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Securities Law Commentary
Makor: “Strong Inference” of Scienter – A New Standard, But No New Results
Tellabs, Inc. v. Makor Issues & Rights, Ltd.
Posted: 10/19/2007
By: Joel B. Ginsberg, Esq.
Companies Mentioned: Makor Issues & Rights, Ltd., Tellabs, Inc.
Introduction
The Tellabs tale really has two parts – part one is a Supreme Court decision, which ultimately remanded the case back to the 7th Circuit to apply its ruling, and part two is the subsequent 7th Circuit decision. The Supreme Court decision in Tellabs Inc. v. Makor Issues & Rights Inc., 127 S.Ct. 2499, 2511 (2007), set forth a new standard for proving scienter in cases alleging violation of Section 10(b) of the Securities Exchange Act of 1934, but many analysts questioned the wisdom of a standard they said would require the court to engage in a “mini-trial” even before discovery. Those concerns were given legs in the 7th Circuit’s opinion on remand – the court essentially came right out and found fraud against the corporate defendant before the case had really even begun.
Detailed Commentary
Background
The plaintiffs in Tellabs alleged that Tellabs, a publicly-traded manufacturer of equipment used in fiber optics networks with a presence in 80 nations, and its CEO Richard Notebaert engaged in securities fraud in violation of Section 10(b) of the 1934 Act by falsely representing to the investing public the market demand, revenues and growth projections for two of its most important products – one product that accounted for more than half of the company’s sales, and that product’s successor. In fact, Tellabs was experiencing a major drop in sales and revenues regarding the original product and had failed to sell or ship a single unit of the successor product. During the relevant class period, Tellabs stock dropped from its peak of $67 to less than $16. Plaintiffs, Tellabs shareholders, filed suit.
The District Court initially dismissed the plaintiffs’ complaint without prejudice on Tellabs’ motion, claiming that plaintiffs had failed to meet the Private Securities Litigation Reform Act requirement that the complaint be plead with particularity.1 The plaintiffs amended their complaint with specific allegations regarding Notebaert’s scienter. The second time around, the District Court found that although the plaintiffs had plead Notebaert’s fraudulent statements with particularity, they had still failed to meet the PSLRA standard for scienter – the District Court again dismissed the case, this time with prejudice.
The plaintiffs appealed to the 7th Circuit, which reversed the District Court’s decision, finding that the amended complaint did properly plead scienter with particularity. The 7th Circuit stated the standard as: “We 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… If a reasonable person could not draw an inference from the alleged facts, the defendants are entitled to dismissal.” Makor Issues & Rights Ltd. v. Tellabs Inc., 437 F.3d 588, 602 (2006).
Tellabs I: Setting a new standard for “strong inference” of scienter
The case then went to the U.S. Supreme Court, which vacated the 7th Circuit’s opinion, declaring its interpretation inaccurate. The Supreme Court said that the PSLRA’s mandate for a “strong inference” of scienter requires that the inference be “more than merely ‘reasonable’ or ‘permissible’… A 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 Inc. v. Makor Issues & Rights Ltd., 127 S.Ct. 2499, 2511 (2007) (“Tellabs I”).
In other words, when confronted a 12(b)(6) motion to dismiss (ii) a Section 10(b) action, the court should:
1) assume all allegations in the complaint are true, in accordance with Leatherman v. Tarrant County Narcotics Intelligent and Coordination Unit, 507 U.S. 164, 164 (1993);
2) Consider the inference of scienter based on complaint in its entirety, collectively, rather than by scrutinizing each allegation separately. 127 S.Ct. at 2509; and
3) Take into account plausible, nonculpable explanations for defendant’s behavior, as well as explanations favoring the plaintiff. “The inference that the defendant acted with scienter need not be irrefutable… It must be cogent and compelling, thus strong in light of other explanations.” Id. at 2510.
The Supreme Court vacated and remanded the case to the Circuit Court to reassess the presence of scienter in plaintiff’s case in light of the Court’s opinion and the new standard.
Many analysts labeled Tellabs I as a great victory and piece of armor for the defense bar and corporate America, claiming the new standard would make it harder for plaintiffs to successfully plead securities fraud claims and withstand motions to dismiss. Tellabs I requires the court to weigh competing inferences and use the facts in the complaint to conduct a “mini-trial” even before the opening of discovery. Immediately following Tellabs I, the analysts’ predictions proved true – a significant number of lower court decisions came out interpreting Tellabs I and granting defendants’ motions to dismiss.3
Tellabs II: Giving Plaintiffs Hope
When the case went back to the 7th Circuit on remand, the 7th Circuit, in an opinion written by highly-respected Judge Richard Posner, surprised a lot of folks. Makor Issues & Rights Ltd. v, Tellabs Inc., ___ F.3d ___ (No. 04-1687, 7th Cir. Jan. 17, 2008) (slip op.) (“Tellabs II”) The opinion is expansive, full of analysis and conclusions that will become a model for determination of “strong inference.” Ultimately, the 7th Circuit again reversed the District Court’s dismissal, holding that the plaintiffs had satisfied the PSLRA’s strong inference requirement, and sending the case back to the District Court for further proceedings, including, if necessary, trial.
The analysts’ predictions came true, to the extent that the 7th Circuit did have to conduct an in-depth analysis and make judgments about the fact based solely on the allegations in the complaint in order to consider both fraudulent and innocent explanations for the defendants’ behavior, per Tellabs I. The plaintiffs claimed that Tellabs and its CEO knew, or were reckless in failing to know, that its statements were false and materially misleading to investors. Tellabs advanced the proposition that while the statements may have been false, “their falsity was the result of innocent, or at worst, careless mistakes at the executive level.” Slip Op., p. 8. Tellabs suggested that the misstatements were mere errors resulting from erroneous information provided by lower-level employees, instead of knowing or reckless deception by management.
The Tellabs II Court didn’t buy Tellabs’ explanation, calling it “exceedingly unlikely” that the company’s CEO and senior management would be unaware of the problems facing the company’s main products. Slip Op., pp. 11, 16. The court stated: “That no member of the company’s senior management who was involved in authorizing or making public statements about the demand for [the top two products] knew that they were false is very hard to credit, and no plausible story has yet been told by the defendants that might dispel our incredulity.” Slip Op., p. 11. The combination of the high-level position of the defendants and the fact that the statements concerned the company’s “core products” made defendants’ tale unbelievable.
No realized profit does not equal no scienter
Tellabs also claimed that they could not have acted with scienter because they did not actually profit from the alleged fraud through stock sales, bonuses, etc. The 7th Circuit rejected this argument, calling Tellabs’ move was a gamble.,4 Even though a gamble ultimately fails, that failure “is not inconsistent with its having been a considered, though because of the risk a reckless, gamble.” Slip Op., p. 14. The court likened Tellabs’ conduct to embezzling money from the company in the hope “that winning at the track will enable the embezzled funds to be replaced before they are discovered to be missing.” Slip Op., p. 15.
Plaintiffs’ reliance on confidential sources is not fatal
Judge Posner and the 7th Circuit took the additional opportunity in Tellabs II to expand upon and clarify the Higginbotham v. Baxter Int’l 5 excoriation of anonymous sources. In Higginbotham, the entire case was based on the statements of three unnamed ex-employees and two unnamed consultants, all of whom were far-removed from the named defendants. In deciding that allegations based on confidential sources had to be discounted, the Higginbotham court wrote that “[p]erhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.” Higginbotham v. Baxter International, No. 06-1312, Slip Op., p. 3 (7th Cir. July 27, 2007).
In contrast, the Tellabs II court pointed out that the confidential sources relied upon by the Tellabs plaintiffs were numerous, able to demonstrate first-hand knowledge of pertinent facts about which they were prepared to testify, and conveyed detailed information that was corroborated by multiple sources. Compared to the confidential sources of Higginbotham, the Tellabs confidential sources demonstrated sufficient credibility to prevent the allegations that relied on those sources from being discounted.
Not really a surprising result
The PSLRA standard requiring a “strong inference,” and by extension, the Tellabs rulings, are designed to discourage the filing of frivolous lawsuits. As the Tellabs II result demonstrates, plaintiffs with meritorious claims will still be able to withstand motions to dismiss. The bar is not set much higher than before, it is just labeled more clearly.
But Tellabs II is not really a strong test of the Tellabs I standard, as the Tellabs facts were particularly one-sided – the allegations of scienter clearly favored the plaintiffs and defendants’ explanations seems virtually ridiculous. The true test of the Tellabs I standard will be the case in which plaintiff’s allegations lead to an inference of scienter that is only as strong as the defendant’s nonculpable explanation. That case has yet to be heard.
The author, Joel B. Ginsberg, Esq., is an associate in the transactional department of Zuber & Taillieu LLP, focusing on corporate law, and securities and finance law.
1 The PSLRA demands that a plaintiff “state with particularity facts giving rise to a strong inference that the defendants acted with the required states of mind.” 15 USC §78u-4(b)(2).
2The Federal Rules of Civil Procedure, Rule 12(b)(6), provides that a defendant can move for dismissal of the entire case, even before filing an initial responsive pleading, on the basis that the complaint fails to state a claim upon which relief can be granted.
3 See, e.g., Skubella v. Checkfree Corp., 2008 WL 1902118 (N.D. Ga. 2008); Goodman Life Income Trust v. Jabil Circuit Inc., 2008 WL 977357 (M.D. Fla. 2008); Grand Lodge of Pa. v. Peters, 2008 AL 697340 (M.D. Fla. 2008).
4The Supreme Court had already rejected this argument in Tellabs I, saying: “While it is true that motive can be a relevant consideration, and personal financial gain may weigh heavily in favor of a scienter inference, we agree with the Seventh Circuit that the absence of a motive allegation is not fatal.”
5495 F.3d 753 (7th Cir. 2007).
Securities Law Summary
Read the related Securities Law summary: Supreme Court Vacates 7th Circuit Judgment in Tellabs v. Makor, Orders Remand
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