On June 21, the Supreme Court issued one of its most important decisions in a securities fraud case in the past decade in Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484. Tellabs is the Court's first opportunity to address the standards for pleading a private securities fraud claim under Section 10(b) of the Securities Exchange Act of 1934 that were enacted in the Private Securities Litigation Reform Act Of 1995 ("Reform Act"). Specifically, the Court explained how federal courts must decide whether a Section 10(b) complaint pleads a "strong inference" of scienter, as is required by the Reform Act. The Court held that to allege scienter a securities plaintiff must plead facts that "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." In so doing, the Court kept the bar high for asserting securities fraud claims and settled some questions that have divided the federal Courts of Appeals.

The element of scienter

A defendant cannot be liable for securities fraud under Section 10(b) and the accompanying SEC Rule 10b-5 unless he or she acted with scienter, or the intent to defraud or deceive. Under the Reform Act, if a Section 10(b) complaint brought by a private plaintiff (as distinguished from the Securities and Exchange Commission) does not plead particularized facts giving rise to a "strong inference" of the scienter of each defendant, it must be dismissed.

Federal courts have reached differing positions about several questions concerning the strong inference requirement since the Reform Act was adopted. In Tellabs, one of these disagreements reached the Supreme Court. It is important to recognize that the Court did not rule on the meaning of "scienter" itself. Scienter exists when a defendant possesses actual knowledge that a statement made to investors is false. In some instances, according to the lower federal courts, scienter also exists if a defendant recklessly disregards whether a statement is false. The Supreme Court has left open the question of whether recklessness suffices for scienter since 1976. The Court reaffirmed that the question remains open in Tellabs, and did not define what constitutes scienter. Rather, the Court only decided how a "strong inference" of scienter must be pleaded.

The lower courts' opinions

The Tellabs lawsuit was filed after the company, a fiber optics equipment manufacturer, announced that demand for its products had declined, and lowered its revenue forecasts. Plaintiffs claimed that the company's CEO had misled investors by issuing earlier, optimistic forecasts which he knew could not be achieved. The amended complaint attempted to support this claim by allegations from 27 anonymous sources.

The district court found that the complaint failed to plead a strong inference of scienter. The Court of Appeals for the Seventh Circuit reversed, and reinstated the lawsuit. It held that the complaint sufficed because, assuming the truth of plaintiffs' factual allegations, a reasonable person could infer from those facts that the CEO acted with scienter. The court rejected an alternative standard used by the Sixth Circuit Court of Appeals, which holds that a strong inference is pleaded only if scienter is the most plausible of competing inferences from the allegations of a complaint. Under that alternative (which is similar to the test used by some of the other Circuits), courts must also take into account inferences drawn from a complaint's allegations that cut against scienter-i.e., explanations of the statements or events in question that do not indicate fraud-in determining whether a strong inference has been pleaded.

The Supreme Court defines "strong inference"

The Supreme Court, with Justice Ginsburg delivering the opinion of six justices, held that the Seventh Circuit had erred in interpreting and applying the Reform Act, and vacated its judgment.

The foundation of the opinion is the Court's definition of the phrase "strong inference." The Court recognized that Congress had not provided clear guidance on the topic. It also explained that while the "strong inference" language had been used by the Second Circuit Court of Appeals before the enactment of the Reform Act, Congress did not mean to adopt the Second Circuit's case law interpreting how a strong inference must be pleaded. The Court thus reasoned that its task was to provide a workable construction of the phrase that would promote the goals of the Reform Act to "curb frivolous, lawyer-driven litigation, while preserving investors' ability to recover on meritorious claims."

With this in mind, and applying an ordinary language analysis, the Court reasoned that a "strong" inference must be "powerful or cogent" and "cogent and compelling," and more than merely "reasonable" or "permissible." An inquiry into whether an inference is strong is "inherently comparative," as it necessarily involves comparison to other inferences that may be drawn from the same facts. Hence, a complaint may survive a motion to dismiss under the Reform Act "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."

Applying the definition

The Supreme Court enunciated a three part test for assessing whether a complaint pleads a strong inference of scienter under its definition. This test must be applied on an individualized basis to each defendant in a securities case, as the Court "did not disturb" the Seventh Circuit's holding that "allegations of scienter made against one defendant cannot be imputed to all other individual defendants."

First, the court must accept all factual allegations in the complaint as true. This is standard practice in all types of cases - not just securities fraud cases - and the defendants did not disagree with it-although, as a concurring opinion from Justice Alito noted, the Reform Act also requires that a complaint plead particularized facts giving rise to scienter, and hence there may be grounds to exclude from the analysis all non-particularized allegations, such as general, speculative or conclusory allegations of wrongdoing.

Second, the court must consider the entirety of the complaint, plus matters of common or undisputed knowledge of which courts may judicial notice, in determining whether a strong inference of a defendant's scienter has been pleaded. The Supreme Court emphasized that there is no single factor that determines whether scienter is pleaded, but rather that courts must look at a complaint as a whole. For example, the Court rejected defendants' contention that the lack of any stock sales by the CEO during the period of the alleged fraud was dispositive of his lack of scienter; rather, the significance to be ascribed to this fact "depends on the entirety of the complaint."

Third, the court must take into account all inferences that plausibly may be drawn from a complaint's allegations and matters of judicial notice, and allow a complaint to survive dismissal only if an inference of scienter is cogent and at least as compelling as any opposing inference one could draw. The Supreme Court thus rejected the position that only inferences which favor the plaintiff may be drawn. Instead, the Court adopted a position consistent with that of the Sixth Circuit and other Circuits, which requires consideration of all inferences. Indeed, the Court arguably went further: it agreed that the lack of key allegations one would expect if a defendant possessed scienter, or ambiguities in a complaint's allegations, are factors that may be held against securities plaintiffs; and it made explicit that matters of judicial notice also are included in the assessment of scienter.

Implications

While Tellabs does not answer all open questions regarding the Reform Act or even the "strong inference" requirement, it is an important decision that will increase the power of motions to dismiss private securities fraud claims.