Today, the Supreme Court resolved a long-disputed issue which is critical to private securities damages actions brought under catch-all antifraud provision, Exchange Act Section 10(b) and Rule 10(b)-5. In Tellabs, Inc. v. Makor, No. 06-484, the Court held that a plaintiff bringing a securities fraud suit for damages need only plead facts “rendering an inference of scienter at least as likely as any plausible opposition inference …” to plead a “strong inference” of scienter as required by the Private Securities Litigation Reform Act of 1995 (“PSLRA”). This holding essentially reflects long-established pleading rules viewed thought the intensified pleading requirements of the PSLRA.
The key issue before the Court concerned the meaning of the phrase “strong inference” of scienter under Section 21D(2)(B) of the PSLRA. That requirement was added to the securities laws in the 1995 amendments to the statutes. Those amendments imposed a number of procedural and substantive limitations and requirements on plaintiffs seeking to bring securities class actions. The point of those amendments, Justice Ginsburg noted in her majority opinion, was to eliminate frivolous suits, but not those which have merit.
The Circuit Courts have been split over the meaning of the pleading requirement. Some courts held that the language reflected a pre-PSLRA test used by the Second Circuit Court of Appeals. Prior to the PSLRA, that Circuit had the most stringent standards for pleading scienter. The phrase “strong inference” was taken from that Court’s decisions. Other Circuits rejected this approach, citing the legislative history to the PSLRA, which repeatedly states that Congress sought to enhance the pleading standards and was not codifying the case law of the Second Circuit. The Seventh Circuit, which was reversed by today’s decision, had concluded that a strong inference was pled where a reasonable person would infer that the defendant had acted with the requisite intent, without evaluating competing inferences. Other Circuits adopted the position that the most “plausible of competing inferences” had to be considered, while another Circuit raised the pleading standard to one which exceeded what a plaintiff would have to prove to prevail at trial.
Justice Ginsburg, in her opinion for the majority, clearly sought a balanced approach in establishing the test for this key pleading requirement. Justice Ginsburg began her opinion by noting that meritorious private securities damages actions have long been recognized as a necessary adjunct to government enforcement actions – a theme the SEC has repeated over the years. At the same time, the opinion notes, if “not adequately contained,” private securities cases can be abusive. The Court noted that both of these points are reflected in the PSLRA and should be carefully considered in crafting the test for evaluating the meaning of a “strong inference” of scienter.
While Congress sought to raise the bar in bringing securities actions, the Court established four key requirements regarding such actions. First, under Federal Civil Rule 12(b)6 which governs motions to dismiss a complaint, the factual allegations must be accepted as true. Second, in evaluating whether a “strong inference” has been pled on such a motion, the entire complaint must be considered. The Court specifically rejected the thesis of Justice Alito in his concurring opinion that only those facts which are pled with particularity as mandated by the PSLRA be considered. Third, plausible competing inferences must be considered. Since this is a pleading requirement, it does not invade the province of the jury or the Seventh Amendment. Finally, in evaluating whether an inference is “strong,” courts should consider the plain meaning of the word as set forth in the dictionary. Those meanings include “powerful or cogent” and “powerful to demonstrate or convince,” the Court noted.
Based on these principles, the Court concluded that to survive a motion to dismiss and properly plead a strong inference a “complaint will survive, we hold, 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.” Since the Seventh Circuit did not apply this test, the Court reversed the lower court’s decision and remanded the case for reconsideration.
Both Justice Scalia and Alito concurred in the result, but argued for a standard which would require the inferences to tip in favor of the plaintiff. Both suggested, however, that, in practice, their test probably differed little from that of the majority. Justice Stevens, who dissented, argued for a “probable cause” standard, rather than the one adopted by the Court.
While the meaning of the PSLRA pleading requirement has been hotly contested by plaintiffs and defendants and was argued in numerous friend of the court briefs filed in the case, the decision should not be viewed as a clear victory for either side. Rather, the decision reflects a balance between the competing interests Justice Ginsburg sought to reflect in her opinion, permitting meritorious classes to proceed, but weeding out those that lack merit. In essence, the standard reflects long-held pleading rules funneled through the PSLRA. Those rules have always required plaintiffs to plead facts sufficient to demonstrate that they have a cause of action and are entitled to relief. The PSLRA added to those standards by establishing a uniform standard for pleading fraud with particularity in securities cases and, in addition, pleading the requisite state of mind. In the standard adopted today, the Court blended together the requirement that plaintiff plead a cause of action properly and the heightened pleading requirements of the PSLRA. At the same time, the Court rejected definitions of “strong inference” that would have made it virtually impossible to plead such a case. Overall, it was a balanced decision by the Court.