What a difference 2 days make. In the wake of Stoneridge, we have proof that securities fraud class actions have not been thrown out of the ballpark, yet. Today, Judge Posner took on Congress and the Supreme Court and, following up on my baseball metaphor on Stoneridge, drew a wide strike zone for plaintiffs seeking to retire the "motion to dismiss" inning of the PSLRA.
In reaffirming the Seventh Circuit's reversal of a district court's dismissal of a securities fraud complaint against Tellabs, Judge Posner’s opinion allows plaintiffs allegations to slide right past the Supreme Courts court’s 8-1 ruling in Tellabs --- drawing wide boundaries for calling "compelling" and "cogent" inferences. These are Judge Posner's calls against defendants arguments:
Strike One ---The gravity of the risk can create a "strong inference" of scienter:
[L]iability requires proof of the defendant's "scienter," which is to say proof that he either knew the statement was false or was reckless in disregarding a substantial risk that it was false. ... A popular definition of recklessness in this context is "an extreme departure from the standards of ordinary care ... to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." .... This looks like two criteria--knowledge of the risk and how big the risk is--but as a practical matter it is only one because knowledge is inferable from gravity ("the danger was either known to the defendant or so obvious that the defendant must have been aware of it"). When the facts known to a person place him on notice of a risk, he cannot ignore the facts and plead ignorance of the risk. ...
Strike Two---Plaintiffs do not need to plead facts of actual knowledge required by the "safe harbor" for those portions of forward looking statements relating to present facts:
The fact that all the statements challenged in this case that we found in our earlier opinion to be materially false are in the present tense is not decisive on the question whether the statements include predictions: "Our earnings are certain to double" is in the present tense, but is a prediction. But a mixed present/future statement is not entitled to the safe harbor with respect to the part of the statement that refers to the present. When Tellabs told the world that sales of its 5500 system were "still going strong," it was saying both that current sales were strong and that they would continue to be so, at least for a time, since the statement would be misleading if Tellabs knew that its sales were about to collapse. The element of prediction in saying that sales are "still going strong" does not entitle Tellabs to a safe harbor with regard to the statement's representation concerning current sales.
Strike Three---First Out! ---Posner then throws his wit as hard as he can at both Congress and the
Supreme Court, revealing, an intellectual distaste for the PSLRA's "strong inference" requirement, and a conclusion that all reasonable inferences must still be drawn in favor of the plaintiff:
To judges raised on notice pleading, the idea of drawing a "strong inference" from factual allegations is mysterious. Even when a plaintiff is required by Rule 9(b) to plead facts (such as the when and where of an alleged fraudulent statement), the court must treat the pleaded facts as true and "draw all reasonable inferences in favor of the plaintiff." .... To draw a "strong inference" in favor of the plaintiff might seem to imply that the defendant had pleaded facts or presented evidence that would, by comparison with the plaintiff's allegations, enable a conclusion that the plaintiff had the stronger case; and therefore that a judge could not draw a strong inference in the plaintiff's favor before hearing from the defendant. But comparison is not essential, and obviously is not contemplated by the Reform Act, which requires dismissal in advance of the defendant's answer unless the complaint itself gives rise to a strong inference of scienter. For a defendant will usually have evidence to present in his defense; and so a complaint that on its face, and without reference to the defendant's case, creates only a weak or bare inference of scienter, suggesting that the plaintiff would prevail only if there were no defense case at all, would be quite likely to fail eventually when the defendant had a chance to put on his case, which would normally be after pretrial discovery. Apparently Congress does not believe that weak complaints should put a defendant to the expense of discovery in a securities-fraud case, which is likely to be complex-as this case is.
Strike One ---Posner makes the call that "apparent authority" and "respondeat superior" are still alive as a grounds for securities fraud liability----perhaps as an apology for having been forced to previously rule that the "group pleading" doctrine did not survive the PSLRA. Posner calls this "corporate scienter:
To establish corporate liability for a violation of Rule 10b-5 requires "look[ing] to the state of mind of the individual corporate official or officials
who make or issue the statement (or order or approve it or its making or issuance, or who furnish information or language for inclusion therein, or the like) rather than generally to the collective knowledge of all the corporation's officers and employees acquired in the course of their employment." .... A corporation is liable for statements by employees who have apparent authority to make them.
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The court in the Southland Securities case said that corporate scienter could be based on the state of mind of someone who furnished false information that became the basis of a fraudulent public announcement. Suppose he had knowingly supplied the false information intending to help the company. His superiors would not be liable for failing to catch the mistake, but Southland implies that the corporation would be liable, just as it would be in a common law tort suit.
Strike Two--- Using "corporate scienter" to get around the arguments defendants and judges often make, that plaintiffs must plead "who knew what and when", Posner teaches us that all we need are sufficient facts to infer that "management" knew that true facts:
The critical question, therefore, is how likely it is that the allegedly false statements that we quoted earlier in this opinion were the result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading. It is exceedingly unlikely. The 5500 and the 6500 were Tellabs's most important products. The 5500 was described by the company as its "flagship" product and the 6500 was the 5500's heralded successor. They were to Tellabs as Windows XP and Vista are to Microsoft. That no member of the company's senior management who was involved in authorizing or making public statements about the demand for the 5500 and 6500 knew that they were false is very hard to credit, and no plausible story has yet been told by the defendants that might dispel our incredulity.
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All this is not to say that the plaintiffs could name "management" as a defendant or, less absurdly, name each corporate officer. That would be an example of "the group pleading doctrine[, which] is a judicial presumption that statements in group-published documents including annual reports and press releases are attributable to officers and directors who have day-to-day control or involvement in regular company operations." ..... As we held in our firs t opinion, the doctrine is inconsis tent with the "strong inference" requirement. ....But it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud. Suppose General Motors announced that it had sold one million SUVs in 2006, and the actual number was zero. There would be a strong inference of corporate scienter, since so dramatic an announcement would have been approved by corporate officials sufficiently knowledgeable about the company to know that the announcement was false.
Strike Three---Two Outs!---Posner next makes the call that, while the Seventh Circuit has rejected "channel stuffing" allegations in the past, they are alive and well when, as in Tellabs, they are so suspect and the goods come back:
Another possible, though again very unlikely, example of innocent misunderstanding is the charge of "channel stuffing." The term refers to shipping to one's distributors more of one's product than one thinks one can sell. A certain amount of channel stuffing could be innocent and might not even mislead-a seller might have a realistic hope that stuffing the channel of distribution would incite his distributors to more vigorous efforts to sell the stuff lest it pile up in inventory. Channel stuffing becomes a form of fraud only when it is used, as the complaint alleges, to book revenues on the basis of goods shipped but not really sold because the buyer can return them. They are in effect sales on consignment, and such sales "cannot be booked as revenue. Neither condition of revenue recognition has been fulfilled-ownership and its attendant risks have not been transferred, and since the goods might not even be sold, there can be no certainty of getting paid. But those strictures haven't stopped some managers from using consigned goods to fatten the top line-that is, the revenue line-of the corporate income statement." ....(Similarly, Tellabs could not properly record revenue on its contract with Sprint before actually transferring title to 6500 systems to Sprint.) The huge number of returns of 5500 systems is evidence that the purpose of the stuffing was to conceal the disappointing demand for the product rather than to prod distributors to work harder to attract new customers, and the purpose would have been formed or ratified at the highest level of management.
Strike One---Finding these inferences to be "at least as compelling," as defendants suggestions or innocence, Posner calls a strike on the Supreme Court's use of the word "cogent" as being still another requirement:
So the inference of corporate scienter is not only as likely as its opposite, but more likely. And is it cogent? Well, if there are only two possible inferences, and one is much more likely than the other, it must be cogent. Suppose a person woke up one morning with a sharp pain in his abdomen. He thought it was due to a recent operation to remove his gall bladder, but realized it could equally well have been due to any number of other things. The inference that it was due to the operation could not be thought cogent. But suppose he went to a doctor who performed tests that ruled out any cause other than the operation or a duodenal ulcer and told the patient that he was 99 percent certain that it was the operation. The plausibility of an explanation depends on the plausibility of the alternative explanations. .... As more and more alternatives to a given explanation are ruled out, the probability of that explanation's being the correct one rises. "Events that have a very low antecedent probability of occurring nevertheless do sometimes occur (the Indian Ocean tsunami, for example); and if in a particular case all the alternatives are ruled out, we can be confident that the case presents one of those instances in which the rare event did occur." ....Because in our abdominal-pain example all other inferences had been ruled out except the 1 percent one, the inference that the pain was due to the operation would be cogent. This case is similar. Because the alternative hypotheses-either a cascade of innocent mistakes, or acts of subordinate employees, either or both resulting in a series of false statements-are far less likely than the hypothesis of scienter at the corporate level at which the statements were approved, the latter hypothesis must be considered cogent.
Strike Two---Posner then applies this strike zone to to the CEO who wanted the court to walk him by calling for a stronger inference that he was just an ignoramus, with fast ball directed at his plea that he could not have possibly had any motive. Posner concludes that the fear of a stock drop on the revelation of such bad news is sufficiently inferred:
And at the top of the corporate pyramid sat Notebaert, the CEO. The 5500 and the 6500 were his company's key products. Almost all the false statements that we quoted emanated directly from him. Is it conceivable that he was unaware of the problems of his company's two major products and merely repeating lies fed to him by other executives of the company? It is conceivable, yes, but it is exceedingly unlikely.
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Against all this the defendants argue that they could have had no motive to paint the prospects for the 5500 and 6500 systems in rosy hues because within months they acknowledged their mistakes and disclosed the true situation of the two products, and because there is no indication that Notebaert or anyone else who may have been in on the fraud profited from it financially. The argument confuses expected with realized benefits. Notebaert may have thought that there was a chance that the situation regarding the two key products would right itself. If so, the benefits of concealment might exceed the costs. Investors do not like to think they're riding a roller coaster. Prompt disclosure of the truth would have caused Tellabs's stock price to plummet, as it did when the truth came out a couple of months later. Suppose the situation had corrected itself. Still, investors would have discovered that the stock was more volatile than they thought, and risk-averse investors (who predominate) do not like volatility and so, unless it can be diversified away, demand compensation in the form of a lower price; consequently the stock might not recover to its previous level. The fact that a gamble-concealing bad news in the hope that it will be overtaken by good news-fails is not inconsistent with its having been a considered, though because of the risk a reckless, gamble…. It is like embezzling in the hope that winning at the track will enable the embezzled funds to be replaced before they are discovered to be missing.
STRIKE THREE ---And finally, Posner calls as a final strike the unexpected curve ball at the Supreme Court's suggestion that the use of confidential witnesses requires a "heavy discount'---unexpected since the Supreme's picked up on that suggestion from the Seventh Circuit itself:
The defendants complain, finally, about the complaint's dependence on "confidential sources." The 26 "confidential sources" referred to in the complaint are important sources for the allegations not only of falsity but also of scienter. Because the Reform Act requires detailed fact pleading of falsity, materiality, and scienter, the plaintiff's lawyers in securities-fraud litigation have to conduct elaborate pre-complaint investigations-and without the aid of discovery, which cannot be conducted until the complaint is filed. Unable to compel testimony from employees of the prospective defendant, the lawyers worry that they won't be able to get to first base without assuring confidentiality to the employees whom they interview, even though it is unlawful for an employer to retaliate against an employee who blows the whistle on a securities fraud, 18 U.S.C. § 1514A, and even though, since informants have no evidentiary privilege, their identity will be revealed in pretrial discovery, though of course a suit might never be brought or if brought might be settled before any discovery was conducted.
The problem with this argument-besides the seeming flimsiness of the asserted need for anonymity-is that allegations based on anonymous informants are very difficult to assess. This concern led us to suggest in Higginbotham v. Barter International, Inc., supra, 495 F.3d at 756-57, that such allegations must be steeply discounted. But that was a very different case from this one. The misconduct alleged consisted of frauds committed by Baxter's Brazilian subsidiary, but because the suit was against the parent, the plaintiffs had to show that the parent knew about the Brazilian fraud. The subsidiary had tried to conceal it from its parent as well as from the Brazilian government. There was no basis other than the confidential sources, described merely as three ex-employees of Baxter and two consultants, for a strong inference that the subsidiary had failed to conceal the fraud from its parent and thus that the management of the parent had been aware of the fraud during the period covered by the complaint.
The confidential sources listed in the complaint in this case, in contrast, are numerous and consist of persons who from the description of their jobs were in a position to know at first hand the facts to which they are prepared to testify, such as the returns of the 5500s, that sales of the 5500 were dropping off a cliff while the company pretended that demand was strong, that the 6500 was not approved by Regional Bell Operating Companies, that it was s till in the beta stage and failing performance tests conducted by prospective customers, and that it was too bulky for customers' premises. The information that the confidential informants are reported to have obtained is set forth in convincing detail, with some of the information, moreover, corroborated by multiple sources. It would be better were the informants named in the complaint, because it would be easier to determine whether they had been in a good position to know the facts that the complaint says they learned. But the absence of proper names does not invalidate the drawing of a strong inference from informants' assertions.
And then, with words sweet to the ears of investors, Posner retires the inning, and tells the plaintiffs that,once again, they are up to bat:
We conclude that the plaintiffs have succeeded, with regard to the statements identified in our previous opinion as having been adequately alleged to be false and material, in pleading scienter in conformity with the requirements of the Private Securities Litigation Reform Act. We therefore adhere to our decision to reverse the judgment of the district court dismissing the suit.
REVERSED AND REMANDED.
Posner has defined the strike zone. The Judges in the Seventh Circuit must take heed of the broad outer boundaries of that mysterious "strong inference" requirement, and the requirement of finding those inferences to be "at least as compelling" and "cogent."
Thursday, October 2, 2008 at 7:01AM 
