The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) is rooted in the language and history of Section 21D(b)(2) of the Reform Act.  That section adopted the “strong inference” language from the Second Circuit, effectively resolving a split among the circuits over the pleading requirements for state of mind in securities fraud actions.  While Congress sought to establish a uniform standard through the Reform Act, the circuits again split on the pleading standards afterwards.

Following the passage of the Reform Act, the circuit courts considered four key issues in interpreting Section 21D(b)(2).  Three of those issues are addressed in this segment of this series, while the fourth will be discussed in the next part. 

The first concerned the applicable state of mind.  Most courts quickly concluded that Congress did not disturb the well developed body of law following the Supreme Court’s decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), which held that a Section 10(b) cause of action requires proof of scienter.  Following that ruling, the circuit courts almost uniformly held that scienter includes reckless conduct.  See, e.g., Ottmann v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 343 n. 3 (4th Cir. 2003) (collecting cases).

The Ninth Circuit was the sole exception.  Based on the legislative history of Section 21D(b)(2), that court concluded that Congress intended to raise the standard.  Following this theory, the court held in In re Silicon Graphics Inc., Sec. Litig., 183 F.3d 970 (9th Cir. 1999) that the requisite mental state must be closer to actual intent – what the court called “deliberate recklessness.”

The circuits split again over a second issue, the meaning of the phrase “strong inference.”  The Second and Third Circuits concluded that Congress intended to adopt the pre-Reform Act Second Circuit case law interpreting the phrase.  Thus, for example, the Second Circuit in Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) held that to establish a “strong inference” of scienter, a securities law “plaintiff must either (a) allege facts to show that ‘defendants had both motive and opportunity to commit fraud’ or (b) allege facts that ‘constitute strong circumstantial evidence of conscious misbehavior or recklessness.’”  Press adopted the circuit’s pre-Reform Act case law.  Later, the SEC filed amicus briefs advocating this position before other circuits.

The Ninth Circuit, on the other hand, rejected the “motive and opportunity” prong of the Second Circuit test as inadequate.  In Silicon Graphics, the court concluded that a securities law plaintiff must plead “particular facts giving rise to a strong inference of deliberate recklessness, at a minimum … .”  Id. at 974. 

Other circuits adopted an intermediate position focused on the specific facts of the case.  For example, the First Circuit in Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999) held that the district court must analyze “the particular facts in each individual case to determine whether the allegations were sufficient to support scienter.”  See also City of Philadelphia v. Fleming Companies, Inc., 264 F.3d 1245 (10th Cir. 2001) (all allegations must be considered). Other circuits such as the Eleventh Circuit held that the motive and opportunity test was insufficient. Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1283 (11th Cir. 1999).  Others such as the Sixth Circuit concluded that such evidence may be sufficient depending on the circumstances.  Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc); see also Ottmann, 353 F.3d 338 (4th Cir. 2003) (motive and opportunity may be sufficient depending on the case); Cf. In Re Green Tree Financial Corp. Options Litig., 270 F.3d 645 (8th Cir. 2001) (arguing that the Second Circuit constricted the motive and opportunity test over time).

A third key issue involved the group pleading doctrine.  Pre-Reform Act cases presumed that misrepresentations in filings were the collective action of officers.  See, e.g., Wool v. Tanden Computers, Inc., 818 F.2d 1433 (9th Cir. 1987).  Following the passage of the Reform Act, the courts split over the continued vitality of the doctrine based on the language of the Act which provided that “particularized” facts be pled as to each defendant.  Compare Southland Sec. Corp. v. Inspire Insurance Solutions, Inc., 365 F.3d 353 (5th Cir. 2004) (doctrine no longer applicable) with Schwartz v. Celestial Seasonings, Inc., 124 F.3d 1246 (10th Cir. 1997) (not inconsistent with Act). 

The final issue concerned the construction of competing inferences – not a traditional issue on a motion to dismiss under Fed. R. Civ. P. 12(b)(6).  The circuits also split over this key question, which is the issue decided by Tellabs against the backdrop of the other three. It will be analyzed in the next part of this series.