The Supreme Court’s June 21, 2007 decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. is critically important to public companies and their directors and officers. The decision is part of a trilogy of cases in which the Supreme Court is recasting the requirements for plaintiffs to bring securities fraud cases and class actions. Two years ago, the court decided Dura Pharmaceuticals, Inc. et al v. Broudo, which, along with its most recent decision in Tellabs, defines key elements of a securities claim. Next term, the Court will decide Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., which will define who can be named in these suits. Overall, these cases are redrawing the landscape of securities fraud suits.
In Tellabs, the Court crafted a balanced decision that levels the playing field for those at risk of being named as defendants in securities fraud suits and class actions. Specifically, the Court clarified the key requirement (which Congress left undefined) that plaintiffs allege a “strong inference” of scienter. This requirement was added to the securities laws as part of the Private Securities Litigation Reform Act of 1995 (“PSLRA”) and was designed to end abuses in filing securities fraud suits and class actions. After specifying that plaintiffs must plead facts “rendering an inference of scienter at least as likely as any plausible opposing inference,” the Court went on to state that, in assessing the strength of this inference, district courts should examine: 1) all the allegations in the complaint; 2) any documents incorporated by reference; and 3) materials of which the Court can take judicial notice. This directive, raised by the Court without any suggestion by the parties or the SEC, should end pleading games in which statements are taken out of context and plaintiffs are permitted to conduct expensive discovery based on selected factual allegations crafted to take advantage of pleading rules that heavily favor them. This standard levels the playing field for defendants at the threshold of the case.
The PSLRA’s Requirement of a “Strong Inference” of Scienter
When enacted in 1995, the PSLRA established certain pleading requirements in private securities actions. As Justice Ginsburg said in her majority decision in Tellabs, the point of those amendments was to eliminate frivolous suits, but not suits that have merit. Section 21D(2)(B), for example, established that plaintiffs must “state with particularity facts giving rise to a strong inference that defendant acted with the required state of mind.” 15 U.S.C. § 78u-4(b)(2). Plaintiffs who failed to satisfy that requirement could have their cases dismissed at an the early pleading stage. However, as Justice Ginsburg pointed out, Congress left the key term “strong inference” undefined.
The Supreme Court Ruling
The Supreme Court accepted certiorari in Tellabs, as Justice Ginsburg described, to “prescribe a workable construction of the ‘strong inference’ standard, a reading geared to the PSLRA’s twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.” Previously, the circuit courts had split over what facts had to be pled to establish a “strong inference”; how to consider conflicting inferences that might be drawn from the allegations in the complaint; the impact in securities cases of Federal Rule of Civil Procedure 12(b)(6) and its traditional liberal pleading standard which, favors plaintiffs being permitted to move forward with discovery; and the requirements of the PSLRA.
Writing for the Court, Justice Ginsburg crafted a balanced decision that levels the playing field for defendants and which may well increase the burden on plaintiffs who attempt to bring and maintain securities fraud actions. The Court began by noting that the PSLRA unequivocally raised the bar for pleading scienter and signaled Congress’ intent to promote greater uniformity in measuring the pleading standards. Following this theme, the Court identified three “prescriptions” for district courts considering a motion to dismiss a securities fraud complaint.
- First, the Court reiterated that when considering a motion to dismiss the complaint under Federal Rule of Civil Procedure 12(b)(6), the factual allegations in the complaint must be accepted as true
- Second, the Court stated that the entire complaint must be considered (including all documents incorporated into the complaint and matters of which the court may take judicial notice). As a result, all of the facts alleged — rather than any individual allegation taken on its own — must be considered when evaluating whether a “strong inference” of scienter has been pled. The Court specifically rejected Justice Alito’s argument in his concurring opinion that only those facts that are pled with particularity, as mandated by the PSLRA, be considered.
- Third, the Court established that plausible competing inferences must be considered. Congress did not require allegations “from which an inference of scienter rationally could be drawn.” Rather, Congress required plaintiffs to plead facts that give rise to an inference that is “strong,” which dictionaries define as “persuasive, effective and cogent” and “powerful to demonstrate or convince.”
Based on these principles, the Court concluded that a “complaint will survive, we hold, 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.” Since the Seventh Circuit did not apply this test, the Supreme Court reversed the lower court’s decision and remanded the case for reconsideration.
The Impact of the Court’s Decision
The Court’s decision is of key importance to those facing damage claims in securities lawsuits. Tellabs levels the playing field consistent with the dictates of the PSLRA and, in essence, rewrites Rule 12(b)(6) in securities cases. Previously, that rule tipped the balance in favor of plaintiffs by permitting a complaint to go into discovery if any construction of its allegations stated a claim. Recognizing that securities fraud claims that proceeded past a motion to dismiss and into discovery frequently settled for sums out of proportion to the merits because of what the Supreme Court has repeatedly called the “vexatious” nature of securities damage claims, Congress, in passing the PSLRA, sought to provide a meaningful opportunity for defendants to test plaintiffs’ allegations at the threshold of the case. The Supreme Court’s decision in Tellabs goes far to fulfill that promise by substituting a procedure under which courts can assess a motion to dismiss on a proper record instead of focusing on what plaintiffs chose to put in their complaint. No doubt this decision will be significant for every company and its officers and directors who have to face a securities fraud suit.