In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) (link) (Westlaw citation: 2007 WL 1773208), the Supreme Court for the first time addressed the heightened requirements for pleading scienter enacted in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”). Rejecting a relaxed “reasonable inference” approach adopted by the Seventh Circuit, the Supreme Court held that a securities fraud complaint will survive dismissal only if, based upon its factual allegations, the inference of defendant’s scienter is “cogent and at least as compelling as any opposing inference.” In the majority opinion by Justice Ginsburg, the Court held that courts must consider at the pleadings stage plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff. The inferences must be “cogent and compelling, and thus strong in light of other explanations.”
The ruling came in a shareholder’s action against Tellabs, Inc., a manufacturer of specialized equipment used in fiber optic networks. The shareholders alleged that Tellabs’ CEO and president, Richard Notebaert (and by imputation, Tellabs), misled investors by providing false assurances of robust demand for Tellabs’ products and by falsely stating that Tellabs was earning record revenue, when he knew the opposite was true, in order to inflate the company’s stock price. The district court in the case found that the plaintiffs had insufficiently alleged that Notebaert acted with scienter. On appeal, the Seventh Circuit reversed, stating that the complaint should survive if it alleges facts from which a reasonable person could infer that the defendant acted with the required intent.
At issue before the Supreme Court was the provision of the Reform Act requiring a private securities complaint to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” The Court noted that Congress gave no clear guidance on the “strong inference” standard other than to state its intention to strengthen existing pleading requirements. The Court stated its task then, was to provide a workable construction of the standard in light of the Reform Act’s twin goals of curbing “frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims.”
Under the Court’s standard, the inquiry focuses on “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.” The Court stated that when deciding whether there is a strong inference of scienter, courts must take into account “plausible opposing inferences,” thereby rejecting the Seventh Circuit’s test that took into account only the plaintiff’s reasonable inferences, and following the approach of (among others) the Ninth Circuit. See, e.g., Gompper v. VISX, Inc., 298 F.3d 893 (9th Cir. 2002). Under this standard then, plaintiffs must “plead with particularity facts that give rise to a ‘strong’ — i.e., a powerful or cogent — inference.” Noting that the inquiry is inherently comparative, the Court stated that courts “must consider plausible nonculpable explanations for the defendant’s conduct, as well as inferences favoring the plaintiff.” However, “the inference that the defendant acted with scienter need not be irrefutable,” nor “even the most plausible of competing inferences.” But the complaint will survive “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.”
Tellabs contended that when competing inferences were weighed, Notebaert’s lack of a pecuniary motive would be dispositive. The Court stated that while motive could be a relevant consideration, and personal financial gain may weigh heavily in favor of finding scienter, “the absence of a motive allegation is not fatal.” Tellabs also maintained that several of the complaint’s allegations were too vague or ambiguous to support a strong inference of scienter. While the Court agreed that “omissions and ambiguities count against inferring scienter,” it noted that “the court’s job is not to scrutinize each allegation in isolation but to assess all the allegations holistically.”
Justices Scalia and Alito wrote separate opinions concurring with the majority, writing that they would have required a higher standard whereby to survive dismissal the inference of scienter must be more plausible than the inference of innocence. Justice Alito further took issue with the majority’s statement that omissions and ambiguities merely count against inferring scienter and that courts should look to all of the allegations together, even nonparticularized ones, when determining whether the “strong inference” standard has been met. Alito wrote that such an interpretation “undermines the particularity requirement’s purpose of preventing a plaintiff from using vague or general allegations in order to get by a motion to dismiss for failure to state a claim.” Only Justice Stevens dissented from the majority’s decision, arguing that the Court should have applied a “probable cause” standard.
The decision in Tellabs underscored the Court’s long-held view that “meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions,” while at the same time giving effect to the Reform Act’s tools enacted to deter meritless strike suits. The majority’s new, untested standard for pleading scienter reflects the majority’s attempt to balance these policy considerations within the language of the Reform Act.
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