Required “Strong Inference” of Scienter Under Private Securities Litigation Reform Act (PSLRA) “Must be More than Merely Plausible or Reasonable – it Must be Cogent and at Least as Compelling as any Opposing Inference of Nonfraudulent Intent” Supreme Court Holds
Plaintiffs filed a class action against Tellabs and its CEO alleging violations of federal securities laws; defense attorneys moved to dismiss the class action complaint on the grounds that the Private Securities Litigation Reform Act (PSLRA) required plaintiffs to plead facts sufficient to support a “strong inference” of scienter, and that the putative class action failed to do so. The district court granted the defense motion, but the Seventh Circuit reversed and reinstated the class action. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. __, 127 S.Ct. 2499 (2007). The Supreme Court granted certiorari and reversed.
The Supreme Court recognized the positive aspects of private actions to enforce federal antifraud securities laws, but noted “if not adequately contained, [they] can be employed abusively to impose substantial costs on companies and individuals whose conduct conforms to the law.” Tellabs, at 2504. One control enacted by Congress consists of the exact pleading requirements in the Private Securities Litigation Reform Act (PSLRA), which “requires plaintiffs to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter, i.e., the defendant’s intention ‘to deceive, manipulate, or defraud.’” Id. (citations omitted). Specifically, the PSLRA requires that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” 15 U.S.C. § 78u-4(b)(2). Congress, however, did not define the term “strong inference” and circuit courts have disagreed on its meaning. Tellabs, at 2504.
In this case, defendant Tellabs manufactures equipment for fiber optic networks. The class action complaint alleged that Tellabs and certain officers “engag[ed] in a scheme to deceive the investing public about the true value of Tellabs’ stock.” Tellabs, at 2505. The details of the alleged wrongdoing are set forth in the Court’s opinion, see id., at 2505-06. Defense attorneys moved to dismiss the class action on the ground that it failed to adequately allege scienter; the district court agreed but the Seventh Circuit reversed. Id., at 2506.The Seventh Circuit held that held that the requirement was satisfied if “a reasonable person could infer” from the facts alleged in the complaint “that the defendant acted with the required intent.” Id., at 2505 (citing 437 F.3d 588, 602 (7th Cir, 2006)). The Supreme Court rejected that interpretation, concluding that it “does not capture the stricter demand Congress sought to convey,” id. The High Court explained at pages 2504 and 2505:
It does not suffice that a reasonable factfinder plausibly could infer from the complaint’s allegations the requisite state of mind. Rather, to determine whether a complaint’s scienter allegations can survive threshold inspection for sufficiency, a court governed by § 21D(b)(2) must engage in a comparative evaluation; it must consider, not only inferences urged by the plaintiff, as the Seventh Circuit did, but also competing inferences rationally drawn from the facts alleged. An inference of fraudulent intent may be plausible, yet less cogent than other, nonculpable explanations for the defendant’s conduct. To qualify as “strong” within the intendment of § 21D(b)(2), we hold, an inference of scienter must be more than merely plausible or reasonable – it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent. (Italics added.)
In order to implement this test, it will be necessary, inter alia, for the district court to “take into account plausible opposing inferences,” something the Seventh Circuit expressly refused to do. Tellabs, at 2509. This must be done because “Congress did not merely require plaintiffs to ‘provide a factual basis for [their] scienter allegations,’… i.e., to allege facts from which an inference of scienter rationally could be drawn,” but rather “to plead with particularity facts that give rise to a ‘strong’ – i.e., a powerful or cogent – inference.” Id., at 2510 (citations omitted). Such inferences, however, “cannot be decided in a vacuum.” Id. Rather, “The inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts?” Id. Put another way, “When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?” Id., at 2511.
Because the district court had not determined whether, using the Supreme Court’s new standard, the allegations in the class action complaint were sufficient to survive a motion to dismiss, it remanded the action for further proceedings. Tellabs, at 2512.
Justice Scalia concurred in the judgment but argued that Congress intended an even stricter standard be applied because “I fail to see how an inference that is merely ‘at least as compelling as any opposing inference’ … can conceivably be called what the statute here at issue requires: a ‘strong inference,’ 15 U.S.C. § 78u-4(b)(2).” Tellabs, at 2513. Justice Scalia argued at page 2514 “it is inconceivable that Congress’s enactment of stringent pleading requirements in the Private Securities Litigation Reform Act of 1995 somehow manifests the purpose of giving plaintiffs the edge in close cases.” Rather, the “normal meaning” of “strong inference” requires a stricter standard than the one adopted in the majority opinion, id., at 2514-15. Justice Alito also separately concurred, agreeing with the Court that the Seventh Circuit “used an erroneously low I agree with the Court that the Seventh Circuit used an erroneously low standard,” id., at 2515, but believing Justice Scalia’s approach more accurately reflected Congressional intent, id., at 2515-16.
Justice Stevens dissented, arguing that interpreting the term “strong inference” as the functional equivalent of “probable cause” would be “easier to apply and more consistent with the statute.” Tellabs, at 2516-17. Additionally, it would invoke “an already familiar legal concept,” id., at 2517. Using such a probable-cause definition, Justice Stevens would find that the class action allegations sufficiently alleged the requisite intent under the PSLRA and would affirm the Seventh Circuit’s judgment. Id., at 2517-18.
NOTE: The Supreme Court noted that it had “previously reserved the question whether reckless behavior is sufficient for civil liability under § 10(b) and Rule 10b-5” and that “[t]he question whether and when recklessness satisfies the scienter requirement is not presented in this case.” Tellabs, at 2507 n.3.