We have returned after an extended hiatus occasioned by several significant hearings in April and May and back-to-back trials over the last month. But important developments in the interim must be immediately addressed -- including those taking place at the Supreme Court during the past week.
In Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. __ (6-21-2007) (slip opinion can be found here), the Court prescribed the proper understanding of the pleading requirement set forth in Section 21D(b)(2) of the Private Securities Litigation Reform Act of 1995 (PSLRA), 15 U.S.C. 78u-4(b)(2), that plaintiffs must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind" -- i.e., with scienter.
The Court's opinion, which commanded a majority of six justices (Justice Ginsburg authored the opinion in which Chief Justice Roberts and Justices Kennedy, Souter, Thomas and Breyer joined), took pains to emphasize that nothing in the PSLRA "casts doubt on the conclusion 'that private securities litigation [i]s an indispensable tool with which defrauded investors can recover their losses' -- a matter crucial to the integrity of the capital markets" (slip op. at 9 n.4, quoting Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71, 81 (2006)), and that the "twin goals" of the PSLRA were "to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims." (Slip op. at 10, 12.)
Eight justices rejected the test formerly applied by the Seventh Circuit (Justice Stevens was the lone dissenter approving the Seventh Circuit standard) that the strong inference requirement would be satisfied if a complaint "allege[d] facts from which, if true, a reasonable person could infer that the defendant acted with the required intent." Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588, 602 (7th Cir. 2006)(emphasis supplied). The Court instead established three prescriptive norms for courts ruling on Rule 12(b)(6) motions to dismiss securities fraud claims brought under Section 10(b) of the Exchange Act:
1. courts must accept all factual allegations in the complaint as true;
2. courts must consider the complaint in its entirety -- that is to say, "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"; and
3. courts must take into account plausible opposing inferences. (Slip op. at 11.)
With respect to the third prescription, the Court explained that Congress did not merely require plaintiffs to allege facts from which an inference of scienter rationally could be drawn, but instead to plead with particularity facts that give rise to a "strong -- i.e., a powerful or cogent -- inference." As the Court elaborated, "[t]he strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative." (Slip op. at 12.)
In considering both plausible non-culpable explanations for a defendant's conduct, as well as inferences favoring the plaintiff, "[t]he 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'." But the comparative inference of scienter must be more than merely "reasonable" or "permissible." (Id.) The Court held that a complaint should not be dismissed "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." (Id. at 12-13.) In other words, a court presented with a Rule 12(b)(6) motion to dismiss must ask: "When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?" (Id. at 14.)
The Court provided clear directions how the strong inference pleading standard should be applied in practice to screen out frivolous suits while allowing actions that may prove to be meritorious to move forward. In rejecting Justice Scalia's more stringent interpretation, the Court observed that Justice Scalia's example ("[i]f a jade falcon were stolen from a room to which only A and B had access, [it could not] possibly be said there was a 'strong inference' that B was the thief") would in fact suffice under the Court's formulation because it was "certainly strong enough to warrant further investigation." (Id. at 13 n.5.) The Court also rejected Justice Alito's suggestion that the appropriate tests "used at the summary-judgment and judgment-as-a-matter-of-law stages" of a case should be transposed to the pleading stage. The inference of scienter does not, at the pleading stage and unaided by discovery, have to be so strong a showing as would warrant a judgment or jury determination in the plaintiff's favor. (Id.) Instead, a plaintiff must plead facts rendering an inference of scienter "at least as likely as any plausible opposing inference." At the subsequent trial stage, the plaintiff must satisfy her burden of proof to a preponderance of the evidence by demonstrating that "it is more likely than not that the defendant acted with scienter." (Id. at 17.)
Finally, the Court agreed with the Seventh Circuit that even the absence of a motive allegation would not be fatal to a complaint because, since the complaint's allegations must be considered collectively, the significance of an allegation of motive (or the lack thereof) depends on the entirety of the complaint. Even though the degree to which allegations are vague or ambiguous would diminish their strength in inferring scienter ("omissions and ambiguities count against inferring scienter"), a court should not disregard such allegations because "the court's job is not to scrutinize each allegation in isolation but to assess all of the allegations holistically." (Id. at 14.)
In our earlier post on the Tellabs oral argument (found here), we predicted a 7-2 reversal of the Seventh Circuit. It turned out to be an 8-1 majority for vacating the Seventh Circuit's judgment. However, Justice Ginsburg did not eviscerate the Seventh Circuit formulation as we had feared. In fact, the Court's test is as close to where we argued the line should be drawn as we could have hoped. As the prior post observed:
Although Congress clearly intended to raise the bar on the pleading standard, nothing in the text of the statute or the legislative history gives any indication that it was altering the burden of persuasion in securities cases, nor that it intended to make it functionally impossible for meritorious claims to proceed to the discovery phase. It only wanted to facilitate the gatekeeping function of judges in weeding out meritless cases without imposing an onerous and expensive discovery burden on innocent defendants.
Accordingly, we advocated for what the correct standard should be:
The pleading standard both internally consistent and faithful to the statutory text is -- taking the allegations set forth in the complaint as a whole, accepting them as true, and liberally construing them in the light most favorable to plaintiff -- could a reasonable person draw a strong inference from the alleged facts and circumstances that the defendant acted with the requisite scienter?
This is essentially what the Seventh Circuit held in Tellabs:
[W]e 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.
Makor Issues v. Tellabs, 437 F.3d 588, 602 (7th Cir. 2006)(emphasis supplied).
The reasons supporting this interpretation of the statutory requirement of pleading facts giving rise to a strong inference of scienter were evident:
The focus on a "reasonable person" does not dilute the strong inference requirement; it does not transform the congressional requirement of a "strong inference" of scienter into a "reasonable inference" of scienter. Rather, it merely erects an objective standard for finding a "strong inference." Certainly, if an unreasonable or irrational person would draw a strong inference of scienter, that is not what Congress could possibly have had in mind. Instead, examining all of the allegations in the complaint, the court must decide whether collectively they establish facts from which a reasonable person could strongly infer that each defendant acted with scienter.
We criticized the advocates, particularly Professor Miller representing the plaintiff's position in Tellabs, for not giving the Court more analytical responses to questioning during oral argument that sought to understand what percentage of probability would constitute a "strong inference" of scienter:
The statutory requirement of a "strong" inference clearly means something more than a "reasonable" inference. So, it has to be more than the evidentiary realm where reasonable minds could differ but the totality of the evidence does not amount to a preponderance (i.e., in the 25-50% range). In fact, without an explicit indication that Congress meant to impose a superburden or to raise the burden of persuasion in securities cases, "strong" must mean "preponderance" -- no more, no less.
Surprisingly, this is exactly the test the Court adopted in Tellabs; "strong inference" means that the inference the defendant acted with scienter is "at least as compelling" as any inference that the defendant acted with a non-culpable state of mind. In other words, the inference of scienter must be strong enough to advance at least to the theoretical 50% preponderance line, but it does not have to cross that line at the pleading stage.
Thus, correctly understood, the Court's only criticism of the Seventh Circuit's standard for pleading the required strong inference of scienter was the latter's missing emphasis on the "strong" part of the inference. In effect, the Court refined the Seventh Circuit's definition from (a) pleading facts from which a reasonable person could infer the defendant acted with scienter to (b) pleading facts from which a reasonable person could strongly infer the defendant acted with scienter. This is identical to the standard we advocated in our earlier post: could a reasonable person draw a strong inference from the alleged facts that the defendant acted with the requisite scienter?
According to the Court, the meaning of "strongly infer" is a comparative assessment of plausible inferences, while constantly assuming the allegations of the complaint to be true, from which reasonable people would deem the inference of scienter to be at least as compelling as any opposing inference.
Now, the law recognizes as a hallmark of summary judgment jurisprudence that reasonable people can ultimately disagree about the conclusions they draw from the same evidence once the aggregate state of the evidence is strong enough to cross the theoretical evidentiary line satisfying the burden of production. The same must be true with respect to the Tellabs test. Once plausible inferences of culpable and non-culpable intent are considered from the allegations of a securities fraud complaint, so long as some reasonable people would conclude that the inference of scienter is at least as compelling as the opposing inference, it is to be expected that other reasonable people would disagree and conclude that the inference of scienter is not as compelling as the inference of a non-culpable state of mind. Therefore, the degree of probability for satisfying the Court's new test would have to be that quantum of inference that is the least strong, cogent and compelling as would still lead some objectively reasonable person to conclude that the inference of scienter was at least equal in compelling force to the opposing inference.
Even though the "at least as compelling" language suggests fixing the threshold at the 50% preponderance line, the Court's focus on an objective, "reasonable person" standard means that the degree of probability to establish the necessary quantum of inferences is actually well short of the 50% preponderance line -- instead, it is the least strength from which a reasonable person could still conclude the competing inferences were in equipoise. In other words, the inferences from the factual allegations at the pleading stage should track the extent of the proof necessary at the summary judgment stage to avoid summary judgment against the party with the burden of proof -- enough proof such that rational minds can reasonably differ as to the conclusions they draw from the facts, which means that such factual issues in dispute must be sent to the factfinder for determination. Thus, summary judgment is properly denied even if the totality of proof is ultimately insufficient to sustain the burden of persuasion to a preponderance of the evidence. Similarly, so long as any reasonable person would draw from the facts alleged an inference of scienter at least as compelling as the opposing inference, a motion to dismiss on the basis of an insufficient allegation of scienter should be denied. This is true even if other reasonable persons, perhaps even the Court, would on balance conclude from the facts alleged that the innocent inferences outweigh the inferences of scienter.
Justice Alito grasped at this point in his separate concurrence in the judgment that supported Justice Scalia's construction of "strong inference" to mean something more than a preponderance of the inferences. Justice Alito was both right and wrong when he observed that "Justice Scalia's interpretation would align the pleading test under [section] 78u-4(b)(2) with the test that is used at the summary-judgment and judgment-as-a-matter-of-law stages, whereas the Court's test would introduce a test previously unknown in civil litigation." He is correct that the pleading test should align with the summary judgment standard by which a party's satisfaction of the burden of production will ultimately be based. He is mistaken that the standard to be satisfied at the pleading stage of a case should be coextensive with the showing necessary to satisfy the burden of persuasion at trial. "Preponderance of the inferences" of scienter is too great a burden for plaintiffs to meet at the pleading stage, before any discovery has been conducted, and there is nothing in the PSLRA to suggest that Congress intended plaintiffs to confront such a formidable obstacle. But a sufficient degree of inferences as would satisfy the burden of production if they were eventually supported by proof aligns the pleading test with the summary judgment standard as Justice Alito urged, and places it exactly where it should be.
The majority correctly rejected Justice Alito's conclusions as inappropriately importing an evidentiary standard of legal sufficiency to the pleading stage, but was too quick to dismiss the more thoughtful implications of his summary judgment comparisons.
One last point. As is well-known, in securities fraud claims the "required state of mind" or scienter refers to "a mental state embracing intent to deceive, manipulate or defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-94 & n.12 (1976). The Court observed in Tellabs that "[e]very Court of Appeals that has considered the issue has held that a plaintiff may meet the scienter requirement by showing that the defendant acted intentionally or recklessly, though the Circuits differ on the degree of recklessness required." (Slip op. at 7 n.3.) The Court did not reach the question whether recklessness satisfies the scienter requirement and did not disturb the unanimous case law among the Courts of Appeals. Recklessness has been defined for these purposes as conduct constituting such an extreme departure from ordinary care that, under the circumstances, it presented a danger of misleading the plaintiff that was either known to the defendant or was so obvious that the defendant must have been aware of it. See, e.g., Ottman v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 343-45 (4th Cir. 2003); Sundstrad Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1044-45 (7th Cir. 1977).
Therefore, the Tellabs test in practice is -- construing the totality of the facts alleged in the complaint as a whole and accepting them as true, whether a reasonable person would deem the inference that the defendant acted either intentionally or recklessly to be at least as compelling as any plausible opposing inference a reasonable person would draw from the facts alleged.
Lyle Roberts of The 10b-5 Daily has this take on the Tellabs decision. Tony Mauro analyzes the case here for Legal Times. Scotusblog has two posts on the Court's opinion here and David Stras' "lingering thoughts" here. The best reporting on the decision includes Robert Barnes of the Washington Post here and Peter Kaplan for Reuters here. Greg Stohr has the story for Bloomberg here, and Pete Yost of the Associated Press reports on the case for BusinessWeek here.