Scienter Pleading and Rule 10b-5: Empirical Analysis and Behavioral Implications

Although the volume of private securities class action filings has dropped recently, these lawsuits remain both a significant worry for issuers, investment banks, auditing firms and other potential defendants, and an arguably useful supplement to governmental enforcement of securities antifraud laws.  Because we both teach a course in accounting ethics and accountants’ liability and have found ourselves at a loss to clearly explain to our students the law of scienter pleading in Rule 10b-5 cases against auditors, we undertook research that culminated in an article entitled Scienter Pleading and Rule 10b-5: Empirical Analysis and Behavioral Implications, just published in the Case Western Law Review.

We first sketch a history of the law of scienter in Rule 10b-5 cases and then survey a host of recent cases against auditors where courts have addressed what plaintiffs have to allege and prove regarding the scienter element of such a claim in the wake of the Private Securities Litigation Reform Act (PSLRA) of 1995.  This survey seems to support the impressions that both of us have formed while teaching the subject—that the law is a muddled mess that gives little helpful guidance to either plaintiffs or defendants regarding what allegations will enable plaintiffs to survive a motion to dismiss.  Regarding virtually every potential factual allegation—that the auditor made large mistakes, that the auditor made multiple mistakes, that the auditor’s mistakes resulted in a restatement of earnings, that the auditor had full access to the client’s books and records, that the auditor knew of various “red flags” such as the client having weak internal controls or large end of quarter transactions, etc—we discover both cases finding that the allegation was indicative of fraud and cases finding that the allegation was indicative only of mere nonactionable negligence.

This survey of case law is extensive but nonsystematic. We thus also empirically examine recent 10b-5 cases against auditors.  We find evidence consistent with the case survey–courts do not appear to be consistently influenced by most of the allegations in plaintiffs’ 10b-5 complaints against auditors, including claims of “red flags” that many courts focus upon as the key to successfully alleging scienter. We find that allegations that the audit client consistently beat financial benchmarks (such as earnings or revenue forecasts), the existence of a restatement, and high audit fees are significant predictors of case dismissals. However, of these variables, only benchmark-beating behavior is generally considered a “red flag” by courts. The presence of a restatement is likely a reflection of the underlying merits of the case, while high audit fees reflect perceived litigation risk by the auditor.

This state of the law suggests that before a court rules upon a motion to dismiss neither plaintiffs nor defendants have guidance sufficient to enable them to accurately evaluate the strength of a Rule 10b-5 case against an auditor.  This is obviously very problematic for both plaintiffs and defendants.  That judges appear to have nearly complete discretion regarding whether or not to grant a motion to dismiss on the scienter element carries additional difficulties.  Prentice has written extensively on the implications of psychological and cognitive research for the law, and in the last portion of the article we explore these difficulties through a behavioral lens, finding that excessive discretion can exacerbate problems that arise from unconscious judicial bias.

The full article is available here.