By Michael Hoenig - New York Law
Journal - April 8, 2013
The courts are tightening up
against the practice of filing complaints that are broad and
conclusory, shy of essential facts, and that read like a list of
generalized elements of a cause of action borrowed from a
treatise. The U.S. Supreme Court's rulings in
Iqbal1 demand that pleaders give their
adversaries fair notice of the claim and the grounds upon which
it rests. Advancing loads of labels, legal conclusions and
formulaic recitations once passed muster but no more. A fuller
factual presentation is required. Claims must be shown to be
When it comes to pleadings
alleging that a defendant committed fraud, for charges that can
stigmatize an adversary or damage one's reputation and that can
easily be fabricated, Federal Civil Procedure Rule 9(b) requires
that the pleader "must state with particularity the
circumstances constituting the fraud…." This rule allows an
informed and early response and deters filing of shaky lawsuits
hopeful of finding something blameworthy during discovery. The
courts expect pleaders of fraud to perform a greater
But how diligent, good and
accurate should the investigation be? Is it sufficient if the
lawyer hires an investigator who goes out and interviews sources
or witnesses, returns with notes of such conversations and
reports about it to the attorney? What if the investigator is
unclear about certain facts the lawyer deems critical to the
pleading of fraud? Can the pleading be filed and the lawyer hope
that additional facts will be gleaned later so the complaint can
be amended? Or should the "due diligence" precede the filing? In
a fraud case, must the lawyer interview the source to verify or
confirm what the investigator is suggesting? Regardless of
whether he must, should he?
What if the investigator
erred or the source later denies telling the investigator what
was claimed? Does the lawyer's failure to verify the source open
him up to sanctions? A U.S. Court of Appeals for the Seventh
Circuit ruling issued weeks ago in a securities fraud class
action suggests that in some cases lawyers who do not heed "red
flags" about pleading weaknesses which they later attribute to
their investigator's shortcomings can be subjected to Rule 11
sanctions. Because valuable lessons can be learned, even beyond
securities fraud cases, this column surveys the recent decision
in some detail.
Securities fraud class action
litigation often is a high-stakes venture for both claimants'
attorneys and the corporate defendants they accuse of violating
the Securities Exchange Act and Rule 10b-5 of the Securities and
Exchange Commission (SEC). The dollar exposure in such cases for
an allegedly untrue statement of a material fact or the omission
to state a fact that makes the statement misleading can be
astronomical. Such claims of fraud require proof of the
defendant's "scienter," i.e., that the person making the
statement either knew the statement was false or was reckless in
disregarding a substantial risk of its being false.
"Recklessness," in turn, has come to mean "an extreme departure
from the standards of ordinary care…to the extent that the
danger was either known to the defendant or so obvious that the
defendant must have been aware of it."3
Because any lawyer drafting a
complaint could easily suggest that a fraud was committed or
allege conclusorily that statements or omissions by a defendant
were deliberately or recklessly misleading, legal rules place a
heavy burden on the pleader to particularize with specificity
the material facts that support the charge. This is especially
true when the corporate statements being impugned were "forward
looking," that is, predictions or speculations made about the
future. Congress, in the Private Securities Litigation Reform
Act of 1995 (Reform Act), requires a plaintiff complaining about
futuristic statements to prove "actual knowledge" of defendant's
falsity, not merely reckless indifference to the danger that a
statement is false.4 Further, the complaint must
detail "facts giving rise to a strong inference that the
defendant acted with the required state of mind."5 A
mere inference is insufficient.
What is a "strong inference"?
The U.S. Supreme Court says it is one where "a reasonable
person" would deem the inference of scienter "cogent and at
least as compelling as any opposing inference one could draw
from the facts alleged." The pleader's recitation of facts must
render an inference of scienter "at least as likely as" any
plausible opposing inference.6
The Reform Act's heavy
pleading burden on plaintiffs induces their lawyers to seek out
confidential sources of information about the defendant, a
problematic task. Additionally, the Reform Act requires the
federal district judge to determine each party's compliance with
Federal Rule of Civil Procedure 11, a rule governing sanctions
for attorney misconduct, and to impose sanctions if at the end
of the case the judge finds that the rule has been violated. The
judge must assess such compliance even if neither party has
filed a Rule 11 motion.
Thus, the "high stakes"
nature of such litigation is reflected not only in the damages
sought, the attorney fees that might be recovered and the high
pleading burden to particularize facts showing culpable intent
or recklessness but, also, in the exposure of the attorneys to
sanctions should they misbehave. The latter quagmire is what
City of Livonia, a Seventh Circuit decision issued on
March 26.7 The lawsuit was brought on behalf of all
persons who bought common stock of the aircraft manufacturer
Boeing between May 4 and June 22, 2009.
Plaintiffs alleged that on
April 21, 2009, Boeing performed a stress test on wings of its
new 787-8 Dreamliner, a plane that had not yet flown. The wings
failed. Metal strips called "stringers" failed to perform
adequately. Yet on May 3 Boeing announced that all structural
tests prior to first flight "are complete." Initial test results
were said to be "positive" though Boeing also said the test data
had not yet been fully analyzed.
Plaintiffs alleged the
implication was that the plane was on track for its so-called
"First Flight" scheduled for June 30, an important milestone in
development of a new model, notwithstanding that much more
additional flight testing had to be done to assure the plane
could begin commercial operation. Despite a mid-May test failure
of modified "stringers," Boeing's chief executive officer (also
a defendant) stated publicly that he thought the plane would fly
in June. The head of Boeing's commercial aircraft division told
Bloomberg News that the Dreamliner "definitely will fly" this
The Paris Air Show began in
the middle of June. The Dreamliner did not fly in the show nor
was it expected to. But Boeing executives made presentations
there about the Dreamliner and its development schedule. On June
23, four days after the show ended, Boeing announced that the
First Flight had been canceled because of an "anomaly" revealed
by the "stringer" tests. An executive explained that the
manufacturer had hoped to solve the problem in time for a June
first flight but had been unable to do so. When Boeing announced
the cancelation, it also announced an unspecified delay in
delivery of ordered Dreamliners. Two days later, Boeing's stock
price dropped by more than 10 percent. In fact, the first flight
occurred in December 2009.
The district judge dismissed
the first amended complaint for failure to create a strong
inference that defendants acted with scienter. Among the hurdles
not overcome was the absence of facts indicating whether
defendant's executives knew that their optimism in public
statements about the First Flight's timing was unfounded.
Although plaintiffs cited "internal e-mails" as confirming the
executives' knowledge, no person was identified as a source and,
so, no "strong inference" of fraud was shown.
As the Seventh Circuit
stated, there is "no securities fraud by hindsight." Further,
the law does not require public disclosure of mere risks of
failure. No prediction has a 100 percent probability of being
correct. The future is shrouded in uncertainty. Thus, if a
mistaken prediction is deemed a fraud, there will be few
predictions, including ones that are well grounded, "as no one
wants to be hostage to an unknown future."
The dismissal of the first
amended complaint was without prejudice, however. Thus,
plaintiffs could file a second amended complaint, and they did.
Now they gave particulars about their confidential source, an
engineer later revealed to be Bishnujee Singh, described as a
"Boeing Senior Structural Analyst and Chief Engineer" who had
worked on the Dreamliner's wing-stress tests and who "had direct
access to, as well as first-hand knowledge" of the contents of
Boeing's stress test files including the failed results of April
and May. The new complaint referred to internal, contemporaneous
corporate communications to the defendant's executives that the
tests failed and might cause a delay in the first flight.
On the basis of these new
allegations the district judge denied the defendant's motion to
dismiss. The allegations purportedly were based on interview
notes by an investigator retained by plaintiffs' lawyers.
However, no one had shown the new complaint to the confidential
source, Singh. Boeing's investigation soon revealed that the
complaint's allegations about engineer Singh could not be
substantiated. Some clearly were false. He had never been
employed by Boeing but, rather, by a contractor. And, although
that contractor had been involved in wing tests for the
Dreamliner, Singh's role in or knowledge of those tests, or of
communications to the executives, was unknown. Defendants'
investigation showed that it was highly improbable that Singh
was involved in the tests or privy to internal communications
with Boeing's top officials.
Singh was deposed by
defendants. He "denied virtually everything the investigator had
reported." He denied that he was doing work for Boeing when the
tests were conducted. He denied that he had ever worked on the
model plane in question, the Dreamliner 787-8. He had worked on
a later model. He denied having access to or knowledge of
internal Boeing communications regarding the tests in question.
Further, the lead engineer for the team of which Singh was a
member, which worked on the later model plane, declared under
oath that Boeing had restricted access to Dreamliner test
results to those with a job-related need for the information,
which Singh did not have because he was not working on that
model. Even this team leader had no access.
On the basis of these
revelations, the district judge reconsidered her denial and
dismissed the complaint, this time with prejudice. The judge did
not try to determine if or when Singh was lying at his
deposition or otherwise, as plaintiffs had first argued, or that
he may have misunderstood or misrepresented what he had told the
investigator, an explanation the lawyers later advanced. Rather,
the judge noted that none of plaintiffs' lawyers had met or
talked to Singh until six months after they filed the second
amended complaint. The judge thought their failure to verify the
allegations in their investigator's notes amounted to a fraud on
Up to Singh's deposition,
plaintiffs' lawyers had vouched for the accuracy of their
investigator's report. Not afterwards, however. At the appellate
oral argument plaintiffs' counsel admitted that Singh would not
be a witness for the plaintiffs due to his recantation. In the
words of Judge Richard A. Posner, writing for the Seventh
Circuit panel, the "plaintiffs' abandonment of their sole
confidential source…was fatal."8 Further, the
district judge's later dismissal of the complaint with prejudice
This now left the appellate
panel to decide the defendant's cross-appeal which complained
about the district judge's failure to consider imposing Rule 11
sanctions on the plaintiffs' lawyers. Plaintiffs argued that,
since defendants never actually moved for sanctions (though they
told the judge they were going to do so), the circuit court
lacked appellate jurisdiction on the issue. This argument
failed, however, because of an unusual provision in the Reform
Act. This provides: "upon final adjudication of the action, the
court shall include in the record specific findings regarding
compliance by each party…with each requirement" of Rule 11, and
if a violation is found "the court shall impose sanctions" on a
party or lawyer who has violated the rule. The statute does not
require that the defendant must ask for imposition of sanctions.
When the district judge, despite harshly criticizing plaintiffs,
failed to determine whether to impose sanctions, this made the
final judgment an appealable order.
The plaintiffs' lawyers had
made "confident assurances" in their complaints about a
confidential source "even though none of the lawyers had spoken
to the source" and their investigator had acknowledged that she
couldn't verify what (according to her) Singh had told her.
Moreover, the investigator "had qualms"—the names the source had
given her of persons to whom he reported in the Boeing chain of
command were inconsistent with what she was able to learn about
the chain. "This should have been a red flag to the plaintiffs'
lawyers." Their failure to inquire further puts one in mind of
"ostrich tactics"—of failing to inquire for fear that the
inquiry might reveal stronger evidence of the lawyers' own
scienter regarding authenticity of the source than the flimsy
evidence of scienter they had marshaled against Boeing.
Representations in a filing
in a federal district court that are not grounded in an "inquiry
reasonable under the circumstances" or that are unlikely to
"have evidentiary support after a reasonable opportunity for
further investigation or discovery" violate Rules 11(b) and
11(b)(3). The appellate panel noted that the same law firm "was
criticized for misleading allegations concerning confidential
sources," made to stave off dismissal of yet another
securities-fraud case much like this one. And the same firm was
described in two other reported cases as having engaged in
"similar misconduct." Posner declared: "Recidivism is relevant
in assessing sanctions."9
The appellate court pondered
whether to impose Rule 11 sanctions or remand to the district
court to decide. The circuit court could do so in a clear case
but "remand generally is the preferable course." The district
court is in a better position to calculate the dollar amount of
the sanctions. It also may have additional insights into the
accused lawyers' conduct since it will have spent more time on
the litigation than the appellate court.10
Accordingly, the matter was remanded for consideration by the
district court whether to impose Rule 11 sanctions and, if so,
in what amount.
is a member of Herzfeld & Rubin.
1. Bell Atlantic v.
Twombly, 550 U.S. 544 (2007); Ashcroft v. Iqbal, 556
U.S. 662 (2009).
2. Baicker-McKee, Janssen,
Corr, Federal Civil Rules Handbook, Rule 9(b), at p. 358 (West
3. City of Livonia
Employees' Retirement System v. Boeing, 2013 U.S. App. Lexis
5975 (March 26, 2013) (citing numerous cases).
4. 15 U.S.C. §78u-5(c)(1)(B).
5. 15 U.S.C. §78u-4(b)(2)(A).
6. City of Livonia,
supra n. 3, LEXIS at *6-*8.
7. City of Livonia,
supra n. 3.
8. Id., Lexis at *19-*21.
9. Id., Lexis at *23-*24
10. In this case, however,
this was unlikely to be a factor since the district judge who
made the rulings at issue on the appeal later recused herself
and was replaced by another district judge. Id., Lexis at *4,
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