On Remand from Supreme Court, Seventh Circuit Holds Allegations of Scienter in Securities Class Action Complaint Satisfied Requirements of Private Securities Litigation Reform Act (PSLRA) Warranting Reversal of District Court Order Granting Defense Motion to Dismiss Class Action
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, and our article discussing that opinion may be found HERE. The High Court remanded the class action to the Seventh Circuit “with directions to consider whether the plaintiffs’ allegations of securities fraud in violation of section 10(b) of the Securities Exchange Act of 1934…and SEC Rule 10b-5…create the ‘strong inference’ of scienter, as defined by the Supreme Court in its opinion, that the [PSLRA] requires for the complaint to survive a motion to dismiss.” Makor Issues & Rights, Ltd. v. Tellabs, Inc., ___ F.3d ___ (7th Cir. January 17, 2008) [Slip Opn., at 1-2]. On remand, the Seventh Circuit adhered to its prior determination and reinstated the class action.
The Supreme Court explained that the PSLRA “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.'” 127 S.Ct. at 2504 (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), and the Supreme Court held 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, … a court governed by § 21D(b)(2)…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.) The newly-enunciated test requires a court “take into account plausible opposing inferences,” something the Seventh Circuit expressly refused to do. Id., at 2509. Accordingly, the High Court remanded the class action to the Seventh Circuit to consider these opposing inferences and answer, “would a reasonable person deem the inference of scienter at least as strong as any opposing inference?” Id., at 2511. Our summary of the Supreme Court opinion may be found here .
In reaffirming its prior decision to reinstate the class action, the Seventh Circuit observed that “[t]o judges raised on notice pleading, the idea of drawing a ‘strong inference’ from factual allegations is mysterious,” particularly when “the court must treat the pleaded facts as true and ‘draw all reasonable inferences in favor of the plaintiff'” even under the heightened pleading requirements of Rule 9(b). Slip Opn., at 4. It noted also that under Seventh Circuit authority a defendant’s “scienter” for purposes of Rule 10b-5 may be established by “proof that he either knew the statement was false or was reckless in disregarding a substantial risk that it was false.” Id. , at 2 (citation omitted). Reckless disregard may be defined as “‘an extreme departure from the standards of ordinary care,'” id. (citation omitted). This, in turn, simply means that “[w]hen the facts known to a person place him on notice of a risk, he cannot ignore the facts and plead ignorance of the risk.” Id. (citations omitted).
The Seventh Circuit concluded that the allegations underlying the securities fraud class action satisfied the heightened pleading standards of the PSLRA, particularly Tellabs representations that sales were “still going strong,” as this implied that sales were expected to continue strong into the future. Slip Opn., at 3. The Circuit Court identified the “critical question” as “how likely it is that the allegedly false statements that we quoted earlier in this opinion were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading.” Id. , at 11. In light of the importance of the product line at issue – which the Seventh Circuit characterized as the “flagship” products, akin to the importance of Windows XP or Vista to Microsoft, the court found it impossible that senior management did not know the true facts concerning future sales of the products. Id. The Circuit Court further found that “corporate scienter” was more likely than its opposite, id. , at 15-16, thus addressing the Supreme Court’s direction on remand. Accordingly, it reaffirmed its holding that plaintiffs adequately pleaded scienter and reversed the district court order dismissing the class action. Id. , at 18.