On June 21, 2007, in a much anticipated ruling affecting the ability of federal securities fraud complaints to withstand a motion to dismiss, the Supreme Court resolved a dispute between the federal circuit courts regarding what securities fraud plaintiffs must plead concerning the state of mind of defendants in order for a complaint to withstand dismissal. The Court squarely reinforced the importance of the heightened pleading standard contained in the Private Securities Litigation Reform Act (“PSLRA”) and settled a dispute between the federal circuit courts over the application of the PSLRA standard in favor of securities fraud defendants. Under the PSLRA, securities fraud plaintiffs are required to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” 15 U.S.C. §78u-4(b)(2).
In Tellabs, Inc. v. Makor Issues & Rights, Ltd., __ U.S. __, No. 06-484, 2007 WL 1773208, (June 21, 2007), the Supreme Court ruled that in order to plead fraudulent intent properly, the strong inference of scienter arising from the alleged facts “must be more than merely plausible or reasonable . . . it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent.” Contained within this standard set down by the Court is the requirement that a trial court must now take into account “plausible opposing inferences.” The Court emphasized the importance of scrutiny and vigilance by the trial courts in filtering securities fraud complaints under the PSLRA. Accordingly, in the wake of the Tellabs decision, it will be significantly more difficult for plaintiffs to survive the pleading stage.
Going even further than the majority holding that a strong inference is one that is “at least as compelling as any opposing inference,” Justice Scalia wrote in a concurring opinion that the test “should be whether the inference of scienter (if any) is more plausible than the inference of innocence.” Justice Alito also wrote a concurring opinion in which he agreed with Justice Scalia that a strong inference of scienter means “an inference that is more likely correct than not correct.” Justice Alito further stated that under the PSLRA “only those facts that are alleged with particularity may properly be considered in determining whether the allegations of scienter are sufficient.”
Harkening back to the concerns that lead to passage of PSLRA, the Tellabs Court stated that “securities fraud actions . . . if not adequately contained, can be employed abusively to impose substantial costs on companies and individuals whose conduct conforms to the law,” and remanded the case for consideration under the Court’s newly articulated standard.
The Tellabs action was brought as a purported class action, in which plaintiffs contended that Tellabs’ then Chief Executive Officer, along with its co-founder and chairman, made misleading statements about the company’s prospects for selling certain network equipment to major telecommunications carriers. The allegations, based on the alleged statements of 27 confidential sources, accused the company of deceiving investors about prospects for two of its products. Tellabs moved to dismiss the complaint on the ground that plaintiffs had failed to plead their claims with the factual particularity required by the PSLRA. The District Court agreed that plaintiffs failed to plead scienter on the part of the CEO, and dismissed the complaint with prejudice. The Seventh Circuit Court of Appeals reversed in relevant part, holding that the plaintiffs had sufficiently alleged facts sufficient to support an inference of scienter. In doing so, the Seventh Circuit adopted the view of courts that had taken a “middle ground” approach and declined to compare competing inferences.
The PSLRA, passed by Congress in 1995, sought to limit frivolous securities fraud cases by requiring plaintiffs to allege, at the initial pleading stage of a case, particularized facts that give rise to a “strong inference” of scienter. Despite the fact that in applying the PSLRA’s heightened standard the term “strong inference” is critical, Congress never defined the term. Because the motion to dismiss stage is a critical milestone in securities fraud class actions, how a court construes that phrase is vitally important to parties involved in such actions. Surviving a motion to dismiss permits plaintiffs to undertake discovery and pursue class certification, costly litigation pressures applied by plaintiffs to force securities fraud defendants to settle even merit-less cases.
After passage of the PSLRA federal courts interpreted the phrase “strong inference” differently and hence developed differing views of what was required to meet the “strong inference” standard. The Second and Third Circuits took the view that plaintiffs need only plead “either motive and opportunity or strong circumstantial evidence of recklessness or conscious misbehavior.” Novak v. Kasaks, 216 F.3d 300, 309-10 (2d Cir. 2000). The Ninth and Eleventh Circuits, on the other hand, believed Congress placed a more onerous burden on plaintiffs and that it is not enough “merely to provide facts showing simple recklessness or a motive to commit fraud and opportunity to do so.” In re Silicon Graphics Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999). Other circuit courts took a middle ground, reasoning that, by enacting the PSLRA, Congress did not endorse any particular type of evidence for proving scienter, but rather called for courts to examine all the allegations in a complaint and then decide whether the complaint in its entirety establishes a strong inference of scienter.
The circuit courts also differed in considering what weight courts should give to competing innocent explanations for a defendant’s actions. The Sixth Circuit imposed a stringent test, ruling that “the strong inference requirement creates a situation in which ‘plaintiffs are entitled only to the most plausible of competing inferences, but that it does not mandate that the inference be ‘irrefutable.’” Fidel v. Farley, 392 F.3d 220, 227 (6th Cir. 2004). Other circuits, however, feared that allowing a judge to dismiss a case based on a more stringent scienter test at the initial pleading stage than would ultimately be applied at trial would invade a plaintiff’s Seventh Amendment right to trial by jury. In the lower court Tellabs decision, the Seventh Circuit applied this approach to the issue, significantly diluting the “strong inference” standard. The Seventh Circuit held that it would allow “the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.” Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588, 602 (7th Cir. 2006).
The Supreme Court closed the door on both the debated meaning of “strong inference” and the weight to be afforded the defendants’ explanations. The Court set forth a three-step process for a trial court evaluating a motion to dismiss a federal securities fraud complaint. First, the factual allegations of the complaint must be taken as true. Second, the compliant must be read as a whole. Third, “in determining whether the pleaded facts give rise to a ‘strong’ inference of scienter, the court must take into account plausible opposing inferences.”
The Court, by re-emphasizing the potential for abuse and by ordering trial courts to weigh competing inferences, reinforced the importance of a trial court’s role as gatekeeper in filtering federal securities fraud cases. In doing so, the Court awarded a significant victory to securities class action defendants. It did so not just by reinforcing the PSLRA’s heightened pleading standard, but by requiring trial courts to weigh competing inferences and declining to adopt the middle ground approach of the Seventh Circuit and others. As the Tellabs Court’s language makes clear, trial courts must now (1) carefully examine all alleged facts at the pleading stage; (2) evaluate the possible inference to be drawn from those facts; (3) determine if the inference posited by the plaintiff is cogent and at least as compelling as any opposing inference of nonfraudulent intent. Tellabs is an important arrow in the motion to dismiss quiver of securities fraud defendants. An arrow that is made all the stronger by the concurring opinions of Justices Scalia and Alito.