In the recent decision of Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court of the United States set a national standard for pleading scienter in securities fraud actions brought under Section 10(b) of the Securities Exchange Act of 1934. Addressing the application of the heightened pleading standards set forth in the Private Securities Litigation Reform Act (PSLRA), the 8-1 Supreme Court decision resolves a split among the federal circuits with regard to the pleading of scienter.
To survive a motion to dismiss under the PSLRA, a plaintiff must allege with particularity facts giving rise to a strong inference that the defendant made the misrepresentations or omissions with scienter, i.e., knowingly or in a severely reckless manner. However, as the Supreme Court noted in Tellabs, the statute does not define “strong inference” and this has led to different interpretations across jurisdictions.
Through Tellabs, the Supreme Court aimed “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.” In furtherance of these goals, the Supreme Court set forth standards to be used by the district courts when evaluating the viability of a complaint.
THE TELLABS PLEADING STANDARD
First, in ruling on a motion to dismiss a securities fraud action, “courts must, as with any motion to dismiss for failure to plead a claim on which relief may be granted, accept all factual allegations in the complaint as true.” Second, courts should consider complaints in their entirety, as well as other sources of information appropriate for courts to consider on a motion to dismiss, such as documents incorporated into a complaint by reference, or public filings and other matters of which a court may take judicial notice. This language suggests that district courts will have less discretion when considering a request for judicial notice. For example, in a case involving allegations of misstatements or omissions in a proxy statement, it may now be mandatory for courts to consider the entirety of the proxy statement when evaluating a motion to dismiss. In this manner, bad facts (from a plaintiff’s perspective) can no longer be ignored at the pleadings stage, but now must be considered and weighed in deciding if the plaintiff’s story is at least as plausible as the facts contained in public filings.
The Supreme Court further explained that the inquiry for the district court is “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.” Thus, the allegations of scienter are to be viewed holistically. It is important to note, however, that only well-pleaded, specific allegations should be considered. As the Supreme Court confirmed, “omissions and ambiguities count against inferring scienter, for plaintiffs must ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.
Finally, and most significantly, the Supreme Court held that “in determining whether the pleaded facts give rise to a ‘strong’ inference of scienter, the court must take into account plausible opposing inferences.” More specifically, a court may not only consider “inferences favoring the plaintiff,” but must also “consider plausible nonculpable explanations for the defendant’s conduct.” As the Supreme Court explained, the district court must conduct a comparative analysis of competing inferences because the PSLRA does “not merely require plaintiffs to ‘provide a factual basis for [their] scienter allegations,’. . . i.e., to allege facts from which an inference of scienter rationally could be drawn. Instead, Congress required plaintiffs to plead with particularity facts that give rise to a ‘strong’—i.e., a powerful or cogent—inference.” Thus, per Tellabs, “the inference of scienter must be more than merely ‘reasonable’ or ‘permissible’—it must be cogent and compelling, thus strong in light of other explanations. . . . [and] at least as compelling as any opposing inference one could draw from the facts alleged.”
APPLICATION OF PLEADING STANDARD
Although the Supreme Court requires courts to weigh inferences, it does not require inferences advanced by plaintiffs to be the most plausible inferences, as the Sixth Circuit had held in Helwig v. Vencor, Inc. Instead, under this new pleading standard, a plaintiff’s case will be permitted to proceed to discovery as long as, when viewed holistically, the allegations of his complaint support an inference of scienter that is at least as plausible as the inference of innocence. For most jurisdictions, other than the Sixth Circuit, the Tellabs decision will represent a tougher pleading standard to be met by the plaintiff’s securities bar.