‘Fraud Pleading Failures Can Lead to Lawyer Sanctions
New York Law Journal
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 Twombly and 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 “plausible.”
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 pre-complaint investigation.2
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 surfaced in 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 month (June).
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 the court.
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 was correct.
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.
Michael Hoenig is a member of Herzfeld & Rubin.
- Bell Atlantic v. Twombly, 550 U.S. 544 (2007); Ashcroft v. Iqbal, 556 U.S. 662 (2009).
- Baicker—McKee, Janssen, Corr, Federal Civil Rules Handbook, Rule 9(b), at p. 358 (West 2013).
- City of Livonia Employees’ Retirement System v. Boeing, 2013 U.S. App. Lexis 5975 (March 26, 2013) (citing numerous cases).
- 15 U.S.C. §78u—5(c)(1)(B).
- 15 U.S.C. §78u—4(b)(2)(A).
- City of Livonia, supra n. 3, LEXIS at *6—*8.
- City of Livonia, supra n. 3.
- Id., Lexis at *19—*21.
- Id., Lexis at *23—*24 (citing cases).
- 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, *25.