The U.S. Supreme Court Decision in Tellabs:  Major Victory or Minor Benefit for Defendants in Securities Class Actions?

For more than 30 years, courts have held that plaintiffs must allege and prove “scienter” as an element of a claim under Section 10(b) of the Securities Exchange Act of 1934, which is the anti-fraud statute typically used by plaintiffs in securities class action lawsuits.  Although courts have adopted different definitions of “scienter,” the term generally refers to a minimum mental state which a defendant must have in order to be liable under Section 10(b).  Either an intent to defraud or reckless misconduct usually is required.

The existence or lack of scienter is one of the most hotly litigated issues in most Section 10(b) claims, particularly in the context of Motions to Dismiss by the defendant directors and officers.  The best chance for defendants in a Section 10(b) securities class action to avoid a large settlement is to win a Motion to Dismiss, and in most cases a critical argument by defendants in the Motion to Dismiss is that plaintiffs failed to allege sufficient facts to demonstrate the existence of scienter.  In other words, the standard by which plaintiffs’ scienter allegations should be judged is very important in determining the value of securities class action lawsuits.

For that reason, the June 21, 2007 decision by the U.S. Supreme Court in Tellabs Inc. v. Makor Issues & Rights, Ltd. attracted a lot of interest.  In that case, the Court held that for purposes of Section 10(b) claims, plaintiffs must allege particularized facts which give rise to an inference of scienter that is cogent and at least as compelling as any opposing inference of non-fraudulent intent.  Alleged facts which merely create a plausible or reasonable inference of scienter are not sufficient to survive a Motion to Dismiss.

This article explains the context, background and scope of the Court’s ruling in Tellabs as well as predicts some of the likely consequences of that decision.

A.         Scienter Requirement

Neither Congress nor the Supreme Court has defined what type of scienter or state of mind is required to establish liability under Section 10(b).  Lower courts have adopted various minimum standards, ranging from simply showing the defendants had a motive and opportunity to defraud investors to the more stringent requirement of showing defendants acted with “deliberate recklessness.”  Whatever the standard, though, courts must determine when ruling on defendants’ Motion to Dismiss whether the facts as alleged by plaintiffs create a sufficient inference that the applicable standard can be satisfied at trial.

The Private Securities Litigation Reform Act of 1995 (the “1995 Reform Act”) sought to impose a heightened scienter pleading standard on plaintiffs, and thus sought to prevent frivolous securities class action litigation, by requiring plaintiffs in a Section 10(b) lawsuit to “state with particularity facts giving rise to a strong inference that the defendants acted with the required state of mind.”  (emphasis added.)

In enacting this “strong inference” standard, according to the legislative history, Congress intended to adopt “uniform and more stringent pleading requirements” in order to deter “those suits whose nuisance value outweighs their merits.”  However, Congress did not define “strong inference.”  As a result, in the years following the 1995 Reform Act, courts struggled to determine which cases alleged misconduct which created a strong inference of scienter (and thus were permitted to proceed) and which did not (and thus were dismissed).

A securities fraud lawsuit rarely is based on direct and undisputed evidence of fraudulent intent, such as e-mails or other written communications evidencing an intent to mislead investors.  Instead, the evidence of alleged fraud is more subtle, and based on circumstantial evidence that requires inferences to be drawn from the conduct.  For example, in the Tellabs case, plaintiffs alleged that optimistic statements made by the CEO were intentionally false because he had seen reports indicating that the demand for the Company’s flagship product was declining.  However, defendants argued that the CEO had not seen those reports, and was sincere in his optimistic statements at the time he made those statements.  This presented a fairly typical fact pattern that required the court to determine in light of the competing inferences whether the plaintiffs presented a strong inference of scienter or whether the case should be dismissed.

Prior to the Supreme Court’s Tellabs decision, Federal Circuit Courts of Appeal differed regarding what is a “strong inference” for purposes of pleading scienter.  Several Circuit Courts adopted a pro-defendant approach by holding that a strong inference of scienter existed only if the inference of scienter was the most plausible between the competing inferences.  Some other Circuits adopted a pro-plaintiff approach by holding that a strong inference of scienter existed if a reasonable person could infer from the alleged facts that the defendants acted with scienter, without regard to any competing inferences.  Yet other Circuit Courts adopted a middle approach by holding that a strong inference of scienter existed if the inference of scienter was at least as plausible as the competing inferences.  The Tellabs decision essentially adopted that middle approach and defined a uniform standard for all Circuits to follow.

B.         Background of the Tellabs Case

Tellabs manufacturers specialized equipment used in fiber optic networks.  After a stock price drop in year 2001, shareholders filed a securities class action lawsuit alleging that the Company and its CEO committed securities fraud in violation of Section 10(b) by making misleading statements about the Company’s products and financial results.  Plaintiffs alleged that the CEO made positive statements about the demand for the company’s key product when he knew that demand was declining.  Plaintiffs also alleged that the Company used improper accounting to inflate its revenues, and misrepresented its financial performance.  Among other things, plaintiffs cited 27 confidential sources regarding the CEO’s knowledge and the improper accounting.  Defendants filed a Motion to Dismiss and argued among other things that the plaintiffs failed to sufficiently allege scienter by the defendants.  The District Court weighed the inferences to be drawn from the allegations, and dismissed the complaint because plaintiffs failed to plead a strong inference of scienter.

Plaintiffs appealed to the Seventh Circuit Court of Appeals, which reversed the dismissal.  The appellate court concluded that plaintiffs had pleaded a strong inference of scienter.  In reaching this conclusion, the Seventh Circuit held that plaintiffs do not need to allege facts showing the most plausible of competing inferences in order to satisfy the strong inference standard.  Instead, the Seventh Circuit ruled that plaintiffs survive a Motion to Dismiss if they “allege facts from which, if true, a reasonable person could infer that the defendants acted with the required intent.”  This reflected a very low hurdle for plaintiffs at the pleading stage since a court would not need to consider any competing inferences proposed by defendants.

The defendants appealed to the United States Supreme Court, seeking a resolution of the conflicting appellate court standards regarding what is a “strong inference.”  The defendants argued that the test adopted by the Seventh Circuit was inconsistent with the heightened pleading standards established by the 1995 Reform Act.

C.         U.S. Supreme Court Decision

Writing for the 8-1 majority, Justice Ginsburg began by noting that since Congress did not define “strong inference,” it was the Court’s responsibility “to prescribe a workable construction of the ‘strong inference’ standard.”  According to Justice Ginsburg, that construction needed to be consistent with the Reform Act’s twin goals: “to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.”

Consistent with those twin goals, the Court chose a balanced approach in defining a “strong inference,” concluding that in order to qualify as “strong” within the meaning of the Reform Act, “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 nonfraudulent intent.”

In order for lower courts to apply this standard, the Court established a three-part test:

—          first, when reviewing a Motion to Dismiss, a court must accept as true all factual allegations in the complaint;

—          second, a court must evaluate the complaint in its entirety, considering whether “all of the facts, as alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard;” and

—          third, a court must “take into account plausible opposing inferences.”

Further amplifying this three-part test, Justice Ginsburg explained that the “strength of an inference cannot be decided in a vacuum,” and that the inquiry is “inherently comparative.”  In language favorable to defendants, she directed that a court “must consider plausible nonculpable explanations for the defendants’ conduct.”  In language favorable to plaintiffs, she stated that the inference of scienter “need not be irrefutable, i.e. of the ‘smoking-gun’ genre, or even the ‘most plausible of competing inferences.’”

D.         Impact of the Decision

The Tellabs decision adopts a balanced approach to the strong inference standard.  While the test is not as demanding as sought by the SEC and many in the defense community (for example, the SEC urged that in order to create a strong inference, the allegations should demonstrate a “high likelihood” of scienter), the test adopted by the Supreme Court is higher than the test applied by the Seventh Circuit and the other less demanding Circuit Courts.  At a minimum, a uniform standard has been established that requires courts to consider non-culpable inferences and permit the case to proceed only if the inference of scienter is at least as plausible as other inferences.

It is obviously too early to know how the Tellabs decision will affect securities class action litigation in the future.  However, it seems likely the decision will have only a modest beneficial impact on defendants in Section 10(b) securities class actions.  The following summarizes some of the reasons why this decision is not likely to be a big win for defendants.

—          The Court did not address the arguably more important issue related to scienter:  what is scienter and what must be proven to establish scienter (i.e. must plaintiffs prove “deliberate recklessness” or some other equivalent of intentional wrongdoing or is mere recklessness sufficient?).

—          The Tellabs decision probably will not materially reduce the number of securities class actions that are filed.  The pleading standard articulated by the Court is not so high that plaintiffs will be discouraged from at least filing the lawsuit.

—          The impact on lower courts will vary depending on their location.  In the previously less demanding Circuits (Seventh and Eighth) courts should now more rigorously compare the competing inferences regarding scienter, which should favor defendants.  However, these are not particularly active Circuits for securities litigation.  In the Circuits that were more demanding prior to Tellabs (First, Sixth, and Ninth), courts will continue to evaluate competing inferences, but should permit the case to proceed if the inference of scienter is at least as plausible as other inferences.  In a few Circuits (Fourth and perhaps Tenth), this new test is essentially the same as pre-Tellabs law.

—          In the past, this issue of the degree of inferences has not been the focus of most courts when ruling on a Motion to Dismiss, indicating that it is not a central issue in the analyses by most courts.

—          The issue of inferences applies only at the Motion to Dismiss stage of the litigation since it is only a pleading standard.  It does affect what plaintiffs must prove at trial.  Once plaintiffs survive the Motion to Dismiss, the settlement value of the case is based primarily on what plaintiffs will likely be able to prove at trial, and therefore Tellabs has no impact on settlement values after a Motion to Dismiss is denied.

—                     As a practical matter, most judges appear to decide motions to dismiss in securities class actions based on their perception of the severity of the wrongdoing.  In other words, they appear to back into the legal analysis based on where they want to end up.  The Tellabs decision continues to give great deference to the judge’s subjective views, and thus probably will not materially change the way judges handle these cases.

—                     Plaintiffs do not need to allege or prove scienter for purposes of a claim under Section 11 or 12 of the Securities Act of 1933 relating to alleged misrepresentations in a company’s initial or secondary stock offering.  Therefore, the Tellabs decision has no impact on those types of securities claims.

In summary, although the decision will likely result in a modest increase in the number of dismissals, the vast majority of motions to dismiss will likely be resolved the same way after the Tellabs decision as they would have been resolved before the decision.  Therefore, neither directors and officers nor D&O insurers should think that the liability from securities class action lawsuits is materially less now, and certainly no one should change their behavior, their underwriting analysis or their liability or coverage expectations as a result of the Tellabs decision.