Part V: Securities Class Actions: Current and Emerging Trends

An analysis of circuit court cases to date following the Supreme Court’s decision in Tellabs, discussed in the prior segment of this series here, suggests not only that the decision vests substantial discretion in the district court, but also that it is difficult to assess the impact of the decision on securities class actions. In some circuits, the case is not having any obvious impact. Some circuits are applying their pre-Tellabs case law along with the Supreme Court’s test. Only two circuits have acknowledged that the decision altered prior standards for pleading scienter. In both instances, the courts concluded that Tellabs lowered the pleading standard.

A review and analysis of decisions in the Seventh, Third and Fifth circuits does not suggest that Tellabs is having a significant impact on scienter pleading standards. Perhaps the best example of these decisions is the Seventh Circuit’s decision in Tellabs on remand from the Supreme Court which chose not to apply its teachings to the facts of the case. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008).

On remand, the Circuit Court began with the premise that fraud had been pled with particularity because its holding on that point had not been appealed to, or considered by, the Supreme Court. Based on that ruling, the court considered two possible inferences regarding whether senior executives of the company had made fraudulent statements about two key products. Under one possibility, the false statements were the product of an error by lower level employees that was not detected by senior officials before they made the statements. Alternatively, the statements were the result of deliberate fraud.

The Seventh Circuit concluded that plaintiffs had in fact met the Tellabs test. The Circuit Court fund that the importance of the products being discussed made it more likely that the false statements were the result of deliberate fraud than simple errors by lower level employees. The Court ruled that the case could go forward. This is the same result reached prior to the Supreme Court’s decision, suggesting that the new Supreme Court equipoise test had little impact. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2005) rev’d, 127 S.Ct. 2499 (2007); see also Higginbotham v. Baxter Int. Inc., 495 F.3d 753 (7th Cir. 2007).

Two decisions by the Third Circuit seem to confirm this point. In Winer Family Trust, the Circuit Court reviewed a complaint based on a claim that the price of the stock had been inflated by omitting key facts from earnings reports and releases. After considering all of the competing inferences, the court concluded that a strong inference of scienter had not been pled. The Winer Family Trust v. Queen, 503 F.3d 319 (3rd Cir. 2007); see also Central Laborers’ Pension Fund v. Integrated Electrical Services, No. 06-20135, 2007 WL 236776 (5th Cir. Aug. 21, 2007) (applying an “all inferences approach to conclude that a complaint had been properly dismissed).

In contrast, in Key Equity Investors, Inc. v. Sel-Leb Marketing, Inc., No. 06-1052, 2007 WL 2510385 (3rd Cir. Sept. 6, 2007), the Circuit Court applied not only the Tellabs test, but also its prior precedents which followed the Second Circuit “motive and opportunity” test which had survived the passage of the PSLRA. Analyzing the facts pled in the complaint under both standards. The majority concluded that sufficient facts had not been pled. The dissent however, using the same approach on the same facts, reached the opposite conclusion. As with the Seventh Circuit’s post-Tellabs cases, these decisions by the Third Circuit suggest that the Supreme Court’s new standard is having little impact. See also ATSI Communications, Inc. v. The Shaar Fund, Ltd., No 05-5132-cv, 2007 WL 1989336 (2d Cir. Jul 11, 2007) (also using a duel test approach of the Tellabs “all inferences” approach and its prior “motive and opportunity” test); Crowell v. Possis Medical, Inc., No. 07-1840 (8th Cir. Mar. 21, 2008) (same).

Only two Circuits have acknowledged that Tellabs altered its prior case law. In ACA Financial Guaranty Corp. v. Advest, Inc., 512 F.3d 46 (1st Cir. 2008), the First Circuit concluded that Tellabs affirmed a portion of its prior case law, but ultimately lowered the scienter pleading standard. In reviewing the dismissal of a securities law complaint, the court first noted that Tellabs affirmed its prior holding that all inferences and the complaint as a whole must be considered. However, the court concluded that Tellabs overruled its prior holding that if the inferences are equal the defendant prevails. Since the inferences were equal here, the complaint could proceed, where as under the First Circuit’s prior case law it would have been dismissed.

The Ninth Circuit reached a similar conclusion in Mississippi Public Employees’ Retirement System v. Boston Scientific Corp., 2008 WL 173590 (9th Cir. Apr. 16, 2008). There, the court reversed the dismissal of a securities law complaint which was based on allegations revolving around a product launch and recall. After concluding that Tellabs lowered the pleading standard for scienter in the circuit, the court permitted the complaint to proceed. The reluctance of the court to permit this result is evident from its cautionary statements noting that it was not endorsing the merits of the claims, only applying the teachings of the Supreme Court. Considering this decision, as well as that of the First Circuit in ACA Financial Guaranty and those of the other circuits clearly draws into question the conclusion that Tellabs is “pro-business.” Indeed, it appears that Tellabs is having little impact in may circuits while lowering pleading standards in the First and Ninth Circuits. Since most securities class actions are filed in either the Second or Ninth Circuits the overall impact of Tellabs may be to ease the pleading burdens for plaintiffs in many instances.

Next: The group pleading doctrine

Part IV: Securities Class Actions: Current And Emerging Trends

Bell Atlantic Corp. v. Twombly, discussed in the last segment of this series here, imposes one pleading standard for securities class actions. The PSLRA adds three other key pleading requirements: 1) the complaint must specify each statement alleged to be misleading; 2) each statement made on information and belief must specify all facts on which it is based; and 3) as to state of mind, Section 21D(b)(2) requires that a “strong inference” be pled.

To craft the PSLRA pleading requirements, Congress borrowed from existing law. The particularity standards were taken from Federal Civil Rule 9(b), which requires that fraud be pled with particularity. That Rule did not however impose a heightened pleading standard for state of mind, requiring only general allegations. Nevertheless, some circuit courts crafted specific pleading standards regarding scienter.

The Second Circuit was viewed as having the most stringent standard in 1995 when the PSLRA was adopted. That standard required that a strong inference of scienter be pled. Under Second Circuit case law this requirement could be met by pleading either: 1) facts establishing motive and opportunity to commit fraud; or 2) facts constituting circumstantial evidence of either reckless or conscious behavior. See, e.g. In re Time Warner, Inc., Sec. Litig., 9 F.3d 1049 (2nd Cir 1993); but see In re GlenFed, Inc, Sec. Litig., 42 F.3d 1541 (9th Cir. 1994) (en banc) (holding that notice pleading was sufficient to plead scienter).

In writing Section 21D(b)(2), Congress adopted the “strong inference” test, but not the Second Circuit case law. The legislative reports however note that the Second Circuit case law should be considered as “instructive.” H.R. Conf. Rep. No. 104-369, at 15 (1995).

Following the passage of the PSLRA, the circuits split as to what constitutes a strong inference of scienter. The Second and Third Circuits followed the Second Circuit’s pre-PSLRA case law. See, e.g., Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 92nd Cir. 1999). The Ninth Circuit adopted what it called the “deliberate recklessness test,” which was a more stringent pleading standard than that used by the Second and Third Circuits. In re Silicon Graphics, Inc., Sec. Litig., 183 F.3d 970 (9th Cir. 1999). The First, Fourth, Sixth, Eighth and Tenth circuits adopted various intermediate positions. See, e.g., Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999); Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999); Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir. 2001) (en banc); City of Philadelphia v. Fleming Co., Inc., 265 F.3d 1245 (10th Cir. 2001); Florida State Bd. Of Admin. v. Green Tree Fin. Corp., 270 F.3d 646 (8th Cir. 2001).

The circuit courts also split over how to deal with competing inferences. Traditionally, under Federal Civil Rule 12(b)(6) on a motion to dismiss all inferences were drawn in favor of the plaintiff. Since Section 21D(b)(2) required that a “strong inference” be pled, a key question became how to consider the various inferences raised by the allegations in the complaint. Again the circuits split. The First Circuit concluded there was no change to existing Rule 12(B)(6) practice. See, e.g., Aldridge v. A.T. Cross Corp., 284 F.3d 72 (1st Cir. 2002). The Ninth Circuit took a similar position, but noted that there was a “tension” between the Rule and the Section. See, e.g., Gompper v. VISX, Inc., 298 F.3d 893 (9th Cir. 2002). The Tenth Circuit, in contrast, concluded that all inferences had to be considered. See, e.g., Pirraglia v. Novell Inc., 339 F.3d 1182 (10th Cir. 2003).

The Supreme Court resolved the interpretation of Section 21D(b)(2) in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 761 (2007). There, the Court essentially held that the Section rewrites Rule 12(b)(6) procedure, requiring facts must be pled rendering an inference of scienter is at least as likely as any plausible opposing inference. While the Court noted that the inference must be “cogent,” the test is one of equipoise.

To assess the competing inferences, the Court held that the district court must: 1) accept all the facts in the complaint to be true as under existing Rule 12(b)(6) procedures; 2) consider the entire complaint; and 3) assess plausible opposing inferences.

Many commentators concluded that Tellabs is another pro-business decision by the Roberts Court. A review of the Circuit Court decisions applying the Tellabs decision however suggests that the impact of the case may be more difficult to assess. Clearly, the decision vests significant discretion in the district court to assess the various inferences. In many ways this may in fact mean that what constitutes a “strong inference” is in the eye of the reader or more appropriately the district court judge.

Next: The impact of Tellabs