Eleven years after Congress enacted the Private Securities Litigation Reform Act (“Reform Act”), the United States Supreme Court will address the Reform Act’s heightened scienter pleading standard and establish a long-awaited uniform interpretation of what is required to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” On January 5, 2007, the Supreme Court granted a petition for a writ of certiorari to review the Seventh Circuit’s decision in Makor Issues & Rights, LTD v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006), cert. granted, No. 06-484, 2007 WL 30549 (U.S. Jan. 5, 2007). The appeal presents the Supreme Court with a four-way split among the Circuit courts regarding the appropriate consideration of inferences in the evaluation of whether a plaintiff has sufficiently pled the requisite mental state of culpable conduct by a defendant. Specifically, the Supreme Court will decide whether, and to what extent, a court may consider on a motion to dismiss inferences that demonstrate a defendant’s lack of scienter in determining whether a complaint adequately pleads the required state of mind under the Reform Act.
Summary of the Issue on Appeal
Among other allegations, the plaintiffs in Tellabs alleged that the individual defendants, by virtue of their positions in the company, both had access to internal reports that contradicted their public statements and engaged in insider trading. Because the plaintiffs did not specify the dates on which the internal reports were issued or specify when each individual defendant allegedly read the reports, a court could draw an inference in favor of the defendants that rebutted the requisite mental state necessary to survive a motion to dismiss. The district court held that, although the complaint sufficiently pled material misstatements, its allegations failed to “support a strong inference that each Defendant acted recklessly or knowingly” when making the statements. The district court further reasoned that the absence of allegations that one of the defendants engaged in insider stock sales during the class period “further weakens Plaintiffs’ argument that the insider sales [of the other defendants] support a strong inference of scienter on the part of that individual defendant.”
The Seventh Circuit’s Decision
The Seventh Circuit reversed, in part, the district court’s dismissal, finding that the standard applied by the lower court to determine whether the complaint had sufficiently pled scienter under the Reform Act was too stringent. In particular, the Seventh Circuit held that a complaint may survive a motion to dismiss “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent,” regardless of any inference that the defendants had acted without the required intent.
In evaluating the effect of the Reform Act on the scienter pleading standard, the Seventh Circuit considered the different approaches taken by other Circuits as to what pleading standard constitutes a “strong inference” of scienter. The Second and Third Circuits have held that the Reform Act requires a plaintiff to plead “either motive and opportunity or strong circumstantial evidence of recklessness or conscious misbehavior.” The Ninth and Eleventh Circuits, in contrast, have construed the Reform Act to require more than mere allegations of motive and opportunity to demonstrate a strong inference of scienter. For example, the Eleventh Circuit requires that a plaintiff must plead with particularity, at a minimum, “severe recklessness” to survive a motion to dismiss. The Seventh Circuit classified itself as taking a “middle ground,” where specific types of allegations, such as motive and opportunity, are neither rejected nor adopted by the Reform Act as sufficient to show scienter, but may be considered.
The Seventh Circuit then turned to the more narrow issue of whether to consider inferences arising from the complaint in favor of the defendant when determining whether the plaintiff had met his pleading burden. The Court recognized that the allegations could give rise to “two seemingly equally strong inferences, one favoring the plaintiff and one favoring the defendant.” In considering how to treat these competing inferences, the Court analyzed the Sixth Circuit’s approach. In the Sixth Circuit, “plaintiffs are entitled only to the most plausible of competing inferences.” Thus, when allegations in the complaint support both an inference in favor of the plaintiffs and another in favor of the defendant, the district court must determine which is more plausible. If the inference in favor of the defendant is at least as plausible as the one in favor of the plaintiffs, the complaint must be dismissed.
In contrast, the Seventh Circuit determined that, “[i]nstead of accepting only the most plausible” inference, it would accept all inferences that a reasonable person would draw in favor of a plaintiff based on the allegations in the complaint. The district court in Tellabs was faced with a “complaint [that] alleges the existence of internal reports discussing the declining demand for [a key product], but nowhere alleges that [the individual defendant] actually reviewed any such report” before making statements regarding stable demand.
Applying its standard, the Seventh Circuit recognized that, although “it is conceivable that [the individual defendant] had yet to see the reports suggesting his company was in trouble, . . . the plaintiffs have provided enough for a reasonable person to infer that [the individual defendant] knew that his statements were false.” Thus, the Seventh Circuit declined to consider inferences that favored the defendants in its analysis.
Competing Approaches to Weighing Inferences
The Seventh Circuit’s holding that, under the Reform Act, a court need not consider an inference in favor of a defendant that may contradict a strong inference of fraud is the portion of its opinion now before the Supreme Court. In addition to the Seventh Circuit’s and the Sixth Circuit’s approach (which the Seventh Circuit directly rejected), two additional approaches to weighing competing inferences exist, which were not reviewed by the Seventh Circuit. Like the Sixth Circuit, the Tenth and Eighth Circuits consider all inferences that arise from the allegations of the complaint – whether they favor the plaintiffs or the defendants – when determining the overall strength of an inference of scienter. Although the Second and Third Circuits also recognize that inferences in favor of the defendants might arise from the allegations, these Circuits take a different approach and require a plaintiff to plead that a defendant had “knowledge of facts or access to information contradicting their public statements” at the time the public statements were made. These additional approaches present the Supreme Court with a four-way Circuit split to resolve.
In an ordinary case that is not subject to the Reform Act’s heightened pleading requirements, a court typically will draw all reasonable inferences in favor of a plaintiff at the motion to dismiss stage. The Seventh Circuit’s decision to consider inferences that a reasonable person could draw only in favor of a plaintiff – the most lenient of the various Circuits’ interpretations – plainly does not alter that pleading standard. Congress, however, intended to strengthen the pleading requirements by enacting the Reform Act so as to “[prevent] the abuse of the securities laws by private litigants.” “[C]redit[ing] only the inferences of a defendant’s mental state that are in the plaintiffs’ favor . . .[would] eviscerate the [Reform Act’s] strong inference requirement.” Accordingly, the majority of Circuits that have addressed the weighing of competing inferences have recognized that the Reform Act altered the way in which inferences should be weighed under Fed. R. Civ. P. 2(b)(6), but have adopted differing approaches in considering these inferences when assessing the sufficiency of a complaint.
The Supreme Court should consider these well-reasoned decisions and adopt an approach that considers any inference in favor of the defendant when determining whether the allegations in a complaint sufficiently plead the necessary strong inference of fraud. Although the question presented in the Petition is limited to inferences raised within the four corners of a complaint, the Supreme Court also could construe its certiorari review as an opportunity to address whether a court may consider inferences raised on a motion to dismiss – which tests the sufficiency of a complaint – that rebut a strong inference of fraud, such as, for example, competing public statements or public facts demonstrating that the defendant’s alleged insider stock sales were innocuous.
Briefing before the Supreme Court begins on February 9, 2007 and is scheduled to be completed by March 20, 2007. The Supreme Court, therefore, could hear the case as soon as during the March 2007 session.