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The U.S. Supreme Court recently heard arguments in a securities litigation action stemming from a 7th U.S. Circuit Court of Appeals opinion – Tellabs Inc. v. Makor Issues & Rights, Ltd. – and the case will be decided by the end of the court’s term in June. In Tellabs, the court is asked to address the standard that courts should use in deciding whether a plaintiff in a securities fraud action has adequately plead that a defendant acted with scienter. The Private Securities Litigation Reform Act of 1995 (PSLRA) requires that a plaintiff asserting a Section 10(b) claim “state with particularity facts giving rise to a strong inference that the defendant acted with [scienter].” Currently, the circuit courts are split on how to determine whether a plaintiff has met the “strong inference” requirement. Specifically, the courts are split on if, and how, a court should consider competing inferences that might be drawn from a plaintiff’s allegations with respect to the culpability of the defendant. If one of the purposes of the PSLRA was to create uniformity in the handling of private securities actions in the federal courts, how did we get to the current split among the circuits? A brief review of the case history provides insight into the how we got to the current Supreme Court case. In response to the proliferation of private securities class action complaints, Congress passed the PSLRA in 1995 to heighten the pleading burden on securities fraud plaintiffs and hopefully stem the tide of frivolous lawsuits against public companies. The PSLRA required that plaintiffs not only allege facts supporting claims of securities fraud with particularity, but for a Section 10(b) claim, the PLSRA required that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with [scienter].” Prior to the PSLRA, the federal courts applied different pleading standards to a plaintiff’s allegations of scienter in connection with a Section 10(b) claim. At the time of the passage of the PSLRA, the 2nd Circuit’s standard for securities fraud allegations was the highest standard in the country for plaintiffs to meet. The 2nd Circuit required plaintiffs to “specifically plead . . . [facts that] give rise to a strong inference that defendants had” the required state of mind. The 2nd Circuit also established two ways that a plaintiff could show such a “strong inference” in his or her pleadings – by alleging facts that defendants had both a motive and clear opportunity for committing fraud, or by identifying circumstances indicating conscious behavior by defendant. This was the standard the 2nd Circuit continued to use after the PSLRA and has likewise been adopted by the 3d Circuit. While the PSLRA adopted the 2nd Circuit’s “strong inference” language, there has been much debate whether Congress set a specific standard to determine whether a plaintiff had adequately plead facts giving rise to a strong inference that a defendant acted with the requisite knowledge. The current debate between the Tellabs’ parties and various amicus curiae submitted in connection with the case questions whether the PSLRA meant to adopt the test used by the 2nd Circuit, whether the PLSRA meant to adopt an even higher standard. Since the PSLRA, other circuits established their own versions of how to weigh a plaintiff’s allegations to determine if a “strong inference” had been properly alleged. Specifically, the differences have to do with how a court considers allegations that raise an inference of innocence versus allegations of culpability. The 1st, 4th, 6th and 9th circuits consider all reasonable inferences that might be drawn from the allegations and then compare the relative plausibility of the culpable inferences to the innocent inferences. In those circuits, a plaintiff must show that the culpable inferences are the most plausible ones to survive a motion to dismiss. The 8th and 10th circuits also consider all inferences that may be drawn from the allegations, but do not weigh the relative plausibility of competing innocent and culpable inferences; rather, in the 10th and 8th circuits, competing inferences that are equally plausible will be decided in favor of plaintiff on a motion to dismiss. In Tellabs, the plaintiff Makor accused Tellabs and its officers of issuing false and misleading statements about the company’s key products, sales forecasts, and projected growth. The lower court dismissed the second amended complaint for failing to meet the PSLRA’s threshold pleading requirements. The 7th Circuit affirmed in part and reversed in part. And, in the process of its review, the 7th Circuit arguably adopted yet another test for determining whether a plaintiff has adequately shown facts giving rise to a strong inference of scienter, a standard that defendant Tellabs contends is too lenient. The 7th Circuit held that the best approach for courts faced with a motion to dismiss a Section 10(b) claim is to examine all the allegations in the complaint and decide whether collectively they establish a strong inference of scienter. In language that has been found to be controversial by Tellabs (and numerous amicus curiae), the 7th Circuit further held that “we will allow a complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.” In addition, the 7th Circuit, sua sponte, raised the issue that any other analysis that required a court to determine which inference is more plausible would invade the province of the jury in possible violation of the Seventh Amendment. In its Supreme Court papers and at oral argument, Tellabs has argued that the 7th Circuit’s standard undermines Congress’ intent when it passed the PSLRA to heighten plaintiff’s burden. According to Tellabs, if a plaintiff merely proves facts that could be equally consistent with innocence or culpability, there cannot consequently be a “strong inference” of scienter. Indeed, Tellabs argued that the 7th Circuit standard has completely removed the word “strong” from the equation. Tellabs also contended that at the time the PSLRA was passed, there was no monolithic 2nd Circuit rule for how to determine whether a “strong inference” was met. Therefore, Tellabs proposed a standard that it alleges is generally consistent with the 2nd Circuit and most other courts’ standards and allows a court to weigh all allegations, including facts that support an inference of innocence; consider the absence or presence of allegations of motive in determining whether there is a “strong inference” of scienter; and not count ambiguous allegations that are equally consistent with innocence and culpability in favor of plaintiff. At oral argument, the justices asked a number of questions about the 7th Amendment issue. They all seemed concerned that Tellabs’ proposed standard could mean a higher standard at the pleading stage than would apply if the case made it to trial. Respondent Makor argued that Tellabs misinterpret the 7th Circuit’s standard; rather, Makor argued that the 7th Circuit’s standard is actually in keeping with the intent of the PSLRA and is not the more lenient pre-PSLRA standard resurrected. Indeed, Makor believes that the PLSRA did intend to adopt the 2nd Circuit’s standard, but a few of other circuit courts have actually added an even more onerous burden on plaintiffs than that standard. According to Makor, the higher standard is inconsistent with the PSLRA, conflicts with the benefit of the doubt that should be afforded a plaintiff at the motion to dismiss stage, and would contravene the jury’s role under the Seventh Amendment to make factual determinations. Interestingly, the SEC and DOJ submitted a joint amicus curiae brief in support of Tellabs that also argued that the 7th Circuit’s standard waters down the meaning and intention of the PSLRA. The SEC contends it has an interest in the litigation because while private securities actions can effectively supplement governmental oversight, abusive private litigation imposes substantial costs on businesses and shareholders. The SEC argued that the PSLRA intended to codify the then-most stringent standard of the 2nd Circuit and that in keeping with Congress’ intent, the court should recognize a uniform and heightened pleading standard built upon the 2nd Circuit’s “strong inference” terminology. The SEC also tried to convince the court that it did not need to reach the Seventh Amendment issue. In fact, the SEC did not appear concerned with whether the court established a uniform standard, but rather informed the court that it could take the more limited path – simply find that the 7th Circuit’s standard was too low and not consistent with the PSLRA and reverse and remand for application of the correct and higher standard. Defense practitioners hope that the court will promulgate a uniform pleading standard, consistent with Congress’ intent in enacting the PSLRA that heightens the pleading requirements for plaintiffs in securities fraud class actions. Justice Antonin Scalia also indicated during oral argument that he hoped the court would establish a standard. Absent such a uniform standard, plaintiffs can engage in forum shopping to bring cases within the circuits with the lowest standards. If the court does establish a uniform standard, it is likely to adopt the standard of the 2nd and 3rd circuits. However, based on many of the justices’ focus on the Seventh Amendment issue, it is not guaranteed that the court will establish a uniform standard or that we will get a majority opinion. In any event, we will have a decision in about a month or so. JAY A. DUBOW is a partner resident in the Philadelphia office of Pepper Hamilton. He focuses his practice on complex business litigation, with a special emphasis on defending against securities class action litigation and representing clients involved in investigations by the U.S. Securities and Exchange Commission, the Pennsylvania Securities Commission and various self-regulatory organizations, including stock exchanges and the National Association of Securities Dealers. Dubow is a former branch chief in the division of enforcement of the U.S. Securities and Exchange Commission in Washington, D.C. NICOLE G. TELL is an associate in the commercial litigation group of Pepper Hamilton, resident in the firm’s Philadelphia office. Tell focuses her practice in a variety of commercial litigation disputes, media and communications and securities litigation.

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