High Court To Decide Class-Action Question

The U.S. Supreme Court has agreed to hear a case later this spring that should clear up the confusion that has developed over what securities-fraud plaintiffs must show to satisfy the heightened pleading standard established by the Private Securities Litigation Reform Act of 1995.

McGuinness

Appellate courts around the country currently use at least four different approaches when it comes to analyzing whether class-action plaintiffs have sufficiently alleged that corporate defendants had the requisite scienter, or intent, to defraud. “The word ‘murky’ does not begin to describe the situation,” says William McGuinness, a litigation partner with the law firm Fried, Frank, Harris, Shriver & Jacobson. “The circuits are all over the place.”

The case that the justices have agreed to hear, Makor Issues & Rights v. Tellabs, comes from the Chicago-based 7th U.S. Circuit Court of Appeals—whose standard is the most favorable to securities plaintiffs. Corporate lawyers hope that the Court’s choice to hear this case indicates that the justices think the 7th Circuit set the bar too low.

“The fact that [the court] took this case rather than a case in which the plaintiffs might have sought [review] suggests that the Supreme Court does not like this standard,” says John Stigi, a litigator in the Los Angeles office of Sheppard, Mullin, Richter & Hampton.

Stigi

Stigisays the issue is “huge … for anybody who practices in this area. This is the show. It’s the core issue that all the practitioners deal with at the threshold of any securities case.”

In agreeing to hear the 7th Circuit case, the Supreme Court expedited the briefing schedule, indicating that the case will be argued this term and decided before the justices break for the summer in early July.

‘Strong’ Inference Of Fraud?

Under the PSLRA, securities-fraud plaintiffs are required to “state with particularity facts giving rise to a strong inference” that the defendant acted with the culpable mental state required for liability. The 7th Circuit case involves Tellabs, a maker of optical networking equipment whose primary customers are telecommunications carriers as well as Internet-service providers.

After Tellabs’ stock price declined in 2001, shareholders sued, claiming that the company improperly booked revenue for the fourth quarter of 2000 due to “channel stuffing” and that, during the relevant period, Tellabs’ revenue projections for 2001 were false and statements of confidence that had been made regarding a key product had been misleading.

FILING

An excerpt follows from the petition for a writ of certiorari

to the 7th Circuit’s decision in Tellab v. Makor Issues & Rights.

QUESTION PRESENTED

Whether, and to what extent, a court must consider or

weigh competing inferences in determining whether a

complaint asserting a claim of securities fraud has alleged

facts sufficient to establish a “strong inference” that the

defendant acted with scienter, as required under the Private

Securities Litigation Reform Act of 1995.

STATEMENT OF THE CASE

This case presents a deep split of authority with respect to

what is perhaps the most important provision of a frequently

invoked federal statute. The Private Securities Litigation

Reform Act of 1995, Pub. L. 104-67, 109 Stat. 737 (“Reform

Act” or “PSLRA”), was passed by Congress to provide a

strict, nationally uniform standard by which complaints

alleging securities fraud under federal law would be judged.

Congress deliberately chose to require that such complaints

plead particularized facts creating a “strong inference” that

the defendant acted with the culpable mental state required

for liability. 15 U.S.C. § 78u-4(b)(2). Absent compliance

with this requirement, litigation is not permitted to proceed

past a motion to dismiss, thereby preventing the substantial

litigation costs that too often forced defendants in such suits

to settle even non-meritorious claims.

More than 10 years later, there is not the clear, uniform

standard that Congress envisioned. Scienter is, of course, the

culpable mental state required for a claim under Section 10(b)

of the Securities Exchange Act of 1934, and is generally

proved by inference rather than with direct evidence. …

The various courts of appeals have adopted four meaningfully

different interpretations of the “strong inference” standard as

applied to claims of scienter. There is now a 4-2-2-1 split of

authority regarding whether and how a court applying the

“strong inference” standard should consider the inferences of

an innocent mental state that could be drawn from the

complaint’s allegations. Only this Court can resolve this

important conflict.

The Seventh Circuit, in the case at hand, has determined

that in ascertaining whether a “strong inference” of scienter

has been adequately pleaded, it will not consider competing

inferences of an innocent mental state that may also be drawn

from the alleged facts. To consider the strength of innocent

inferences as against any potentially culpable inferences at the

plausibility of competing innocent and culpable inferences.

… The Tenth Circuit nonetheless considers the innocent inferences to determine “whether

plaintiff’s suggested inference is ‘strong’ in light of its overall

context.” … The Eighth Circuit considers innocent and

culpable inferences similarly.

…

Finally, two courts—the Second and Third Circuits—have

adopted an altogether different approach to evaluating

whether the “strong inference” of scienter exists. Rather than

consider all the allegations together, these courts have divided

the allegations relating to mental state into two distinct types,

“motive and opportunity” on the one hand, and “strong

circumstantial evidence” that a defendant knowingly or

recklessly issued false statements on the other, either of which

might independently satisfy the “strong inference” standard.

…

That diverse approaches to the interpretation and

application of the “strong inference of scienter” standard

currently prevail in the courts of appeals is directly contrary

to Congress’s intent to create a uniform standard for pleading

securities fraud nationwide. See H.R. Rep. No. 104-369, at

41 (1995… In addition, the weakened version of the “strong inference”

standard adopted by the Seventh Circuit in this case, the most

lenient of any circuit, is also inconsistent with Congress’s

expressed desire to end the pernicious practice of pleading

fraud with hindsight whenever a company’s stock price

tumbles, subjecting businesses to the Hobson’s choice of

paying out a quick settlement for a baseless claim or incurring

massive risk and litigation costs. See S. Rep. No. 104-98, at 4

(1995).

Court can clarify the “strong inference” standard—

particularly how lower courts should consider inferences that

the defendant was innocent—and provide the uniformity that

Congress indisputably sought.

Source

Petition For Writ Of Certiorari In Tellabs v. Makor Issues & Rights (U.S. Supreme Court; Oct. 3, 2006)

A trial judge twice dismissed the suit, finding that the allegations in the complaint were too vague to create a “strong inference” that the company intentionally acted fraudulently. But the 7th Circuit reinstated the suit, adopting a standard that allows a complaint to survive “if it alleges facts from which a reasonable person could infer that the defendant acted with the required intent.”

The 7th Circuit held that any inferences offered by the company to show that it acted innocently should not be considered in determining whether the plaintiffs had established a “strong inference” of fraudulent intent. Balancing such inferences is the job of the jury, not the judge, the court said.

How much weight to give various inferences from the set of facts disputed in litigation is a large part of determining whether a case should proceed. That standard differs from others used by various appellate courts:

The toughest standard for plaintiffs is imposed by four circuits, including the influential San Francisco-based 9th Circuit. These courts allow innocent inferences to play a significant role in evaluating whether a complaint alleges facts from which a “strong inference” that the defendant acted with scienter may be drawn. They require a direct comparison of the plausibility of competing inferences, and have held that a court should consider all of the reasonable inferences that might be drawn. Unless the culpable inference is the most plausible, then it is not “strong,” and the complaint should be dismissed.

Two other courts also consider all of the inferences, both of scienter and of an innocent mental state, that may be drawn from the record, but have expressly declined to follow the rule that an inference is only “strong” if it’s the “most plausible.”

In the New York-based 2nd Circuit, as well as in the Mid-Atlantic 3rd Circuit, the courts divide allegations relating to mental state into “motive and opportunity” and “strong circumstantial evidence” that a defendant knowingly or recklessly issued false statements. Under this approach, either type of allegation can satisfy the “strong inference” standard.

What Did Congress Mean?

The issue before the high court, says Jerrold Ganzfried, of the Howrey law firm, boils down to one question: What did Congress mean when it said that securities plaintiffs must show a “strong inference” that the company acted with fraudulent intent?

Ganzfried

The court “will look to Congress to make the policy decision about what the pleading requirements should be in individual classes of cases,” says Ganzfried, who handled Supreme Court appeals for the government as an assistant U.S. solicitor general during the Reagan Administration.

Which standard is applied is significant, says William Freeman, a securities litigator at the law firm Cooley Godward Kronish. “The problem with securities class actions is that so many of them are strike suits, and courts have problems separating the wheat from the chaff,” he says. “It’s important to try to do that as early as possible because the cases themselves become very expensive. If meritless cases are allowed to proceed to trial, companies may be forced to settle because the risk of an adverse judgment is too high.”

Freeman

The 7th Circuit standard makes it much easier for plaintiffs to get past a motion to dismiss, Freeman says, by requiring a court to indulge all inferences in their favor—“to give them the benefit of any doubt in their pleadings.” In the 9th Circuit, however, plaintiffs must produce evidence that points strongly to the intentional wrongdoing. “If the Supreme Court adopts the more lenient standard, many cases will get past the initial stage that shouldn’t,” he says.

Predicting how the high court will come down on the issue is difficult, Stigi says, although the approaches taken by the 2nd and 9th circuits could be particularly influential because these jurisdictions handle the bulk of securities class actions. “There’s so many different ways they could go. I would guess that they’re going to reject the 7th Circuit standard,” he says, “but how they try to rationalize is a shot in the dark.”

Companies that currently have cases pending against them can’t do much except wait to see how the Court rules, Stigi adds, other than asking a court that has a pending dismissal motion before it to hold off until the justices have their say.