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No. 19-132
————————————————————————— In The Supreme Court Of The United States
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RED RIVER; JAMES WILSON,
Petitioners,
v.
TEACHER RETIREMENT SYSTEM OF FORDHAM; FORDHAM MUNICIPAL RETIREMENT FUND,
Respondents.
—————————————————————————
ON WRIT OF CERTIORARI TO THE FOURTEENTH CIRCUIT
—————————————————————————
BRIEF FOR PETITIONERS
—————————————————————————
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Counsel for Petitioner
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TABLE OF CONTENTS TABLE OF CONTENTS ..................................................................................... i TABLE OF AUTHORITIES ............................................................................... iii QUESTIONS PRESENTED ............................................................................. vii STATEMENT OF THE CASE ............................................................................ 1
SUMMARY OF ARGUMENT ............................................................................. 4
ARGUMENT .................................................................................................... 5
I. Red River and Wilson’s Statements and Omissions are Inactionable
under § 10(b) of the Securities Exchange Act because they are neither material nor plead with adequate scienter. ............................................. 5
A. The Statutory and Regulatory Text .................................................... 5
B. Statements Which Are Immaterial Cannot Serve as a Basis for a
§ 10(b) or Rule 10b-5 Claim. .............................................................. 7
C. The Decision Below is Inconsistent with § 10(b) Because Red River
and Wilson’s Statements were not “Material” and a Reasonable Investor Would Not Consider Them to Be. ....................................... 10
D. The Court Below Disregarded Established Categories of Statements
Which Are Inactionable As a Matter of Law Under § 10(b) and Rule 10b-5. ............................................................................................. 11
1. Mere Puffery ................................................................................. 13
2. Corporate Mismanagement ........................................................... 15
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II. Even If Red River’s Statements Were Material and Actionable, TRSF and FMRF Did Not Plead Adequate Scienter Under the Private Securities Litigation Reform Act. .......................................................................... 17
A. Statements from the March 1, 2018 10-K. ....................................... 19
B. Statement from the June 1, 2018 10-Q. .......................................... 20
C. Wilson’s statement on May 15, 2018. .............................................. 20
III. TRSF and FMRF Failed to Allege Wilson was a Culpable Participant Who
is Subject to Control Person Liability. ................................................... 21
A. Requiring Culpable Participation for Control Person Liability is
Consistent with the Language of the 1934 Act. ................................ 22
B. Requiring Culpable Participation is Consistent § 20(a)’s Legislative
History and the Intent of Congress. ................................................. 24
C. Under the PSLRA, the Plaintiffs were Required to State Facts
Demonstrating the Defendant’s Culpable Participation Beyond that of Negligence. ...................................................................................... 26
1. The PSLRA’s Heightened Pleading Standards Apply to § 20(a)
Claims. ........................................................................................ 27
2. TRSF and FMRF were Required to Establish with Particularity that
Wilson Acted Culpably Beyond Mere Negligence. .......................... 28
CONCLUSION ............................................................................................... 30
APPENDIX ..................................................................................................... 1a
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TABLE OF AUTHORITIES Page(s)
Cases ATSI Comm., Inc. v. Shaar Fund, Ltd.,
493 F.3d 87 (2d Cir. 2007) .......................................................................... 20 Basic v. Levinson,
485 U.S. 224 (1988) ...................................................................................... 9 Blue Chip Stamps v. Manor Drug Stores,
421 U.S. 723 (1975) ...................................................................................... 7 Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,
511 U.S. 164 (1994) .................................................................................. 7, 8 Chiarella v. U.S.,
445 U.S. 222, (1980) ................................................................................... 16 City of Monroe Emp. Ret. Sys. v. Bridgestone Corp.,
399 F.3d 651 (6th Cir. 2005) ................................................................. 14, 15 City of Omaha, Neb. Civilian Emps.’ Ret. Sys. v. CBS Corp.,
679 F.3d 64 (2d Cir. 2012) .................................................................... 10, 11 City of Westland Police and Fire Ret. Sys. v. MetLife, Inc.,
129 F. Supp. 3d 48 (S.D.N.Y. 2015) ....................................................... 12, 13 De Vito v. Liquid Holdings Grp., Inc.,
2018 WL 6891832 (D.N.J. Dec. 31, 2018) .................................................... 17 ECA, Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase Co.,
553 F.3d 187 (2d Cir. 2009) .................................................................. 13, 14 Emergent Capital Mgmt. Grp., LLC v. Stonepath Grp., Inc.,
343 F.3d 189 (2d Cir. 2003) .......................................................................... 9 Erica P. John Fund, Inc. v. Halliburton Co.,
563 U.S. 804 (2011) ...................................................................................... 6 Ernst & Ernst v. Hochfelder,
425 U.S. 185 (1976) ............................................................................. Passim Field v. Trump,
850 F.2d 938 (2d. Cir. 1988) ....................................................................... 12
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GAF Corp. v. Heyman, 724 F.2d 727 (2d Cir.1983) ......................................................................... 16
Hanon v. Dataproducts Corp.,
976 F.2d 497 (9th Cir. 1992) ......................................................................... 9 Hilson Partners, Ltd. Partnership v. Adage, Inc.,
42 F.3d 204 (4th Cir. 1994) ........................................................................... 9 Hollinger v. Titan Corp.,
914 F.2d 1564 (9th Cir. 1990) ............................................................... 22, 24 In re Banco Bradesco S.A. Sec. Litig.,
277 F. Supp. 3d 600 (S.D.N.Y. 2017) ........................................................... 13 In re BP p.l.c. Sec. Litig.,
843 F. Supp. 2d 712 (S.D. Tex. 2012) .................................................... 13, 14 In re Citigroup, Inc. Sec. Litig.,
330 F. Supp. 2d 367 (S.D.N.Y. 2004) ..................................................... 15, 16 In re Dynengy, Inc. Sec. Litig.,
339 F. Supp. 2d 804 (S.D. Texas 2008) ......................................................... 8 In re Livent, Inc.,
151 F. Supp. 2d 371 (S.D.N.Y 2001) ................................................ 21, 22, 26 Kohn v. Am. Metal Climax, Inc.,
458 F.2d 255 (3d Cir. 1972) ........................................................................ 23 Lanza v. Drexel & Co.,
479 F.2d 1277 (2d Cir. 1973) ...................................................................... 21 Lapin v. Goldman Sachs Grp., Inc.,
506 F. Supp. 2d 221 (S.D.N.Y. 2006) ..................................................... 26, 27 Lorenz v. CSX Corp.,
1 F.3d 1406 (3d Cir. 1993) .......................................................................... 16 Matrixx Initiatives, Inc., v. Siracusano,
563 U.S. 27 (2011) ................................................................................ 17, 18 Mishkin v. Ageloff,
1998 WL 651065 (S.D.N.Y. Sept. 23, 1998) .................................................. 22 Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund,
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___ U.S. ___, 135 S. Ct. 1318 (2015) ...................................................... 12, 13 Parnes v. Gateway 2000, Inc.,
122 F.3d 539 (8th Cir. 1997) ......................................................................... 9 Raab v. Gen. Physics Corp.,
4 F.3d 286 (4th Cir. 1993) ............................................................................. 9 Rochez Bros., Inc. v. Rhoades,
527 F.2d 880 (3d Cir. 1975) ...................................................... 21, 22, 23, 25 Santa Fe Indus., Inc. v. Green,
430 U.S. 462 (1977) .............................................................................. 12, 15 SEC v. First Jersey Sec., Inc.,
101 F.3d 1450 (2d Cir. 1996) ...................................................................... 21 SEC v. Mgmt. Dynamics, Inc.,
515 F.2d 801 (2d Cir. 1975) ........................................................................ 23 Shushany v. Allwaste, Inc.,
992 F.2d 517 (5th Cir.1993) ........................................................................ 13 Sinay v. Lamson & Sessions Co.,
948 F.2d 1037 (6th Cir. 1991) ..................................................................... 19 Superintendent of Ins. of State of N.Y. v. Bankers Life & Cas. Co.,
404 U.S. 6 (1971) ........................................................................................ 15 Tellabs, Inc. v. Makor Issues & Rights, Ltd.,
551 U.S. 308 (2007) ........................................................................ 17, 18, 19 TSC Indus., Inc. v. Northway, Inc.,
426 U.S. 438 (1976) ...................................................................................... 9 Tuchman v. DSC Communications Corp.,
14 F.3d 1061 (5th Cir. 1994) ......................................................................... 8 U.S. v. O'Hagan,
521 U.S. 642 (1997) ...................................................................................... 8 United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Associates, Ltd.,
484 U.S. 365 (1988) .................................................................................... 22 Wielgos v. Commonwealth Edison, Co.,
892 F.2d 509 (7th Cir. 1989) ............................................................. 9, 10, 11
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Statutes 15 U.S.C. § 77k (2018) .................................................................................. 10 15 U.S.C. § 78t(a) (2018) ............................................................................... 20 15 U.S.C. § 78u-4(b)(2) (2018) ........................................................... 17, 24, 25 15 U.S.C. §§ 78j, 78j(b) (2018) ......................................................................... 8 Rules Fed. R. Civ. P. 12(b)(6) ..................................................................................... 3 Fed. R. Civ. P. 9(b) ........................................................................................... 7 Regulations 17 C.F.R. § 240.10b-5(a) (2018) ....................................................................... 8 Other Authorities H.R. Rep. No. 104-369, at 31 ......................................................................... 24
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QUESTIONS PRESENTED 1. Under 15 U.S.C. § 78j(b), does a § 10(b) claim challenging a company’s
statements about environmental practices and risks fail as a matter of law
when the statements are not “material,” are mere puffery, or are claims of
corporate mismanagement. Similarly, does the same § 10(b) claim fail as a
matter of law when the complaint does not prove adequate scienter.
2. Under 15 U.S.C. §78t(a), does a valid § 20(a) claim for control person
liability require a claimant to allege a defendant’s culpable participation in
connection with the underlying violation, in addition to a primary violation and
control of the alleged primary violator.
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STATEMENT OF THE CASE Petitioners Red River and James Wilson (“Wilson”) seek to prevent
Respondents Teachers Retirement System of Fordham (“TRSF”) and Fordham
Municipal Retirement Fund (“FMRF”) from using the federal securities laws to
recover investment losses. The Fourteenth Circuit, in interpreting § 10(b) of the
Exchange Act, held a number of Red River and Wilson’s statements or
omissions were materially misleading, did not fail as a matter of law, and TRSF
and FMRF alleged sufficient scienter to withstand a Fed. R. Civ. P. 12(b)(6)
motion to dismiss. The Fourteenth Circuit also held culpable participation was
not required for TRSF and FMRF’s § 20(a) claim.
Red River is an oil and natural gas company, and James Wilson is its
founder, CEO and Chairman of the Board. R. at 3. In 1985, Red River decided
to go public. Id. at 2–3. Through underwritten offers, Wilson divested himself of
eighty-five percent of his company, registered with the SEC and the New York
Stock Exchange, and began issuing common stock. Id. at 3.
Soon after, Red River hired Pamela Thompson as its Chief Operating and
Environmental Officer and Sandra Grimes as its Senior Vice President and
General Counsel. Id. Both Thompson and Grimes have substantial experience
in the oil and gas industry and are familiar with the onerous requirements on
publicly traded companies. Id. In the late 1990s, Wilson learned about a new
oil and gas extraction process, colloquially referred to as “fracking.” Id. at 3–4.
The process uses vertical wells to pump material into rock formations to reach
shale, crack oil and gas from the shale, and capture the newly-freed oil and
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gas. Id. at 4. In some instances, the rock shale is primed by traditional blasting
methods. Id. Red River and Wilson decided to implement this new technology,
and by 2000, Red River was operating its first fracking well. Id. By 2018, Red
River’s market capitalization was over one hundred billion dollars. Id.
Thompson and Grimes continued to reiterate the need for compliance with SEC
reporting requirements, maintaining appropriate tone in disclosure documents,
and providing sufficient information to the market. Id. Red River and Wilson
continued to ensure compliance with SEC reporting requirements. Id. at 4, 5.
In late 2017, Red River received phone calls informing them of low-level
seismic activity in the Eagle Ford Shale, where Red River was among those
operating. Id. at 5. Red River’s Environmental Compliance Team reviewed the
reports and determined they did not warrant disclosure. Id. Wilson also
discussed the reports with Thompson and Grimes in December 2017, and
again determined the reports did not warrant disclosure. Id. Wilson also
engaged in conversations with Red River engineers about its wastewater
storage facility. Id. While the storage facility was structurally sound and not at
capacity, engineers told Wilson it came close to reaching capacity on a number
of occasions. Id. Wilson determined the storage facility was adequate, but if Red
River expanded drilling, they would expand wastewater storage facility too. Id.
Following a conference on February 2, 2018, Wilson encouraged
Thompson and Grimes to underscore Red River’s commitment to
environmental compliance, its expenditures in that effort, and the steps the
company takes to prevent and solve environmental challenges. Id. at 6.
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On March 1, 2018, Red River issued its Annual Report and Form 10-K (“March
10-K”), containing a number of statements about the company’s environmental
practices. See R. at 6; R. at 36, app.A (stmts. 1–5). The statements included
information on Red River’s priorities and commitments, environmental
protection, damage prevention and remediation, and technological investment.
See id. Red River also reiterated its drilling practices posed risks akin to
traditional drilling techniques. See id. at stmt. 5.
In May 2018, Red River received two third-party calls reporting low-level
seismic activity in the Eagle Ford Shale; Thompson was also aware of similar
anecdotal events in South Dakota. Id. at 7. After consideration, Wilson,
Thompson, and Grimes decided against a market-roiling disclosure and to
investigate the activity during its July environmental review. Id. On May 15,
Wilson hosted a number of institutional investors to whom he expressed his
personal opinions about the West Texas Oil Patch’s environmental stability. Id.
On June 1, Red River filed its Form 10-Q (“June 10-Q”), which listed a number
of risk factors, including language about the impact a future natural disaster
or terrorist attack could have on Red River’s operations. Id. at 7–8.
On June 3, with Red River’s March 10-K and June 10-Q impounded into
the market, TRSF and FMRF purchased $27 and $31 million worth of Red
River shares on the open market, respectively. Id. at 8. On June 10 a mid-level
seismic event destroyed Red River’s wastewater storage facility in the Eagle
Ford Shale. Id. at 8. Trading throughout the day resulted in Red River shares
losing a quarter of their value by the time the markets closed. See R. at 8.
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After investigation, it could not be determined whether Red River was
proximately responsible for the seismic activity in the region. Id. The report
determined fracking was the proximate cause of the wastewater leak and Red
River’s wastewater storage facility was beyond recommended capacity at the
time. Id. Red River’s independent geologist’s investigation reached the same
conclusions. Id. TRSF and FMRF filed this action after these events occurred.
SUMMARY OF ARGUMENT However attractive the securities laws may appear as a vehicle to recover
for investment losses, they were not designed to provide a ready-made remedy
for investors who incur losses. The high pleading standard for a private
securities fraud claim based on § 10(b) validate this view. A claim must
demonstrate: a material misrepresentation or omission; plead with adequate
scienter; a connection between the misstatement or omission and the purchase
of the security; reliance by the plaintiff on the misrepresentation or omission;
economic loss; and loss causation. See Erica P. John Fund, Inc. v. Halliburton
Co., 563 U.S. 804, 809–10 (2011).
If a statement is not material, it cannot be the basis for a § 10 claim.
What is material is determined by a reasonableness standard, a standard
which accounts for the sophisticated nature of modern securities markets.
Further, courts have routinely excluded statements of mere puffery and
corporate mismanagement as inactionable as a matter of law. Red River and
Wilson’s statements are not material, nor are they actionable as a matter of
law. Even if statements are material and actionable, they must be plead with
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adequate scienter under the Private Securities Litigation Reform Act (“PSLRA”).
In an effort to deter vexatious litigation and easy pleadings for plaintiffs, the
Act requires even more than pleading fraud under Federal Rule of Civil
Procedure 9(b). This is a high burden, one which TRSF and FMRF cannot meet.
When Congress enacted § 20(a), it sought to expand liability under
securities law. It did not, however, seek to extend liability to a controlling
person who was not a culpable participant in an underlying violation. Here, the
Fourteenth Circuit held TRSF and FMRF adequately pled Red River acted with
severe recklessness in an underlying violation without requiring TRSF and
FMRF to show Wilson acted with similar culpability as a controlling person.
However, § 20(a) liability without a controlling person’s culpable participation
contradicts both the overall language and legislative history of the Exchange
Act, as § 20(a) liability is limited by a state-of-mind condition. Moreover,
because the PSLRA establishes a heightened pleading standard, TRSF and
FMRF must establish particularized facts of Wilson’s conscious misbehavior or
recklessness. Accordingly, TRSF and FMRF failed to adequately plead a valid §
20(a) claim.
ARGUMENT I. RED RIVER AND WILSON’S STATEMENTS AND OMISSIONS ARE INACTIONABLE
UNDER § 10(B) OF THE SECURITIES EXCHANGE ACT BECAUSE THEY ARE NEITHER MATERIAL NOR PLEAD WITH ADEQUATE SCIENTER. A. The Statutory and Regulatory Text
For any question about the construction of a statute, the starting point is
necessarily “the language itself.” Ernst & Ernst v. Hochfelder, 425 U.S. 185, 197
(1976) (quoting Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 756
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(1975) (Powell, J., concurring)). This is especially true when interpreting
§ 10(b). See Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A.,
511 U.S. 164, 174 (1994) (“[S]tatutory duties, especially in cases interpreting §
10(b), establishes that the statutory text controls the definition of conduct
covered by § 10(b).”).
The statutory and regulatory framework of federal securities law
prohibits a variety of conduct regarding the sale of securities, including
prohibitions on fraudulent misstatements and omissions. While encompassing
a variety of fraudulent conduct, § 10(b) and Rule 10b-5 specifically and directly
address fraudulent misstatements and omissions.
Section 10(b) makes it unlawful for someone “to use or employ, in
connection with the purchase or sale of any security . . . any manipulative or
deceptive device or contrivance in contravention of” SEC rules. 15 U.S.C.
§§ 78j, 78j(b) (2018). The SEC exercises its authority under § 10(b) through
Rule 10b-5. For a misstatement to be actionable under the Rule, it must first
be actionable under the statute. U.S. v. O'Hagan, 521 U.S. 642, 651 (1997)
(citing Hochfelder, 425 U.S. at 214, and Cent. Bank, 511 U.S. at 173). “Acts
that are not themselves manipulative or deceptive within the meaning of the
statute,” cannot give rise to liability under the statute or the rule. Cent. Bank,
511 U.S. at 177–78.
Rule 10b-5(a) prohibits “employ[ing] any device, scheme, or artifice to
defraud” a purchaser of securities. 17 C.F.R. § 240.10b-5(a) (2018). Subpart (c)
prohibits “engag[ing] in any act, practice, or course of business which operates
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or would operate as a fraud . . . in connection with the purchase or sale of any
security.” Id. at § 240.10b-5(c). Together, they constitute what is commonly
referred to as “scheme liability.”
Subpart (b) of the rule, on the other hand, prohibits making “any untrue
statement of a material fact” or omitting “a material fact necessary” to make the
statement or omission, “in the light of the circumstances under which they
were made, not misleading.” Id. at § 240.10b-5(b). “A misstatement is not
actionable unless it is material.” In re Dynengy, Inc. Sec. Litig., 339 F. Supp. 2d
804, 882 (S.D. Texas 2008) (citing Tuchman v. DSC Communications Corp., 14
F.3d 1061, 1067 (5th Cir. 1994)).
At the pleading stage, there are certain types of statements which cannot
provide the basis for § 10(b) and 10b-5 liability. Allegations cannot be premised
on any misstatement or omission, they must be premised in material
misstatements or omissions.
B. Statements Which Are Immaterial Cannot Serve as a Basis for a § 10(b) or Rule 10b-5 Claim.
A misrepresentation or omission, to be material must “significantly alter[]
the ‘total mix’ of information made available” when “viewed by the reasonable
investor.” Basic v. Levinson, 485 U.S. 224, 231–32 (1988) (emphasis added).
The reasonable investor standard is objective; it varies depending on the nature
of, and who trades in the market. See TSC Indus., Inc. v. Northway, Inc., 426
U.S. 438, 445 (1976); Emergent Capital Mgmt. Grp., LLC v. Stonepath Grp., Inc.,
343 F.3d 189, 196 (2d Cir. 2003) (plaintiffs could not sustain a § 10(b) claim
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based on misrepresentations because the “plaintiff was a sophisticated
investor” and could have “readily evaluate[d] the risks of the transaction.”).
The materiality requirement does not attribute “a childlike simplicity” to
investors in the securities markets; materiality is what a reasonable investor
determines to be significant at the time of investment. Basic, at 232–34. There
is “no duty to advise investors of what was already commonly known.” Raab v.
Gen. Physics Corp., 4 F.3d 286, 291 (4th Cir. 1993) (company had no duty to
inform investors the end of the Cold War may impact its weapons production
business). See also Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547–48 (8th
Cir. 1997) (misstating assets by $6.8 million was immaterial to the reasonable
investor); Hilson Partners, Ltd. P’ship v. Adage, Inc., 42 F.3d 204 (4th Cir. 1994)
(a reasonable investor knows capital improvement projects may run into
unforeseen expenses); Hanon v. Dataproducts Corp., 976 F.2d 497, 505 (9th
Cir. 1992) (company had no duty to disclose the airline industry had not
implemented technology required to make its product useful); Wielgos v.
Commonwealth Edison, Co., 892 F.2d 509, 515 (7th Cir. 1989) (no duty to
disclose regulatory conditions regarding permits for nuclear power reactors).
Weilgos, an individual investor, purchased securities through a shelf
offering by Commonwealth Edison (“ComEd”), an electric company involved in
building nuclear power plants. Id. at 510. ComEd’s registration documents
included statements about operating costs and projections for nuclear power
plants currently under construction, despite lacking operating permits. Id.
ComEd was denied the requisite permits, resulting in $200 billion in losses and
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a substantial decline in stock price. Id. at 510–11. Weilgos suffered an
investment loss and filed a class action on behalf of investors who participated
in the shelf offering. Id. at 511. The basis of the complaint were ComEd’s
assumptions, statements, and omissions regarding the cost of the nuclear
reactors, based on § 11’s antifraud provisions. Id. at 511–12 (§ 11 antifraud
provisions are substantially similar to § 10(b). They preclude making untrue
statements “of a material fact,” making “false or misleading” statements “with
respect to any material fact,” or omitting a material fact. Weilgos, at 513; 15
U.S.C. § 77k (2018)). See also City of Omaha, Neb. Civilian Emps.’ Ret. Sys. v.
CBS Corp., 679 F.3d 64, 67–68 (2d Cir. 2012) (Section 11 and § 10(b) “share a
material misstatement or omission element.” (citation omitted)). Weilgos
contended ComEd’s cost estimates were unfairly biased and the company failed
to disclose the amount needed to complete the reactors. Weilgos, at 512, 515.
In affirming the lower court’s decision in favor of ComEd, Judge
Easterbrook explained the market knew of ComEd’s assumptions and
“discounted them accordingly.” Id. at 515. The “professional analysts knew—
although perhaps Weilgos did not—that [ComEd’s] estimates were biased . . . .”
Id. ComEd’s business, nuclear power generation, had inherent “hazards of its
business” “apparent to all serious observers and most casual ones” because in
the nuclear energy sector, “something always goes wrong” and “the unexpected
is the norm.” Id.
ComEd was not required to disclose “Murphy’s Law or the Peter
Principle, even though these have substantial effects on business.” Weilgos at
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515. Neither should Red River be required to do so.The reasonable investor
uses disclosure documents, relies on the market price, and trusts the collective
wisdom of sophisticated investors. Like Weilgos, TRSF and FMRF failed to
appreciate the information available in the market when they invested in Red
River.
C. The Decision Below is Inconsistent with § 10(b) Because Red River and Wilson’s Statements were not “Material” and a Reasonable Investor Would Not Consider Them to Be.
Red River’s statements in disclosure documents are not material for
purposes of § 10(b), no liability attaches to them, and they cannot form the
basis of TRSF and FMRF’s § 10(b) complaint. The risks, including the
environmental risks, associated with fracking are “apparent to all serious
observers and most casual ones.” Weilgos, 892 F.2d at 515. Any statement
regarding environmental risk is impounded into the market, understood by the
reasonable investor, and does not substantially change the total mix of
information available.
Red River, a publicly traded company, is subject to a variety of reporting
requirements. See R. at 1–2. Red River’s primary revenue-producing activity
since the early 2000s has been fracking. See R. at 3–4. Red River’s March 10-K
discussed drilling activity, drilling technology, and environmental damage
prevention and remediation. See R. at 36, app.A. Its June 10-Q warned a
natural disaster or terrorist attack could potentially disrupt drilling and
extraction. Id.
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Drilling, like nuclear power generation, is an inherently risky endeavor,
no matter the method by which it is conducted. See R. at 36, app.A. (“Fracking
involves no serious environmental issues not associated with conventional
drilling.”) (emphasis added). The hazards of the drilling business include
environmental risks, which have the potential to cause loss exposure to any
drilling company. Red River acknowledged this risk. R. at 36, app.A. (“Our
operations could be subject to disruption by natural disasters . . . .”). In the oil
industry, the unexpected is the norm, and the norm is impounded into the
market.
The reasonable investor understands and appreciates these facts about
fracking and discounts company statements accordingly. Any casual
discussion of environmental risk and remediation does not substantially alter
the total mix of what investors understand about Red River; its statements
cannot be considered “material” under § 10(b). If the Court determines
otherwise, Red River’s statements are inactionable as a matter of law under
long-recognized exceptions to § 10(b) liability.
D. The Court Below Disregarded Established Categories of Statements Which Are Inactionable As a Matter of Law Under § 10(b) and Rule 10b-5.
There is no cause of action under § 10(b) when “shareholders [are]
treated unfairly by a fiduciary.” See Santa Fe Indus., Inc. v. Green, 430 U.S.
462, 477 (1977). A breach of fiduciary duty absent “deception,
misrepresentation, or nondisclosure,” does not violate § 10(b). Id. at 476
(emphasis added). Deception comes in two flavors: either an affirmative
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misrepresentation or nondisclosure. See Field v. Trump, 850 F.2d 938, 947 (2d.
Cir. 1988). The courts have recognized a number of misrepresentations which
are inactionable as a matter of law for purposes of securities litigation.
Rule 10b-5(b) places onerous requirements on plaintiffs attempting to
use the opinions and beliefs of corporate officers to substantiate securities
fraud claims. The Rule differentiates between statements of fact, statements of
opinion or belief, and omission of necessary information. See City of Westland
Police and Fire Ret. Sys. v. MetLife, Inc., 129 F. Supp. 3d 48, 68–70 (S.D.N.Y.
2015). For liability to attach to statements of fact, a plaintiff must merely show
“the statement is, in fact, false” and therefore “untrue.” Id. at 69 (citing
Omnicare, Inc. v. Laborers Dist. Council Const. Indus. Pension Fund, ___ U.S.
___, 135 S. Ct. 1318, 1326 (2015)). This Court raised the requirements in
Omnicare for liability on statements of opinion and belief. Id. A statement must
be “a factual misstatement in itself” or “rendered misleading by the omission of
discrete factual representations.” Id. (citing Omnicare, at 1325). To prove an
opinion is “a factual misstatement in itself,” a plaintiff must show the speaker
did not “actually hold” the belief. Id. To prove an opinion is missing information
necessary to make it “not misleading,” a plaintiff must “call into question the
issuer's basis for offering the opinion.” Id. at 69–70 (citing Omnicare, at 1328,
1332). Here, the statements in the 10-K and 10-Q, as well as those made by
Wilson, are not deceptive and do not amount to liability because they are
merely puffery and statements of corporate mismanagement.
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1. Mere Puffery Puffery is not an actionable misrepresentation under § 10(b) as a matter
of law. See ECA, Local 134 IBEW Joint Pension Trust of Chi. v. JP Morgan Chase
Co., 553 F.3d 187, 206 (2d Cir. 2009); In re BP p.l.c. Sec. Litig., 843 F. Supp. 2d
712, 748 (S.D. Tex. 2012) (“Vague optimistic statements are not actionable.”)
([BP I]). Statements of puffery are “too general to cause a reasonable investor to
rely on them.” In re Banco Bradesco S.A. Sec. Litig., 277 F. Supp. 3d 600, 647
(S.D.N.Y. 2017). Puffery includes statements which amount to “corporate
cheerleading,” projections about future performance, positive statements
lacking concrete facts, risk management strategies, and business practices,
among others. See Local 134 IBEW, at 206; BP I, at 748. Statements which are
“predictive in nature” are only actionable “if they were false when they were
made.” BP I, at 748 (citing Shushany v. Allwaste, Inc., 992 F.2d 517, 524 (5th
Cir.1993)).
Generalized statements about commitments to safety and safety
processes, when “untethered to anything measurable,” constitute inactionable
puffery. BP I, at 757 (finding statements making “specific reference to BP's
progress following the Texas City explosion and the Baker Panel's findings”
were actionable, but more general statements were not.); see also City of
Monroe Emp. Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 671 (6th Cir. 2005).
In connection with the Deepwater Horizon accident, plaintiffs alleged BP made
46 material misrepresentations about drilling safety. Id. at 750. Many of BP’s
general statements were found to be puffery, including: “Safety has always
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been one of our core priorities”; “We continued to make significant investment
and took numerous actions to improve the three dimensions of safety”; and “BP
aspires to be an industry leader in the three dimensions of safety—personal
safety, process safety and the environment.” BP I, at 728.
Business practices and risk management strategy are also inactionable
puffery. See Local 134 IBEW, at 206. A number of investors alleged JP Morgan
Chase (“JPMC”) defrauded shareholders by “downplaying its Enron-related
exposure” and “portraying itself as a low-risk company with a reputation for
fiscal discipline and integrity.” Id. at 194, 205. (JPMC claimed it had a
“standard-setting reputation for integrity.”). Plaintiffs decried fraud, but the
court disagreed: the statements were not guaranteeing JPMC could or “would
prevent failures in its risk management practices.” Id. at 206. They were
instead generalizations about “business practices.” Red River’s statements were
similar generalizations.
The Fourteenth Circuit correctly found Statements One and Six were
inactionable puffery. See R. at 16. The March 10-K and June 10-Q statements,
in addition to Wilson’s statement at the investor conference, should also be
considered inactionable puffery. See R. at 36, app.A.
Statements Two, Three, and Four constitute puffery analogous to the
statements made by BP: generalized commitments to safety and corporate
priorities untethered to any metric. Statement Two reiterated Red River has “no
higher priority” to conducting drilling with the aim to prevent an environmental
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event. Id. Statements Three and Four merely reiterate Red River’s commitment
to “environmental best practices” and “investment” in those practices. Id.
Statement Five is directly related to risk management, akin to JP
Morgan’s risk management statements. Id. Red River is not required to
guarantee perfection in its drilling activities, nor did it guarantee fracking was
low risk or risk free; instead it clearly stated its activities did not entail
environmental risk “not associated with conventional drilling.” Id. Additionally,
Statement Eight reiterated general risks to any business operation, including
“natural disasters beyond [Red River’s] control.” Id. Similarly, Wilson’s
statement that “a major environmental event” has “about a zero percent
chance” of occurring on Red River property is just the type of corporate
cheerleading courts have repeatedly found to be puffery. Id. Not only are Red
River’s statements puffery, they are inactionable statements regarding
corporate mismanagement.
2. Corporate Mismanagement Statements alleging “internal corporate mismanagement” are generally
inactionable under § 10(b), as federal securities laws do not regulate corporate
fiduciary duties. See Santa Fe, 430 U.S. at 474–76, 479–80. See also
Superintendent of Ins. of State of N.Y. v. Bankers Life & Cas. Co., 404 U.S. 6, 12
(1971) (“Congress by [§] 10(b) did not seek to regulate transactions which
constitute no more than internal corporate mismanagement.”). Corporate
mismanagement falls outside the scope of § 10(b) because it amounts to
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second-guessing internal business decisions. See In re Citigroup, Inc. Sec. Litig.,
330 F. Supp. 2d 367, 375–76 (S.D.N.Y. 2004).
Plaintiffs sued Citigroup under § 10(b), alleging “Citigroup's business
would have been conducted differently” if they had “adhered to the
management principles disclosed in its public filings.” Id. at 376. Plaintiffs
argued Citigroup “knew or should have known” Enron was in financial trouble
and therefore Citigroup should have limited its exposure. Id. The court
disagreed: “securities laws were not designed to provide an umbrella cause of
action for the review of management practices . . . that ultimately result in
losses.” Id. at 377. Business decisions, including the decision to disclose
certain information, absent deception, is not actionable under § 10(b).
When a § 10(b) claim is “based upon a nondisclosure, there can be no
fraud absent a duty to speak.” Chiarella v. U.S., 445 U.S. 222, 235, (1980). See
also, e.g., Lorenz v. CSX Corp., 1 F.3d 1406, 1418 (3d Cir. 1993) (rejecting a
nondisclosure claim because if there was no fiduciary requirement to disclose
under state law and Chiarella, there is not one under § 10(b)). Similarly, a
company is not required to accuse itself of wrongdoing. See, e.g., GAF Corp. v.
Heyman, 724 F.2d 727, 740 (2d Cir.1983). To hold otherwise and find Red
River’s corporate decision-making is material under § 10(b) impermissibly
expands the reach of statute.
Red River and its board members should not be subject to liability under
the securities laws for their decision-making processes. Corporate management
and fiduciary duties are an issue of state law, not federal securities law. Red
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River made a number of corporate decisions regarding its drilling operations,
including how it conducted the fracking process and treated wastewater. R. at
14–15. It also decided to take seismic reports under advisement and
incorporate them into their scheduled safety and risk management review. R.
at 14. While unfortunate shareholders lost money on a risky investment,
§ 10(b) is not an insurance policy on investments. The Court should not
disregard these long-held exceptions to § 10(b) liability, and the Fourteenth
Circuit decision should be reversed accordingly.
Even if this Court disregards the text and interpretation of § 10(b) by
determining Red River’s statements were material misstatements and
omissions, and Wilson’s statement was materially misleading, no statement
was made with the scienter required by § 10(b) and the PSLRA.
II. EVEN IF RED RIVER’S STATEMENTS WERE MATERIAL AND ACTIONABLE, TRSF AND FMRF DID NOT PLEAD ADEQUATE SCIENTER UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT. TRSF and FMRF’ s complaint failed to properly plead scienter under the
PSLRA. 15 U.S.C. § 78u-4(b)(2) (2018). This Court has established a three-step
process to determine whether a PSLRA complaint properly pleads scienter: all
factual allegations in the complaint are taken as true; facts are considered
holistically, not separately; and the complaint must create a “‘strong’ inference
of scienter,” so “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.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S.
308, 322–324 (2007). See, e.g., De Vito v. Liquid Holdings Grp., Inc., Civ. No. 15-
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6969 (KM) (JBC), 2018 WL 6891832 (D.N.J. Dec. 31, 2018) (applying Tellabs to
scienter under the PSLRA.).
This Court has defined scienter as “‘a mental state embracing intent to
deceive, manipulate, or defraud.’” Tellabs, at 319 (citing Hochfelder, 425 U.S. at
193–194, n.12). This Court has never decided whether recklessness constitutes
adequate scienter. Id. at 319, n.3. Without discussion, this Court accepted
“deliberate recklessness” satisfies scienter requirements under the PSLRA, but
it did not adopt the standard in its holding. Matrixx Initiatives, Inc., v.
Siracusano, 563 U.S. 27, 48 (2011). Here, the Fourteenth Circuit applied a
“severe recklessness” standard. R. at 19. This requires “an extreme departure
from the standard of ordinary care that presents a danger of misleading
shareholders” and “is either known to the defendant or is so obvious that the
defendant must have been aware of it.” R. at 20 (citation and quotation
omitted). Like Matrixx, Red River and Wilson do not dispute severe recklessness
is an adequate standard for scienter under the PSLRA.
However, the Fourteenth Circuit incorrectly determined TRSF and FMRF
sufficiently alleged a strong inference of scienter. R. at 21–22, 36. The claim of
scienter relies on Red River’s knowledge of seismic activity and Wilson’s
knowledge of concerns about Red River’s wastewater storage capacity. R. at 21.
Though the Fourteenth Circuit did “not find [Red River’s inference] any more
plausible than the inference that [TRSF and FMRF] would have us draw.” Id.
This goes against the weight of the facts when taken holistically.
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TRSF and FMRF claim eight misstatements were made with sufficient
scienter. To satisfy the PSLRA, a reasonable person must find the inference of
scienter reasonably as compelling as any opposing inference. Tellabs, 551 U.S.
at 324. The court below identified two facts leading to a strong inference of
scienter: how Red River handled information about seismic activity and its
wastewater storage facilities. R. at 21. Taken holistically, however, the
inference of scienter drawn by the court below is less compelling than any
opposing inference, and TRSF and FMRF’s claims fail as a matter of law.
A. Statements from the March 1, 2018 10-K. First, the statements in the March 10-K do not create a strong inference
of scienter. It was filed after reported seismic activity in the Eagle Ford Shale
and Wilson’s discussion with company engineers about wastewater storage
capacity. R. at 5. These allegations do not create a strong inference of scienter.
TRSF and FMRF failed to allege Red River knowingly filed the March 10-
K containing material misrepresentations or omissions within, or they should
have known the same. Red River’s environmental compliance team confidently
reported fracking was not likely causing seismic activity. R. at 5. Relying on
these reports, Red River believed the seismic activity did not necessitate
disclosure. See id. TRSF and FMRF failed to allege, as of March 1, Red River
knew or should have known this belief was factually incorrect. Though Wilson
and Red River’s engineers discussed the capacity of the wastewater treatment
facility, TRSF and FMRF failed to allege Wilson should have reasonably believed
it posed any risk or was cause for ongoing concern. Id. at 5.
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The March 10-K made clear Red River believed neither the seismic
activity nor the wastewater treatment facility posed an environmental risk. See
R. at 5. Although this belief later proved incorrect, statements must be judged
on the facts at the time they occur. See, e.g., Sinay v. Lamson & Sessions Co.,
948 F.2d 1037, 1040 (6th Cir. 1991). TRSF and FMRF’s allegations about the
March 2018 statements do not allege intentional misrepresentation or
omissions, nor do they rise to severe recklessness. TRSF and FMRF failed to
allege adequate scienter for the March 2018 statements.
B. Statement from the June 1, 2018 10-Q. TRSF and FMRF also incorrectly alleged the environmental statement in
the June 10-Q rises to the level of severe recklessness. In late May, Red River
received additional notice of low-level seismic activity in the Eagle Ford Shale.
R. at 7. TRSF and FMRF contend the company knew or should have known
there was anecdotal evidence linking their fracking to low-level seismic activity.
However, TRSF and FMRF failed to allege any fact suggesting Red River was
aware or should have been aware the seismic activity would cause disruption
to its operations. The allegation stemming from the June 10-Q similarly fails to
allege scienter sufficient under the PSLRA.
C. Wilson’s statement on May 15, 2018. Last, Wilson’s statement regarding Red River’s environmental practices
and his honest belief “a major environmental event has about a zero percent
chance of occurring” do not rise to the level of severe recklessness. R. at 7. At
the time of his remarks, Wilson was aware of anecdotal information linking
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seismic activity to fracking in a different part of the country and low-level
seismic activity in the Eagle Ford Shale. See R. at 7.
At the time, there was no established, credible link between fracking in
the Eagle Ford Shale and the “low-level” seismic activity. The reports were
limited and anecdotal; it is within reason for Red River to infer this would not
cause a “major environmental event.” The facts, as alleged, cannot sustain a
strong inference of scienter regarding Wilson’s May 15 statements.
The Fourteenth Circuit was incorrect to hold TRSF and FMRF pled
sufficient scienter under the PSLRA. Even allowing for severe recklessness to
serve as adequate scienter, TRSF and FMRF scienter argument cannot
withstand a motion to dismiss.
III. TRSF AND FMRF FAILED TO ALLEGE WILSON WAS A CULPABLE PARTICIPANT WHO IS SUBJECT TO CONTROL PERSON LIABILITY. Under § 20(a) of the Exchange Act, “unless the controlling person acted
in good faith and did not directly or indirectly induce” actions by a primary
violator, someone who “controls” a primary violator is “liable jointly and
severally,” but only “to the same extent as such controlled person.” See 15
U.S.C. § 78t(a) (2018).
Accordingly, lower courts consistently find control liability rests on two
factors: a primary violation by a controlled person and control of the primary
violator by the defendant. See, e.g., ATSI Comm., Inc. v. Shaar Fund, Ltd., 493
F.3d 87, 108 (2d Cir. 2007). However, this Court clarified in Hochfelder each
provision of the 1934 Act, including § 20(a), “contains a state-of-mind
condition.” Hochfelder, 425 U.S. at 209 n.28. To establish § 20(a) liability, the
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complainant must allege a third element, “culpable conduct,” demonstrating
“the controlling person was in some meaningful sense a culpable participant.”
SEC v. First Jersey Sec., Inc., 101 F.3d 1450, 1472 (2d Cir. 1996).
TSRF and FMRF failed to demonstrate Wilson’s actions amount to
culpable conduct, demonstrated by meaningful culpable participation in a
primary violation. In assessing liability under § 20(a), addressing culpable
participation, in addition to a primary violation and control, is consistent with
the language and legislative history of the Exchange Act and the heightened
pleading standards required by the PSLRA.
A. Requiring Culpable Participation for Control Person Liability is Consistent with the Language of the 1934 Act.
Each provision of the Exchange Act “expressly creat[ing] civil liability[]
contains a state-of-mind condition.” Hochfelder, 425 U.S. at 209 n.28.
Moreover, in assessing control person liability under § 20(a), the intent of
Congress was to impose liability “only on those . . . who are in some
meaningful sense culpable participants.” Lanza v. Drexel & Co., 479 F.2d 1277,
1299 (2d Cir. 1973). Requiring culpable participation is underscored by the
legislative history of § 20(a), which necessitates alleging “the element of
culpability . . . to impose liability on a securities law violator.” Rochez Bros., Inc.
v. Rhoades, 527 F.2d 880, 890 (3d Cir. 1975). The language of the Act and its
legislative history require TRSF and FMRF to allege Wilson’s culpable
participation.
In the context of the language of the Exchange Act as a whole, this Court
made clear a plaintiff alleging § 20(a) liability must allege facts suggesting
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conduct which exceeds mere negligence. See In re Livent, Inc., 151 F. Supp. 2d
371, 417 (S.D.N.Y 2001) (citing Hochfelder, 425 U.S. at 209 n.28). After all,
“[s]tatutory interpretation . . . is a holistic endeavor” and courts should not
look merely to a particular clause but rather to the “connection with the whole
statute.” See United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Associates,
Ltd., 484 U.S. 365, 371 (1988). Consequently, examining § 20(a) within the
context of the entire Exchange Act makes clear culpability is a central element
to control person liability.
The Court explicitly cited § 20(a) as an example of the Exchange Act’s
civil liability requiring “a state-of-mind condition.” Hochfelder, 425 U.S. at 209
n.28. Moreover, in the broad context of the Act, Congress used words like
“‘cunning,’ ‘manipulative,’ ‘deceptive,’ ‘fraudulent,’ ‘illicit,’ ‘fraud,’ and lack of
‘good faith,’” suggesting liability should not attach without an element of
culpability. See Rochez, 527 F.2d at 885; See also In re Livent, Inc., 151 F.
Supp. 2d at 417 (noting the Court in Hochfelder “reasoned in part that
Congress’s use of the words ‘manipulative or deceptive device or contrivance’ in
the language of §10(b) ‘strongly suggest[s] that § 10(b) was intended to
proscribe knowing or intentional misconduct.’”). Viewed broadly, courts have
noted the interrelated components of the regulatory scheme governing
securities: “the standard of culpability is ever-present in securities laws.”
Rochez, 527 F.2d at 885. Not only is it reasonable to apply the same culpability
or scienter requirement to § 20(a), the culpability standards under § 20(a) and
§ 10(b) are symmetrical. See In re Livent, Inc., 151 F. Supp. 2d at 417; see also
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Mishkin v. Ageloff, No. 97 Civ. 2690 LAP, 1998 WL 651065, at *25 (S.D.N.Y.
Sept. 23, 1998).
In contrast to the language of the Exchange Act, § 20(a), and this Court’s
view in Hochfelder, the Fourteenth Circuit concluded TRSF and FMRF were not
required to plead culpable participation for a legally sufficient claim under
§ 20(a). See R. at 24. In their view, the clearest reading of § 20(a) pins liability
solely on the control relationship, unless the defendant can establish a good
faith defense. See id. (citing Hollinger v. Titan Corp., 914 F.2d 1564, 1575 (9th
Cir. 1990)).
Yet, this reading of § 20(a) in isolation creates an illogical result, where
culpability or scienter is required for a primary violation under § 10(b), without
a similar culpability requirement under § 20(a). Certainly, as the lower court
points out, § 20(a) might act to “expand, rather than restrict, the scope of
liability under securities law.” R. at 24 (citing SEC v. Mgmt. Dynamics, Inc., 515
F.2d 801, 812 (2d Cir. 1975)). However, in light of Hochfelder and the language
surrounding § 10(b) and § 20(a), § 20(a) liability is limited by a state-of-mind
condition where someone was, in some meaningful sense, a culpable
participant. Simply put, excluding the element of culpable participation, as the
Fourteenth Circuit has here, creates an inconsistency between § 10(b) and
§ 20(a) and is contrary to the broader language of the Exchange Act.
B. Requiring Culpable Participation is Consistent § 20(a)’s Legislative History and the Intent of Congress.
Absent culpable participation, a control person could not be held liable if,
for example, they allegedly failed to disclose information affecting the value of a
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stock purchase. See Rochez, 527 F.2d at 883, 890. In Rochez, after initially
remanding the case, the Third Circuit refused to find a defendant liable
because the plaintiffs could not show deliberate or intentional conduct, or
inaction, to further fraud. See id. at 890. Rather, in the court’s view, Congress
intended culpability to be proven and mere inaction was insufficient to
demonstrate conscious intent by the defendant to aid a fraudulent scheme. See
id. at 890. Citing the legislative history of § 20(a), the court concluded, by
adopting the House version, Congress preferred the “fiduciary standard” to the
Senate’s “insurer’s liability” standard. See id. at 884, 890; See also Kohn v. Am.
Metal Climax, Inc., 458 F.2d 255, 289–90 (3d Cir. 1972) (Adams, J., concurring
in part and dissenting in part). Consequently, the plaintiff was required to
demonstrate culpable participation: acts which are “deliberate and done
intentionally to further the fraud.” Id.
Here, based in part on Hollinger, the majority below surmises § 20(a)
“does not contain any sort of scienter requirement.” See R. at 25. In their view,
if a primary violation occurs, a mere showing of control is sufficient for liability
absent the affirmative defense of the defendant acting in good faith. See R. at
25. Nevertheless, a more comprehensive examination of § 20(a)’s legislative
history reveals “its primary purpose was to limit securities fraud liability to
those whose conduct is in some sense culpable.” Hollinger, 914 F.2d at 1579–
80 (Hall, J., dissenting). Certainly, a defendant can establish a good faith
defense to avoid liability. However, without some showing Wilson consciously
intended to further an underlying § 10(b) violation, imposing liability on the
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basis of control is contradictory to the overall statutory scheme of the
Exchange Act.
Applied broadly, without contributing to, causing, intending to cause, or
taking part in an underlying violation, a rule disregarding culpable
participation creates the specter of potentially crushing liability. If adopted, the
majority’s reasoning below would undermine Congressional intent. Rather, the
majority’s reasoning would impose liability on those who are not, in some
meaningful sense, culpable participants.
C. Under the PSLRA, the Plaintiffs were Required to State Facts Demonstrating the Defendant’s Culpable Participation Beyond that of Negligence.
The PSLRA sought to address frivolous private securities litigation, which
often targeted specific defendants, seeking settlement, without regard to their
actual culpability. See H.R. Rep. No. 104-369, at 31 (1995). In line with this
mandate, the PSLRA applies to “any private action . . . in which the plaintiff
may recover money damages only on proof that the defendant acted with a
particular state of mind.” 15 U.S.C. § 78u-4(b)(2) (2018) (emphasis added).
Further, the language of the Exchange Act, conforming with Congressional
intent, requires § 20(a) liability to rest in part on “a state-of-mind condition
requiring something more than negligence.” Rochez, 527 F.2d at 883-84, 890;
Hochfelder, 425 U.S. at 209 n.28.
As highlighted by the dissent below, the PSLRA also requires a plaintiff to
“state with particularly the facts demonstrating the defendant’s culpable
participation.” R. at 33; See 15 U.S.C. § 78u-4(b)(2) (2018). Not only do the
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PSLRA’s heightened pleading standards apply to § 20(a) claims, but TRSF and
FMRF were required to establish, with particularity, facts demonstrating
Wilson acted with the requisite culpability beyond mere negligence as to the
primary § 10(b) violation.
1. The PSLRA’s Heightened Pleading Standards Apply to § 20(a) Claims.
Under § 20(a), “a plaintiff must ultimately establish a defendant’s state of
mind.” Mishkin, at *23. Citing the plaintiff’s failure to adequately establish a
controlling defendant’s culpable participation in an alleged § 10(b) violation,
the district court granted the defendant’s motion to dismiss. See id. at *26. In
the court’s view, while a defendant can argue he acted in good faith, ultimately
a plaintiff must “prove a defendant’s state of mind in order to prevail.” Id. at
*23–24. The decision emphasized, and the court reasoned, the language of
PSLRA makes it “applicable to more than just Section 10(b) claims.” Id. at *28.
Rather, the PSLRA is applicable to “any private action.” Id. at *25.
Further, the PSLRA specifically “links its heightened pleading standard to
any cause of action where a particular state of mind is an element of a
plaintiff’s case, regardless of the stage at which that element must be proven.”
Id. at *23. Thus, in order to survive a motion to dismiss, a § 20(a) claim must,
in addition to alleging the underlying primary violation and control over the
primary violator, allege “particularized facts of the controlling person’s
conscious misbehavior as a culpable participant in the fraud.” Id.
Here, the lower court relies on the view that § 20(a) “lacks a scienter
element,” making the PSLRA inapplicable. R. at 25. However, this reliance is
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misplaced. Under this Court’s position in Hochfelder, § 20(a) liability is
predicated on a culpable mental state. As Mishkin reiterates, the heightened
pleading standard of the PSLRA applies when a particular state of mind is an
element of the plaintiff’s case; TRSF and FMRF must prove Wilson’s state of
mind in order to prevail. Here, even the majority below recognized “a
defendant’s ultimate liability may depend on the plaintiff’s ability to show that
the defendant did not act in good faith[.]” R. at 25. TRSF and FMRF’s § 20(a)
claim must fail under the PSLRA as they were required to allege facts
demonstrating Wilson’s conscious misbehavior as a culpable participant.
2. TRSF and FMRF Were Required to Establish with Particularity that Wilson Acted Culpably Beyond Mere Negligence.
The heightened pleading standard under the PSLRA raise the question of
how to define culpable participation for purposes of § 20(a) liability. While
Hochfelder made clear a § 20(a) plaintiff must allege facts suggesting something
more than negligence, it is not clear what standard beyond negligence is
required. See, e.g., In re Livent, Inc. Noteholders Sec. Litig., 151 F. Supp. 2d at
417. If Hochfelder means culpable participation requires something more than
mere negligence, the heightened pleading standard of the PSLRA requires a
§ 20(a) plaintiff to “allege at a minimum, particularized facts of the controlling
person’s conscious misbehavior or recklessness.” Lapin v. Goldman Sachs Grp.,
Inc., 506 F. Supp. 2d 221, 246 (S.D.N.Y. 2006).
In applying the PSLRA’s heightened pleading requirements, “some level of
culpable participation at least approximating reckless in the § 10(b) context
must be alleged to state a § 20(a) claim.” Id. at 248. In Lapin, the court granted
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Goldman Sachs’ then-CEO Henry Paulson’s motion to dismiss in regard to a
§ 20(a) claim after the plaintiffs failed to allege his culpable participation in
connection with alleged misrepresentations in securities research analysis. See
id. at 248, 228. In the court’s view, a § 20(a) claim must allege, at the very
least, particularized facts of “conscious misbehavior or recklessness.” Id. at
246. Under Lapin, its interpretation of Hochfelder, and the PSLRA as applied to
§ 20(a), TRSF and FMRF should be required to allege something more than
negligence.
To conform with the PSLRA, a § 20(a) plaintiff must demonstrate a
controlling person’s conscious misbehavior or recklessness, something TRSF
and FMRF neither alleged nor established. Instead, the majority below
disregards the applicability of the PSLRA to a § 20(a) claim. However, as the
Court in Lapin pointed out, the PSLRA requires a level of culpable participation
at least approximating reckless in the § 10(b) context for a valid § 20(a) claim.
Moreover, within the framework of the Exchange Act, the text of § 20(a) has
remained unchanged since Hochfelder, where this Court explicitly required a
“state-of-mind condition” for § 20(a) liability. Consequently, a § 20(a) claim
under the PSLRA requires a plaintiff to allege culpable participation at least
approximating reckless.
Not only does the language of § 20(a) include a “state-of-mind condition,”
but the legislative history shows Congress intended control liability to attach
only when a person acted with meaningful culpable participation. Moreover, for
a § 20(a) claim, a plaintiff must ultimately establish a defendant’s state of mind.
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To the extent culpable participation was not previously an element of § 20(a)
liability, the enactment of the PSLRA requires TRSF and FMRF to allege, at a
minimum, particularized facts of Wilson’s conscious misbehavior or
recklessness. Although the plaintiffs allege Wilson was aware of wastewater
storage issues and low-level seismic activity, such allegations do not suffice to
show conscious misbehavior or recklessness. For these reasons, TRSF and
FMRF failed to adequately allege Wilson’s requisite culpable participation with
particularity for a valid § 20(a) claim.
CONCLUSION Red River and Wilson’s statements are not material to a reasonable
investor under § 10(b) and Rule 10b-5. Even if the statements are material,
they only amount to statements of puffery and corporate mismanagement,
which are inactionable as a matter of law. Further, even if the statements were
material and actionable, TRSF and FMRF did not meet the scienter
requirements of the PSLRA. Finally, contrary to the language and legislative
history of the Exchange Act and the heightened pleading standards required by
the PSLRA, TRSF and FMRF failed to allege Wilson’s requisite culpable
participation for a valid § 20(a). For these reasons, the Fourteenth Circuit
should be reversed.
1a
APPENDIX
2a
TABLE OF CONTENTS APPENDIX .................................................................................................................................... 1a
TABLE OF CONTENTS ............................................................................................................... 2a
15 U.S.C. § 78j(b) ...................................................................................................................... 3a
15 U.S.C. 78t(a) ......................................................................................................................... 4a
17 C.F.R. 240.10b-5 ................................................................................................................... 5a
3a
15 U.S.C. § 78j(b)
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-- . . . (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement1 any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
4a
15 U.S.C. 78t(a)
(a) Joint and several liability; good faith defense Every person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person to any person to whom such controlled person is liable (including to the Commission in any action brought under paragraph (1) or (3) of section 78u(d) of this title), unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.
5a
17 C.F.R. 240.10b-5 It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
