JUNE 2007
Strong words: the Supreme Court defines the statutory
requirement to plead a “strong inference” of scienter in
securities fraud complaints
By Carolyn Nussbaum
June 25, 2007
On June 21, 2007, in an 8-to-1 decision authored by Justice Ginsburg, the United States Supreme
Court decided Tellabs, Inc., v. Makor Issues & Rights Ltd. Vacating the decision of the Seventh Circuit,
the Supreme Court held that the requirement of the Private Securities Litigation Reform Act of 1995
(PSLRA) that a plaintiff plead “with particularity facts giving rise to a strong inference” of scienter, or
fraudulent intent, means that “[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.”
Background and context
The PSLRA imposes pleading burdens for securities fraud claims in addition to those in the Federal
Rules of Civil Procedure. While the PSLRA codified the plaintiff’s obligation to plead a “strong
inference” of scienter, the Courts of Appeals have divided on how to apply that standard in the
context of a motion to dismiss.
Plaintiffs in Tellabs alleged that the company and its chief executive inflated Tellabs’ financial results
through the use of “channel stuffing” transactions, and issued overly optimistic sales projections, all
the while knowing that demand for Tellabs products had dramatically declined. The District Court
dismissed the complaint without prejudice, affording plaintiffs another opportunity to file an
adequate pleading. The court then dismissed with prejudice the amended complaint because, despite
citing 27 confidential sources, it failed to meet the PSLRA standard for pleading scienter. Declining
to consider or weigh competing inferences that could be drawn from the facts alleged, which it
feared
would usurp the role of the jury, the Seventh Circuit reinstated the case, holding “we will allow the
complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the
defendant acted with the required intent.” Makor Issues & Rights Ltd. v. Tellabs, Inc., 437 F.3d 588, 602
(7th Cir. 2006). This formulation was perhaps the most liberal of the varying constructions of the
PSLRA and emphasized the conflict among the Circuits. The Supreme Court granted certiorari.
The Supreme Court decision
The Supreme Court squarely rejected the Seventh Circuit analysis and adopted a comparative test to
evaluate the sufficiency of allegations of scienter in a securities fraud complaint. The Court held that
Congress did not merely require a plaintiff to allege facts from which an inference of scienter could be
drawn; rather, the PSLRA requirement of a “strong inference” of scienter means that the reasonable
person must deem the inference of scienter at least as plausible as nonculpable explanations for the
defendant’s conduct. The inference of scienter need not be irrefutable, or even the “most plausible,”
but it must be more than “reasonable” or “permissible,” and “thus strong in light of other
explanations.”
The majority decision includes the following key points:
•
Courts must consider all of the facts alleged, collectively, as well as the other sources
traditionally examined on a dismissal motion, such as documents incorporated into a
complaint, to determine whether there is a strong inference of scienter, rather than whether
any individual allegation, in isolation, meets the standard.
•
In employing this “holistic” approach, the Court agreed that vagueness, omissions, and
ambiguities in the complaint, such as an absence of dates and details, may count against a
strong inference of scienter. However, the majority declined to adopt Justice Alito’s position
in his concurrence, which would have excluded from consideration all nonparticularized
allegations in a complaint.
•
Personal financial gain may be a relevant consideration and may weigh heavily in favor of a
scienter inference, but the absence of a motive allegation is not fatal.
•
In dicta, the Court declined to disturb the Seventh Circuit’s holding that allegations of
scienter made against one defendant cannot be imputed to other individual defendants,
noting that although there is continuing disagreement among the Circuits over the viability
of the “group pleading” doctrine, the plaintiffs did not contest this holding.
The Justice Department and the Securities and Exchange Commission had argued for an even
greater pleading burden, as did Justices Alito and Scalia in concurring opinions. While the
government advocated for a “high likelihood” standard, Justice Scalia urged a comparative test that
would require the inference of scienter to be “more plausible” than the inference of innocence.
Notably, in a separate concurrence, Justice Alito suggested that the distinction between the majority’s
definition of a “strong inference” and the definition proposed by Justice Scalia is “unlikely to make
any practical difference.” He complained, however, that the majority was introducing a test
“previously unknown in civil litigation.” In his dissent, Justice Stevens called for a “probable cause”
standard because Congress could not have intended a civil standard more exacting than that required
in criminal cases.
The practical effect of Tellabs
In his dissent in Tellabs, Justice Stevens suggests that the meaning of “strong inference” is in the “eye
of the beholder.” The decision may be characterized as a compromise that gave neither the
defendants’ nor the plaintiffs’ bar all that they sought. Indeed, the practical application of the
pleading standard will remain closely linked to the specificity (or lack thereof) of allegations in a
particular case. The Tellabs decision provides an analytical framework to challenge the adequacy of a
securities fraud complaint, but it may be difficult to predict with clarity whether a court will decide
that a particular complaint pleads a “strong inference” of scienter. Securities litigators will be
watching intently when the District Court attempts to apply the Supreme Court’s construction of the
PSLRA to the Tellabs complaint on remand.
Significantly, however, the Tellabs case is the second decision by the Supreme Court in the last week
to limit class actions by investors. In Credit Suisse v. Billing, decided on June 16, the Supreme Court
held that the securities laws preempted antitrust law remedies, precluding investors from invoking
antitrust laws and the specter of treble damages to challenge underwriting practices in the IPO
markets. Left for the Court’s fall term is the case of StoneRidge Investment Partners LLC v. Scientific
Atlanta, Inc., which will decide whether the PSLRA permits claims against third parties, such as
lenders and vendors, who are alleged to have participated in or facilitated a fraudulent scheme.
__________________________
If you would like to discuss, review or comment on these proposed rules or have any questions or
require further information regarding these or other matters, please call your regular Nixon Peabody
contact or feel free to contact one of the attorneys listed below:
•
in our Rochester office, Carolyn Nussbaum (585) 263-1558
•
in our Manchester office, Scott O’Connell (603) 628-4087
•
in our Boston office, George Skelly (617) 345-1220
•
in our New York City office, Christopher Mason (212) 940-3017
•
in our San Francisco office, Richard Hoffman (415) 984-8242
•
in our Washington, D.C. office, John Partigan 202-585-8535
This Alert is provided by Nixon Peabody LLP for education and information purposes only. It is not
a full analysis of the matters summarized and is not intended, and should not be construed, as legal
advice. This publication may be considered advertising under applicable laws.