Following the Supreme Court’s decision in Tellabs, Inc.  v.  Makor Issues & Rights, Ltd., No. 06-484, 2007 WL 1773208 (June 21, 2007) two weeks ago, many commentators have speculated as to whether the decision is pro-business. While many have come to that conclusion, the reality is not that simple.  Prior to Tellabs, the Circuit Courts were split on at least two key issues regarding the requirement of Section 21D(2)(b) of the Private Securities Litigation Reform Act  of 1995 that plaintiffs plead a “strong inference” of the required state of mind.  15 U.S.C.§ 78u-4(b)(2).  Once issue which might be labeled the “what evidence?” question concerned the use of the Second Circuit’s “motive and opportunity” test as evidence establishing a “strong inference” of scienter.  A second issue focused on how inferences should be drawn from the facts alleged in the complaint on a motion to dismiss – the “construing the inferences” issue.  While the Supreme Court only agreed to resolve the second issue, in fact it probably also resolved the first as we discussed in the post of June 21, 2007 (available at  Whether the Court’s resolution favors one side or the other has to be assessed on a circuit-by-circuit basis and probably ultimately depends on the District Courts, given the large amount of discretion the decision grants the District Courts.  Indeed, one recent District Court case concluded that Tellabs did not make much difference.  Elam v. Neidorff, Case No. 4:06CV1142 (CDP) slip op. (E.D. Mo. June 29, 2007) (“I do not believe that the Tellabs decision is much different from the Eighth Circuit law. … The vast majority of the Eighth Circuit decisions might just as well have been decided un the ‘at least as compelling’ standard.”). 

Perhaps a more interesting question is the position of the SEC, which filed an amicus brief in Tellabs. Many commentators concluded that the SEC’s brief was “pro-business,” a position which seems to have presaged the comments on the Court’s decision.  Many of those commentators criticized the agency, claiming it had abandoned its shareholder protection mandate.  

Again, however, the question is not so simple.  A review of the SEC’s brief suggests that the agency did in fact alter its position on pleading a “strong inference” of scienter.  Prior to Tellabs, the SEC had filed amicus briefs in a number of Circuits Court cases arguing that the pre-Reform Act Second Circuit “motive and opportunity” test should be used to assess a “strong inference” of scienter.  See, e.g., Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999).  In its amicus brief in Tellabs however, the SEC argued that in enacting the Section 21D(2)(b) “strong inference” standard, Congress “built” on the Second Circuit standard, suggesting that a higher standard is now required.  This argument, which seems focused on the first question of “what evidence?,” rather than the second regarding how to construe inferences,  suggests that the SEC changed its position, adopting one more favorable to defendants.  The agency appears to have tried to evade this point by dropping a footnote in its brief, arguing that the motive and opportunity test had not been raised in Tellabs by the parties. 

The real question here, however, is not whether the SEC changed positions, but rather whether it should.  Stated differently, the question is:  Does the SEC always have to adopt a position in favor of the shareholder plaintiffs?  No doubt the SEC has repeatedly argued that private damage actions are a necessary supplement to its enforcement program.  No doubt the SEC should protect the interests of shareholders.  But that does not mean that the agency must always side with plaintiffs.  In litigation, plaintiff shareholders can be expected to take positions which will enable them to win.  From the point of view of a regulator charged with administering the securities laws however, arguments advanced by plaintiffs seeking a money settlement or judgment may not always represent the best interpretation of the statutes.  If not, there is no reason that the SEC should side with the shareholders.  Rather, the SEC should make the legal argument which it considers consistent with its overall statutory mandate and the intent of Congress.  In this context, whether the SEC’s Tellabs brief favored plaintiffs or defendants is not relevant.  The real question should be whether that brief offered the Supreme Court a proper interpretation of the statute – something the Court should be entitled to expect from a regulator such as the SEC.  The answer seems to be ‘”no.”  In Tellabs, the Supreme Court ignored the views of the SEC.  This may say something about how the SEC is carrying out its statutory mandate.  At the same time, it may also say something about the validity of the comments that both the SEC and the Court took a pro-business approach.

In tracing the road which will eventually lead to the Supreme Court’s decision in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc. next term and will define the scope of liability under Section 10(b), we have reviewed the three tests used by the Circuit Courts to differentiate between primary and secondary actors in securities fraud suits.  In theory, there are clear dividing lines between the “substantial participation” test, the “bright line” test and “scheme” liability.  District Courts have struggled to apply these theories to complex business transactions however, revealing that the lines between these tests are not always so clear. 

In jurisdictions following the “bright line” test, for example, the courts have not always required that the defendant actually make the statement.  Consider the result in In re Vivendi Universal, S.A. Sec. Litig., No. 02 CIV 5571, 2003 U.S. Dist LEXIS 19431 (S.D.N.Y. Nov. 3, 2003).  There, the court declined to dismiss claims against a CFO where statements were made by the company.  Similarly, in In re Lernout & Hauspie, 230 F. Supp. 2d 166 (D. Mass. 2002), the Court permitted a claim to go forward against the outside auditors on the theory that it could be inferred that the auditor made the statements.  These holdings seem somewhat at odds with the focus of the “bright line” test.  Indeed, in some senses the rulings begin to resemble something one might expect under the substantial participation test.  

At the same time, the Ninth Circuit is not the only court to adopt scheme liability.  Consider for example, two cases from the Southern District of New York where the bright line test is the rule of choice from the Second Circuit.  In In re Global Crossing, 313 F. Supp. 2d 189 (S.D.N.Y. 2003), the Court permitted a securities fraud claim to proceed against an outside auditor based on a scheme liability theory.  There, the Court ruled that the auditors could be held liable based on allegations that they masterminded the scheme. However, the Court noted that the auditors could not be held liable for specific misrepresentations of others involved in the scheme.  

Another decision based on scheme liability is In re Parmalat Sec. Lit., 376 F. Supp. 2d 472 (S.D.N.Y. 2005).  That case involved claims against a group of banks who were alleged to have participated in a scheme under which the company cooked the books using various transactions engaged in by the banks.  Judge Kaplan permitted claims against one group of banks to go forward based on allegations that the transactions in which they were involved were sham transactions with no substance.  Other claims based on business transactions which were booked incorrectly by the company to facilitate a fraud were dismissed, however.  Those claims, the court ruled did not involve deception by the banks.  As we will discuss in subsequent parts of this series, Plaintiffs seeking review of the Fifth Circuit’s decision in Regents of the Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Pet. For Cert. filed, 75 U.S.L.W. 3557 (March 5, 2007) (No. 06-13) (Enron), which could be combined with Stoneridge if certiorari is granted, are arguing a sham transaction theory similar to the one Judge Kaplan permitted to proceed in In re Parmalat Sec. Litig. 

Next:  The Supreme Court grants certiorari in Stoneridge