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Supreme Court deals blow to securities class actions, 8-1
By Roger Parloff
Thursday, June 21, 2007

By a resounding 8-1 margin, the Supreme Court dealt a blow to securities class action plaintiffs this morning by, in effect, requiring that they be able to show fairly convincing evidence of fraud before they can even initiate a lawsuit.  The opinion was authored by the relatively liberal Justice Ruth Bader Ginsburg, and the only dissenter was Justice John Paul Stevens.

The much anticipated case, Tellabs v. Makor Issues and Rights, involves a crucial issue that arises in virtually every class action securities fraud case:  how strong a case of fraud must the plaintiffs allege in their initial complaint to avoid having the case get immediately thrown out. In an effort to weed out frivolous securities class actions early, Congress enacted legislation in 1995 (the Private Securities Litigation Reform Act) that began requiring plaintiffs to allege specific facts creating a “strong inference” that the defendant company and officials acted with fraudulent intent.  But Congress did not further define that phrase at the time and the Supreme Court had never addressed the issue until now.

“To qualify as ’strong,’” Ginsburg wrote, “an inference of [knowing wrongdoing] must be ‘more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference’ of a lack of intent to defraud.”

She continued: “A complaint will survive, we hold, only if a reasonable person would deem the inference of [wrongful intent] … at least as compelling as any opposing inference one could draw from the facts alleged.”  This language appears to require a stronger showing from the plaintiffs than has been required of them previously by most federal appeals courts to date.

“The opinion gives defendants about 90% of what they could reasonably have hoped for in terms of the standard for pleading fraudulent intent,” says Meir Feder, who heads the appellate unit of Jones Day’s New York office.  “This standard will help companies and their officers and directors defeat lawsuits before having to undergo expensive and time-consuming discovery — and it will be a particular obstacle to the type of lawsuit that seems to get filed reflexively, without much real evidence of fraud, as soon as a company announces some bad news that makes its stock drop.”

“The 10% that defendants didn’t get here,” Feder continues, “is that they didn’t get a ruling that fraud has to be a more likely inference than a non-fraud explanation of what happened.”  In separate concurring opinions, Justices Antonin Scalia and Samuel Alito said they would have given defendants that, too. Scalia (memorably) wrote:  “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.”

Because Scalia’s and Alito’s more draconian views were rejected, plaintiffs class action lawyer Sean Coffey, of Bernstein Litowitz Berger & Grossmann, says he’s relieved about the ruling.  “It’s not bad,” he says.  “I’m pleasantly surprised.”  He says that “now in the event of a tie, the plaintiff wins.  There’s a lot for investors to be relieved about, and maybe even pleased about.”

The ruling reverses that of the federal appeals court in Chicago, which had allowed the case to go forward, but will not necessarily result in dismissal of the case either. Instead, the case will go back to the district court, in Chicago, for reconsideration in light of the standard articulated today.

In dissent, Justice Stevens would have required plaintiffs to meet only a lower “probable cause” standard, like the one used for criminal arrests or indictments.  “It is most unlikely that Congress intended us to adopt a standard that makes it more difficult to commence a civil case than a criminal case.”

The definition of “strong inference” is so important, because it tests what plaintiffs lawyers must allege even before the discovery process has begun — i.e., the process whereby plaintiffs can force the company to produce documents and let their officers be examined under oath.  If a case can be dismissed at that initial stage, defendant companies can avoid a discovery process that will cost millions of dollars and likely last two years or longer.  If, on the other hand, a case gets past the defendants’ initial motion to dismiss, and does enter that discovery process, the defendants are much more likely to settle, in order to avoid those litigation costs, regardless of the ultimate merits of plaintiffs claims.

“To cut through the legal gobbledy-gook,” says Feder, “this is really the number one issue on which securities class actions can get dismissed at the threshold of litigation.”

Plaintiffs lawyers have also considered the Tellabs case crucial.  In their opening brief to the Supreme Court the plaintiffs (represented by lead counsel Richard Weiss of Milberg Weiss & Bershad and Harvard Law School professor Arthur Miller) wrote:  “Like sharks scenting blood in the water, an array of corporate interests has mobilized in an attempt to administer a coup de grace to private securities enforcement by convincing this Court to raise the pleading standard to unprecedented heights.”

The case arose from the sudden collapse of the telecommunications industry in 2000-2001.  Tellabs (TLAB) makes optical networking equipment that is sold to telecommunications carriers and Internet service providers.  As late as December 2000 its then CEO, Richard Notebaert, was still projecting 30% earnings growth for his company for the following year.  (Notebaert, now CEO of Qwest (Q), is often given credit for having helped pulled Qwest out of the accounting scandal in which it was mired when he arrived in 2002.)  In March and April 2001 Notebaert twice adjusted Tellabs’s earnings estimates downward, and finally in June 2001 he withdrew all guidance, acknowledging that the market had radically changed for the worse from what it had been the previous year.  The plaintiff investors were alleging that Notebaert had known his optimistic projections were misleading at the time he delivered them.  But neither Notebaert or any other Tellabs official was accused of insider training or of having otherwise benefited from the alleged misstatements.

The case is the latest in a series of setbacks that class action plaintiffs in business related cases have been dealt by the High Court.  On Monday, in Credit Suisse Securities v. Billing, the court threw out (by a 7-1 vote) an antitrust challenge brought against the way investment banks handled initial public offerings during the dot-com boom and in May, in Bell Atlantic v. Twombley, it raised the pleading standards required to bring an antitrust case based upon a conspiracy theory.  Last term, in Merrill Lynch v. Dabit, it also stanched plaintiffs’ attempts to circumvent the strictures of the 1995 securities class action reform law by filing certain cases in state court.

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