How Misinterpretation of an Important Federal Securities Fraud Statute Led to the Dismissal of the Case Against Former MCI WorldCom Executives
By BRIAN LEHMAN
|Thursday, Sep. 04, 2003|
Last week, Oklahoma's Attorney General made headlines by filing criminal charges against MCI WorldCom and six of its former high-ranking employees of the company. They are charged with criminal complaint accuses each of these defendants of committing securities fraud by understating WorldCom's expenses, overstating its income, and (to make the ledgers balance) debiting various accounts without any legitimate reason.
Several years ago, a similar civil securities fraud case, Goldstein v. MCI WorldCom, was brought against two of the defendants - former CEO Bernard Ebbers and former CFO Scott Sullivan. In that case, WorldCom investors claimed the defendants had understated the company's expenses to the tune of $500 million. Recently, the Fifth Circuit dismissed the complaint.
That civil complaint was 110 pages long. The current criminal indictment, by contrast, is brief - each count takes up less than a page. But there is little - if any - chance that the indictment will meet the same fate as the civil complaint, and be dismissed. And this is true even though the maximum criminal penalty is 10 years in prison for each violation, while the investors in the civil case only sought money damages.
Courts have repeatedly said that dismissing an indictment is a "drastic remedy" that should take place only as a "last resort" to save a defendant from incurable prejudice (such as prosecutorial misconduct). Thus, if the WorldCom criminal defendants are found not guilty, it will be because of the lack of evidence, not because of deficiencies in the indictment.
This stands in sharp contrast to a civil complaint filed more than two years ago against two of the same defendants - former Chief Executive Officer Bernard Ebbers and former Chief Financial Officer Scott Sullivan. In that case, investors in WorldCom sued Ebbers and Sullivan for understating the company's expenses by not writing off over $500 million of uncollectible accounts. The investors' two claims were set forth in a 110-page, 285-paragraph complaint. Less than two months ago, the Fifth Circuit found this complaint insufficient in Goldstein v. MCI WorldCom and dismissed the complaint.
It seems anomalous that civil securities fraud complaints should be subject to earlier dismissal than their far more threatening criminal counterparts. This anomaly rests on a misinterpretation of the law - and, in particular, of the Private Securities Litigation Reform Act (PSLRA). Based on this misinterpretation, courts wrongly require plaintiffs, in effect, to prove - rather than simply plead - their claim in their civil complaint.
If this misinterpretation were corrected, then civil securities fraud complaints might be almost as unlikely to be dismissed as criminal securities fraud indictments.
The PSLRA and Its "Strong Inference" Requirement
In 1995, on the cusp of Newt Gingrich's Republican revolution and the "Contract with America," Congress enacted the PSLRA, with the goal of ending certain abuses in securities litigation. Congress believed that far too often, plaintiffs' lawyers were filing claims of securities fraud - for example, accusations that the defendant failed to disclose an important piece of information - even if they did not have a good faith reason to believe that the companies and its officers had violated the law. The goal of these so-called strike suits was to force even innocent defendants to settle, rather than face the burden and cost of litigation.
To combat such frivolous lawsuits, Congress, in the PSLRA, placed a special pleading burden on claims of securities fraud. Under the PSLRA, Congress decided that, as always, plaintiffs would have to comply with the Federal Rules of Civil Procedure - but they would also have to do more.
Specifically, they would have to plead "facts giving rise to a strong inference" that the defendant either intentionally or recklessly committed the alleged fraud. And if a defendant argued that they had failed to do so, then the court would be required to automatically stay all discovery of evidence until the pleading issue was resolved - so that the defendants would not have to endure litigation based on a possibly deficient complaint.
Defining What a "Strong Inference" Means
What, exactly, is a "strong inference"? No clear consensus has emerged in the case law. But Congress's intent in passing this requirement is not difficult to discern.
The origins of the "strong inference" requirement are to be found in a 1979 decision by the U.S. Court of Appeals for the Second Circuit, Ross v. A.H. Robins Co. There, the Second Circuit imposed a requirement that plaintiffs "supply a factual basis for their conclusory allegations," by pleading facts or events that "give rise to a strong inference" that the defendants indeed committed the fraud.
With this requirement, the Second Circuit attempted to ensure that frivolous complaints would be dismissed. But it did not attempt to place the burden on plaintiffs of proving their case prior to discovery - after all, collecting proof is the very purpose of discovery. Nor did it invite judges to decide, at the pleading stage, whether it seemed likely that plaintiffs would ultimately prevail before a jury - for that is not the judicial role.
The proponents of the PSLRA had something very similar in mind. For example, when introducing the bill, Senator Pete Domenici said that it would help eliminate the "race to the courthouse" in which plaintiffs "filed frivolous suits without any research into their validity." Supporters of the bill also said that they sought to eliminate "poorly researched, kitchen sink complaints."
But like the Second Circuit, PSLRA sponsors had no intention of requiring proof before discovery - a classic example of putting the cart before the horse. To the contrary, they promised that "[p]laintiffs' lawyers should have no trouble meeting these standards if they have legitimate cases and have looked at the facts."
How Lower Federal Courts Have Misinterpreted the PSLRA
Over the years since the PSLRA was enacted, its "strong inference" requirement has been repeatedly misinterpreted - usually because courts do not look to its origins or the relevant legislative history.
Indeed, many courts don't even attempt to explain how high - or modest, or low - a threshold they believe the "strong inference" provision requires, and why they hold that belief. Instead, with no more than cursory discussion, courts tend to invoke the requirement, dismiss (or decline to dismiss) a complaint, and have done with it.
Of course, many complaints alleging securities fraud have nonetheless survived. Yet, in a substantial number of cases, courts have used the "strong inference" requirement as a basis for erroneous dismissals - interpreting the PSLRA to authorize them to judge the merits of the future evidence in a case, based on the allegations of the complaint alone.
Consider, for example, the Fifth Circuit's decision in MCI. There, the complaint did make allegations that gave rise to a "strong inference" of securities fraud. It claimed the CEO and CFO of MCI knew that the company failed to write off over $500 million in uncollectible accounts - a writeoff that, if disclosed, would have reduced the value of the company in the eyes of most investors. Moreover, the investors alleged that these officers failed to do this in order to facilitate a pending merger with Sprint, which naturally would have been interested in the true value of MCI.
If these facts were proved, they would plainly show fraud. So why did the appeals court uphold the dismissal of the complaint?
The court conceded that upon the facts alleged, the officers had a motive and opportunity to commit the fraud. But it found that the complaint was lacking "circumstantial evidence" that the defendants knew of, or recklessly disregarded the fact of, the uncollectible accounts. The complaint did not, for example, allege that the officers ever received a write-off request from anyone in the company.
Note, however, that this omission is not the plaintiffs' fault: Since the PSLRA prohibits plaintiffs from conducting any discovery until the complaint is evaluated, they could not have served a document request relating to writeoffs even if they had wanted to.
At the pleading stage, when no such document requests could be served or responded to, the sheer size of the writeoff - the equivalent of 62% of all of MCI's reserve funds - should have been circumstantial evidence enough. Asking plaintiffs to come up with state of mind evidence relating to motive and intent before discovery begins is illogical and unfair.
As the Supreme Court once explained in the context of an antitrust case, Poller v. Columbia Broadcasting System, Inc., "where motive and intent play leading roles, the proof is largely in the hands of the alleged conspirators, and hostile witnesses thicken the plot. It is only where witnesses are present and subject to cross-examination that their credibility and the weight to be given their testimony can be appraised."
Litigants, and the Supreme Court, Should Correct These PSLRA Interpretations
The MCI decision is not alone in misinterpreting the PSLRA. Earlier this summer, for example, a court threw out a complaint alleging that Merrill Lynch had committed securities fraud by failing to disclose conflicts among its analysts.
As in MCI, the pleading and proof stages were wrongly conflated. The judge in the Merrill Lynch case reasoned that that the investors had failed to demonstrate the alleged conflict was a substantial cause of any losses they may suffered. Yet, causation (like state of mind) is typically considered a question for the jury.
What can be done about this situation? The hope is that the Supreme Court will sooner or later grant review to resolve this issue - and in the meantime that other federal circuits will not follow the Fifth Circuit's misguided path.
In addition, when plaintiffs' attorneys brief this issue in an attempt to avoid this pitfall, they should include the legislative history. To do so will help make clear to the courts that Congress did not seek to force plaintiffs to do the impossible and produce evidence, prior to discovery, that can only be procured in discovery.
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