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Every fan of our national pastime knows that a tie “goes to the runner” at first base. 1On a baseball diamond, lots of runners are fun – how else could we see the double (triple) play, steal (double steal), balk, infield fly rule, etc., let alone crooked numbers on the scoreboard? The 1995 Private Securities Litigation Reform Act (PSLRA) gave federal courts the sign that, in the field of securities fraud litigation, lots of runners – i.e., cases permitted to proceed to discovery – are not fun. They use resources of courts and litigants, and may make the U.S. financial ballpark less attractive to foreign teams. The PSLRA aimed to reduce activity in this field by requiring private securities fraud complaints to support a “strong inference” that defendants acted with scienter, the fraudulent state of mind. Against this background, the Supreme Court delivered recently its decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd. , resolving a conflict among the circuits regarding what is needed to get a securities fraud complaint to first base under the PSLRA, and particularly whether judicial inquiry into the “strong inference” of fraudulent intent should include consideration of rival inferences of nonfraudulent intent. If the answer is yes, the next question is what happens if the inference of guilt and the inference of innocence end up in a tie – is the case “out,” or may it proceed to discovery? The Court first held that the PSLRA’s “strong inference” standard is “inherently comparative,” and that courts must therefore consider “not only inferences urged by the plaintiff but also competing inferences rationally drawn from the facts alleged.” (Slip Op. at 2.) However, although Justices Antonin Scalia and Samuel Alito are not happy with the call, the majority awarded a tie between inferences of fraud and nonfraud to the plaintiff. While stating that the inference of scienter must be “cogent” and “at least as compelling as any opposing inference of nonfraudulent intent,” the majority declined to hold that the scienter inference cannot be “strong” within the meaning of the PSLRA where there exists an equally plausible “nonculpable” inference. ‘Strong Inference’ of Scienter Under PSLRA The PSLRA sought to reduce the number of nonmeritorious securities fraud cases reaching discovery and trial by requiring that a complaint “state with particularity facts giving rise to a strong inference that the defendant acted with an intent to deceive, manipulate, or defraud.” Pre-PSLRA cases were governed by Federal Rule of Civil Procedure 9(b), which permits state of mind to be “averred generally,” and Rule 12(b)(6), which affords to the plaintiff any “reasonable” inference of culpability. The PSLRA’s stricter standard sought to raise the bar especially in “fraud by hindsight” cases, where a plaintiff alleges a change in forecasts or restatement of historical financial information, and reasons as follows: “Earlier Statement A was different from later Statement B. Therefore, Statement A was fraudulent.” Since the enactment of the PSLRA in 1995, the Courts of Appeals have used various verbal formulations in applying the “strong inference” standard. Some of the differences appear capable of leading to different outcomes, particularly as to whether the court should weigh the strength of innocent explanations of the defendant’s conduct against the culpable inferences advocated by the plaintiff. The U.S. Courts of Appeal for the Sixth and Ninth circuits have suggested that a “strong inference” can be found only where the inference of fraudulent intent is more plausible than any competing inference. On this view, if culpable and innocent inferences are equally plausible, the complaint must be dismissed. See Gompper v. VISX, Inc.,298 F3d 893 (9th Cir. 2002) (affirming dismissal where innocent inference was “equally if not more plausible”); Helwig v. Vencor, Inc. , 251 F3d 540, 553 (6th Cir. 2001) (“plaintiffs are entitled only to the most plausible of competing inferences”). The U.S. Courts of Appeal for the Eighth and Tenth circuits, while agreeing that innocent inferences should be considered along with culpable inferences, hold that a complaint should survive if innocent and culpable inferences are “equally strong.” See Pirraglia v. Novell, Inc. , 339 F3d at 1187-88 (10th Cir. 2003); In re K-tel Int’l, Inc. Sec. Litig. , 300 F3d 881, 889 n.6 (8th Cir. 2002). The U.S. Court of Appeal for the Second Circuit, which had been a leading proponent of higher scienter pleading standards prior to enactment of the PSLRA, holds that a plaintiff can satisfy the statute “either (a) by alleging facts to show that defendants had both motive and opportunity to commit fraud or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness.” Kalnit v. Eichler, 264 F3d 131, 138 (2d Cir. 2001). The U.S. Courts of Appeal for the Third Circuit test is similar. GSC Partners CDO Fund v. Washington , 368 F3d 228 (3d Cir. 2004). Seventh Circuit: Competing Inferences Early this year, the Supreme Court granted certiorari to review the decision of the U.S. Court of Appeal for the Seventh Circuit in Makor Issues & Rights, Ltd. v. Tellabs, Inc. , 437 F3d 588 (7th Cir. 2006). In December 2000, Tellabs had issued positive forecasts for ensuing periods, and subsequent statements by its CEO allegedly encouraged analysts to believe that demand for the company’s products was good. In April 2001, during a period of declining fortunes for the company’s telecom customers, two downward revisions were made, followed by a third downward revision in June 2001 that, according to the complaint, finally expressed the “truth.” Tellabs stock, having been as high as $67 during the preceding six months, reached a low of $15.87 the next day. The complaint sought to draw the inference that the company and its CEO must have been aware of or foreseen the negative trend, and that the earlier forecasts and statements were knowingly false. The defendants asserted that the pattern alleged in the complaint – voluntary downward revisions as telecom industry effects became clear and concededly accurate disclosure shortly thereafter – was inconsistent with claims of motive or intent to issue fraudulent forecasts, and in fact supported the contrary inference of innocent state of mind. Further, the absence of stock transactions by the CEO was claimed to exclude any “pecuniary motive” on his part to engage in fraud. The Seventh Circuit found the complaint sufficient as against the company and its CEO because a “reasonable person” could find that their alleged knowledge of weakening demand supported an inference that the defendants acted with scienter. However, the court refused to consider the strength of the inference of innocence or to weigh it against the inference of culpable state of mind. Drawing support from the traditional reluctance to choose between competing inferences at the pleading stage, the Seventh Circuit went so far as to state that for a court to engage in such a weighing process might “be misunderstood as a usurpation of the jury’s role,” in violation of the Seventh Amendment. The Tellabsdefendants, the Solicitor General’s Office and a chorus of amici (including, notably, the SEC) supported reversal, principally on the ground that the Seventh Circuit’s approach was more “lax” than that of any other circuit and failed to give meaning to the statute’s requirement that the inference of culpability be “strong,” not merely “reasonable.” The “reasonable person” approach focused solely on the inference of culpability (without considering the strength of rival inferences) was criticized as indistinguishable from the pre-PSLRA regime under Rule 12(b)(6), which asked only whether there was any reasonable inference of guilt. ‘Strong Inference’ Defined After reviewing the divergent approaches of the circuit courts to application of the PSLRA pleading standard, the court stated as follows:
Our task is to prescribe a workable construction of the “strong inference” standard, a reading geared to the PSLRA’s twin goals: to curb frivolous, lawyer-driven litigation, while preserving investors’ ability to recover on meritorious claims. (Slip Op. at 10.)
The Court’s three-part “prescription” for consideration of Rule 12(b)(6) motions in securities fraud cases began with adoption of existing law requiring acceptance of well-pleaded allegations as true and giving consideration to the complaint “in its entirety,” including documents “incorporated into the complaint by reference, and matters of which a court may take judicial notice.” (Slip Op. at 11.) The critical third step, determining whether the complaint supports a “strong inference” of fraudulent state of mind, requires a court to “take into account plausible opposing inferences.” The Seventh Circuit erred when it declined to undertake this “comparative inquiry” in the decision under review. In the Supreme Court’s view, the term “strong” implies a process that is “inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts?” (Id. at 12.) The inference of scienter must accordingly be more than merely “reasonable” or “permissible,” the test that had been applied by the Seventh Circuit. A complaint may survive “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” (Id. at 13.) Justice Antonin Scalia (joined by Justice Samuel Alito) concurred in the result, but disagreed that an inference of scienter that was merely “at least as compelling” as the inference of nonculpable state of mind could “conceivably be called” the strong inference required by the PSLRA. (Slip Op. at 1.) Instead, the test should be whether the inference of scienter is “more plausible than the inference of innocence.” Only this interpretation, in the view of Justice Scalia, could capture the normal meaning of “strong inference.” Noting the majority’s citation to exceptional circumstances where an inference “at least as likely” as competing inferences can warrant recovery, Justice Scalia declined to use this as a guide to interpretation of the PSLRA: “[t]here is no indication that the statute at issue here was meant to relax the ordinary rule under which a tie goes to the defendant.” Conclusion The Court’s decision in Tellabsrepresents a new template for analysis of scienter pleading under the PSLRA. Accordingly, courts across the country will now need to engage in a “comparative inquiry” into all plausible inferences suggested by the pleaded facts and related materials, which will typically include SEC filings and other documents referenced in the complaint. That a tie will go to the plaintiff may or may not have practical significance. In the words of Justice Scalia: “How often is it that inferences are precisely in equipoise?” The answer must await experience with the approach announced by the Court in Tellabs. David W. Wiltenburg is a partner at Hughes Hubbard & Reed. Endnote: 1. See Official Rules of Baseball, �6.05(j) (batter is out “when after he hits a fair ball, he or first base is tagged before he touches first base”).

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