Commercial Litigation and Arbitration

Second Circuit Declines to Extend Akin-to-Contempt/Bad Faith Standard for Sua Sponte Rule 11 Sanctions — Holds that PSLRA Trumps Pennie & Edmonds

Six years ago, in In re Pennie & Edmonds LLP, 323 F.3d 86 (2d Cir. 2003), a divided panel of the Second Circuit held that district courts imposing sua sponte sanctions under Rule 11 were required to make a finding of subjective bad faith before imposing sanctions. It is my view that the dissenting opinion of Judge Underhill was correct and that the holding of the Pennie majority is irreconcilable with the text of Federal Rule of Civil Procedure 11. Joseph, Sanctions: The Federal Law of Litigation Abuse § 17(A)(3)(b) (4th ed. 2008).

In ATSI Commc’ns v. Peronti, 2009 U.S. App. LEXIS 19753 (2d Cir. Sept. 2, 2009), the Second Circuit refused to apply Pennie to sanctions imposed pursuant to the Private Securities Litigation Reform Act (PSLRA):

The chief question presented on appeal is whether the rule established in In re Pennie & Edmonds LLP, 323 F.3d 86 (2d Cir. 2003)("Pennie") required the district court to make a finding of subjective bad faith before imposing sanctions. The ATSI attorneys argue that here, as in Pennie, such a finding is needed because the sanctions procedure (initiated by the district court after the litigation was over) afforded them no 21-day safe harbor in which to withdraw or amend the challenged pleading. We conclude that Pennie's subjective bad faith requirement does not exist in the context of the PSLRA because the statute itself puts litigants on notice that the court must (and therefore will) make Rule 11 findings at the conclusion of private litigations arising under the federal securities laws. Such notice alleviates the concern that animates Pennie: that Rule 11 sanctions should not be sprung on lawyers when they no longer have the chance to withdraw or amend a challenged claim. At the same time, however, that concern should inform consideration as to whether opposing attorney's fees are "reasonable" under 15 U.S.C. § 78u-4(c)(3). ***

In In re Pennie & Edmonds LLP, 323 F.3d 86, 91 (2d Cir. 2003), we recognized an exception to the standard of objective unreasonableness applicable when a district court initiates Rule 11 sanctions sua sponte "long after" the sanctioned lawyer had an opportunity to correct or withdraw the challenged submission. In such cases, a lawyer may be sanctioned only upon a finding of subjective bad faith.... The exception is justified in order to strike a proper "balance," and prevent over-deterrence.... We focused on the procedural differences in how sanctions are imposed under Rule 11(c)(2) and (c)(3). When the sanctions process is initiated by a motion from an opposing party (under Rule 11(c)(2)), the challenged lawyer has a 21-day "safe harbor" to withdraw or amend. When sanctions are initiated by a court sua sponte (under Rule 11(c)(3)), no such safe harbor is afforded. The Advisory Committee's note to the 1993 amendments to Rule 11 explained: "Since show cause orders will ordinarily be issued only in situations that are akin to a contempt of court, the rule does not provide a 'safe harbor' to a litigant for withdrawing a claim, defense, etc., after a show cause order has been issued on the court's own initiative." Fed. R. Civ. P. 11 advisory committee's note to 1993 Amendments. Pennie reasoned that since show cause orders should only issue in situations "akin to" contempt, and contempt sanctions require a finding of bad faith, Schlaifer Nance, 194 F.3d at 338, then court-initiated Rule 11 sanctions should also require a finding of subjective bad faith, at least when sanctions are imposed at the end of a litigation and the sanctioned lawyer has had no opportunity to withdraw or amend. Pennie, 323 F.3d at 90. We perceived a risk that, otherwise, lawyers would be inhibited from filing

submissions that they honestly believe have plausible evidentiary support for fear that a trial judge, perhaps at the conclusion of a contentious trial, will erroneously consider their claimed belief to be objectively unreasonable. This risk is appropriately minimized, as the Advisory Committee contemplated, by applying a "bad faith" standard to submissions sanctioned without a "safe harbor" opportunity to reconsider.

Id. at 91. Pennie stopped short, however, of a blanket rule that the subjective bad faith standard applied whenever there was no longer a safe harbor, finding it sufficient in that case that the court sua sponte initiated sanctions proceedings "long after" the lawyer had an opportunity to amend or withdraw. 323 F.3d at 91.

[Footnote 7] We wrote: "It is arguable, as [appellant] contends, that a 'bad faith' standard should apply to all court-initiated Rule 11 sanctions because no 'safe harbor' protection is available and because the Advisory Committee contemplated such sanctions for conduct akin to contempt. However, we need not make so broad a ruling in the pending case." 323 F.3d at 91.

Pennie drew a sharp dissent, which argued that all Rule 11 violations should be assessed under the standard of objective reasonableness, and that the majority over-read the intent of the Advisory Committee. And some circuits have declined to follow Pennie. See Young v. City of Providence ex rel. Napolitano, 404 F.3d 33, 40 (1st Cir. 2005) (declining to follow Pennie and noting that "only [the Second Circuit] has read the present rule to require bad faith"); Kaplan v. DaimlerChrysler, A.G., 331 F.3d 1251, 1256 (11th Cir. 2003) (declining to "resolv[e] the . . . 'mens rea' issue that split the Pennie panel").

[Footnote 8] Judge Underhill, sitting by designation, argued that Rule 11 liability should be consistently assessed under the objective reasonableness standard because that standard is set forth in Rule 11(b): "The fundamental flaw in the majority's interpretation of Rule 11 is that it seeks to use procedural distinctions drawn in section (c), regarding how sanctions can be imposed with and without a motion, to modify the substantive requirements of section (b), which controls whether a violation of Rule 11 has occurred. Under a plain reading of Rule 11, the procedural distinctions set forth in section (c) have no bearing whatsoever on the state-of-mind requirement of section (b)." 323 F.3d at 94 (Underhill, J., dissenting).

[Footnote 9] Instead of requiring subjective bad faith, other circuits have urged district courts to use extra care in imposing sanctions after a lawyer has lost the opportunity to amend or withdraw the challenged claim. See, e.g., Hunter v. Earthgrains Co. Bakery, 281 F.3d 144, 151 (4th Cir. 2002) (In the absence of the safe harbor, "a court is obliged to use extra care in imposing sanctions."); United Nat'l Ins. Co. v. R & D Latex Corp., 242 F.3d 1102, 1115 (9th Cir. 2001) (Rule 11(b)(2) standard "is applied with particular stringency where, as here, the sanctions are imposed on the court's own motion."); Barber v. Miller, 146 F.3d 707, 711 (9th Cir. 1998). None of the other circuits has required a heightened mens rea.

In this case, the ATSI attorneys' principal argument is that, because the sanctions against them were initiated by the court at a time when the ATSI attorneys no longer had an opportunity to amend or withdraw the pleading, Pennie barred imposition of sanctions without a finding of subjective bad faith.

This case is distinguishable from Pennie because the statutory wording of the PSLRA puts private securities litigants on sufficient notice that their actions will be the subject of Rule 11 findings. The statute requires district courts, at the conclusion of private actions arising under federal securities laws, to make Rule 11 findings as to each party and each attorney, 15 U.S.C. § 78u-4(c)(1); and if a Rule 11 violation is found, the statute requires courts to impose sanctions, 15 U.S.C. § 78u-4(c)(2). Such statutory notice is the functional equivalent of the forewarning given litigants by the pendency of a Rule 11 finding. The express congressional purpose of the PSLRA provision was to increase the frequency of Rule 11 sanctions in the securities context, and thus tilt the "balance" toward greater deterrence of frivolous securities claims. "Recognizing what it termed 'the need to reduce significantly the filing of meritless securities lawsuits without hindering the ability of victims of fraud to pursue legitimate claims,' and commenting that the '[e]xisting Rule 11 has not deterred abusive securities litigation,' the 104th Congress included in the [PSLRA] a measure intended to put 'teeth' in Rule 11." Simon DeBartolo, 186 F.3d at 166-67 (quoting H.R. Conf. Rep. No. 104-369 (1995), reprinted in 1995 U.S.C.C.A.N. 730). By virtue of this statutory notice, consideration of sanctions in the PSLRA context can never be sua sponte and can never come as a surprise, because Congress, not the court, has prompted and mandated a Rule 11 finding.

The PSLRA sanctions provision forecloses the kind of safe harbor afforded in Rule 11(c)(2). The PSLRA explicitly directs courts to make Rule 11 findings "upon final adjudication of the action," 15 U.S.C. § 78u-4(c)(1), and it is well-settled that no safe harbor could apply retroactively. See Pennie, 323 F.3d at 89. "The PSLRA . . . does not in any way purport to alter the substantive standards for finding a violation of Rule 11, but functions merely to reduce courts' discretion in choosing whether to conduct the Rule 11 inquiry at all and whether and how to sanction a party once a violation is found." Simon DeBartolo, 186 F.3d at 167 (emphasis added). It is therefore significant that, when the PSLRA was enacted in 1995, Pennie had not yet been decided, and all Rule 11 violations at the time were assessed under the objective reasonableness standard. See, e.g., Ted Lapidus, 112 F.3d at 96.

In sum, the mandate of the PSLRA obviates the need to find bad faith prior to the imposition of sanctions. At the same time, the concerns identified in Pennie have some bearing in the PSLRA context. As will be discussed in Part III, the ex post nature of PSLRA sanctions may influence whether an opposing party's fees are reasonable under the circumstances; it could not have been Congress's intent to incentivize undue delay, or discourage lawyers from promptly filing their own Rule 11 motions simply because the court will automatically make Rule 11 findings at the end of a litigation. ***

Although the concerns identified in Pennie do not require a finding of bad faith, they may bear on the question of the reasonableness of Knight's fees. As we noted in Pennie, one purpose of the 21-day safe harbor is to provide an incentive to opposing attorneys to file Rule 11 motions promptly: delay past the point at which a pleading or motion may be amended or withdrawn may work a forfeiture of Rule 11 remedies. See Pennie, 323 F.3d at 89 ("Although Rule 11 contains no explicit time limit for serving the motion, the 'safe harbor' provision functions as a practical time limit, and motions have been disallowed as untimely when filed after a point in the litigation when the lawyer sought to be sanctioned lacked an opportunity to correct or withdraw the challenged submission.").

The PSLRA's mandatory sanctions provision can operate to reverse this incentive. By directing a district court to make findings "upon final adjudication of the action," 15 U.S.C. § 78u-4(c)(1), the statute might discourage the filing of prompt Rule 11 motions, allowing lawyers to dither, or even wait on purpose in order to increase costs that can be shifted onto sanctioned counsel. Such a delay would waste judicial resources, and impose unfair burdens. Nothing in the PSLRA prevents an adversary from filing a Rule 11 motion at an earlier point in the litigation, before heavy costs have accrued. Even in the context of the PSLRA, a Rule 11 letter from an opposing counsel may bring new facts to light, or prompt a challenged attorney to reconsider. Thus, in determining whether a party's fees are "reasonable" under 15 U.S.C. § 78u-4(c)(3), a district court should consider whether the opposing party's failure to move for Rule 11 sanctions more promptly may have unnecessarily increased the costs, and thereby unnecessarily increased the sanctions. If so, a "reasonable" award might be only the amount of fees that would likely have been incurred if a Rule 11 motion had been promptly made.

In this case, Knight did not move for Rule 11 sanctions until it was invited to do so by the district court, after the Third Amended Complaint had been dismissed. We have no reason, on this record, to think that Knight's failure to move for Rule 11 sanctions at an earlier stage was the product of undue delay, or a bad faith tactic to shift additional fees and costs onto ATSI. Nevertheless, the district court should have the opportunity to consider in the first instance whether Knight's failure to move for Rule 11 sanctions at an earlier stage had any bearing on whether its fees were "reasonable."

[Footnote] 15 The PSLRA's rebuttable presumption that an appropriate sanction is an award of the opposing party's fees (under § 78u-4(c)(3)(A)(i) or (ii)) does not appear to preclude a court from imposing a greater sanction, with the remainder going to the court. This way, a district court may impose as great a monetary sanction as it deems necessary (in light of the seriousness of the Rule 11 violation), without impairing the defendant's incentive to act promptly to reduce overall litigation costs.

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