NYT - Justice Deals a Blow to Investors Alleging Corporate Fraud

Friday, June 22, 2007

So let me recount. The current administration does not want to look too close into hedge funds, can permit companies to withhold price relevant information if it is in "the national interest" (hello Freddie and Fannie) and does not want to inquire the mortgage sector either(hello Freddie and Fannie again). Only earlier this week Treasury secretary Henry Paulson also opined that third parties in contract with a fraudster should be immune from civil prosecution.
Justice dealt shareholders another blow by raising the threshold for investors wanting to sue a company for alleged fraud, the NYT reports. The 8:1 decision in the Supreme Court will make it easier for companies to dismiss lawsuits and block the often embarrassing pre-trial fact finding.
The decision stems from a lawsuit against Tellabs which had given an overly optimistic financial picture of the company. Read the article in its full length:
The Supreme Court dealt a new blow today to investors suing companies over accusations of fraud when it set a higher standard to prevent the lawsuits from being dismissed.
The decision was the second this week by the court that was a defeat for shareholders and a victory for the defendant companies. On Monday, the justices ruled that securities underwriters on Wall Street are generally immune from civil antitrust lawsuits.
It comes as senior officials including Treasury Secretary Henry M. Paulson Jr. have been pushing for the imposition of new limits on shareholder lawsuits. Mr. Paulson, along with other Bush administration officials and some senior Congressional Democrats and Republicans, have maintained that shareholder lawsuits and regulations written in the aftermath of the corporate scandals involving such companies as Enron and Worldcom may be causing too many companies to look to overseas markets to raise capital.
Earlier this week, Mr. Paulson told a Congressional committee that investors should not be permitted to sue third parties accused of assisting a company that engages in fraud. Mr. Paulson, a former chief executive at the investment bank Goldman Sachs, was responding to a question about a case before the Supreme Court that could determine whether investors will be able to sue law firms, investment banks and others that work with companies accused of fraud. The administration has also been considering a request by the nation’s top accounting firms to impose new limits on their liability from lawsuits.
Administration critics say that there are unrelated reasons why more companies are using foreign markets, and that there are already significant limits that have been imposed on shareholders to prevent frivolous suits. They cite the steadily sharp decline in of shareholder lawsuits in recent years and say the increasing number of restrictions imposed on such suits would deter investors from bringing meritorious claims. They also maintain that the threat of investor lawsuits makes them more transparent to shareholders and is beneficial to the way corporations are governed.
Today, the Supreme Court waded into the debate on the side of the defendants. By a vote of 8-to-1, it set a legal standard that makes it easier for companies and their executives to get shareholder lawsuits dismissed.
The decision involved a securities fraud lawsuit against Tellabs Inc., a maker of equipment for fiber optic networks, for statements made by senior executives in 2000 and 2001 that turned out to be overly optimistic about the company's financial picture.
The investors accused the company and top executives, including Richard C. Notebaert, the chief executive at the time, of overstating projections of revenues and demand for certain products. A federal district judge in Chicago found that the investors had produced enough evidence to show that Mr. Notebaert's statements were misleading, but that there was not enough evidence to show that he and others had intentionally mislead investors.
The central dispute in the case was a provision of the Private Securities Litigation Reform Act of 1995. It was adopted by Congress as a check on abusive lawsuits.
The law imposes more exacting standards on investor complaints with a goal of giving judges greater authority to dismiss suits that have no merit before defendants have to participate in costly and potentially embarrassing, pretrial fact-finding.
The law requires shareholders to "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." That state of mind - the intention "to deceive, manipulate or defraud" - is known as scienter.
Congress provided virtually no guidance on how to calculate a "strong inference" of scienter, leaving the appeals courts around the nation to impose different rules about how much evidence the investors needed to prevent their complaints from being dismissed. A central issue in the cases was the amount of weight that the courts must give to alternative explanations provided by defendants.
In allowing the case against Tellabs to proceed, a federal appeals court in Chicago rejected stiffer standards adopted by other appeals courts and found that the investors had provided enough evidence to show the company's intention to defraud. The court said it would permit the complaint to proceed if "a reasonable person could infer that the defendant acted with the required intent."
But the Supreme Court said that was not enough. Writing for the court, Justice Ruth Bader Ginsburg said that judges considering whether to dismiss a case at the outset must give credit to explanations offered by companies and their executives.
"The inference of scienter must be more than merely 'reasonable' or 'permissible' - it must be cogent and compelling, thus strong in light of other explanations," Justice Ginsburg said. "A complaint will survive, we hold, 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."
Tellabs and Mr. Notebaert maintained that he had no financial reason to mislead investors because he did not sell any stock during the relevant period. Justice Ginsburg said that courts should weigh the possible motives of the defendants but that "the absence of a motive allegation is not fatal."
The court sent the case, Tellabs v. Makor Issues and Rights, back to the lower court to apply the new standard.
Justice John Paul Stevens dissented. He said he would apply a standard of "probable cause" of guilt, the same burden of proof used for criminal warrants and 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," he said. Under such a standard, he said, he would have affirmed the judgment of the appeals court.
While concurring with the majority opinion, Justices Antonin Scalia and Samuel A. Alito Jr. wrote separate opinions calling for a higher standard than the one adopted by the court. They would have required investors to show the inference of scienter was “more plausible” than the inference of innocence.
Criticizing the court’s new standard, Justice Scalia 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, and I therefore think that the court’s test must fail."


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