Tellabs redux

On Thursday, January 17, a Seventh Circuit Court of Appeals panel led by Judge Richard A. Posner handed down the Circuit’s second crack at the “strong inference” standard in the Tellabs matter. Makor Issues & Rights, Ltd. v. Tellabs, Inc., __ F.3d __, No. 04-1687, 2008 U.S. App. LEXIS 975 (7th Cir. Jan. 17, 2008). This latest Tellabs opinion (“Tellabs II”) arose out of a “comeback” case for the Seventh Circuit, following the United States Supreme Court’s June 2007 rejection of the Circuit’s initial attempt to divine the Securities Exchange Act of 1934’s “strong inference” of scienter requirement, as amended by the Private Securities Litigation Reform Act of 1995 (“PSLRA”). See Tellabs, Inc. v. Makor Issues & Rights, Ltd., ___ U.S. ___, 127 S. Ct. 2499 (2007) (vacating and remanding Makor Issues & Rights, Ltd. v. Tellabs, Inc. (“Tellabs I”), 437 F.3d 588 (7th Cir. 2006)).

By way of background, the Tellabs saga involved a manufacturer of specialized fiber-optic equipment which, along with several of its top officers, was accused of securities fraud by investors. After repeatedly providing optimistic reassurances in late 2000/early 2001 about the company’s financials, projected revenues/earnings, and demand for its main products, the bombshell, contradictory truth burst in mid-2001: the fiber-optics bubble had already burst in the prior year, purported demand for Tellabs’s core products was actually a sham, and the company’s revenues and profits were plummeting. Not surprisingly, Tellabs stock fell from its class-period peak of $67 to just under $16, and outraged investors filed suit.

Following the district court’s dismissal of the investors’ securities-fraud complaint, the Seventh Circuit reversed in part and held that the investors had met the “strong inference” of scienter standard by alleging facts “from which, if true, a reasonable person could infer that the defendant acted with the requisite intent.” (While stating that holding, the Seventh Circuit explicitly rejected a more-stringent standard that had been adopted by the Sixth Circuit – i.e., that plaintiffs’ inferences had to be more plausible than any competing inferences. Cf. Fidel v. Farley, 392 F.3d 220, 227 (6th Cir. 2004) (PSLRA’s heightened pleading requirements mean that “‘plaintiffs are entitled only to the most plausible of competing inferences’”)).

Granting certiorari, the Supreme Court rejected both views: While the scienter inferences in plaintiffs’ favor need not be irrefutable, or even the most plausible of competing inferences, nor will they suffice if merely “‘reasonable’ or ‘permissible.’” Plaintiffs satisfied the PSLRA’s strong-inference requirement “only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”

On remand to the Seventh Circuit, the Tellabs II panel applied the Supreme Court’s newly enunciated standard. Judge Posner’s opinion is wide-ranging, to be sure, but within its wide expanse there are several gems that are sure to provoke a flurry of supplemental briefing in securities-fraud cases around the country. (Oddly, on the case’s remand the Tellabs II panel was composed of just two of three Circuit judges from Tellabs I; Judge Posner replaced Judge Ripple.) In no particular order, here are several – albeit not all – of the conclusions that Tellabs II reaches concerning strong-inference factors:

The “Core” Product Inference

Judge Posner reaffirms the vitality of what some securities practitioners call the “core product” inference: Contributing to the overall strong inference of scienter was the fact that the company’s troubles directly involved two of its most important products – the “Titan 5500” and “Titan 6500” switching systems. “The 5500 and the 6500 were Tellabs’s most important products,” with the 5500 described by Tellabs as its “‘flagship’” product, and the 6500 its heralded successor. While Judge Posner considers the opposing inference – that the public falsehoods resulted from innocent or merely careless mistakes at the executive level – the sheer importance of the two systems to Tellabs’s fortunes made that supposition “exceedingly unlikely.” Indeed, “[t]hat 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.”

Posner’s embrace of the core-product inference is important, for in the wake of the PSLRA, defense practitioners often attempt to argue that the inference cannot rise to the level of, or even contribute to, a “strong” inference. Yet the core-product inference has a long and storied history, dating back at least to the Second Circuit’s decision in Cosmas v. Hassett, 886 F.2d 8, 12-13 (2d Cir. 1989), where plaintiffs pleaded facts “which give rise to a strong inference that the defendants possessed the requisite fraudulent intent” by “alleg[ing] facts from which one can reasonably infer that sales to the [Peoples Republic of China] were to represent a significant part of [the company’s] business.” Such facts “give rise to a strong inference that the defendants . . . had knowledge of the PRC import restrictions, since the restrictions apparently eliminated a potentially significant source of income for the company.” Significantly, the Second Circuit is generally acknowledged to be the font from which the PSLRA’s strong-inference requirement flows.

Thus, with Tellabs II‘s acknowledgment that undisclosed problems with a “core” product can bolster a strong inference of scienter, Judge Posner has dipped a toe back into that font, and possibly muted the protests of those who insist that the PSLRA does not allow strong inferences to flow from the nature of the fraud’s subject.

A Defendant’s High-Level Position

Also noteworthy in terms of a strong-scienter inference, explains Judge Posner, is that Tellabs’s Chief Executive Officer Richard Notebaert was doing much of the talking. While defense counsel usually argue that a securities-fraud defendant’s management status adds little, if anything, to a scienter analysis, Judge Posner holds otherwise: “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.” Was it conceivable that a CEO was unaware of problems roiling his company’s main products? “It is conceivable, yes, but it is exceedingly unlikely.” The CEO’s position, coupled with the important nature of the products and his statements concerning them, combine to add yet another bolstering factor to a strong inference of the requisite scienter.

Channel Stuffing

Judge Posner acknowledges that, while there may occasionally be innocent explanations for “channel stuffing” – shipping to one’s distributors more of a product than one thinks one can sell – the practice often heralds a more-sinister reality: It can be used “to book revenues on the basis of goods shipped but not really sold because the buyer can return them.” In Tellabs II, the huge number of Titan 5500 returns was “evidence ” that the channel stuffing there was intended “to conceal the disappointing demand for the product rather than to prod distributors to work harder to attract new customers.” Tellingly, the improper “purpose would have been formed or ratified at the highest level of management.”

Defendants’ Motivation to Commit Fraud

Securities-fraud defendants often carp that there can be no scienter associated with their actions because they didn’t actually profit from the alleged fraud; they didn’t sell their company’s inflated stock, or reap unusual bonuses for their troubles. Along these lines, the defendants in Tellabs II argued that any scienter inference was undermined because (1) there was no indication anyone at the company profited from the fraud, and (2) in any event, within months they had ‘fessed up’ and acknowledged the mistakes concerning the prospects for their core products.

The Tellabs II panel was unimpressed: That argument “confuses expected with realized benefits.” Moreover, even if Tellabs’s CEO thought the situation might right itself, that in itself might comprise a relevant benefit: “[T]he benefits of concealment might exceed the costs.” At bottom, even though a gamble ultimately fails, that failure “is not inconsistent with its having been a considered, though because of the risk a reckless, gamble.”

Judge Posner is on solid, albeit already trodden ground here. In the opinion that remanded Tellabs back to the Seventh Circuit, the Supreme Court rejected the defendants’ argument that Notebaert’s “evident lack of pecuniary motive” is dispositive of scienter: “While it is true that motive can be a relevant consideration, and personal financial gain may weigh heavily in favor of a scienter inference, we agree with the Seventh Circuit that the absence of a motive allegation is not fatal.”

The Seventh Circuit Expands Upon Confidential “Sources”

In mid-2007, the Seventh Circuit announced in Higginbotham v. Baxter that the Supreme Court’s recent Tellabs decision meant that – given Higginbotham‘s unique fact pattern, at least – “we must discount allegations that the complaint attributes to five ‘confidential’ witnesses.” Higginbotham v. Baxter Int’l, Inc., 495 F.3d 753, 756-57 (7th Cir. 2007) (J. Easterbrook). Defendants around the country breathed a collective sigh of relief as the influential Judge Easterbrook wrote that the allegations from the anonymous sources in that case had to be discounted – for “[p]erhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.”

That collective sigh may have morphed into a sharp intake of breath, however, for Tellabs II (and its author, Judge Posner, who sat on the Higginbotham panel) explains exactly what the problem was with the anonymous Higginbotham witnesses who were located far away from the “knowing” defendants:

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.

Indeed, “[t]here 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.”

Here, in contrast, the confidential sources providing information about Tellabs’s internal problems were “numerous,” and described sufficiently to conclude that they were in “position[s] to know at first hand the facts to which they are prepared to testify.” Moreover, the information from the confidential sources was set forth in “convincing detail,” and “some” of it was “corroborated by multiple sources.” While the Seventh Circuit would have preferred that the sources be named, it was not an inviolate requirement: “[T]he absence of proper names does not invalidate the drawing of a strong inference from informants’ assertions.”

With this section of Tellabs II, Judge Posner reconciles Higginbotham‘s seemingly stingy view of confidential sources with the reality of the fact-intensive nature of these cases. (He may have recognized, as well, that Higginbotham appears to go just a bit too far in excoriating the anonymous sources there. Some practitioners have commented that Higginbotham‘s casual suggestion that perhaps the confidential witnesses there were “lying” or “don’t even exist” irreconcilably conflicts with the Supreme Court’s recent admonition in Tellabs that courts at the pleading stage cannot decide whether witnesses are truthful: “[T]he case will fall within the jury’s authority to assess the credibility of witnesses.” Accord Bell Atl. Corp. v. Twombly, ___ U.S. ___, 127 S. Ct. 1955, 1965 (2007) (“‘Rule 12(b)(6) does not countenance . . . a judge’s disbelief of a complaint’s factual allegations.’”). But that is a matter for another day.)

At bottom, Tellabs II provides yet another touchstone in the great mosaic of securities law that is being pieced together in these heady times of financial boom and bust.