Amicus Curiae Brief — Tellabs, Inc. v. Makor Issues & Rights, Ltd.

e MAR 3 — NN;

No. 06-484. MAR 3 - 200)

xg LERK O

i: SUPREME COURT US:

IN THE San cel ee

Supreme Court of the United States

TELLABS, INC., ET AL..

Petitioners.

We

MAKOR ISSUES & RIGHTS. LTD.. ET AL..

Respondents.

On Writ of Certiorari to the

United States Court Appeals

for the Seventh Circuit

BRIEF OF THE NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC., AS

AMICUS CURIAE IN SUPPORT OF RESPONDENTS

ALFRED EZ T. RUSCH *

Senior Counsel

District of Columbia Securities Bureau

REX AL STAPLES

General Counsel

STEPHEN W. HALL

Deputy General Counsel

JOSEPIEV. BRADY

Associate General Counsel

LESLEY M. WALKER

Associate Counsel

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC,

750 First Street. N.E.. Suite 1140

Washington, D.C. 20002

* Counsel of Record (202) 737-0900

March 9, 2007

WILSON-EPES PRINTINGCO INC - (202) 789-0096 -— WASHINGTON D C. 20002

TABLE OF CONTENTS

FAIRS GE ALT TIRE Ui ececcccvccsncesonescccsscnsssccsosseosnse

INTEREST OF THE AMICUS CURIAE. ........cc0cc0ccc0000s

SUMMARY OF THE ARGUMENT ........... ce eeeeeeeeeee

DSi ec tA MOEN TT |

L.

THE SEVENTH CIRCUIT CORRECTLY

FORMULATED AND APPLIED THE

PLEADING STANDARD FOR SCIENTER

UNDER THE REFORM ACT ................cccssseees

A. The Seventh Circuit Test Follows The

Plain Language Of The Reform Act............

B. The Seventh Circuit Test Comports With

The Legislative History ...........ccccccsssssccssserss

C. The Seventh Circuit Test Advances The

Goal Of Limiting Groundless Class Action

Lawsuits, While Minimizing The Adverse

Impact On Meritorious Claims By Injured

Pet icciecciitecsinditenissibbebstiinteansaciaianadanciiesinnsiitions

THE TEST ADVANCED BY THE PETI-

TIONERS FINDS NO SUPPORT IN THE

REFORM ACT; IT CONFLICTS WITH

RULE 12(b)(6) AS WELL AS THE SEV-

ENTH AMENDMENT; AND [fT AGGRA-

VATES RATHER THAN AMELIORATES

THE ALREADY EXCESSSIVE BURDENS

FACING INJURED INVESTORS SEEKING

REDRESS IN THE COURTG..............ccccccsssesese

A. The Language And The Legislative His-

-tory Of The Reform Act Do Not Support

The Petitioners’ Interpretation Of The

SUNN iis cischictinncegnindonecicsiadinnntanitons

13

il

TABLE OF CONTENTS—Continued

Page

B. The Pleading Standard Advanced By The

Petitioners Conflicts With The Judicially

Established Procedures For Applying Rule

STITT sevisiniencatsdinieiisuiinliononpedinbisiiendabinidgenialdiin 15

C. The Petitioners’ Insistence That Courts

Balance Competing Inferences To Resolve

A Motion To Dismiss Conflicts With The

Seventh Amendmeni’s Right To Trial By

TY sissintistcailteicialbecleibebiia tiie ldaas iat lai 16

D. If The Seventh Circuit’s Ruling Is Re-

versed, An Increasing Number Of Inves-

tors Will Suffer Irretrievable Losses At

The Hands Of Those Committing Fraud ..... 18

TN scininsscsennconccinsninitentintieinssintaitainiadeiivedin 19

iil

TABLE OF AUTHORITIES

CASES

Anderson v. Liberty Lobby, Inc., 477 U.S. 242

ISIE UINiiiiciihaccnicetildeahdladabahddildidipenidaaiasipiaaiibiniaiimeinias

Basic Inc. v. Levinson, 485 U.S. 224 (1988).........

Beacon Theatres, Inc. v. Westover, 359 U.S. 500

Societies ioiceenisiniesliececiaiiaiapaiigdeibi

Blue Chip Stamps v. Manor Drug Stores, 421

een Pan NTTII ciisasdiidibeihalibeiedaiaebssiinenlselae

City of Monroe Employees Ret. Sys. v. Bridge-

stone Corp., 399 F.3d 651 (6th Cir.), cert.

denied, 126 S.Ct. 423 (2005)... ceceeeceeeeeeees

Conley v. Gibson, 355 U.S. 41 (1957)........... cece

Ex Parte Peterson, 253 U.S. 300 (1920)......... indie

Group Life & Health Ins. Co. v. Royal Drug Co.,

4 |. SRS areas

Helwig v. Vencor, 251 F.3d 540 (6th Cir. 2001),

cert. dismissed, 536 U.S. 935 (2002).................

Hunt v. Bradshaw, 251 F.2d 103 (4th Cir. 1958)..

In re Advanta Corp. Sec. Litig., 180 F.3d 525 (3d

Rane ensicislliiai hia casecttoanuinsicteabdanigeiiniilieiiianiidtete

In re Colonial Mortg. Bankers Corp., 324 F.3d

I i

Kaufman v. i-Stat Corp., 754 A.2d 1188 (N.J.

Leatherman v. Tarrant County Narcotics

Intelligence & Coordination Unit, 507 U.S.

SU IIITTTIITTIT tdci ieee ubabecnlanstoeciatepicaaicliesiblaaaiin

Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437

F.3d 588 (7th Cir. 2006), cert. granted, 127

Se MT icssiahininscitidinheeiieneciiciniadsieemmepiialiaiian

Mirkin v. Wasserman, 858 P.2d 568 (Cal. 1993) ..

Ottman v. Hanger Orthopedic Group, Inc., 353

ae EE a CIE ciintiencoccntennitisitiltininnetsiiens

Pirraglia v. Novell, Inc., 339 F.3d 1182 (10th

Sue aa cicshhntivsheesiincesinnsibetipsinisiaiteisiaeansnaibiiiinnaiabicnnichie

Page

passim

12

iV

TABLE OF AUTHORITIES—Continued

Page

Reeves v. Sanderson Plumbing Products, 530

re Ne IU ciicceniceasicnsieciidcdiieaciapiieiiienaeineiaaines 17

SEC v. Capital Gains Research Bureau, Inc., 375

Se, SEED niccditsiteniicshiinaheiendininipiadniaidasietnoienadie 8

Small vy. Fritz Companies, Inc., 65 P. 3d 1255

Se MI desniheiseilhnisticiastiaiilaaeticihiiiilataians 12-13

CONSTITUTIONS, STATUTES, AND RULES

ee ls MINIS WIP siccisiisctcatnpictenbninitsiiniteniicsiosen 16

Pub. L. No. 105-353, § 2(1), (2), 112 Stat. 3227... 11-12

Se ag ie I siiiciicishcdiieiciinisinccieinieciicsiniginibdetsiaidatint 12

Re Ride: Ie aT cericiindnscincicineonnvenienennasicinsdenies 6

a en Ee EE © TRIED sentcunindenisiinbinsnninmittenisinaiene 9

SY SIP TIE csisinsiscesshinmatiicnesnasiticsnpmtisibitedibiainin 10

a ss: UE NOTE ctistieiihiinaishesierithenpdiiianiennceseinaticeteminbiahinith 10

Ns ns Py MII ss isicicescetidiadstttenialttmadnianidnbesiie 15

SA TE Tis IU cticageiiehinsaieteptingpttudeiianeatiibsiabanieatianiebiniin l

Ns Peat TaAs SUN ictnteiennnceinnincinteirincenelapeenibncapatininnslei l

LEGISLATIVE HISTORY

H.R. Conr. REP. No. 104-369 (1995), reprinted

BES od at Dy) nae 7,8

H.R. Rep. No. 107-414 (2002), 2002 WL 661614

ST TI insuictasecsedisisstiniccltichsineedtaniciiuiinnbenigi 10

S. REP. No. 104-98 (1995), reprinted in 1995

Saas TUT cinsieiitsicnsenhcsienieibapantnesieariciidesitiie 4,8

Brief of the North American Securities Admin-

istrators Association, Inc., as Amicus Curiae,

in Support of Respondents Broudo ef ai., in

Dura Pharmaceuticals, Inc. v. Broudo, Case

No. 03-932 (U.S. Nov. 17, 2004), available at

http://www.nasaa.org/content/F iles/BroudoBri

Vv

TABLE OF AUTHORITIES—Continued

Brief of the North American Securities Admin-

istrators Association, Inc., as Amicus Curiae,

in Support of the People of the State

California, in People v. Edward D. Jones &

Co., Case No. CO53407 (Cal. Ct. App. Feb.

23, 2007), available at http://www.nasaa.org/

content/Files/ED JONES FINAL.pdf..............

- 5B CHARLES ALLEN WRIGHT & ARTHUR R.

MILLER, FEDERAL PRACTICE AND PROCEDURE

BD SSO7 COC OE, Fe i rerevenstitemnennevnntiniiataien

Joel Seligman, Rethinking Private Securities

Litigation, 73 U. Cin. L. Rev. 95 (2004)...........

Kevin S. Schmelzer, The Door Slammed Shut

Needs to be Reopened: Examining the Plead-

ing Requirements Under the Private Securities

Litigation Reform Act, 78 Temp. L. Rev. 405

Press Release, No. 2002-179, SEC, NY peceeaneen

General, NASD, NASAA, NYSE and State

Regulators Announce Historic Agreement to

Reform Investment Practices (SEC, Dec. 20,

2002), available at http://www.sec.gov/news/

SUSE EEE FOIE vicescstsviniscinbiinnnengueliiiisionennen

Press Release, State Investigation Reveals

Mutual Fund Fraud (Office of the New York

Attorney General, Sept. 3, 2003), available at

http://www.oag.state.ny.us/press/2003/sep/sep

Gh TU ccncesisvccceitesminincinmnsiasnassiaiieisiisseslimsamanaintes

Page

15

1]

vi

TABLE OF AUTHORITIES—Continued

Page

Ronald |. Miller, Todd Foster, and Elaine

Buckberg, Recent Trends in Shareholder Class

Action Litigation: Beyond the Mega-Settle-

ments, is Stabilization Ahead? Apr. 2006,

available at http://www.nera.com/image/BRO

_RecentTrends2006 SEC979_PPB-

FINAL.pdf (National Economic Associates,

ESN eee 10

Hearing on H.R. 5491, Before the House

Committee on Financial Services, Subcom-

mittee on Capital Markets, Insurance, and

Government Sponsored Enterprises, 109th

Cong. (2006) (Statement of James D. Cox),

available at www.law.duke.edu/features/pdf/

iii eretenialenisttnganseuatnesncesosues 10

IN THE

Supreme Court of the United States

No. 06-484

TELLABS, INC., ET AL.,

Petitioners,

Vv.

MAKOR ISSUES & RIGHTS, LTD., ET AL.,

Respondents.

On Writ of Certiorari to the

United States Court Appeals

for the Seventh Circuit

BRIEF OF THE NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC., AS

AMICUS CURIAE IN SU?PORT OF RESPONDENTS

INTEREST OF THE AMICUS CURIAE '

The North American Securities Administrators Associa-

tion, Inc. (“NASAA”), is the nonprofit association of state,

provincial, and territorial securities regulators in the United

States, Canada, and Mexico. It has 67 members, including

' Pursuant to Sup. Cr. R. 37.6, NASAA represents that no counsel

for any party authored this brief in whole or in part, and no person or

entity, other than NASAA, its members, or its counsel, made any mone-

tary contribution to the preparation or submission of the brief. Pursuant to

Sup. Cr. R. 37.3, NASAA further represents that all parties to this appeal

have consented to the filing of this brief. Copies of their written consents

have been filed with the Court.

2

the securities regulators in all 50 states, the District of Colum-

bia, Puerto Rico, and the U.S. Virgin Islands. Formed in

1919, it is the oldest international organization devoted to

pratecting investors from fraud and abuse in the offer and sale

of securities.

The U.S. members of NASAA are responsible for admin-

istering state securities laws and regulations. Their activities

include regulatory functions such as licensing broker-dealers,

registering local securities offerings, and conducting compli-

ance examinations. Especially important is their enforcement

role: protecting the nation’s investors by bringing literally

thousands of enforcement actions every year against the firms

and individuals who have committed fraud and abuse in the

sale of securities. In those cases, state securities regulators

often seek restitution to help make injured investors whole,

although both state and federal regulators recognize that the

best hope of recovery for the vast majority of defrauded

investors is through the courts in private actions for damages.

NASAA supports the work of its members through training

programs, enforcement assistance, and legislative analysis.

Another important role of the association is representing the

membership’s position as amicus curiae in significant cases

brought by private plaintiffs as well as government regulators

involving the interpretation of the securities laws and the

rights of investors. See, e.g., Brief of the North American

Securities Administrators Association, Inc., as Amicus Curiae,

in Support of Respondents Broudo ef a/., in Dura Pharma-

ceuticals, Inc. v. Broudo, Case No. 03-932 (U.S. Nov. 17,

2004) (supporting investors’ position on the pleading

requirements for Joss causation in a private action for

securities fraud), available at http://www.nasaa.org/content/

Files/BroudoBrief.pdf; Brief of Amicus Curiae North Ameri-

can Securities Administrators Association, Inc., in Support of

the People of the State of California, in People v. Edward D.

Jones & Co., Case No. CO53407 (Cal. Ct. App. Feb. 23,

3

2007), available at http://www.nasaa.org/content/Files/ED _

JONES_FINAL.pdf.

NASAA and its members have a stake in the outcome of

this appeal because it will have a profound impact upon the

ability of investors to seek redress in cases where unscrupu-

lous issuers and corporate executives have perpetrated a fraud

on the market. The Seventh Circuit correctly ruled that a

complaint for securities fraud satisfies the pleading require-

ments for scienter under the Private Securities Litigation

Reform Act of 1995 (“Reform Act” or “Act”) if the allega-

tions in the complaint collectively establish a strong inference

of scienter. See Makor Issues & Rights, Lid. v. Tellabs, Inc.,

437 F.3d 588, 601 (7th Cir. 2006), cert. granted, 127 S.Ct.

853 (2007). The court rightly rejected the far more onerous

requirement that courts actually evaluate competing infer-

ences upon a motion to dismiss and afford_the plaintiff only

those inferences that are most plausible. /d. at 602. If this

Court were to reverse the lower court and establish the more

burdensome standard as the federal rule governing scienter at

the pleading stage, many victims of securities fraud with

meritorious claims would lose the opportunity to recover their

damages. As advocates for the rights of investors to seek

redress, NASAA and its members have an interest in support-

ing affirmance and minimizing this threat.

This Court’s decision will also affect the role of private

actions as a deterrent against securities fraud. Private actions

by defrauded investors are an enormously important comple-

ment to regulatory enforcement actions as a means of polic-

ing the securities marketplace. State and federal securities

regulators work tirelessly to detect, enjoin, and punish finan-

cial fraud. However, private actions not only provide the

principal means of redress for victims of securities fraud, they

also play a vitally important role in protecting the integrity of

the marketplace through deterrence. Congress and the courts

alike have recognized this fact. The Senate Report accom-

4

panying the Reform Act described the importance of private

rights of action as follows:

The SEC enforcement program and the availability of

private rights of action together provide a means for

defrauded investors to recover damages and a powerful

deterrent against violations of the securities laws. As

noted by SEC Chairman Levitt, “private rights of action

are not only fundamental to the success of our securities

markets, they are an essential complement to the SEC’s

own enforcement program.” (citation omitted)

See S. REP. No. 104-98, at 8 (1995) (“Senate Report”), re-

printed in 1995 U.S.C.C.A.N. 679, 687; see also Basic Inc. v.

Levinson, 485 U.S. 224, 230-31 (1988) (observing that the

private cause of action for violations of Section 10(b) and

Rule 10b-5 constitutes an “essential tool for enforcement of

the 1934 Act’s requirements”). To the extent that the Court

erects unwarranted barriers to recovery in private actions,

such as the pleading requirements for scienter advanced by

the Petitioners, the Court will undermine an important deter-

rent that benefits the marketplace as a whole. For this addi-

tional reason, NASAA and its members support affirmance of

the circuit court’s decision.

SUMMARY OF THE ARGUMENT

The Seventh Circuit correctly held that a complaint for

securities fraud satisfies the pleading requirements for sci-

enter under the Reform Act if the allegations in the complaint

collectively establish a strong inference of scienter. This

formulation is precisely what the Reform Act says and what

Congress intended the courts to apply. Moreover, the Sev-

enth Circuit’s rule advances the Congressional policy of

discouraging meritless lawsuits, while minimizing restrictions

on access to the courts by the ever-increasing number of

investors who are genuine victims of securities fraud. The

rule advanced by Petitioners and their amici, suggesting that

courts must instead evaluate competing inferences upon a

5

motion to dismiss and afford the plaintiff only those infer-

ences that are most plausible, should be rejected. It has no

support in the language or legislative history of the Reform

Act. Moreover, by calling upon courts to weigh competing

evidentiary claims, it violates the universally accepted inter-

pretation of Rule 12(b)(6), as well as the Seventh Amendment

guarantee of trial by jury. And the Petitioners’ rule would

severely limit access to the courts for injured investors, at a

time when the need to address rampant financial fraud far

outweighs the need to protect companies and their executives

from strike suits.

ARGUMENT

I. THE SEVENTH CIRCUIT CORRECTLY FOR-

MULATED AND APPLIED THE PLEADING

STANDARD FOR SCIENTER UNDER THE

REFORM ACT |

The Seventh Circuit held that when evaluating the ade-

quacy of scienter allegations on a motion to dismiss under the

Reform Act, courts should examine all of the allegations in

the complaint and decide whether collectively they establish a

strong inference of scienter. Makor, 437 F.3d at 601. This

simple test faithfully adheres to the actual language of the

Reform Act, it comports with the Act’s legislative history,

and it strikes the right balance between the two policies

underlying the Act: eliminating meritless strike suits while

preserving the right of investors to seek damages for securi-

ties fraud. The circuit court’s interpretation of the Reform

Act was therefore correct and should be affirmed.

A. The Seventh Circuit’s Test Follows The Plain

Language Of The Reform Act

“[ T]he starting point in any case involving the meaning of

a statute is the language of the statute itself.” Group Life &

Health Ins. Co. v. Royal Drug Co., 440 U.S. 205, 210 (1979);

In re Advanta Corp. Sec. Litig., 180 F.3d 525, 533 (3rd Cir.

6

1999) (focusing attention on the Reform Act’s plain lan-

guage, “which is the customary starting point in statutory

interpretation”). With respect to allegations of scienter, the

Reform Act simply provides that a complaint alleging securi-

ties fraud must “state with particularity facts giving rise to a

strong inference that the defendant acted with the required

state of mind.” 15 U.S.C. § 78u-4(b)(2) (emphasis added).

This is precisely the test that the Seventh Circuit adopted in

its opinion. See, e.g., Makor, 437 F.3d at 603 (“We can now

assess whether the complaint states, with respect to each of

these actionable statements, facts that give rise to a strong

inference of scienter.”) (emphasis added); id. at 605 (“[W]e

find that the complaint contains enough detail to establish a-

strong inference that Notebaert knew of the channel stuffing

and therefore knew Tellabs had exaggerated its fourth quarter

2000 revenues.”) (emphasis added); id. at 604 (“We conclude

that the plaintiffs have pleaded sufficient facts to ‘giv[e] rise

to a strong inference,’ 15 U.S.C. § 78u-4(b)(2), that Notebaert

knowingly lied . . . .”) (emphasis added).? The Seventh

Circuit clearly based its analysis on an accurate reading of the

Reform Act.

? These excerpts from the Seventh Circuit's opinion refute any sug-

gestion that the court’s test for pleading scienter afier adoption of the

Reform Act is no more stringent than the test applicable before adoption

of the Reform Act. See also Makor, 437 F.3d at 601 (the Reform Act “did

unequivocally raise the bar for pleading scienter”); id. at 600 (adequately

pleading scienter under the Reform Act requires plaintiffs to clear “another,

even more arduous hurdle”). Nor does the Seventh Circuit’s reference to

a “reasonable person” standard support the Petitioners’ contention on this

issue. The court used that phrase not to dilute the “strong inference”

requirement, but as an alternative to the Sixth Circuit’s unacceptable sug-

gestion that courts must weigh competing inferences and afford plaintiffs

only those that are most reasonable. /d. at 602. Rather than balancing

inferences, the court’s role under the Seventh Circuit's analysis is simply

to determine if a “reasonable person” could arrive at the requisite strong

inference.

7

B. The Seventh Circuit’s Test Comports With The

Legislative History

The Seventh Circuit also considered the legislative history

of the Reform Act. Although generally regarded as “contra-

dictory and inconclusive,” see Makor, 437 F.3d at 601 (quot-

ing In re Advanta Corp., 180 F.3d at 533), the legislative

history is clear at least on this point: Congress deliberately

chose to fashion a strong but simple test, unencumbered with

embellishments derived from the case law. The Conference

Report confirms that the standard was intended to be pre-

cisely what the statute says: the plaintiff's facts, stated with

particularity, “must give rise to a ‘strong inference’ of the

defendant’s fraudulent intent.” H.R. CONF. REP. No. 104-

369, at 41 (1995) (“Conference Report”), reprinted in 1995

U.S.C.C.A.N. 730, 740. While acknowledging that the stan-

dard was derived in part from the test in the Second Circuit,

the Report expressly disavows any intention “to codify the

Second Circuit’s case law interpreting this pleading stan-

dard.” /d. The report further explains that “for this reason,

the Conference Report chose not to include in the pleading

standard certain language relating to motive, opportunity, or

recklessness.” Conference Repori at n.23. The legislative

history thus supports the Seventh Circuit’s observation,

shared by the majority of the federal circuit courts, that

“Congress chose neither to adopt nor reject particular meth-

ods of pleading scienter-—such as alleging facts showing

motive and opportunity—but instead only required plaintiffs

to plead facts that together establish a strong inference of

scienter.” See Makor, 437 F. 3d at 601 (quoting Ottman v.

Hanger Orthopedic Group, Inc., 353 F.3d 338, 345 (4th Cir.

2003)).

8

C. The Seventh Circuit’s Test Advances The Goal

Of Limiting Groundless Class Action Lawsuits,

While Minimizing The Adverse Impact On

Meritorious Claims By Injured Investors

In the Reform Act, Congress sought to “strike the right

balance between protecting the rights of victims of securities

fraud and the rights of public companies to avoid costly and

meritless litigation.” See Senate Report at 10. Congress

clearly wanted to inhibit abusive lawsuits, but at the same

time it recognized that “[p]|rivate securities litigation is an

indispensable tool with which defrauded investors can re-

cover their losses without having to rely upon government

action.” See Conference Report at 31. Moreover, Congress

recognized that “[s]uch private lawsuits promote public and

global confidence in our capital markets and help to deter

wrongdoing and to guarantee that corporate officers, auditors,

directors, lawyers and others properly perform their jobs.” Jd.

The Conference Report begins with the affirmation that “(t]he

overriding purpose of our nation’s securities laws is to protect

investors and to maintain confidence in our capital markets

.... (emphasis added). See Conference Report at 31; see

also Makor, 437 F.3d at 595 (establishing, as a backdrop to

its analysis, that “the modern securities laws were designed

. . to ‘substitute a philosophy of full disclosure for the

philosophy of caveat emptor and thus to achieve a high stan-

dard of business ethics in the securities industry”) (quoting

SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180,

186 (1963)).

The Seventh Circuit’s interpretation of the Reform Act's

heightened pleading standard for allegations of scienter

accommodates both of these Congressional policy goals. The

circuit court’s analysis obviously recognizes that allegations

of scienter in a securities fraud action must be subjected to

more “arduous” scrutiny under the Reform Act. See Makor,

437 F.3d at 600. The court’s holding thus serves the purpose

9

of deterring unfounded lawsuits. At the same time, however,

the court refused to graft onto the statute’s plain language the

vastly more repressive balancing-of-inferences test advocated

by the Petitioners. The court’s holding thus also advances

Congress’s goal of preserving meaningful recourse for bona

fide victims of securities fraud.”

The need to ensure that investors have meaningful private

remedies in federal court has become starkly apparent since

the passage of the Reform Act. Over the last several years,

there has been a marked rise in the incidence of corporate

accounting fraud and securities law violations affecting large

classes of investors. See, e.g., Press Release, No. 2002-179,

SEC, NY Attorney General, NASD, NASAA, NYSE and

State Regulators Announce Historic Agreement to Reform

Investment Practices (SEC, Dec. 20, 2002), available at

http://www.sec.gov/news/press/2002-179.htm; see also Press

Release, State Investigation Reveals Mutual Fund Fraud

(Office of New York Attorney General, Sept. 3, 2003),

available at http://www.oag.state.ny.us/press/2003/sep/sep

03a_03.html.

Congress recognized the seriousness of the problem, and

the need for at least a partial legislative response, when it

enacted the Sarbanes-Oxley Act of 2002, 15 U.S.C. §§ 7201-

7266. The House Report accompanying the House bill aptly

describes the problem of deceptive corporate practices that

harm investors:

The collapse of the Enron Corporation provided irrefu-

table evidence of serious, systemic problems in our

* On its face, at least, the Seventh Circuit’s disposition of the Peti-

tioners’ specific challenges to the complaint suggests that the “strong

inference” standard is a rigorous screening mechanism for fraud claims.

Although the court sustained a number of fraud allegations against one of

the two individual defendants, it dismissed all of the complaint’s allega-

tions against the other individual defendant, finding that “the plaintiffs did

not meet the strict PSLRA standards for pleading Birck’s scienter.” See

Makor, 437 F.3d at 603-04.

10

financial reporting system and our capital markets. Far

from being an isolated instance, Enron was only the

most spectacular example of what has become a com-

mon phenomenon---earnings manipulation and deceptive

accounting by our largest companies. Before Enron,

company after company—Waste Management, Sun-

beam, Cendant, W.R. Grace, and many others—-were

found to have manipulated their accounting to present

a picture to investors that did not match reality. As

evidenced by the record number of investigations

opened by the SEC thus far this year [2002], the problem

has only become more acute.

See H.R. Rep. No. 107-414 (2002). 2002 WL 661614, *47

(Minority Views).*

This corporate fraud has harmed millions of investors

nationwide, inflicting huge personal losses. Yet the number

of securities fraud class action lawsuits filed in the federal

courts has declined, and dismissal rates have increased, since

the Reform Act was passed. See generally Hearing on H.R.

5491, Before the House Committee on Financial Services,

Subcommittee on Capital Markets, Insurance, and Govern-

ment Sponsored Enterprises, 109th Cong. (2006) (Statement

of James D. Cox), available at http://www.law.duke.edu/

features/pdf/ coxtestimony.pdf; Ronald I. Miller, Todd Foster,

and Elaine Buckberg, Recent Trends in Shareholder Class

Action Litigation: Beyond the Mega-Setilements, is Stabili-

zation Ahead? Apr. 2006, available at http://www.nera.

* For the most part, the laudable provisions of Sarbanes-Oxley are

focused on enhancing the regulatory oversight of corporate accounting

practices and toughening the penalties for violations of the securities laws.

See, e.g., Title 1, 15 U.S.C. §§ 7211-19 (establishing an accounting over-

sight board for public companies); Title VIII, Section 807, 18 U.S.C.

§ 1348 (increasing criminal penalties for defrauding shareholders of pub-

licly traded companies). It remains for the courts to interpret the securi-

ties laws in a manner that affords investors an adequate means of redress

for corporate malfeasance.

1]

com/image/BRO_RecentTrends2006_SEC979_PPB-FINAL.

pdf (National Economic Research Associates, Inc.). These

conflicting trends have prompted experts in the securities

field to surmise that because of the Reform Act, “the balance

has been tipped too far in favor of preventing claims (some of

which would, after discovery, turn out to have merit) rather

than protecting investors who have suffered losses. That is,

Congress swung the pendulum too far in protecting defen-

dants.” Kevin S. Schmelzer, The Door Slammed Shut Needs

to be Reopened: Examining the Pleading Requirements

Under the Private Securities Litigation Reform Act, 78 Temp.

L. Rev. 405, 426 (2005); see also Joel Seligman, Rethinking

Private Securities Litigation, 73 U. Cin. L. Rev. 95, 113

(2004) (“the diminution in the effectiveness of private federal

securities litigation was one of the several facts that con-

tributed to a reduction in fraud deterrence.”). The Seventh

Circuit’s ruling at least minimizes this regulatory imbalance

that favors defendants at the expense of investors.

Another factor supporting the Seventh Circuit’s interpreta-

tion of the Reform Act is the limited availability of alternative

recourse for the victims of securities fraud in the state courts.

This Court has observed that the disadvantages posed by a

restrictive interpretation of federal securities law can be

“attenuated” where adequate remedies are available under

state law. See Blue Chip Stamps v. Manor Drug Stores, 421

U.S. 723, 738 n.9 (1975) (standing to bring private cause

of action under Rule 10b-5 limited to actual purchasers or

sellers). Conversely, where state courts do not offer an ade-

quate alternative forum for plaintiffs’ claims, federal courts

have a correspondingly greater justification for providing

relief.

In this case, state law offers limited recourse for investors

in the Respondents’ position. Congress has expressly limited

the use of class action suits seeking recovery for securities

fraud under state law. In 1998, Congress enacted the Securi-

12

ties Litigation Uniform Standards Act (“SLUSA”) to address

the concern that “securities class action lawsuits [had] shifted

from Federal to state courts” as a means of circumventing the

Reform Act. See Pub. L. No. 105-353, § 2(1), (2), 112 Stat.

3227. With certain exceptions, SLUSA provides that no class

action based upon state law may be maintained in any state

court on behalf of more than 50 class members. See 15

U.S.C. § 77p(b). Moreover, state courts generally have not

recognized the doctrine of fraud-on-the-market in cases

seeking relief under state common law, further limiting the

state courts as an alternative forum for investors aggrieved by

large-scale market manipuiation of the sort alleged in this

case. See, e.g., Kaufman v. i-Stat Corp., 754 A.2d 1188,

1193-94 (N.J. 2000); Mirkin v. Wasserman, 858 P.2d 568,

584 (Cal. 1993).

Precisely because of the massive corporate frauds that have

surfaced in recent years, some state courts have recognized

the need to reevaluate barriers to civil actions alleging

securities fraud. The California Supreme Court, for example,

has cited the troubling increase in corporate fraud as a reason

to recalibrate the balance between the interests of investors

and the interests of corporations, in favor of providing greater

judicial recourse to victims of fraud:

When Congress enacted the Private Securities Litigation

Reform Act of 1995 and the Uniform Standards Act of

1998, it was almost entirely concerned with preventing

nonmeritorious suits. (Stout, supra, 38 Ariz. L. Rev.

711). But events since 1998 have changed the perspec-

tive. The last few years have seen repeated reports of

false financial statements and accounting fraud, demon-

strating that many charges of corporate fraud were

neither speculative nor attempts to extort settlement

money, but were based on actval misconduct. “To open

the newspaper today is to receive a daily dose of scan-

dal, from Adelphia to Enron and beyond. Sadly, each of

us knows that these newly publicized instances of

accounting-related securities fraud are no longer out of

13

the ordinary, save perhaps in scale alone.” (Schulman,

et al., The Sarbanes-Oxley Act: The Impact on Civil

Litigation under the Federal Securities Laws from the

Plaintiff's Perspective (2002 ALI-ABA Cont. Legal Ed.

p.l1.) The victims of the reported frauds, moreover, are

often persons who were induced to hold corporate stock

by rosy but false financial reports, while others who

knew the true state of affairs exercised stock options and

sold at inflated prices. (See Purcell, The Enron Bank-

ruptcy and Employer Stock in Retirement Plans, Con-

gressional Research Service (Mar. 11, 2002)). Eliminat-

ing barriers that deny redress to actual victims of fraud

now assumes an importance equal to that of deterring

nonmeritorious suits.

See Small v. Fritz Companies, Inc., 65 P.3d 1255, 1263-64

(Cal. 2003) (a person wrongfully inducedto hold stock may

bring an action for fraud under state common law). However,

unless and until this shift in state law gains currency, inves-

tors must depend upon the federal courts to afford complete

relief where corporate executives and others have perpetrated

a fraud on the market. As financial crimes abound and as

alternative forums for aggrieved investors remain limited, it is

especially important that the federal courts interpret federal

law in a way that, to the extent possible, affords meaningful

remedies to victims of securities fraud. The Seventh Circuit’s

ruling accomplishes this objective and should be affirmed.

Il. THE TEST ADVANCED BY THE PETITION-

ERS FINDS NO SUPPORT IN THE REFORM

ACT; IT CONFLICTS WITH RULE 12(b)(6) AS

WELL AS THE SEVENTH AMENDMENT; AND

IT AGGRAVATES RATHER THAN AMELIO-

RATES THE ALREADY EXCESSIVE BURDENS

FACING INJURED INVESTORS SEEKING

REDRESS IN THE COURTS

The Petitioners argue that the “strong inference” standard

requires courts to apply a host of additional! tests to determine

14

if a complaint adequately pleads scienter under the Reform

Act. At the heart of the Petitioners’ argument is the notion

that a court must exclude the possibility of innocence by

entertaining inferences that favor the defendant as well as the

plaintiff, and balancing those inferences to determine which

are more plausible—those that indicate innocence or those

that support culpability. See, e.g., Brief of Petitioners, No.

06-484, 2007 WL 432763 at *25-26 (S.Ct. Feb. 9, 2007)

(“Reform Act requires the complaint to paint a detailed

picture of the facts that meaningfully tends to exclude the

possibility of innocence. . . . “); id. at 35 (inference cannot be

strong if claimed culpable inference appears no more plaus-

ible than alternative, innocent inferences). This standard,

however, finds no support in the language or the legislative

history of the Reform Act. Moreover, it conflicts with the

time-honored principle that on a motion to dismiss, ail rea-

sonable inferences are to be drawn in favor of the plaintiff.

It also violates the right to trial by jury by asking courts to

choose between competing factual interpretations. Finally,

and perhaps most important, the Petitioners’ harsh formula

undermines the policies that the Reform Act and the secu-

rities laws more generally were intended to serve: it will

routinely extinguish meritorious fraud claims at the pleading

stage without significantly enhancing the goal of discourag-

ing frivolous suits.

A. The Language And The Legislative History Of

The Reform Act Do Not Support The

Petitioners’ Interpretation Of The Pleading

Standard

Nowhere does the Reform Act make any reference to

drawing inferences that favor the defendant, balancing com-

peting inferences regarding scienter, or excluding the pos-

sibility of innocence. As discussed above, a complaint

satisfies the Act if it pleads facts giving rise to a strong

inference of scienter. The legislative history also contains no

hint that Congress intended to incorporate the Petitioners’

15

burdensome standard into the Reform Act. On the contrary,

as discussed supra, the Conference Report disavows any

Congressional intent to incorporate specific requirements

other than the “strong inference” test.

B. The Pleading Standard Advanced By The

Petitioners Conflicts With The Judicially

Established Procedures For Applying Rule

12(b)(6)

An enormous body of case law developed under Rule

12(b)(6) of the Federal Rules of Civil Procedure, FED. R. Civ.

P. 12(b)(6), has established three core principles that apply

whenever a court entertains a motion to dismiss for failure to

state a claim upon which relief can be granted. First, the

complaint is construed in the light most favorable to the

plaintiff. Second, the allegations as pled in the complaint are

taken as true. Third, and most important for the purposes of

this appeal, all reasonable inferences that can be drawn from

the pleading are drawn in favor of the pleader. 5B CHARLES

ALLEN WRIGHT & ARTHUR R. MILLER, FEDERAL PRACTICE

AND PROCEDURE §1357 (3d ed. 2004). When considering a

motion to dismiss pursuant to Rule 12(b)(6), a court is bound

to “assume the truth of all well-pleaded facts and indulge all

reasonable inferences that fit the plaintiff's stated theory of

liability.” See In re Colonial Mortg. Bankers Corp., 324 F.3d

12, 15 (1st Cir. 2003). The rationale for this doctrine is that,

on a motion to dismiss, the court is not weighing evidence,

but only testing the legal sufficiency of the plaintiff's claim to

determine if relief may be granted. See Pirraglia v. Novell,

Inc., 339 F.3d 1182, 1187 (10th Cir. 2003). This Court has

instructed that “a complaint should not be dismissed for

failure to state a claim unless it appears beyond doubt that

plaintiff can prove no set of facts in support of his claim

which would entitle him to relief.” Conley v. Gibson, 355

U.S. 41, 45-46 (1957). This instruction leaves no room for

16

the trial judge to consider the ihferences that cast a defendant

in the best light.

Congress evinced no intent to amend Rule 12(b)(6) or

overturn its judicial underpinnings when it adopted the

Reform Act. “[{T]he Reform Act did not reverse the polarity

of securities pleading.” Helwig v. Vencor, Inc., 251 F.3d 540,

553 (6th Cir. 2001), cert. dismissed, 536 U.S. 935 (2002). In

the absence of such an amendment, federal courts are bound

to follow the dictates of Rule 12(b)(6). See Leatherman v.

Tarrant County Narcotics Intelligence & Coordination Unit,

507 U.S. 163 (1993). Accordingly, its requirements apply no

less to allegations of scienter in a securities fraud case than

they do to any other case. The Petitioners’ assertion that on a

motion to dismiss, courts must entertain inferences in favor of

the defendant directly conflicts with the canons of Rule

12(b)(6). The Seventh Circuit’s interpretation of the pleading

standard for scienter creates no such conflict, and for this

reason, the court’s ruling should be affirmed.

C. The Petitioners’ Insistence That Courts Bal-

ance Competing Inferences To Resolve A

Motion To Dismiss Conflicts With The Seventh

Amendment’s Right To Trial By Jury

The Seventh Amendment to the Constitution provides that

“the right of trial by jury shall be preserved, and no fact tried

by a jury, shall be otherwise reexamined in any Court of the

United States, than according to the rules of the common

law.” U.S. Const. amend. VII. It is well settled that “when

there is a debatable issue of fact in the trial of a suit at com-

mon law in a court of the United States, the right to have it

determined by a jury is guaranteed by the Seventh Amend-

ment of the Constitution.” See Hunt v. Bradshaw, 251 F.2d

103, 108 (4th Cir. 1958). The Seventh Amendment ensures

“the enjoyment of the right of trial by jury be not obstructed,

and that the ultimate determination of issues of fact by the

jury be not interfered with.” Ex Parte Peterson, 253 U.S.

17

300, 309-310 (1920). “[MJaintenance of the jury as a fact-

finding body is of such importance and occupies so firm

a place in our history and jurisprudence that any seeming

curtailment of the right to a jury trial should be scrutinized

with the utmost care.” Beacon Theatres, Inc. v. Westover.

359 U.S. 500, 501 (1959).

The right to trial by jury places limits on the nature of the

issues that a judge may decide on a dispositive motion, such

as a motion to dismiss or a motion for summary judgment.

Courts certainly are empowered to make procedural rulings

with a view to formulating the issues. However, when a court

weighs competing inferences and “fails to draw all reasonable

inferences in favor of [the plaintiff],” it acts as a fact finder

and “impermissibly substitute[s] its judgment concerning the

weight of the evidence for the jury’s.” Reeves v. Sanderson

Plumbing Products, 530 U.S. 133, 153 (2000); cf Anderson

v. Liberty Lobby, Inc., 477 U.S. 242, 255 (1986) (“Credibility

determinations, the weighing of the evidence and the drawing

of legitimate inferences from the facts are jury functions, not

those of a judge, whether ruling on a motion for summary

judgment or for a directed verdict.”). .

The Petitioners’ interpretation of the Reform Act calls upon

courts to engage in just these sorts of factual determinations:

considering the relative weight of inferences drawn in favor

of both parties, in conflict with the Seventh Amendment. The

Seventh Circuit recognized the constitutional implications of

the Petitioners’ test:

{W]e think it wiser to adopt an approach that cannot be

misunderstood as a usurpation of the jury’s role. Instead

of accepting only the most plausible of competing infer-

ences as sufficient at the pleading stage. we will allow

the complaint to survive if it alleges facts from which, if

true, a reasonable person could infer that the defendant

acted with the required intent. “Faced with two seem-

ingly equally strong inferences, one favoring the plaintiff

18

and one favoring the defendant, it is inappropriate for us

to make a determination as to which inference will

ultimately prevail, lest we invade the traditional role of

the factfinder.”

See Makor, 437 F.3d at 602 (quoting Pirraglia, 339 F.3d at

1188); see also City of Monroe Employees Ret. Sys. v.

Bridgestone Corp., 399 F.3d 651, 683 n.25 (6th Cir.), cert.

denied, 126 S.Ct. 423 (2005) (“One might argue that for cases

where a juror could conclude that the facts pleaded show

scienter, but that conclusion would not be the most plausible

of competing inferences, a Seventh Amendment problem is

presented.”). Unlike the Petitioners’ test, the Seventh Cir-

cuit’s interpretation of the Reform Act avoids a conflict with

the right to trial by jury, and for this reason the court’s ruling

should be affirmed.

D. If The Seventh Circuit’s Ruling Is Reversed,

An Increasing Number Of Investors Will Suf‘er

Irretrievable Losses At The Hands Of Those

Committing Fraud

While the Seventh Circuit’s ruling imposes manageable

burdens on investors who have legitimate claims for securi-

ties fraud, the Petitioners’ formula for pleading scienter under

the Reform Act heaps additional, unreasonable requirements

on those same investors. Under that formula, meritorious

claims involving fraud on the market will be barred in

instances where a class of plaintiffs, at the pleading stage and

without the benefit of discovery, cannot yet perform the

daunting task of disproving all innocent explanations for the

defendants’ fraudulent conduct. As a result, plaintiffs will be

unjustly deprived of the right to recover damages for fraud

and abuse that unquestionably caused them injury. Because

the Petitioners’ interpretation of the pleading requirements for

scienter under the Reform Act will so undermine the purposes

of the securities laws, and because it is neither compelled nor

warranted by the applicable statutory language, it should be

19

rejected. The Seventh Circuit’s ruling avoids this unfairness

to investors, without betraying the obligation to fulfill

Congress’s policy objectives under the Reform Act, and it

should therefore be affirmed.

CONCLUSION

For the reasons set forth above, the decision of the Seventh

Circuit should be affirmed.

Respectfully submitted,

ALFRED E. T. RUSCH *

Senior Counsel

District of Columbia Securities Bureau

REX A. STAPLES

General Counsel

STEPHEN W. HALL.

Deputy General Counsel

JOSEPH V. BRADY

Associate General Counsel

LESLEY M. WALKER

Associate Counsel

NORTH AMERICAN SECURITIES

ADMINISTRATORS ASSOCIATION, INC.

750 First Street, N.E., Suite 1140

Washington, D.C. 20002

* Counsel of Record (202) 737-0900

March 9, 2007