The Supreme Court’s decision in the Tellabs case (about which refer here) is still new and as yet untested in the lower courts. But post-decision publications and discussions are continuing, as key players wrestle with its possible implications. In particular, D & O industry participants have been struggling to discern whether or not the decision represents a significant shift in D & O exposure. (A copy of the Tellabs opinion can be found here.)
Upon consideration of these post-decision publications and discussions, I have some further reflections about the Tellabs decision (beyond those in my initial post on the case, here) which are as follows.
Private Securities Suits Are “Essential”: In its opening lines, the majority’s Tellabs opinion states that “this Court has long recognized that meritorious private actions to enforce federal antifraud securities lawsuits are an essential supplement to criminal prosecutions and civil enforcement actions brought, respectively by the Department of Justice and the Securities and Exchange Commission.” (Emphasis Added). As if this statement were not sufficiently emphatic, the majority opinion returns to this same theme again, in footnote 4, where it states that “private securities litigation is an indispensable tool with which defrauded investors can recover their losses.”
These statements not only underscore the importance that the Supreme Court attaches to private securities litigation, but they also represent an important (and perhaps influential) perspective in the current debate surrounding possible securities litigation reform (about which refer here and here). The Court’s statements provide a significant counterpoint to the contentions of would-be reformers who propose to eliminate private securities litigation, in favor of arbitration or of a government-action only model.
Scienter Requirements Deferral: One ever-present wildcard when the Supreme Court agrees to hear a securities case is the possibility that the Court might finally get around to addressing the long-deferred Hochfelder question — that is, whether reckless behavior is sufficient for civil liability in a Section 10(b) action. The Tellabs court, in footnote 3, specifically acknowledged that it had “previously reserved” this question, but noted further that the question whether and when recklessness satisfies the scienter requirement was “not presented in the Tellabs case.”
The Tellabs court noted that all of the Circuit Courts agree that recklessness is sufficient to satisfy the scienter requirement, although the court noted further that the Circuits “differ in the degree of recklessness required.” The court’s forebearance on this issue leaves in place the Ninth Circuit’s anomalous holding that the scienter requirement requires a showing of “deliberate or conscious recklessness.” For whatever this current state of affairs may represent, the pre-Tellabs disposition of the circuits on this issue remains unchanged. The Ninth Circuit’s more demanding standard (about which refer here), which has resulted in a greater dismissal rate and arguably a reduced filing rate in that Circuit, remains in place.
Uniform Standard, Disparate Impact: The Supreme Court agreed to hear the Tellabs case in part because of the disagreement in the Circuits over what satisfies the PSLRA’s requirement that a securities complaint plead facts that give rise to a “strong inference” that the plaintiff acted with scienter. As a result of the Tellabs majority’s opinion, the district courts in the various Circuits will now apply a uniform standard going forward. But because the Circuit Courts previously had differing standards, the practical impact of this uniform standard will vary by Circuit according to the standard that previously applied. This means, as the Morgan Lewis law firm noted in its memorandum commenting on Tellabs (here), that “whether the Tellabs decision improves the litigation climate for a defendant depends on where the defendant has been sued.”
The most obvious impact will be in the Seventh Circuit, where the Tellabs case originated. The Supreme Court overturned the Seventh Circuit’s standard (which the K&L/Gates law firm in its memorandum commenting on the Tellabs decision, here, characterized as an “outlier”) that a complaint was sufficient if it alleges facts “from which, if true, a reasonable person could infer that the defendants acted with the requisite intent.”
This outcome represents a victory for defendants in the Seventh Circuit, but at most a “mild” victory, in the words of the Morgan Lewis law firm’s memorandum. The Seventh Circuit’s standard, requiring only that an inference be plausible, clearly falls short of the statute’s requirement that that the inference be “strong.” (The inadequacy of the Seventh Circuit’s standard was so manifest that the Securities Law Prof Blog, here, characterized its rejection by the Supreme Court as “quite predictable.”)
On the other hand, the Supreme Court rejected the standard urged by Justices Scalia and Alito in their concurring opinions, that the statute requires a plaintiff to allege facts sufficient to support the “most plausible competing inferences.” In rejecting this standard, the K&L/Gates law firm’s memorandum notes, the Supreme Court appears to have rejected the standard adopted by at least four of the Circuit Courts (the Sixth, First, Ninth and Fourth). For defendants in these circuits, it may now prove more difficult than in the past for defendants to prevail on a motion to dismiss, as a result of the rejection of the more rigorous standard. By the same token, the Tellabs standard, according to the K&L/Gates memo, appears substantially similar to the standards that applied in the Eighth, and arguably, the Tenth Circuits.
The Tellabs opinion’s impact in the Second and Third Circuit may be less clear. The Supreme Court did not adopt the “motive and opportunity” standard that had applied in those Circuits, but in articulating its own standard, the Court noted that while “motive can be a relevant consideration,” the absence of a motive is “not fatal.” District courts in the Second and Third Circuits will adapt to this subtle shift in the pleading standard, but whether this change will prove outcome determinative remains to be seen.
In short, the practical impact of the Tellabs decision necessarily will be a mixed bag. That is undoubtedly why the Securities Law Prof blog opined (here) that the balance that the Tellabs courts struck “probably inflicted the least amount of damage on the plaintiffs” among realistic outcomes given the language of the statute.
Does Tellabs Change D & O Exposure?: Despite these considerations, the popular press generally has characterized the Tellabs case as a victory for the defendants and as a defeat for plaintiffs — for example, here and here. (This view has also been expressed in some law firms’ memoranda as well; for example, refer to the Proskauer Rose law firm’s memorandum, here.) This perception that Tellabs represented a major victory for defendants seems, at least based on my recent conversations, to be the view most predominant in the D & O industry as well. This view in turn has led some to whom I have spoken in the D & O insurance industry to question whether the Tellabs decision represents a significant reduction in D & O exposure, and that D & O insurance pricing therefore should be expected respond accordingly.
This discussion is highly reminiscent of the debate that followed the original enactment of the PSLRA in the mid-90s. Then, several key players took the view that the statute had dramatically reduced securities litigation risk, and they cut their D & O insurance prices accordingly. But securities litigation levels soon returned to (or beyond) pre-PSLRA levels, and the D & O industry has taken years to recover from the ensuing bloodbath. This all-too-recent episode, caused by erroneous presumptions about reductions in the risk exposure, should give everyone pause as they speculate about the possible effects of the Tellabs decision.
Another reason for caution is that it is far too early to predict how district courts will apply the Tellabs case. The discussion above about the opinion’s likely disparate impact further argues against jumping to conclusions about how it will affect overall D & O risk exposure.
It is entirely possible that the Tellabs decision will not, in the end, have that much of an impact one way or the other. Indeed, Justice Scalia expressly acknowledged this possibility in voting with the majority notwithstanding his view that the statute requires a more rigorous standard that the majority opinion adopted; as he stated, “I doubt in this instance, what I deem the correct test will produce results much different from the Court’s.”
The one category of cases that Tellabs undoubtedly will affect is that in which the existence of the allegedly fraudulent scheme is implausible. Not only is this the correct and desirable outcome, but as a practical matter, it is almost certainly the outcome to which the district courts would tend, regardless of the theoretical legal standard to be applied.
My crystal ball is no better than anyone else’s, but I believe that the Tellabs court’s balanced approach will in the end not have a material impact on the number of cases that get dismissed or on the number of cases that get filed. To be sure, the Tellabs opinion has clarified where battle lines must be drawn, and the placement of the battle lines may well affect some skirmishes. But neither side has been handed a strategically decisive weapon, and so the battle will rage on, in many ways much as before. In that regard, I think everyone should consider the press release that the Milberg Weiss firm issued the day the Tellabs decision was released (here); the press release says, “Investors everywhere should be very comfortable with the Supreme Court’s decision. We believe that the decision will not have an adverse impact on the prosecution of securities fraud cases.” I think they mean it; I also think they are right.
For these reasons, I am skeptical that the Tellabs decision represents a material change in D & O exposure, and I think it would be a mistake for D & O industry participants to change their behavior solely because of Tellabs, as least without substantial further evidence about how the trial courts are going to implement it.
But by the same token, there may be other factors out there that are altering D & O exposure. To cite but one example, I think the Dura Pharmaceuticals case has had and will continue to have a material impact on whether some complaints survive a motion to dismiss. Indeed, the impact from Dura may be one factor in the decline in the number of securities suits (about which more here). Because of Dura and other factors, I believe it is important for D & O industry participants to inquire whether the D & O risk exposure is changing. I just think it is premature (at best) for the industry to assume that the Tellabs decision alone represents a material change in D & O risk exposure.
In addition to the law firm memos cited above, some others I have read and are worth linking to here include the memos about the Tellabs decision from the following: Debevoise & Plimpton (memo here); Chadborne & Parke (memo here); Sidley Austin (memo here). The 10b-5 Daily has a round up of articles and comments on the Tellabs case, here.