Do Your Due Diligence: Objective unreasonableness of a defendant’s conduct may give rise to an inference of scienter in establishing a violation of the Securities Exchange Act.

April 7th, 2010
By: Erich Schiefelbine, Stephens Friedland LLP

In the recent case of Gebhart v. S.E.C., 595 F. 3d 1034 (9th Cir. 2010), the primary issue pertained to establishing a violation of Section of 10(b) and Rule 10b-5, and the requirement that the SEC show that there has been a misstatement or omission of material fact made with scienter.  Alvin and Donna Gebhart were found by the National Association of Securities Dealers (NASD) to have committed securities fraud in violation of section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 by making false statements to clients in connection with the sale of promissory notes that were used to finance the conversion of mobile home parks to residential ownership.  The Gebharts conducted no independent investigation concerning the investment program and eventually sold nearly $2.4 million in promissory notes.  They admitted that they relied solely on the assurances of a promoter of the investment program.

The NASD’s Department of Enforcement filed a complaint against the Gebharts for securities fraud in 2002.  A NASD hearing panel found the Gebharts had acted in good faith and rejected the fraud charges.  This decision was reversed by the NASD National Adjudicatory Council and they imposed a lifetime ban on Alvin Gebhart and imposed a one-year suspension on Donna and a $15,000 fine.

The Gebharts petitioned for review of the SEC decision and the case was vacated and remanded in an unpublished opinion because of a concern that the SEC had applied a purely objective scienter standard that had disregarded the Gebharts’ actual state of mind.  The case was remanded to the SEC for reconsideration of the question of scienter.  On remand the SEC again determined that the Gebharts had acted with scienter and reaffirmed the SEC decision.

The Court’s legal analysis was as follows:  Frist, in order to establish a violation of section of 10(b) and Rule 10b-5, the SEC is required to show that there has been a misstatement or omission of material fact made with scienter.  It is established that plaintiffs may establish scienter by proving “either actual knowledge or recklessness.”  In re Software Toolworks, Inc., 50 F.3d 615, 626 (9th Cir. 1994); see also Ponce v. SEC, 345 F.3d 722, 729 (9th Cir. 2003).  This rule has also been recognized in other circuits as well.  See SEC v. Lyttle, 538 F.3d 601, 603 (7th Cir. 2008); South Cherry Street, LLC v. Hennessee Group LLC, 573 F.3d 98, 109 (2nd Cir. 2009); Levinson v. Basic Inc., 786 F.2d 741, 749 (6th Cir. 1986).

Second, scienter can be established by direct or circumstantial evidence.  Scienter is a subjective inquiry that turns on the defendants actual state of mind.  However, objective unreasonableness of a defendant’s conduct may give rise to an inference of scienter.  Therefore, objective unreasonableness of the defendant’s conduct may raise an inference of scienter that must be rebutted.   The factfinder must consider the direct and circumstantial evidence as a whole to determine whether the defendant acted with scienter.

Third, substantial evidence, in a SEC case, means more than a mere scintilla but less than a preponderance of the evidence.  It means such relevant evidence as a reasonable mind might accept as adequate to support a conclusion.

Based on the foregoing, the court determined that the SEC properly considered the objective unreasonableness of the Gebharts’ actions as evidence supporting the inference that the Gebharts acted with scienter.  While the objective evidence was not dispositive, the SEC found that the evidence from the Gebharts about their subjective belief was not sufficient to overcome the inference of scienter created by the evidence as a whole.   Therefore, the court determined that the SEC applied the correct scienter standard and the Gebharts were guilty of fraud.

Thus, it appears that in prosecuting or defending securities fraud actions, parties must be cognizant of not just the subjective knowledge of the actors, but an objective view as well.  Furthermore, any party engaged in the sale of investments should consider conducting an independent investigation regarding the investment opportunity.

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