At a time when investors and securities law plaintiffs’ lawyers are reeling from a series of court defeats, the U.S. Supreme Court’s June 21, 2007 decision in Tellabs v. Makor Issues & Rights, Ltd.1 was a reprieve from the possible death sentence that the Court could have dealt to private securities litigation. The elements of a securities fraud claim under section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder are: (1) in connection with the purchase or sale of a security, (2) the making of a misrepresentation or the omission, (3) with scienter, (4) of a material fact (5) upon which the plaintiff reasonably relies and (6) that causes the plaintiff to lose money. In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA), which, among other things, established heightened pleading requirements for several of these elements.
The Supreme Court’s decision in Tellabs interpreted only one of the most important provisions of the PSLRA: the requirement that a plaintiff in a private securities fraud action “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” i.e., scienter or an intent to deceive, manipulate or defraud.
Nonetheless, to understand Tellabs one must be aware of the other major pleading requirement of the PSLRA: that “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” Although the Supreme Court has not interpreted this provision, it has been held by various courts to require detailed allegations specifying the factual underpinnings for an allegation that a fraud has been committed. This requirement alone has led to the dismissal of many a case that, under a looser pleading standard, would clearly not have been dismissed.
For the scienter requirement to be decisive, therefore, one must assume that a plaintiff has satisfactorily pled the existence of a fraud. The issue is whether the plaintiff has adequately pled that each of the named defendants has committed the fraud with an intent to deceive. The PSLRA requires that the plaintiff plead facts giving rise to a “strong inference” that this is so.
The Supreme Court’s holding was that “[a] complaint will 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.” The first question, at least for headline writers, is whether this case is a “win” or a “loss” for investors and corporate America. From the defendants’ viewpoint, the decision can be viewed as somewhat of a disappointment. The lower courts had split on what the “strong inference” test meant. At one end of the spectrum was the standard announced in the Seventh Circuit’s decision in the Tellabs case, which was rejected by eight of the nine Justices: a complaint will survive dismissal “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.” At the other end of the spectrum was the standard in the Sixth Circuit: a complaint will survive only if the inference of scienter is “most plausible of competing inferences.” The Supreme Court rejected both standards and appears to have taken a middle-ground approach.
Interestingly, the Court declined to apply its new test to the complaint before it, a puzzling result when the issue, had it been addressed, would have been precisely the same as that now left to either the Seventh Circuit or, if remanded, the district court: whether this complaint passes muster under the newly announced test. The fact that the Supreme Court decided not to interpret the complaint could very well be the result of an impasse among the six Justices joining the opinion, if not the two issuing concurring opinions, concerning whether or not the Tellabs complaint passed the test. If that is so, it portends considerable disagreement at the lower court level concerning exactly how to apply this standard.
Among the issues that will inevitably confront a judge in deciding this question are the following:
- What is the significance of the word “cogent” in the phrase “cogent and at least as compelling as any opposing inference one could draw from the facts alleged”? The word “cogent” is defined as “compelling belief, assent, or action; forcible; convincing.”2 Does the term “cogent” add anything of substance to the plaintiff’s burden and, if so, what? Does it just mean, in this context, that the inference of fraudulent intent must be “reasonable” or “permissible,” leaving for analysis whether the inference is at least as compelling as any inference of non-intent? Or does it mean that the inference of fraudulent intent be stronger than merely reasonable, i.e., forceful, leaving for analysis the comparison to other forcibly compelled inferences – or to other merely reasonable inferences? A possible answer to this question lies in the sentence that precedes the actual holding in Tellabs: “[T]he inference of scienter must be more than merely ‘reasonable’ or ‘permissible’ – it must be cogent and compelling, thus strong in light of other explanations.”
- All things being equal, is an intent to deceive as likely as an intent to be honest? Will judges necessarily tip the scales, or start the analysis, with the assumption that business people are, or are not, likely to commit fraud? Is a preconception, one way or the other, proper in this analysis, even if psychologically unavoidable, or should a judge view the question without any assumptions about human nature?
- How significant will be the language in the opinion that the issue will be “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 that standard”? Will plaintiffs argue, in effect, that the whole is greater than the sum of its parts? Will judges find that a persuasive argument?
- What significance will courts attach to the Supreme Court’s repeated reference to “the conclusion ‘that private securities litigation [i]s an indispensable tool with which defrauded investors can recover their losses’ – a matter crucial to the integrity of domestic capital markets”? While this is hoary language that, in light of 30 years of restrictive Supreme Court decisions in 10b-5 litigation, might seem to ring a bit hollow, does the fact that it was emphasized by the majority opinion of Justice Ginsburg somehow signal the lower courts to exercise their discretion carefully so as not to foreclose possibly meritorious claims from proceeding, i.e., tilting the scales ever so slightly in the plaintiff’s favor?
- How exactly does one draw an inference of fraudulent intent from a set of allegations borne out of necessity, without any discovery, at least in the case before the court? The Supreme Court, for example, held that contemporaneous selling of company shares by the defendant is not required to satisfy the “strong inference” test, but, as a practical matter, will judges find it hard to rule that the allegations satisfy the test without allegations of sales and, likewise, will judges find it hard to rule that they do not satisfy the test when sales are alleged?
- A collateral observation is that savvy plaintiffs’ lawyers may start (if they have not done so already) using the courts of the state of incorporation to press for access to corporate records. This follows the strong suggestion of Delaware state court judges that before they bring a shareholder derivative action, they use the Delaware statute permitting shareholders access to corporate records to determine whether such an action is merited. In this respect, if the result is to bolster the allegations that can be fairly alleged against a prospective defendant, the Supreme Court’s decision in Tellabs will be less imposing a hurdle than it might otherwise be.
In conclusion, the Supreme Court’s decision in Tellabs is a middle-of-the-road decision that hides the uncertainty that evolves from determining exactly how the standard announced by the majority shall and should be administered by the lower courts. Whether it provides sufficient guidance for those courts to achieve the desired uniformity of analysis is an unanswered question. By declining to tackle the issue directly before it – whether the complaint in Tellabs passed the test announced in the decision itself – the Court may have done relatively little to achieve that uniformity in the short run. On the other hand, no matter what standard it announced and how it might have applied that standard to the allegations in the Tellabs case, the task of judicial parsing of language and inferences therefrom may simply be so subjective in nature as to render true uniformity a practical impossibility.