LIABILITY IN SECURITIES FRAUD DAMAGE ACTIONS: Part X: Tellabs and Section 21D(2)(b)

The Supreme Court’s recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), in some ways may appear to have resolved a question of little real import, since it deals only with the requirements for pleading one element of a Section 10(b) cause of action for fraud. While significant amount of time and ink have been expended on the decision that will be handed down next term in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43, the significance of Tellabs and its recasting of the rules for resolving a motion to dismiss should not be over looked. Long term, the “jade falcon” standard crafted by the Court – a title borrowed from a hypothetical offered by Justice Scalia in his concurring opinion and adopted by the majority as an illustration of its holding – will have a significant impact on private securities litigation.Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Tellabs has its roots in the Private Securities Litigation Reform Act of 1995 (“Reform Act”) passed by Congress in 1995 and splits in the circuits concerning the pleading requirements for scienter, which predated and postdated that legislation. After hearing repeated testimony about lawyer-driven securities class actions suits filed by nominal plaintiffs based on complaints containing few facts, but which were used to drive huge settlements with no relation to the merit because of imposing discovery demands and costs, Congress passed the Reform Act. The aim of the package of substantive and procedural amendments incorporated into the Reform Act was to eliminate frivolous suits at the outset, while permitting those with merit to proceed. The Reform Act incorporates new requirements for selecting the lead plaintiff, adds procedural limits on settlements and fees and heightened new pleading requirements.

Section 21D(b)(2), which was a key provision of the Reform Act, provides in pertinent part:

In any private action, the complaint shall … state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

Congress did not define “the required state of mind.” Likewise Congress did not define the phrase “strong inference,” or otherwise indicate how the courts should evaluate whether such an inference had been pled in a securities fraud complaint. And, Congress did not identify how the courts should make that evaluation in the context of existing Fed. R. Civ. P. 12(b)(6) motion to dismiss procedures which heavily favored plaintiffs by permitting most cases to proceed into discovery. Congress clearly did, however, specify that then-existing motion to dismiss procedures should be changed by including a provision in the Reform Act precluding discovery until a motion to dismiss is resolved. This contrasts sharply with standard procedure in other suits where the filing of a motion to dismiss does not preclude the commencement of discovery.

Congress did not write Section 21D(b)(2) on a clean slate. The backdrop to the section is a split in the circuits over how to plead scienter. Interestingly, the resolution by Congress of that split which is Section 21D(b)(2) spawned another split in the circuits which was resolved in Tellabs. The coming segments of this series will discuss these splits and analyze the significance of the Tellabs decision.

This Week At the SEC (July 30 to August 3, 2007)

Key issues raised about securities enforcement this week concern the vitality of the SEC enforcement program and the potential Supreme Court decision in Stoneridge Inv. Partners, LLC. v. Scientific-Atlanta, Inc. and Motorola, Inc., No. 06-43. These issues arise from the Senate testimony of Chairman Christopher Cox and the filing of an amicus brief by two Congressmen in Stoneridge.

On July 31, 2007, SEC Chairman Cox testified before the Senate Committee on Banking, Housing and Urban Affairs. Mr. Cox has moved the SEC forward in important areas since becoming Chairman, such as the internationalization of the securities markets. There, he and the agency have initiated some potentially far reaching initiatives concerning the use of international accounting standards and potential use of company filings which meet the standards of a foreign regulator by the SEC.

At the same time, what some have called the “crown jewel” of the SEC over the years – the enforcement division – seems less than vigorous, despite the statements of Mr. Cox to the Senate this week. In his Senate testimony, Mr. Cox argued that the division is vigorously moving forward with investigations and enforcement actions. While this is clearly true in some instances, there are important questions about the overall vitality of the program. Consider the key cases brought this week by enforcement.

• SEC v. Integrated Silicon Solution, Inc., Case No. C 07-3945 HRL (N.D. Ca. filed August 1, 2007). Here, the agency charged Silicon Solutions and its former CFO with engaging in a long-running options backdating scheme. To settle the action, both the company and its former CFO, Gary Fischer, consented to the entry of statutory injunctions prohibiting future violations of the antifraud and books and records provisions of the federal securities laws. In addition, Mr. Fischer also agreed to pay over $400,000 is disgorgement and interest, a $125,000 civil penalty and to an order barring him for five years from acting as an officer or director of a public company.

• SEC v. Argo, Civil Action No. 07-1397 (JR) (D.D.C. Aug. 1, 2007). Here, the SEC brought an options backdating complaint against the former president, COO and CFO of SafeNet, Inc. The case is in litigation.

• SEC v. Frohna, Civil Action No. 07-C-0702 (E.D. Wis. August 2, 2007). This is a settled insider trading case against Joseph Frohna, a former portfolio manager with U.S. Bancorp Asset Management. According to the SEC’s complaint, Mr. Frohna sold all of U.S. Bancorp’s shares in XOMA, Ltd. in 2002, based on inside information about that company that he learned from his brother, who was the leader of a key drug study for that company and another. To settle the action Mr. Frohna consented to the entry of a statutory injunction enjoining future violations of the antifraud provisions and to an order directing him to pay over $950,00 in disgorgement plus interest of over $315,000 and a civil penalty of $954,776.

These cases seem like good results for enforcement. But look further. The two option backdating cases are the latest to trickle out of the SEC’s inventory of investigations in the area which reportedly involves about 140 companies. This scandal has been going on for a considerable period of time. Many companies have conducted through internal investigations, which in many instances are far more probing than anything the SEC enforcement division typically conducts. Yet, only a comparative handful of those investigations have been resolved. Dozens remain in progress.

The insider trading case is based on trades from 2002. Not terribly old for an agency that earlier this year brought case rooted in before the turn of the century conduct. But still, the case is based on conduct that is five years old. Wine improves with age. Enforcement investigations do not.

Policing the securities markets is a key mission for the SEC. Today and tomorrow are key. Yesterday and long ago yesterday should be left to historians. The slow-moving enforcement division seems to need a healthy dose of the forward looking vision Mr. Cox has instilled in some of the SEC’s international initiatives.

Finally, the fact that two members of Congress, Representatives Barney Frank, Chairman of the House Financial Services Committee, and John Conyers, Jr., Chairman of the House Judiciary Committee, filed an amicus brief in Stoneridge this week revives the question of the SEC’s position on this key case. Stoneridge, as we have noted in earlier posts, is potentially the most important case regarding private securities actions in years. While the Bush administration apparently blocked the solicitor general from filing the amicus brief the SEC voted to prepare, that should not be the end of the matter. The SEC should seek and be permitted to file brief in its own right, as it has done in the past. This has nothing to do with the merits of whatever position the SEC want to argue. It has everything to do with the Supreme Court having the benefit of all views, as it makes the critical decision in Stoneridge. Indeed, it is only fitting and proper that the Court have the benefit of the agency Congress created to administer the federal securities laws when interpreting those statutes in a most important case.