Originally published April 8, 2009
Keywords: pleading requirements, securities law, group pleading doctrine, Baines v Moores, Federal Rule of Civil Procedure 9(b), Kamen, summary judgment, California
On March 20, 2009, the California Court of Appeal for the Fourth Appellate District harmonized state and federal securities jurisprudence, signaling that summary judgment now may be as available in state-law derivative actions as it is in federal securities lawsuits. In Baines v. Moores, No. D052533, the court rejected the use of the "group publication" or "group pleading" doctrine as a way of forestalling summary judgment on state-law securities fraud claims and adopted other federal securities doctrines limiting the scope of permissible inferences of fraud.
California law, as Federal Rule of Civil Procedure 9(b) does, typically requires that allegations of fraud be pled with particularity. The group pleading doctrine permits plaintiffs to generally aver the role each individual defendant played in the alleged fraudulent activities by creating a presumption, for pleading purposes, that statements made in public documents—such as registration statements, prospectuses, and periodic SEC filings—are attributable to the officers and directors who signed the documents. "The rationale for group pleading is that facts about fraud flowing from the internal operation of a corporation are peculiarly, and often exclusively, within the control of the corporate insiders who manage the parts of the corporation involved in the fraud." In re Interactive Network, Inc. Sec. Litig., 948 F. Supp. 917, 920 (N.D. Cal. 1996).
Federal courts have applied the group pleading doctrine in federal securities law cases, but only one published California case discusses it. In Kamen v. Lindly, 94 Cal. App. 4th 197 (Cal. Ct. App. 2001), the Court of Appeal, applying federal standards, held that the group pleading doctrine may be invoked as to outside directors only if they either had participated in the day-to-day management of the particular part of the company involved in the alleged fraud, or had a "special relationship" with the corporation.
The Kamen court applied the group pleading doctrine to determine the adequacy of the plaintiff's pleadings. In Baines v. Moores, plaintiffs asked the Court of Appeal to apply the doctrine in the context of a motion for summary judgment involving California state-law securities fraud claims.
In Baines, the trial court granted summary judgment in favor of some former outside directors, ruling that the plaintiffs, former Peregrine Systems, Inc. shareholders, failed to raise a triable issue of fact as to the directors' knowledge of the alleged fraud. Plaintiffs appealed, arguing that, under the group pleading doctrine, they had presented sufficient evidence to support a finding that defendants had a "special relationship" with Peregrine.
On appeal, the Baines court observed that "the rationale" for the group pleading "doctrine arises only in the context of determining the sufficiency of a plaintiff's pleadings." Based on its examination of federal precedent, the Court of Appeal held that "the group published information doctrine, or group pleading doctrine, as its alternative name suggests, is a pleading device that has no application in the summary judgment context."
The Baines decision not only removed the group pleading doctrine as a barrier to obtaining summary judgment under state law, but also adopted other federal-law limits on the evidence required to support an inference of fraud. The Baines plaintiffs had argued that four categories of evidence raised triable issues of fact with respect to defendants' knowledge of the fraud at Peregrine: (i) defendants' sales of Peregrine stock; (ii) inconsistencies between information presented to Peregrine's board and Peregrine's public disclosures; (iii) evidence or purported red flags identified by plaintiffs' expert; and (iv) one defendant's receipt of an email from a Peregrine employee.
The court drew on federal precedent to make short shrift of plaintiffs' purported evidence. Based on Ninth Circuit case law, the court found that sales that amounted to less than 35 percent of a defendant's total holdings are insufficient to support an inference of scienter. The court also relied on federal precedent to find that "[e]xpressions of concern among members of a firm regarding the firm's accounting procedures are not inconsistent with reports of record revenue." Finally, the court found that the single email from a Peregrine employee was "far too insubstantial a foundation on which to base a finding that defendants knew about the extensive fraud at Peregrine."
As a practical matter, derivative actions under California law have long exposed officers and directors in California to liability beyond that sustainable under federal securities law. Although California continues to lack the pleading-stage protections available in the federal system, the convergence between state and federal liability standards signaled in Baines provides welcome predictability along with an increased chance of early disposition of meritless claims.
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