Client Alert: Supreme Court Raises Pleading Bar for Securities Fraud Lawsuits
January 1, 2007
New Standard Adopted
On June 21, 2007, in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 2007 WL 1773208 (2007), the U.S. Supreme Court adopted a new pleading standard for scienter – a mental state embracing the intent to deceive, manipulate or defraud – with which private plaintiffs must comply in order to maintain securities fraud lawsuits.
Under the new standard, “a complaint will survive … 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.” In short, a plaintiff must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference.
Section 21D(b)(2) of the Private Securities Litigation Reform Act of 1995
At issue in Tellabs was the meaning of the term “strong inference” as that term is used in Section 21D(b)(2) of the Private Securities Litigation Reform Act of 1995 (PLSRA). 15 U.S.C. Section 78u-4(b)(2).
Congress enacted the PSLRA to curb abuses of the securities laws by class action lawyers seeking nuisance settlements from “deep pockets” in the securities industry. Congress did so by creating a range of substantive and procedural controls with which a plaintiff must comply before it may maintain a securities fraud action. This includes special pleading standards under Section 21D(b)(2), which provides that when a plaintiff’s cause of action requires proof that the defendant acted with a particular state of mind, the plaintiff must plead with particularity facts giving rise to a “strong inference” that the defendant acted with the required state of mind relative to each act or omission alleged to have violated the securities law at issue. 15 U.S.C. Section 78u-4(b)(2).
While the “strong inference” standard unequivocally raised the bar for pleading scienter in securities fraud cases, Congress did not delineate what facts would create such a “strong inference,” nor could the courts subsequently agree on this issue. In Tellabs, the Court sought to resolve the ambiguity and the case law conflicts.
In Tellabs, plaintiffs were shareholders of Tellabs, and they filed a class action against the company and its chief executive officer (CEO) for allegedly engaging in a scheme to deceive the investing public about the true value of the company’s stock. This included allegations that the CEO falsely reassured public investors that Tellabs enjoyed strong demand and record revenues for its products when he purportedly knew the opposite was true, and that the Company had strong demand for its next-generation networking device that was purportedly ready for delivery, when in fact production was behind schedule and demand was weak.
The U.S. District Court for the Northern District of Illinois dismissed the complaint, finding that plaintiffs had insufficiently alleged that the CEO acted with scienter. The Seventh Circuit reversed. In doing so, the Seventh Circuit employed a relatively low pleading standard, requiring only that a reasonable person could draw an inference of scienter from the facts alleged. This approach was in open conflict with the Sixth Circuit’s more stringent standard that plaintiffs are entitled only to the most plausible of competing inferences when pleading scienter. The Supreme Court granted certiorari to resolve the conflict.
The Supreme Court’s Decision
Upon review, the Supreme Court reversed the Seventh Circuit and held that a 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. This inference must be strong in light of other possible explanations.
In applying this standard, courts are to employ the following process:
Accept all factual allegations in the complaint as true
Consider the complaint in its entirety, and whether all of the facts as alleged, taken collectively, give rise to a strong inference of scienter
In determining whether the pleaded facts give rise to a “strong inference” of scienter, the court must take into account plausible opposing inferences
Two rules emerge from the Court’s decision. First, an inference cannot be decided in a vacuum. Rather, all allegations must be considered collectively to determine whether they create a “strong inference” of scienter. This includes allegations of motive or personal financial gain, which the Court instructed may or may not weigh heavily in favor of an inference of scienter when taken in light of the allegations as a whole. Similarly, omissions and ambiguities in a plaintiff’s complaint will count against an inference of scienter, as plaintiffs are required to state with particularity the facts giving rise to a “strong inference” that the defendant acted with the required state of mind.
Second, courts must engage in a comparative inquiry regarding how likely it is that one conclusion, as compared to others, follows from the facts alleged. Plausible, nonculpable explanations for the defendant’s conduct must be considered, as well as inferences favoring the plaintiff. For the complaint to survive, the plaintiff must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference. As viewed by the Court, a plaintiff will never have to plead more than it is required to prove at trial.
If the plaintiff survives this threshold pleading standard, it may then attempt to prove its case at trial by a preponderance of the evidence.
While the Tellabs standard is likely to generate lively analysis of the range of competing plausible inferences of a defendant’s state of mind in a given case, we believe the Court’s message is clear – facially frivolous or poorly pled complaints are not to be allowed access to the federal courthouse. While facially meritorious claims will survive under this standard, it is likely that the Court’s opinion will force plaintiffs to push their due diligence forward and to plead what they intend to prove in order to demonstrate the seriousness of their securities fraud lawsuits. Consequently, opportunities should increase significantly for defendants to dismiss lawsuits generated by plaintiffs unwilling or unable to undertake such due diligence and care in their pleadings.
Should you have any questions regarding the Court’s opinion in Tellabs, or any other issues affecting your securities litigation, compliance, or regulatory needs, please contact Scott Meyers at 312.476.7576, David Porteous 312.476.7592 or any other member of Levenfeld Pearlstein, LLC’s Securities & Commodities Litigation Service Group.