Securities Fraud: Tellabs, Inc. v. Makor Issues & Rights, Ltd.
Securities Fraud:
Tellabs, Inc. v. Makor Issues & Rights, Ltd.
Michael V. Seitzinger
Legislative Attorney
American Law Division
Summary
The United States Supreme Court granted the petition for certiorari in the case
Tellabs, Inc. v. Makor Issues & Rights, Ltd. The case was appealed from a decision by
the Court of Appeals for the Seventh Circuit. It presented the question whether and to
what extent a court must consider or weigh competing inferences in determining
whether a complaint asserting a claim of securities fraud has alleged facts sufficient to
establish a “strong inference” that the defendant acted with scienter, as required by the
Private Securities Litigation Reform Act of 1995 (PSLRA). On June 21, 2007, the
Supreme Court held that the pleading standard (what is in fact necessary to establish the
strong inference of scienter) required by the PSLRA must be more than merely
“plausible” or “reasonable.” It must be “cogent,” and at least as compelling as any
opposing inference of nonfraudulent intent. This report will not be updated.
On January 5, 2007, the United States Supreme Court granted the petition for
certiorari in the case Tellabs, Inc. v. Makor Issues & Rights, Ltd.1 The case was appealed
from a decision by the Court of Appeals for the Seventh Circuit2 and presented the
question of whether and to what extent a court must consider or weigh competing
inferences in determining whether a complaint asserting a claim of securities fraud has
alleged facts sufficient to establish a “strong inference” that the defendant acted with
scienter,3 as required by the Private Securities Litigation Reform Act of 1995 (PSLRA).4
Oral argument occurred on March 28, 2007. The Supreme Court issued its decision on
June 21, 2007.
1 No. 06-484.
2 437 F.3d 588 (7th Cir. 2006).
3 “Latin term for a person’s guilty knowledge; i.e., knowing that a person’s actions are wrong.”
MODERN DICTIONARY FOR THE LEGAL PROFESSION (3d ed. 2001).
4 15 U.S.C. § 78u-4.
The case was a class action against Tellabs, Inc., which is a manufacturer of
specialized equipment used in fiber optic cable networks. The plaintiffs in the case, a
class of Tellabs shareholders, alleged that Tellabs’s fraudulent conduct began with the
issuing of a press release which stated that Tellabs had signed a multi-year, $100 million
contract for one of Tellabs’s next-generation products, the Titan 6500. Tellabs’s chief
executive officer (CEO), Richard Notebaert, predicted to financial analysts that, in
addition to the Sprint contract, there would be continuing growth of the Titan 5500, the
6500’s predecessor. Based in part on these representations, market analysts recommended
that investors buy Tellabs stock. In addition, further optimistic statements signed by
Notebaert and Richard Birck, Tellabs’s chairman and former CEO, included “Tellabs’s
growth is robust,” “Our markets hold significant potential for sustained growth,” and “Our
core business is performing well.” As time passed, Notebaert continued to issue upbeat
statements. Within two years of the first optimistic statement issued by Notebaert,
Tellabs significantly reduced its projected earnings and its stock price plunged.
Plaintiffs then filed a class action suit against Tellabs and 10 of its executives,
alleging that the executives knowingly lied to the public in specific ways, such as that they
knew that the Titan 6500 was not available and that they knew that the demand for the
Titan 5500 was waning, instead of growing. Plaintiffs also alleged that Birck engaged in
illegal insider trading. The district court twice dismissed the shareholders’ suit on the
basis that the shareholders had failed to prove scienter under the PSLRA.5 The plaintiffs
appealed to the Seventh Circuit, arguing that 1. Some of the statements that the court
dismissed as “mere puffery” were legally actionable; 2. The complaint provided enough
detail to support a strong inference of scienter for each of the defendants; and 3.The
disclaimer which accompanied Tellabs’s forecasts was insufficient and that therefore
Tellabs could not rely upon the PSLRA’s safe harbor provision.6
The Court of Appeals for the Seventh Circuit first listed three distinct statutory
violations that plaintiffs’ complaint alleged. First, the plaintiffs contended that Tellabs,
as a company, and that Notebaert and Birck, as individuals, violated section 10(b),7 the
general antifraud provision, of the Securities Exchange Act of 1934,8 and Securities and
Exchange Commission (SEC) Rule 10b-5,9 the SEC rule which implements the general
antifraud provision. Second, the complaint alleged that Notebaert, Birck, and certain
other Tellabs executives were “control persons” and therefore liable under section 20(a)10
of the Securities Exchange Act for the corporation’s fraudulent acts. Third, the plaintiffs
alleged that Birck committed insider trading violations.11
5 Johnson v. Tellabs, Inc., 303 F. Supp. 2d 941 (N.D. Ill. 2004).
6 The safe harbor provision for forward-looking statements under the PSLRA may be found at
7 15 U.S.C. § 78j(b).
8 15 U.S.C. §§ 78a et seq.
9 17 C.F.R. § 240.10b-5.
10 15 U.S.C. § 78(t).
11 15 U.S.C. § 78t-1.
In analyzing the issues of the case, the Seventh Circuit noted that the PSLRA, which
governs class actions brought for securities law violations, sets out particularity for fact
pleading that exceeds the requirements under Rule 9(b) of the Federal Rules of Civil
Procedure.12 Under the PSLRA, a securities fraud (section 10(b) “complaint shall specify
each statement alleged to have been misleading, the reason or reasons why the statement
is misleading, and, if an allegation regarding the statement or omission is made on
information and belief, the complaint shall state with particularity all facts on which that
belief is formed”13 and “state with particularity facts giving rise to a strong inference that
the defendant acted with the required state of mind.”14
There has been debate within the courts of appeals as to how much factual detail in
the pleadings is enough to satisfy the “strong inference” of scienter required by the
PSLRA. For example, the Ninth Circuit has stated that, in enacting the strong inference
requirement, Congress raised the bar under the PSLRA for the substantive state of mind
requirement for securities fraud allegations.15 The Seventh Circuit decision stated that it
was not convinced that Congress intended to raise the bar under the PSLRA because,
prior to the enactment of the PSLRA, every circuit considering the substantive standard
had held that a showing of recklessness was sufficient to allege scienter.16 The Seventh
Circuit stated that, because the PSLRA refers to the “required state of mind,” it seemed
likely that Congress approved of the state of mind standard used before passage of the
PSLRA and that, if Congress wanted a stricter scienter standard to be used, Congress
would have placed a new standard in the law.
The Seventh Circuit went on to discuss that, although it believed that the PSLRA did
not impose a stricter substantive scienter standard, the act did raise the bar for pleading
scienter. In addition to having to meet a particularity requirement, plaintiffs, according
to the Seventh Circuit, had to meet a substantive requirement by pleading sufficient facts
to create a “strong inference” of scienter. The Seventh Circuit could not find
congressional intent as to what facts will create such an inference. Further, according to
the Seventh Circuit, there is conflict in the circuits as to how to demonstrate the required
“strong inference.” The Second and Third Circuits follow the reasoning that the PSLRA
12 See, e.g., In re Rockefeller Center Properties, Inc. Securities Litigation, 311 F. 3d 198 (3d Cir.
13 15 U.S.C. § 78u-4(b)(1).
14 15 U.S.C. § 78u-4(b)(2).
15 In re Silicon Graphics Securities Litigation, 183 F.3d 970, 979 (9th Cir. 1999): A plaintiff must
allege facts that create a strong inference of “deliberate or conscious recklessness” or a “degree
of recklessness that strongly suggests actual intent.”
16 See Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990); In re Philips
Petroleum Securities Litigation, 881 F.2d 1236, 1244 (3d Cir. 1989); Van Dyke v. Coburn Enter,th
Inc., 873 F.2d 1094, 1100 (8 Cir. 1989); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809,thth
Rockwell International Corp., 642 F.2d 929, 961-62 (5 Cir. 1981); Mansbach v. Prescott, Ballthst
& Turben, 598 F.2d 1017, 1023-25 (6 Cir. 1979); Cook v. Avien, Inc., 573 F.2d 685, 692 (1 Cir.nd
Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1044 (7 Cir. 1977).
adopted the Second Circuit’s pre-PSLRA pleading standard for scienter.17 The Ninth and
Eleventh Circuits, however, believe that Congress considered but rejected the Second
Circuit’s approach and instead chose a more onerous burden.18 The remaining six
circuits, according to the Seventh Circuit, have taken a middle ground and have reasoned
that “Congress chose neither to adopt nor reject particular methods of pleading scienter
— such as alleging facts showing motive and opportunity — but instead only required
plaintiffs to plead facts that together establish a strong inference of scienter.”19 The
Seventh Circuit in this case decided to follow this middle ground.
Having decided the line of reasoning that it would take concerning the threshold of
what constitutes a strong inference of scienter, the Seventh Circuit held that plaintiffs’
complaint against Notebaert met the threshold but that the complaint against Birck did
not meet the threshold. Notebaert’s guilt derived, according to the court, from the
evidence that he likely knew that the optimistic statements which he made concerning
Tellabs’s Titan 5500 and Titan 6500 were false. Birck, on the other hand, made
optimistic projections only up until the time that he likely knew of the Titan 5500’s
market weakness. The federal securities laws impose liability not only on the person who
actually commits the securities law violation but also on the persons who “directly or
indirectly”20control the violator. Therefore, the plaintiffs’ claims against Notebaert,
Birck, and the other Tellabs executives for controlling person liability survived. The
executives, according to the court, may later have an opportunity to prove that they acted
in good faith. Further, since Notebaert acted within the scope of his position as CEO of
Tellabs, his knowledge of the falsity of his statements could be imputed to the corporate
entity Tellabs. Finally, the charge against Birck for insider trading survived because of
his possibly being found to be a control person.
Conflict among the circuit courts as to how to demonstrate the required “strong
inference” was the reason for the Supreme Court’s granting of certiorari in the Tellabs
case.21 In its decision the Supreme Court held that, to qualify as a strong inference of
scienter under the PSLRA, the inference must be more than merely plausible or
17 “[P]laintiffs may continue to state a claim by pleading either motive and opportunity or strong
circumstantial evidence or recklessness or conscious misbehavior.” Novak v. Kasaks, 216 F.3d
18 “Congress intended to elevate the pleading requirement above the Second Circuit standard
requiring plaintiffs merely to provide facts showing simple recklessness or a motive to commit
fraud and opportunity to do so.” In re Silicon Graphics Securities Litigation, 183 F.3d 970, 974th
(9 Cir. 1999). “Because the clear purpose of the [PSLRA] was to curb abusive securities
litigation, and because we believe that the motive and opportunity analysis is inconsistent withth
that purpose, we decline to adopt it.” Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1286 (11
Cir. 1999).
19 Ottoman v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 345 (4th Cir. 2003); accord Florida
State Board of Administration v. Green Tree Financial Corp., 270 F.3d 645, 659-60 (8th Cir.th
20 15 U.S.C. § 78t(a).
21 Slip op., at 6.
reasonable. It must be “cogent,” and at least as compelling as any opposing inference of
nonfraudulent intent.
The Court in its analysis stated that Congress has the authority to provide the
standard for pleading a claim.
Congress, as creator of federal statutory claims, has power to prescribe what
must be pleaded to state the claim, just as it has power to determine what must be
proved to prevail on the merits. It is the federal lawmaker’s prerogative, therefore,
to allow, disallow, or shape the contours of — including the pleading and proof
requirements for — §10(b) private actions. No decision of this Court questions that22
authority in general....
Finding no clear guide from Congress in the statute or in the legislative history on
what would satisfy the requirements for a strong inference, the Court established three
prescriptions for satisfying the standard: 1. Faced with a motion to dismiss a section 10(b)
action under the Rules of Civil Procedure, courts must accept all factual allegations in the
complaint as true; 2. Courts must consider the complaint in its entirety, as well as other
sources, such as documents incorporated into the complaint by reference and matters of
which a court may take judicial notice; and 3. In determining whether the pleaded facts
give rise to a “strong” inference of scienter, a court must take into account plausible23
opposing inferences.
The Court ended its opinion by stating that it would not decide whether, under the
three prescriptions for the standard it described as necessary for a strong inference of
scienter, the shareholders’ allegations warranted a strong inference that Notebaert and
Tellabs acted with the required state of mind. The lower courts did not have the
opportunity to consider the matter in the light of these prescriptions. Therefore, the Court
vacated the Seventh Circuit’s judgment and remanded the case for further proceedings
consistent with its opinion.
22 Slip op., at 15-16.
23 Slip op., at 11.