LIABILITY IN SECURITIES FRAUD ACTIONS: Part XV: The Decision in Tellabs – The Seventh Circuit’s Decision

The Seventh Circuit’s decision in Makor Issues & Rights, Ltd. v. Tellabs, Inc. , 437 F.3d 558 (7th Cir. 2006), which was reviewed by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), reflects the trends and splits among the circuits on key issues regarding Section 21D(b)(2) of the Private Securities Litigation Reform Act.  The case is a securities class action in which the shareholders made claims that:  (1) sales for a key product were stable, when in fact they were not; (2) statements concerning the next generation of product were wrong; (3) quarterly results were incorrect because they were based on channel stuffing; and (4) earnings and revenue projections were exaggerated.  The District Court dismissed the initial complaint and an amended complaint. 

The Seventh Circuit affirmed in part and reversed in part in an opinion which discusses each of the four key issues (discussed in an earlier posts in this series — Part XIII and Part XIV) on which the circuits had split.  Makor Issues & Rights, Ltd. v. Tellabs, Inc. , 437 F.3d 558 (7th Cir. 2006).  First, the court held that the Reform Act did not alter the definition of scienter.  This conclusion was in line with most of the courts.  At the same time, the court concluded that the Reform Act “raised the bar for pleading scienter.” 

Second, in considering the group pleading doctrine, the court noted that there is a significant amount of debate about the issue.  It went on to conclude that “[w]hile we will aggregate the allegations in the complaint to determine whether it creates a strong inference of scienter, plaintiffs must create this inference with respect to each individual defendant … .”

The key holding by the court, however, involved the question of inferences.  Initially, the court concluded that the best approach “is for courts to examine all the allegations in the complaint and then to decide whether collectively they establish … [a strong] inference.  Motive and opportunity may be useful indicators, but nowhere in the statute does it say that they are either necessary or sufficient.”  The court thus joined with those circuits which concluded that all inferences should be considered.  At the same time, the court seemed to suggest that while the motive and opportunity prong of the Second Circuit test may be sufficient evidence of a strong inference, it is more important to consider all the evidence. 

The court’s final conclusion, however, placed a different gloss on the “all evidence” test. Here, the court concluded that “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 … .”  Thus while the court’s “all inferences” interpretation of Section 21D(b)(2) is consistent with some other circuits, its “reasonable person” position rejects the conclusion of the Sixth Circuit, while creating a new approach to interpreting a “strong inference.” 

Next: the opinion of the Supreme Court.