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Securities lawsuit ruling favors defendants

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WASHINGTON--A U.S. Supreme Court ruling that standardizes how federal courts should determine whether securities class action claims should survive initial dismissal efforts slightly favors defendants but ultimately will make little difference, say several legal experts.

The closely watched case, Tellabs Inc. et al. vs. Makor Issues & Rights Ltd. et al., turned on a provision in the 1995 Private Securities Litigation Reform Act that requires claimants to allege detailed facts sufficient to establish "a strong inference" that the defendants acted with scienter, or intent to commit fraud.

Shareholders in 2002 sued Naperville, Ill.-based Tellabs, charging that the telecommunications equipment manufacturer issued misleading statements on the company's earnings and demand for its products.

A district court dismissed the case in 2004, ruling that the plaintiffs were misled but that they did not demonstrate that the defendants intended to committed fraud.

But, on appeal, 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. The 7th Circuit refused to consider inferences that the defendants knowingly had acted innocently.

Courts in other circuits consider inferences of culpability and innocence but balance them in different ways when determining whether to dismiss a case. That inconsistency prompted the Supreme Court to review the Tellabs case (BI, Jan. 15).

In its 8-1 decision on June 21, the high court rejected the 7th Circuit's model for determining a "strong inference" of intent to commit fraud and established a standard that requires a court to consider all inferences before deciding whether the case should survive. The inference that a defendant acted with intent need not be irrefutable, but it must be "cogent and at least as compelling as any opposing inference one could draw from the facts alleged," Justice Ruth Bader Ginsburg wrote for six of the justices in the majority.

The court also rejected a defense argument that the case should be dismissed because the plaintiffs did not show that the company had a motive to deceive investors or reaped personal financial gain as a result. The court ruled that the absence of those otherwise "relevant" factors does not doom a case if other evidence leads to a strong inference of culpability.

The court remanded the case to a district court for review under the new standard.

Legal experts agree that the ruling at most will lead to a slight increase in dismissals.

"I think it will result in a few more cases being dismissed, but it's not going to be a large number of cases being dismissed that otherwise would not be," said insurer attorney Dan A. Bailey, a partner with Bailey Cavalieri L.L.C. of Columbus, Ohio.

The biggest benefit of the ruling is that it establishes a consistent standard among the circuits, Mr. Bailey said.

Plaintiffs attorney Carol Gilden, president of the Washington-based National Assn. of Shareholder and Consumer Attorneys, largely agreed.

"This is not the knockout punch that the defense bar and corporate America had hoped for," said Ms. Gilden, a partner at Cohen Milstein Hausfeld & Toll P.L.L.C. in Chicago.

"Most cases (plaintiffs attorneys) bring on behalf of investors already meet the (new) standard," so dismissal rates should not increase, she said.

Some legal experts said the new standard likely will not change how judges generally handle motions to dismiss cases.

Many dismissal rulings are "based on a gut reaction to the case." The judges then "back into" the standards designed to drive their decisions, Mr. Bailey said.

In addition, because the "standard is one of great interpretation," when analyzing similar evidence, "you will get different views by different courts," said Carol A.N. Zacharias, senior vp and underwriting counsel for ACE USA in New York. "Unfortunately, that means further clarification is going to have to be made," she said.

Meanwhile, legal experts noted, the court skipped an opportunity to standardize a more significant inconsistency among federal judicial circuits: how claimants must meet the scienter standard.

Those requirements range from showing motive and opportunity to commit a wrongful act to demonstrating deliberate recklessness.

As a result of that inconsistency, similar cases might survive in some circuits and perish in others, some legal experts said.

Ms. Gilden disagreed. She said the court provided guidance on how plaintiffs can establish scienter when the justices observed that a lack of evidence on motive and personal financial gain does not doom a plaintiff's case.

James Cox, a professor of corporate and securities law at Duke University in Durham, N.C., agreed. That language likely will push all courts close to a standard that would include motive, opportunity and other facts that can create an inference of scienter, he said.

D&O policyholders, meanwhile, should not expect the ruling to influence the market.

The ruling is slightly favorable to policyholders and insurers but not advantageous enough to them to further soften the market, said Steve Shappell, managing director of the legal and claims practice for Aon Financial Services Group in Denver.

Tony Galban, a senior vp and the global D&O underwriting manager for Warren, N.J.-based Chubb Corp., said the ruling is "not a windfall one way or the other."

"Frankly, I've never seen a court decision impact the normal ebb and flow of a market," Mr. Galban said.

Tellabs Inc. et al. vs. Makor Issues & Rights Ltd. et al., U.S. Supreme Court, June 21; No. 06-484.