By Joseph Merschman
Shareholders’ ability to successfully pursue securities fraud lawsuits may be significantly hampered if the U.S. Supreme Court sides with the defendants in a pending case.
The issue centers on the pleading standards established under the Private Securities Litigation Reform Act of 1995 (PSLRA), which overhauled securities law and increased the requirements for investors seeking legal recourse against companies that mislead shareholders.
Under the PSLRA, plaintiffs must demonstrate a “strong inference” of scienter for a case to move forward. (Scienter is a legal term indicating that the defendants knew – or were extremely reckless in not knowing – that they were doing something illegal.)
Federal appeals courts have offered varying interpretations of exactly what constitutes a “strong inference.” The lawyers for Tellabs Inc., an Illinois-based telecommunications equipment manufacturer, have asked the Supreme Court for clarification, hoping a stricter standard will prevail.
Specifically, Tellabs argues that the U.S. Court of Appeals for the Seventh Circuit in Chicago erred by allowing a securities fraud plaintiff to plead facts that might lead a “reasonable person” to infer that the defendants intended to mislead investors. Tellabs argues that the 7th Circuit should have applied the standard used by some circuits, requiring the plaintiff to show that fraudulent intent was the “most plausible” conclusion – a much higher hurdle.
Already, the PSLRA forces plaintiffs to meet a considerably higher pleading burden than any other form of private litigation. Outside the securities context, courts always assume that the plaintiffs’ claims are true and read all inferences in the plaintiffs’ favor. In other words, the court allows the case to proceed if the allegations, as presented by the plaintiffs, would constitute a legal violation.
The strong inference clause in securities actions already ups the ante. And a “most plausible” interpretation would make it that much more difficult for investors to bring meritorious securities claims.
If adopted by the Supreme Court, the standard would open the door for defendants to introduce a host of issues not alleged in the complaint. In the hopes of muddying the waters and getting a case dismissed, defense lawyers would bombard the court with every conceivable explanation for their clients’ conduct. This not only would pit the plaintiffs’ allegations against facts not alleged in the complaint, it would invite the court to look at the complaint piecemeal, rather than considering the plaintiffs’ allegations as a whole.
Because the PSLRA prohibits discovery in the pleading stage of the case – further tilting the field toward defendants – the plaintiffs rarely have a smoking gun at the pleadings stage showing that corporate officers acted knowingly to commit a fraud. Instead, plaintiffs must marshal the available facts as best as they can so a court can infer that the behavior was intentional or extremely reckless.
In the Tellabs litigation, plaintiffs provided the court with 27 confidential sources who stated that the company and its former CEO knew Tellabs had illegally inflated revenues at the end of 2000 and that officials were aware of an eroding market, despite telling analysts the contrary.
But because these informants could not provide precise details about exactly what the CEO knew, the district court dismissed the case, agreeing with defense claims that it was just as plausible that the CEO did not know about slowing demand.
On appeal, the 7th Circuit reversed the decision and reinstated the case. The Supreme Court is expected to issue a ruling this summer.
The case has drawn support from the usual pro-business suspects, including the U.S. Chamber of Commerce, which has filed an amicus brief in support of Tellabs. But in a particularly troubling sign for investors, the defendants have also found a friend in the SEC, which filed a pro-Tellabs amicus brief in conjunction with the Justice Department.
SEC Chairman Christopher Cox has been quoted as saying that a stricter pleading standard is just one mechanism to reduce “fraudulent lawsuits” filed by “professional plaintiffs.”
Fortunately, several institutions and investors’ groups have stepped forward to urge the court to protect the rights of shareholders. Among those that filed briefs: two dozen attorneys general, the Council of Institutional Investors and the National Conference on Public Employee Retirement Systems.
If the court sides with Tellabs, “meritorious complaints will be dismissed along with frivolous ones; fraud on the market will increase; and state pension funds, state employees, and state taxpayers will suffer,” argue the AGs, in a brief led by Ohio Attorney General Marc Dann.
Just a few short years after investors lost billions of dollars due to frauds at some of America’s biggest companies, the business community – and the SEC – are trying to make it harder for investors to hold corporate wrongdoers accountable.
Joseph Merschman is an attorney in the firm’s Boston office.