Tellabs Decision: A Tighter Noose For Plaintiffs?

The Supreme Court has handed defendants in class-action securities lawsuits yet another bulwark to fend off shareholder litigation, raising the bar for how much scienter, or knowing intent to commit wrongdoing, that plaintiffs must prove.

The case, Tellabs v. Makor Issues & Rights, stems from a shareholder lawsuit against Tellabs Corp., accusing the communications equipment company of falsely overestimating its prospects and engaging in alleged channel-stuffing. The Chicago-based Seventh Circuit Court of Appeals set a very low pleading standard for the plaintiffs to meet, saying that a complaint could proceed to trial “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”

That pleading standard was widely considered to be more liberal than those set by other federal appeals courts, particularly the Cincinnati-based Sixth Circuit. Tellabs took its case to the Supreme Court, arguing that the Seventh Circuit’s standard improperly deviated from the “strong inference” pleading standard set forth by Congress in the Private Securities Litigation Reform Act.

The Supreme Court’s ruling is considered a two-part decision.

Smith

First and most importantly, according to James Smith, a partner with the law firm Dewey Ballantine, the Court put legal muscle behind the statutory language of the “strong inference of scienter” that the PSLRA dictates a plaintiff must plead to survive a motion to dismiss. Lower courts had interpreted this language to mean anything from “a merely plausible” to “the most plausible” inference.

In rejecting the Seventh Circuit’s standard that “any reasonable inference of scienter” suffices, Smith says, the Supreme Court held that a “strong inference” should go beyond a reasonable inference and be “cogent, intellectually compelling and convincing.”

Assuming the plaintiff succeeds on that front, the second part of the test set forth in the Supreme Court’s decision instructs lower courts to consider alternative “plausible, nonculpable explanations for the defendant’s conduct”—something the Seventh Circuit had declined to do. Now, unless the district court concludes that the inference of scienter created by the facts as pled is “cogent and compelling” and that this strong inference is at least as compelling as any alternative inference, the complaint must be dismissed.

The High Court also provided three “prescriptions” to guide judges when deciding inferences of scienter at the motion-to-dismiss stage. The courts must:

accept all factual allegations in the complaint as true;

consider the complaint in its entirety, as well as external sources such as documents incorporated by reference and matters of public record of which courts may take judicial notice;

take into account plausible opposing inferences, including “plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff,” according to a legal bulletin from Dewey Ballantine.

“A complaint will survive … only if a reasonable person would deem the inference cogent and as compelling as any opposing inference one could draw from the facts alleged,” according to another legal bulletin, from the firm Weil Gotshal.

Warren

“The Supreme Court’s use of the word ‘would’ as opposed to ‘could’ is very significant,” explains Irwin Warren, a partner at Weil Gotshal. “It sets a high standard for plaintiffs and consciously does not use the ‘could’ standards used by the Seventh Circuit.”

Putting The Standard Into Practice

How will the heightened standard affect plaintiffs? Now the courts cannot merely take the facts in a vacuum, legal experts say. Rather, they must take them in their totality.

Hart

THE DECISION

Below is the Supreme Court's three-part test to determine whether sufficient scienter exists to allow a securities lawsuit to proceed.

We establish the following prescriptions: First, faced with a Rule 12(b)(6) motion to dismiss a §10(b) action, courts must, as with any motion to dismiss for failure to plead a claim on which relief can be granted, accept all factual allegations in the complaint as true. On this point, the parties agree.

Second, courts must consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss, in particular, documents incorporated into the complaint by reference, and matters of which a court may take judicial notice. The inquiry, as several Courts of Appeals have recognized, is whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard.

Third, in determining whether the pleaded facts give rise to a “strong” inference of scienter, the court must take into account plausible opposing inferences. The Seventh Circuit expressly declined to engage in such a comparative inquiry. A complaint could survive, that court said, as long as it “alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent”; in other words, only “[i]f a reasonable person could not draw such an inference from the alleged facts” would the defendant prevail on a motion to dismiss. But in §21D(b)(2), Congress did not merely require plaintiffs to “provide a factual basis for [their] scienter allegations,” i.e., to allege facts from which an inference of scienter rationally could be drawn. Instead, Congress required plaintiffs to plead with particularity facts that give rise to a “strong”—i.e., a powerful or cogent—inference.

The strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts? To determine whether the plaintiff has alleged facts that give rise to the requisite “strong inference” of scienter, a court must consider plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff. The inference that the defendant acted with scienter need not be irrefutable, i.e., of the “smoking-gun” genre, or even the “most plausible of competing inferences.” Recall in this regard that §21D(b)’s pleading requirements are but one constraint among many the PSLRA installed to screen out frivolous suits, while allowing meritorious actions to move forward. Yet the inference of scienter must be more than merely “reasonable” or “permissible—it must be cogent and compelling, thus strong in light of other explanations. A complaint will survive, we hold, only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.

Source

U.S. Supreme Court (June 21, 2007)

For example, in a hypothetical channel-stuffing case, the plaintiff may argue that the defendant increased shipments to beat analyst estimates and drive up the stock price. The defendant, however, can counter that it did not engage in channel stuffing, but simply shipped out a lot of product to clear the way for the next generation product. “The Court must look at this to see whether it is cogent and compelling,” says Barbara Hart, of the law firm Labaton Sucharow & Rudoff.

The same holds true for restatements. There now seems to be more of a need to tie a prior error with a motive to drive up a stock’s price, say experts.

Or take a case where, say, nine executives have been skimming cash. In the past, an investor might have sued the nine executives as well as the outside auditor for missing the scheme. Under the Tellabs ruling, district courts must take a holistic approach in determining whether a case should move forward against the auditor, rather than look at its role alone. It may be insufficient to say the auditor should have known about the fraud, if the complaint as a whole shows that the executives falsified the books being audited, defrauded the auditor, and so forth. The upshot may have been that the auditor was negligent, but not reckless.

Even though the Court could have imposed still higher standards, lawyers believe no other civil pleading standard is as high as what the Supreme Court just set. “What Congress intended when the PSLRA was enacted was to make the pleading standard higher than is generally faced in normal civil litigation,” Smith says.

Brownlie

“In all other types of civil litigation, the Courts must assume factual allegations are true and draw all inferences as fact,” says Robert Brownlie of the DLA Piper law firm. “Here, it is a break from normal jurisprudence. The courts must consider all inferences—positive or negative—and then take one step further and weigh those inferences.”

How will the Tellabs decision impact future cases? Will attorneys need to change the way they plead their cases? “When institutional investors bring fraud cases, we always set cogent and compelling inferences,” Hart asserts. “We always allege facts that are stronger than the innocent explanation.”

Grant

Stuart Grant, a founder and managing partner of the law firm Grant & Eisenhofer, is quick to stress that, “Good plaintiffs have already been doing this. I don’t think a lawsuit that was good two weeks ago will not survive because of Tellabs.”

In fact, experts don’t expect the Tellabs decision to affect the number of cases filed, which have in general been declining over the past two years. Brownlie believes more cases may be dismissed in the Seventh Circuit. Says Smith: “One of the motivating factors of the PSLRA was to weed out cases and claims that were nonmeritorious at the early stage, so as not to subject defendants to costly burdens.”