United States Supreme Court Rules That Inference of Fraudulent Intent Meets Minimum Statutory Requirements Only When It Is at Least as Compelling as an Opposing Inference of Nonfraudulent Intent
The United States Supreme Court issued an important opinion on June 21, 2007, that will likely make antifraud securities lawsuits more difficult to pursue,
helping to better protect would-be defendants from frivolous and abusive lawsuits. This case, Tellabs, Inc. v. Makor Issues & Rights, Ltd., decided on June 21, 2007, resolved a split among Courts of Appeal as to how to impose the heightened pleading standard set forth in the Private Securities Litigation Reform Act of 1995 (PSLRA) in antifraud cases.
For over a decade, the PSLRA has imposed specific pleading requirements on private plaintiffs in securities fraud lawsuits, requiring, among other things, that all facts be pleaded with particularity, including facts that evidence scienter—a defendant’s fraudulent and/or manipulative intent. To plead facts that meet this requirement, PSLRA Section 21(D)(b) requires that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”1 Differences of opinion in Courts of Appeal as to what satisfies the “strong inference” requirement have led to significantly different outcomes, and led to the Supreme Court offering its ultimately authoritative opinion with an 8-1 majority as to what Congress intended with that section of the PSLRA.
The Tellabs decision clarified that in order to consider a pleading sufficient to establish the required “strong inference” of scienter, courts must
(1) consider the complaint holistically rather than each allegation individually, and
(2) consider the scienter inference to be cogent and compelling in light of plausible opposing inferences.
If the inference does not survive these two prescriptions, it cannot survive a motion to dismiss.
Tellabs, a manufacturer of specialized equipment for use in fiber optic networks, and its CEO and president, Richard Notebaert, were sued by shareholders who accused Tellabs and Notebaert of deceiving the public about business operations that significantly affected the value of Tellabs’ stock. The shareholders claimed, among other things, that for at least six months, Notebaert falsely proclaimed that both its flagship networking device and its next-generation replacement were experiencing strong demand and that the company’s revenue statements and projections were overstated. Increasingly cautious sales projections were made over a period of several months, culminating in Tellabs’ June 19, 2001 disclosure of a simultaneous significant drop in both the demand for the flagship product and revenue projections for the second quarter of 2001. The next day, Tellabs’ stock price dropped precipitously.
Shareholders later filed a class action suit alleging securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. Tellabs moved to dismiss on the grounds that the complaint was not pleaded with the particularity required by the PSLRA. The District Court agreed and dismissed the case. The plaintiffs then submitted an amended complaint with references to numerous confidential sources, but the District Court dismissed again, stating that although the claims about the misleading nature of Notebaert’s statements were pleaded with sufficient particularity, they had not sufficiently alleged scienter. The Seventh Circuit reversed on appeal, stating that scienter had been sufficiently pleaded. After noting the split among circuits on this issue, the Supreme Court agreed to hear the case.
What Does the PSLRA Require?
The Seventh Circuit believed that the plaintiffs sufficiently pleaded facts alleging scienter because it interpreted the PSLRA as requiring pleaded facts that, if true, would allow a reasonable person to infer that the defendant acted with the required intent. The court rejected the Sixth Circuit standard that plaintiffs were entitled only to the “most plausible of competing inferences.”
The Supreme Court concluded that in enacting the PSLRA, Congress intended to create a uniform pleading standard for actions involving violations of Section 10b of the Exchange Act, in an attempt to deter harassing and frivolous private lawsuits while still allowing recovery on meritorious claims. The Court thus determined that in Section 10(b) actions, courts must consider whether all the facts together support a strong inference of scienter, as opposed to considering allegations individually. Courts must also consider plausible nonfraudulent inferences when determining the strength of the inference of scienter. A factual basis for scienter allegations is only sufficient when it gives rise to a powerful and “cogent” inference as compared to plausible alternative explanations. Although the scienter inference need not be irrefutable, or even the most plausible of competing inferences, it must be “compelling” in light of other explanations. A complaint survives only if a reasonable person would deem the inference of fraudulent behavior cogent, and at least as compelling as any opposing inference that could be drawn from the facts.
The Court also notes that the absence of an allegation of motive is not necessarily fatal to a complaint. Because allegations must be considered holistically, the impact of a failure to allege motive is heavily context-dependent. Similarly, omissions and ambiguities in complaints count against the inference of scienter, but are not necessarily fatal – if such a conclusion would require assessment of individual allegations in isolation rather than together, it is invalid.
Concurrences and Dissent
Justice Scalia in his concurring opinion stated that the “strong inference” requirement means that the standard should be more compelling than an opposing inference, rather than at least as compelling, noting that the natural meaning of the term “strong inference” lends itself to his conclusion. Justice Alito’s concurrence agrees with Scalia’s “more likely than not” analysis, and adds that only facts alleged with particularity should be considered in determining the scienter inference. He states that allowing vague or general allegations in determining scienter undermines the purpose of pleading with particularity by allowing unfit complaints to survive motions to dismiss. Alito also states that although he agrees with Scalia’s interpretation, it is unlikely that the “at least as” versus “more” distinction will make any practical difference.
Justice Stevens in his dissent stated that the purpose of the heightened pleading requirements of the PSLRA is served more simply and practically by adopting a “probable-cause standard,” which is a workable term with which judges are already familiar, and which roughly means “strong inference” anyway. Stevens says that the new standard created by the majority actually makes it more difficult to bring a civil case than a criminal one, which was unlikely to have been Congress’ intent in passing the PSLRA. In addition to noting the utility of the probable-cause standard, Stevens points out that there are times when “strong inferences” can be and are made without having to explicitly weigh competing inferences, implying that the majority’s addition of this standard is unnecessary and burdensome.
The impact this case will have on securities fraud lawsuits is significant. Plaintiffs to now survive a motion to dismiss must plead facts that are sufficiently strong to create a cogent and compelling inference of scienter relative to opposing inferences of nonculpable behavior. Many more complaints than previously will be dismissed for failing to meet this higher standard. However, although the PSLRA’s heightened pleading standard has been clarified, there is still room for differences of opinion by judges as to what constitutes a “incognant inference.”