The U.S. Court of Appeals for the First Circuit has previously held that the Tellabs decision lowered the pleading standard for scienter in its court. While that determination did not lead to a reversal of the dismissal in the ACA Financial case, the same cannot be said of a new First Circuit decision issued this week.
In Mississippi Public Employees' Retirement System v. Boston Scientific Corp., 2008 WL 1735390 (1st Cir. April 16, 2008), the court specifically noted that its application of Tellabs lead it to conclude that the district court, which "did not have the benefit" of the Supreme Court's opinion, had erroneously dismissed the complaint based on a failure to adequately plead scienter. The court based its holding on allegations suggesting that Boston Scientific may have known of the relevant manufacturing problem during the class period, the closeness in time between alleged misstatements by the company and an announced product recall, and stock sales by the individual defendants.
On the issue of insider trading, the court addressed the defendants' argument that many of the alleged insider stock sales were effectuated pursuant to Rule 10b5-1 trading plans and therefore could not have supplied a motive to engage in fraud. The court concluded, however, that there was insufficient evidence about the nature of the plans to credit this argument. (The author of The 10b-5 Daily has co-written an article on the potential use of Rule 10b5-1 trading plans in defending against securities class actions, including the importance of public disclosure of the nature of the plans. In addition, a discussion of other relevant cases can be found here.)
Quote of note: "It was the defendants' choice to move to dismiss the case on the pleadings without presenting evidence. As a result, there is no evidence of when the [Rule 10b5-1] trading plans went into effect, that such trading plans removed entirely from defendants' discretion the question of when sales would occur, or that they were unable to amend these trading plans."
The Seventh Circuit is determined to be the market leader in interpreting U.S. Supreme Court securities litigation opinions. Following up on its application of Tellabs, last week it issued the first appellate decision utilizing the Stoneridge decision.
In Pugh v. Tribune Co., 2008 WL 867739 (7th Cir. April 2, 2008), the court considered the issue of "scheme liability" in the context of a corporate insider's activities (as opposed to the actions of a third party). One of the individual defendants was a Tribune vice-president, as well as the director of circulation for a subsidiary. In his capacity as an officer of the subsidiary, the individual defendant allegedly signed false circulation audits that inflated the paid circulation figures for two publications. The plaintiffs argued that it was "'forseeable' that this scheme [to defraud the advertisers] would result in improper revenue which, in turn, would be reflected in Tribune's published financial statements."
The Seventh Circuit found that these allegations were insufficient. As in Stoneridge, the individual defendant "participated in a fraudulent scheme but had no role in preparing or disseminating Tribune's financial statements or press releases." Moreover, there was no allegation that Tribune investors had been informed of the false circulation audits. Accordingly, the plaintiffs failed to establish "the requisite proximate relation" between the advertiser fraud and the harm to Tribune's investors.
Interestingly, the Seventh Circuit also addressed the issue of whether the scienter of this individual defendant could be imputed to Tribune on a respondeat superior theory. The court concluded that it could not because: (a) the individual defendant had no primary liability; (b) the misconduct of an employee of a subsidiary is not normally attributable to the corporate parent; and (c) the advertiser fraud was not undertaken to benefit Tribune. (For a discussion of the lower court's decision on corporate scienter, see this post.)
Holding: Dismissal affirmed.
Was the U.S. Supreme Court's Tellabs decision interpreting the "strong inference" pleading standard for scienter a victory for defendants? Not if the defendant is being sued in Boston (or any other locale within the U.S. Court of Appeals for the First Circuit).
In ACA Financial Guaranty Corp. v. Advest, Inc., 512 F.3d 46 (1st Cir. 2008), the First Circuit addressed the effect of Tellabs on its existing law. The court concluded that Tellabs was consistent with the scienter pleading standard previously applied by the court, except in one respect. Whereas the First Circuit had held "that where there were equally strong inferences for and against scienter, this resulted in a win for the defendant," it was now clear under the Supreme Court's "at least as compelling" standard for weighing inferences of scienter that "the draw goes to the plaintiff."
Holding: Dismissal affirmed.
The U.S. Court of Appeals for the Seventh Circuit is making up for lost time. Although it was one of the last circuits to issue an opinion interpreting the PSLRA's heightened pleading standards, the U.S. Supreme Court's decision to review (and reverse) the case has put the Seventh Circuit in the limelight.
In Tellabs, the Supreme Court held that courts must take into account "plausible opposing inferences" when examining whether a plaintiff has adequately plead a strong inference of scienter (i.e., fraudulent intent). A complaint can survive a motion to dismiss "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." The Court then remanded the case back to the Seventh Circuit for further proceedings.
The Seventh Circuit's decision on remand - Makor Issues & Rights, Ltd. v. Tellabs, Inc., 2008 WL 151180 (7th Cir. Jan. 17, 2008) (Tellabs II) - may be just as controversial as its first decision. In an opinion by Judge Posner, the court touched on a number of hot button scienter pleading issues that were not addressed by the Supreme Court.
(1) Corporate scienter - In the Seventh Circuit's earlier decision, the court found that the plaintiffs had adequately plead scienter as to Tellabs' CEO and then imputed that scienter to the corporation. Judge Posner, however, decided that Tellabs' scienter should be examined separately. Although the court found that it was inappropriate to consider the collective knowledge of the corporation's employees in assessing Tellabs' scienter, it also declined to look to the state of mind of the CEO who made the allegedly false or misleading statements. Instead, the court appeared to embrace what The 10b-5 Daily has described as the "weak" or "narrow" version of the collective scienter theory, holding that it was "possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud." In this case, the court held that because the the alleged false or misleading statements concerned Tellabs' "most important products" and a significant amount of alleged channel-stuffing, it was much more likely that the statements were the result of an intent to deceive or recklessness on the part of management rather than "merely careless mistakes at the management level based on false information fed it from below." Given that the inference of corporate scienter was much more likely, it was also cogent.
(2) Motive - The court expressed little concern over the fact that the plaintiffs were unable to allege that any of the defendants profited from the fraud, finding that the "argument confused expected with realized profits." Judge Posner speculated that the CEO "may have thought there was a chance the situation regarding the two key products would right itself" and, therefore, wanted to conceal the truth and avoid causing volatility in the company's stock price.
(3) Confidential witnesses - Shortly after the Supreme Court decided Tellabs, the Seventh Circuit applied the holding in a different case. In Baxter, the court found that the failure to name sources cited in the complaint "conceals information that is essential to the sort of comparative evaluation required by Tellabs" because the court is unable to fully evaluate the reliability of the witnesses. Accordingly, allegations from confidential witnesses must be "discounted" in determining whether a plaintiff has plead a strong inference of scienter and that discount will usually be "steep." Although there is nothing in Baxter suggesting that the holding concerning confidential witnesses was limited to the facts of that case, Judge Posner concluded that the steep discount should not be applied to the more numerous and reliable confidential witnesses in the Tellabs complaint.
Holding: Reverse the judgment of the district court dismissing the suit.
Quote of note: "Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false."
Here is a roundup of Stoneridge commentary available on the web.
(1) Stoneridge: Pro-Business, Pro-SEC Enforcement, Not The "Decision of the Century"; The Supreme Court’s Ruling in the Enron Litigation and Simpson Help Define Stoneridge - SEC Actions
(3) The Stoneridge opinion; More Stoneridge: Taming the monster, not turning it around; The future of scheme liability; Stoneridge and the Enron zombie; What does the Enron cert denial mean? - Ideoblog
(3) Stoneridge and the Judicial Role - Business Associations Blog
(4) Stoneridge and the Legislative Role of the Supreme Court - HLS Corporate Governance Blog
(5) Stoneridge Securities Fraud Opinion from the Supreme Court - Truth On The Market
(6) Supreme Court Rules in Stoneridge Defendants’ Favor - The D&O Diary
(7) Scheme Liability Survives Stoneridge - Barely - SixthCircuitBlog
(8) Enron: Extortion, Interrupted - The N.Y. Sun (Ted Frank)
(9) Stoneridge and the Rule of Law - Wall Street Journal (Paul Atkins)
The first impact of the Stoneridge decision has been felt. The U.S. Supreme Court issued an order today denying review of California Regents v. Merrill Lynch, the Enron-related case from the Fifth Circuit that raised similar scheme liability issues.
The Court also vacated and remanded a Ninth Circuit case on scheme liability, Avis Budget Group, Inc. v. Ca. State Teachers' Retirement, for further consideration in light of Stoneridge (see here for a summary of the Ninth Circuit opinion). Bloomberg and SCOTUSBlog have reports on the decisions.
Quote of note (Bloomberg): "The court's rejection of the Enron investor appeal came without any published dissent. The rebuff 'further confirms that there is no financial services exception' to the Stoneridge ruling, said [counsel for] the suppliers in last week's case."
In the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. (a.k.a. Charter Communications) case, the U.S. Supreme Court has held that the implied private right of action under Sec. 10(b) for securities fraud does not extend to third parties who neither make alleged misstatements nor engage in deceptive conduct on which investors relied. The 5-3 decision (Justice Breyer did not participate) authored by Justice Kennedy resolves a circuit split over the scope of "scheme liability."
In Stoneridge, the plaintiffs alleged that Charter and two of its suppliers and customers, Scientific-Atlanta and Motorola, knowingly engaged in a business scheme that allowed Charter to artificially inflate its reported revenues and operating cash flow. The plaintiffs sought to hold Scientific-Atlanta and Motorola primarily liable for the misstatements contained in Charter's financial statements. The district court, with an affirmance from the U.S. Court of Appeals for the Eighth Circuit, dismissed these claims. On the issue of scheme liability, the Eighth Circuit found that Scientific-Atlanta and Motorola had not participated in the making of the misstatements and "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5."
On appeal, the Supreme Court took a notably different approach. The Court rejected the Eighth Circuit's decision to the extent that it could be "read to suggest there must be a specific oral or written statement before there could be liability under Sec. 10(b) or Rule 10b-5." The Court found that "[c]onduct itself can be deceptive" and provide the basis for liability. Instead, the Court focused on whether the Charter investors could be said to have relied upon the deceptive acts of Scientific-Atlanta and Motorola in purchasing their securities.
The Court concluded that there was no basis for finding that the investors could be presumed to have relied upon the relevant deceptive acts. First, Scientific-Atlanta and Motorola had no duty to disclose their conduct to Charter's investors. Second, the fraud-on-the-market doctrine was inapplicable because the conduct was "not communicated to the public." Accordingly, the Court held that the investors could not "show reliance upon any of respondents' actions except in an indirect chain that we find too remote for liability."
The rest of the opinion is devoted to various legal and policy defenses of this limitation on the scope of scheme liability. The Court noted that Charter's investors were seeking to apply Section 10(b) "beyond the securities markets - the realm of financing business - to purchase and supply contracts - the realm of ordinary business operations." To do so would "invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees." Moreover, adopting the position advocated by Charter's investors would "revive in substance the implied cause of action against all aiders and abettors except those who committed no deceptive act in the process of facilitating the fraud" and would undermine Congress' determination in the PSLRA that this "class of defendants should be pursued by the SEC and not by private litigants." Finally, the Court expressed concern that "scheme liability" would "raise the cost of being a publicly traded company" and "shift securities offerings away from domestic capital markets."
Holding: Affirmed.
Notes on the Decision
(1) The Court adhered closely to the argument made by the Department of Justice in its amicus brief. Although some commentators predicted that outcome, the Court's focus on reliance is interesting given that Chief Justice Roberts (who joined the majority opinion) expressed skepticism at oral argument over whether the issue was properly before the Court. The dissent (Stevens, J.) agreed that the issue was not ripe and suggested that "the fairest course to petitioner would be for the majority to remand to the Court of Appeals to determine whether petitioner properly alleged reliance, under a correct view of what Section 10(b) covers."
(2) While the media is likely to trumpet the decision as a victory for corporate defendants, it is important to note that the victory was not as sweeping as it could have been. Contrary to the holdings of both the Eighth Circuit and the Fifth Circuit (see here), the Court held that deceptive conduct, even without the existence of an oral or written misstatement, can provide the basis for securities fraud liability if the plaintiffs can establish that they relied on that conduct. Indeed, many courts have defined the distinction between "aider and abettor" and "primary violator" by reference to the level of participation of the individual defendant in making the misstatement at issue and whether the public became aware of the defendant's alleged involvement. Does Stoneridge open the door to a broader view of "participation"?
(3) The Court's references to the possible deterrence of overseas firms from doing business in this country and the shifting of "securities offerings away from domestic capital markets" are going to draw criticism as being excessively policy oriented (see here for an early example).
(4) In support of its holding that the investors could not establish reliance, the Court repeatedly cited the investors' lack of knowledge about the "deceptive acts" in which Scientific-Atlanta and Motorola were alleged to have engaged. Presumably the Court was referring to the failure of the investors to allege that they were aware of the transactions between the companies and Charter, not to a lack of knowledge that the transactions were deceptive. Nevertheless, it struck a discordant note when the Court stated, for example, that the defendants' "deceptive acts were not communicated to the public." If the deceptive acts had been communicated to the public, of course, the defendants would have had a completely different lack of reliance defense.
This month has seen two noteworthy decisions from the U.S. Court of Appeals for the Seventh Circuit.
(1) In Sutton v. Bernard, 2007 WL 2963940 (7th Cir. Oct. 12, 2007), the court addressed an appeal by the lead counsel in a securities class action brought against Marchfirst, Inc. Following the settlement of the case, the district court rejected the lead counsel's fees request, reducing it from 28% of the gross settlement amount to 15% or $2,605,000. On appeal, the court held that the district court had improperly failed to take into account "the market price for legal services" in making its determination, instead focusing only on the results achieved in the case.
Quote of note: "The trouble we have with the district court's methodology is that the fee determination began and ended with the amount actually recovered for the class; the court did not consult the market for legal services for guidance in what constituted, as an abstract matter, a 'reasonable percentage.'"
(2) In Asher v. Baxter Int'l Inc., 2007 WL 3010617 (7th Cir. Oct. 17, 2007), the court considered another appeal in a case that had previously generated a well-known decision on the PSLRA's safe harbor for forward-looking statements. This time the court addressed whether, pursuant to Fed. R. Civ. P. 23(f), a plaintiff is entitled to appeal subsequent denials of class certification if it does not appeal the first denial within the 10-day statutory period. The court found that the "time limit would not be worth anything if it restarted with each new motion" and declined to allow the appeal. The opinion also contains interesting dicta on the representative plaintiff selection process in the case.
Quote of note: "The district court deemed both the Alaska and the Fayetteville funds inadequate because their investments are much smaller than those of other mutual or pension funds. One can't help thinking that the unwillingness of any substantial shareholder to step forward as a representative suggests that the suit may not be in investors' interest. To the district judge, the fact that two modestly sized pools with modest stakes in Baxter had been recruited by the lawyers already trying to represent a plaintiff class implied that they would be subservient to counsel."
Despite all of the fanfare leading up to the oral argument in the Stoneridge (a.k.a. Charter Communications) case on scheme liability, the aftermath has been quite subdued. That may be because the post-argument consensus (at least in the blogosphere) is that the plaintiff investors have no chance of obtaining a reversal. On exactly what basis the court will decide against them, however, is still the subject of debate. Summaries and predictions can be found at BusinessAssociationsBlog, Legal Pad, Securities Law Prof Blog, Business Law Prof Blog, Ideoblog, and The Race to the Bottom.
The Supreme Court has released the transcript of today's oral argument in the Stoneridge case. A few highlights from the justices:
(1) Justice Scalia noted that private actions pursuant to Rule 10b-5 are a judicial creation. He then wondered why they could not also be judicially limited.
"If it's our creation, couldn't we sensibly limit it so that, for example, schemes can be attacked by the SEC, but schemes do not form the basis for private attorney generals' actions? You need actual conveyance of a misrepresentation to the injured party." (p. 5)
(2) Chief Justice Roberts, on the other hand, appeared inclined to defer to Congress given its active legislating in the area of securities litigation.
"My suggestion is that we should get out of the business of expanding [Rule 10b-5 liability], because Congress has taken over and is legislating in the area in the way they weren't back when we implied the right of action under 10(b)." (p. 7)
(3) Justice Kennedy expressed concern over the potentially broad scope of liability under a scheme theory (while painting an unflattering portrait of the corporate world).
"[T]here are any number of kickbacks and mismanagements and petty frauds that go on in business, and business people know that any publicly held company's shares are going to be affected by its profits, so I see no limitation to your - to your proposal []." (p. 18)
(4) Justice Ginsburg wondered whether scheme liability occupied a middle ground between aiding and abetting, which is a claim that can only be brought by the SEC, and a primary violation by the company.
"That's if they are aiders and abettors, which is what Congress covered. And I again go back to, is there another category or is everyone - either Charter, the person whose stock is at stake, the company whose stock is at stake and everyone else is an aider?" (p. 35)
(5) Justice Souter alluded to the public controversy over the Solicitor General's amicus brief by asking the government "whether the SEC has publicly taken a position" on the question of whether there was a violation of Rule 10b-5. Counsel for the government outlined the course of events, but noted that there has not been "any official SEC Commission statement." (pp. 49-50)
(6) Chief Justice Roberts and Justice Ginsburg expressed skepticism over whether the issue of reliance, which the government focused on, was addressed by the appellate court. Counsel for the government replied that "it's not as complete a discussion of the reliance issue as we would have thought appropriate if we had been writing the opinion, but it certainly does touch on the question and we think it's wholly presented." (pp. 56-7)
Early reports from today's Supreme Court oral argument in the Stoneridge case suggest that the court is unlikely to side with the plaintiff investors and adopt a broad definition of "scheme liability." First-hand accounts can be found at SCOTUSBlog and the WSJ Law Blog. (Also worth reading is today's coverage of the case in the Wall Street Journal, including an op-ed by SEC Commissioner Paul Atkins.)
Quote of note (SCOTUSBlog): "'Congress has kind of taken over for us . . . They picked up the ball and are running with it . . . My suggestion is that we should get out of the business of expanding [the key securities fraud section]; Congress has taken over,' the Chief Justice told New York attorney Stanley M. Grossman."
As predicted by some observers, Chief Justice Roberts is rejoining the Stoneridge (a.k.a. Charter Communications) case after initially recusing himself. The speculation is that he has sold the securities that caused the conflict of interest. Justice Breyer remains recused, however, setting up the possibility of a split decision. Coverage can be found in SCOTUSBlog, the Blog of Legal Times, and the WSJ Law Blog.
Quote of note (SCOTUSBlog): "If the Court were to divide evenly, 4-4, on Stoneridge, the result would simply be to affirm the Eighth Circuit decision without an opinion. The Court might then seek another test case in which to address the underlying legal question. A major Enron case, California Regents v. Merrill Lynch, et al. (docket 06-1341), raises the same issue; that case apparently is being held to await the outcome of the Stoneridge case."
Two recent appellate decisions of interest:
(1) In Central Laborers' Pension Fund v. Integrated Electrical Services, Inc., 2007 WL 2367776 (5th Cir. August 21, 2007), the court addressed the pleading of scienter under the Supreme Court's recent Tellabs decision. Notably, the court found that (a) the confidential witness allegations lacked sufficient detail supporting their reliability (although the court stopped short of suggesting that the plaintiffs should provide the names of the witnesses), (b) the argument that the stock trading of one of the defendants was non-suspicious because he traded pursuant to a Rule 10b5-1 plan was "flawed" because the plan was put into effect during the class period, and (c) an inference of scienter cannot be drawn from a Sarbanes-Oxley certification unless the person signing the certification had reason to know or should have suspected that the financial statements contained misrepresentations. The court concluded that the "allegations read in toto do not permit a strong inference of scienter."
(2) In Employers-Teamsters Local Nos. 175 & 505 Pension Trust Fund v. Anchor Capital Advisors, 2007 WL 2325079 (9th Cir. August 16, 2007), the court considered whether a lead plaintiff decision can be appealed following the dismissal of the underlying case. A group of public pension funds had unsuccessfully moved to serve as lead plaintiff. The lower court subsequently granted the defendants' motion to dismiss the case. The appointed lead plaintiff declined to file an amended complaint and instead requested that the individual uncertified actions be dismissed with prejudice. The pension funds moved to appeal the earlier lead plaintiff decision, but the appellate court held that because the pension funds never filed their own complaint or intervened in the pending action, they were merely "potential class members in a potential class action suit" and had no standing to bring an appeal.
Two more items regarding the Stoneridge (a.k.a. Charter Communications) case on scheme liability:
(1) Although Chief Justice Roberts and Justice Breyer initially recused themselves from the case because of personal stockholdings, the New York Law Journal reports that they may be back in time for the argument (scheduled for October 9, 2007). Under a new federal law, the justices could sell their stockholdings and, because the sale was done to resolve a conflict of interest, defer any capital gains tax. The article speculates that Chief Justice Roberts may have rejoined a case earlier this year, the day before oral argument, by resolving a conflict through a stock sale.
Quote of note: "'The justices who recused are - I don't want to use the term - business-friendly,' said Stephen Bainbridge, who participated in a brief that opposed the investors' broad liability theory. But Mr. Bainbridge, a professor at UCLA School of Law, said the Court can be especially unpredictable in securities cases, because the justices and their law clerks are 'institutionally incompetent' to resolve complex securities cases. 'I would never count the chickens before they hatch,' he said."
(2) The WSJ Law Blog has a post on the large number of amicus briefs that have been filed in the case.
Quote of note: "At final count, about 30 'friend of the court' briefs (aka amicus briefs) were filed with the court in Stoneridge, which asks whether shareholders can sue to hold third parties — e.g., investment banks, accountants and law firms — liable for a company’s fraud. It’s a 'startling' number of friend-of-the-court briefs for a securities-law case, says Tom Goldstein, a Supreme Court practitioner at Akin Gump, not involved in the case."
The long wait is over and everyone will be at least slightly disappointed. After significant public and private debate, the Solicitor General has submitted an amicus brief in support of the corporate defendants in the Stoneridge (a.k.a. Charter Communications) case on scheme liability.
The government's legal argument appears to be something of a compromise position. The brief states that the Eighth Circuit erred to the extent it held that "non-verbal deceptive conduct is somehow beyond the reach of Section 10(b)." Instead, the plain language of the statute makes it clear that it reaches "all conduct that is 'manipulative' or 'deceptive,'" in whatever form.
Nevertheless, the government argues that the Eighth Circuit correctly upheld the dismissal of the complaint based on the plaintiffs' failure to adequately plead reliance and loss causation. The plaintiffs allege "only that the backdating of the contracts assisted Charter in mischaracterizing the payments from [its business partners] as revenue (and thus inflating its operating cash flow in its financial statements)." The "critical point" is that it was Charter's misrepresentation of its cash flow, not the allegedly deceptive conduct of its business partners, on which the plaintiffs relied in purchasing their shares. The presumption of reliance created by the fraud-on-the-market theory also is unavailable to the plaintiffs, the government argues, because it applies only to public misrepresentations and the complaint "does not identify any public statements or actions" by the business partners. Finally, the brief states that for "many of the same reasons" the complaint fails to adequately allege that the conduct of the business partners caused the plaintiffs' losses.
A few additional notes: (1) SCOTUSblog has a summary of the filing and additional coverage can be found on the WSJ Law Blog and the Blog of the Legal Times; (2) many (if not all) of the briefs in the case, including the briefs of the corporate defendants filed today, are available on the DU Sturm College of Law Corporate Governance site; and (3) the Stoneridge docket reveals that oral argument in the case has been scheduled for October 9, 2007.
Quote of note (SG's brief - citations omitted): "More fundamentally, Congress’s unwillingness to recognize a private right of action for aiding and abetting suggests that this Court should be loath to create the functional equivalent of such a right of action itself. Such an action would upset the deliberate balance struck by Congress. Insofar as petitioner and its amici advance various policy arguments in favor of broad liability for secondary actors, there are ample policy arguments to the contrary (some of which apparently struck a chord when Congress last expressly addressed the issue). In any event, all of those policy arguments 'are more appropriately addressed to Congress than to this Court.'"
The Wall Street Journal has an editorial (subscrip. req'd) on the amicus brief filed by Congressmen Frank and Conyers in the Stoneridge case. The newspaper is critical of the congressmen's decision to have a law firm that does lobbying work for plaintiffs lawyers write the brief.
Quote of note: "We trust the Supreme Court Justices, who are due to hear Stoneridge arguments as early as October, will notice the provenance of Mr. Frank's legal wisdom."
The first circuit court opinion to extensively apply the Tellabs decision has arrived and it contains a number of interesting holdings. Given that the opinion comes from the U.S. Court of Appeals for the Seventh Circuit and is authored by Judge Easterbrook, that will come as no surprise to any regular reader of this blog.
In Higginbotham v. Baxter Intern., Inc., 2007 WL 2142298 (7th Cir. July 27, 2007), the court addressed the impact of Tellabs on the use of confidential witnesses. Noting that the Supreme Court has required plaintiffs to plead an inference of scienter that is both cogent and at least as compelling as any opposing inference that can be drawn from the alleged facts, the court found that "anonymity frustrates that process." In particular, the failure to name sources "conceals information that is essential to the sort of comparative evaluation required by Tellabs," because the court is unable to fully evaluate the reliability of the witnesses. Accordingly, allegations from confidential witnesses must be "discounted" in determining whether a plaintiff has plead a strong inference of scienter and that discount will usually be "steep."
The court went on to find that the plaintiffs had failed to plead a strong inference of scienter. In addition to discounting the statements of confidential witnesses, the court also poked holes in a number of other alleged inferences of scienter put forward by the plaintiffs. Notably, the court found that allegations of a publicly-announced antitrust investigation, stock sales by two company managers, and the company's failure to disclose a fraud at its Brazilian subsidiary as soon as management was informed of its possible existence were insufficient to meet the plaintiffs' pleading burden.
Holding: Dismissal affirmed.
Quote of note: "It is hard to see how information from anonymous sources could be deemed 'compelling' or how we could take account of plausible opposing inferences. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don't even exist."
Quote of note II: "Prudent managers conduct inquiries rather than jump the gun with half-formed stories as soon as a problem comes to their attention. Baxter might more plausibly have been accused of deceiving investors had managers called a press conference before completing the steps necessary to determine just what had happened in Brazil. Taking the time necessary to get things right is both proper and lawful. Managers cannot tell lies but are entitled to investigate for a reasonable time, until they have a full story to reveal."
The Solicitor General's decision not to support the investor plaintiffs in the Stoneridge (a.k.a. Charter Communications) case has spurred another attempt at a post-deadline amicus brief filing, this time from a pair of prominent congressmen. The Washington Post reports that House Financial Services Committee Chairman Barney Frank (D-Mass.) and House Judiciary Committee Chairman John Conyers Jr. (D-Mich.) have sought permission to file an amicus brief in the case. The effort follows on the heels of a similar request from a group of former high-ranking SEC officials. The congressmen's proposed amicus brief can be found here.
Quote of note (proposed amicus brief): "The interpretation of Section 10(b) and Rule 10b-5 adopted by the Court of Appeals and urged by Respondents ultimately rests on policy considerations at odds with the statutory text that should more appropriately be addressed to Congress than to this Court."
The Washington Post has an article on an unusual effort by three former high-ranking SEC officials to file a post-deadline amicus brief in the Stoneridge (a.k.a. Charter Communications) case. The request evidently is being made in response to the Solicitor General's decision not to file a brief in support of the investor plaintiffs. Professor Arthur Miller, who recently argued the Tellabs case before the U.S. Supreme Court, is representing the officials.
Chairman Christopher Cox of the SEC testified before the House Financial Services Committee this week. CFO.com has an article on a mostly unnoticed part of his testimony where Chairman Cox discussed his participation in the SEC's decision to ask the Solicitor General to support the investor plaintiffs in the Stoneridge (a.k.a. Charter Communications) case. The Solicitor General ultimately decided not to file the requested amicus brief.
Quote of note: "Cox's vote was part of the majority in a 3-2 SEC vote in the so-called StoneRidge case. 'It is my view that precedent matters,' he said during a House Financial Services Committee hearing at which all five commissioners attended. 'The SEC rules and policies should not be so effervescent as to change with one or two people on board.' . . . In 2004 — a year before Cox joined the commission — the SEC weighed in favor of a broad definition of liability for companies indirectly involved in violations of the securities laws."
Addition: In a related story, the WSJ Law Blog had an interesting post this week on the campaign by the American Association of Justice (i.e., the main trial lawyer association) to influence public opinion regarding the government's position in the case.
In the Tellabs v. Makor Issues & Rights case, the U.S. Supreme Court has held that in determining whether the pleaded facts give rise to a "strong inference" of scienter, a court must take into account "plausible opposing inferences." The 8-1 decision authored by Justice Ginsburg addresses the application of the PSLRA's heightened scienter pleading standard.
To survive a motion to dismiss, a securities fraud complaint must contain factual allegations giving rise to a "strong inference" that the defendant acted with scienter (i.e., fraudulent intent). In creating this pleading standard as part of the PLSRA, however, Congress did not define the term "strong inference" and courts subsequently construed it differently. Among the outstanding issues was how courts should address competing inferences in determining whether the standard is met.
In Tellabs, the Court described its task as prescribing "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." To that end, the Court established a three-step evaluation process for lower courts.
First, when faced with a motion to dismiss a securities fraud claim, "courts must, as with any motion to dismiss for failure to plead a claim on which relief may be granted, accept all factual allegations in the complaint as true."
Second, courts should consider complaints in their entirety, as well as other sources of information it is appropriate for courts to consider on a motion to dismiss. The proper inquiry is "whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation, meets that standard."
Finally, courts must take into account "plausible opposing inferences." A complaint can survive a motion to dismiss "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."
Although the Court evaluated the factual allegations in the Tellabs complaint, it did not reach any conclusions. Instead, the Court merely emphasized that courts must "assess all the allegations holistically." To that end, it found that the mere absence of insider trading allegations or the existence of "omissions or ambiguities" in the allegations of improper channel-stuffing may "count against inferring scienter," but they were not, by themselves, dispositive as to whether the plaintiffs had met the "strong inference" standard. The Court also addressed an issue that attracted a great deal of attention at oral argument: whether the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit in violation of the Seventh Amendment right to jury trial. The Court held that Congress has the power to establish pleading standards for a federal statutory claim and this power did not implicate the Seventh Amendment.
Holding: Judgment vacated and case remanded for further proceedings
Notes on the Decision
(1) Justices Scalia and Alito wrote concurrences. Justice Scalia argued that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence." Although he noted that this test is unlikely "to produce results much different from the Court's," Justice Scalia found that it is more in keeping with the "normal meaning" of "strong inference." Justice Alito agreed with the "more plausible" test put forward by his colleague and also argued that a court should not consider "nonparticularized" allegations in evaluating scienter.
(2) Justice Stevens filed a dissent and argued that Congress had "implicitly delegated significant lawmaking authority to the Judiciary in determining how [the scienter] standard should operate in practice." He suggested that applying a "probable cause" standard "would be both easier to apply and more consistent with the statute." Under that standard, Justice Stevens believed it "clear" that the plaintiffs had sufficiently plead scienter.
(3) Although attention is likely to be focused on the Court's "competing inferences" holding, it is worth noting that the Court's "holistic" approach to evaluating scienter also addresses a circuit split. The decision would appear to alter the evaluation of scienter in the Second Circuit and Third Circuit, both of which have held that a court can examine allegations of motive or knowledge/recklessness separately to find that the "strong inference" standard has been met.
(4) The majority opinion contains some ambiguities itself. In two consecutive sentences, for example, it states: (a) the inference of scienter "must be cogent and compelling, thus strong in light of other explanations;" and (b) the inference of scienter must be "cogent and at least as compelling as any opposing inference one could draw from the facts alleged." The second statement (which also appears in the introduction to the opinion) appears to allow for a "tie" to go to the plaintiff. As noted by Justice Scalia in his dissent, this result arguably is not in keeping with Congress' desire to heighten the pleading standard.
The Stoneridge (a.k.a. Charter Communications) case on scheme liability pending before the U.S. Supreme Court may or may not be "the biggest securities litigation case in a generation," but it has certainly generated more pre-argument media coverage than Dura and Tellabs put together. Much of that coverage has focused on whether the SEC/DOJ would submit a brief today in support of the plaintiff investors (see here, here, and here). The Wall Street Journal had an editorial on the topic this past weekend.
Although the SEC apparently recommended that the Solicitor General file the brief - see this Bloomberg article for the details - it does not appear that the recommendation was accepted. Reuters reported earlier today that it was "unlikely" the filing would be made and, as of the time of this post, there is no indication that it has happened. If not, the government has the option of filing a brief in support of the defendants (due in 30 days) or simply remaining silent.
Whatever the government's position, however, the show goes on for the parties. The plaintiff investors filed their brief today and it can be found here.
Quote of note (plaintiffs' brief): "Legitimate business will be unaffected if the Court adopts a test giving effect to the plain text of Section 10(b) and Rule 10b-5, but going no further. One proposed test would be that: a person engages in a deceptive act as part of a scheme to defraud investors, and violates Section 10(b) and Rule 10b-5(a) and/or (c), if the purpose and effect of his conduct is to create a false appearance of material fact in furtherance of that scheme."
Addition: As predicted, the government did not file an amicus brief in support of the investor plaintiffs. Press coverage can be found in Bloomberg and the Washington Post.
Some interesting tidbits from around the web on the Stoneridge (a.k.a. Charter Communications) case on scheme liability set to be heard by the U.S. Supreme Court next term.
Whether, and on which side, the SEC will participate in the case has been a hot issue. SCOTUSblog reports that there are two dates to keep in mind: (1) amicus briefs urging the Supreme Court to hear a similar Enron-related case on scheme liability (maybe in tandem or consolidated with Stoneridge) are due on June 1; and (2) amicus briefs in support of the investor plaintiffs in Stoneridge are due on June 11.
Meanwhile, Point of Law speculates that Justice Alito may be the swing vote in the Stoneridge case. Justices Breyer and Roberts are recused because of stockholdings, leaving seven justices to consider the case.
There has been a fair amount of media and blog coverage of the oral argument in the Tellabs case. Here is a partial roundup:
Media - Articles can be found in the Washington Post, the Associated Press (here and here), and Bloomberg News.
Blogs - Commentary, with some predictions on the outcome of the case, can be found on the Wall Street Journal Law Blog, the Sixth Circuit Blog, and LawMemo.
Click here for the transcript.
Oral argument in the Tellabs v. Makor Issues & Rights case took place in the U.S. Supreme Court this morning (links to most of the briefs can be found here). The question presented was: "Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a 'strong inference' that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995."
All of the justices participated in the hearing. Argument was heard from Carter G. Phillips of Sidley Austin on behalf of petitioners Tellabs and Notebaert; Professor Arthur Miller of Harvard Law School on behalf of the respondent shareholders; and Assistant to the Solicitor General Kannon Shanmugam on behalf of the United States as an amicus in support of Tellabs.
Overall Impressions - Predicting how the Supreme Court will rule based on oral argument, especially where there are multiple possible approaches to the issue, is difficult. That said, the Court appeared likely to reject the Seventh Circuit's "reasonable person" standard as incompatible with the "strong inference" scienter pleading requirement. As noted by Justice Roberts and Justice Breyer, the "reasonable person" standard appears to allow for the possibility that the case will go forward even if the plaintiffs are only able to allege facts establishing a weak inference of scienter. There also appeared to be considerable support for the need to weigh competing inferences.
A few notes on the main issues discussed:
Is There A Seventh Amendment Violation? - Perhaps to the surprise of Tellabs' counsel, who had argued in his briefs that the Court did not have to reach this issue, the justices spent a fair amount of time discussing whether there needed to be uniformity between the pleading and proof standards for scienter. In their brief, the shareholders had argued that the heightened pleading standard for scienter improperly required a court to act as a fact-finder on the merits of the suit. Justice Scalia and Justice Breyer expressed skepticism over the idea that Congress could not create a heightened pleading standard, noting that there are lots of barriers to entry to federal courts (including diversity and amount in controversy requirements). Justice Breyer wondered whether there was really any difference between saying a plaintiff's case has to be "really strong" and saying that a plaintiff has to be "really suffering." That said, a number of justices (Justice Breyer most of all) seemed concerned that the "strong inference" pleading standard was higher than the "preponderance of the evidence" proof standard. Tellabs' counsel and government counsel both argued that if the Court wanted to address this question, it would need to reconsider the standard of proof, as opposed to watering down the PSLRA.
Can You Infer A CEO's Knowledge About Financial Issues Based On His Position? - Justice Kennedy appeared anxious to get an answer to this question, asking it of both parties. Tellabs' counsel responded that the CEO's title was insufficient; plaintiffs needed to provide particularized facts regarding the CEO's scienter. Shareholders' counsel, however, suggested that it was unlikely that a CEO would not know about important financial issues. Moreover, the confidential witnesses cited in the complaint confirmed the existence of scienter for Tellabs' CEO.
Competing Inferences - Justice Alito took center stage on the issue of how to evaluate competing inferences with the following analogy: if you see a person walking down the street toward the Supreme Court, this fact would create a strong inference that the person is going to the Supreme Court if it is the only building around. If there are a lot of other buildings, however, doesn't a court have to consider the inference that the person is going to another location? In response to this analogy and further prodding from Justice Ginsburg and Justice Souter, shareholders' counsel conceded that the court could consider other facts that were subject to judicial notice, but stopped short of agreeing that this constituted an evaluation of competing inferences.
How To Decide This Case - Justice Ginsburg noted that the phrase "strong inference" is not "self-defining" and other justices also appeared to struggle with its meaning. As to how to decide the case in front of them, Justice Scalia expressed a desire to provide lower courts with guidance on what is a "strong inference" of scienter and, during his rebuttal time, Tellabs' counsel urged the same course.
Prof. Miller v. Justice Scalia - By his own admission, Prof. Miller has a more "colloquial" argument style. That got him into some hot water with Justice Scalia, with whom he traded barbs. Justice Stevens asked Prof. Miller if he could translate the "strong inference" standard into a probability percentage. Justice Scalia quipped that he thought it was 66 2/3%, in response to which Prof. Miller asked if that was "because you never met a plaintiff you really liked?" Justice Scalia got his revenge a few minutes later when Prof. Miller stated "don't take me literally" on a certain comment and Justice Scalia replied that he would write that down. At that point, Justice Roberts called it a draw.
A transcript of the argument will be released later today. The 10b-5 Daily reserves the right to edit this post if it turns out that the transcript creates a "competing inference" as to the accuracy of the author's scribbled notes.
The U.S. Supreme Court has turned its gaze to securities litigation and does not appear to like the circuit splits it is seeing. This week features an unprecedented amount of Supreme Court activity on securities issues, with two arguments and a noteworthy grant of certiorari.
An early report on today's argument in the Credit Suisse case suggests that several justices were skeptical about applying antitrust law to the same allegations raised in the IPO allocation cases. Meanwhile, oral argument in the Tellabs case on scienter pleading is scheduled for tomorrow. Previews of the two cases can be found in the Wall Street Journal (subscrip. req'd), Bloomberg, and the Financial Times.
On Monday, the Supreme Court also granted cert in the Charter Communications case from the Eighth Circuit that addresses scheme liability. The timing could hardly have been better. As discussed in this recent post, the circuit split on the issue expanded just last week when the Fifth Circuit declined to grant class certification in the securities fraud case brought against Enron's banks.
The question presented in Charter Communications is: "Whether this Court’s decision in Central Bank [], forecloses claims for deceptive conduct under [Section 10(b) and Rule 10b-5] where Respondents engaged in transactions with a public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where Respondents themselves made no public statements concerning those transactions." Chief Justice Roberts and Justice Breyer will not participate in the case (probably because of stock ownership). The Associated Press has an article and Securities Litigation Watch has a post.
In two decisions issued last year, the Eighth Circuit and the Ninth Circuit split over the extent to which secondary actors (e.g., accountants, lawyers, or bankers) can be held primarily liable under Rules 10b-5(a) and (c) for deceptive devices, schemes, and acts. The Eighth Circuit limited the scope of potential liability, holding that "any defendant who does not make or affirmatively cause to be made a fraudulent misstatement or omission, or who does not directly engage in manipulative securities trading practices, is at most guilty of aiding and abetting and cannot be held liable under Sec. 10(b) or any subpart of Rule 10b-5." In contrast, the Ninth Circuit created a broader test, finding that "to be liable as a primary violator of Sec. 10(b) for participation in a 'scheme to defraud,' the defendant must have engaged in conduct that had the principal purpose and effect of creating a false appearance of fact in furtherance of the scheme." In a decision issued yesterday, the Fifth Circuit has sided squarely with the Eighth Circuit and limited the scope of liability.
In Regents of the Univ. of California., et al. v. Credit Suisse First Boston (USA), Inc., et al., 2007 WL 816518 (5th Cir. March 19, 2007), the issue presented was whether the district court had properly granted class certification for Rule 10b-5 claims brought against three banks that had entered into transactions with Enron. The "common feature of these transactions is that they allowed Enron to misstate its financial condition; there is no allegation that the banks were fiduciaries of the plaintiffs [Enron investors], that they improperly filed financial reports on Enron's behalf, or that they engaged in wash sales or other manipulative activities directly in the market for Enron securities." Nevertheless, the district court held that class certification was appropriate because a "deceptive act" included participation in a transaction whose principal purpose and effect was to create a false appearance of revenues. Because the banks had failed in their duty not to engage in a fraudulent scheme, the district court found that plaintiffs were "entitled to rely on the classwide presumption of reliance for omissions and fraud on the market." On appeal, the Fifth Circuit disagreed.
As an initial matter, the court found that it could address the district court's definition of "deceptive act" because it was the basis for the district court's determination that the plaintiffs were entitled to a presumption of reliance. Without that presumption, class certification would fail.
The court then turned to whether plaintiffs could properly rely on a presumption of reliance created by either the existence of actionable omissions or a fraud on the market. First, the court held that the banks had not made any actionable omissions because they "did not owe plaintiffs any duty to disclose the nature of the alleged transactions." Second, the court found that the district court's definition of "deceptive act" was "inconsistent with the Supreme Court's decision that Sec. 10 does not give rise to aiding and abetting liability." After examining relevant Supreme Court precedent, the court held that the Eighth Circuit's definition of "deceptive act" (i.e., conduct involving "either a misstatement or a failure to disclose by one who has a duty to disclose") was correct. In contrast, the banks' acts "at most aided and abetted Enron's deceit by making its misrepresentations more plausible." Finally, the court concluded that the transactions did not constitute market manipulation because the banks "did not act directly in the market for Enron securities." Because the banks' transactions with Enron were not deceptive acts and did not constitute market manipulation, there could be no fraud on the market presumption of reliance and class certification failed.
A few additional notes on the panel's decision:
(1) There is a "concurrence" that, in fact, is a vigorous dissent from the primary legal holdings in the majority opinion. In particular, the concurring judge found that the majority had overreached in deciding the substantive scope of Rule 10b-5 on an appeal from class certification and that its definition of "deceptive act" was too narrow.
(2) There has been a significant amount of commentary on the decision already. For an internet roundup, see this Point of Law post.
(3) One obvious question is whether this ruling will have any effect on the previous bank settlements in the Enron securities litigation totaling over $7 billion. According to a Wall Street Journal article in today's edition, the answer is "no," because the settlements are already final.
Quote of note (opinion): "We recognize, however, that our ruling on legal merit may not coincide, particularly in the minds of aggrieved former Enron shareholders who have lost billions of dollars in a fraud they allege was aided and abetted by the defendants at bar, with notions of justice and fair play. We acknowledge that the courts' interpretation of § 10(b) could have gone in a different direction and might have established liability for the actions the banks are alleged to have undertaken. Indeed, one of our sister circuits - the Ninth - believes that it did. We have applied the Supreme Court's guidance in ascribing a limited interpretation to the words of § 10, viewing the statute as the result of Congress's balancing of competing desires to provide for some remedy for securities fraud without opening the floodgates for nearly unlimited and frequently unpredictable liability for secondary actors in the securities markets."
The briefing is complete in Tellabs, Inc. v. Makor Issues & Rights, Ltd., the scienter pleading case currently before the U.S. Supreme Court. The extensive list of amicus briefs can be found on the court docket. The briefs available via public link include:
Petitioners (Tellabs, Inc. and Richard Notebaert)
Respondents (Makor Issue & Rights, Ltd., et al.)
Securities Industry and Financial Markets Association and Chamber of Commerce of the United States of America (Amicus/Petitioners)
American Institute of Certified Public Accountants, et al. (Amicus/Petitioners)
Washington Legal Foundation (Amicus/Petitioners)
SEC and DOJ (Amicus/Petitioners)
North American Securities Administrators Association (Amicus/Respondents)
Ohio and 23 Other States, Territories and Commonwealths (Amicus/Respondents)
Council of Institutional Investors (Amicus/Respondents)
National Conference on Public Employee Retirement Systems and National Association of Shareholder and Consumer Attorneys (Amicus/Respondents)
Arkansas, Seven Other States, and Two Public Pension Funds (Amicus/Respondents)
Oral argument is set for March 28, 2007. The question presented is: "Whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint asserting a claim of securities fraud has alleged facts sufficient to establish a 'strong inference' that the defendant acted with scienter, as required under the Private Securities Litigation Reform Act of 1995."
Readers are encouraged to send in public links to any Tellabs briefs not listed here.
Addition: Thanks to Adam Savett for links to the Petitioners' brief and a few of the amicus briefs (added above).
The U.S. Court of Appeals for the Fourth Circuit has issued a decision that addresses two pressing securities litigation issues. In Teachers' Retirement System of Louisiana v. Hunter, 2007 WL 509787 (4th Cir. Feb. 20, 2007), the court considered: (a) whether the plaintiffs could establish the scienter of the corporate defendant using a collective scienter theory; and (b) what is the proper pleading standard for loss causation. (For a discussion of the lower court decision, see this post.)
Collective scienter - The court rejected the idea that a corporate defendant's scienter can be established based on the collective knowledge of its employees. Specifically, the court held that "if the defendant is a corporation, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation, since corporate liability derives from the actions of its agents." Although the court did not expressly determine whether the agent also must be alleged to have made a misstatement, the court's citation to the Southland decision (5th Cir.) offers some support for that interpretation.
Loss causation - The court noted that in Dura the U.S. Supreme Court expressly did not decide whether the pleading of loss causation is governed by Fed. R. Civ. P. 9(b). In examining the issue, the court found that a "strong case can be made that because loss causation is among the 'circumstances constituting fraud' for which Rule 9(b) demands particularity, loss causation should be pleaded with particularity." Based on this observation and the public policy concerns outlined in Dura, the court concluded that loss causation must be plead "with sufficient specificity to enable the court to evaluate whether the necessary causal link exists." In the instant case, the court found that the plaintiffs did not adequately plead loss causation. Although the disclosure that caused the stock price decline accused the corporate defendant of fraud, it did not provide any "new facts" that "revealed [the corporate defendant's] previous representations to have been fraudulent."
Holding: Dismissal affirmed (based on the failure to adequately plead falsity, scienter, and loss causation).
Disclosure: The author of The 10b-5 Daily represented the defendants in this litigation.
A recent decision by the U.S. Court of Appeals for the Second Circuit offers some interesting clarifications on the scope of accountant liability for securities fraud. In Lattanzio v. Deloitte & Touche LLP, 2007 WL 259877 (2d Cir. Jan. 31, 2007), the court addressed whether Deloitte could be held liable for statements in audited and unaudited financial filings.
As to the company's unaudited financial filings, the court found that Deloitte's regulatory obligation to review the company's quarterly statements did not turn those statements into accountant's statements. Even if the public understood that Deloitte was engaging in these reviews, the accountant's "assurances were never communicated to the public." The court also rejected plaintiffs' argument that the reviews created a duty to correct the quarterly financial statements if false and that a breach of this duty amounted to a misstatement by Deloitte. The court noted that there is a distinct difference between the duties and liabilities created by a review of interim financial statements and those created by an audit of annual financials.
As to the company's audited financial filings, the court dismissed the relevant claims based on a failure to adequately plead loss causation. The court held that the "plaintiffs had to allege that Deloitte's misstatements [in the company's annual reports concerning accounts payable and inventories] concealed the risk of [the company's] bankruptcy." Given that Deloitte had issued a going concern warning - along with the disclosed (if understated) collapse in the company's value - the risk of bankruptcy was apparent. Accordingly, the court found that the plaintiffs had not alleged facts showing that Deloitte's misstatements were the "proximate cause of plaintiffs' loss; nor have they alleged facts that would allow a factfinder to ascribe some rough proportion of the whole loss to Deloitte's misstatements."
Holding: Dismissal affirmed.
Quote of note: "Public understanding that an accountant is at work behind the scenes does not create an exception to the requirement that an actionable misstatement be made by the accountant. Unless the public's understanding is based on the accountant's articulated statement, the source for that understanding - whether it be a regulation, an accounting practice, or something else - does not matter."
Addition: Retired Supreme Court Justice Sandra Day O'Connor sat on the panel.
The U.S. Supreme Court's decision to hear a case on the pleading standards for scienter (i.e., fraudulent intent) has received little media attention . . . until today. The New York Times has an article on the SEC's recent activities related to private securities litigation, including the agency's decision to file an amicus brief in the Tellabs case in support of the defendants.
In their brief, the SEC/DOJ rejected the "reasonable person" test applied by the U.S. Court of Appeals for the Seventh Circuit in evaluating whether the "strong inference" of scienter pleading standard was met (see this post under "Competing Inferences"). Instead, "a court should determine whether, taking the alleged facts as true, there is a high likelihood that the conclusion that the defendant possessed scienter follows from those facts." If the same facts both support and negate an inference of scienter, "the court should consider the relative strength of both inferences, because, where there is a substantial possibility that the defendant acted without scienter, the inference of scienter will not be 'strong.'"
Quote of note (New York Times): "Critics said that the moves signaled a major retrenchment from the post-Enron changes and showed that a lobbying push by big companies, Wall Street firms and the accounting industry was gaining traction as they seek to roll back what they see as onerous regulation and excessive investor litigation. But Christopher Cox, the chairman of the commission, said in an interview Monday that both efforts were in the best interests of investors because they aimed at preventing the accounting industry from further consolidation and at limiting what he called 'fraudulent lawsuits,' including some he said were filed by 'professional plaintiffs.'"
After eleven years, the PSLRA's scienter pleading standard finally will be addressed by the U.S. Supreme Court. On Friday, the court granted certiorari in Tellabs, Inc. v. Makor Issues & Rights, Ltd. on appeal from the U.S. Court of Appeals for the Seventh Circuit. (The 10b-5 Daily's summary of the lower court decision can be found here.)
The question presented on appeal is whether, and to what extent, a court must consider or weigh competing inferences in determining whether a complaint has alleged sufficient facts to establish a strong inference of scienter. The Seventh Circuit held that the plaintiff was entitled to more than the most plausible of competing inferences. Instead, a court should "allow the 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 their cert petition (via SCOTUSblog), defendants argued that this is the most lenient of the "four meaningfully different interpretations of the strong inference standard" that have been adopted by federal circuit courts and urged the Supreme Court to resolve the circuit split.
Links to the various cert petition briefs can be found on SCOTUSblog, which also notes that the Supreme Court has ordered expedited briefing in the case and may be planning to hear it during the March 2007 session. Thanks to Greg Harris for the tip.
In an opinion issued in the IPO allocation cases, the Second Circuit has held that in evaluating a motion for class certification under Federal Rule of Civil Procedure 23, district judges must receive and re