Supreme Court deals blow to securities class actions, 8-1
By a resounding 8-1 margin, the Supreme Court dealt a blow to securities class action plaintiffs this morning by, in effect, requiring that they be able to show fairly convincing evidence of fraud before they can even initiate a lawsuit. The opinion was authored by the relatively liberal Justice Ruth Bader Ginsburg, and the only dissenter was Justice John Paul Stevens.
The much anticipated case, Tellabs v. Makor Issues and Rights, involves a crucial issue that arises in virtually every class action securities fraud case: how strong a case of fraud must the plaintiffs allege in their initial complaint to avoid having the case get immediately thrown out. In an effort to weed out frivolous securities class actions early, Congress enacted legislation in 1995 (the Private Securities Litigation Reform Act) that began requiring plaintiffs to allege specific facts creating a “strong inference” that the defendant company and officials acted with fraudulent intent. But Congress did not further define that phrase at the time and the Supreme Court had never addressed the issue until now.
“To qualify as ’strong,’” Ginsburg wrote, “an inference of [knowing wrongdoing] must be ‘more than merely plausible or reasonable — it must be cogent and at least as compelling as any opposing inference’ of a lack of intent to defraud.”
She continued: “A complaint will survive, we hold, only if a reasonable person would deem the inference of [wrongful intent] … at least as compelling as any opposing inference one could draw from the facts alleged.” This language appears to require a stronger showing from the plaintiffs than has been required of them previously by most federal appeals courts to date.
“The opinion gives defendants about 90% of what they could reasonably have hoped for in terms of the standard for pleading fraudulent intent,” says Meir Feder, who heads the appellate unit of Jones Day’s New York office. “This standard will help companies and their officers and directors defeat lawsuits before having to undergo expensive and time-consuming discovery — and it will be a particular obstacle to the type of lawsuit that seems to get filed reflexively, without much real evidence of fraud, as soon as a company announces some bad news that makes its stock drop.”
“The 10% that defendants didn’t get here,” Feder continues, “is that they didn’t get a ruling that fraud has to be a more likely inference than a non-fraud explanation of what happened.” In separate concurring opinions, Justices Antonin Scalia and Samuel Alito said they would have given defendants that, too. Scalia (memorably) wrote: “If a jade falcon were stolen from a room to which only A and B had access, could it possibly be said there was a ’strong inference’ that B was the thief? I think not.”
Because Scalia’s and Alito’s more draconian views were rejected, plaintiffs class action lawyer Sean Coffey, of Bernstein Litowitz Berger & Grossmann, says he’s relieved about the ruling. “It’s not bad,” he says. “I’m pleasantly surprised.” He says that “now in the event of a tie, the plaintiff wins. There’s a lot for investors to be relieved about, and maybe even pleased about.”
The ruling reverses that of the federal appeals court in Chicago, which had allowed the case to go forward, but will not necessarily result in dismissal of the case either. Instead, the case will go back to the district court, in Chicago, for reconsideration in light of the standard articulated today.
In dissent, Justice Stevens would have required plaintiffs to meet only a lower “probable cause” standard, like the one used for criminal arrests or indictments. “It is most unlikely that Congress intended us to adopt a standard that makes it more difficult to commence a civil case than a criminal case.”
The definition of “strong inference” is so important, because it tests what plaintiffs lawyers must allege even before the discovery process has begun — i.e., the process whereby plaintiffs can force the company to produce documents and let their officers be examined under oath. If a case can be dismissed at that initial stage, defendant companies can avoid a discovery process that will cost millions of dollars and likely last two years or longer. If, on the other hand, a case gets past the defendants’ initial motion to dismiss, and does enter that discovery process, the defendants are much more likely to settle, in order to avoid those litigation costs, regardless of the ultimate merits of plaintiffs claims.
“To cut through the legal gobbledy-gook,” says Feder, “this is really the number one issue on which securities class actions can get dismissed at the threshold of litigation.”
Plaintiffs lawyers have also considered the Tellabs case crucial. In their opening brief to the Supreme Court the plaintiffs (represented by lead counsel Richard Weiss of Milberg Weiss & Bershad and Harvard Law School professor Arthur Miller) wrote: “Like sharks scenting blood in the water, an array of corporate interests has mobilized in an attempt to administer a coup de grace to private securities enforcement by convincing this Court to raise the pleading standard to unprecedented heights.”
The case arose from the sudden collapse of the telecommunications industry in 2000-2001. Tellabs (TLAB) makes optical networking equipment that is sold to telecommunications carriers and Internet service providers. As late as December 2000 its then CEO, Richard Notebaert, was still projecting 30% earnings growth for his company for the following year. (Notebaert, now CEO of Qwest (Q), is often given credit for having helped pulled Qwest out of the accounting scandal in which it was mired when he arrived in 2002.) In March and April 2001 Notebaert twice adjusted Tellabs’s earnings estimates downward, and finally in June 2001 he withdrew all guidance, acknowledging that the market had radically changed for the worse from what it had been the previous year. The plaintiff investors were alleging that Notebaert had known his optimistic projections were misleading at the time he delivered them. But neither Notebaert or any other Tellabs official was accused of insider training or of having otherwise benefited from the alleged misstatements.
The case is the latest in a series of setbacks that class action plaintiffs in business related cases have been dealt by the High Court. On Monday, in Credit Suisse Securities v. Billing, the court threw out (by a 7-1 vote) an antitrust challenge brought against the way investment banks handled initial public offerings during the dot-com boom (see here), and in May, in Bell Atlantic v. Twombley, it raised the pleading standards required to bring an antitrust case based upon a conspiracy theory. Last term, in Merrill Lynch v. Dabit, it also stanched plaintiffs’ attempts to circumvent the strictures of the 1995 securities class action reform law by filing certain cases in state court.
Qwest Communications hired me to work in Columbus Ohio right around 2001. It was a pretty good offer 57,000 a year salary plus stock options. I signed a 1 year lease on a nearby apartment. Boy did they push the stock options. Meanwhile I was noticing that then CEO Nachio was selling his stocks like crazy.
To make a long story short, within 7 weeks of being hired and assured my job would be stable, and after buying lots of stock, the better part of our department was layed off.
Thanks alot qwest and all the greedy losers who wrecked my life.
You’ll meet your maker some day and have to answer for your greed. Have fun in purgatory.
Sincerely,
Jesse L. Studebaker
Corpsman United States Navy
I really feel bad for Dave Garcia.
Everyone is dumping on him, but he was cheated out of his money. These stockbrokers are nothing more than high-class snakeoil salesman. All they care about is making a quick buck off of an investor. They pretend as if they are interested in their clients. All they want is their commissions. I think that we need to be able to sue these slimeball brokers, financial advisors, and these other organizations that prey on the little man investing out here.
We work hard for our money. Just to have it taken from us by some fancy guy in a suit and tie is maddening! I think they need to have tougher laws for these financial misdeeds out here. These people are robbing the ordinary Joe out of his retirement money! I am mad as hell too Dave! These guys are worthless!
JDSU Dave…
I too lost tons more than the $30K you lost, and I blame (drum roll please … 
ME. Why? Warning signs were all over. People who have no idea what they were getting themselves into were blindly jumping in. Read up on the Tulip Chaos in Europe. The events that led up to the 1929 crash. I admit, I didn’t think it was “Time” yet.
I followed Tellabs, Lucent, Motorola, JDSU, CMGI, Ebay, etc. - all of them since the early 90’s and made lots of money. The concept is “when is enough enough”? I got greedy and ended up giving quite a bit back. It was a valuable lesson, and am back in the game stronger and smarter than I ever was before.
Recoup? From who? From those smarter than me that got out - and “made enough”?
To those that think someone (read corporate america - brokers, etc) are responsible for sating your greed - get real. You are the only one that can keep yourself out of financial ruin. Trust yourself. Make the money and run Never fall in love with a stock (do I need to go on?)
Anyone who calls someone, especially, one of our Supreme Court Judges, a “I hate America leftie” is surely leaning on the poisoned philosophy of paranoid former Senator Joe McCarthy. Or, in other words, who died and put them in charge of Patriotic values? In fact, those type of fools are simply the worst kind of citizen this country can offer. In addition, just to make it to the Supreme Court requires one to be fairly conservative in the first place. Calling a Supreme Court judge a liberal is simply juvenille and demonstrates the true dumming down of America.
This is not a blow to invenstors…it’s a blow to lawyers and others who pursue frivolous lawsuits for profit, IMO.
Dave, haven’t you ever heard of diversification? If you invested so much money on one signal stock you took on additional systematic risk for no additional return and possessed an inefficient investment portfolio. Your loss was due to your lack of experience and understanding in investing. There are always going to be winners and loosers in the stock market. However, as you know, the stock market in the long run as a whole has historically returned higher profits for investors then other safer investments such as bonds, cds, or precious metals. You fail to understand the basic concept of risk and return. The higher the risk, the higher the return on the investment. If you invest for short periods of time then there is a higher probability that the sometimes volatile stock market will not perform as you desire, especially if you pick and choose individual stocks which exposes you to even greater risk than say an index fund for example. Learn to invest and quit complaining. We live in a ridiculous cultural of frivolous law suits. Have you heard of the judge that is suing a dry cleaner for 2 million dollars over a pair of pants. Outrageous!
How did Dave as a “small investor” lose $30K on one stock anyway?
Dave, I completely agree with you. Everyone is out out to get you, including the folks at JDSU, Wall Street, your broker and the administration. But don’t stop there. The entire financial system is out to get you and all the small investors. I would suggest putting all your money under your mattress and holing up in some compound in the Midwest to avoid this worldwide conspiracy to defraud you and the millions of investors who see stock ownership as a way to develop a diversified portfolio of financial assets which will help them maintain their purchasing power.
As the “winner” of so many lawsuits that I have lost count, I have to agree that the only losers here were the trial lawyers. My average recovery has been a few dollars (and I mean few - like $5 to $10, I think my big one was $19). However the lawyers have walked away with millions. I only go ahead an process my claims to take some of the money from the lawyers. Otherwise, I would consider it a waste of my time.
The headline was about the most biased I have ever seen. It should have read, SUPREME COURT DEALS BLOW TO TRIAL LAWYERS AND FRIVOLOUS LAW SUITS.
Since when is Ruth Bader Ginsburg relatively liberal? That’s like saying Antonin Scalia is relatively conservative. Ginsburg was an ACLU activist before she became a judge.
I am a small investor and do just fine in the market overall . The claim that this “hurts” small investors or that somehow the market is “rigged” against the little man is horse hockey .There has never been a time in our nations history where the diligent small investor has had more tools at their disposal .
People too lazy to properly do their own due diligence on stocks are probably also clueless that companies now are being sued at the drop of a hat ( or stock dip) by multiple ambulance chasing lawfirms every time the wind blows . I am more than aware of that fact because I read the wire releases on companies I own ( Hint: That requires one to do at least some of their own fact finding instead of relying on “hot tips” from your stockbroker , your cabbie or the bus boy in your local dining establishment )
If they can’t substantiate the flood of frivilous lawsuits that has become the norm ( which also sucks life from companies forced to fight them whether they have merit or not ) then kick their butts out of court .
Goodness, Dave, thanks for not blaming me as well in your rant. Face it, investing has risks and markets change. If you do something stupid, it is not George W’s fault, or the courts. Your broker is out for your broker. Just remember, ownership makes money - and that is exactly what stocks do in the long run. However, you should always have an early exit strategy that limits your losses. That is not “the administration’s” responsibility … it is yours.
First of all, the headline “Supreme Court Deals Blow to Investors” is hogwash - the only group being “dealt a blow” by this are lawyers. In the long run, investors are more likely to benefit since the companies they invest in will waste less money defending against unfounded lawsuits. Note that the author of this piece is “formerly a practicing litigation attorney” - what a surprise.
And a note to Dave Garcia - this action has nothing to do with getting bad advice from a broker. I lost money on my last trip to Vegas - who should I sue?
The average settlement in a class-action suit is less than a penny on the dollar. The law firm initiating the suit is paid multi-millions for their administrative cost and the residual value of the stock, if any, is further depressed by the looming class action. Only the law firms that benefit from this form of “justice” will miss the opportunity to initiate these lawsuits.
What a stupid way to stop lawyers.I believe that the greedy senior exec’s know when they are steeling.
Justice Ginsburg is “relatively liberal”? True, perhaps, compared to Fidel Castro. Compared to others on the bench, however, Ginsburg is an unqualified radical ACLU “I hate America” leftie.
A blow to investors? No. Not at all. This is a blow to TRIAL LAWYERS. What a dishonest article.
Being the small guy investor who lost the 30K I invested in JDSU during the dot-bomb when their stock plummeted from the 143.00 I paid a share to 6.00 while all along my stockbroker was telling me to HOLD and I then tried to re-coup by attempting to join a class action, I can tell you this decision does not sit well with me and simply tells me the current administration is obviously in bed with big business and as a result sided with them on this issue. Shame on me for trusting my broker and Wall street, as in my opionion the only ones that make out big in stocks are those with big bucks. The stock market is no no way shape or form fair or open with the small investor and hence has caused me to shy away from stocks. So as it goes and has been said many times, the rich get richer and the rest of us don’t.
As a CEO trying to run a medium sized company, it is important that there exists a definitive amount of evidence of fraud before any kind of legal action can take place. Many lives are destroyed by these kinds of Frivolous Accusations by any disgruntled stockholders.
First and foremost it is important to protect the integrity of the company and its employees. The foundation of the company must prevail in order to allow for the continuity of its existance.
A legal threat alone is extortion unless it can provide evidence of definitive fraud.
A struggling corporation can be at the mercy of a minority stockholders emotional outlook on the management of the company.
It is important to note, in this case that the Company must be protected to insure the continuing function of its productive capacity, creating cash flows necessary for its survival.
Any and all frivolous attempts of legal extortion by any minority stockholder should force legal repercussions to that minority stockholder forcing him or her to have exact information upoholding their claim.
Isn’t this better, in the long run, for legitimate class-action lawsuits? If this reduces the incentive to file frivolous lawsuits then presumably lawsuits that are filed will be more likely to be perceived to be legitimate by the courts.
An allegation of fraud always required clear and convincing evidence before a Plaintiff could get an audience before a jury. So why should these plaintiffs who could destroy lives by mere filing a law suit be entitled to a lower burden than that which is required by the general law?
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This blog is about legal issues that matter to business people, and it's geared for nonlawyers and lawyers alike. Roger Parloff is Fortune magazine's senior editor (legal affairs). He practiced law for five years in Manhattan before becoming a full-time journalist.
I just read Dave’s lament and have this to say - If you don’t understand the risks in the stock market then get out! I manage my father’s investments and at the time of the Enron debacle, his financial advisor was advising me that his analyist was saying Enron was set to go to $100 or more. After reviewing the data available, I finally figured out that it was all smoke and mirrors and bailed at $72. Ironically dad’s financial advisor saw me bail and advised his other clients to bail too. A short while later, Enron was headed to the cellar. Saved more than one person’s bacon on that one. Not to mention I made a good gain of roughly 25% to boot. If you can’t run with the big dogs then buy CD’s!