SEC Urges “Exceedingly High” Pleading Standard?

As discussed in February 13, 2007 New York Times article entitled “SEC Seeks to Curtail Investor Suits” (here), the SEC and the DOJ have jointly filed an amicus brief in the Tellabs case pending on writ of certiorari before the United States Supreme Court, in which brief the agencies urge the Court to adopt a restrictive test that plaintiffs must satisfy in order to meet the heightened pleading standard under the Private Securities Litigation Reform Act. The agencies’ amicus brief can be found here.

The Tellabs case is before the Supreme Court to determine whether the Seventh Circuit applied the right test to determine whether the plaintiffs’ allegations satisfied the PSLRA’s requirement that the complaint “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind.” A copy of the Seventh Circuit opinion can be found here. The Seventh Circuit held, in reversing the district court’s dismissal and holding the plaintiff’s allegations to be sufficient, that a complaint satisfied the PSLRA’s requirements to support a “strong inference” if it “alleges facts from which, if true, a reasonable person could infer that the defendant acted with the requisite intent.”

The agencies argue in their amicus brief that in enacting the heightened pleading standard in the PSLRA, Congress sought to require more than a “reasonable” inference. The agencies contend that courts must consider whether or not the facts alleged support competing inferences, including the possibility whether there are “non-culpable explanations for the defendants conduct,” and consider the relative strength of the inferences to determine whether the inference the plaintiff urges is “strong.” Specifically, the agencies argue that:

in evaluating whether a plaintiff has alleged particular facts that “giv[e] rise” to a “strong” inference of scienter, a court should determine whether, taking the alleged facts as true, there is a high likelihood that the conclusion that the defendant possessed scienter follows from these facts. (emphasis added)

The agencies’ brief is succinct and well-written. But its lawyerly elegance notwithstanding, the brief has already been the target of criticism, particularly its advocacy of the “high likelihood” requirement. The Times article quotes Fordham Law Professor Jill Fisch as saying that it is unusual for the SEC to side against investors in a fraud lawsuit in the Supreme Court: “One has to wonder if the SEC is now on the side of the defense bar.” Professor Fisch describes the “high likelihood” standard urged by the agencies as “exceedingly high.”

Illinois Law Professor Christine Hurt, writing on the Conglomerate blog (here), suggests that the “high likelihood” standard is higher than is required to get to a jury in a criminal securities case. Professor Hurt notes that “in criminal cases, prosecutors don’t even lose on directed verdict for not showing this kind of evidence of intent.” Rather, “prosecutors get to instruct the jury that the defendant can be guilty of securities fraud if the were willfully blind to the actions of others.”

The Supreme Court may yet choose to adopt the standard that the agencies propose. But The D & O Diary notes that while the PSLRA did enact a heightened pleading standard, the “high likelihood” test does not appear in the statute. The statute requires the facts to support “a strong inference” that the defendant acted with scienter – not that the inference of scienter is the only inference, or even that it is the strongest inference, but that it is an inference and that it is strong.

It can be questioned whether the Seventh Circuit’s “reasonable inference” test can be squared with the statute, but I also believe there is serious question whether the “high likelihood” test can be squared with the statute. I don’t believe the PSLRA requires courts considering motions to dismiss to determine which inference is strongest – that seems like a job for a jury to me. Rather, on a motion to dismiss, the court’s job ought to be to examine whether the facts alleged taken as true support a strong inference that the defendant acted with scienter, emphasis on the word “a”.

The 10b-5 Daily has a post about the agencies' Tellabs amicus brief here and a prior post here about the Seventh Circuit's opinion.

SEC Advocating Auditor Liability Caps?: As The D & O Diary has previously noted (here), the European Commission is actively looking at the possibility of caps for auditor liability. Conrad Hewitt, the SEC’s Chief Accountant, has previously come out in favor of auditor liability caps (here), and the Times article linked above reports on similar remarks from Hewitt on a more recent occasion. Hewitt’s concern is that without these caps, auditors could face ruinous liability and bankruptcy, which could force further consolidation in the already overconcentrated accounting industry.

The limits of competition among the Remaining Four accounting firms poses a serious issue. Nevertheless, as I have previously argued (here), the concern here is that the SEC (and for that matter, the PCAOB) not put itself in the position of protecting the Big Four accounting firms.

Insurance Coverage Implications of the Delaware Chancery Court’s Recent Options Backdating Decision: As I noted in a recent post (here), the Delaware Chancery Court’s opinions in the Maxim Intergrated options backdating case (here) and in the Tyson Foods options springloading case (here) have important implications for the many other options backdating related shareholders derivative lawsuits. In addition, as noted in an excellent memorandum by my good friend Joe Monteleone of the Tressler, Soderstrom, Maloney & Preiss law firm, entitled “A Bad Week for the Defense in Options Backdating Litigation” (here) the Delaware Chancery Court opinions may have important insurance coverage implications as well.

The memorandum notes that even though the opinions did not address coverage issues, “the decisions suggest that coverage issues already raised by insurers in these claims are likely to be continuing sources of contention.” The memorandum is particularly concerned with the potential applicability of conduct exclusions in the D & O policy, give the forceful language of the Chancery Court’s opinions. The memorandum also discuses whether he rulings may also raise important questions about the insurability of settlement or judgment amounts.

The Latest Options Backdating Litigation Tally: Readers may be interested to know that according to the latest D & O Diary tally (here), there have been 147 companies named as nominal defendants in shareholders' derivative lawsuits raising options backdating allegations.

An "Essential Supplement" to the SEC: In a prior post (here) commenting on Professor Grundfest's proposal to eliminate private securites lawsuits, I commented that the private securities bar provides outsourced securities law enforcement for the SEC. As Adam Savett notes on the newly revitalized Securities Litigation Watch blog (here), the SEC even went so far as to state in its amicus brief in the Tellabs case that "meritorious private actions are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively, by DOJ and the SEC." Savett presents additional "gentle rebuttal" against Grundfest's proposal as well.