The US Supreme Court recently took up two important issues in the area of securities litigation. In June, the court decided Tellabs v Makor Issues & Rights (2007), elaborating on the standard plaintiffs must satisfy to plead scienter in a securities fraud claim under Section 10(b) of the Securities Exchange Act.
In October, the court heard argument in Stoneridge Investment v Scientific-Atlanta (2007) that presents questions about how far Section 10(b)’s ban on ‘deceptive’ conduct extends, and whether private plaintiffs may sue those who merely participate in a fraud scheme, but make no false statements or omissions themselves.
Under the Private Securities Litigation Reform Act of 1995 (PSLRA), plaintiffs alleging federal securities fraud must plead “with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind”, which in Section 10(b) claims means a mental state amounting to the intent to deceive, manipulate or defraud. The US lower courts had been divided on what is a sufficiently ‘strong inference’ of scienter to allow a complaint to survive a motion to dismiss a Section 10(b) claim.
The Seventh Circuit had held that a plaintiff must allege “facts from which, if true, a reasonable person could infer that the defendant acted with the required intent”, irrespective of any competing non-culpable inferences. The Sixth Circuit, by contrast, had required dismissal of the complaint unless “the most plausible of competing inferences” supports scienter.
In Tellabs, the Supreme Court rejected the Seventh Circuit’s lenient standard, recognising that an inference of scienter could not be strong without a weighing of all plausible culpable and non-culpable explanations for the defendant’s conduct. But the court also rejected the Sixth Circuit’s approach, holding that a strong inference of scienter is one that is “cogent and compelling” and “at least as compelling as any opposing inference one could draw from the facts alleged”. The court thus did not require that a culpable inference of scienter be more plausible than any non-culpable inference to be strong.
The Supreme Court’s decision has been helpful to defendants seeking quick dismissal of some meritless securities lawsuits, but is not as potent a weapon as some had hoped. Trial courts must consider credible, innocent explanations for a defendant’s conduct. Lack of a sufficient allegation of motive will count against a plaintiff.
Vague and ‘non-particularised’ allegations will not be given any weight because the trial court must be able to probe their impact. Defendants also emphasise the court’s description of Congress’s statutory pleading requirements as “exacting” and designed “to curb perceived abuses of the Section 10(b) private action”, including “nuisance filings” and “targeting of deep-pocket defendants”.
The Tellabs decision, however, affords plaintiffs some room because it appears to allow complaints to survive where the competing inferences are equally strong. For example, one court found that alleged accounting irregularities “actually understated the company’s net income”, which is “hardly support for an inference that [the defendant executives] were wrongly trying to inflate the company’s worth and enrich themselves through accounting misdeeds”, but held that the executives’ stock sales and the allegation that the accounting fraud occurred ‘on their watch’ made for a sufficiently strong inference of scienter to survive dismissal.
The issue in Stoneridge is the scope of ‘deceptive’ conduct under Section 10(b). Charter Communications’ shareholders sued two of the company’s vendors for allegedly engaging in business transactions with it knowing that Charter would account for them improperly, thus amounting to participation in a scheme to defraud. The Eighth Circuit disagreed, holding that the vendors “did not issue any misstatement relied upon by the investing public”, and that their conduct was not deceptive. The Supreme Court will decide the case soon.
The viability of so-called ‘scheme liability’ claims has been the subject of intense debate, with some suggesting private Section 10(b) claims should extend to those “who simply cooperate in a fraud”, and others who “dismiss it as a search for deep pockets”. Plaintiffs have pursued scheme liability against third parties who could not be swept in under secondary liability theories after the court’s Central Bank of Denver v First Interstate Bank of Denver (1994) decision foreclosed private Section 10(b) actions for mere “aiding and abetting”.
The oral argument in Stoneridge suggests it is unlikely the plaintiffs persuaded a majority of justices to adopt their broad definition of ‘deception’, which would subject secondary actors, such as banks, underwriters, accountants, business partners and others, who do not make an alleged misstatement or omission to the public markets, to private liability.
Chief Justice Roberts noted that after Central Bank, in the PSLRA Congress chose to vest only the Securities Exchange Commission (SEC), and not private plaintiffs, with the authority to bring aiding and abetting claims.
Justices Alito, Scalia and Kennedy also indicated that they saw little difference between the plaintiffs’ expansive view of Section 10(b) and an improper private aiding and abetting theory. Most commentators thus have predicted a big win for the defence bar, but oral argument questions are not always reliable indicators of outcome.
Importantly, even if the court does rule for the defence, cutting off many private actions against secondary actors, it could do so on narrow grounds that still preserve the government’s ability to bring SEC enforcement actions and criminal prosecutions against secondary actors in certain cases. The vendors argued that the plaintiffs’ claim is barred for many reasons, including the plaintiffs’ failure to allege they relied upon any vendor statement or omission, or that these were the cause of the plaintiffs’ harm, elements that must be proven by private plaintiffs, but not by the government.
The US government argued as amicus curiae that the court should side with the vendors by barring private claims on these narrow grounds. But the vendors went further, arguing that they engaged in no deceptive act at all. If this theory is adopted, their only potential exposure would be to aiding and abetting claims by the government.
The government disagrees, arguing if true, the allegations in Stoneridge showed that the vendors’ actions met a broad proposed definition of ‘deception’ under Section 10(b) that includes “conduct that has the effect of conveying a false appearance of material fact concerning a transaction into which the person has entered”.
If the court was to adopt this view, the SEC and US Department of Justice could bring enforcement actions or prosecute mere ‘participants’ in a fraud not only for aiding and abetting, but also for primary violations of Section 10(b).
The extent to which such a broader definition of deception would have much impact on government actions against secondary actors is unclear, given that it already has ‘aiding and abetting’ in its arsenal. Nevertheless, the broad and ambiguous definition of ‘deception’ it proposes would make little sense. Charter’s vendors did not ‘convey’ any ‘appearance’ at all to Charter’s shareholders. It was up to Charter to account for its transactions properly, and if – as the shareholders allege – it failed to do so, it was Charter, and not the vendors, who deceived the shareholders.
Whether the court will resolve the outer bounds of what is actionable ‘deceptive’ conduct or, as in Tellabs, stops short of giving the securities defence bar all that it wanted, the Stoneridge decision is much anticipated. And the banks, accountants and others that are typically the subject of private plaintiffs’ efforts to reach third-party ‘deep pockets’ will achieve a significant victory, so long as the decision cuts off most private actions at the pass.
•Alexandra Shapiro is a partner and Robert Malionek a senior associate at Latham & Watkins