Supreme Court Reversal Could Drive Down D&O Claims

In making its ruling the court must decide what Congress meant in 1995 when it passed the Private Securities Litigation Reform Act.

The underlying case involves the question of whether Richard Notebaert, Tellabs Inc.'s chief executive officer, told investors the firm's growth prospects were solid when he allegedly knew in fact that demand for its best-selling product had begun to drop.

How the High Court might ultimately rule in Tellabs Inc. v. Makor Issues & Rights is unclear from a transcript of yesterday's arguments. It does reveal, however, that the justices spent a lot of time questioning not just how high a wall Congress intended plaintiffs to climb to bring cases to trial, but also raised concerns over the issue of whether it makes sense to have pleading standards set higher than the standards for proving a case to a jury.

The PSLRA provision that is the focus of Tellabs requires a complaint alleging securities fraud to state "with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind"–with some evil intent to defraud investors.

Defendants argue that when there are competing inferences that can be drawn from a set of facts–both inferences of evil intent and innocence–that courts should base the decision on whether a case proceeds on the most plausible inference.

In Tellabs, the 7th Circuit rejected this approach. "Instead of accepting only the most plausible of competing inferences at the pleading stage, we will allow the complaint to survive if it alleges facts from which, if true, a reasonable person could infer that the defendant acted with reasonable intent," the court said.

At the hearing yesterday, Kannon Shanmugam, assistant to the Solicitor General, Department of Justice, argued for a high pleading standard on behalf of the government. "Congress was concerned…with the problem of abusive pleading. That much is crystal clear," he said.

During the earlier questioning of Tellabs attorney Carter G. Phillips, Justice Antonin Scalia seemed to agree. "I don't think Congress was trying to achieve an alteration in the…jury standard. What it was concerned with is the enormous expense of discovery," he said.

At the Professional Liability Underwriting Society D&O Symposium, earlier this month, Denise Amantea, a partner with insurance broker Woodruff-Sawyer in San Francisco, said that if the 7th Circuit view prevails, "it's going to be a lot easier for plaintiffs to make their complaints stick."

She noted that since the 1995 PSLRA, the dismissal rate of securities class actions has jumped from 14 percent to 33 percent. "If Tellabs sticks at an easy pleading standard, I think the dismissal rate is going to decrease," she said.

Plaintiffs lawyers Joseph Cotchett, a lawyer for Cotchett, Pitre, Simon & McCarthy in Burlingame, Calif., worried about the reverse.

He predicted that the Supreme Court would not only reverse the lower court, but could hear and render a defendant-friendly decision in another case that would erode the theory of "scheme liability." That theory helps plaintiffs recover damages from securities underwriters, accountants and others who allegedly aid or abet schemes to defraud investors.

He also predicted that the force of pro-defendant rulings in these cases, along with one in a Second Circuit case last year, would combine to drive class action securities cases down by 50 percent.