Supreme Court Adopts A High Pleading Standard For Securities Class Actions

On June 21, 2007, the United States Supreme Court issued an important ruling that clarified and strengthened the pleading standard in securities fraud class action cases. The Court's 8-1 opinion in Tellabs, Inc. v. Makor Issues & Rights will make it more difficult for plaintiffs to survive a motion to dismiss with weak or conclusory allegations of fraud. See the complete opinion here.

Background: Federal Securities Litigation and the Private Securities Litigation Reform Act

In 1995, Congress passed the Private Securities Litigation Reform Act (PSLRA). The legislative history of the PSLRA shows that Congress was greatly concerned that frivolous securities lawsuits were causing significant damage to investors, the securities markets and the national economy. In particular, the pleading standards for securities complaints were felt to be too low, allowing too many frivolous suits to survive a motion to dismiss and imposing on defendants the significant costs of discovery and trial. To remedy this situation, Congress adopted new procedural hurdles for federal securities class action lawsuits, including stricter requirements for pleading fraud and an automatic stay of all pre-trial discovery until after a court had determined that the complaint might have merit.

For most federal cases, the rules governing pleading reflect a presumption that the plaintiff is entitled to proceed to discovery and trial unless the complaint is clearly groundless. A complaint need only set forth a "short and plain statement of the claim." Fraud cases require, in addition, that "the circumstances constituting fraud . . . be stated with particularity." In ruling on a motion to dismiss, the court must draw all reasonable inferences from the facts alleged in favor of the plaintiff.

The PSLRA made these requirements stricter by requiring that a complaint in a securities case "state with particularity facts giving rise to a strong inference" that the defendant acted with intent to deceive. Congress, however, did not define what it meant by a "strong inference." This was the issue before the Court in Tellabs.

Over the past few years, the federal appeals courts issued conflicting opinions on how lower courts should analyze complaints under the PSLRA. The Ninth Circuit, for example, ruled that instead of indulging all inferences in favor of the plaintiff, courts should consider "all reasonable inferences to be drawn from the allegations, including inferences unfavorable to...