Last week, the U.S. Supreme Court ruled that securities fraud plaintiffs must plead facts establishing a “cogent and compelling” basis to conclude defendants intended to deceive in order to survive a motion to dismiss, voting eight-to-one to reverse the Seventh Circuit Court of Appeals and remand the case of Tellabs v. Makor Issues & Rights, Ltd. for further proceedings. The decision undoubtedly represents a positive development for defense of federal securities fraud class action litigation brought under the Private Securities Litigation Reform Act of 1995 ("PSLRA") — just how positive will depend on interpretations by lower courts going forward.
The Court's majority opinion, written by Justice Ginsburg and joined by five other Justices (additional concurrences were filed by Justices Scalia and Alito, with Justice Stevens as the sole dissenter), holds that a PSLRA complaint will survive a motion to dismiss only if the “strong inference” requirement of showing intent under the PSLRA is met after a comparative analysis of competing inferences. Specifically, the Court held that “an inference of scienter must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of non-fraudulent intent.”
In other words, it is not enough for the complaint to allege facts that give an inference of the defendant's fraudulent intent if the alleged facts are more consistent with an innocent explanation. For example, allegations of aggressive sales efforts toward the end of a quarter (plaintiffs in Tellabs alleged “channel stuffing”) may likely be evidence of a company's eagerness to meet its goals rather than evidence of fraudulent intent, without more to support the allegation. Thus, such allegations, standing by themselves, would fall short of the required pleading standard of a "strong inference" of fraudulent intent under the PSLRA.
While Tellabs clarifies that federal securities fraud plaintiffs will have to meet a stricter pleading standard than that which had been imposed in the Seventh Circuit, the Court expressly did not adopt an even stricter standard advocated by Justices Scalia and Alito, that would be more consistent with the standard previously followed by the Sixth Circuit. And, as with any new test prescribed by the Court, the real impact of Tellabs remains to be seen as lower courts implement the Court’s holding. One need only remember that in the days immediately following the 2005 Supreme Court decision in Dura Pharmaceuticals v. Broudo, 544 U.S. 336 (2005), many speculated that the decision would have a more far-reaching effect on private securities fraud litigation than it has had to date.
The Tellabs decision comes just days after the important antitrust victory for Wall Street firms in Credit Suisse Securities v. Billing. In that case, investors alleged Wall Street investment firms and institutional investors had engaged in a conspiracy to drive up the after-market prices of IPO stocks during the Internet Bubble era in violation of federal antitrust laws. The Supreme Court sided with the defendants, ruling that federal securities laws preclude application of federal antitrust laws against these defendants. The case gives Wall Street an important Court-certified exemption to general antitrust prohibitions applicable to others engaged in commerce.
The Tellabs and Credit Suisse decisions evidence a disposition among the clear majority of the Court sympathetic to business interests and averse to expanding avenues of private litigation. Perhaps the most important test of how far this Court is willing to go to protect business interests and contain private securities litigation will come this fall when it considers Stoneridge Investment Partners v. Scientific-Atlanta, Inc. on appeal from the Eighth Circuit. At issue in Stoneridge is “scheme liability” and the question of whether and when attorneys, investment bankers, accountants and others may be held liable as primary violators in private litigation under the federal securities laws when a company with which they do business engages in fraud. The Securities and Exchange Commission (at the urging of the Regents of the University of California, lead plaintiff in the private securities fraud suit pending against investment banks involved in the Enron fiasco) has indicated support for the plaintiff’s position in Stoneridge. The Bush administration, however, blocked the U.S. Solicitor General from submitting an amicus brief to the Court supporting the “scheme liability” theory in Stoneridge, as requested by the SEC. Many commentators have observed that “scheme liability” could eviscerate the important limitation on secondary liability under the federal securities laws announced by the Supreme Court a decade ago in Central Bank of Denver v. First Interstate Bank, 511 U.S. 164 (1994).
Crucial legal issues affecting the integrity and competitiveness of U.S. capital markets continue to make their way before the Court. Although recent decisions appear to indicate a trend, only time and lower court implementation will reveal the long-term impact these decisions may have in eliminating frivolous litigation.