Sixth Circuit Blog

Scheme Liability Survives Stoneridge - Barely

In its long-awaited decision announced on Tuesday in Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., 552 U.S. __ (2008) (the Court's slip opinion is here), the Supreme Court ruled that so-called scheme liability under SEC Rules 10b-5(a) and (c) -- claims based on deceptive conduct and manipulative acts and practices (and/or on the participation of secondary actors in deceptive or manipulative schemes to defraud) rather than on material misrepresentations or omissions -- may continue to state a valid claim under the federal securities laws.  At the same time, the Court upheld the dismissal of the complaint by focusing its analysis on the reliance (i.e., causation-in-fact) element of such claims and finding it lacking in Stoneridge.  From this precarious vantage point, scheme liability survives, even if perhaps only for another day or Term.

Writing for a 5-3 majority, Justice Kennedy's opinion for the Court reaffirms the principle that claims seeking to impose liability on “secondary actors who commit primary violations” of the securities laws are actionable under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and SEC Rule 10b-5.  Stoneridge, 552 U.S. at __, slip op. at 15, citing Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994).  In other words, even though the Section 10(b) implied private right of action does not extend to mere aiders and abettors, id., slip op. at 6-7, following the holding of Central Bank of Denver, supra, 511 U.S. at 177, 180, 191, a secondary actor can be liable if its conduct independently satisfies each of the elements for liability under Section 10(b) and Rule 10b-5.  After Stoneridge, status as a secondary actor cannot be argued to automatically and concomitantly confer immunity from civil liability as a mere aider and abettor.

The Court of Appeals for the Eighth Circuit had upheld the dismissal of the plaintiffs’ complaint in Stoneridge on the basis that (i) the complaint did not allege that the defendants had made any misstatements relied upon by the public, and (ii) the defendants (suppliers and customers of the company, Charter Communications, Inc. (“Charter”), in which the plaintiffs had invested) did not have a duty to disclose and therefore did not (indeed, could not) violate such duty.  The Eighth Circuit based its decision on the belief that only misstatements and omissions by one who has a duty to disclose are deceptive within the meaning of Section 10(b) and Rule 10b-5.  Slip op. at 4, 7, citing In re Charter Communications, Inc. Securities Litigation, 443 F.3d 987, 992 (8th Cir. 2006).

The Supreme Court affirmed the result reached by the Eighth Circuit but not on the same grounds or based on the same reasoning.  Indeed, the Court explicitly concluded (contrary to the views of the Fifth and Eighth Circuits) that conduct standing alone, without statements or omissions, can constitute actionable deception or manipulation, and that any suggestion that “there must be a specific oral or written statement before there [can] be liability under § 10(b) or Rule 10b-5” would be “erroneous.”  Stoneridge, slip op. at 7.

The Supreme Court affirmed the dismissal of
the complaint in Stoneridge because the investor-plaintiffs did not rely
in deciding to purchase or sell securities on any of the deceptive acts committed
by the defendants in that case.  The
decision was based solely on the missing element of reliance.

A plaintiff’s reliance on a defendant’s deceptive act (or false or misleading statement or omission) is an essential element of the Section 10(b) private cause of action.  Reliance ensures the “requisite causal connection” between a defendant’s misrepresentation or omission, or deceptive or manipulative conduct, on the one hand and the plaintiff’s injury on the other.  Id., slip op. at 8, citing Basic Inc. v. Levinson, 485 U.S. 224, 243 (1988);  Afiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 154 (1972) (requiring “causation in fact”).  As the Court noted, “reliance is tied to causation” -- “whether [the defendants’] acts were immediate or remote to the injury.”  Slip op. at 9.  The Court further noted that the deceptive act must not only be relied on in a meaningful way, it must also be committed “in connection with the purchase or sale of any security.”  Id., quoting 15 U.S.C. § 78j(b).

The suppliers/customers in Stoneridge had no duty to disclose and their deceptive acts were not communicated to investors.  Slip op. at 8.  Therefore, no cognizable claim was asserted against them because “[n]o member of the investing public had knowledge, either actual or presumed, of [their] deceptive acts during the relevant times [and,] as a result, [plaintiff] cannot show reliance upon any of [defendants’] actions except in an indirect chain that we find too remote for liability.”  Id.  The deceptive acts of the suppliers/customers were too remote because “[i]t was Charter not [defendants] that misled its auditor and filed fraudulent financial statements; nothing [defendants] did made it necessary or inevitable for Charter to record the transactions as it did.”  Id. at 10.

Finally, the Court noted that the plaintiff in Stoneridge sought to apply the Section 10(b) private cause of action in the realm of ordinary business transactions, such as purchase and supply contracts, which are outside of the securities markets.  Id.  The deceptive acts committed by Charter’s suppliers and customers “took place in the marketplace for goods and services, not in the investment sphere.”  Id. at 16.  The Court stated that Section 10(b) “does not reach all commercial transactions that are fraudulent” (id. at 11), and that it “should not be interpreted to provide a private cause of action against the entire marketplace in which the issuing company operates.”  Id.  The Court found this limitation on the reach of Section 10(b) private causes of action to be in accord with both Congress’ intent in responding to the decision in Central Bank of Denver (id. at 11-12) and enacting the PSLRA (id. at 13-15), and sound policy considerations.  Id. at 12-13 (“[o]verseas firms with no other exposure to our securities laws could be deterred from doing business here” which may, in turn, “raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets”).

Early blog commentary on Stoneridge has been as widely disparate as the 30 amicus briefs filed with the Court and spans the entire political spectrum.  Among the more thoughtful examples, Lyle Denniston has this post on the case for Scotusblog, and Lyle Roberts provides his typically cogent analysis for The 10b-5 Daily here.  Elizabeth Nowicki's criticism of the opinion at the Truth on the Market blog can be found here.  Meanwhile, the National Association of Shareholder and Consumer Attorneys (NASCAT) apparently agrees with much of my reading of the opinion, as reported here.  And Larry Ribstein's provocative and insightful critique, per usual, is here.

We will have more coverage of and comments on the Stoneridge decision and the evolving contours of scheme liability under Section 10(b) and Rule 10b-5(a) and (c) in the coming days and weeks as developments warrant.

SLUSA Provision Authorizing Federal Courts to Stay State Court Discovery to Prevent "Circumvention" of PSLRA Discovery Stay Has No Practical Applications or Effect

The Private Securities Litigation Reform Act of 1995 (PSLRA), at 15 U.S.C. 78u-4(b)(3)(B), provides for a mandatory stay of "all discovery and other proceedings" in private securities actions:

In any private action arising under this chapter, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.

The Securities Litigation Uniform Standards Act of 1998 (SLUSA) added a provision to the PSLRA, at 15 U.S.C. 78u-4(b)(3)(D), entitled "Circumvention of Stay of Discovery" which reads, in its entirety:

Upon a proper showing, a court may stay discovery proceedings in any private action in a State court, as necessary in aid of its jurisdiction, or to protect or effectuate its judgments, in an action subject to a stay of discovery pursuant to this paragraph.

The difficulty arises when two lawsuits are pending at the same time -- one in federal court asserting federal securities claims and another in state court alleging different claims -- against the same defendant arising out of common or related facts or issues.  The defendant may contend that discovery in the state action should also be stayed because permitting discovery on those facts or issues the two cases have in common would "circumvent" the discovery stay in the federal case.

Thus, when a discovery stay is automatically imposed pending resolution of a defendant's motion to dismiss in a federal securities case, the PSLRA also explicitly authorizes the defendant, upon a "proper showing" to the court in that case, to seek an order staying discovery in pending state litigation "as necessary in aid of [the federal court's] jurisdiction, or to protect or effectuate [the federal court's] judgments."

But should this congressional language be construed as broadly as it may appear at first blush?  And if so, does this provision exceed the limits, rooted in the Supreme Court's well-entrenched principles of federalism and comity, on Congress' power to authorize federal courts to intrude so expansively on the prerogatives of state judges?

As the prerequisite for a federal court's exercise of the power to stay discovery in a state court case, SLUSA's circumvention provision adopts in identical language two of the three exceptions to the broad prohibition on enjoining state court proceedings found in the Anti-Injunction Act, 28 U.S.C. 2283.  By so doing, Congress was obviously trying to clothe federal discovery-stay orders in the traditional trappings of permissible federal court interference with state court litigation.

The "protect or effectuate its judgments" language has been interpreted in connection with the identical Anti-Injunction Act provision to authorize a stay or injunction when necessary to promote or effectuate an earlier judgment by a federal court.  It is usually referred to as the "relitigation exception" because it permits federal courts to issue injunction or stay orders only to ensure the preclusive effect of an earlier federal court judgment.  The relitigation exception thus applies only in situations where a state court should not hear a case because of res judicata principles but is proceeding to do so anyway.  Moreover, the exception only applies to federal court judgments on the merits, in which case the merits decision can be upheld by injunction if necessary.  If, on the other hand, the federal court dismissed a case on procedural grounds, or otherwise issued a ruling not on the merits, a state court is free to hear the matter.  See Atlantic Coast Line Railroad v. Brotherhood of Locomotive Engineers, 398 U.S. 281 (1970).

Therefore, this language authorizes federal intrusion in state court litigation only if a judgment on the merits has already been entered in the federal case that is in need of being "protect[ed] or effectuate[d]" by barring relitigation in state court.  But how does this operative context justify resorting to a federal stay of state discovery?  How can discovery in a state court lawsuit ever threaten the primacy or efficacy of a prior federal judgment on the merits?  And when would there even be a prior federal court judgment on the merits while a discovery stay in the federal action is still pending?  It would seem that the basis Congress chose for authorizing a federal stay of state discovery makes its use a logical and practical impossibility.

The second statutory justification for staying discovery requests in separate state court actions is if a stay is "necessary in aid of [the federal court's] jurisdiction.  Once again, the identical term "necessary in aid of jurisdiction" in the Anti-Injunction Act has been narrowly construed.  It applies in only two circumstances:  where a case is removed from state court to federal court, and where a federal court first acquires jurisdiction over a case involving the disposition of real property.

With respect to the first circumstance, if a case is removed from state court to federal court and the state court does not properly relinquish jurisdiction, the federal court may enjoin further state court proceedings.  See Reviser's Note to the 1948 revision to Section 2283 (the purpose of this exception is "to make clear the recognized power of the Federal courts to stay proceedings in State cases removed to the district courts");  Mitchum v. Foster, 407 U.S. 225, 234-37 (1972).  As to the second circumstance, it has long been established that whatever court initially acquires in rem or quasi-in-rem jurisdiction over a matter involving real property can enjoin all other courts from hearing the matter.  In fact, the only instance in which the Supreme Court has authorized the reverse situation, where a state court may enjoin parties from litigating in federal court, is where the state court first acquired jurisdiction over real property.  In other words, the general rule is that whichever court first gains jurisdiction in a case concerning the disposition of real property has exclusive jurisdiction to decide claims to that property and may enforce its jurisdiction with stays or injunctions if necessary.  See Donovan v. City of Dallas, 377 U.S. 408, 412 (1964);  Princess Lida v. Thompson, 305 U.S. 456, 465-68 (1939).  The Supreme Court has been firm in ruling that the "in aid of jurisdiction" exception applies only in real property situations and not in in-personam cases.  Atlantic Coast Line Railroad v. Brotherhood of Locomotive Engineers, 398 U.S. 281, 295-96 (1970) ("the state and federal courts had concurrent jurisdiction . . . and neither court was free to prevent either party from simultaneously pursuing claims in both courts . . .  Therefore the state court's assumption of jurisdiction . . . did not hinder the federal court's jurisdiction so as to make an injunction necessary to aid that jurisdiction").

There are few if any conceivable respects in which staying discovery requests in state litigation would be necessary to aid a federal district court in exercising or maintaining its jurisdiction over a federal securities action, especially in the limited sense in which the term-of-art has been consistently interpreted for decades by authoritative Supreme Court decisions.

Moreover, in the context of discovery in multiple federal court cases (which avoids to added complication of federal-state federalism and comity concerns), federal courts have allowed discovery to proceed notwithstanding the PSLRA automatic stay regarding non-securities claims pending between the same parties in separate actions in the same court, or even in the same action.  For example, in In re FirstEnergy Shareholder Derivative Litigation, 219 F.R.D. 584 (N.D. Ohio 2004), the court observed that "[t]he PSLRA, by its terms, is limited to actions filed under the federal securities laws and does not apply outside this context."  The court specifically held that even though "the securities fraud claims [in one case] and the shareholder derivative claims [in other cases] include similar facts, this is insufficient to bring the state law derivative claims within the ambit of [the discovery stay of] the PSLRA. . . .  These claims fall outside the PSLRA's discovery stay."

Another district court has also rejected this same argument that Congress intended a PSLRA stay also to stay discovery in related litigation involving the same or similar parties.  In Tobias Holdings, Inc. v. Bank United Corp., 177 F. Supp.2d 162, 167 (S.D.N.Y. 2001), the court found no congressional intent to prevent discovery in non-securities-fraud cases simply because the cases share facts in common with securities fraud cases.  In that case the non-securities-fraud claims were combined with federal securities claims in the one action, and the court held that "permitting discovery [in connection with the state law claims] to proceed here would not represent an impermissible 'end run' around the PSLRA's automatic stay provisions."

The federal stay of state court discovery permitted by 15 U.S.C. 78u-4(b)(3)(D) requires an application and "proper showing" to the federal court.  Based on the statutory language requiring a stay to be "necessary in aid of [the federal court's] jurisdiction" or needed "to protect or effectuate its judgments," It would seem that there are few circumstances in which a party could make such a showing that it was entitled to a stay of otherwise proper state court discovery merely because of the pendency of a discovery stay in the related federal securities litigation.

Weil Gotshal Publishes Survey of 2006 Securities Fraud Litigation

Our thanks to Paul Ferrillo of Weil Gotshal & Manges for alerting us to his firm's comprehensive 2006 survey of securities fraud litigation.  You can view the full publication here or download the pdf file from Weil Gotshal's website here.  Paul and his colleagues have done an excellent job, per usual.

Tellabs Defines "Strong Inference" for Pleading Securities Fraud Under the PSLRA -- It Could Have Been Much Worse!

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.

Tellabs Redux

The Washington Post carried this story about Wednesday's oral argument in Tellabs vs. Makor Issues & Rights.  The AP reported on the pointed exchanges between Professor Arthur Miller and Justice Scalia, as did the Washington Post in a story here.

Kevin LaCroix at Oakbridge Insurance has this splendid piece explaining why the Tellabs case matters.

Meanwhile, the Law Blog of the Wall Street Journal has this post regarding the Supreme Court's decision to grant review of the Eighth Circuit's decision in Stoneridge Investment Partners v. Scientific-Atlanta, which has been called "the most important case for the securities industry in a generation."  The same article quoted William Lerach as planning to seek Supreme Court review in the wake of the Fifth Circuit's recent dismissal of his similar "scheme liability" class action on behalf of Enron shareholders.

Tellabs Argument -- Opportunities Squandered

Today's oral argument before the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd. was as frustrating to many of the Justices as it was to this observer and a packed gallery gathered to hear the most significant case concerning the heightened pleading requirements for securities fraud claims brought under Section 10(b) of the Exchange Act and SEC Rule 10b-5 since Congress enacted the Private Securities Litigation Reform Act (PSLRA) more than a decade ago.

In response to the perceived need to curtail frivolous and abusive "strike" suits, Congress passed the PSLRA in 1995 which contained, among other provisions designed to limit meritless claims (including new lead-plaintiff requirements), a heightened burden of pleading securities fraud.  A complaint will be dismissed under Rule 12(b)(6) if it fails to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind" -- viz., with scienter (intentionally or recklessly).  The "strong inference of scienter" pleading requirement is at the heart of the issues raised in Tellabs.

Carter G. Phillips of Sidley & Austin argued for Petitioners, Kannon K. Shanmugam, assistant to the Solicitor General, argued for the United States as amicus curiae, and Professor Arthur R. Miller of Harvard Law School argued for Respondents.  Jason Harrow of Scotusblog posted a preview of the Tellabs argument here and Gretchen Sund collected articles on today's argument from the Wall Street Journal and elsewhere in Scotusblog's Round-Up.  The parties' merits briefs are collected here and many of the amici briefs are here and here.  The transcript of the argument can be found here.

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.

At this morning's argument, so many clear opportunities were missed to give the Court the straightforward guidance it was clearly seeking that I feel compelled to answer the Court's unanswered questions.  First, the Court asked both sides what the pleading standard should be in securities cases given the civil rules and the PSLRA.  Notwithstanding the Government's argument that PSLRA functionally amended the civil rules to eliminate the usual inferences and constructions on motions to dismiss, it cannot fairly be read that way nor is there support for such a reading in the legislative history.

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:

House Financial Services Committee Holds Hearing on H.R. 5491

The Capital Markets, Insurance and Government-Sponsored Enterprises Subcommittee of the House Financial Services Committee held a hearing on June 28, 2006 on H.R. 5491, a bill entitled the "Securities Litigation Attorney Accountability and Transparency Act," that would amend the PSLRA.  Lyle Roberts of The 10b-5 Daily reports that the key provisions of the bill would:

(1) allow a prevailing defendant to argue to the court that the plaintiff's attorney should pay the prevailing defendant's fees and expenses because the "position of the plaintiff was not substantially justified;"

(2) require disclosure to the court of any conflict of interest between a plaintiff and his attorney and permit the court to disqualify the attorney if necessary; and

(3) permit courts to approve lead counsel in securities class actions through "alternative means," including a competitive bidding process.

Among the witnesses who appeared before the Subcommittee, Chief Judge Vaughn R. Walker of the Northern District of California and Theodore H. Frank of the American Enterprise Institute spoke in favor of the legislation, while Duke Law School Professor James D. Cox opposed the bill.  Their prepared testimony to the Subcommittee appears here.  The excellent albeit partisan blog Point of Law has two posts on the hearing here and here.

Should Law Firm Diversity Be a Criterion in the Appointment of Lead Class Counsel?

Adam Savett has a post in his blog Lies, Damn Lies & Forward-Looking Statements regarding a recent order from the District of Minnesota requiring counsel seeking appointment as lead class counsel to provide the Court with, inter alia, "information concerning the minority and gender membership in your respective law firms ..."  This begs the very interesting question whether the diversity characteristics of lawyers and law firms seeking appointment as lead class counsel under the PSLRA can properly be taken into account by district courts making such determinations.  The Volokh Conspiracy weighs into the debate with an initial reaction that race, gender and ethnicity may not lawfully be considered.