The 10b-5 Daily

The Washington Post has an article on an unusual effort by three former high-ranking SEC officials to file a post-deadline amicus brief in the Stoneridge (a.k.a. Charter Communications) case. The request evidently is being made in response to the Solicitor General’s decision not to file a brief in support of the investor plaintiffs. Professor Arthur Miller, who recently argued the Tellabs case before the U.S. Supreme Court, is representing the officials.

Chairman Christopher Cox of the SEC testified before the House Financial Services Committee this week. CFO.com has an article on a mostly unnoticed part of his testimony where Chairman Cox discussed his participation in the SEC’s decision to ask the Solicitor General to support the investor plaintiffs in the Stoneridge (a.k.a. Charter Communications) case. The Solicitor General ultimately decided not to file the requested amicus brief.
Quote of note: “Cox’s vote was part of the majority in a 3-2 SEC vote in the so-called StoneRidge case. ‘It is my view that precedent matters,’ he said during a House Financial Services Committee hearing at which all five commissioners attended. ‘The SEC rules and policies should not be so effervescent as to change with one or two people on board.’ . . . In 2004 � a year before Cox joined the commission � the SEC weighed in favor of a broad definition of liability for companies indirectly involved in violations of the securities laws.”
Addition: In a related story, the WSJ Law Blog had an interesting post this week on the campaign by the American Association of Justice (i.e., the main trial lawyer association) to influence public opinion regarding the government’s position in the case.

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.