Category Archives: Appellate Monitor

In the Tellabs v. Makor Issues & Rights case, the U.S. Supreme Court has held that in determining whether the pleaded facts give rise to a “strong inference” of scienter, a court must take into account “plausible opposing inferences.” The 8-1 decision authored by Justice Ginsburg addresses the application of the PSLRA’s heightened scienter pleading standard.

To survive a motion to dismiss, a securities fraud complaint must contain factual allegations giving rise to a “strong inference” that the defendant acted with scienter (i.e., fraudulent intent). In creating this pleading standard as part of the PLSRA, however, Congress did not define the term “strong inference” and courts subsequently construed it differently. Among the outstanding issues was how courts should address competing inferences in determining whether the standard is met.

In Tellabs, the Court described its task as prescribing “a workable construction of the ‘strong inference’ standard, a reading geared to the PSLRA’s twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.” To that end, the Court established a three-step evaluation process for lower courts.

First, when faced with a motion to dismiss a securities fraud claim, “courts must, as with any motion to dismiss for failure to plead a claim on which relief may be granted, accept all factual allegations in the complaint as true.”

Second, courts should consider complaints in their entirety, as well as other sources of information it is appropriate for courts to consider on a motion to dismiss. The proper inquiry 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.”

Finally, courts must take into account “plausible opposing inferences.” 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.”

Although the Court evaluated the factual allegations in the Tellabs complaint, it did not reach any conclusions. Instead, the Court merely emphasized that courts must “assess all the allegations holistically.” To that end, it found that the mere absence of insider trading allegations or the existence of “omissions or ambiguities” in the allegations of improper channel-stuffing may “count against inferring scienter,” but they were not, by themselves, dispositive as to whether the plaintiffs had met the “strong inference” standard. The Court also addressed an issue that attracted a great deal of attention at oral argument: whether the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit in violation of the Seventh Amendment right to jury trial. The Court held that Congress has the power to establish pleading standards for a federal statutory claim and this power did not implicate the Seventh Amendment.

Holding: Judgment vacated and case remanded for further proceedings

Notes on the Decision

(1) Justices Scalia and Alito wrote concurrences. Justice Scalia argued that “the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence.” Although he noted that this test is unlikely “to produce results much different from the Court’s,” Justice Scalia found that it is more in keeping with the “normal meaning” of “strong inference.” Justice Alito agreed with the “more plausible” test put forward by his colleague and also argued that a court should not consider “nonparticularized” allegations in evaluating scienter.

(2) Justice Stevens filed a dissent and argued that Congress had “implicitly delegated significant lawmaking authority to the Judiciary in determining how [the scienter] standard should operate in practice.” He suggested that applying a “probable cause” standard “would be both easier to apply and more consistent with the statute.” Under that standard, Justice Stevens believed it “clear” that the plaintiffs had sufficiently plead scienter.

(3) Although attention is likely to be focused on the Court’s “competing inferences” holding, it is worth noting that the Court’s “holistic” approach to evaluating scienter also addresses a circuit split. The decision would appear to alter the evaluation of scienter in the Second Circuit and Third Circuit, both of which have held that a court can examine allegations of motive or knowledge/recklessness separately to find that the “strong inference” standard has been met.

(4) The majority opinion contains some ambiguities itself. In two consecutive sentences, for example, it states: (a) the inference of scienter “must be cogent and compelling, thus strong in light of other explanations;” and (b) the inference of scienter must be “cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” The second statement (which also appears in the introduction to the opinion) appears to allow for a “tie” to go to the plaintiff. As noted by Justice Scalia in his dissent, this result arguably is not in keeping with Congress’ desire to heighten the pleading standard.

The Stoneridge (a.k.a. Charter Communications) case on scheme liability pending before the U.S. Supreme Court may or may not be “the biggest securities litigation case in a generation,” but it has certainly generated more pre-argument media coverage than Dura and Tellabs put together. Much of that coverage has focused on whether the SEC/DOJ would submit a brief today in support of the plaintiff investors. The Wall Street Journal had an editorial on the topic this past weekend.

Although the SEC apparently recommended that the Solicitor General file the brief – see this Bloomberg article for the details – it does not appear that the recommendation was accepted. Reuters reported earlier today that it was “unlikely” the filing would be made and, as of the time of this post, there is no indication that it has happened. If not, the government has the option of filing a brief in support of the defendants (due in 30 days) or simply remaining silent.

Whatever the government’s position, however, the show goes on for the parties. The plaintiff investors filed their brief today.

Quote of note (plaintiffs’ brief): “Legitimate business will be unaffected if the Court adopts a test giving effect to the plain text of Section 10(b) and Rule 10b-5, but going no further. One proposed test would be that: a person engages in a deceptive act as part of a scheme to defraud investors, and violates Section 10(b) and Rule 10b-5(a) and/or (c), if the purpose and effect of his conduct is to create a false appearance of material fact in furtherance of that scheme.”

Addition: As predicted, the government did not file an amicus brief in support of the investor plaintiffs. Press coverage can be found in Bloomberg and the Washington Post.

Some interesting tidbits from around the web on the Stoneridge (a.k.a. Charter Communications) case on scheme liability set to be heard by the U.S. Supreme Court next term.

Whether, and on which side, the SEC will participate in the case has been a hot issue. SCOTUSblog reports that there are two dates to keep in mind: (1) amicus briefs urging the Supreme Court to hear a similar Enron-related case on scheme liability (maybe in tandem or consolidated with Stoneridge) are due on June 1; and (2) amicus briefs in support of the investor plaintiffs in Stoneridge are due on June 11.

Meanwhile, Point of Law speculates that Justice Alito may be the swing vote in the Stoneridge case. Justices Breyer and Roberts are recused because of stockholdings, leaving seven justices to consider the case.

There has been a fair amount of media and blog coverage of the oral argument in the Tellabs case. Here is a partial roundup:

Media – Articles can be found in the Washington Post.

Blogs – Commentary, with some predictions on the outcome of the case, can be found on the Wall Street Journal Law Blog  and the Sixth Circuit Blog.

Oral argument in the Tellabs v. Makor Issues & Rights case took place in the U.S. Supreme Court this morning. The question presented was: “Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a ‘strong inference’ that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995.”

All of the justices participated in the hearing. Argument was heard from Carter G. Phillips of Sidley Austin on behalf of petitioners Tellabs and Notebaert; Professor Arthur Miller of Harvard Law School on behalf of the respondent shareholders; and Assistant to the Solicitor General Kannon Shanmugam on behalf of the United States as an amicus in support of Tellabs.

Overall Impressions – Predicting how the Supreme Court will rule based on oral argument, especially where there are multiple possible approaches to the issue, is difficult. That said, the Court appeared likely to reject the Seventh Circuit’s “reasonable person” standard as incompatible with the “strong inference” scienter pleading requirement. As noted by Justice Roberts and Justice Breyer, the “reasonable person” standard appears to allow for the possibility that the case will go forward even if the plaintiffs are only able to allege facts establishing a weak inference of scienter. There also appeared to be considerable support for the need to weigh competing inferences.

A few notes on the main issues discussed:

Is There A Seventh Amendment Violation? – Perhaps to the surprise of Tellabs’ counsel, who had argued in his briefs that the Court did not have to reach this issue, the justices spent a fair amount of time discussing whether there needed to be uniformity between the pleading and proof standards for scienter. In their brief, the shareholders had argued that the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit. Justice Scalia and Justice Breyer expressed skepticism over the idea that Congress could not create a heightened pleading standard, noting that there are lots of barriers to entry to federal courts (including diversity and amount in controversy requirements). Justice Breyer wondered whether there was really any difference between saying a plaintiff’s case has to be “really strong” and saying that a plaintiff has to be “really suffering.” That said, a number of justices (Justice Breyer most of all) seemed concerned that the “strong inference” pleading standard was higher than the “preponderance of the evidence” proof standard. Tellabs’ counsel and government counsel both argued that if the Court wanted to address this question, it would need to reconsider the standard of proof, as opposed to watering down the PSLRA.

Can You Infer A CEO’s Knowledge About Financial Issues Based On His Position? – Justice Kennedy appeared anxious to get an answer to this question, asking it of both parties. Tellabs’ counsel responded that the CEO’s title was insufficient; plaintiffs needed to provide particularized facts regarding the CEO’s scienter. Shareholders’ counsel, however, suggested that it was unlikely that a CEO would not know about important financial issues. Moreover, the confidential witnesses cited in the complaint confirmed the existence of scienter for Tellabs’ CEO.

Competing Inferences – Justice Alito took center stage on the issue of how to evaluate competing inferences with the following analogy: if you see a person walking down the street toward the Supreme Court, this fact would create a strong inference that the person is going to the Supreme Court if it is the only building around. If there are a lot of other buildings, however, doesn’t a court have to consider the inference that the person is going to another location? In response to this analogy and further prodding from Justice Ginsburg and Justice Souter, shareholders’ counsel conceded that the court could consider other facts that were subject to judicial notice, but stopped short of agreeing that this constituted an evaluation of competing inferences.

How To Decide This Case – Justice Ginsburg noted that the phrase “strong inference” is not “self-defining” and other justices also appeared to struggle with its meaning. As to how to decide the case in front of them, Justice Scalia expressed a desire to provide lower courts with guidance on what is a “strong inference” of scienter and, during his rebuttal time, Tellabs’ counsel urged the same course.

Prof. Miller v. Justice Scalia – By his own admission, Prof. Miller has a more “colloquial” argument style. That got him into some hot water with Justice Scalia, with whom he traded barbs. Justice Stevens asked Prof. Miller if he could translate the “strong inference” standard into a probability percentage. Justice Scalia quipped that he thought it was 66 2/3%, in response to which Prof. Miller asked if that was “because you never met a plaintiff you really liked?” Justice Scalia got his revenge a few minutes later when Prof. Miller stated “don’t take me literally” on a certain comment and Justice Scalia replied that he would write that down. At that point, Justice Roberts called it a draw.
A transcript of the argument will be released later today. The 10b-5 Daily reserves the right to edit this post if it turns out that the transcript creates a “competing inference” as to the accuracy of the author’s scribbled notes.

The U.S. Supreme Court has turned its gaze to securities litigation and does not appear to like the circuit splits it is seeing. This week features an unprecedented amount of Supreme Court activity on securities issues, with two arguments and a noteworthy grant of certiorari.

An early report on today’s argument in the Credit Suisse case suggests that several justices were skeptical about applying antitrust law to the same allegations raised in the IPO allocation cases. Meanwhile, oral argument in the Tellabs case on scienter pleading is scheduled for tomorrow. Previews of the two cases can be found in the Wall Street Journal (subscrip. req’d), Bloomberg, and the Financial Times.

On Monday, the Supreme Court also granted cert in the Charter Communications case from the Eighth Circuit that addresses scheme liability. The timing could hardly have been better. As discussed in this recent post, the circuit split on the issue expanded just last week when the Fifth Circuit declined to grant class certification in the securities fraud case brought against Enron’s banks.

The question presented in Charter Communications is: “Whether this Court’s decision in Central Bank [], forecloses claims for deceptive conduct under [Section 10(b) and Rule 10b-5] where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions.” Chief Justice Roberts and Justice Breyer will not participate in the case (probably because of stock ownership). The Associated Press has an article andSecurities Litigation Watch has a post.

The briefing is complete in Tellabs, Inc. v. Makor Issues & Rights, Ltd., the scienter pleading case currently before the U.S. Supreme Court. The extensive list of amicus briefs can be found on the court docket. The briefs available via public link include:

Petitioners (Tellabs, Inc. and Richard Notebaert)

Respondents (Makor Issue & Rights, Ltd., et al.)

American Institute of Certified Public Accountants, et al. (Amicus/Petitioners)

Washington Legal Foundation (Amicus/Petitioners)

SEC and DOJ (Amicus/Petitioners)

Oral argument is set for March 28, 2007. The question presented is: “Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a ‘strong inference’ that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995.”

Readers are encouraged to send in public links to any Tellabs briefs not listed here.

Addition: Thanks to Adam Savett for links to the Petitioners’ brief and a few of the amicus briefs (added above).

The U.S. Court of Appeals for the Fourth Circuit has issued a decision that addresses two pressing securities litigation issues. In Teachers’ Retirement System of Louisiana v. Hunter, 2007 WL 509787 (4th Cir. Feb. 20, 2007), the court considered: (a) whether the plaintiffs could establish the scienter of the corporate defendant using a collective scienter theory; and (b) what is the proper pleading standard for loss causation.

Collective scienter – The court rejected the idea that a corporate defendant’s scienter can be established based on the collective knowledge of its employees. Specifically, the court held that “if the defendant is a corporation, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation, since corporate liability derives from the actions of its agents.” Although the court did not expressly determine whether the agent also must be alleged to have made a misstatement, the court’s citation to the Southland decision (5th Cir.) offers some support for that interpretation.

Loss causation – The court noted that in Dura the U.S. Supreme Court expressly did not decide whether the pleading of loss causation is governed by Fed. R. Civ. P. 9(b). In examining the issue, the court found that a “strong case can be made that because loss causation is among the ‘circumstances constituting fraud’ for which Rule 9(b) demands particularity, loss causation should be pleaded with particularity.” Based on this observation and the public policy concerns outlined in Dura, the court concluded that loss causation must be plead “with sufficient specificity to enable the court to evaluate whether the necessary causal link exists.” In the instant case, the court found that the plaintiffs did not adequately plead loss causation. Although the disclosure that caused the stock price decline accused the corporate defendant of fraud, it did not provide any “new facts” that “revealed [the corporate defendant’s] previous representations to have been fraudulent.”

Holding: Dismissal affirmed (based on the failure to adequately plead falsity, scienter, and loss causation).

Disclosure: The author of The 10b-5 Daily represented the defendants in this litigation.

A recent decision by the U.S. Court of Appeals for the Second Circuit offers some interesting clarifications on the scope of accountant liability for securities fraud. In Lattanzio v. Deloitte & Touche LLP, 2007 WL 259877 (2d Cir. Jan. 31, 2007), the court addressed whether Deloitte could be held liable for statements in audited and unaudited financial filings.

As to the company’s unaudited financial filings, the court found that Deloitte’s regulatory obligation to review the company’s quarterly statements did not turn those statements into accountant’s statements. Even if the public understood that Deloitte was engaging in these reviews, the accountant’s “assurances were never communicated to the public.” The court also rejected plaintiffs’ argument that the reviews created a duty to correct the quarterly financial statements if false and that a breach of this duty amounted to a misstatement by Deloitte. The court noted that there is a distinct difference between the duties and liabilities created by a review of interim financial statements and those created by an audit of annual financials.

As to the company’s audited financial filings, the court dismissed the relevant claims based on a failure to adequately plead loss causation. The court held that the “plaintiffs had to allege that Deloitte’s misstatements [in the company’s annual reports concerning accounts payable and inventories] concealed the risk of [the company’s] bankruptcy.” Given that Deloitte had issued a going concern warning – along with the disclosed (if understated) collapse in the company’s value – the risk of bankruptcy was apparent. Accordingly, the court found that the plaintiffs had not alleged facts showing that Deloitte’s misstatements were the “proximate cause of plaintiffs’ loss; nor have they alleged facts that would allow a factfinder to ascribe some rough proportion of the whole loss to Deloitte’s misstatements.”

Holding: Dismissal affirmed.

Quote of note: “Public understanding that an accountant is at work behind the scenes does not create an exception to the requirement that an actionable misstatement be made by the accountant. Unless the public’s understanding is based on the accountant’s articulated statement, the source for that understanding – whether it be a regulation, an accounting practice, or something else – does not matter.”

Addition: Retired Supreme Court Justice Sandra Day O’Connor sat on the panel.