Does Tellabs Have Any Impact In the Second Circuit?

Part IV of the series Securities Class Actions: Current and Emerging Trends discusses the impact of the Supreme Court’s decision in Tellabs. That decision construed the “strong inference” of scienter requirement of PSLRA Section 21D(b)(2). That part of the series concluded that at least in some circuits Tellabs appears to be having little impact. A recent decision by the Second Circuit Court of Appeals confirms that conclusion for that circuit.

In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court reviewed the dismissal of a securities fraud complaint for failure to comply with the pleading requirements of Federal Civil Rule 9(b), which requires that fraud be pled with particularity, and the PSLRA. In discussing the adequacy of the complaint with respect to pleading scienter, the circuit court did not cite or discuss the Supreme Court’s decision last year in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 761 (2007). Rather, the court relied on one of its own pre-Tellabs decision, applying the two-prong test crafted prior to the passage of the PSLRA: “We have held that a securities fraud plaintiff’s scienter allegations must ‘give rise to a strong inference of fraudulent intent,’ and that such a plaintiff may establish the requisite intent either ‘(a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness,” quoting Learner v. Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir. 2006).

In analyzing the scienter allegations in the Bay Harbour complaint, the circuit court applied its traditional two-prong test of scienter rather than Tellabs. There is no mention of Tellabs or the Supreme Court’s directives to consider: 1) all the allegations in the complaint; 2) assess whether there was a strong, cogent inference of scienter; or 3) determine whether that inference is at least as strong as any competing inference. Indeed, in discussing scienter, the court did not even cite its own decision applying Tellabs which incorporated the teachings of the Supreme Court and the circuit’s traditional two-prong test. See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007). Rather, the test the court applied is the same one it has used since the passage of the PSLRA. Indeed, it is the same test the court has used since prior to the passage of that Act. Compare Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) with In re Time Warner, Inc., Sec. Litig., 9 F.3d 1049 (2nd Cir. 1993).

Perhaps the Second Circuit concluded that only half of its ATSI Communications analysis was required to affirm the dismissal of what it apparently viewed as a weak complaint. Yet, it would seem that any analysis of this question should start with Tellabs, not omit the Supreme Court’s newly minted test. In fact, Bay Harbour, like some others decisions discussed in the earlier post analyzing circuit court decisions following Tellabs, suggests that at least in some circuits the Supreme Court’s teachings are having little impact.

Part VII: Securities Class Actions: Current And Emerging Trends

Prior installments of this series have considered various pleading requirements for securities class actions. Another key pleading issue involves the use of confidential witnesses. Following the passage of the PSLRA, and prior to the Supreme Court’s decision in Tellabs, the question was whether facts pled in a complaint based on confidential sources complied with the “all facts” pleading requirement of the Reform Act.

Some early cases concluded that the “all facts” provision required that the sources be identified. See, e.g., In re Nice Sys. Lid. Sec. Litig., 135 F. Supp. 551 (N.N.J. 2001).

In what became the leading case on the question, the Second Circuit in Novak v. Kasaks, 216 F.3d 3000 (2nd Cir.) cert. denied, 531 U.S. 1012 (2000) concluded that “our reading of the PSLRA rejects any notion that confidential sources must be named as a general matter.” The court reasoned that naming informants could have a chilling effect. The First, Third, Fifth, Seventh, Eighth, Ninth and Tenth Circuits subsequently agreed. See, e.g., In re Cabletron Sys., Inc., 311 F.3d 11 (1st Cir. 2002); Cal Pub. Employees’ Ret. Sys. v. Chubb Corp., 394 F.3d 126 (3d Cir. 204); ABC Arbitrage Plaintiffs Group v. Tchruk, 291 F.3d 336 (5th Cir. 2002). As the Seventh Circuit held: the “bright line rule obligating the plaintiffs to reveal their sources has the potential to deter informants from exposing malfeasance. Such a rule might also invite retaliation.” Makor Issues & Rights, 437 F.3d. 588 (7th Cir. 2005) reversed on other grounds, 127 S.Ct. 2499 (2007).

Under Novak, the key question became what must be pled to permit the court to evaluate the allegations from confidential witnesses. The Second Circuit concluded that the sources must be “described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.” Novak, 216 F.3d at 314. While the Fifth and Seventh Circuits agreed with this approach, the First developed an alternative approach. In Cabletron Sys., Inc., 311 F.3d 11 (2002) the court held that the test should be an “evaluation … of the level of detail provided by the confidential sources, the cooberative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, the reliability of the sources, and similar indicia.” The Third and Ninth Circuits adopted a similar approach.

The Tenth Circuit crafted a third approach. In Adams v. Kinder-Morgan, Inc., 340 F.3d 1083 (2003), the Circuit Court concluded that “source information is more important for allegations that are difficult to confirm than for claims that ‘many be objectively verifiable’ such as contract terms, financial results and similar information.”

In Tellabs, the Supreme Court did not consider the issue of confidential witnesses. Prior to review by the Supreme Court, the Seventh Circuit considered the question and followed Novak. However, the question was not presented for review by the High Court.

Following Tellabs, the Seventh Circuit initially seemed to reverse its position. In Higginbotham v Baxter International, Inc., the court concluded that “One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five ‘confidential witnesses’ … It is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inference. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.” 495 F.3d 753, 756-757 (7th Cir. 2007). Interestingly, the decision was based on Section 21D(b)(2) rather than the “all facts” requirement.

Subsequently, however, the Seventh Circuit reverted to its prior position. When the court considered the question in Tellabs on remand, it explained Higginbotham as being devoid of facts about the confidential sources, other than the fact that they were three ex-employees of the company. The court then went on to credit allegations from confidential sources in applying the Tellabs test noting that they “are numerous and consist of persons who from the description of their jobs were in a position to know first hand the facts…” In addition, the material from the confidential informants “is set forth in convincing detail” and in some cases “corroborated by multiple sources.” Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008).

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