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6/21. The Supreme Court issued its
opinion [33 pages in
PDF] in Tellabs v. Makor, a case regarding the heightened pleading requirements
of the Private Securities Litigation Reform Act (PSLRA). The opinion gives a
meaning to the term "strong inference" that will make it harder for class action
securities complaints to survive motions to dismiss. The Court vacated the
opinion of the Court of Appeals. However, it did not adopt the even higher
standard sought by Justice Scalia and critics of class action securities fraud
litigation. To the extent that many of these suits are brought against tech
companies, this is a modest victory for the tech sector.
Summary. The 106th Congress passed the PSLRA, which is codified at
15 U.S.C. § 78u-4 and
§ 78u-5, to insulate defendants, and especially information and biotech
companies, from abusive class action law suits.
The PSLRA creates both a safe harbor for forward looking statements, and a heightened
pleading requirement. Plaintiffs must "state with particularity facts giving rise to a
strong inference that the defendant acted with the required state of mind." However,
this language is vague, and its meaning has perplexed lower courts, which offered divergent
interpretations. In particular, there is no definition of the term "strong
inference".
This opinion, written by Justice Ruth Ginsberg, vacates and remands to the Court of
Appeals. It reduces the uncertainty regarding the pleading standard. The opinion will make
it harder for plaintiffs' class action lawyers' complaints to survive Rule 12(b)(6) motions
to dismiss for failure to state a claim.
Justice Antonin Scalia indicated at oral argument, and in his concurring opinion, that
he favored a stricter pleading standard. However, he only partially won over one other
Justice, Alito, who wrote a separate concurring opinion.
Proceedings Below. Tellabs makes equipment used in fiber optic cable networks.
It is a publicly traded company. The plaintiffs are nominally Makor Issues & Rights,
Ltd. and others. However, this is a class action lawsuit brought by Milberg Weiss.
The plaintiffs filed a complaint in U.S. District
Court (NDIll) against Tellabs, Richard Notebaert and others alleging securities fraud
in violation of § 10(b) of the Securities Exchange Act of 1934, which is codified in
15 U.S.C. § 78j, and Rule 10(b)(5) thereunder, and control person liability by Tellabs
executives.
The District Court dismissed the complaint pursuant to
Rule 12(b)(6) of the Federal
Rules of Civil Procedure (FRCP) for failure to state a claim upon which relief can be
granted. It held that the complaint failed to satisfy the scienter requirements established
by the PSLRA.
The Court of Appeals reversed in part. A three judge panel of the
U.S. Court of Appeals (7thCir) issued its
initial
opinion [28 pages in PDF] on January 25, 2006. It held that the "strong
inference" standard is met if the complaint alleges facts from which, if true, a
reasonable person could infer that the defendant acted with the required intent.
In contrast, other courts, such as the U.S. Court
of Appeals (6thCir), held that plaintiffs are entitled only to the most plausible of
competing inferences. See, for example, Fidel v. Farley, 392 F.3d 220 (6thCir,
2004).
The same panel of the Court of Appeals issued its
Order on
Petition for Rehearing [2 pages in PDF] on July 10, 2006, in which it denied rehearing,
and modified one paragraph in the original opinion regarding control person liability.
The Supreme Court granted certiorari on January 5, 2007. See, story titled
"Supreme Court Grants Certiorari in PSLRA Case Regarding Pleading of Scienter"
in TLJ Daily E-Mail
Alert No. 1,515, January 8, 2007.
Statute and Rules. Section 10(b) of the Securities Exchange Act of
1934, which is codified at
15 U. S. C. §78j(b), provides in part that "It shall be unlawful for any
person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility of any national
securities exchange ... any manipulative or deceptive
device or contrivance in contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the public interest or
for the protection of investors".
Then, SEC rules 10b-5 provides in part that it is unlawful "(a) To employ any
device, scheme, or artifice to defraud, (b) To make any untrue statement of a
material fact or to omit to state a material fact necessary in order to make the
statements made ... not misleading, or (c) To engage in any act, practice, or
course of business which operates or would operate as a fraud or deceit upon any
person, in connection with the purchase or sale of any security."
The key language of the PSLRA (Public Law No. 104-67) is codified in
15 U.S.C. § 78u-4.
Subsection (b)(2) provides that "In any private action arising under this chapter
in which the plaintiff may recover money damages only on proof that the defendant acted
with a particular state of mind, the complaint shall, with respect to each act or omission
alleged to violate this chapter, state with particularity facts giving rise to
a strong inference that the defendant acted with the required state of mind."
(This was contained in Section 21D(b)(2) of the PSLRA.)
This eliminates notice pleading in certain cases. The general pleading rule is set out in
Rule 8 of the FRCP. Rule 8(a)
provides that "A pleading which sets forth a claim for relief, whether an original
claim, counterclaim, cross-claim, or third-party claim, shall contain (1) a short and
plain statement of the grounds upon which the court's jurisdiction depends, unless the
court already has jurisdiction and the claim needs no new grounds of jurisdiction to support
it, (2) a short and plain statement of the claim showing that the pleader is entitled to
relief, and (3) a demand for judgment for the relief the pleader seeks. Relief in the
alternative or of several different types may be demanded." Rule 8(e) adds that
"Each averment of a pleading shall be simple, concise, and direct. No technical forms
of pleading or motions are required."
There is, however, a heightened general rule for pleading fraud.
Rule 9(b)
provides that "In all averments of fraud or mistake, the circumstances
constituting fraud or mistake shall be stated with particularity. Malice,
intent, knowledge, and other condition of mind of a person may be averred
generally."
This rule governed securities fraud litigation prior to the PSLRA. The PSLRA raised the pleading bar still higher.
However, while the PSLRA provides special rules for pleading securities
fraud, it does not provide an explanation or definition of keys concepts, such
as the meaning of "strong inference".
Supreme Court Holding. The Supreme Court vacated the judgment of the
Court of Appeals, and remanded. Justice Ginsburg wrote the opinion of the Supreme Court.
She wrote that the District Court "must engage in a
comparative evaluation; it must consider, not only inferences urged by the
plaintiff, as the Seventh Circuit did, but also competing inferences rationally
drawn from the facts alleged. An inference of fraudulent intent may be
plausible, yet less cogent than other, nonculpable explanations for the
defendant’s conduct. To qualify as ``strong´´ within the intendment of
§21D(b)(2), we hold, an inference of scienter must be more than merely plausible
or reasonable -- it must be cogent and at least as compelling as any opposing
inference of nonfraudulent intent."
Ginsburg elaborated. "We establish the following prescriptions: First, faced
with a Rule 12(b)(6) motion to dismiss a §10(b) action, courts must, as with any
motion to dismiss for failure to plead a claim on which relief can be granted,
accept all factual allegations in the complaint as true."
"Second", wrote Ginsburg, "courts must consider the complaint in its
entirety, as well as other sources courts ordinarily examine when ruling on Rule
12(b)(6) motions to dismiss, in particular, documents incorporated into the
complaint by reference, and matters of which a court may take judicial notice."
"Third, in determining whether the pleaded facts giverise to a ``strong´´
inference of scienter, the court must take into account plausible opposing inferences."
She added that "The strength of an inference cannot be decided in a vacuum.
The inquiry is inherently comparative: How likely is it that one conclusion, as
compared to others, follows from the underlying facts? To determine whether the
plaintiff has alleged facts that give rise to the requisite ``strong inference´´
of scienter, a court must consider plausible nonculpable explanations for the
defendant’s conduct, as well as inferences favoring the plaintiff. The inference
that the defendant acted with scienter need not be irrefutable, i.e., of the
``smoking-gun´´ genre, or even the ``most plausible of competing inferences,´´".
Scalia wrote a concurring opinion. He too favored vacating the Court of Appeals.
However, he would have set an even higher standard. He wrote, "I fail to see how an
inference that is merely ``at least as compelling as any opposing inference,´´ ... can
conceivably be called what the statute here at issue requires: a ``strong
inference,´´".
Finally, Ginsburg wrote, "Yet the inference of scienter must be more than merely
``reasonable´´ or ``permissible´´ -- it must be cogent and compelling, thus strong in light
of other explanations. A complaint will survive, we hold, 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."
7th Amendment Right to Jury Trial. Justice Ginsburg wrote
that setting a different standard (strong inference) at the pleading stage than
at the jury verdict stage (preponderance of the evidence) does not violate the
7th Amendment right to trial by jury. Plaintiff's counsel had raised this
argument, and several Justices asked questions about, and debated, this issue at
oral argument in March.
The 7th Amendment to the Constitution provides, in full, that "In suits at common
law, where the value in controversy shall exceed twenty dollars, the right of
trial by jury shall be preserved, and no fact tried by a jury shall be otherwise
re-examined in any Court of the United States, than according to the rules of
common law."
Ginsburg wrote in the Court's opinion that "A court's comparative assessment
of plausible inferences, while constantly assuming the plaintiff's allegations
to be true, we think it plain, does not impinge upon the Seventh Amendment right
to jury trial."
She continued that "Congress, as creator of federal statutory claims, has power
to prescribe what must be pleaded to state the claim, just as it has power to determine
what must be proved to prevail on the merits. It is the federal lawmaker’s prerogative,
therefore, to allow, disallow, or shape the contours of -- including the pleading and proof
requirements for -- §10(b) private actions. No decision of this Court questions that
authority in general, or suggests, in particular, that the Seventh Amendment inhibits
Congress from establishing whatever pleading requirements it finds appropriate for
federal statutory claims."
She also wrote that "under our construction of the ``strong inference´´ standard,
a plaintiff is not forced to plead more than she would be required to prove at
trial."
Justice Breyer argued at oral argument in March that "I don't see a way of avoiding
this 7th Amendment problem". Ginsburg argued in March that the PSLRA requires
"stating two different claims" -- one for pleading, and the other for the jury.
She said she knew of no other type of case where this exists. In the end, Justices Ginsburg
and Breyer overcame their 7th Amendment scruples.
Delegation of Legislative Authority to the Judiciary. When faced with opposing
alternatives for statutory language, neither of which can garner enough votes for enactment,
members of Congress sometimes compromise by drafting vague intermediate language that
inevitably leads to protracted litigation, and a court made law. Arguably, such was the
case with the "strong inference" language of the PSLRA.
Even if this was not clear to the members and staff who negotiated the PSLRA, it was
apparent when the Congress again took up securities litigation reform when it debated and
enacted the Securities Litigation Uniform Standards Act (SLUSA) in 1998. Nevertheless,
the Congress did nothing to clarify the meaning of the statute. Any resolution of the
uncertainty would have risked preventing the SLUSA from passing.
Justice Ginsburg wrote that the PSLRA left "undefined" the term "strong
inference". She did not elaborate on the nature of the legislative process.
Justice Stevens wrote a dissenting opinion in which he commented that the Congress
"thus implicitly delegated significant lawmaking authority to the Judiciary in
determining how that standard should operate in practice. Today the majority
crafts a perfectly workable definition of the term ..."
Merits of Class Action Securities Litigation. Class action securities
litigation enables a class of shareholders to recover from a publicly traded
company. However, since companies are owned by shareholders, the litigation
works a transfer from one group of innocent shareholders to another.
Moreover, these shareholders ultimately bear the cost of defense legal fees and expenses.
Also, much
of any recovery is consumed by the plaintiffs' class action lawyers.
The rationale that class action litigation serves as a deterrent to corporate wrongdoing
is blunted by the presence of both criminal prosecutions by the
Department of Justice (DOJ) and the civil enforcement by
the Securities and Exchange Commission (SEC).
There is also the matter that class action litigation disrupts the operation
of some defendant companies.
Nevertheless, in briefing and at oral argument, neither the parties, the U.S.
as amicus curiae, nor any of the nine Justices, suggested that securities class
action litigation is unnecessary.
The Supreme Court wrote in its opinion that "This Court has long recognized
that meritorious private actions to enforce federal antifraud securities laws
are an essential supplement to criminal prosecutions and civil enforcement
actions brought, respectively, by the" DOJ and SEC.
Although, the Court added that "Private securities fraud actions, however, if
not adequately contained, can be employed abusively to impose substantial costs
on companies and individuals whose conduct conforms to the law."
The plaintiffs bar is a highly effective lobbying group, and hence, it is
highly unlikely that the Congress, especially a Democratic Congress, would
eliminate, or further limit class action securities litigation.
There is, however, the possibility of public traded companies amending their charters
to provide for mandatory arbitration, as opposed to litigation, of shareholder disputes.
Historically, the SEC has not allowed this practice. However, the SEC could change.
The House Financial Services Committee
(HFSC) will hold a hearing on Tuesday, June 26, at 2:00 PM. The five SEC
Commissioners are scheduled to testify. See,
notice.
The subject of arbitration of shareholder disputes may be discussed.
Rep. Barney Frank (D-MA), the Chairman
of the HFSC, is supportive of the plaintiffs' bar. SEC Chairman
Chris Cox, who
previously represented a California district in the House of Representatives,
was supportive of technology companies and shareholders when he served in the House.
Case Information. This case is Tellabs, Inc. and Richard
Notebaert v. Makor Issues & Rights, Ltd., et al., Sup. Ct. No. 06-484, a petition
for writ of certiorari to the U.S. Court of Appeals for the 7th Circuit, App. Ct. No.
04-1687. See also, Supreme Court
docket.
Arthur Miller,
a professor at Harvard law school, and author of leading works on civil procedure, argued
the case for the plaintiffs. The plaintiffs have also been represented by
Richard Weiss
of the law firm of Milberg Weiss Bershad &
Schulman.
Carter Phillips, of the Washington DC office of the law firm of
Sidley Austin, argued the case for the defendants.
Kannon Shanmugam argued the case for the Office of
the Solicitor General.
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