For a second term in a row, the U.S. Supreme Court has taken the opportunity to further refine the scope of securities class action litigation in the wake of the Securities Litigation Uniform Standards Act of 1998 (SLUSA) and the Private Securities Litigation Reform Act of 1995 (PSLRA). After giving SLUSA real teeth in Merrill Lynch v. Dabit by reversing the Second Circuit and holding that the Act preempted all state law claims asserted “in connection” with a purchase or sale of covered securities, the Court turned to the PSLRA in Tellabs, Inc. v. Makor Issues & Rights, Ltd, and purportedly reversing the Seventh Circuit. In Tellabs while the Court confirmed that the PLSRA formally adopted the Second Circuit's "strong inference" requirement, the Act does not adopt Second Circuit case law. Accordingly, in many jurisdictions Tellabs is appropriately seen as raising the pleading standard. However, practitioners in the Second Circuit should proceed with caution.

The PSLRA requires that when pleading a federal securities class action, under Rule 10B-5, the plaintiff must both plead the facts constituting the alleged violation with particularity as well as provide “facts giving rise to a strong inference of the defendant’s intent to deceive, manipulate or defraud.” In Tellabs, the issuer’s CEO allegedly made knowingly false statements exaggerating the market demand for its products, overstating financial results, and exaggerating revenue projections after he allegedly had access to contrary reports. Based on these statements, analysts recommended Tellabs’ stock. As is common in these claims, when Tellabs began to repeatedly lower its revenue projections and revise its statements to reflect the declining market demand, Tellabs’ stock ultimately plunged by over 75% from a high of $67 to under $16 per share. The District Court held that the amended complaint sufficiently pleaded the facts of the alleged violation, that is falsity, but dismissed for insufficiently pleading scienter — that the CEO acted with the requisite intent to deceive — and found that the statements were nothing more than nonactionable “puffery.” The Seventh Circuit reversed, holding effectively that the PSLRA’s “strong inference” requirement is met where a pleading sets forth facts that create competing inferences if a reasonable person could infer that the defendant acted with the required intent. The Seventh Circuit expressly rejected the rule adopted in other courts that “plaintiffs are entitled only to the most plausible of competing inferences.” The Supreme Court granted cert to explain “whether, and to what extent, a court must consider competing inferences in determining whether a securities fraud complaint gives rise to a strong inference of scienter.”

And herein lies the semantic joust: the Seventh Circuit held that the PSLRA’s “strong inference” requirement was met because when “[f ]aced with two seemingly equally strong inferences, one favoring the plaintiff and one favoring the defendant, it is inappropriate for us to make a determination as to which inference will ultimately prevail[.]” This, the Supreme Court tells us, is wrong. Rather, it held that a court should ask, “Would a reasonable person deem the inference of scienter at least as strong as any opposing inference?” To the Court there is apparently a great distinction between an opposing inference that is “at least as strong as” and one that is “equally strong.” However, even though the Court confirmed that the PSLRA codified the Second Circuit’s “strong inference” requirement for securities claims (which the Second Circuit derived from Rule 9(b) of the Federal Rules), the Court both expressly rejected (and implicitly by adopting an “at least as compelling” test) the notion that the PSLRA also codified this Circuit’s case law. In so doing, there is real risk that the plaintiffs’ bar will feel free to attack this and other circuits’ standards to relitigate the contours of a “strong inference” as a result of Tellabs.

Traditionally, the Second Circuit has allowed plaintiffs to allege scienter under 10B-5 by offering specific facts that show the defendant either had both motive and opportunity to commit fraud or facts which constitute strong circumstantial evidence of conscious or reckless behavior. The vagaries of these tests do not appear to be in threat — general allegations of intent without specific references to the “what, who, when and how” will, and should continue to, fail to create a strong inference of scienter. Nor can scienter be pleaded by urging the presence of a motive common to all issuers — such as the desire to achieve high earnings or value — or by alleging insider trades without specific facts that show an unusual pattern of trades during the class period.

As stated, however, in regard to competing inferences, there is a risk that Tellabs may lower the standard in this and other circuits that generally abided by the rule that while a pleading need not foreclose other inferences, it must nevertheless show that its inference is “highly likely,” “most plausible,” or other variations that either exceed even odds or reject “reasonable yet weak inferences for intent.” The issue for further consideration by the circuits is whether the “at least as strong” test creates a 50-50 standard whereby a complaint will survive if two inferences — one innocent, one fraudulent — are reasonably construed from a complaint with equal force. In this Circuit, courts remind us that insiders need not be overly cautious in their predictions; an insider’s “misguided optimism” is no more actionable than an investor’s high expectations. What was once dismissed as “puffery” with no “strong inference” to manipulate the market could, under a rule of reason, pass a 50-50 standard. Just as materiality — also judged under a rule of reason — is not typically a successful basis to dismiss a complaint — so would a “rule of reason” render scienter. Since Tellabs, the Second Circuit has only had the opportunity to dismiss a complaint where they found a “plausible nonculpable explanation for the defendants' actions that is more likely than any inference that the defendants intended to manipulate the market.” Accordingly, whether Tellabs will have any fallout in this Circuit remains to be seen.

Please contact Matt for assistance or to discuss this issue - (516) 535-4419 or Matthew Bryant.