United States: U.S. Supreme Court Toughens Pleading Standards In Securities Fraud Cases

In a highly anticipated decision, the U.S. Supreme Court has made it more difficult for plaintiffs to sustain securities fraud actions at the outset of litigation. The Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. establishes a strict standard for pleading fraudulent intent (known as "scienter"): a securities fraud action will be dismissed unless the inference of scienter is cogent and compelling, based on the pleaded facts, and not merely plausible or reasonable.

In 1995, Congress enacted the Private Securities Litigation Reform Act (PSLRA) to check perceived abuses in securities fraud litigation. Among other things, the PSLRA imposes heightened pleading requirements for private securities actions. To survive a motion to dismiss, a complaint alleging that a defendant made false or misleading statements must (a) specify each statement alleged to have been misleading and the reasons why the statement is misleading; and (b) state particular facts giving rise to a strong inference that the defendant acted with fraudulent intent. Congress did not, however, define the term "strong inference" and the federal courts have subsequently been divided on its meaning.

In Tellabs, plaintiff-shareholders of the computer networking equipment manufacturer commenced a class action alleging that Tellabs’ then-president and CEO (Notebaert) made misleading statements concerning demand for the company’s products and its projected revenues, and that he condoned the practice of "channel stuffing," whereby Tellabs improperly inflated revenues by flooding customers with unsolicited products. Tellabs moved to dismiss the complaint on grounds that the plaintiffs failed to plead their claims with the particularity required by the PSLRA. The trial court agreed, dismissing the action, but allowed the plaintiffs to re-plead their claims. The trial court again dismissed the action because the amended complaint failed to adequately allege that Notebaert acted with the requisite scienter.

On appeal, the Court of Appeals for the Seventh Circuit reversed the second dismissal, holding that the amended complaint adequately pleaded scienter because it alleged "facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." The Seventh Circuit declined to adopt a stricter standard followed by the Sixth Circuit, which requires plaintiffs to plead facts from which, if true, scienter is the most plausible of competing inferences. The Supreme Court granted review, recognizing the split among the federal appellate courts on this issue.

The Supreme Court reversed the Seventh Circuit’s decision, specifically rejecting that court’s scienter analysis as failing to "capture the stricter demand Congress sought to convey" in the PSLRA. In determining whether a complaint raises a "‘strong inference’ of scienter," courts must take into account non-culpable, opposing explanations for a defendant’s conduct as well as inferences favoring the plaintiff. According to the Court, "The inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts?" The inference that the defendant acted with the requisite scienter need not be irrefutable (or even the most plausible) to meet the PSLRA’s requirements but, the Court held, it must be more than merely "reasonable" or "permissible." The inference must, therefore, be cogent and compelling in light of other explanations.

In sum, the Court directed lower courts to employ a balancing test on motions to dismiss by which they must determine whether the plaintiff’s allegations give rise to an inference of scienter that is "at least as likely as any plausible opposing inference."

Tellabs represents the second significant decision on the PSLRA to be handed down by the Supreme Court in the past two years. In 2005, the Court, in Dura Pharmaceuticals v. Broudo, raised the standard for pleading and proving "loss causation" when it held that a plaintiff must do more than show that a misrepresentation simply caused the price of a stock to be "artificially inflated" on the day the plaintiff bought the stock. In 2008, the Court will again visit the securities fraud arena in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. This will be the Court’s first opportunity, following the PSLRA’s enactment, to determine whether plaintiff-shareholders can sue a public company’s advisers, including its banks and lawyers, by alleging that those third parties engaged in a scheme to defraud the shareholders. On the basis of Dura and Tellabs, the Court can be expected to limit such "scheme liability" and reaffirm its seminal 1994 decision, Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., which held that a defendant cannot be liable for "aiding and abetting" securities fraud.