Plaintiffs in private securities fraud litigation frequently point to insider trading as support for a “strong inference” that the defendant acted with scienter, as required to survive a motion to dismiss under the Private Securities Litigation Reform Act of 1995.  The defendant sold her stock, the plaintiff argues, because she knew that the price was inflated as a result of false information in the market.  Generally this argument works only if the trading was somehow suspicious, such as where the defendant sold an especially large percentage of her holdings. 

Last August, in Metzler Investment GMBH v. Corinthian Colleges, Inc., 540 F.3d 1049 (9th Cir. 2008), the Ninth Circuit rejected a plaintiff’s insider trading argument as to one of three defendants, in part on the ground that the other defendants’ sales weren’t suspicious.  Id. at 1067 (“Moore sold only 37% of his total stock holdings during the Class Period. We typically require larger sales amounts—and corroborative sales by other defendants—to allow insider trading to support scienter.” (emphasis added)).  One of the other defendants had sold no stock during the relevant period, “suggesting,” the court reasoned, “that there was no insider information from which to benefit.”  Id. The court cited two cases in support of this inference, neither of which does support it, although they do generally support the other point the court made in the same sentence.  See In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 987-88 (9th Cir. 1999); Tripp v. Indymac Fin., Inc., 2007 WL 4591930 at *4-5 (C.D. Cal. Nov.29, 2007).

Regardless of support, though, can this be the right rule—that if one defendant’s sales were not suspicious, then sales by a different defendant weren’t either?  There is some sense to it.  An insider’s failure to capitalize on the fraud through insider trading undermines allegations of his scienter.  And if one defendant didn’t know, then it’s certainly more likely that another didn’t, either.  While this sort of group-scienter argument is not available to plaintiffs, no one ever claimed that the PSLRA was intended to create reciprocal benefits to plaintiffs and defendants.

My view, though, is that without some affirmative reason for thinking that defendant B wouldn’t have known unless defendant A did, too, it’s an unreasonable inference in favor of the defendant.  (Unlike on most motions to dismiss, the court is supposed to consider defendant-favoring inferences.)  The same principle, moreover, could as easily be applied to any allegations bearing on scienter, not just to insider trading.  If it were applied broadly, it could affect plaintiffs’ decisions about whom to name as individual defendants.  I suppose it’s an open question whether the Metzler court would have considered in defendants’ favor the failure of the plaintiffs to allege insider trading by insiders who were not named—and/or documents offered by the defendants at the pleading stage to show the innocence of unnamed insiders’ trades.  Either way, a plaintiff could lower the likelihood that insider A’s comparatively innocent behavior would rub off on insider B by not naming A.  That a plaintiff might leave a less guilty-looking defendant off the complaint for this reason could be viewed as either a positive or a negative consequence of the rule, depending probably on how one views the balance of interests in the current system of enforcement.

I used to be a plaintiff’s lawyer, which presumably shapes my perspective on this to some degree at least.  Also, I’m an admirer of Judge Betty Fletcher, who authored the Metzler court’s opinion, and usually agree with her.  For these reasons, among others, I’m quite open to the possibility that I’m not weighing this right.  If anyone with a view on this is reading, please share it.

(For more on Metzler, see the Corporate Securities Blog and the 10b-5 Daily.)

Tags: 10b-5, insider trading, PSLRA, Securities Exchange Act

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