In our June 21 memorandum, “Supreme Court Establishes Standard for Reviewing ‘Strong Inference’ of Scienter in Securities Fraud Cases,” we discussed the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., which held that a securities fraud complaint may survive a motion to dismiss “only if a reasonable person would deem the inference of scienter [the required state of mind] cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” The Court concluded that, in enacting the Private Securities Litigation Reform Act (“PSLRA”), Congress had displaced the usual standard applied to motions to dismiss in which any and all potential inferences from the facts alleged are drawn solely in plaintiffs’ favor.
In a decision released last Friday, July 27, Higginbotham v. Baxter Int’l, Inc., No. 06-1312, the Seventh Circuit applied the Tellabs standard to scienter allegations based on information from anonymous or confidential sources and stock trading activity. The Seventh Circuit’s assessment of both types of allegations suggests that the Tellabs standard will have a real impact in weeding out cases brought with insufficiently specific allegations at the beginning of the litigation.
Most significantly, the Baxter decision is harshly critical of what has become common practice since the enactment of the PSLRA — the use of anonymous or confidential sources of information in securities fraud complaints. The Seventh Circuit determined that, at least as far as scienter allegations are concerned, “facts” attributed to anonymous accusers will almost never suffice to establish a compelling inference of scienter because concealing the source’s identity inherently frustrates the court’s ability to determine what opposing inferences may be drawn. While the court did not exclude the possibility that under certain circumstances allegations attributed to anonymous sources could bolster other allegations of scienter, anonymous source allegations will be “discounted” and that “[u]sually that discount will be steep.
The Seventh Circuit’s sweeping condemnation of the use of anonymous sources is particularly striking because the Supreme Court’s opinion in Tellabs itself observed in passing that the complaint in that case had relied heavily on such sources but did not suggest any view as to the validity of that practice under the new standard it announced. Indeed, prior to Tellabs, federal courts had held the practice to be acceptable to varying degrees. Baxter thus suggests that, in light of Tellabs, the time is ripe for other circuits to reconsider the treatment of allegations made by confidential sources in securities fraud cases. While the Baxter decision was focused on the element of scienter, the court’s broader rejection of plaintiffs’ rationale for the use of confidential sources — the need to protect sources from the possibility of retaliatory treatment — strongly suggests that courts may now more generally revisit how to deal with confidential sources in securities cases.