By Joe Hylkema
Andrews Publications Correspondent

Courts must consider both inferences of fraudulent and innocent intent when determining whether to allow securities fraud lawsuits to move beyond their early stages, the U.S. Supreme Court has ruled in a closely watched case.

In an 8-1 decision the court resolved a four-way split among the federal appellate courts on the heightened pleading standards under the Private Securities Litigation Reform Act.

Although some commentators see the decision as a victory for large corporations and a setback for shareholder plaintiffs, others say the ruling only clarified existing law.

Under the PSLRA, shareholders must allege specific facts showing a "strong inference" that the defendant acted with scienter, or intent to deceive investors. If the allegations do not raise a strong inference, the suit will not survive a motion to dismiss.

The Supreme Court's ruling means that trial courts must look at competing inferences that could be drawn from the circumstances of the case.

To qualify as a "strong inference" under the PSLRA, 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 nonfraudulent intent," Justice Ruth Bader Ginsburg wrote for the court.

"It does not suffice that a reasonable fact finder plausibly could infer from the complaint's allegations the requisite state of mind," the opinion says. "[The court] must engage in a comparative evaluation; it must consider, not only inferences urged by the plaintiff ... but also competing inferences rationally drawn from the facts alleged."

A dissent by Justice John Paul Stevens proposed a "probable cause" standard that he said would be "easier to apply and more consistent with the statute."

One of the co-drafters of the PSLRA, Los Angeles attorney Bruce G. Vanyo of Katten Muchin Rosenman LLP, praised the ruling.

"This decision ends any uncertainty about whether a court must engage in a genuine analysis of competing inferences from an alleged set of facts," he said in a statement.

"It is also important that the court specified that a judge must look not only at the complaint, but any other sources that can be examined in ruling on a motion to dismiss," according to Vanyo, whose firm was not involved in the case.

"The Supreme Court got this one right," said Katten Muchin attorney David H. Kistenbroker.

"The reversal was appropriate, however this is not a landmark shift in the law," he said in a statement. "It really only serves to more clearly articulate the law as put on the books by Congress."

The case began in 2002 when shareholders of Tellabs Inc. sued the fiber-optics company and CEO/President Richard Notebaert in the U.S. District Court for the Northern District of Illinois.

They alleged that the defendants made materially false and misleading statements about demand for the company's networking products from December 2000 until June 2001, when Tellabs restated its financial projections.

But Tellabs said Notebaert did not know of any adverse internal reports prior to making positive statements about demand for the products.

The shareholders also alleged that the defendants engaged in "channel-stuffing" so as to falsely prop up Tellabs' sagging sales figures.

Channel-stuffing is when a company ships unordered product to suppliers or customers. The orders are then booked as sales, but the products are usually returned later, after that quarter's financials are completed.

In dismissing the case the trial court found, among other things, that the complaint defined channel-stuffing so broadly that it could also include innocent conduct such as providing discounts to customers or extending credit.

The court also said the investors failed to sufficiently allege exactly when in early 2001 that Notebaert got information that the demand for Tellabs' premium product was dropping.

After allowing an amended complaint, the trial court dismissed the suit with prejudice, and the plaintiffs appealed.

The U.S. Court of Appeals for the 7th Circuit reinstated the lawsuit, saying it would not compare inferences of innocent or fraudulent intent.

The appeals court ruled that a securities fraud complaint could survive a motion to dismiss if it alleges facts from which a reasonable person could infer that the defendant acted with the required state of mind.

To consider the competing inferences of an innocent mental state against any potentially culpable inferences may usurp the role of the jury, in violation of the Seventh Amendment to the U.S. Constitution, the court said.

After the case was appealed to the Supreme Court, at least 20 friend-of-the-court briefs were filed, with the Securities and Exchange Commission and the Justice Department on one side and 24 state attorneys general on the other.

The states' brief said the new high standard would block many meritorious claims.

Weighing competing inferences would give judges - not juries - the power to assess the plausibility of every allegation of scienter and prevent legitimate suits from being decided on the merits, they argued.

But the SEC said in its brief that the PSLRA's plain language requires more than a "reasonable inference" standard, and courts must consider whether the facts alleged in a suit have innocent explanations of a defendant's conduct.

To comment, ask questions or contribute articles, contact West.Andrews.Editor@Thomson.com.

Tellabs Inc. et al. v. Makor Issues & Rights Ltd. et al., No. 06-484, 2007 WL 1773208 (U.S. June 21, 2007).