Supreme Court Endorses Strict Standard for Securities Fraud Actions

The requirement that investors in a private securities fraud action state facts that the defendants acted with a strong inference of scienter means that the fraud claim will survive only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. This was the US Supreme Court’s ruling on a provision of the Private Securities Litigation Reform Act providing that plaintiffs must .state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. (Tellabs, Inc. v. Makor Issues & Rights, Ltd., Dkt. No. 06-484)

Importantly, the allegations must also be considered collectively. A federal judge must not scrutinize each allegation in isolation, said the Court, but must assess all the allegations ``holistically.’’ In sum, the reviewing court must ask the question of when the allegations are accepted as true and taken collectively would a reasonable person deem the inference of scienter at least as strong as any opposing inference.

In an opinion written by Justice Ginsburg, the Court crafted what it called a ``workable construction’’ of the strong inference standard that is designed to achieve the PSLRA’s goal of curbing frivolous, lawyer-driven litigation, while preserving the ability of investors to recover on meritorious claims. Justices Scalia and Alito filed opinions concurring in the judgment; and Justice Stevens filed a dissenting opinion.

Congress included exacting pleading requirements among the control measures in the reform act. The Act requires plaintiffs to state with particularity both the facts constituting the alleged violation, and the facts evidencing scienter, which is an intent to defraud. But Congress left undefined the key term strong inference, noted the Court, and the federal courts of appeals have divided on its meaning.

In this case, the Seventh Circuit Court of Appeals held that the strong inference standard would be met if the complaint alleged facts from which, if true, a reasonable person could infer that the defendant acted with the required intent. Rejecting that formulation, the Supreme Court said that it does not capture the stricter demand Congress sought to convey in the PSLRA. It does not suffice that a reasonable fact finder plausibly could infer from the allegations the requisite state of mind. Rather, to determine whether scienter allegations can survive a threshold inspection for sufficiency, instructed Justice Ginsburg, a court must engage in a comparative evaluation and consider, not only inferences urged by the plaintiff, but also competing inferences rationally drawn from the facts alleged.

An inference of fraudulent intent may be plausible, yet less cogent than other, nonculpable explanations for the defendant’s conduct. To qualify as strong, reasoned the Court, 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 non-fraudulent intent.

Further, the judicial inquiry must be into 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. Moreover, in determining whether the stated facts give rise to a strong inference of scienter, a federal judge must take into account plausible opposing inferences. The Seventh Circuit expressly declined to engage in such a comparative inquiry.

The Court also noted that the strength of an inference cannot be decided in a vacuum. The inquiry is inherently comparative and centers on how likely it is that one conclusion, as compared to others, follows from the underlying facts. To determine whether the alleged facts give rise to a strong inference. of scienter, a court must consider plausible non-culpable 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, said the Court, that is it need not be of the ``smoking-gun genre,’’ or even the .most plausible of competing inferences. That said, however, the inference of scienter must be more than merely .reasonable or permissible. It must be cogent and compelling, thus strong in light of other explanations.


Finally, the Court dismissed as undue the Seventh Circuit’s concerns, raised on its own initiative, that the standard being adopted would usurp the jury’s role. In the Court’s view, mandating a comparative assessment of plausible inferences, while constantly assuming the allegations to be true, does not impinge on the Seventh Amendment right to a jury trial. As the creator of federal statutory claims, reasoned the Court, Congress has the power to prescribe what must be pleaded to state the claim. More specifically, Congress has the prerogative to allow, disallow, or shape the contours of securities fraud actions, including the pleading and proof requirements.

On this issue, the Court also emphasized that its construction of the strong inference standard does not force investors to plead more than they would be required to prove at trial. A plaintiff alleging fraud in a securities fraud action must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference.