On January 5, 2007, the United States Supreme Court granted certiorari in Tellabs, Inc. v. Makor Issues & Rights, 437 F.3d 588 (7th Cir. 2006), to resolve a split of authority over the meaning of a key provision of the Private Securities Litigation Reform Act of 1995 (“Reform Act”). That provision requires plaintiffs in securities fraud actions to plead facts giving rise to a “strong inference” that each defendant acted with scienter, an intent to defraud investors.
Congress enacted the Reform Act to abolish the practice of suing for securities fraud based solely on a drop in a company’s stock price. To accomplish this purpose, Congress established a heightened standard for pleading a claim of securities fraud. Under this new standard, plaintiffs had to plead facts — with particularity and at the outset of litigation — giving rise to a strong inference that each defendant acted with scienter. If a plaintiff was unable to establish this strong inference, the Reform Act mandated dismissal of the complaint.
Over the past decade, however, Congress’s vision of a uniform, national standard has not been realized. Rather, the various Courts of Appeals have arrived at differing views of what it means to plead a strong inference of scienter. Most courts have concluded that to determine whether an inference is strong, they must weigh the relative strength of competing inferences on a motion to dismiss.
In Tellabs, the Seventh Circuit rejected this prevailing view and adopted an interpretation of the strong inference requirement that is more lenient than that adopted by any other circuit, essentially requiring only a “reasonable inference” of scienter.
The district court in Telltabs dismissed the plaintiff’s original complaint and a subsequent amended complaint on the grounds that the plaintiff had failed to plead facts giving rise to an inference of scienter that was, on balance, strong. On appeal, the Seventh Circuit concluded that weighing the relative strength of competing inferences of scienter on a motion to dismiss could “be misunderstood as a usurpation of the jury’s role” in violation of the Seventh Amendment. To avoid this potential usurpation, the court held that a complaint alleging securities fraud should survive “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”
Applying this rule to the facts, the Seventh Circuit reversed the district court in part and held that the plaintiff had pleaded a strong inference of scienter with respect to the company’s CEO, and thus the company itself. Although it was “conceivable” that the CEO was unaware of the company’s problems when he made the challenged statements, the court found that a reasonable person “could” conclude otherwise. The court refused to consider any contrary inferences, such as the absence of any plausible motive for the CEO to commit fraud.
Although it is difficult to predict how the Supreme Court will rule on this issue, the standard espoused by the Seventh Circuit goes against the great weight of circuit authority and appears inconsistent with the plain language of the Reform Act. That language requires an inference of scienter that is “strong.” If an inference in the defendant’s favor is more compelling than an inference of scienter on the facts alleged, the inference of scienter is not strong. Courts simply cannot make this determination unless they weigh competing inferences at the motion to dismiss stage.
The standard adopted by the Seventh Circuit also seems inconsistent with the purpose of the Reform Act. It would make it significantly easier for plaintiffs’ lawyers to leverage baseless claims into an expensive “nuisance” settlement by surviving a motion to dismiss and obtaining access to costly discovery. Perhaps for these reasons, on February 9, 2007, the Securities & Exchange Commission and the Department of Justice filed a joint amicus brief in support of the defendants, urging the court to adopt a strict interpretation of the scienter requirement.
The Supreme Court has established an expedited briefing schedule in the Tellabs case and oral argument is set for March 28, 2007.