The U.S. Court of Appeals for the Seventh Circuit is making up for lost time. Although it was one of the last circuits to issue an opinion interpreting the PSLRA’s heightened pleading standards, the U.S. Supreme Court’s decision to review (and reverse) the case has put the Seventh Circuit in the limelight.
In Tellabs, the Supreme Court held that courts must take into account “plausible opposing inferences” when examining whether a plaintiff has adequately plead a strong inference of scienter (i.e., fraudulent intent). A complaint can survive a motion to dismiss “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.” The Court then remanded the case back to the Seventh Circuit for further proceedings.
The Seventh Circuit’s decision on remand – Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2008 WL 151180 (7th Cir. Jan. 17, 2008) (Tellabs II) – may be just as controversial as its first decision. In an opinion by Judge Posner, the court touched on a number of hot button scienter pleading issues that were not addressed by the Supreme Court.
(1) Corporate scienter – In the Seventh Circuit’s earlier decision, the court found that the plaintiffs had adequately plead scienter as to Tellabs’ CEO and then imputed that scienter to the corporation. Judge Posner, however, decided that Tellabs’ scienter should be examined separately. Although the court found that it was inappropriate to consider the collective knowledge of the corporation’s employees in assessing Tellabs’ scienter, it also declined to look to the state of mind of the CEO who made the allegedly false or misleading statements. Instead, the court appeared to embrace what The 10b-5 Daily has described as the “weak” or “narrow” version of the collective scienter theory, holding that it was “possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud.” In this case, the court held that because the the alleged false or misleading statements concerned Tellabs’ “most important products” and a significant amount of alleged channel-stuffing, it was much more likely that the statements were the result of an intent to deceive or recklessness on the part of management rather than “merely careless mistakes at the management level based on false information fed it from below.” Given that the inference of corporate scienter was much more likely, it was also cogent.
(2) Motive – The court expressed little concern over the fact that the plaintiffs were unable to allege that any of the defendants profited from the fraud, finding that the “argument confused expected with realized profits.” Judge Posner speculated that the CEO “may have thought there was a chance the situation regarding the two key products would right itself” and, therefore, wanted to conceal the truth and avoid causing volatility in the company’s stock price.
(3) Confidential witnesses – Shortly after the Supreme Court decided Tellabs, the Seventh Circuit applied the holding in a different case. In Baxter, the court found that the failure to name sources cited in the complaint “conceals information that is essential to the sort of comparative evaluation required by Tellabs” because the court is unable to fully evaluate the reliability of the witnesses. Accordingly, allegations from confidential witnesses must be “discounted” in determining whether a plaintiff has plead a strong inference of scienter and that discount will usually be “steep.” Although there is nothing in Baxter suggesting that the holding concerning confidential witnesses was limited to the facts of that case, Judge Posner concluded that the steep discount should not be applied to the more numerous and reliable confidential witnesses in the Tellabs complaint.
Holding: Reverse the judgment of the district court dismissing the suit.
Quote of note: “Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.”