When the U.S. Supreme Court issued its landmark Tellabs v. Makor decision in 2007, setting a high standard for what plaintiffs must prove in a class-action securities lawsuit, Corporate America celebrated. Three more recent court rulings have proven that the Tellabs standard is here to stay.
Specifically, Tellabs spelled out how much “scienter,” or knowing intent to commit wrongdoing, that plaintiffs must prove when suing a company … and plaintiffs have prove a lot. As part of its decision, the Supreme Court instructed lower courts to take a holistic approach in determining whether all of the plaintiffs’ allegations together comprise a “strong inference” of scienter.
Hartley
“You have to take all the allegations together, as opposed to reviewing them in silos,” says Michael Hartley of the law firm Alston & Bird. “You have to also step back and look at the broader picture and see whether those allegations together amount to the strong inference that you need.”
The loophole? The Supreme Court didn’t give much guidance about precisely how lower courts should make that holistic determination, says Christian Word of the law firm Latham & Watkins. As a result, some plaintiffs took Tellabs to mean that they need not plead any single fact that strongly suggests scienter, as long as all the facts collectively create a strong inference, he says.
But one recent ruling by the Second Circuit Court of Appeals, and two back-to-back rulings by the Ninth Circuit, challenge that argument.
“ I think there’s been a fair amount of uniformity in how Tellabs has been applied by lower courts since it’s come out.”
— Michael Hartley,
Partner,
Alston & Bird
In the most recent case, Malin v. XL Capital Limited, plaintiffs alleged that XL Capital and a number of its executives knowingly misrepresented the company’s financial condition by failing to reserve adequate capital for its reinsurance unit.
Like any other “garden-variety securities class action,” Word says, plaintiffs attempted to establish a strong inference of scienter by relying on insider stock sales by executives, violations of Generally Accepted Accounting Principles, and other internal accounting policies.
A federal court in Connecticut, however, dismissed the case, reasoning that, since no single fact created a strong inference of scienter, neither can all the facts when examined as a whole. “Plaintiffs cannot establish scienter by combining inadequate allegations of motive with inadequate allegations of recklessness," the court said.
On appeal, plaintiffs relied on Tellabs to argue that the district court was wrong; it should have considered the facts collectively first, rather than review their allegations on a fact-by-fact basis. In March, the ever-important Second Circuit Court of Appeals in New York disagreed. “Having concluded that none of the plaintiffs’ allegations showed even a weak inference of scienter, there is no logical way that the District Court could have determined that the combined effect of the allegations would form a strong inference of scienter,” the court said.
Similar Decisions
For the most part, district courts have adopted the holistic approach established under Tellabs. “I think there’s been a fair amount of uniformity in how Tellabs has been applied by lower courts since it’s come out,” Hartley says.
Word
But there’s also been a fair amount of give-and-take by courts, as well. Some have changed the way they present the analysis to adopt the holistic idea, rather than individual suggestions of scienter, Word says. Other districts, while paying lip service to Tellabs continue to do almost the exact same thing they were doing before, he adds.
Two appellate decisions in the California-based Ninth Circuit serve as examples of that. In the most thorough decision to date—all 41 pages of it—the Ninth Circuit ruled in Zucco Partners v. Digimarc Corp. on Jan. 12 that Tellabs “does not materially alter the particularity requirements for scienter claims established in our previous decisions.”
The Zucco case arose out of claims that Digimarc and certain of its officers had intentionally overstated the company’s earnings and prospects by improperly capitalizing various internal software development costs that should have been treated as operating expenses. The plaintiffs believed they had enough proof that “the intent was there by the company, as opposed to a simple mistake, or legitimate difference in opinion, as to how things should be capitalized,” Hartley says.
A federal district judge in Oregon, however, granted defendants’ motions to dismiss, finding that each allegation on its own was insufficient to give rise to the required strong inference of scienter.
The plaintiffs appealed, and the appellate court then put a two-part test into practice to determine whether sufficient scienter had been demonstrated. Part one: determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter. Part two: if no individual allegations are sufficient, “we will conduct a ‘holistic’ review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or recklessness,” the court said.
The court had applied this same two-part test one day earlier, in Rubke v. Capitol Bancorp. In that case, plaintiffs alleged that Capitol Bancorp deliberately understated the value of stock subject to a pending tender offer by making false statements to key minority shareholders, so that the company could purchase the shares at below market value.
In both Zucco and Rubke, the Court of Appeals concluded that even when considered “holistically,” the combined inferences failed in these cases. The Court observed that while in some circumstances “a set of allegations may create an inference of scienter greater than its parts,” it was just as likely that a group of weak inferences means an equally weak inference overall. As a result, the court upheld the dismissal of both complaints.
The three decisions together are likely to be good news for defendant companies in future cases.
“This is really going to change the way cases are argued in district courts,” Word says. “I think that’s helpful to defendants, because if you can shine the light on the fact that each of these allegations considered by themselves is innocuous, you have a much stronger chance of getting a dismissal.”
No comments yet