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More on Today’s Opinion in Tellabs, Inc. v. Makor Issues and Rights

This entry was authored by Carolyn Hadgikosti, a summer associate at Akin Gump and a student at the University of Michigan Law School.

In 1995, Congress enacted the Private Securities Litigation Reform Act (“PSLRA”), which was intended to curb abusive private securities fraud suits. Reflecting Congress’s belief that traditional notice pleadings failed to prevent investors from filing bringing frivolous suits, the Act imposed a heightened pleading standard — requiring plaintiffs to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” Today, by a vote of eight to one, the Supreme Court attempted to clarify what Congress meant by “strong inference.” In Tellabs v. Makor Issues and Rights, the Court – in an opinion by Justice Ginsburg – held that to qualify as “strong,” an inference of wrongful intent must be “more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference” suggesting lack of intent to defraud.

The dispute in Tellabs began in December 2002, when Tellabs shareholders filed a securities fraud claim alleging (inter alia) that the company’s Chief Executive Officer, Richard Notebaert, purposely misled the public when – despite being aware that demand for the company’s new fiber-optic networking product was declining – he boasted of rosy financial expectations for the product. The district court dismissed the case for failure to meet the heightened pleading requirements imposed by the PSLRA. [For more background on the case, you can read Anitha Reddy’s pre-argument summary here.]

As relevant here, the Seventh Circuit reversed. It held that the shareholders had sufficiently alleged facts giving rise to a “strong inference” that Notebaert knowingly violated the law. In the court’s view, a complaint’s allegations meet the “strong inference” standard as long as a “reasonable person could infer [from them] that the defendant acted with the required intent”; a court need not accept “only . . . the most plausible of competing inferences” as sufficient at the pleading stage. The court reasoned that, in the face of “two seemingly equally strong inferences, one favoring the plaintiff and one favoring the defendant,” it would be inappropriate for a court to determine at the pleadings stage which will ultimately prevail, as to do so would invade the jury’s factfinding role.
Today, the Court rejected the Seventh Circuit’s interpretation as failing to adequately embody Congress’s intent to raise the pleading requirement in securities fraud cases. When determining whether to dismiss a securities fraud complaint, the Court held, courts must consider not only inferences favoring the plaintiff filing the securities fraud suit but also any “plausible nonculpable explanations” for the defendant’s conduct. And although an inference need not be “irrefutable,” it must be more than merely the “reasonable” inference required by the Seventh Circuit. The Court also dismissed the Seventh Circuit’s concern that requiring courts to weigh the plausible inferences arising from the facts alleged would infringe on the Seventh Amendment right to a jury trial. A plaintiff alleging securities fraud, the Court explained, will have to plead facts “rendering an inference of scienter at least as likely as any plausible opposing inference” and will then need to prove her case by a “preponderance of the evidence” at trial. Finally, the Court remanded the case to the lower courts for application of the new “cogent and compelling inference” test.

In his concurring opinion, Justice Scalia criticized the new standard. In his view, the phrase “strong inference” cannot conceivably mean “at least as compelling as any opposing inference.” To illustrate his critique, he asks: “if a jade falcon were stolen from a room to which only A and B had access, could it be said there was a strong inference that B was the thief?” Instead, he posits, a natural reading of the statute would result in a test that asks whether an inference of scienter is “more plausible than the inference of innocence.”

Justice Alito, in a separate concurrence, agreed with Justice Scalia’s interpretation, which he characterized as in line with a summary judgment inquiry. Moreover, Justice
Alito added, when Congress heightened the pleadings standard for securities suits, it could not have meant to adopt an approach previously “unknown in civil litigation” and would have instead adopted a “known quantity” such as the summary judgment standard. Justice Alito also disagreed with the portion of the majority opinion holding that a court should consider all allegations of scienter to determine whether the “strong inference” standard is met. In his view, this approach would – contrary to the statutory language – allow an inference to be drawn from facts that were not stated with particularity in the plaintiff’s complaint.

Justice Stevens filed a dissenting opinion. Suggesting that it is unnecessary to weigh competing inferences to determine whether pleaded facts give rise to a strong inference of scienter, he would take an entirely different approach and use the “probable cause standard” instead.