Article by Douglas M. Branson
In a common law fraud action for damages, a plaintiff had to allege and prove that defendant had an intent to deceive. Under the securities laws' general antifraud rules, most notably rule 10b-5, lawyers and commentators generally supposed that to recover damages a plaintiff could prove something less than the intentional conduct the common law required. How much less a rule 10b-5 plaintiff need prove, however, was an unanswered question. Most often lawyers and courts addressed the question by asking whether simple negligence, gross negligence, knowing conduct, or knowing conduct coupled with intent to defraud would serve as a basis upon which to ground recovery. In answering that question, courts differed.
In 1974, the Court of Appeals for the Ninth Circuit decided White v. Abrams, which attempted to deal with the so-called "scienter" element of securities fraud actions by importing a new mode of analysis into the area. The decision outlined a flexible duty concept: the standard of care applied to a defendant depended upon the nature of the defendant's relationship to the plaintiff. Whether the law applied a higher or lower standard depended upon a sliding scale of factors, such as the length of the parties' relationship, the degree of trust plaintiff had placed in defendant's counsel or expertise, the benefit defendant had derived from the relationship, defendant's access to investment information as compared to plaintiff's access, and like factors.
Shortly before White, the Court of Appeals for the Second Circuit tentatively began evolving its own flexible analysis based upon sets of sliding-scale factors. The court's application of these factors in Lanza v. Drexel & Co. intimated that a defendant's duty could vary from a simple duty to disclose actual knowledge, to a duty to investigate if notified of something awry, or to an absolute duty to investigate and then disclose. In the proxy area, where a general antifraud rule similar to rule 10b-5 prevails, Gerstle v. Gamble-Skogmo, Inc. indicated the existence of a similar variable duty, depending upon the presence or absence of sliding-scale factors. Thus, negligence might suffice in one case, but reckless or intentional conduct would be the prerequisite to recovery in another.
A scant two years after White, Lanza, and Gerstle, the Supreme Court addressed the scienter question in Ernst & Ernst v. Hochfelder. The Court firmly held that simple negligence could not be a ground for money damage recovery under rule 10b-5. Other than mere citation, the Court made no mention of White, Lanza, and Gerstle, or of flexible analysis concepts. Pointedly, the Court left unanswered a number of other questions concerning the scienter element.
Commentators and courts have supposed that Hochfelder's strident tone and its express holding overrule modes of flexible analysis. Alternatively, they posit that Hochfelder's establishment of a "bright line" rule leaves no room for sliding-scale analysis to operate. By footnote, however, the Court left unanswered the question whether proof of more than mere negligence, but less than intentional misconduct, that is, gross negligence, would be a sufficient basis upon which to ground recovery for misrepresentations or omissions in securities transactions. Similarly, the Court failed to test the long-held hypothesis that in actions for prophylactic relief the Government need prove only negligence on defendant's part.
The purpose of this article is to explore and dispel notions that Hochfelder eliminated flexible analysis of scienter questions in antifraud rule cases. Commentators have neglected to study the gradations of common law gross negligence, but imaginative lawyers will surely argue that those gradations are operative now that Hochfelder has eliminated negligence as the frontier. Hochfelder will merely shift the possibility of flexible analysis to other antifraud rule issues: whether gross negligence will be sufficient for damages in all cases, whether mere negligence can ground an injunction in some disputes, and whether mere negligence will suffice under the securities laws' more delimited general antifraud provisions. Hence, in the wake of Hochfelder, it becomes important to determine if White, Lanza, Gerstle, and similar flexible analysis concepts remain viable as law, as the next road to retrenchment in the securities fraud area, and as sound modes of analysis in securities fraud actions generally.
About the Author
Douglas M. Branson. Associate Professor of Law, University of Puget Sound. Visiting Associate Professor of Law, Arizona State University. B.A. 1965, University of Notre Dame; J.D. 1970, Northwestern University; LL.M. 1974, University of Virginia.
Citation
52 Tul. L. Rev. 50 (1977)