June 21, 2007

Today the Supreme Court issued one decision, described below, of interest to the business community.

• Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484 (PSLRA pleading standard)

Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484 (previously discussed in the January 8, 2007 Docket Report). In an effort to curb abusive securities fraud litigation, the Private Securities Litigation Reform Act of 1995 ("PSLRA") requires plaintiffs to "state with particularity facts giving rise to a strong inference that the defendant acted" with scienter, i.e., that the defendant's intention was to deceive, manipulate, or defraud. 15 U.S.C. § 78u-4(b)(2) (emphasis added). Today, the Supreme Court held that, in order to qualify as "strong," "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."

Tellabs manufactures specialized equipment for fiber optic networks. In June 2001, after the company announced declining demand for one of its main products and lowered its revenue projections, Tellabs' stock price fell precipitously. Subsequently, the company and several of its executives were sued by a class of shareholders who contended that the defendants had engaged in a scheme to deceive investors about the true value of Tellabs' stock. The district court dismissed the suit for failure to satisfy the PSLRA's pleading requirement. The Seventh Circuit reversed, holding that the statute's "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 an opinion by Justice Ginsburg, the Court rejected the Seventh Circuit's standard as inadequately faithful to the language of the PSLRA.

The Court recognized that, in adopting the "strong inference" standard, Congress intended both to "raise the bar" for pleading scienter in private securities cases and to promote uniformity among the Circuits. In seeking a "workable" construction of that standard, Tellabs establishes several important propositions. First, all factual allegations in the complaint must be taken as true. Second, rather than "scrutinize each allegation in isolation," courts should instead view securities complaints "holistically," interpreting "omissions and ambiguities" against an inference of scienter. Third, and most significantly, when evaluating a complaint's scienter allegations, courts must consider "plausible opposing inferences." The Court pointed out that, because "[t]he strength of an inference cannot be decided in a vacuum," reasonable nonculpable explanations for the defendant's conduct may not be ignored. In sum, a complaint can 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."

This decision represents an important victory for the business community. The PSLRA's "strong inference" pleading standard was intended to dispose of frivolous securities claims before defendant companies have to engage in costly discovery. By rejecting the Seventh Circuit's permissive construction of that standard, Tellabs will make it easier for securities-fraud defendants to get weak cases dismissed at the pleading stage. At the same time, however, the Court did not strengthen the pleading requirement as much as it might have. Justices Scalia and Alito, each of whom wrote a separate concurring opinion, would have gone further and read "strong inference" as requiring an inference of scienter that is more plausible than any competing inference of innocence.