The United States Supreme Court will consider what shareholders must allege to survive motions to dismiss securities fraud lawsuits. Tellabs Inc. v. Makor Issues & Rights Ltd., 06-484. Under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), plaintiffs must plead "facts giving rise to a strong inference" that the defendant acted either intentionally or recklessly in making the alleged misrepresentation. Several interpretations of the "strong inference" standard have emerged, causing inconsistencies amongst the circuit courts.
Shareholders sued Tellabs after its stock price dropped in 2001 on news that demand for its product was down. The plaintiffs alleged the company had illegally inflated revenues in the fourth quarter of 2000 and made false projections for 2001, supposedly telling analysts that demand was growing when defendants knew the market was evaporating.
The district court dismissed the case twice, but on appeal the Seventh Circuit revived the plaintiffs’ claims against the company and its former CEO. In doing so, the appellate court adopted a relatively weak standard for what must be alleged to raise a "strong inference" of intent to defraud. The Seventh Circuit’s interpretation allows a securities fraud complaint to survive a motion to dismiss "if it alleges facts from which, if true, a reasonable person could infer that defendants acted with the required intent."
Tellabs argues that "[t]he approach adopted by the Seventh Circuit in this case does serious violence to the deliberately high pleading standard adopted by Congress and to its desire to provide business with relief from costly strike suits." The Securities Industry and Financial Markets Association and U.S. Chamber of Commerce filed an amicus brief in support of Tellabs’ position.
Tellabs asks that the Supreme Court adopt the interpretations of the First, Fourth, Sixth and Ninth Circuits, which weigh all reasonable inferences that might be drawn (both in favor of and against defendants) and permit the action to proceed only if the "most plausible" inference is that defendants intentionally or recklessly committed fraud.
The Eighth and Tenth Circuits have adopted variations on this approach, which are somewhat less rigorous but still require more from plaintiffs than the Seventh Circuit. The Second and Third Circuits have adopted a different approach altogether, under which, if the defendant's motive to defraud is not clearly alleged, circumstantial evidence of intent to defraud must be pleaded in more detail.
A ruling by the Supreme Court imposing stricter pleading standards for securities fraud lawsuits would help companies win early dismissal of frivolous lawsuits. This is important to public companies because, when class-action litigation is permitted to proceed past a motion to dismiss, the substantial cost of discovery and the characteristics of directors’ and officers’ insurance coverage often force defendants to settle even nonmeritorious claims.
The Court is set to hear the issue in March, and a ruling is expected by mid-year. The case is Tellabs Inc. v. Makor Issues & Rights Ltd., 06-484.
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