Shariah’s Black Box

Unlike materiality, which is an element in any type of fraud action, scienter, or intent, is a critical element of the common law and of most statutory provisions imposing liability on a wrongdoer, but certainly not all.[209] As classically understood by the common law, a plaintiff’s claim for deceit could only survive a motion to dismiss (or its equivalent) if the pleadings properly alleged that the defendant knew of the falsity of the representation and that the false representation was made in an effort to induce reliance by the plaintiff. It is well known that over time, this standard has been relaxed to include not merely false representations but also half-truths. This means that having opened the door to a representation, the putative defendant must be certain to have told the whole truth, or at least, as set out above, the whole material truth.[210]

But the question still remains: Having omitted some important part of the story, and assuming that omission was material, did the defendant withhold the omitted part (a) knowingly and (b) with intent to deceive? Successful civil and criminal fraud litigation is as much about properly alleging scienter as it is proving it.[211] Judges will decide the former; jurors are most likely to decide the latter[212], although it is fair to say that a defendant who cannot get a judge to dismiss fraud claims as a matter of law due to faulty allegations is more than likely to settle or, in the criminal world, to accept a plea bargain, so as not to face a jury verdict looking to right a wrong.

Today, fraud claims alleging a failure to disclose might be based upon violations of federal securities laws, state blue sky laws, state consumer protection laws, and other federal and state anti-fraud statutes. While the common law has generally moved away from requiring a specific intent to defraud and toward a standard of recklessness — and in those jurisdictions which have adopted Section 552 of the Restatement (Second) Of Torts[213] the move has included even negligent misrepresentation — specific claims under federal or state anti-fraud statutes will vary depending upon the statute, the specific jurisdiction, and whether the action is administrative, civil, or criminal.

For example, under federal securities laws, there are statutes and rules permitting SEC administrative and civil enforcement actions and private causes of action which do not impose a requirement to plead or prove scienter. Thus, under the 1933 Act, which has arguably become far more important for those seeking to pursue class action claims[214], Sections 17(a)(2) and (a)(3) are free of any scienter requirement for SEC civil actions and to the extent that a private right of action exists, and there is authority for such, the no-scienter rule is likely to extend to private plaintiffs.[215]  Also, Section 11, which relates to misrepresentations in a registration statement, imposes an absolute liability on the issuer without any reference to scienter but does provide for reasonable care defenses as a kind of substitute for scienter for other defendants.[216] Section 12(2) imposes liability without reference to scienter in public offerings[217] but provides an out for the defendant who can “sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.”[218]