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PLEADING
SCIENTER
IN
SECURITIES
FRAUD
CASES:
THE
SUPREME
COURT’S
“COMPARATIVE-INFERENCE”
TEST
By
Robert
Y.
Lewis,
Founding
Partner,
Freeman
Lewis
LLP
A
critical
first
phase
in
virtually
all
federal
private
actions
charging
securities
fraud
under
section
10(b)
of
the
Securities
Exchange
Act
of
1934
is
the
motion
to
dismiss
for
failure
to
state
a
claim
for
relief.
Often
the
most
hotly
contested
issue
is
whether
the
element
of
scienter
(that
is,
a
defendant’s
intention
“to
deceive,
manipulate,
or
defraud”,
Ernst
&
Ernst
v.
Hochfelder,
425
U.S.
185,
194,
and
n.12
(1976)),
is
properly
pleaded.
The
Supreme
Court
recently
spoke
on
the
issue
in
Matrixx
Initiatives,
Inc.
v.
Siracusano,
131
S.
Ct.
1309
(2011),
which,
together
with
its
decision
four
years
earlier
in
Tellabs
v.
Makor
Issues
&
Rights,
Ltd.,
551
U.S.
308
(2007),
provides
insight
into
what
is
needed
to
successfully
plead
scienter
in
federal
securities
fraud
cases.
I.
The
Private
Securities
Litigation
Reform
Act’s
“Strong
Inference”
Standard
Sixteen
years
ago
Congress
passed
the
Private
Securities
Litigation
Reform
Act
(”PSLRA”)
over
President
Clinton’s
veto.
There
was
general
agreement
that
many
securities
fraud
cases
were
nothing
more
than
high-class
shake
downs
and
that
they
were
imposing
unjustified
costs
on
companies
and
executives
whose
conduct
conformed
to
the
law.
The
PSLRA
was
designed
to
weed
out
frivolous
or
very
weak
cases
at
an
early
stage
by,
among
other
things,
imposing
on
plaintiffs
the
burden
of
pleading
“with
particularity
facts
giving
rise
to
a
strong
inference
that
the
defendant
acted
with
the
required
state
of
mind.”
PSLRA
§21(D)
(b)(2).
This
pleading
requirement,
everyone
agreed,
was
much
more
stringent
than
“notice
pleading”,
used
in
run-of-the-mill
cases,
where
it
is
only
necessary
for
the
plaintiff
to
plead
facts
from
which
one
can
hypothesize
some
set
of
facts
consistent
with
the
complaint
that
would
entitle
the
plaintiff
to
relief.
Sanville
v.
McCaughtry,
266
F.3d
724,
732
(7th
Cir.
2001).
However,
because
the
PSLRA
left
the
term
“strong
inference”
undefined,
its
precise
meaning
remained
unknown.
II.
The
Tellabs
Definition
of
“Strong
Inference”
Over
the
next
decade,
circuit
courts
crafted
different
formulae
for
determining
whether
the
complaint
met
the
PSLRA’s
“strong
inference”
standard.
In
2007,
the
Supreme
Court
spoke
for
the
first
time
on
the
issue.
In
Tellabs
v.
Makor
Issues
&
Rights,
551
U.S.
308,
323-324
(2007),
the
Court
set
forth
a
comparative
test:
“The
inquiry
is
inherently
comparative:
How
likely
is
it
that
one
conclusion,
as
compared
to
others,
follows
from
the
underlying
facts?
To
determine
whether
the
plaintiff
has
alleged
facts
that
give
rise
to
the
requisite
‘strong
inference’
of
scienter,
a
court
must
consider
plausible
nonculpable
explanations
from
the
defendant’s
conduct,
as
well
as
inferences
favoring
the
plaintiff.”
For
an
inference
of
scienter
to
be
strong,
“a
reasonable
person
[must]
deem
[it]
cogent
and
at
least
as
compelling
as
any
opposing
inference
one
could
draw
from
the
facts
alleged.”
Id.
at
324.
In
so
defining
the
PSLRA’s
strong-inference
test,
the
Court
specifically
rejected
the
test
applied
by
the
Seventh
Circuit,
from
whence
the
case
originated,
which
eschewed
comparative
analysis
and
simply
asked
if
the
inference
of
scienter
was
reasonable.
Id.
at
317-324.
III.
The
Seventh
Circuit’s
Application
of
the
Tellabs
Comparative-Inference
Test
on
Remand
The
Tellabs
Court
did
not,
however,
apply
this
“comparative-inference”
test
to
the
facts
in
Tellabs,
remanding
for
the
Seventh
Circuit
to
do
that.
On
remand,
the
Seventh
Circuit
(Posner,
J.)
held
that
the
facts
alleged
met
the
comparative-inference
test.
Makor
Issues
&
Rights,
Ltd
v.
Tellabs
Inc.,
513
F.3d
702
(7th
Cir.
2008).
1 of 4
Tellabs
manufactures
equipment
used
in
fiber
optic
cable
networks.
Telephone
companies
are
its
principal
customers.
In
December
2000,
a
switching
system
called
TITAN
5500
was
Tellabs’
principal
product,
accounting
for
over
half
its
sales.
The
complaint
alleged
that
Tellabs
and
its
top
executives
made
a
series
of
false
statements,
including
(i)
overstating
demand
for
the
TITAN
5500
in
press
releases,
statements
to
analysts
and
a
stockholder
letter;
(ii)
misrepresenting
in
a
press
release
that
the
next
generation
product,
the
TITAN
6500,
was
available
for
delivery
to
the
market,
when
it
in
fact
wasn’t;
(iii)
overstating
revenues
in
financials;
and
(iv)
giving
revenue
projections
that
were
overly
optimistic.
The
complaint
also
alleged
that
the
company
was
“channel
stuffing”,
that
is,
flooding
its
customers
with
millions
of
dollars
worth
of
5500’s
that
the
customers
had
not
requested
in
order
to
create
an
illusion
of
demand.
Eventually
Tellabs
announced
a
major
drop
in
revenues,
and
its
share
price
dropped
from
a
peak
of
$67
during
the
class
period
to
$16.
Id.
at
706-707.
In
applying
the
comparative-inference
test,
the
Seventh
Circuit
asked
whether
the
inference
that
the
company
had
made
the
statements
knowing
them
to
be
false
was
as
strong
as
or
stronger
than
the
inference
that
the
company
had
made
them
without
fraudulent
intent,
that
is,
carelessly.
The
court
noted
that
most
of
the
statements
were
made
by
the
company’s
chief
executive
officer.
It
then
examined
the
“careless”,
that
is,
not
liable,
hypothesis
--
that
the
CEO
made
the
statements
based
on
false
information
he
received
from
lower-level
employees
who
themselves
may
have
made
them
knowingly
or
carelessly.
So
the
question
was
whether
the
statements
by
the
CEO
were
the
result
of
merely
careless
mistakes
at
the
management
level
based
on
false
information
fed
it
from
below,
or
rather,
intent
to
deceive
or
a
reckless
indifference
to
whether
the
statements
were
misleading.
Id.
707-709.
Judge
Posner
noted
that
while
a
corporate
executive
may
not
be
held
liable
for
securities
fraud
where
she
negligently
relies
on
bad
information
from
a
low-level
employee,
there
is
some
authority
that
the
corporation
itself
could
be
held
liable
where
the
low-level
employee
acted
with
fraudulent
intent.
However,
because
plaintiff
did
not
argue
the
point,
the
court
did
not
explore
it.
Id.
at
708.
Judge
Posner
found
the
inference
of
scienter
stronger
than
the
inference
of
carelessness
primarily
because
the
products
about
which
the
misstatements
were
made
were
the
company’s
most
important,
what
“Window
XP
and
Vista
are
to
Microsoft”.
Id.
at
709.
He
reasoned
that
a
claim
that
no
member
of
the
company’s
senior
management
who
authorized
or
made
the
statements
knew
they
were
false
“is
hard
to
credit.”
Id.
at
709.
The
Seventh
Circuit
also
focused
on
the
channel-stuffing
allegation.
It
considered
the
non-fraudulent
inference,
noting
that
“channel
stuffing”
might
in
some
instances
be
innocent,
such
as
where
it
is
engaged
in
with
“the
realistic
hope
that
stuffing
the
channel
of
distribution
would
incite
distributors
to
more
vigorous
efforts
to
sell
the
stuff
lest
it
pile
up
in
inventory.”
Id.
at
709.
However,
in
this
case,
the
court
decided
that
the
“huge
number
of
returns
of
5500
systems
is
evidence
that
the
purpose
of
the
stuffing
was
to
conceal
the
disappointing
demand.”
Id.
710.
Finally,
the
Seventh
Circuit
considered
the
fact
that
plaintiff’s
relied
heavily
on
a
number
of
“confidential
sources”
to
ground
its
allegations.
Although
acknowledging
that
“allegations
based
on
anonymous
informants
are
very
difficult
to
assess”
(Id.
at
711),
and
that
“[i]t
would
be
better
were
the
informants
named
in
the
complaint,
because
it
would
be
easier
to
determine
whether
they
had
been
in
a
good
position
to
know
the
facts
that
the
complaint
says
they
learned,
.
.
.
the
absence
of
names
does
not
invalidate
the
drawing
of
a
strong
inference
from
informant’s
assertions.”
Id.
at
712.
This
was
true,
the
court
said,
because
the
confidential
sources
were
numerous
and
the
complaint
described
their
positions
in
the
company
with
sufficient
detail
to
determine
that
they
knew
first
hand
the
facts
to
which
they
were
prepared
to
testify.
Id.
at
712.
IV.
The
Matrixx
Court’s
Application
of
the
Tellabs
Comparative-Inference
Test
On
March
22,
2011,
the
Supreme
Court
issued
Matrixx
Initiatives
v.
Siracusano,
131
S.
St.
1309
(2011),
for
the
first
time
itself
applying
the
Tellabs
scienter
test
to
a
complaint.
Matrixx
is
a
pharmaceutical
company.
The
gravamen
of
the
complaint
was
that
Matrixx
had
failed
properly
to
disclose
field
reports
of
patients
losing
their
sense
of
smell
(a
condition
called
anosmia),
after
taking
Zicam
Cold
Remedy.
Zicam
accounted
for
approximately
70
percent
of
Matrixx’s
sales.
The
complaint
alleged
that
in
1999
Matrixx
received
several
complaints
from
customers
about
the
ansomia.
In
response,
Matrixx’s
vice
president
for
research
and
development
called
one
of
the
treating
physicians,
a
researcher
at
the
University
of
Colorado,
who
informed
him
of
“previous
studies
linking
zinc
sulfate
[,the
active
ingredient
in
Zicam,]
to
loss
of
smell.”
Matrixx
also
hired
a
consultant
to
review
the
product.
Later,
upon
learning
that
another
researcher
from
the
University
of
Colorado
was
planning
to
present
a
talk
about
the
Zicam/ansomia
connection,
Matrixx
demanded
that
he
not
use
the
Zicam
name.
Perhaps
most
significantly,
after
the
Dow
Jones
Newswires
reported
that
the
FDA
was
looking
into
complaints
that
Zicam
might
be
linked
to
anosmia
and
Matrixx's
stock
fell
from
$13.55
per
share
to
$11.97
per
share,
Matrixx
issued
a
press
release
stating
that
Zicam
2 of 4
was
not
linked
to
anosmia
and
that
the
safety
and
efficacy
of
zinc
sulfate
was
well-established.
The
day
after
Matrixx
issued
this
press
release,
Matrixx's
stock
rebounded
to
$13.40
per
share.
In
fact,
Matrixx
had
not
conducted
any
studies
relating
to
anosmia,
and
the
scientific
evidence
at
the
time
was
insufficient
to
determine
whether
Zicam
did
or
did
not
cause
anosmia.
The
complaint
further
alleged
that
in
November
2003,
Matrixx
filed
a
Form
10-Q
with
the
SEC
that,
while
mentioning
the
potential
adverse
effect
of
products
liability
claims
brought
against
the
company,
failed
to
specifically
name
the
two
suits
regarding
Zicam’s
anosmia
effect
which
had
already
been
filed.
Matrixx
argued
that
plaintiffs
failed
to
meet
the
“strong
inference”
test
because
they
did
not
allege
that
defendants
knew
of
statistically
significant
evidence
of
causation.
Thus,
defendants
argued,
“the
most
obvious
inference
is
that
petitioners
did
not
disclose
the
[reports]
simply
because
petitioners
believed
they
were
far
too
few
.
.
.
to
indicate
anything
meaningful
about
adverse
reactions
to
use
of
Zicam.”
Id.
at
1324.
The
court
pointed
out
that
a
lack
of
statistically
significant
data
does
not
mean
that
medical
experts
have
no
reliable
basis
for
inferring
a
casual
link
between
a
drug
and
adverse
events.
Medical
experts
rely
on
other
evidence
to
establish
an
inference
of
causation.
Nor
does
the
FDA
limit
evidence
it
considers
for
assessing
causing
and
taking
regulatory
action
to
statistically
significant
data.
Id.
at
1320-1321.
The
Court
emphasized
that
at
the
same
time
Matrixx
was
affirmatively
denying
any
linkage,
it
was
taking
various
steps
internally
to
investigate
the
complaints,
such
as
hiring
a
consultant
to
review
the
product,
asking
a
researcher
to
participate
in
an
animal
study,
and
convening
a
panel
of
physicians
and
scientists
to
respond
to
a
critical
academic
presentation.
The
Court
also
considered
a
defense
argument
that
one
could
infer
that
Matrixx
delayed
releasing
information
regarding
anosmia
complaints
in
order
to
provide
itself
an
opportunity
to
carefully
review
all
evidence
regarding
any
link
between
Zicam
and
anosmia.
While
granting
that
this
could
be
true
in
some
cases,
the
misleading
nature
of
the
press
release
affirmatively
stating
that
there
was
no
causation
made
this
innocent
explanation
less
compelling
than
a
fraudulent
inference.
Id.
at
1324
n.
15.
The
Supreme
Court
concluded
that
looking
at
the
allegations
“holistically”,
“the
inference
that
Matrixx
acted
recklessly
(or
intentionally,
for
that
matter)
is
at
least
as
compelling,
if
not
more
compelling,
than
the
inference
that
it
simply
thought
the
reports
did
not
indicate
anything
meaningful
about
adverse
reactions.”
Id.
at
1324.
V.
The
Contours
of
Proper
Scienter
Pleading
and
Other
Takeaways
Although
the
Supreme
Court
has
only
spoken
twice
on
successfully
pleading
scienter
in
private
securities
fraud
actions
under
the
PSLRA,
its
two
pronouncements
(and
the
Seventh
Circuit’s
on
remand
in
Tellabs)
have
begun
fill
in
the
gap
left
by
the
PSLRA’s
failure
to
define
“strong
inference”.
Here
are
some
takeaways
from
those
cases.
First,
the
comparative-inference
pleading
standard,
though
high,
is
by
no
means
impossible
to
meet.
Both
the
Tellabs
and
the
Matrixx
complaints
survived
the
test.
Second,
in
both
cases,
the
complaints
satisfied
the
test
without
alleging
motive
for
the
fraud.
Such
motive
might
exist
if,
for
example,
the
top
executives
responsible
for
the
misstatements
profited
personally
by
selling
company
stock
during
the
alleged
fraudulent
period,
or
held
stock
options
or
warrants
that
would
be
worth
more
if
the
stock
price
remained
high
for
a
particular
period.
In
both
Tellabs
and
Matrixx
the
Supreme
Court
specifically
stated
that
a
pleading
of
motive,
though
relevant,
is
not
essential
to
successfully
pleading
scienter.
Tellabs,
551
U.S.
at
325;
Matrixx,
131
S.
Ct.
at
1324.
Third,
in
both
cases,
the
misstatements
concerned
flagship
products
of
the
companies
about
which
it
can
be
assumed
senior
management
who
made
the
false
statements
was
very
interested
and
well
informed.
Fourth,
in
both
cases,
the
misstatements
were
several
and
made
over
several
months,
which
increased
the
likelihood
that
intent,
rather
than
carelessness,
underpinned
them.
Fifth,
although
the
Court
did
not
specifically
address
the
question,
it
appears
that
the
comparative-inference
test
does
not
apply
to
SEC
enforcement
actions,
which
are
not
governed
by
the
PSLRA.
See
e.g.,
In
re
the
Reserve
Fund
Securities
and
Derivative
Litigation,
732
F.
Supp.
2d
310,
318-319
(S.D.N.Y.
2010).
Finally,
in
both
cases
the
Court
noted
that
it
was
reserving
for
another
day
the
issues
of
(i)
whether
reckless
behavior
(as
opposed
to
intentional)
is
sufficient
for
civil
liability
under
section
10b-5,
and
if
so,
(ii)
what
degree
of
recklessness
is
required.
The
Matrixx
Court
noted
that
every
Court
of
Appeals
that
has
considered
the
issue
has
held
that
a
plaintiff
may
meet
the
scienter
requirement
by
showing
that
the
defendant
acted
intentionally
or
recklessly,
though
the
Circuits
differ
on
the
degree
of
recklessness
required.
Id.
at
319
n.3.
It
would
therefore
not
be
surprising
if
in
the
near
future
the
Court
3 of 4
granted
certiorari
in
a
case
alleging
securities
fraud
grounded
in
reckless,
rather
than
intentional,
misrepresentation.
About
Freeman
Lewis
LLP
Freeman
Lewis
LLP
is
a
boutique
business
dispute
resolution
firm,
whose
founders
Jennifer
Freeman
and
Robert
Y.
Lewis
together
have
more
than
50
years
of
experience
assisting
clients
resolve
business
disputes
through
litigation,
arbitration,
mediation
and
negotiation.
Their
firm
focuses
on
commercial
litigation,
employment
law,
securities
arbitration,
white-collar
criminal,
and
ERISA.
For
more
information,
visit
http://www.freemanlewis.com.
FFoorrw
waarrdd eem
maaiill
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