the defendant must be correspondingly greater. Id. (citing Glickman v. Alexander & Alexander Services, Inc., 1996 WL 88570, *14 (S.D.N.Y. 1996) (citing Beck, 820 F.2d at 50). As shown above, see Section III(A), supra, the ultimate source of this part of the Time Warner standard cited in Marksman Partners--Beck--did not provide that scienter could be pleaded by mere allegations of recklessness. Following Marksman Partners, another district court judge in Friedberg v. Discreet Logic Inc., ___ F. Supp. ___, 1997 WL 109228 (D. Mass. Mar. 7, 1997), recognized that Beck had not cited recklessness as a means of pleading scienter, and declined to adopt the Time Warner standard. See Section IV(B)(2), infra.

Limitations of the Marksman Partners approach

Other courts have followed Marksman Partners' lead, without paying close attention to the restricted holding of that case. The limitations of this line of cases are two-fold. First, in two respects discussed in the remainder of this section, these cases have departed from the Second Circuit standard they purport to apply. Second, this line of cases cannot explain significant portions of the Reform Act's legislative history. That issue is discussed in the next section, in the course of analyzing cases that have applied pleading standards stricter than the Time Warner standard.

One manner in which the Marksman Partners cases have departed from pre-Reform Act Second Circuit law is in assigning undue weight to a defendant's relatively minor stock sales. Acito and San Leandro Emergency Medical Profit Sharing Plan had rejected as insufficient plaintiffs' attempts to plead scienter via motive and opportunity, even though in both cases, plaintiffs had pointed to a corporate officer who had sold stock near the end of the class period. Acito, 47 F.3d at 54; San Leandro Emergency Med. Profit Sharing Plan, 75 F.3d at 813-14. Marksman Partners, in contrast, found that the fact that the chief executive officer of the defendant company had sold 20% of her stock during the class period (and had not sold any stock in the three previous years) sufficed to plead scienter against the officer and her company. 927 F. Supp. at 1313. To be certain, courts that have purported to apply a pleading standard stricter than the Second Circuit have taken this same path. See Section IV(B), infra. It is more significant, however, that cases purporting to look only to Second Circuit law have not necessarily followed the precepts of that law.

In addition, none of the Marksman Partners line of cases considered the Second Circuit's actual practice in post-Time Warner cases with respect to the pleading of scienter via recklessness--probably because that question was not contested until Silicon Graphics. See Section IV(B), infra. Notwithstanding Time Warner's inclusion of the word "recklessness" in the second prong of the pleading standard, subsequent pre-Reform Act cases focused on whether a complaint pleaded a strong inference that the defendants actually knew that their statements were false when made-not on whether the defendants were merely reckless in issuing the statements. See Shields, 25 F.3d at 1129 (although plaintiff "strongly suggests that the defendants should have been more alert and more skeptical," complaint it did not plead a strong inference of fraudulent intent because "it did not adduce the kind of circumstantial evidence that would indicate conscious fraudulent behavior"); Acito, 47 F.3d at 53 (theory that company knew and should have disclosed that key manufacturing plant would fail FDA inspection did not plead scienter); San Leandro Emergency Med. Profit Sharing Plan, 75 F.3d at 812-13 (because the defendants' statements were not falsified by any specifically pleaded adverse information available to them at the time of the statements, plaintiffs had failed to allege facts supporting a strong inference of scienter). In other words, at the time the Reform Act was enacted, the Second Circuit, for all practical purposes, did not focus on the pleading of facts suggesting recklessness in ascertaining whether a complaint pleaded a strong inference of fraudulent intent. Again, it is significant that cases purporting to look only to Second Circuit law did not detect this nuance.

Cases Holding That The Reform Act's Pleading Standard Is Stronger Than the Second Circuit Standard

In the short history of the Reform Act, a second line of cases has emerged that has given force to Congress' stated intent to impose a pleading standard that is stricter than the Second Circuit Time Warner standard.

Silicon Graphics

The first case to hold that the Reform Act did not merely adopt the Second Circuit=s pleading standard but rather adopted a strengthened version of that standard, is Judge Fern Smith's decision in In re Silicon Graphics, Inc. Securities Litigation, [1996-97 Tr. Binder] Fed. Sec. L. Rep. (CCH) & 99,325, at 95,957 (N.D. Cal. Sept. 25, 1996) ("Silicon Graphics I").

The Court began its analysis with an extensive review of the Reform Act's legislative history. It found that the Conference Report reflected Congress' "inten[t] to strengthen existing pleading requirements" and to exclude from the Reform Act's pleading standard "'certain language relating to motive, opportunity, or recklessness.'" Id. at 95,962 (quoting Conf. Rep. at 41 & n.23). The Court also found significant Congress' override of President Clinton's veto, which had been premised upon the President's belief that Congress "inten[ded] to raise the [pleading] standard even beyond [the Second Circuit] level" Id. (quoting H.R. Doc. No. 104-150). Silicon Graphics I reasoned from this history that "Congress did not simply codify the Second Circuit standard . . . Congress intended to strengthen it." Id. at 95,961-2. Thus, the Court held that, in order to satisfy the Reform Act's pleading standard, a plaintiff must allege something more than motive, opportunity, or recklessness. Instead, a plaintiff must allege "specific facts that constitute circumstantial evidence of conscious behavior by defendants." Id.

Silicon Graphics I found that plaintiffs' complaint failed to satisfy this exacting standard. Although the Court found that plaintiffs had adequately pled the falsity of defendants' statements concerning Silicon Graphics' projected growth, it ruled that plaintiffs had failed to plead that those statements were made with the mental state required under Section 10(b) and Rule 10b-5. According to the Court, "[i]n establishing circumstantial evidence of conscious behavior or actual knowledge, as required by the [Reform Act], plaintiff must do more than speculate as to defendants' motives or make conclusory allegations of scienter; plaintiff must allege specific facts." Id. at 95,966. The Court found plaintiffs failed to do this. It rejected plaintiffs allegation that unspecified "negative internal reports" reflected defendants' knowledge of undisclosed material facts: ""Every sophisticated corporation uses some kind of internal reporting system reflecting earlier forecasts; allowing plaintiff to go forward with a case based on general allegations of 'negative internal reports' would expose all those companies to securities litigation whenever their stock prices dropped." Id.

Silicon Graphics I also held that plaintiffs' allegations concerning insider stock sales did not give rise to a strong inference of fraud. Plaintiffs alleged that nine Silicon Graphics directors and officers sold approximately 390,000 shares of Silicon Graphics stock for proceeds in excess of $14 million during the class period. Based upon documents that defendants had filed with the Securities and Exchange Commission, however, the Court found that the alleged sales constituted "only a small fraction of [defendants'] total [Silicon Graphics] holdings . . . [d]efendants collectively had available millions of options that could have been exercised and sold during the class period." Id. Thus, when considered in context, "defendants' actual sales were relatively small, and do not give rise to a strong inference of fraud." Id. at 95,967. Moreover, unlike the situation in Marksman Partners, defendants'stock sales were "generally consistent in amount with sales made in previous quarters, suggesting they were not motivated by an intent to defraud." Id. Because plaintiffs failed to satisfy the Reform Act's requirements for pleading scienter, the Court dismissed their Complaint with leave to amend.

Plaintiffs filed an amended complaint, and contended that it met Reform Act standards. In addition, the Securities and Exchange Commission urged Judge Smith to reconsider her statement that allegations of recklessness did not suffice to plead scienter. In In re Silicon Graphics, Inc. Securities Litigation, [Current Tr. Binder] Fed. Sec. L. Rep. (CCH) & 99,468, at 97,118 (N.D. Cal. May 22, 1997) ("Silicon Graphics II"), Judge Smith considered these contentions, and dismissed plaintiffs= Amended Complaint with prejudice.

Notwithstanding the SEC's contentions, Silicon Graphics II reaffirmed that the Reform Act strengthened existing pleading standards. The Court recognized the existence of "conflicting authority about what constitutes scienter for purposes of Section 10(b)," as explained in Section III(A), supra. Id. at 97,124. In view of this conflict, the Court held that footnote 23 of the Conference Committee Report, which references the deletion of the language relating to motive, opportunity, or recklessness, evidenced Congress' choice of the line of Second Circuit cases requiring something more than motive, opportunity, or recklessness to state a claim. Id. at 97,125. Thus, Silicon Graphics II held that the Reform Act adopted a "narrower first prong" of the Second Circuit standard: "plaintiff must create a strong inference of knowing or intentional misconduct." Id. at 97,126. To satisfy this standard, "plaintiff must do more than speculate as to defendants' motives or make conclusory allegations of scienter . . . ." Id. at 97,133 (citing Wexner, 902 F.2d at 172-73; Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978)). Nor may plaintiff allege that defendants made optimistic statements when they possessed Anegative internal reports,@ without specifically identifying the authors, recipients, dates, and contents of those reports. Id. (citing San Leandro Emergency Med. Plan, 75 F.3d at 812-13). Rather, in order to satisfy the Reform Act's standard, plaintiffs must plead specific facts that "create a strong inference of knowing or intentional misconduct," although "intentional misconduct" could include deliberate recklessness, as described in Hollinger v. Titan Capital Corp., 914 F.2d 1564 (9th Cir. 1990), and alluded to in Ernst & Ernst v. Hochfelder, 425 U.S. 185. Id. at 97,126.

Silicon Graphics II concluded that plaintiffs' Amended Complaint failed to plead specific facts giving rise to a strong inference of intentional misconduct. In the Amended Complaint, plaintiffs alleged that defendants knew their public statements concerning Silicon Graphics' prospects were false based upon internal documents such as a "Fiscal Year 1996 Plan/Budget," monthly "Flash" reports, and "Stop Ship" reports. Id. at 97,133 (internal quotation marks omitted). Although these allegations were "more elaborate" mthan those contained in plaintiffs' original Complaint, the Court found they were "too generic to create a strong inference of fraud under the [Reform Act]." Id. The court held that, in order to satisfy the Reform Act, plaintiffs "must provide more details about the alleged negative internal reports," including "the titles of the reports, when they were prepared, who prepared them, to whom they were directed, their content, and the sources from which plaintiffs obtained this information." Id.

For the reasons discussed in the Court's prior decision, Silicon Graphics II also held that plaintiffs' allegations concerning defendants' stock sales did not give rise to a strong inference of scienter. The Court rejected plaintiffs' evidentiary challenge to its consideration of SEC filings reflecting defendants' Silicon Graphics stock holdings in connection with a motion to dismiss. The Court held that "a district court may take judicial notice of the contents of relevant public disclosure documents required to be filed with the SEC as facts capable of accurate and ready determination by resort to sources whose accuracy cannot reasonably be questioned." Id. at 97,126 (quoting Kramer v. Time Warner, Inc., 937 F.2d 767, 774 (2d Cir. 1991)). Silicon Graphics II also held that defendants' SEC filings could be considered under the incorporation by reference doctrine. In the Amended Complaint, plaintiffs alleged that their allegations were based, in part, upon Aa review of [Silicon Graphics' ] SEC filings.@ Id. According to the Court, A[a]lthough plaintiffs do not cite to defendants' SEC forms in framing their insider trading allegations, the allegations can be derived only from those publicly-filed documents.@ Id. at 97,127. Finally, because plaintiffs had raised the stock sale issue and had submitted the declaration of an expert who expressly relied upon defendants' Forms 3s and 4s, plaintiffs had no basis for objecting to defendants' submission of those documents.

Finally, in holding that the Amended Complaint still failed to satisfy the Reform Act, the Court specifically addressed the Reform Act's requirements for pleading on the basis of information and belief; i.e., if a complaint is pled on information and belief, the plaintiff must "state with particularity all facts upon which that belief is formed." See Section III(B), infra The Court found that the Amended Complaint failed to satisfy this requirement. It rejected plaintiffs' contention that their Amended Complaint was not pled on information and belief. In rejecting this contention, the Court specifically cited the following paragraph contained in the Amended Complaint:

  1. Plaintiffs have alleged the foregoing based upon the investigation of their counsel, which included a review of [Silicon Graphics'] SEC filings, securities analysts reports and advisories about the Company, press releases issued by the Company, media reports about the Company and discussions with consultants, and believe that substantial evidentiary support will exist . . . after a reasonable opportunity for discovery.

Id. at 97,130. The Court held that this allegation did not sufficiently describe the basis of plaintiffs= belief that defendants had committed fraud.

The Court based this conclusion on the text of the Reform Act and on legislative history relating to the Act's information and belief pleading provision. In particular, it noted that Representative Bryant had protested the Reform Act's information and belief pleading requirement because "at the beginning of the case plaintiff would have to set forth with specificity all information . . . that forms the basis for the allegations of the plaintiff, meaning any whistle-blower within a securities firm involved would have to be uncovered in the pleadings in the very, very beginning" Id. (quoting 141 Cong. Rec. H2848 (Mar. 8, 1995)). Representative Dingell offered a similar interpretation of the information and belief pleading requirement, stating that a plaintiff "must literally, in [the] pleadings, include the names of confidential informants, employees, competitors, Government employees, members of the media, and others who have provided information leading to the filing of the case." Id. at 97,131 (quoting 141 Cong. Rec. H2849 (Mar. 8, 1995)). Because Congress rejected an amendment proposed by Representative Bryant that "would have permitted plaintiffs to plead simply facts that support their beliefs[,]" the Court concluded that plaintiffs were required to "plead the sort of information described by Reps. Bryant and Dingell to meet the requirements of the [Reform Act] as enacted." Id.

The Court refused to consider a declaration that plaintiffs' =counsel had submitted in camera that purportedly discussed the investigation that counsel conducted before filing the Amended Complaint. In so doing, the Court noted the general rule that "a district court may not consider any material beyond the pleadings in ruling on a Rule 12(b)(6) motion." Id. at 97,126 (quoting Hal Roach Studios, Inc. v. Richard Feiner & Co., Inc., 896 F.2d 1542, 1555 n.19 (9th Cir. 1990)). It also relied upon Ninth Circuit decisions, which "make[] clear that the Court should not tolerate such ex parte submissions, in the interest of justice." Id.

Merits of the Silicon Graphics Approach

Other courts have agreed with Silicon Graphics' holding that the Reform Act's pleading standard is stronger than the Second Circuit's motive, opportunity, or recklessness test, although not all of those courts have applied the standard in the manner advanced by Silicon Graphics. These courts have been wise to cite Silicon Graphics' holding, because the decisions in that case affirm a pleading standard that is most consistent with the Reform Act's legislative history.

Marksman Partners relied on Conference Committee and Senate Banking Committee comments to the effect that the Reform Act's pleading standard was based on Second Circuit law. As shown above, however, there is a line of Second Circuit cases that is consistent with Silicon Graphics, implementation of the strong inference of scienter standard. See Section III(A), supra. Thus, Silicon Graphics enunciated a pleading standard that is both supported by Second Circuit precedent, but is also stricter than the standard set forth in the rejected Specter Amendment.

Silicon Graphics, basis in Second Circuit law has been recognized by Friedberg v. Discreet Logic Inc., ___ F. Supp. ___, 1997 WL 109228 (D. Mass. Mar. 7, 1997). In that case, Judge Harrington, like Judge Smith in Silicon Graphics, concluded that Congress purposely did not include in the Reform Act's pleading standard "language derived from Second Circuit case law relating to motive, opportunity or recklessness." Id. at *8. As the Court continued, "[i]t is important to note, however, that in the Second Circuit there was available one additional approach to pleading a 'strong inference' of scienter. In addition to motive and opportunity or recklessness, a plaintiff could plead a 'strong inference' of scienter by alleging facts constituting circumstantial evidence of conscious behavior." Id. (quoting Beck, 820 F.2d at 50). "The 'conscious behavior' approach is more stringent because the plaintiff's allegations must be supported by 'strong' circumstantial evidence." Id. Thus, the Court supported the Silicon Graphics I pleading standard on the basis that it reflected Second Circuit law, while at the same time enunciated a stricter standard than certain Second Circuit cases.

Moreover, while not relying exclusively on Silicon Graphics, Judge Spencer Williams of the Northern District of California recognized the merits of that decision=s approach to Second Circuit precedent. In Zeid v. Kimberly, No. 96-20136 SW, slip op. (N.D. Cal. May 6, 1997), the Court found that the differences between the interpretations of the Reform Act in Silicon Graphics I and Marksman Partners reflected inherent difficulties in interpreting the Act's legislative history. Zeid, slip op. at 13. To resolve the issue, the Court held that "courts can and should modify, or, in some instances, reject, any case law that is inconsistent with the letter or spirit of the Reform Act," i.e., cases that do not recognize the need to plead specific facts giving rise to a strong inference of scienter. Id. at 14. Thus, Zeid, like Silicon Graphics, recognizes that district courts are not bound by Time Warner or any other case, if, in the judge's opinion, the case is not consistent with the Reform Act=s heightened pleading standards.

In contrast, Marksman Partners cannot explain the Reform Act's legislative history. If the Reform Act adopted Time Warner's motive, opportunity, or recklessness standard, it must be the case that everyone involved in the debate over that Act was wrong. The Conference Committee that wrote the final version of the Reform Act must have been mistaken when it stated that it based the Act's pleading standard on Second Circuit law, but deliberately rejected the Specter Amendment's relaxed interpretation of that standard in order to allow for even stricter standards. The Reform Act's proponents must have been wrong when they contended the same on the floor of Congress. President Clinton must have been wrong when he, too, reasoned that the Conference Committee had adopted a heightened pleading standard. And the Reform Act's opponents were wrong when they opined that the defeat of the Specter Amendment's looser standards hurt securities fraud plaintiffs.


Silicon Graphics' reasoned contribution to the debate over the Reform Act's pleading standards correctly allows us to view the Reform Act for what it is: an extraordinary statute. After years of false starts, Congress decided that the potential for (and reality of) abuse in a particular set of lawsuits required a legislative remedy. In particular, Congress recognized that existing pleading standards rendered it too easy to name companies and individuals as defendants, and allowed plaintiffs to automatically impose the high costs of discovery upon surviving the motion to dismiss. Significantly, Congress did not find that these abuses were not present in the Second Circuit; it was a nationwide problem that Congress sought to address.

The legislative history of the Reform Act is overwhelmingly clear that Congress believed that it could remedy these abuses only by adopting a pleading standard that was stricter than existing standards. As Silicon Graphics recognizes, Congress= view was correct. Securities plaintiffs must be required to plead all of the bases for their allegations if courts are to consider whether there is a reason for a lawsuit to proceed and the costs of discovery to be imposed. Those allegations must give rise to an inference of intentional misbehavior for the Reform Act to be consistent with Ernst & Ernst v. Hochfelder