Judicial Gatekeeping: The Pleading Standard, Materiality, and Class Certification
Tellabs, Inc. v. Makor Issues & Rights, Ltd. interprets the PSLRA’s “strong inference” standard for pleading scienter—the defendants’ state of mind—in Rule 10b-5 cases. After the enactment of the PSLRA, the circuits diverged in applying the strong inference standard. The Second Circuit relied on the legislative history and held that the PSLRA codified its pre-PSLRA pleading approach based on motive and opportunity and on recklessness. The Ninth Circuit also relied on the PSLRA’s legislative history, but concluded that the statute raised the standard above that of the Second Circuit. Under the higher Ninth Circuit pleading standard, plaintiffs had to plead, “at a minimum, particular facts giving rise to a strong inference of deliberate or conscious recklessness.” Most circuits, however, took a middle course, concluding that motive and opportunity allegations might suffice to support a strong inference of scienter, but courts would need to evaluate such allegations on a “case-by-case” basis.
When the Supreme Court finally entered the fray in Tellabs over the interpretation of the strong inference standard, it did not resolve this long-standing split among the circuits over the application of the standard, which most observers had been expecting. Instead, it addressed a collateral, but related, issue on which the circuits also had split: in considering whether the facts alleged by the plaintiff meet the strong inference standard, how should courts assess the different possible inferences that might be drawn from the allegations in the complaint with respect to scienter? In particular, should a court consider competing inferences arising from those facts?
Prior to the Supreme Court’s Tellabs opinion, the circuit courts split into three groups in assessing competing inferences. The First, Fourth, Sixth, and Ninth Circuits adopted a “preponderance” standard. The preponderance standard requires the inference that the defendants had the requisite scienter be the most plausible when compared with competing inferences that the defendants did not have scienter. Combined with the Ninth Circuit’s higher deliberate or conscious recklessness scienter standard, this standard made it easier for defendants to obtain dismissal in the Ninth Circuit. The Second, Eighth, Tenth, and Eleventh Circuits required that the inference that the defendants acted with the requisite scienter be at least equally plausible with competing inferences. Finally, the Third and Seventh Circuits followed the most plaintiff-friendly approach, adopting the “reasonableness” standard that did not require any assessment of competing inferences, looking only at the plausibility of the plaintiff’s allegations. Under the Seventh Circuit’s reasonableness standard as set forth in Makor Issues & Rights, Ltd. v. Tellabs, Inc. (the lower court opinion before the Supreme Court in Tellabs), a complaint should survive “if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with the required intent.”
The Seventh Circuit standard faced an uphill fight in the Supreme Court. The government’s Tellabs amicus brief argues that the Seventh Circuit’s reasonableness standard would have made Congress’s effort in enacting the strong inference standard toothless, as it would mean reverting to pre-PSLRA standards under Rule 9(b) of the Federal Rules of Civil Procedure.
The government’s brief is notable in that it sides with the defendants, an unusual occurrence in its amicus practice. The SEC has historically sided with the plaintiffs’ bar, and even minor deviations from that role bring a firestorm of criticism from the plaintiffs’ bar and its allies. The SEC’s support for the plaintiffs’ bar in part reflects its own institutional interests. The agency favors broad interpretations of its governing statutes; a narrow interpretation of § 10(b) could reduce the SEC’s enforcement discretion. The agency commonly sides with the plaintiffs’ bar, however, even on issues that relate purely to the terms of the implied Rule 10b-5 cause of action. So here the Court faced the unusual scenario of the government siding with the defendants.
The Court was unmoved by this unusual alignment. Ginsberg characterized her role as framing “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" Having framed the inquiry in this way, naturally Ginsberg settled on the intermediate position. She rejected the reasonableness standard adopted by the lower court, instead requiring a comparative inquiry: “A complaint will survive, we hold, 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" That conclusion was compelled by Congress’s use of the word strong. According to Ginsberg, “The strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative: How likely is it that one conclusion, as compared to others, follows from the underlying facts?” At a minimum, therefore, the Court felt compelled to choose the intermediate “equal inference” standard, rejecting “reasonableness.” Ties go to the plaintiff, but the plaintiff must show that the fraudulent inference is at least as likely as an innocent one.
The Court rejected the “preponderance” standard favored by the defendants and the government, which won the support ofJustices Scalia and Alito in their concurrences. Scalia gets points for his colorful illustration of his disagreement with Ginsberg:
If a jade falcon were stolen from a room to which only A and B had access, could it possibly be said there was a “strong inference” that B was the thief? I think not, and I therefore think that the Court’s test must fail. In my view, the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence.
This provoked the predictable exchange between Scalia and Ginsberg over the analogy, and more fundamentally, the “meaning” of the word strong. Scalia also engaged in a familiar debate with both the majority and Stevens (who dissented) over the appropriate approach to statutory interpretation generally, complete with the standard Scalia complaint about the use of legislative his- tory. Scalia was particularly provoked by Stevens’s freewheeling approach to statutory interpretation. For Scalia, such discretion is “conferred upon administrative agencies, which need not adopt what courts would consider the interpretation most faithful to the text of the statute, but may choose some other interpretation, so long as it is within the bounds of the reasonable.” Courts “must apply judgment, to be sure. But judgment is not discretion.”
Stevens shot back that “[t]he meaning of a statute can only be determined on a case-by-case basis and will, in each case, turn differently on the clarity of the statutory language, its context, and the intent of its drafters.” Stevens preferred a “probable cause” standard because “it is a concept that is familiar to judges” and “[a]s a matter of normal English usage, its meaning is roughly the same as ‘strong inference.’ ” It is unclear who normally uses “probable cause” at all, other than criminal defense lawyers and prosecutors. Stevens, however, made no pretense: Congress intended “probable cause” in adopting the “strong inference” phrasing. Suffice it to say, none of the participants in this intramural debate persuaded the others.
In fairness to the justices, it is not altogether clear that much of anything was at stake once the implausible “reasonableness” standard was rejected. Is there much difference between the equal inference and preponderance standards? In theory, the two differ only when the competing inferences are tied. The equal inference standard awards ties to the plaintiffs, leading to a rejection of the defendants’ motion to dismiss on scienter grounds; the preponderance standard awards ties to the defendants, leading to a dismissal. As Justice Scalia noted in his concurrence, the difference between the equal inference and preponderance standards is likely to be determinative in only a small fraction of cases: “How often is it that inferences are precisely in equipoise?”
Given the limited change to the law effected by Tellabs in most circuits, would it make any difference to outcomes? It turns out that it does. Steve Choi and I, in a study comparing motions to dismiss based on the pleading standard before and after Tellabs, found that dismissals declined sharply in the Ninth Circuit after Tellabs, and that the incidence of nuisance settlements climbed in that circuit. The justices were debating amongst themselves the proper approach to statutory interpretation; their somewhat theoretical debate had real consequences for litigants. That observation, however, is one made only in hindsight.
-  551 U.S. 308 (2007).
-  Exchange Act § 21D(b)(2).
-  Novak v. Kasaks, 216 F.3d 300, 311 (2000).
-  See In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 974 (9th Cir. 1999).
-  Id.
-  Greebel v. FTP Software, Inc., 194 F.3d 185 (1st Cir. 1999); Ottman v. Hanger OrthopedicGroup, Inc., 353 F.3d 338 (4th Cir. 2003); Nathenson v. Zonagen, Inc., 267 F.3d 400 (5th Cir. 2001);In re Comshare, Inc. Sec. Litig., 183 F.3d 542 (6th Cir. 1999); Makor Issues & Rights, Ltd. v. Tellabs,Inc., 437 F.3d 588 (7th Cir. 2006); Fla. State Bd. of Admin v. GreenTree Fin. Corp., 270 F.3d 645(8th Cir. 2001); In re Silicon Graphics, 183 F.3d 970 (9th Cir. 1999); City of Philadelphia v. FlemingCos., 264 F.3d 1245 (10th Cir. 2001); Bryant v. Avado Brands, Inc., 187 F.3d 1271 (11th Cir. 1999). The choice of scienter standard has important consequences: the Ninth Circuit, in adopting themost stringent standard post-PSLRA., also substantially increased its dismissal rate. An earlier studyfound that Ninth Circuit courts dismissed cases at a 63 percent rate, while Second Circuit courtsdismissed only 36 percent. See A. C. Pritchard & Hillary Sale, What Counts as Fraud? An EmpiricalStudy of Motions to Dismiss under the Private Securities Litigation Reform Act, 2 J. Empirical LegalStud. 125 (2005).
-  In re Credit Suiss First Boston Corp., 431 F.3d 36 (1st Cir. 2005); Ottman v. HangerOrthopedic Group, Inc., 353 F.3d 338 (4th Cir. 2003); Helwig v. Vencor, Inc., 251 F.3d 540 (6th Cir.2001); Gompper v. VISX, Inc., 298 F.3d 893 (9th Cir. 2002).
-  Acito v. IMCERA Group, Inc., 47 F.3d 47 (2d Cir. 1995); Rosenzweig v. Azurix Corp., 332F.3d 854 (5th Cir. 2003); Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645 (8th Cir.2001); Pirraglia v. Novell, Inc., 339 F.3d 1182 (10th Cir. 2003); Garfield v. NDC Health Corp., 466F.3d 1255 (11th Cir. 2006).
-  In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256 (3rd Cir. 2006).
-  437 F.3d 588 (7th Cir. 2006).
-  Brief for the United States as Amicus Curiae Supporting Petitioners, Tellabs, Inc. v. MakorIssues & Rights, Ltd., 551 U.S. 308 (2007) (No. 06-484), 2007 WL 460606, at *23 (arguing that “thecourt of appeals’ standard appears to be equivalent to the standard that it (and some other courts ofappeals) had applied before the enactment of the Reform Act, under which a complaint was sufficientif the plaintiff pleaded facts that supported at least a reasonable inference of state of mind”).
-  See id. at *26 (arguing that “if the alleged facts give rise to two seemingly equally strong competing inferences, a court must conclude that the inference of scienter is not itself strong”) (citationsand quotation marks omitted).
-  See Pritchard, supra note 2, at 923 (quoting Lewis Powell complaining that “SEC usually favorsall п. I can’t recall a case in which this was not so”).
-  See, e.g., Stephen Labaton, S.E.C. Seeks to Curtail Investor Suits, N.Y. Times, February 13, 2007,at C1; Stephen Labaton, Is the S.E.C. Changing Course?, N.Y. Times, March 1, 2007, at C1. Labaton isthe son of a prominent plaintiffs’ lawyer, Ed Labaton.
-  Tellabs, 551 U.S. at 322.
-  Id. at 324.
-  Id. at 323.
-  Id. at 329 (Scalia, J., concurring); Id. at 331 (Alito, J., concurring).
-  Id.
-  Id. at 331-32 (Scalia, J., concurring).
-  Id. at 329 (Scalia, J., concurring) (“Even if I agreed with the Court’s interpretation of ‘strong inference,’ I would not join the Court’s opinion because of its frequent indulgence in the last remaininglegal fiction of the West: that the report of a single committee of a single House expresses the will ofCongress.”).
-  Id. at 332 (Scalia, J., concurring).
-  Id.
-  Id. at 335, 336 n.1 (Stevens, J., dissenting).
-  Id. at 336 (Stevens, J., dissenting).
-  Id. at 331 (Scalia, J., concurring).
-  See Stephen J. Choi & A. C. Pritchard, The Supreme Court's Impact on Securities Class Actions: AnEmpirical Assessment of Tellabs, 28 J. L., EcoN., & Org. 850 (2012).