Congress passed the Private Securities Litigation Reform Act 12 years ago to curb abuses in securities fraud class actions. Among other reforms, the Act requires shareholder plaintiffs to plead a “strong inference” of scienter, or fraudulent intent, for each defendant to survive a motion to dismiss.48 In June 2007, the Supreme Court issued its first decision on this requirement: Tellabs, Inc. v. Makor Issues & Rights, Ltd.49
Tellabs resolved a split among the circuit courts on whether inferences favorable to a defendant must be considered on a motion to dismiss. The Supreme Court held that “a [district] court must consider plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff.”50 Thus, to qualify as “strong” under the Reform Act, “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.”51
There has been much speculation regarding how Tellabs would affect motions to dismiss in shareholder securities class actions. A number of decisions have now been issued applying Tellabs. These decisions, described below, demonstrate that defendants are already realizing significant benefits from the opinion.
A Weapon to Fight Conclusory Allegations and Generalized Speculation
Tellabs directs that “omissions and ambiguities [in complaint allegations] count against inferring scienter . . . .”52 Thus, on a motion to dismiss, plaintiffs will not receive the benefit of inferences that flow from vague and non-specific allegations of knowledge by the defendants based on, for example, their positions as company executives.53 Dismissal is required where the district court is “left to speculate about what particular information was hidden, what financial figures were manipulated, and when any of the defendants knew of or implemented such fraudulent devices.”54 Claims are similarly deficient where the complaint “does no more than infer that ‘someone’ in the ‘management’ . . . had to know about the scheme.”55
This trend toward greater scrutiny of claims pending against each of the named defendants is beneficial to all defendants in a case. Scienter must be pled as to each defendant and each misstatement separately.56 If plaintiffs are unable to plead scienter for the individual defendants (i.e., the officers and directors of the company at issue), then the entire case must be dismissed. A corporation can only act through its employees and, under this scenario, no scienter can be imputed to the corporate defendant.57
Inferences Available from Source Materials Outside of the Complaint
Tellabs also made clear that courts should consider not only those inferences from the complaint favorable to defendants, but also inferences available from other sources ordinarily examined on motions to dismiss, such as documents incorporated by reference into the complaint, SEC filings, and other matters of public record that are susceptible to judicial notice.58 A defendant’s ability to rely on these materials has proven to be important for purposes of establishing competing inferences.59
Moreover, plaintiffs have every incentive to omit public record facts that undercut an inference of scienter. Under Tellabs, plaintiffs cannot prevail simply because they have attempted to plead around facts contrary to their cause. Defendants are allowed to bring these discrepancies to the court’s attention so that they may be factored into the analysis.60
Use of Confidential Informants Rejected under Tellabs
Tellabs also calls into question plaintiffs’ use of information supposedly derived from “confidential informants” who purport to be former employees of the company. 61 The Seventh Circuit held that Tellabs requires a court to “discount” allegations purportedly derived from informants and that this discount will usually be “steep.”62 Indeed, it is “hard to see how information from anonymous sources could be deemed ‘compelling’ or how [a court] could take account of plausible opposing inferences” as required under Tellabs.63 Confidential sources could have axes to grind, be lying, or perhaps do not even exist.64
Similarly, the Fifth Circuit in the wake of Tellabs has required more detail surrounding such allegations before they may be credited as a basis for inferring scienter.65 Additional facts must be pled as a prerequisite for consideration such as the witness’s job description, individual responsibilities, specific employment dates, and a detailed basis for personal knowledge.66 Moreover, the mere fact that informants can shed some light on a company’s inner workings will not suffice. Thus, an informant’s ability to provide employee names or to identify certain software utilized by a company does not give rise to a strong inference that the defendants knowingly made false or misleading public statements.67 Rather, there must be particularized allegations showing that the supposed misconduct was “communicated up the corporate chain of command to the individually-named [d]efendants or . . . members of senior management who were responsible for preparing the public statements [p]laintiffs have alleged contained false and misleading information.”68
Greater Scrutiny of Stock Sales Allegations
Plaintiffs often attempt to plead scienter through defendants’ stock sales. They argue that these sales were motivated by a desire to “cash out” of the stock before adverse facts about the company become public. Where other benign inferences are available from the sales (or the lack of sales), Tellabs requires that they must be considered in ruling on a motion to dismiss.69 For example, courts dismiss claims under Tellabs where plaintiffs attempt to rely on executives’ stock sales pursuant to SEC Rule 10b5-1.70 Rule 10b5-1 is designed to allow executives to trade in stock via a pre-determined plan and thereby avoid second-guessing as to what motivated the sales. Courts recognize that pre-arranged sales are insufficient to plead scienter, particularly where plaintiffs also fail to allege facts showing that the sales were unusual in any respect.71
Tellabs also directs that courts must consider non-culpable inferences that arise from such sales, such as the fact that the sales were a small percentage of the individual’s total stock holdings.72 Plaintiffs often fail to allege defendants’ prior sales history or the total number of shares held.73 Tellabs directs that this omitted information must be considered and defendants may bring this information to the court’s attention through the appropriate SEC filings. In this respect, Tellabs prevents plaintiffs from pleading scienter based solely on the fact that some stock sales took place.
As described above, Tellabs preserves both the letter and the spirit of the reforms instituted by Congress many years ago. The Supreme Court properly rejected the more liberal view that any rationale inference should suffice, which would have read the word “strong” out of the statute and returned litigants to pre-Reform Act standards. One of the most significant developments in 2007 has been the extent to which lower courts have embraced Tellabs and demonstrated a willingness to dismiss deficient allegations that fail to meet its standards. Indeed, in most instances over the past year where courts have engaged in a rigorous application of Tellabs, the end result has been the dismissal of the claims at issue.