On June 21, 2007, the U.S. Supreme Court handed down
a decision that provides welcome news to any public
company, officer or director facing the prospect of a
securities class action lawsuit. In Tellabs, Inc. v. Makor
Issues & Rights, Ltd., the Court resolved a significant
and long-standing split on how courts should interpret
the "strong inference" of scienter pleading standard set
forth in the Private Securities Litigation Reform Act of
1995 ("Reform Act") for securities fraud actions. After
emphasizing that "securities fraud actions... if not
adequately contained, can be employed abusively to
impose substantial costs on companies and individuals
whose conduct conforms to the law," the Court made
clear that courts must be vigilant in scrutinizing
– and filtering – such actions at the pleading stage.
In particular, the Court held that a securities fraud
complaint may survive dismissal only if the inference of
scienter arising from the well-plead facts stated therein
was "cogent and at least as compelling as any opposing
inference one could draw from the facts alleged."
The Reform Act sets forth a heightened pleading
standard for securities fraud complaints. With respect
to the scienter requirement of a claim under Section
10(b) of the Securities Exchange Act of 1934, the Reform
Act requires that a complaint "state with particularity
facts giving rise to a strong inference that the defendant
acted with the required state of mind [i.e., the intent to
deceive investors]." At issue in Tellabs was the extent to
which a court must weigh competing factual inferences
in determining whether a strong inference of scienter
had been plead. Some circuits had ruled that, in effect,
a court should consider only those inferences favorable
to plaintiffs. Other courts, including the Ninth Circuit,
held that the Reform Act instead requires courts to
consider the factual allegations and weigh all competing
inferences, including those unfavorable to the plaintiff.
The plaintiffs in Tellabs purported to represent a class of
shareholders who purchased stock between December 11, 2000 and June 19, 2001. Their complaint was
premised principally on allegedly false and misleading
statements by the CEO concerning the company's
Tellabs moved to dismiss the complaint on the ground
that plaintiffs had failed to plead their claims with the
factual particularity required by the Reform Act. The
District Court agreed that plaintiffs failed to plead
scienter on the part of the CEO, and dismissed the
complaint with prejudice. The Seventh Circuit Court
of Appeals reversed in relevant part, holding that the
plaintiffs had sufficiently alleged facts sufficient to
support an inference of scienter.
Supreme Court's Opinion
In an 8-1 decision, the Supreme Court reversed the
Seventh Circuit, and rejected the appellate court's
formulation of the term "strong inference" as only
meaning "facts from which, if true, a reasonable person
could infer that the defendant acted with the required
intent." Rather, the Court made clear that the Congress
intended to mandate a more stringent requirement:
specifically, that all of the relevant factual allegations,
considered in their entirety, must give rise to an inference
of fraud that is not merely "plausible" or "reasonable,"
but is "cogent and at least as compelling as any opposing
inference of nonfraudulent intent." (Emphasis added).
Thus, the court in a securities fraud case must assess
the relevant facts at the pleading stage and engage
in a comparative inquiry of factual inferences – i.e.,
it must consider plausible nonculpable explanations
for the defendant's conduct, as well as inferences
favoring the plaintiff, and measure their relative merits.
Unless plaintiffs can show that the inferences weigh in
their favor, or are at least equal to those favoring the
defendants, the complaint should be dismissed.
The majority also rejected the argument that the Reform
Act's heightened pleading standard violates the Seventh Amendment by demanding a higher showing at the
pleading stage than at trial. The majority concluded that
the "strong inference" standard does not demand that a
plaintiff plead more than she would be required to prove
at trial. To the contrary, the requirement that a pleading
set forth facts showing that a plausible inference of fraud
is at least as likely as any opposing inference is entirely
consistent with plaintiff's ultimate burden at trial to prove
her case by a "preponderance of the evidence."
Implications of the Ruling
By underscoring the potential abuses of securities fraud
actions and the critical gatekeeping role that courts must
play to curtail such harm, the Tellabs ruling is a major
victory for defendants. There is no longer any doubt that
a court must carefully examine all relevant facts at the
pleading stage, evaluate the competing inferences to be
drawn from those facts, and dismiss an action if the scale
tips even slightly toward defendants. This standard is
substantially higher than the lenient "notice pleading"
required in most cases, and is even more stringent than
the heightened requirements applicable to other types of
fraud cases (as set forth in Federal Rule of Civil Procedure
9(b)). Accordingly, the Supreme Court has confirmed
that, as the Ninth Circuit previously stated in Ronconi v.
Larkin, 253 F.3d 423, 437 (9th Cir. 2001), "[i]n few other
areas are motions to dismiss.... so powerful."
Kevin P. Muck, Partner, Litigation Group
Felix S. Lee, Associate, Litigation Group
Gaurav Mathur, Associate, Litigation Group
©2007 Fenwick & West LLP. All Rights Reserved.
This update is intended by Fenwick & West LLP to summarize recent
developments in the law. It is not intended, and should not be regarded,
as legal advice. Readers who have particular questions about these
issues should seek advice of counsel.