In Tellabs, Inc. v. Makor Issues & Rights Ltd., the United States Supreme Court clarified the standard for pleading scienter under the Private Securities Litigation Reform Act of 1995 (the "PSLRA"). To establish liability under Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, a private plaintiff must plead and prove, among other things, that the defendant acted with scienter, that is, with "a mental state embracing intent to deceive, manipulate, or defraud." 2 However, in an effort to curb perceived abuses of the Section 10(b) private cause of action, particularly in the class action context, Congress enacted certain new procedures and controls in the PSLRA, including heightened pleading standards for private litigants in Section 10(b) actions.
In particular, the PSLRA requires a plaintiff to allege with particularity both the facts constituting the alleged violation, and the facts evidencing scienter. With respect to the latter requirement, Section 21D(b)(2) of the PSLRA mandates that in a private securities fraud action brought under Section 10(b), a plaintiff must "state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind."3 However, Congress left unspecified precisely what plaintiffs had to allege to establish a "strong inference" of scienter, and the courts of appeal had adopted differing standards that litigants had to meet to satisfy that provision.
In Tellabs, the Court rejected the standard adopted by the Seventh Circuit, which permitted a plaintiff to satisfy the "strong inference" standard merely by alleging facts "'from which, if true, a reasonable person could infer that the defendant acted with the required intent.'"4 Concluding that the Seventh Circuit's standard did not "capture the stricter demand Congress sought to convey in § 21D(b)(2),"5 the Court instead held that
[T]o determine whether a complaint's scienter allegations can survive threshold inspection for sufficiency, a court governed by § 21D(b)(2) must engage in a comparative evaluation; it must consider, not only inferences urged by the plaintiff, as the Seventh Circuit did, but also competing inferences rationally drawn from the facts alleged. An inference of fraudulent intent may be plausible, yet less cogent than other, nonculpable explanations for the defendant's conduct. To qualify as "strong" within the intendment of § 21D(b)(2), we hold, an inference of scienter must be more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent. 6
The Court went on to articulate a three-step analytical approach that a district court must apply on a Rule 12(b)(6) motion to dismiss in adjudicating the sufficiency of scienter allegations asserted by a private litigant in a Section 10(b) action. First, as with any motion to dismiss, the court must accept as true all factual allegations asserted in the complaint.7
Second, the court also must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on motions to dismiss, including "documents incorporated into the complaint by reference, and matters of which a court may take judicial notice." The Court emphasized that "[t]he inquiry, as several Courts of Appeals have recognized, is whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets the standard."8 This requirement is particularly significant in that it requires a court on a motion to dismiss to review a wide range of materials found outside the pleadings themselves. This requirement could severely limit a plaintiff's ability to selectively quote from various documents and public filings in the complaint in an effort to satisfy the strict pleading standards of the PSLRA.
Third, the court must take into account plausible opposing inferences.9 That is, "[t]o determine whether the plaintiff has alleged facts that give rise to the requisite 'strong inference' of scienter, a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff."10 Although the inference that the defendant acted with the requisite state of mind "need not be irrefutable," the Court emphasized that "the inference of scienter must be more than merely 'reasonable' or 'permissible' — it must be cogent and compelling, thus strong in light of other explanations."11
Although it appears that any private plaintiff asserting a Section 10(b) action will face a steep hurdle at the motion-to-dismiss stage, only time will tell whether the pleading standard adopted by the Court in Tellabs is effective in weeding out at the motion-to-dismiss stage frivolous securities actions brought under Section 10(b).