In a potentially ominous development for corporations, a handful of decisions by federal judges in New York have strayed from the traditional rule that a company can’t be found to have had fraudulent intent—known in the law as scienter—unless the individual making a false or misleading material statement actually had such an intent.
Under a new theory of “collective scienter,” fraudulent intent can be imputed to the corporation by aggregating the intent of employees who had nothing to do with a false corporate statement. At its most extreme, the knowledge of a janitor who came across a discarded document in the trash in a remote office could be the basis of finding that a corporation knew a statement was false.
The theory has been flatly rejected by two federal circuit courts: the 5th Circuit in New Orleans and the 9th Circuit in San Francisco. But the 6th Circuit in Cincinnati “seemed to apply the collective scienter theory” in a 2004 decision, notes Peter Huang, a securities law professor at Temple Law School, and now the issue is headed to the pivotal 2nd Circuit in New York.
“People are waiting to see what they decide,” Huang says. “It’s a very influential court; the 2nd and 9th Circuits are considered to be the leading circuits in this area.”
If the 2nd Circuit were to adopt some version of the collective scienter theory, that would create a split in the federal appellate courts that could ultimately prompt the U.S. Supreme Court to clarify the issue, says Michael Piazza, a partner with the law firm Dorsey & Whitney.
Piazza says that if the courts ultimately recognize collective scienter, “that would open the door to corporate liability on a scale that I don’t think anyone has really thought through.”
Defense Now A Weapon
Collective scienter had its roots in an insurance coverage dispute from California in the mid-1990s, says Paul Straus, a partner with the law firm King & Spalding. “One side was arguing that a corporation could be liable but not its directors and officers; it suggested that it might be possible for the corporation to have scienter based on the theory of accreting knowledge of all employees to the corporation.”
Companies “picked up on this as a defense,” Straus says, and argued that securities plaintiffs had failed to meet the scienter requirement because the individual who allegedly made the misleading statement had no fraudulent intent.
Most courts initially agreed with the defense view, he says. “Courts have essentially held that a corporation is deemed to have requisite scienter only if the individual corporate officer has the requisite level of scienter at the time he or she makes the statement in question.”
But plaintiffs “have been unhappy with this defense and have tried to turn the argument around to say that courts should consider all the information in the minds of all the employees of the corporation” when making the scienter analysis, Straus says.
Huang notes that two versions of the collective scienter theory actually exist. In the first, plaintiffs can establish that a company had fraudulent intent if a particular management-level employee had knowledge, even though that particular employee said nothing false.
The second, “stronger version,” Huang says, would allow plaintiffs to establish that a corporation had fraudulent intent without showing that any particular individual had knowledge that the statement was false.
Huang says this version of collective scienter “raises philosophical paradoxes,” and adds that the more limited version makes some sense. “If you can say to a corporation that you can escape liability even if the general counsel knows about something, that provides incentive for the CEO to say to the general counsel, ‘Don’t tell me anything.’”
New York Courts Cast Doubt
Despite the traditional hostility of courts toward the collective scienter theory, three decisions from federal judges in New York in the past two years have created anxiety that the tide may be turning.
In a 2005 ruling in the WorldCom securities litigation, a judge held that “to carry their burden of showing that a corporate defendant acted with scienter, plaintiffs in securities fraud cases need not prove that any one individual employee of a corporate defendant also acted with scienter. Proof of a corporation’s collective knowledge and intent is sufficient” by showing that the firm as a whole was reckless through the sum of its employees’ activities and knowledge.
Last February, the judge presiding in litigation against Dynex Capital ruled that a “plaintiff may … allege [collective] scienter on the part of a corporate defendant without pleading scienter against any particular employees of the corporation.” The Dynex case is now headed to the 2nd Circuit because, on June 2, the judge took the unusual step of certifying an appeal before trial to determine whether his view of the law was correct.
Most recently, on July 20, a judge in securities litigation involving the $12 billion professional services firm Marsh & McLennan said “the collective knowledge doctrine serves an important function in situations where widespread corporate fraud cannot be connected to individual defendants at the pleading stage.”
Joseph De Simone, a lawyer with the law firm Mayer, Brown, Rowe & Maw, says the courts that have provided impetus to the collective scienter theory are out of step.
“I would characterize the few maverick district court decisions which seem to endorse this long-discredited theory as living examples of the old adage ‘bad facts make bad law,’” De Simone says. “These cases [are] out of the mainstream decisions in which the courts, in light of the high profile series of corporate scandals … have swung the pendulum too far in favor of plaintiffs.”
What To Do?
In light of the uncertainty about the validity of collective scienter, Straus says it makes sense for companies, “in an abundance of caution, to learn as much as they can about what is in the minds of senior management.”
Although the collective scienter theory “doesn’t focus exclusively on senior management,” Straus says, “that seems to be where the cases fall out.”
Another category of employees to monitor, Straus says, are those “who have particularly relevant knowledge—for example, if a company is making an announcement about the capabilities of a new product, it would be prudent for the company to know what the engineers who have worked on the product think about the information that the company is conveying.”
Piazza says precautionary actions that companies can take to protect against the possible application of a collective scienter theory are limited. “We’re talking about multiple people with different knowledge and different intent, and I don’t know how you guard against a wide open theory of collective corporate scienter,” he says. “Other than tightening on the internal controls already in place, I’m not sure what else you can do beyond that.”
And Noel Hensley, a partner with the law firm Haynes and Boone, notes that “one of the things that is really complicating matters” is the fact that the New York judges applying collective scienter “are not speaking with the one voice.”
Some judges “are looking to find motive for the corporation based on the scienter of somebody—not the person making the statement, but at least somebody,” she notes. “Other judges are allowing cases to go forward based on no individual showing [of knowledge]—based simply on allegations that the corporation acted through some sort of pattern or in a regular or systematic way. That makes it pretty difficult to advise a corporation.”