February 23, 2009
2008 Scienter Decisions After Tellabs
Holland & Knight Bulletin
Many commentators thought the 2007 decision by the U.S. Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499, 2510 (2007) added a powerful arrow to the defense quiver. In that case, the Supreme Court held that a complaint would 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 scienter decisions in 2008, however, suggest that the Tellabs analysis could be more boomerang than arrow for the defense bar as it has forced plaintiffs to come up with more creative, and often successful, theories of pleading scienter.
For example, several circuits last year – relying on statements in Tellabs – adopted the “collective scienter” theory and its closely-related cousin, the “core operations” doctrine, to keep corporate defendants in past a motion to dismiss in securities fraud suits. Previously, defendants argued that to allege scienter against a corporation, the plaintiffs must show a strong inference of scienter to an individual executive defendant who made the material misstatement or omission. Courts applying these, however, have kept corporations in actions while dismissing all the individual defendants if plaintiffs allege specific facts showing that some unnamed person(s) within the corporation knew the truth that was at odds with the company’s public statements. See Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008) (Tellabs II) (On remand from the United States Supreme Court, Judge Posner in Tellabs II gave the example that if GM announced it had sold one million SUVs when the actual number was zero, there would be a strong inference of scienter as to GM even if plaintiffs could not allege facts that showed the individual defendants knew the falsity); Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195 (2d Cir. 2008) (adopting collective scienter doctrine but finding that the allegations against the corporation were too conclusory to pass muster under Tellabs); South Ferry LP, #2 v. Killinger, 542 F.3d 776 (9th Cir. 2008).
While the Second, Seventh and Ninth circuits have relaxed the standards for pleading scienter as to corporations, the Fifth and Eleventh Circuits have not. In Mizzaro, the Eleventh Circuit held that a corporation’s state of mind is determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement” rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment. Mizzaro v. Home Depot, Inc., 544 F.3d 1230, 1255 (11th Cir. 2008).
Another aspect of scienter that received attention in 2008 was whether 10b5-1 trading plans created an inference for or against fraudulent intent. Insider trading remains one of the significant factors courts will put on the scienter scale. Courts still require trades to be unusual in timing or scope before placing trades on the side favoring scienter. Some courts have found trades pursuant to 10b5-1 plans caused the scale to tip to the non-scienter side. In re IAC/InterActiveCorp Sec. Litig., 478 F. Supp. 2d 574, 605 (S.D.N.Y. 2007) (quoting Wietschner v. Monterey Pasta Co., 294 F. Supp. 2d 1102, 1117 (N.D. Cal. 2003)) (a 10b5-1 trading plan “could raise an inference that the sales were pre-scheduled and not suspicious.”). However, courts are casting a critical eye at such plans particularly where the plans have been frequently amended with exquisite timing. For example, the court found that Countrywide’s CEO’s frequent and timely amendments to his 10b5-1 plans actually supported rather than negated an inference of scienter. In re Countrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132 (C.D. Cal. 2008).
Some courts have read Tellabs as discouraging reliance on unnamed confidential witnesses – oftentimes the primary source that plaintiffs’ counsel relies on to attempt to allege scienter. For example, the Seventh Circuit found that it was hard to see how information from unnamed sources could meet the “compelling” standard of Tellabs. The court speculated that the witnesses could have axes to grind, were lying or perhaps did not even exist. Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753 (7th Cir. 2007). The Eleventh Circuit has been equally critical of confidential witnesses but stopped short of instructing courts not to rely on unnamed sources, particularly if they are adequately described by position and time so that it is reasonable to infer they know what they are alleged to have said. Mizzaro, 544 F.3d at 1247.
In summary, while Tellabs set forth what many viewed as a stricter standard for pleading scienter, the cases applying the standard have not necessarily provided the expected results for the defendants. Expanding notions of collective scienter and imputed knowledge of core operations have kept companies in actions past the motion to dismiss stage and Rule 10b5-1 plans have not proven to be a bullet-proof scienter defense.
For example, several circuits last year – relying on statements in Tellabs – adopted the “collective scienter” theory and its closely-related cousin, the “core operations” doctrine, to keep corporate defendants in past a motion to dismiss in securities fraud suits. Previously, defendants argued that to allege scienter against a corporation, the plaintiffs must show a strong inference of scienter to an individual executive defendant who made the material misstatement or omission. Courts applying these, however, have kept corporations in actions while dismissing all the individual defendants if plaintiffs allege specific facts showing that some unnamed person(s) within the corporation knew the truth that was at odds with the company’s public statements. See Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008) (Tellabs II) (On remand from the United States Supreme Court, Judge Posner in Tellabs II gave the example that if GM announced it had sold one million SUVs when the actual number was zero, there would be a strong inference of scienter as to GM even if plaintiffs could not allege facts that showed the individual defendants knew the falsity); Teamsters Local 445 Freight Div. Pension Fund v. Dynex Capital, Inc., 531 F.3d 190, 195 (2d Cir. 2008) (adopting collective scienter doctrine but finding that the allegations against the corporation were too conclusory to pass muster under Tellabs); South Ferry LP, #2 v. Killinger, 542 F.3d 776 (9th Cir. 2008).
While the Second, Seventh and Ninth circuits have relaxed the standards for pleading scienter as to corporations, the Fifth and Eleventh Circuits have not. In Mizzaro, the Eleventh Circuit held that a corporation’s state of mind is determined by looking “to the state of mind of the individual corporate official or officials who make or issue the statement” rather than generally to the collective knowledge of all the corporation’s officers and employees acquired in the course of their employment. Mizzaro v. Home Depot, Inc., 544 F.3d 1230, 1255 (11th Cir. 2008).
Another aspect of scienter that received attention in 2008 was whether 10b5-1 trading plans created an inference for or against fraudulent intent. Insider trading remains one of the significant factors courts will put on the scienter scale. Courts still require trades to be unusual in timing or scope before placing trades on the side favoring scienter. Some courts have found trades pursuant to 10b5-1 plans caused the scale to tip to the non-scienter side. In re IAC/InterActiveCorp Sec. Litig., 478 F. Supp. 2d 574, 605 (S.D.N.Y. 2007) (quoting Wietschner v. Monterey Pasta Co., 294 F. Supp. 2d 1102, 1117 (N.D. Cal. 2003)) (a 10b5-1 trading plan “could raise an inference that the sales were pre-scheduled and not suspicious.”). However, courts are casting a critical eye at such plans particularly where the plans have been frequently amended with exquisite timing. For example, the court found that Countrywide’s CEO’s frequent and timely amendments to his 10b5-1 plans actually supported rather than negated an inference of scienter. In re Countrywide Fin. Corp. Sec. Litig., 588 F. Supp. 2d 1132 (C.D. Cal. 2008).
Some courts have read Tellabs as discouraging reliance on unnamed confidential witnesses – oftentimes the primary source that plaintiffs’ counsel relies on to attempt to allege scienter. For example, the Seventh Circuit found that it was hard to see how information from unnamed sources could meet the “compelling” standard of Tellabs. The court speculated that the witnesses could have axes to grind, were lying or perhaps did not even exist. Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753 (7th Cir. 2007). The Eleventh Circuit has been equally critical of confidential witnesses but stopped short of instructing courts not to rely on unnamed sources, particularly if they are adequately described by position and time so that it is reasonable to infer they know what they are alleged to have said. Mizzaro, 544 F.3d at 1247.
In summary, while Tellabs set forth what many viewed as a stricter standard for pleading scienter, the cases applying the standard have not necessarily provided the expected results for the defendants. Expanding notions of collective scienter and imputed knowledge of core operations have kept companies in actions past the motion to dismiss stage and Rule 10b5-1 plans have not proven to be a bullet-proof scienter defense.