'Holistic' Review in Federal Securities Litigation

This is the latest in a series of columns by O’Melveny & Myers attorneys, focusing on key legal issues specific to a variety of U.S. industries.

In recent years, plaintiffs in federal securities cases have seized on language from two landmark U.S. Supreme Court decisions—Tellabs, Inc. v. Makor Issues & Rights, Ltd. (2007) and Matrixx Initiatives, Inc. v. Siracusano (2011)—in an attempt to erode the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA). These decisions recommend that courts take a “holistic” review of a complaint when deciding a motion to dismiss, that scienter allegations be analyzed “collectively” and not in “isolation.” Though unremarkable in context, plaintiffs argue that such language implies diminished scrutiny—an argument, plaintiffs suggest, that is supported by recent Sixth and Ninth Circuit references to a “quick” analysis and a consideration of “less precise allegations.” (See, e.g., Frank v. Dana Corp. (6th Cir. 2011) and South Ferry LP, No. 2 v. Killinger (9th Cir. 2008)).

The good news for general counsel potentially facing securities litigation is that the case law makes clear that was never the Supreme Court’s intent.

In Tellabs and Matrixx, the Supreme Court simply held that a reviewing court must look at all of the allegations relating to scienter and examine the complaint “in its entirety.” The call was for thoroughness, not “quick” or slackened scrutiny. Despite the push by plaintiffs for an easing of the standard, the good news for corporate defendants is that district court judges have thus far continued to hold plaintiffs to the PSLRA’s exacting pleading standard. Even when those courts cite the need for a “holistic” review, they decline to diminish the level of scrutiny.

The Long Shadow of Tellabs: Origins of the ‘Holistic’ Review in Context

Striving to curb frivolous litigation, Congress in 1995 passed the PSLRA. It requires plaintiffs in federal securities class actions to “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind,” a term that varies across jurisdictions but generally means knowledge of wrongdoing or extreme recklessness. Because Congress left “strong inference” undefined, however, courts worked to come up with a definition, sometimes conflicting with one another.

Twelve years after the PSLRA became law, the Supreme Court set out to remove any confusion. In Tellabs, the Supreme Court held that “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.”

Further, the Court held that “[a] complaint will survive . . . 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.” In so holding, however, the Court also noted that the complaint must be considered “in its entirety, as well as [with] other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss,” and that “[t]he inquiry . . . is whether all of the facts alleged, taken collectively, give rise to a strong inference of scienter, not whether any individual allegation, scrutinized in isolation meets that standard.” (Emphasis in original).

While the Supreme Court made clear that it was directing courts not to view allegations in a vacuum—that “omissions and ambiguities” still “count against inferring scienter”—a few lower courts nonetheless have expanded on this language in ways that can lead to confusion.

The ‘Holistic’ Review in the Ninth Circuit: South Ferry and Zucco