Under the Private Securities Litigation Reform Act of 1995 ("PSLRA"), a private securities fraud complaint must allege with particularity facts giving rise to a strong inference that the defendant acted with scienter i.e., the intent to deceive, manipulate or defraud. In its Tellabs opinion, the Supreme Court describes the scope of that statutory hurdle.
Plaintiffs brought claims under Section 10(b) of the Securities Exchange Act of 1934, alleging that Tellabs, Inc., a supplier of equipment used in fiber optic cable networks, inflated its stock price by: (1) representing that demand for its flagship product was growing, when in fact it was waning, (2) representing that a new product was available for delivery and was in high demand, when in fact it was experiencing technical problems and demand was weak, (3) overstating its financial results by engaging in "channel stuffing," including delivering products that customers did not want, and (4) overstating revenue projections. The motion to dismiss turned on whether the scienter allegations against the company's Chief Executive Officer and President met the PSLRA's heightened standard.
The district court held the scienter allegations insufficient and dismissed the complaint. (1) Allegations that the CEO was active in the company's business and spoke with executives about the affected products did not plead scienter, absent allegations of what he learned and knew. Similarly inadequate were allegations that senior management received written reports that showed the falsity of the CEO's statements, absent particularized allegations of what those reports said, who received them, and when they were received. Finally, allegations that the CEO participated in, and was aware of, the "channel stuffing" activities were inadequate because at least some of the activity that plaintiffs so characterized, e.g., offering customer incentives, was not improper.
The Seventh Circuit reversed. On the central issue of what "degree of imagination courts can use in divining whether a complaint creates a 'strong inference,'" the Seventh Circuit held that a complaint sufficiently alleges scienter if a reasonable person could infer that the defendant acted with the required intent. Given the importance of the products at issue to the defendant's business, the court thought it "sufficiently probable" that the CEO had derived information from his involvement in the business that would have suggested the falsity of his statements. The court conceded it was "conceivable" that the CEO had not seen the reports that showed his statements to be false, but held that a reasonable person could still infer that he knew his statements were false.
Reversing the Seventh Circuit in an opinion authored by Justice Ginsburg, the Supreme Court held that it is not sufficient that an inference of scienter be merely plausible or reasonable. Nor may a court consider only the inferences urged by plaintiffs. Rather, when adjudicating a motion to dismiss, a court must also consider innocent inferences urged by defendants.
At the same time, the Court rejected the Sixth Circuit's standard, which permitted a securities fraud claim to proceed to discovery only if scienter was the most plausible of competing inferences. Under the standard propounded by the Supreme Court in Tellabs, to survive a motion to dismiss, the inference of scienter must be powerful and cogent and "at least as compelling as any opposing inference of nonfraudulent intent." (2)
The Supreme Court had little difficulty dismissing the Seventh Circuit's concern that weighing competing inferences on a motion to dismiss violates plaintiffs' Seventh Amendment rights to a jury trial. Holding that Congress, as the creator of federal statutory claims, has power to prescribe pleading standards, the Court noted that there are many examples of "gatekeeping judicial determinations," including summary judgment and judgment as a matter of law. The Court also observed that its pleading standard does not require a plaintiff to plead more than it must prove at trial. At the pleading stage, it is sufficient that the inference of scienter is at least as likely as any innocent inference, while at trial the plaintiff must demonstrate that it is more likely than not, i.e., on a preponderance of the evidence, that the defendant acted with scienter.
On the issue of what facts suffice to create an inference of scienter, in particular on an issue that has divided the Courts of Appeals – whether "motive and opportunity" is necessary or sufficient to plead scienter – the Supreme Court held that the complaint must be considered in its entirety, to determine whether all the facts alleged, taken together, give rise to a strong inference of scienter. Motive can be an important consideration, and personal financial gain may weigh heavily in favor of scienter, but the absence of motive is not fatal. Rather, the significance of motive or the lack thereof depends on the entirety of the complaint, which must be read holistically. The Supreme Court expressly reserved judgment on whether recklessness meets the scienter requirement and, if so, what degree of recklessness is sufficient. Ultimately, the Supreme Court did not decide whether the complaint was sufficient, but remanded the case for further proceedings.
As in its earlier opinions this term, Bell Atlantic Corp. v. Twombly and Credit Suisse Securities (USA) LLC v. Billing, the Supreme Court has recognized in Tellabs the danger of expensive, abusive, lawyer-driven litigation. While reaffirming the proper role of private securities actions in enforcement of the securities laws, the Tellabs opinion, like the Supreme Court's Twombly opinion, highlights the important role of motions to dismiss and pleading standards in combating the danger of vexatious litigation.
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(1) See Johnson v. Tellabs, Inc., 303 F. Supp. 2d 941 (N.D. Ill. 2004), rev'd sub nom. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006).
(2) Justices Scalia and Alito disagreed with the majority. In their view, a securities fraud complaint should be dismissed unless the inference of scienter is more plausible than any inference of innocence.