The 10b-5 Daily

It took ten years, but the U.S. Court of Appeals for the Seventh Circuit has finally issued an opinion that comprehensively interprets the PSLRA’s heightened pleading standards. In Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2006 WL 172142 (7th Cir. Jan. 25, 2006) (Wood, J.), the court addressed the following issues:

(1) Pleading of all facts – Although the PLSRA requires a complaint based on information and belief to state “all facts on which that belief is formed,” courts generally have held that this requirement should not be applied literally. The Seventh Circuit agreed with the Second Circuit that the relevant question is “whether the facts alleged are sufficient to support a reasonable belief as to the misleading nature of the statement or omission.”

(2) Confidential witnesses – In accord with a number of other circuit courts, the Seventh Circuit found that plaintiffs are not required to provide the identify of their confidential sources. It is enough for plaintiffs to describe the sources with sufficient particularity to support the probability that the person would “have access to, or knowledge of, the facts underlying the allegations.”

(3) Substantive scienter standard – The Seventh Circuit found that the PSLRA did not raise the substantive scienter standard for securities fraud, which continues to be knowledge or recklessness. (Only the Ninth Circuit has reached a different conclusion.)

(4) Pleading scienter – Under the PSLRA, a plaintiff must plead sufficient facts to create a “strong inference” of scienter or the complaint shall be dismissed. The key issue has been whether motive and opportunity allegations (e.g., insider stock trading), by themselves, can meet this pleading burden. The Second and Third Circuits say yes. The Ninth and Eleventh Circuits disagree. A number of other circuit courts, however, have taken a more holistic approach and require that all of the allegations in the complaint be collectively examined to determine whether the requisite strong inference of scienter is demonstrated. The Seventh Circuit adopted this middle ground, finding that motive and opportunity allegations may be “useful indicators.”

(5) Competing inferences – Although the Sixth Circuit has found that the “strong inference” requirement creates a situation in which plaintiffs are only entitled to the most plausible of competing inferences when a court evaluates their scienter allegations, the Seventh Circuit disagreed. Instead, the Seventh Circuit stated that it “will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”

(6) Group pleading for scienter – The Seventh Circuit found that the PSLRA requires a strong inference of scienter to be pled for each defendant. Accordingly, scienter allegations made against one defendant cannot be imputed to other defendants on the theory that the officers of the company acted collectively.

For all of the legal windup, the application of the law to the facts in Makor is surprisingly brief. The district court had found that the plaintiffs failed to adequately allege scienter for any of the defendants. On appeal, the Seventh Circuit held that the allegations concerning marketing, sales, and production information available to the CEO were sufficient to establish a strong inference that he acted with fraudulent intent. The CEO’s scienter could then be imputed to the company. As for the other individual defendant, the company’s Chairman, the scienter allegations appeared to be of the “must have known” variety, and he only sold 1% of his stock holdings during the class period. Accordingly, the Rule 10b-5 claim against the Chairman was dismissed.

Holding: Affirmed in part, reversed in part. (The court also evaluated whether falsity and materiality was adequately pled for all of the statements and whether the forward-looking statements were protected by the PSLRA’s safe harbor, but its holdings on these issues were not dispositive of the overall claims against any of the defendants.)

Early reports from today’s Supreme Court oral argument in Merrill Lynch v. Dabit (see post below) suggest that the Second Circuit may be reversed. The justices evidently were skeptical that Congress, in passing SLUSA, meant to allow holders to bring a securities class action in state court, while forcing purchasers and sellers to bring the same case in federal court. Dow Jones Newswires (via wsj.com – subscrip. req’d) and the Financial Times (via MSNBC.com) have articles, while the Wall Street Journal’s Law Blog gets a first-hand report from a law professor who attended the hearing.

Quote of note (Financial Times): “Justice Stephen Breyer said he was worried that permitting such suits in state court would allow investors to circumvent the limits imposed by federal securities laws on purchaser and seller suits. Mr. Breyer said nothing would stop them from proceeding in state court, simply by filing their suits as holders rather than sellers. Justice Ruth Bader Ginsburg asked: ‘Why would Congress with respect to this category want there to be a more plaintiff-friendly rule than it put in place for the purchaser-seller?'”