Corporate Governance

The Tellabs Excuse (A Recap)(Part 2)

By J. Robert Brown

We are conducting a recap of the Supreme Court's analysis in Tellabs and, a year later, examining the lower court interpretation of the case.  The results to a large degree bear out the Tellabs Excuse.  Some circuits have, in the aftermath of Tellabs, cited the case as authority for a relatively harsh interpretation of the pleading standards for scienter.  In general, these courts have engaged in a fairly clear misuse of the decision.  The Eighth and Eleventh Circuits are the circuits most likely to take this approach.

In a number of other cases, however, circuits have gone in the opposite direction.  They have relied upon the reasoning in Tellabs to expand rather than contract the circumstances in which complaints will be deemed to have adequately pled scienter.  The 9th Circuit is the clearest example of this approach.

Let us turn to more specific observations.

First, it is clear from lower court opinions that Tellabs imposed a certain degree of discipline over the analysis of pleading standards for scienter.  Prior to the decision, courts would take the facts alleged by plaintiff, examine each factor individually, then venture a conclusion as to whether they demonstrated a "strong inference" of fraud.  The conclusion often seemed to be little more than an example of "I'll know it when I see it" reasoning.

Tellabs, however, provided a more concrete framework.  Courts were instructed to consider all factors raised by plaintiffs.  Thus, in the past, courts had rejected allegations that officers could be charged with knowledge of the fraud solely because of their position in the company.  Sometimes referred to as the "core operations" inference, plaintiffs sometimes alleged that individual defendants knew that a statement was false because they had knowledge of the core operations and the core operations contradicted the information disseminated to the public. 

The Fifth Circuit notwithstanding, the courts interpreted Tellabs to require consideration of all inferences raised by the plaintiff.  Thus, in South Ferry v. Killinger, 542 F.3d 776 (9th Cir. 2008), the panel had to consider whether, in pleading scienter, officers could be charged with knowledge of “core operations or important transactions” solely because of their position.  Although prior cases in the same circuit had found such allegations insufficient,  the court determined that Tellabs had altered the analysis.  As the opinion noted:

• Silicon Graphics, Vantive, and Read-Rite, read without reference to Tellabs, will generally prevent a plaintiff from relying exclusively on the core operations inference to plead scienter under the PSLRA. Plaintiffs recognize this. However, the Supreme Court's recent Tellabs decision also discusses the level of detail required under the PSLRA, and with its controlling and persuasive weight, it suggests that perhaps Silicon Graphics, Vantive, and Read-Rite are too demanding and focused too narrowly in dismissing vague, ambiguous, or general allegations outright. . . . Tellabs counsels us to consider the totality of circumstances, rather than to develop separately rules of thumb for each type of scienter allegation.

In construing evidence of scienter, courts could take into account “a series of less precise allegations to be read together to meet the PSLRA requirement."  This included “[a]llegations that rely on the core-operations inference.”   The court, however, went even further.  Although the "core operations inference" alone would ordinarily not be enough to establish scienter, sometimes it would.  “[I]n some unusual circumstances, the core operations inference, without more, may raise the strong inference required by the PSLRA.” 

In one opinion, the 9th Circuit went from excluding "core operations inferences" to concluding that the pleading of "core operations inferences" could sometimes be enough to establish scienter.  The panel used Tellabs to effectively overturn the Silicon Graphics case, which had established the highest, strictest standard for establishing scienter.

Not all circuits seem as open to this approach.  See Mizzaro v. Home Depot, 2008 U.S. App. LEXIS 21091 (11^th Cir. Oct. 8, 2008)(“To begin with, we indulge at least some skepticism about allegations that hinge entirely on a theory that senior management "must have known" everything that was happening in a company as large as Home Depot, which operates over 2000 stores. The amended complaint, therefore, must at least allege some facts showing how knowledge of the fraud would or should have percolated up to senior management.”)(record citation omitted); see also Elam v. Neidorff, 2008 U.S. App. LEXIS 21579 (8^th Cir. Oct. 16, 2008)(“This court has not expressly addressed the core operations method of pleading scienter, and we note that the Fifth and Ninth Circuits have rejected it.”).   Nonetheless, it is an approach compelled by Justice Ginsburg's analysis.  Tellabs does not dictate the weight the inference should be given but does dictate that it be taken into account.

We will share some more views in the next post.

Full post as published by The Race to the Bottom on November 12, 2008 (boomark / email).