LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part X: Tellabs and Section 21D(2)(b)

The Supreme Court’s recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), in some ways may appear to have resolved a question of little real import, since it deals only with the requirements for pleading one element of a Section 10(b) cause of action for fraud. While significant amount of time and ink have been expended on the decision that will be handed down next term in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, the significance of Tellabs and its recasting of the rules for resolving a motion to dismiss should not be over looked. Long term, the “jade falcon” standard crafted by the Court – a title borrowed from a hypothetical offered by Justice Scalia in his concurring opinion and adopted by the majority as an illustration of its holding – will have a significant impact on private securities litigation.Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Section 21D(b)(2), which was a key provision of the Reform Act, provides in pertinent part:

In any private action, the complaint shall … state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

Congress did not define “the required state of mind.” Likewise Congress did not define the phrase “strong inference,” or otherwise indicate how the courts should evaluate whether such an inference had been pled in a securities fraud complaint. And, Congress did not identify how the courts should make that evaluation in the context of existing Fed. R. Civ. P. 12(b)(6) motion to dismiss procedures which heavily favored plaintiffs by permitting most cases to proceed into discovery. Congress clearly did, however, specify that then-existing motion to dismiss procedures should be changed by including a provision in the Reform Act precluding discovery until a motion to dismiss is resolved. This contrasts sharply with standard procedure in other suits where the filing of a motion to dismiss does not preclude the commencement of discovery.

Congress did not write Section 21D(b)(2) on a clean slate. The backdrop to the section is a split in the circuits over how to plead scienter. Interestingly, the resolution by Congress of that split which is Section 21D(b)(2) spawned another split in the circuits which was resolved in Tellabs. The coming segments of this series will discuss these splits and analyze the significance of the Tellabs decision.