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A major showdown is looming before the U.S. Supreme Court within weeks over the issue of what must be pleaded to demonstrate scienter under Rule 10b-5. Section 21D(b)(2) of the Securities Exchange Act of 1934 requires the plaintiff to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” On March 28, the court is scheduled to hear Tellabs Inc. v. Makor Issues and Rights Ltd., No. 06-484, in which the 7th U.S. Circuit Court of Appeals took an unusually permissive view of what this standard requires. Since the Private Securities Litigation Reform Act (PSLRA) was passed in 1995, each federal circuit has developed its own interpretation, and they differ significantly. Uncharacteristically, the U.S. Securities and Exchange Commission (SEC) and the solicitor general have filed an amicus brief asking the Supreme Court to reverse the decision of the 7th Circuit and impose a higher pleading standard. As soon as the SEC took this position, a political controversy erupted. First, a story appeared on the first page of the New York Times business section with the headline, “S.E.C. Seeks to Curtail Investor Suits.” N.Y. Times, Feb. 13, 2007, at C1. Two weeks later, a similar story appeared on that page, captioned, “Is the S.E.C. Changing Course?” N.Y. Times, March 1, 2007, at C1. Both quoted plaintiff-friendly commentators who deplored the SEC’s change in stance and saw investor interests as being sold down the river. Both stories were written by Stephen Labaton, a Times reporter who is also the son of Edward Labaton, one of the leading securities class action plaintiffs’ attorneys in the nation and a founder of the New York law firm Labaton Sucharow & Rudoff. The hidden conflicts of interest in the media may be greater than those on Wall Street. Business interests file policy-oriented amicus brief Not to be outdone, the business community organized, and the U.S. Chamber of Commerce has filed an unusually policy-oriented amicus curiae brief, which argues that securities class action litigation based on Rule 10b-5 is eroding the competitiveness of the nation’s capital markets and injuring, rather than serving, the interests of investors. Although no one will be misled by this brief, it is making a frankly political argument for change in the law. Much of the Chamber of Commerce’s argument rests on a foundation of serious academic research. Today, it is hard to maintain that secondary-market securities litigation either compensates injured investors or deters wrongdoers effectively. Primarily, this is because the recovery in the typical secondary-market “stock drop” class action will be entirely funded by the subject corporation and its liability insurer; thus, the costs fall on shareholders, with the shareholders who purchased during the class period receiving the recovery and those shareholders who did not paying it. Over time, diversified shareholders sometimes receive and sometimes pay these wealth transfers, but on balance they systematically lose because from each of these pocket-shifting wealth transfers must be deducted enormous transaction costs, including the legal fees of both sides. Undiversified shareholders fare even worse, because they are typically “buy and hold” investors who did not buy within the class period, which is typically less than one year. Thus, securities class actions probably transfer wealth systematically from undiversified “buy and hold” investors to active traders. But even if secondary-market securities class actions are dysfunctional, it does not necessarily follow that elevating the scienter level to the “high probability of fraud” standard that the SEC’s and solicitor general’s amicus brief advocates is the best tool by which to address these problems. The real problem is that today, in some contexts, the risk of being sued is probably too low for society’s good. For example, in 2006, according to Stanford’s Securities Class Action Clearinghouse, only one securities class action was filed naming an auditor as a defendant (down from a mere five in 2005). High pleading standards may already excessively insulate some categories of defendants. The Supreme Court is, of course, unlikely to rely on policy arguments, at least explicitly, in determining how to interpret � 21D(b)(2)’s “strong inference” standard. Here, the 7th Circuit curiously went out of its way to invite appellate review. In Makor Issues & Rights Ltd. v. Tellabs Inc., 437 F.3d 588 (7th Cir. 2006), both the 7th Circuit and the district court agreed that the plaintiffs had adequately pleaded that Tellabs Inc.’s chief executive, Richard Notebaert, had (1) falsely assured investors that the company was continuing to experience strong demand for its products, including two versions of its Titan 5500 networking device; (2) sanctioned the practice of “channel stuffing” under which Tellabs flooded its distribution channels with discounted products; and (3) overstated revenue projections. Yet the district court still dismissed the complaint because the plaintiffs had failed to sufficiently allege scienter. Probably, this was because Notebaert had not sold stock during the class period, but was merely alleged to have attended meetings at which other employees informed him about the true state of affairs at Tellabs. Nonetheless, the 7th Circuit reversed and reinstated the action, finding first that Congress “only required plaintiffs to plead facts that together establish a strong inference of scienter.” 437 F.3d at 601. Had the decision stopped there, it probably would not have been “cert. worthy.” But it went on to reject the 6th Circuit’s position under which the court must accept only “the most plausible of competing inferences.” See Fidel v. Farley, 392 F.3d 226, 227 (6th Cir. 2004). Disagreeing, the 7th Circuit panel ruled: “Instead of accepting only the most plausible of competing inferences as sufficient at the pleading stage, we will allow the complaint to survive if it alleges facts from which, if true, a reasonable person would infer that the defendant acted with required intent.” Id. at 602. This statement appears to have been the basis for the solicitor general’s and the SEC’s decision to side with Tellabs on appeal. Going further, the solicitor general and the SEC have now argued that � 21D(b)(2)’s “strong inference” language requires that “there must be a high likelihood that the conclusion that the defendant possessed scienter follows from the facts alleged with particularity.” This goes well beyond even the 6th Circuit’s “most plausible of competing inferences” standard that the 7th Circuit rejected in Tellabs. Indeed, a “high probability” standard might make it impossible to assert a Rule 10b-5 cause of action against an auditor who certified cooked books or an underwriter who used a misleading prospectus. Conversely, there seems little chance that the 7th Circuit’s more permissive approach will be upheld, as it seemingly reduces the statutory “strong inference” standard to only a “reasonable inference” standard. Where then should the line be drawn? Here, it needs to be remembered that the “strong inference” language was first used not by Congress, but by the 2d Circuit in Ross v. A.H. Robins Co., 607 F.2d 545, 558 (2d Cir. 1979). The PSLRA essentially adopted this “strong inference” language to indicate a congressional intent to mandate a pleading standard at least as strict as the 2d Circuit’s. But the 2d Circuit never framed its test in terms of a “high probability” or any similar mathematical standard. Instead, it has required plaintiffs either (1) to “allege facts showing a motive for committing fraud and a clear opportunity for doing so” ( Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1967)), or (2) to identify “circumstances indicating conscious behavior by the defendant, although the strength of the circumstantial allegations must be correspondingly greater.” Id. at 50; Novak v. Kasaks, 216 F.3d 300, 311 (2d Cir. 2000). 2d Circuit’s unquantified approach has advantages The advantage of this unquantified approach becomes evident when we consider a more egregious case in which the CEO defendant has bailed out and dumped half his stock ownership in the company during the six-month class period. Such a bailout scenario is very different from the Tellabs fact pattern, but under the solicitor general’s proposed “high probability” standard, such a CEO might still be able to obtain a dismissal on the ground that, although his stock sales gave rise to a more-probable-than-not likelihood that he acted with the requisite intent, it did not generate a high probability of fraudulent intent. Where there is significant self-dealing, concealment or involvement in illegality, no social interest justifies letting the defendant obtain a dismissal because the probability that he had a fraudulent intent was not “high” enough. Further, the term “strong inference” does not normally mean or connote a “high probability.” As the solicitor general’s brief, itself, acknowledges, the ordinary meaning of “strong” in this context is, depending on the dictionary used, “cogent, powerful, forceful” or “persuasive, effective and cogent.” See Brief for United States at 20. Thus, if the court is intent on fashioning a common standard for all circuits by which to implement � 21D(b)(2), it should read that section to require the pleading with particularity of cogent and persuasive factual evidence, showing that the defendant either (1) had a motive to commit fraud and an opportunity for doing so, or (2) engaged in conscious behavior designed to mislead those within the plaintiff class. But terms like “high probability” should be avoided. Ultimately, a heightened pleading rule cannot solve all, or even most, of the problems that arise in Rule 10b-5 litigation, but an overbroad rule would confer immunity on some very culpable defendants. The better answer is for the SEC to proceed by rulemaking, and thus the political debate should continue. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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