D&O Liability - U.S. Supreme Court Vacates and Remands Seventh Circuit’s Reversal of the District Court’s Grant of Tellabs, Inc.’s Motion to Dismiss
On June 21, 2007, the Supreme Court issued its decision in Tellabs, Inc., et al. v. Makor Issues & Rights, Ltd., et al., No. 06-484. Justice Ginsburg wrote the opinion vacating and remanding the Seventh Circuit’s
reversal of the district court’s grant of Tellabs’ motion to dismiss. The majority defined the strong inference standard that had divided the Courts of Appeals, holding that “to qualify as ‘strong’
within the intendment of Section 21D(b)(2)…an inference of scienter must be more than merely plausible or reasonable – it must be cogent and at least as compelling as an opposing inference of nonfraudulent intent.”
Justices Scalia and Alito filed concurring opinions. Justice Stevens filed a dissenting opinion.
Tellabs was sued by a class of its shareholders, who alleged that Tellabs and its then CEO and President, Richard Notebaert, engaged in securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Securities
and Exchange Commission Rule 10b-5. The complaint also alleged control person liability on behalf of Notebaert. Tellabs moved to dismiss on the ground that the plaintiffs failed to plead with the specificity
required by the PSLRA. The district court dismissed plaintiffs’ complaint without prejudice, and the plaintiffs amended their complaint to include references to 27 confidential sources and to make more specific allegations
regarding the mental state of Notebaert. The district court granted the second motion to dismiss with prejudice, but the Seventh Circuit reinstated the complaint in relevant part, stating that a securities complaint may survive
a motion to dismiss “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.” The Seventh Circuit reasoned that a court should examine all of
a complaint’s allegations to determine whether the allegations collectively establish a strong inference of scienter. However, the Seventh Circuit declined to weigh inferences supporting scienter against inferences supporting
innocence.
The Supreme Court recognized that the Courts of Appeals received little guidance from Congress regarding what it takes to establish a strong inference of scienter, and, as a result, had arrived at divergent standards. The Supreme
Court concluded that its task was to “prescribe a workable construction of the ‘strong inference’ standard, a reading geared toward the PSLRA’s twin goals: to curb frivolous, lawyer-driven litigation,
while preserving investors’ ability to recover on meritorious claims.”
Justice Ginsburg outlined three prescriptions for courts faced with a Rule 12(b)(6) motion to dismiss a Section 10(b) claim. First, the court must accept all factual allegations in the complaint as true. Second,
the court must consider the facts alleged in the complaint as a whole. The proper inquiry, according to Justice Ginsburg, is whether “all the facts alleged, taken collectively, give rise to a strong inference of scienter,
not whether any individual allegation, scrutinized in isolation, meets that standard.” Third, the court must consider plausible opposing inferences (the Seventh Circuit expressly had declined to consider those inferences
that would have supported Tellabs’ innocence). According to Justice Ginsburg, in order for an inference to be strong, it must be strong in light of the other inferences, including those inferences that weigh in favor
of innocence. In other words, whether or not a strong inference exists cannot be decided in a vacuum. “A complaint will survive only if a reasonable person would deem the inference of scienter cogent and at least
as compelling as any plausible opposing inference one could draw from the facts alleged.”
The holistic approach taken by the Court led to its rejection of Tellabs’ argument that the lack of motive by Notebaert was dispositive. The Court concluded that absence of a motive on the part of Notebaert was a factor
to be considered, but was not dispositive. The Court agreed with Tellabs that the vague allegations in the Complaint, particularly those regarding channel stuffing, a practice which could be illegal or legitimate, weighed against
a finding of a strong inference. The Court rejected the Seventh Circuit’s stated concerns about the impingement on the right to a jury trial, concluding that Congress had the ability to prescribe what must be pleaded
to state a claim. The Court emphasized that its construction of a strong inference of scienter did not require a plaintiff to plead more than it would have to prove at trial. The Court declined to decide whether the allegations
evidenced a strong inference of scienter, remanding the case to be reexamined in light of its decision.
Justice Scalia’s concurrence argued for a stricter standard, namely that the inference of scienter must be more plausible than the inference of innocence. Justice Scalia argued that the Court should employ the
normal meaning of a “strong inference.” According to Justice Scalia, if Congress had wished for the inference of scienter merely to be at least as compelling as the inference of innocence, it would have
so stated. In his concurrence, Justice Alito agreed with Justice Scalia’s formulation of a test that would require the inference of scienter to be more likely than not. Justice Alito further argued in his concurrence
that only those facts alleged with particularity should be considered.
The only dissenting justice, Justice Stevens, argued that the strong inference should be analyzed as a probable cause standard. He argued that under the Court’s formulation of a strong inference, the standard to
bring a civil case would be higher than the standard to bring a criminal case, a result that Congress did not intend. Justice Stevens concluded that there was probable cause to conclude that Notebaert acted with the required
intent.
Because our firm is representing a D&O insurer in connection with the Tellabs claim, we are not including in this Alert our analysis of what we expect to happen following the remand of the case in Tellabs. As a general
matter, however, even though Justice Ginsburg’s opinion does not impose as strict a standard as the concurring justices would have had the Court impose, the Court’s express requirement that plausible opposing inferences
must be considered and that an inference of scienter must be cogent and at least as compelling as the innocent inferences should result in additional cases being dismissed in the future. The motion to dismiss battleground will
now shift to whether a particular inference is cogent and to comparing the inferences of scienter with the opposing inferences of nonfraudulent intent. We anticipate a flurry of activity at various procedural stages of securities
litigation as defendants seek to take advantage of the Court’s ruling.