One To Watch (Supreme Court To Raise Curtain On Securities Fraud Proof)
Following up my article from last week regarding the significant drop in federal securities class action lawsuits filed over the past few years, the Supreme Court has indicated it will review a case considering the standard of proof necessary for shareholder class actions to proceed to trial. The timing of the Court's decision is fortuitous in light of recent renewed interest in class action filing trends.
As background, Congress enacted the Private Securities Litigation Reform Act (PSLRA) in 1995 to curb the number of frivolous class action securities fraud lawsuits filed. Among other things, the PSLRA added to securities fraud pleading requirements an element that required plaintiffs to plead "facts giving rise to a strong inference" that the defendant either intentionally or recklessly committed the alleged fraud. The intended effect of the PSLRA was quickly borne out as evidenced by a reduced number of fraud-based securities class actions filed in subsequent years.
What constitutes a "strong inference" was not specified in the Act and ultimately left to the determination of federal courts hearing these matters. The thought (and perhaps hope) of many commentators is that a uniform standard for determining what constitutes a "strong inference" would provide clear guidance to both plaintiffs and defendants litigating federal securities fraud claims.
On January 5, 2007, the Supreme Court granted certiorari in Tellabs, Inc. v. Makor Issues & Rights, Ltd. Briefing by the parties is to be completed by March 20, 2007. The United States District Court for the Northern District of Illinois previously dismissed plaintiffs' section 10(b) claims against Tellabs and two officers, and plaintiffs appealed to the Seventh Circuit Court of Appeals, which affirmed and reversed, in part, the district court's decision.
The thrust of the allegations in the complaint were that Tellabs and current and former officers knowingly and/or recklessly made false and/or misleading statements in marketing and financial materials by exaggerating or fabricating heightened demand through "channel stuffing." The Seventh Circuit noted that plaintiffs must meet the substantive pleading requirements of the PSLRA by pleading sufficient facts to create “a strong inference” of scienter but that "Congress did not, unfortunately, throw much light on what facts will suffice to create such an inference." The Courts of Appeals follow three different approaches to demonstrating the required “strong inference.” The Seventh Circuit chose the middle ground approach, adopted by six other Courts of Appeals, and reasoned that "the best approach is for courts to examine all of the allegations in the complaint and then to decide whether collectively they establish such an inference. Motive and opportunity may be useful indicators, but nowhere in the statute does it say that they are either necessary or sufficient."
Following are some of the key findings made by the Court:
- strong inference of scienter not sufficiently plead where chairman and former chief executive officer's statement that demand for product was “still growing strong” as the product's declining status was not apparent until after chairman's statement, and chairman's contemporaneous stock sale represented only one percent of his holdings, notwithstanding the fact chairman signed the company's 10-K which allegedly fabricated appearance of demand through channel stuffing, and although chairman should have assured himself that numbers being represented were accurate, his trust in his CEO did not constitute required level of recklessness; and
- strong inference of scienter sufficiently plead with respect to chief executive officer's statements that product was “available now” and was “being shipped” as complaint alleged that company did not ship any units during class period, and according to sales director, the CEO saw weekly sales reports and production projections.
The Seventh Circuit's decision reads like a law school exam as virtually all areas of securities fraud pleadings are touched upon. The potential for long range and rippling effects of the Supreme Court's decision in this case make it indeed - one to watch!
