Spin Control: Supreme Court Sets Record Straight on Securities Fraud Claims

Much like political commentary and major-league pitching, corporate securities litigation is often all about "spin." Plaintiffs' lawyers make their living weaving a tale of corporate deception, coupled with a drop in stock price, into a securities fraud claim. The most crucial element—a defendant's intent to deceive—is almost always supplied by "spin," or inference from other facts, in the face of protestations of innocent mistake by the defendant.

In Tellabs, Inc., et al. v. Makor Issues & Rights, Ltd., --- S. Ct. ----, No. 06-484, 2007 WL 1773208 (June 21, 2007), the U.S. Supreme Court made it clear that in considering whether plaintiffs have made an adequate showing of intent to defraud, courts must look not just at the spin on the facts provided by plaintiffs, but at all plausible inferences. Plaintiffs can proceed only if their "spin" is "cogent and compelling" when viewed from this "holistic" perspective.

The recent decision reaffirms earlier efforts made by Congress to create a uniform pleading standard that would help stem the tide of abusive shareholder litigation. The Private Securities Litigation Reform Act of 1995 instituted, among other things, heightened pleading standards in securities cases. The Reform Act specifically requires plaintiffs to "state with particularity" both the facts constituting the alleged securities law violation and the facts evidencing a "strong inference" of scienter—that is, that the defendant acted with the intent to "deceive, manipulate, or defraud." Congress left "strong inference" undefined.

Because of this lack of definition, the courts of appeals have reached varied interpretations of the term "strong inference." Most courts have held that in order to determine whether the requisite scienter has been pleaded, they must weigh the relative strength of competing inferences in ruling on a motion to dismiss. In other words, it is not sufficient to establish that a reasonable fact-finder could infer from the complaint's allegations that the defendant had the intent to defraud. Rather, most courts have required that in order to determine whether the allegations are sufficient to show the requisite level of intent, they must consider not whether the inference of scienter is merely plausible, but rather whether the inference of scienter is plausible in light of competing inferences.

However, in Tellabs, Inc., et al. v. Makor Issues & Rights, Ltd., 437 F.3d 588 (2006), the U.S. Court of Appeals for the 7th Circuit rejected this prevailing view and adopted an interpretation of the strong inference requirement that is more lenient than that adopted by any other circuit, effectively requiring only a reasonable inference of scienter without consideration of plausible competing inferences:

"[W]e will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent ... if a reasonable person could not draw such an inference from the alleged facts, the defendants are entitled to dismissal" (emphasis added).

In order to address the split among the courts of appeals on this important issue, the United States Supreme Court agreed to hear the case. On June 21, 2007, the Supreme Court issued its opinion in Tellabs, by a margin of 8–1, rejecting the 7th Circuit's imposition of a more lenient pleading standard and remanding the case for further proceedings consistent with its ruling.

Writing for majority, Justice Ruth Bader Ginsberg began the analysis by noting that the court's "task is to prescribe a workable construction of the "strong inference" standard, a reading geared to the [Reform Act's] twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims."

The court held that in evaluating the sufficiency of pleading as it relates to intent, courts must "take into account plausible opposing inferences" because the "strength of an inference cannot be decided in a vacuum":

"The inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts? To determine whether the plaintiff has alleged facts that give rise to the requisite ‘strong inference' of scienter, a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff."

The court was careful to explain that the inference of scienter need not be "irrefutable." In other words, the complaint does not need to allege the proverbial "smoking gun," nor, contrary to various courts of appeals, does the complaint need to allege the most plausible inference. Yet, the court explained, "the inference of scienter must be more than merely ‘reasonable' or ‘permissible'—it must be cogent and compelling, thus strong in light of other explanations" (emphasis added).

The upshot is that a complaint will survive only if a "reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."

Holding otherwise, the court noted, would directly undermine Congress' requirement that plaintiffs allege a "strong inference" of scienter and thus would effectively allow unmeritorious and abusive claims to go forward.

So, what does this mean? While the Tellabs decision could be viewed as placing further restrictions on plaintiffs' ability to bring securities fraud actions, as a practical matter, the decision really does nothing more than reaffirm what Congress intended in the first place: that plaintiffs be required to plead facts sufficient to show strong evidence of intent to deceive. As the court recognized, inherent in this inquiry is a consideration of facts and explanations that may not be indicative of bad intent. The 7th Circuit's rejection of this comparative or "holistic" approach effectively undermined Congress' intent and permitted artful "spin" to prevail over common sense. Moreover, given that most courts have traditionally applied the more stringent and balanced standard adopted by the court, we may not see a widespread difference in application of the scienter standard post Tellabs.

Tellabs does make clear, however, that going forward it will be important for a company to get its story of what happened into the record, so the court can actually weigh competing inferences. Perhaps the best way to tell the story is in the context of Securities and Exchange Commission filings, which courts may—and often do—consider at the motion to dismiss stage.