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Case could set dismissal standards for securities lawsuits


WASHINGTON—A securities class action lawsuit that the U.S. Supreme Court has agreed to review could standardize how federal courts nationwide decide whether plaintiffs' claims are strong enough to survive defendants' initial efforts to dismiss them.

Securities class action experts, however, disagree over whether the high court's decision in Makor Issues & Rights Ltd. vs. Tellabs Inc. would lead to substantial changes in case dismissals.

In addition, because of the narrow issue at stake in Tellabs, the Supreme Court's decision may not resolve the main inconsistency in how federal courts determine whether allegations of securities fraud meet the standard-of-proof requirement established by federal law, one attorney said.

The Supreme Court agreed on Jan. 5 to hear the case, which centers on a provision in the Private Securities Litigation Reform Act of 1995. The act, designed in part to reduce frivolous securities fraud lawsuits, requires claimants to allege detailed facts sufficient to establish "a strong inference" that the defendants acted with scienter, or the intent to commit fraud.

Ruling that the plaintiffs' accusations were too vague to meet that test, a federal district court judge dismissed the Tellabs litigation.

But, in overturning the district court, the 7th U.S. Circuit Court of Appeals ruled that the case could proceed because a reasonable person could infer that the defendants acted with fraudulent intent. In its decision, the 7th Circuit refused to consider inferences that the defendants acted innocently.

Several other, though not all, federal appellate courts also have ruled on how innocent inferences play into the PSLRA's scienter provision.

Some circuits--the 1st, 4th, 6th and 9th--reject securities fraud cases when an innocent inference is just as plausible as a guilty inference, attorneys said.

Other circuits--the 8th and 10th--will not weigh competing inferences but will factor innocent inferences into their decisions on whether a case should survive, attorneys said. The 10th Circuit also has stated that it will not dismiss cases from which equally strong competing inferences can be drawn, said Carol A.N. Zacharias, senior vp and underwriting counsel for ACE USA in New York.

Despite the inconsistency among the circuits, the percentage of cases dismissed varies only nominally from circuit to circuit, Ms. Zacharias said. That could mean that the Supreme Court's decision in Tellabs will not meaningfully change the case dismissal rate, she said.

But insurer attorney Dan A. Bailey said the high court's ruling could dramatically influence case dismissal rates. District courts have to interpret their appellate court's interpretation of the PSLRA, so the reasoning behind case dismissal rulings within a circuit may vary considerably, said Mr. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio.

In addition, some circuits have not ruled on the issue, he said.

Therefore, if the Supreme Court creates a national standard, it could change the direction in which many courts nationwide are headed, he said.

To do that, however, the high court would have to look beyond the "strong inference" issue and also address the variability in how circuits define scienter, he said.

For example, in the 2nd Circuit, plaintiffs only need to show that the defendants had the motive and opportunity to commit a wrongful act to satisfy the PSLRA's scienter requirement, Mr. Bailey said.

In the 9th Circuit, however, plaintiffs must show that the defendants acted with "deliberate recklessness," he said.

In applying those scienter standards to securities cases, courts then must consider whether and how to factor in competing inferences of culpability and innocence, Mr. Bailey said.

So, the high court could clear up the narrower "strong inference" issue and leave the circuits divided on the broader issue of scienter, he said.

Attorneys would not predict how the Supreme Court would rule. But insurer attorney Arthur Washington said he does not think the Supreme Court will like the 7th Circuit's explanation that it would not consider innocent inferences because doing so could be mistakenly viewed as the court taking away the jury's role in the case.

That explanation "betrays a little gap in the court's reasoning," said Mr. Washington, a partner with Mendes & Mount L.L.P. in New York. "It doesn't matter if someone gets a false impression, because it's a false impression," he said.