The Supreme Court issued an opinion in Tellabs, Inc. v. Makor Issues, 06-484 (June 21, 2007) yesterday, a case examining the pleading standards for scienter contained in the PSLRA. The SEC's amicus brief can be found at the DU Corporate Governance web site; the opinion will be up later today.

The case interpreted the requirement in the PSLRA that plaintiffs plead with particularity facts giving rise to a "strong inference" of scienter. The Seventh Circuit interpreted the language to require the pleading of facts "from which, if true, a reasonable person could infer that the defendant acted with the required intent." 437 F. 3d 588, 602 (2006). The Court rejected this approach by a commanding 8-1 vote. Justice Ginsburg, writing for six justices, found that "an inference of scienter must be more than merely plausible or reasonable, it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent."  In other words, equally competing inferences were enough to establish scienter. On this point, Justices Scalia and Alito disagreed.

Essentially the case required the Court to decide how to handle pleadings that included facts that gave rise to competing inferences with respect to scienter, a problem that can, at least conceptually, arise often.  Inferences from the same behavior can be good or bad. Justice Ginsburg noted this during oral arguments with respect to channel stuffing. Petitioners essentially argued that the "strong inference" language abrogated the requirement that all inferences be construed in the plaintiffs favor and required that plaintiffs show that its inference was the more likely one.

That the opinion by Justice Ginsburg disagreed with the Seventh Circuit was no surprise. The "strong inference" language had to be given meaning, something the "reasonable person" standard used by the 7th Circuit did not do. The majority did so, however, in a fundamentally pro-shareholder manner. The opinion first made clear that in construing the pleadings, the complaint had to be considered in its entirety, including "documents incorporated into the complaint by reference, and matters of which a court may take judicial notice." The allegations in the pleadings, therefore, had to be examined collectively and not "scrutinized in isolation." This aided shareholders by prohibiting courts from examining factual allegations one by one, finding each inadequate, and concluding that scienter had not been adequately pled.

The opinion did require courts to take into account "plausible opposing inferences." The inference could not, however, be "decided in a vacuum." Instead, the:

• "inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts? To determine whether the plaintiff has alleged facts that give rise to the requisite 'strong inference' of scienter, a court must consider plausible nonculpable explanations for the defendant's conduct, as well as inferences favoring the plaintiff. The inference that the defendant acted with scienter need not be irrefutable, i.e. , of the 'smoking-gun' genre, or even the 'most plausible of competing inferences.'"

This meant that the courts had to weigh all of the facts and competing inferences, including nonculpable explanations.  But it was enough for the plaintiffs to show an inference of scienter that was "at least as compelling as any opposing inference."   It did not have to be the most plausible explanation as petitioners had suggested. 

As a practical matter, the weighing of all facts and all inferences is probably not very different from what courts already do. For example, in considering motive, courts will consider whether insiders traded during the relevant period. Courts do not, however, automatically assume a negative inference when insiders are alleged to have traded.  They require additional allegations that the trading occurred in unusual amounts at unusual times.  Only after weighing all of these allegations will they determine whether the allegations are sufficient to plead scienter.  In fact, the 7th Circuit in Tellabs found that allegations of scienter based upon insider trading were insufficient with respect to one of the defendants.  See 437 F.3d at 604.

Scalia in contrast wanted to impose higher pleading standards. "In my view, the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence." For him, this was the only logical reading of language requiring a "strong inference." On this Alito agreed. Alito further noted that Scalia's approach would align the pleading standards under the PSLRA with those for summary judgment and judgment as a matter of law, avoiding the introduction of a test "previously unknown in civil litigation."  Alito also disagreed that scienter should be based upon a consideration of all of the allegations in the complaint. "It follows that facts not stated with the requisite particularity cannot be considered in determining whether the strong-inference test is met."

Commentary on the case will likely characterize it as a loss for shareholders.  It is not.  The standards adopted are not significantly different from what in practice the courts are already doing.  Moreover, the requirement that courts consider the allegations in the complaint in its totality will in some cases help plaintiffs.  Finally, it shows that securities cases can fracture the conservative-liberal split on the Court.

It may also tell us something about Alito and the outcome in the primary liability case, Stoneridge.  As I suggested in a post written here, he may be the deciding vote in that case.  In his concurring opinion in Tellabs, he disagrees with the majority but adopts a reasonable construction of the statute, albeit one less generous to shareholders.  Moreover, he is willing to disagree with the other conservative members, even if on a small point (the facts that must be considered in determining whether a "strong inference" has been pled).  Alito's opinion contains a narrow reading of the statute but it is not ideologically driven.  If he continues this approach, he is likely to favor a narrow interpretation of primary liability in Rule 10b-5 but unlikely to fully adopt the broad reasoning of the 8th Circuit in Stoneridge or the 5th Circuit in Regents.