The Sixth Circuit Concludes That Tellabs Lowers Its Scienter Pleading Standard

The Tellabs decision, construing the PSLRA’s “strong inference” of scienter requirement, continues to have a significant impact on pleading requirements in securities damage actions. The Sixth Circuit is the latest circuit to conclude that the Supreme Court’s decision reduced the pleading burden on securities plaintiffs in that circuit. Frank v. Dana Corp., No. 07-235 (6th Cir. Decided Nov. 19, 2008).

Dana is a securities class action brought initially against Dana Corp., a now-bankrupt auto parts manufacturer, and two of its officers, claiming securities fraud. Specifically, the complaint claims that Michael Burns and Robert Richter, Dana’s Chief Executive Officer and Chief Financial Officer, respectively, misled investors by reporting strong earnings, declaring positive financial outlooks, and touting sound internal accounting procedures, none of which were true. In addition, for each quarter during the class period of April 21, 2004 through October 7, 2005, plaintiffs claim that the two officer defendants executed false SOX Section 302 certifications.

The Sixth Circuit reversed the decision of the district court which had granted defendants’ motion to dismiss for failure to comply with the pleading standards of the Private Securities Litigation Reform Act. The district court held that plaintiffs were required to “establish an inference of scienter that is more plausible and powerful than competing inferences of defendants’ state of mind.”

The Sixth Circuit began its analysis by noting that, in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), the Supreme Court prescribed a specific three-step analysis to be followed in assessing whether the allegations of a complaint adequately plead a strong inference of scienter as required by the PSLRA. First, the factual allegations in the complaint must be accepted as true. Second, the court must consider the complaint in its entirety. In this regard, all of the allegations must be examined and the court must determine whether the inference of scienter is “cogent and compelling, thus strong in light of other explanations,” the Circuit Court concluded, quoting Tellabs. Finally, in assessing whether the facts pled give rise to a strong inference, the court must consider the opposing inferences. Under this test the complaint will survive if a reasonable person would conclude that the inference of scienter is at least as compelling as any opposing inferences.

Here, the district court properly applied the first two prongs of the Tellabs test, but not the third, according to the Circuit Court. In analyzing the final prong of the test, the district court used the standard adopted by the Sixth Circuit in its 2001 en banc decision in Helwig v. Vencor, Inc., 251 F.3d. 540 (6th Cir. 2001) (en banc). In that decision, discussed here, the Circuit Court concluded that the strong inference standard “‘means that plaintiffs are entitled only to the most plausible of competing inferences,'” quoting from Helwig. The standard adopted in that case is “no longer good law” after Tellabs, the Sixth Circuit concluded.

Dana is the latest circuit court decision construing Tellabs. As in the Ninth Circuit, the Sixth Circuit concluded that the equipoise test adopted by the Supreme Court reduced the pleading burden on securities law plaintiffs as to the scienter element in that circuit. Other circuits, such as the Second, have combined the Tellabs test with their prior jurisprudence which focuses on the pre-PSLRA motive and opportunity test. Overall Tellabs continues to have an impact on securities damage actions.

The SEC, USAO, CFTC and FRB: A Financial Fraud Case Based On Derivatives

There has been a lot of discussion as the market crisis continues to unfold about reorganizing the regulators in Washington. An action filed on Tuesday by the SEC suggests that at least sometimes the market regulators can in fact work together.

The case filed by SEC is based on a fraudulent scheme keyed to derivatives. It named as defendants David Lee, a former commodity option trader at a subsidiary of Bank of Montreal, and Kevin Cassidy, Edward O’Connor and Scott Connor, all former employees of Optionable, Inc., a commodity brokerage whose shares are traded on the OTC Bulletin Board. The SEC’s action was coordinated with the U.S. Attorney’s Office for the Southern District of New York, the Federal Reserve Board, the Commodity Futures Trading Commission and the Manhattan District Attorney’s Office. SEC v. Lee, Civil Action No. 08-CIV-9961 (S.D.N.Y. Nov. 18, 2008).

The Commission’s complaint, which outlines the claims in the various cases, is based on scheme which has three principle victims, the shareholders of the bank, the shareholders of the brokerage firm and the New York Mercantile Exchange. First the bank’s shareholders were defrauded by the four defendants in what the complaint calls a “u-turn” scheme. Here, the SEC claims that when Mr. Lee could not obtain market prices for trading positions in natural gas options, he inserted prices or marks which were verified by the Optionable defendants. At first Mr. Lee engaged in this scheme to inflate his trading results and compensation. Later, when the market turned against him, he used it to mask losses. The victims of this scheme are the shareholders of the Bank of Montreal.

As a result of the scheme, Bank of Montreal announced on May 17, 2007 that it was reducing its reported income by a total of $680 million Canadian dollars. That resulted in a $327 million Canadian dollar reduction in net income for the six months ended April 30, 2007. On May 29, 2007 the bank restated its financial results for the quarter ended January 31, 2007, reducing previously reported income by $237 million Canadian dollars. The SEC’s action is in litigation.

The shareholders of Optionable are also the victims. The periodic reports of this company were false. They claimed that “touted the synergistic benefits of the derivatives valuation services that Optionable purportedly provided to multiple brokerage clients …,” but failed to disclose that the primary client was Bank of Montreal and that the services provided to that client were fraudulent.

The third victim was New York Mercantile Exchange. According to the complaint, in April 2007, Optionable sold over $10 million of its shares to the exchange based on its periodic reports. Those reports were materially false. On May 9, 2007, one day after Bank of Montreal announced it had placed Mr. Lee and his supervisor on leave and suspended its relationship with Optionable, the share price of the brokerage firm fell almost 40% from $4.64 to $2.81 and dropped below fifty cents when Mr. Cassidy’s prior criminal record was disclosed in press reports.

The U.S. Attorney’s Office for the Southern District of New York announced the unsealing of a six count indictment against Mr. Cassidy at the same time the SEC filed its case. In doing, so the USAO noted that Mr. Lee had pled guilty to a four count criminal information on November 13, 2008. These charges were based on the same scheme outlined in the SEC complaint. Mr. Lee also pled guilty to violating New York State’s Banking Law. In a separate action, he consented to the issuance of a Consent Order of Prohibition, according to the Federal Reserve Board.