The Ninth Circuit recently issued two decisions addressing how the United States Supreme Court’s opinion in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 1499 (2007), has impacted the Ninth Circuit’s analysis of the scienter pleading requirement: Zucco Partners, LLC v. Digimarc Corp., No. 06-35758, 2009 WL 57081 (9th Cir. Jan. 12, 2009); Rubke v. Capitol Bancorp Ltd., No. 07-15083, 2009 WL 69278 (9th Cir. Jan. 13, 2009). Both decisions acknowledge that Tellabs requires an additional step in the court’s analysis of scienter allegations on a motion to dismiss. But both decisions also confirm that the overall requirements for pleading scienter are no less stringent than before.
The main issue, addressed most directly in Zucco, was a claimed tension between Tellabs and the Ninth Circuit’s existing framework for analyzing scienter. The Ninth Circuit had, since passage of the Private Securities Litigation Reform Act (the “Reform Act”), developed certain rules for analyzing different types of scienter allegations – confidential informant allegations, defendant stock sales, etc. – to determine whether they gave rise to the required “strong inference of scienter.” Zucco, 2009 WL 57081, at *6. Courts in the Ninth Circuit were required to apply these rules to each group of allegations separately to determine whether any of them, standing alone, would provide the necessary strong inference of scienter. Id. If not, the complaint did not meet the Reform Act’s pleading requirements and was dismissed.
Tellabs, many plaintiffs argued, significantly diluted, if not outright rejected, this “segmented” analysis of scienter. See id. at *1. The Supreme Court concluded that a securities fraud complaint will survive a motion to dismiss “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.” Tellabs, 127 S. Ct. at 2510. That determination, the Supreme Court explained, was an “inherently comparative” process in which judges were required to take into account “plausible opposing inferences.” Id. To do so, those judges had to “consider the complaint in its entirety,” and determine whether “all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individualized allegation, scrutinized in isolation, meets that standard.” Id. at 2509. Plaintiffs have argued that this language implicitly rejected the allegation-by-allegation approach previously required in Ninth Circuit.
Zucco addressed this argument head-on, and in doing so for the first time “fully explained how the [Supreme] Court’s Tellabs decision relates to much of our analysis.” Zucco, 2009 WL 57081, at *1. The Ninth Circuit’s conclusion was that “Tellabs does not materially alter the particularity requirements for scienter claims established in our previous decisions.” Id.
The Court began by acknowledging the apparent tension between Tellabs and the Ninth Circuit’s existing approach to scienter. “Although we have developed a set of rules to analyze different types of scienter allegations, we recognize that Tellabs calls into question a methodology that relies exclusively on a segmented analysis of scienter. We read Tellabs to mean that our prior, segmented approach is not sufficient to dismiss an allegation of scienter.” Id. at *6.
That being said, however, the Court noted that it “continued to employ the old standards in determining whether . . . a plaintiff’s allegations of scienter are as cogent or as compelling as an opposing innocent inference.” Id. The only difference was that the Court must now “also view the allegations as a whole.” Id. The result was a two-part inquiry: “[F]irst we will determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a ‘holistic’ review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or recklessness.” Id.
The Court applied this two part analysis to the facts before it in both Zucco and Rubke, and upheld the dismissal of both complaints. Zucco involved claims that the defendant corporation and certain of its officers had intentionally overstated the company’s earnings and prospects by improperly capitalizing (rather than expensing) various internal software development costs. Zucco, 2009 WL 57081, at *1. The scienter allegations included allegations regarding: (1) confidential witness statements; (2) restatements of earnings; (3) the resignations of various key accounting executives and the corporation’s outside auditor during the class period; (4) statements made in the corporation’s Sarbanes-Oxley certificates; (5) the compensation packages of the individual defendants; (6) the stock sales of the individual defendants during the class period; and (7) a private placement by the corporation during the class period. Id. at *6. The Court, in an extremely detailed analysis, applied its existing rules for each of these different types of allegations, and found each of them insufficient, by themselves, to give rise to the required strong inference of scienter. Id. at *7-*20.
Rubke involved claims that the defendant corporation had deliberately understated the value of stock subject to a pending tender offer, by making various false statements in telephone calls to key minority shareholders, so that the company could purchase the shares at below market value. Rubke, 2009 WL 69278, at *2. The Court addressed the scienter allegations relating to the telephone calls in significant detail, and much like in Zucco, concluded that none of them individually supported a strong inference of scienter. Id. at *8-*9.
In both cases, after addressing the individual scienter allegations, the Ninth Circuit then performed the additional Tellabs inquiry, and addressed whether, when all of the inferences from each complaint were viewed together, they gave rise to a strong inference of scienter that was absent when each was considered alone. Zucco, 2009 WL 57081, at *21; Rubke, 2009 WL 69278, at *9. In both cases, the Court of Appeals concluding that, even when considered “holistically,” the combined inferences failed in these cases. Id. In both cases, the Court observed that, while in some circumstances “a set of allegations may create an inference of scienter greater than its parts,” it was just as likely that combining the group of weak inferences together simply resulted in an equally weak inference overall. Zucco, 2009 WL 57081, at *21; see also Rubke, 2009 WL 69278, at *9. As such, the “additional” Tellabs inquiry worked no material change on the Ninth Circuit’s pre-existing framework for analysis. Id.