On June 21, 2007, the Supreme Court issued its opinion in the first of two securities fraud cases pending before the Court: Tellabs, Inc. v. Makor Issues & Rights, Ltd. In Tellabs, the Court reviewed a prior decision from the Seventh Circuit Court of Appeals, which held that a district court should not consider inferences favorable to a defendant in ruling on a motion to dismiss. The Supreme Court reversed the Seventh Circuit, holding that a consideration of competing inferences was not only permissible, but indeed was required to give full effect to the heightened pleading requirements of the Private Securities Litigation Reform Act (the “Reform Act”). The Tellabs decision makes clear that, on a motion to dismiss in a securities fraud case, “a court must consider [all] plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff.”
Congress passed the Reform Act over 11 years ago in an attempt to curb abuses in securities fraud class actions. One issue that was hotly litigated after the Act’s passage was the requirement that a plaintiff must state with particularity facts giving rise to a “strong inference” of scienter or fraudulent intent in order to survive a motion to dismiss. The statute, however, did not expressly define what a “strong inference” means and, thus, courts were left to develop their own definition.
With the Tellabs decision, the Supreme Court sought to resolve an existing split among the circuits regarding one aspect of the strong inference requirement: whether district courts should consider competing inferences in determining whether an inference of scienter is “strong.”
The Court set as its goal the establishment of “a workable construction of the ‘strong inference’ standard, . . . geared to[wards] the [Reform Act’s] twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.” The Court’s construction of this standard yielded the following guidelines for district courts when faced with motions to dismiss under the Reform Act.
First, as with any motion to dismiss, a court must accept all of the factual allegations in the complaint as true. This instruction reflects the existing standards regarding initial motion practice.
Second, the Court held that a complaint must be considered in its entirety, along with other sources district courts ordinarily examine when ruling on motions to dismiss, such as documents incorporated by reference into the complaint or SEC filings and other matters of public record that are susceptible to judicial notice. Here, the Supreme Court followed the majority rule that a court must consider all of the pertinent well-pled facts to determine whether scienter has been established for a particular defendant. As noted above, this rule, however, comes with an important caveat for defendants – i.e., this “holistic” analysis is not limited to the four corners of the complaint. Indeed, a defendant’s ability to rely on other source materials has proven to be very important in these cases, particularly for the purpose of establishing the competing inferences that must be considered.
Third, and most importantly, Tellabs directs courts to take into account any plausible opposing inferences in determining whether the pleaded facts give rise to a strong inference of scienter. The Seventh Circuit, thus, erred in refusing to engage in such an inquiry. The Seventh Circuit had instead adopted the view that a complaint could survive so long as it “alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”
The Supreme Court concluded that this interpretation did not comport with the intent of Congress. Congress did not require merely that plaintiffs provide some factual basis for scienter allegations. Nor did Congress suggest that inferences that are simply “reasonable” or “permissible” will prevail. Instead, Congress explicitly directed that plaintiffs “must plead with particularity facts that give rise to a ‘strong’ – i.e., a powerful or cogent – inference.”
The Supreme Court correctly observed that “[t]he strength of an inference cannot be decided in a vacuum.” It is an “inherently comparative” analysis that necessarily must take into consideration plausible inferences that undercut scienter. In other words, there is no way to determine whether an inference is “strong” unless the district court looks at all the inferences that can be drawn from the complaint or other relevant source materials. A complaint may survive “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”
Unlike the Seventh Circuit, the Supreme Court was not persuaded that a weighing of inferences at the motion to dismiss stage raises Seventh Amendment concerns. Accordingly, the issue of the right to a jury trial, which had been the focus of the Tellabs oral argument before the Supreme Court, did not factor significantly into the Court’s decision-making. The Court simply held that “[a district] court’s comparative assessment of plausible inferences, while constantly assuming the plaintiff’s allegations to be true, . . . does not impinge upon the Seventh Amendment right to jury trial.” Indeed, at the motion to dismiss stage, there can be no conflict with the ultimate fact-finder because the judge in ruling on the motion is not making any findings of fact or considering evidence as would occur later in the case.
After setting forth the guidance for lower courts to follow, the Supreme Court remanded the case to the district court so that it might have the opportunity to consider the case-specific allegations and inferences in light of this new guidance. The Court did caution, however, that vague and ambiguous allegations will count against inferring scienter because Congress clearly directed that securities fraud claims must be pled with particularity. Thus, the quality, or lack thereof, of a plaintiff’s scienter allegations must be considered in determining whether the requisite strong inference has been pled.
The Tellabs decision preserves both the letter and the spirit of the reforms instituted by Congress in 1995. The Seventh Circuit’s view that any reasonable or rationale inference should suffice would have read the word “strong” out of the statute and returned litigants to pre-Reform Act standards. Only those claims supported by inferences that are strong in comparison to other possible inferences should be allowed to proceed to discovery. If a plaintiff could prevail based on an illogical scienter theory or one that represented the least likely explanation for events, motions to dismiss would fail their gate-keeping function of preventing frivolous claims. Tellabs prevents such a result.