Seven months ago, the U.S. Supreme Court set what many say is a sharply higher standard that shareholders must prove when alleging corporate fraud. Now, however, a recent federal appeals court decision shows the new standard isn’t insurmountable.
The Supreme Court’s decision, Tellabs vs. Makor Issues & Rights, spelled out the “scienter,” or knowing intent to commit wrongdoing, that plaintiffs must prove companies had when filing suit against the company for a class-action securities fraud lawsuit. The high court then sent the case (against networking equipment maker Tellabs Inc.) back to the Seventh Circuit Appeals Court to weigh whether the plaintiffs actually could meet that standard. On Jan. 17, the appeals court ruled that they could.
Murphy
While Tellabs is widely viewed as raising the bar for pleading scienter in a securities fraud class action, the Seventh Circuit’s latest decision shows that plaintiffs “can survive the test,” says Lewis Murphy, a partner at the law firm Squire, Sanders & Dempsey who often defends companies against securities class actions. “The Seventh Circuit remand shows that the Tellabs standard can be met if you do it right, and if you don’t, the courts are more than likely to dismiss the complaint.”
Murphy notes that since the Supreme Court ruling was handed down, several circuit courts have dismissed securities fraud lawsuits based on Tellabs. A similar number of district courts also have “applied Tellabs to rigorously police deficient complaints.”
In its 8-1 decision handed down last June, the Supreme Court held that “an inference of scienter must be more than merely plausible or reasonable; it must be cogent and at least as compelling as any opposing inference of non-fraudulent intent,” and ordered the Seventh Circuit to reconsider whether the plaintiffs had shown former Tellabs CEO Richard Notebaert knew statements about the company’s financial prospects were misleading when he allegedly made them. Investors say Notebaert made overly optimistic claims about the company’s performance while demand for its products plunged.
Prior to the Supreme Court decision, lower courts were split over the proper approach to pleading scienter under the Private Securities Litigation Reform Act, enacted in 1995 legislation to curb frivolous lawsuits.
Murphy says Tellabs “clarified where the courts should be” and “put the bar where it was supposed to be all along.”
Bernstein
Still, Richard Bernstein of the law firm Willkie Farr & Gallagher says the lower courts’ application of Tellabs makes it harder for plaintiffs to survive early calls to dismiss their claim.
“If you look at the post-Tellabs cases, there are two significant messages,” Bernstein says. “The bar is higher for plaintiffs to plead scienter. You have to plead real evidence indicating that management either knew or was recklessly indifferent to wrongdoing at lower levels of the company.”
TEST OF KNOWLEDGE
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).
Bernstein and others say Tellabs is generally understood to hold that a tie goes to the plaintiff: If the court concludes that the inference of scienter is “cogent and compelling,” and that inference is at least as compelling as the opposing inference (the inference of lack of scienter) the lawsuit proceeds.
Bernstein says the other message to come out of Tellabs is that companies that take aggressive steps to identify potential fraud once they hear about it “do better in scienter decisions than companies that don’t have a record of trying to investigate and understand the problem.” He cites another case, Higginbotham v. Baxter International, where the Seventh Circuit Appeals Court upheld dismissal of a securities lawsuit against Baxter, which had restated earnings to correct errors created by fraud at a Brazilian subsidiary. In its decision, the court stated: “Taking the time necessary to get things right is both proper and lawful. Managers cannot tell lies, but are entitled to investigate for a reasonable time, until they have a full story to reveal.”
Stigi
John Stigi, a corporate lawyer with the firm Sheppard Mullin Richter & Hampton, says it’s still too soon to judge how the Tellabs standard will be applied. While on its face, the new standard is “definitely harder … By and large, the standard is the same as before. How we’re arguing whether there is or isn’t a strong inference of scienter has changed, but in terms of results, not much has changed.”
Indeed, in some circuits plaintiffs might find a slightly relaxed environment, because some lower courts had employed an even higher standard than what the Supreme Court set forth in Tellabs. That could be particularly true of the Sixth and Ninth Circuits, says John Coffey, a former U.S. attorney and now a plaintiff’s lawyer with the law firm Bernstein Litowitz Berger & Grossmann.
Coffey
And echoing Stigi’s comments, Coffey says: “We haven’t found any case that has been decided since Tellabs that would’ve been decided differently had Tellabs not occurred … In my view, it didn’t provide the knock-out punch many in the corporate lobby were hoping for.”
Coffey does say that the appeals court’s Jan. 17 decision, which he describes as “a breath of fresh air,” is one “investors will cite regularly in the coming months and years.”
Bradford Kaufman, head of securities litigation at the law firm Greenberg Traurig, disagrees. “It seems to me the Supreme Court said … you’d better be able to plead the existence of direct facts or evidence which demonstrates intent of fraud, rather than motivational facts,” he says. “The courts will be looking at those pleadings with a very careful eye.”
Kaufman says his firm has seen a “stemming of the tide” in class actions and more of an effort to focus on derivative actions in state court—a trend he expects to continue.
Research released this month by Stanford Law School Securities Class Action Clearinghouse and Cornerstone Research found that the number of companies sued in securities fraud class-action litigation rose 43 percent last year, from 116 in 2006 to 166 in 2007. That was the first jump in several years, fueled largely by the sub-prime mortgage crisis.
Still, 2007’s numbers were 14 percent below the 10-year historical average of 194 companies sued annually between 1997 and 2006. If litigation related to the 2007 sub-prime crisis is excluded from the calculation, researchers note the resulting core litigation rate of 126 companies sued in the calendar year is well below the average from 1997 through 2006.
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