Tellabs on Remand – The 7th Circuit’s Ruling
After defining the pleading requirement for a “strong inference” of scienter, the Supreme Court remanded Tellabs for reconsideration in view of its decision as discussed here. On remand, the Seventh Circuit concluded that the complaint met the pleading standard established by the Supreme Court. Makor Issues & Rights, Ltd. v. Tellabs, Inc., ___ F.3d ___ (7th Cir. Jan. 17, 2008) (slip op.).
The Opinion
In its opinion the Seventh Circuit considered four key points: 1) the pleading standard; 2) standards for corporate liability; 3) the group pleading doctrine; and 4) the use of confidential sources.
First, the court addressed the meaning of a “strong inference” of scienter, concluding that a two-part test must be met: “So first the inference must be cogent, and second it must be as cogent as the opposing inference, that is, the inference of lack of scienter.” The test does not, however, require comparison. Rather, the question is whether the complaint gives rise to a strong inference of scienter because the defendant can, according to the court, typically be expected to have some alternative explanation for the claim.
Second, the court considered the question of corporate liability. While the rule of respondeat superior can result in entity liability for the acts of its agents, this rule would be too broad in securities litigation, according to the court. In securities cases, it is more appropriate to look to the state of mind of the “individual corporate official or officials who make or issue the statement … . A corporation is liable for statements by employees who have apparent authority to make them.” Id.
Third, the court rejected the group pleading doctrine. Under that judicially created presumption, statements in group-published documents such as annual reports are attributable to officers and directors who control the company. “As we held in our first opinion, the doctrine is inconsistent with the ‘strong inference’ requirement.” Id. at 13.
In this context, the key question, according to the court, focuses on whether it is likely that the false statements were the result of merely careless mistakes by lower employees that were later reiterated by senior management named as defendants or the result of an intent to deceive. Here, it is more plausible that the statements are the product of fraud, in view of the fact that the statements are about the sale and projected sales of the two most important products of the company. In this regard, the court rejected defendants’ claim that they did not have a motive to falsify because the truth about the products and sales would quickly surface does not change this conclusion since “[t]he fact that a gamble … fails is not inconsistent with its having been a considered, though because of the risk a riskless, gamble.” Id. at 14. The innocent explanation was less plausible than the inference of scienter also means that the inference is cogent.
Finally, the court rejected the claim that a strong inference had not been pled because key facts came from confidential sources. Confidential sources, the court noted pose, a particular problem. Where, for example, those sources are the basis for the allegations, and the only thing known about them is that they are former employees, the allegations may be insufficient.
In this case however, the information from these sources is sufficient. Here, there are numerous sources, their job descriptions and positions with the company were identified and their allegations were made in what the court called “convincing detail.” Thus, the “absence of proper names does not invalidate the drawing of a strong inference from informants’ assertions.” Id. at 18.
Analysis
While the court’s discussion follows the analytical outlines of the Supreme Court’s decision, its overall approach seems at odds with Tellabs. In its opinion, the Supreme Court repeatedly stated that its test is one of equipoise – that is, the inference of scienter need only be as strong as opposing inferences. At the same time, the Court stressed that all of the fact had to be considered. To emphasize this point, the court resolved what had been a long simmering dispute among the lower courts by holding that, on a motion to dismiss, the District Court could consider facts of which it took judicial notice. Thus, the decision on a motion to dismiss should carefully assess all of the available facts – those in the complaint and others which might be brought before the court through judicial notice – to assess the strength of the competing inference. In this way, the motion to dismiss is something of a mini-trial.
The Seventh Circuit’s opinion, however, does not follow the Tellabs blueprint. Rather than focus on the totality of the information available, the Seventh Circuit seems to use a type of inward tunnel vision base its decision on of apriori reasoning and suggestive examples. Starting with the proposition that the fraud had been pled as required by the PSLRA, the court focused two possible explanations for it – negligent error or scienter and fraud. Through a series of hypothetical examples, the court essentially analyzes the probability that the senior corporate officials named as defendants would make erroneous statements about the company’s most important products. Finding this unlikely, the court concluded that the inference of scienter is more probable and, as such, also cogent. Deductive reasoning, no matter how good, is not the evidence-driven approach of Tellabs.
The Circuit Court’s approach also seems at odds with equipoise standard of the Tellabs Court. Throughout its opinion, the Supreme Court emphasized that a strong inference need only be equal to the competing inference. Indeed, Justice Scalia chided the majority on this very point in his dissent with his “jade falcon” example. Nevertheless, the Seventh Circuit’s analysis seems to focus on determining plausibility in an inductive reasoning sense and predominance.
Finally, the court’s reliance on confidential informants also raises questions about its approach. Reliance on information from confidential sources seems consistent with the Seventh Circuit’s conclusion that the Supreme Court’s standard does not require comparison. At the same time however, it appears to be inconsistent with the Tellabs command that the court assess all of the evidence and determine if the inference is at least as cogent and strong as competing inferences since it is difficult as the Seventh Circuit concedes to assess information from confidential sources. The Seventh Circuit’s reliance on information from confidential sources, along with its overall approach, appears to be inconsistent with the Supreme Court’s decision.