To the delight of the business community and to the chagrin of class action plaintiff lawyers, the United States Supreme Court has made it more difficult for shareholders to pursue securities fraud lawsuits. The high court's opinion, issued in Tellabs, Inc. v. Makor Issues & Rights, Ltd., is one of the most important securities fraud decisions in recent years.
The Supreme Court addressed an issue that arises in almost every class action securities fraud case: how strong a case of fraud must the plaintiffs allege in their initial lawsuit to avoid having the case immediately dismissed.
In an effort to curb abusive securities litigation, Congress enacted the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). The Reform Act requires that a complaint in a securities fraud case to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." Congress left the key term "strong inference" undefined, and courts across the country have divided on its meaning.
In Tellabs, the Seventh Circuit held that a securities fraud complaint should not be dismissed so long as "it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." By an 8-1 vote, the Supreme Court rejected that lenient standard, holding that it did not "capture the stricter demand Congress sought to convey [in the Reform Act]." Writing for the majority, Justice Ruth Bader Ginsburg noted: "The appeals court drew inferences favoring plaintiffs, but declined to consider opposing inferences. That one-sided approach, we hold, was erroneous."
"To qualify as ‘strong,’" Justice Ginsburg wrote, "an inference of [knowing wrongdoing] must be ‘more than merely plausible or reasonable -- it must be cogent and at least as compelling as any opposing inference’ of a lack of intent to defraud." Justice Ginsburg further noted that "[t]o determine whether the plaintiff has alleged facts that give rise to the requisite ‘strong inference’ of [knowing wrongdoing], a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff."
This new heightened pleading standard has been welcomed by business groups, who believe it will significantly reduce the number of securities fraud cases brought by disgruntled shareholders. This is because lower courts will be forced to carefully scrutinize future securities fraud lawsuits to determine if they meet the new pleading standard.
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