Order Code RS22634
Updated March 30, 2007
Securities Fraud: Tellabs, Inc. v.
Makor Issues & Rights, Ltd.
Michael V. Seitzinger
Legislative Attorney
American Law Division
Summary
The United States Supreme Court granted the petition for certiorari in the case
Tellabs, Inc. v. Makor Issues & Rights, Ltd. The case was appealed from a decision by
the Court of Appeals for the Seventh Circuit. It presents the question whether and to
what extent a court must consider or weigh competing inferences in determining
whether a complaint asserting a claim of securities fraud has alleged facts sufficient to
establish a “strong inference” that the defendant acted with scienter, as required by the
Private Securities Litigation Reform Act of 1995. This report will be updated.
On January 5, 2007, the United States Supreme Court granted the petition for
certiorari in the case Tellabs, Inc. v. Makor Issues & Rights, Ltd.1 The case was appealed
from a decision by the Court of Appeals for the Seventh Circuit2 and presents the question
of whether and to what extent a court must consider or weigh competing inferences in
determining whether a complaint asserting a claim of securities fraud has alleged facts
sufficient to establish a “strong inference” that the defendant acted with scienter,3 as
required by the Private Securities Litigation Reform Act of 1995 (PSLRA).4 Oral
argument occurred on March 28, 2007.
The case is a class action against Tellabs, Inc., which is a manufacturer of specialized
equipment used in fiber optic cable networks. The plaintiffs in the case, a class of Tellabs
shareholders, allege that Tellabs’s fraudulent conduct began with the issuing of a press
release which stated that Tellabs had signed a multi-year, $100,000,000 contract for one
of Tellabs’s next-generation products, the Titan 6500. Tellabs’s chief executive officer
(CEO), Richard Notebaert, predicted to financial analysts that, in addition to the Sprint
1 No. 06-484.
2 437 F.3d 588 (7th Cir. 2006).
3 “Latin term for a person’s guilty knowledge; i.e., knowing that a person’s actions are wrong.”
MODERN DICTIONARY FOR THE LEGAL PROFESSION (3d ed. 2001).
4 15 U.S.C. § 78u-4.

CRS-2
contract, there would be continuing growth of the Titan 5500, the 6500’s predecessor.
Based in part on these representations, market analysts recommended that investors buy
Tellabs stock. In addition, further optimistic statements signed by Notebaert and Richard
Birck, Tellabs’s chairman and former CEO, included “Tellabs’s growth is robust,” “Our
markets hold significant potential for sustained growth,” and “Our core business is
performing well.” As time passed, Notebaert continued to issue upbeat statements.
Within two years of the first optimistic statement issued by Notebaert, Tellabs
significantly reduced its projected earnings and its stock price plunged.
Plaintiffs then filed a class action suit against Tellabs and ten of its executives,
alleging that the executives knowingly lied to the public in specific ways, such as that they
knew that the Titan 6500 was not available and that they knew that the demand for the
Titan 5500 was waning, instead of growing. Plaintiffs also alleged that Birck engaged in
illegal insider trading. The district court twice dismissed the shareholders’ suit on the
basis that the shareholders had failed to prove scienter under the PSLRA.5 The plaintiffs
appealed to the Seventh Circuit, arguing that 1. Some of the statements that the court
dismissed as “mere puffery” were legally actionable; 2. The complaint provided enough
detail to support a strong inference of scienter for each of the defendants; and 3.The
disclaimer which accompanied Tellabs’s forecasts was insufficient and that therefore
Tellabs could not rely upon the PSLRA’s safe harbor provision.6
The Court of Appeals for the Seventh Circuit first listed three distinct statutory
violations that plaintiffs’ complaint alleged. First, the plaintiffs contended that Tellabs,
as a company, and that Notebaert and Birck, as individuals, violated section 10(b),7 the
general antifraud provision, of the Securities Exchange Act of 1934,8 and Securities and
Exchange Commission (SEC) Rule 10b-5,9 the SEC rule which implements the general
antifraud provision. Second, the complaint alleged that Notebaert, Birck, and certain
other Tellabs executives were “control persons” and therefore liable under section 20(a)10
of the Securities Exchange Act for the corporation’s fraudulent acts. Third, the plaintiffs
alleged that Birck committed insider trading violations.11
In analyzing the issues of the case, the Seventh Circuit noted that the PSLRA, which
governs class actions brought for securities law violations, sets out particularity for fact
pleading that exceeds the requirements under Rule 9(b) of the Federal Rules of Civil
Procedure.12 Under the PSLRA, a securities fraud (section 10(b) “complaint shall specify
each statement alleged to have been misleading, the reason or reasons why the statement
5 Johnson v. Tellabs, Inc., 303 F. Supp. 2d 941 (N.D. Ill. 2004).
6 The safe harbor provision for forward-looking statements under the PSLRA may be found at
15 U.S.C. section 78u-5.
7 15 U.S.C. § 78j(b).
8 15 U.S.C. §§ 78a et seq.
9 17 C.F.R. § 240.10b-5.
10 15 U.S.C. § 78(t).
11 15 U.S.C. § 78t-1.
12 See, e.g., In re Rockefeller Center Properties, Inc. Securities Litigation, 311 F. 3d 198 (3d Cir.
2002).

CRS-3
is misleading, and, if an allegation regarding the statement or omission is made on
information and belief, the complaint shall state with particularity all facts on which that
belief is formed”13 and “state with particularity facts giving rise to a strong inference that
the defendant acted with the required state of mind.”14
There has been debate within the courts of appeals as to how much factual detail in
the pleadings is enough to satisfy the “strong inference” of scienter required by the
PSLRA. For example, the Ninth Circuit has stated that, in enacting the strong inference
requirement, Congress raised the bar under the PSLRA for the substantive state of mind
requirement for securities fraud allegations.15 The Seventh Circuit decision stated that it
was not convinced that Congress intended to raise the bar under the PSLRA because,
prior to the enactment of the PSLRA, every circuit considering the substantive standard
had held that a showing of recklessness was sufficient to allege scienter.16 The Seventh
Circuit stated that, because the PSLRA refers to the “required state of mind,” it seemed
likely that Congress approved of the state of mind standard used before passage of the
PSLRA and that, if Congress wanted a stricter scienter standard to be used, Congress
would have placed a new standard in the law.
The Seventh Circuit went on to discuss that, although it believed that the PSLRA did
not impose a stricter substantive scienter standard, the act did raise the bar for pleading
scienter. In addition to having to meet a particularity requirement, plaintiffs must meet
a substantive requirement by pleading sufficient facts to create a “strong inference” of
scienter. The Seventh Circuit could not find congressional intent as to what facts will
create such an inference. Further, according to the Seventh Circuit, there is conflict in the
circuits as to how to demonstrate the required “strong inference.” The Second and Third
Circuits follow the reasoning that the PSLRA adopted the Second Circuit’s pre-PSLRA
pleading standard for scienter.17 The Ninth and Eleventh Circuits, however, believe that
Congress considered but rejected the Second Circuit’s approach and instead chose a more
13 15 U.S.C. § 78u-4(b)(1).
14 15 U.S.C. § 78u-4(b)(2).
15 In re Silicon Graphics Securities Litigation, 183 F.3d 970, 979 (9th Cir. 1999): A plaintiff must
allege facts that create a strong inference of “deliberate or conscious recklessness” or a “degree
of recklessness that strongly suggests actual intent.”
16 See Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990); In re Philips
Petroleum Securities Litigation
, 881 F.2d 1236, 1244 (3d Cir. 1989); Van Dyke v. Coburn Enter,
Inc.
, 873 F.2d 1094, 1100 (8th Cir. 1989); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809,
814-15 (11th Cir. 1989); Hackbart v. Holmes, 675 F.2d 1114, 1117-18 (10th Cir. 1982); Broad v.
Rockwell International Corp.,
642 F.2d 929, 961-62 (5th Cir. 1981); Mansbach v. Prescott, Ball
& Turben
, 598 F.2d 1017, 1023-25 (6th Cir. 1979); Cook v. Avien, Inc., 573 F.2d 685, 692 (1st Cir.
1978); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 44-47 (2nd Cir. 1978); and Sundstrand
Corp. v. Sun Chemical Corp.
, 553 F.2d 1033, 1044 (7th Cir. 1977).
17 “[P]laintiffs may continue to state a claim by pleading either motive and opportunity or strong
circumstantial evidence or recklessness or conscious misbehavior.” Novak v. Kasaks, 216 F.3d
300, 309-10 (2d Cir. 2000); In re Advanta Corporation Securities Litigation, 180 F.3d 525, 530-
35 (3d Cir. 1999).

CRS-4
onerous burden.18 The remaining six circuits, according to the Seventh Circuit, have
taken a middle ground and have reasoned that “Congress chose neither to adopt nor reject
particular methods 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.”19 The Seventh Circuit in this case decided to follow this
middle ground.
Having decided the line of reasoning that it would take concerning the threshold of
what constitutes a strong inference of scienter, the Seventh Circuit held that plaintiffs’
complaint against Notebaert met the threshold but that the complaint against Birck did
not meet the threshold. Notebaert’s guilt derived, according to the court, from the
evidence that he likely knew that the optimistic statements which he made concerning
Tellabs’s Titan 5500 and Titan 6500 were false. Birck, on the other hand, made
optimistic projections only up until the time that he likely knew of the Titan 5500’s
market weakness. The federal securities laws impose liability not only on the person who
actually commits the securities law violation but also on the persons who “directly or
indirectly”20control the violator. Therefore, the plaintiffs’ claims against Notebaert,
Birck, and the other Tellabs executives for controlling person liability survived. The
executives, according to the court, may later have an opportunity to prove that they acted
in good faith. Further, since Notebaert acted within the scope of his position as CEO of
Tellabs, his knowledge of the falsity of his statements could be imputed to the corporate
entity Tellabs. Finally, the charge against Birck for insider trading survived because of
his possibly being found to be a control person.
In its brief, the petitioner (Tellabs) states:
The Seventh Circuit in this case interpreted and applied the “strong inference”
standard in a way that is inconsistent with its text and purpose. The court of appeals
adopted an approach to a securities fraud complaint that rewards ambiguous pleading
by reading such allegations exclusively in the plaintiff’s favor, and one-sidedly
considers the strength of claimed inferences of scienter by themselves, without
placing the allegations putatively supporting such an inference in the context provided
by the complaint and and other materials properly before the court.
Contrary to the Seventh Circuit’s approach, the Reform Act requires a plaintiff to
plead specific facts that, considered in the overall context created by the complaint
18 “Congress intended to elevate the pleading requirement above the Second Circuit standard
requiring plaintiffs merely to provide facts showing simple recklessness or a motive to commit
fraud and opportunity to do so.” In re Silicon Graphics Securities Litigation, 183 F.3d 970, 974
(9th Cir. 1999). “Because the clear purpose of the [PSLRA] was to curb abusive securities
litigation, and because we believe that the motive and opportunity analysis is inconsistent with
that purpose, we decline to adopt it.” Bryant v. Avado Brands, Inc., 187 F.3d 1271, 1286 (11th
Cir. 1999).
19 Ottoman v. Hanger Orthopedic Group, Inc., 353 F.3d 338, 345 (4th Cir. 2003); accord Florida
State Board of Administration v. Green Tree Financial Corp.
, 270 F.3d 645, 659-60 (8th Cir.
2001); Nathansen v. Zonagen, Inc., 267 F.3d 400, 411-12 (5th Cir. 2001); Helwig v. Vencor, Inc.,
251 F.3d 540, 550-52 (6th Cir. 2001); Greebel v. FTP Software Inc.,194 F.3d 185, 195-97 (1st Cir.
1999).
20 15 U.S.C. § 78t(a).

CRS-5
as a whole and other materials properly before the court, demonstrate that the
plaintiff’s claim that the defendant acted with scienter has substantial merit.21
Respondents (shareholders), on the other hand, argue that:
Petitioners ask the Court to ignore the PSLRA’s actual language and fabricate an
impossible-to-meet heightened pleading burden that obliges a plaintiff to provide
sufficient evidentiary detail to foreclose any possibility that the defendant’s intent
was not fraudulent. Such a requirement has no basis in more than a decade of
applying the PSLRA, and it is at odds with the established principle that a plaintiff
is not required to provide detailed evidence or to prove the merits of its case in the
complaint. The variant super-heightened pleading standards conjured up by
petitioners and supporting amici are very likely to throw out the meritorious wheat
along with the chaff. The PSLRA was never intended to leave the securities
marketplace so vulnerable to malfeasance.22
The issue of what should constitute a “strong inference” that a person acted with
scienter in committing a securities fraud violation for purposes of bringing a class action
seems to be at the heart of the PSLRA. In the act’s legislative history there are statements
which the Court may look to if it does not believe that the meaning of the statute is plain
on its face. For example, in the conference report for the legislation the following was
stated concerning the “heightened pleading standard”:
Naming a party in a civil suit for fraud is a serious matter. Unwarranted fraud claims
can lead to serious injury to reputation for which our legal system effectively offers
no redress. For this reason, among others, Rule 9(b) of the Federal Rules of Civil
Procedure requires that plaintiffs plead allegations of fraud with ‘particularity.’ The
Rule has not prevented abuse of the securities laws by private litigants [footnote
omitted]. Moreover, the courts of appeals have interpreted Rule 9(b)’s requirement
in conflicting ways, creating distinctly different standards among the circuits
[footnote omitted]. The House and Senate hearings on securities litigation reform
included testimony on the need to establish uniform and more stringent pleading
requirements to curtail the filing of meritless lawsuits.
The Conference Committee language is based in part on the pleading standard of the
Second Circuit. The standard also is specifically written to conform the language to
Rule 9(b)’s notion of pleading with ‘particularity.’
Regarded as the most stringent pleading standard, the Second Circuit requirement is
that the plaintiff state facts with particularity, and that these facts, in turn, must give
rise to a ‘strong inference’ of the defendant’s fraudulent intent. Because the
Conference Committee intends to strengthen existing pleading requirements, it does
not intend to codify the Second Circuit’s case law interpreting this pleading standard
[footnote omitted]. The plaintiff must also specifically plead with particularity each
statement alleged to have been misleading. The reason or reasons why the statement
is misleading must also be set forth in the complaint in detail. If an allegation is made
21 [http://www.abanet.org/publiced/preview/briefs/pdfs/06-07/06-484_Petitioner.pdf], at 2.
22 [http://www.abanet.org/publiced/preview/briefs/pdfs/06-07/06-484_Respondent.pdf], at 16.

CRS-6
on information and belief, the plaintiff must state with particularity all facts in the
plaintiff’s possession on which the belief is formed.23
It is interesting to note that, just as a conflict in the circuits existed in the interpretation
of Rule 9(b) of the Rules of Civil Procedure, so a conflict now exists in the interpretation
of the pleading standard under the PSLRA. Although it is not possible to predict how the
Supreme Court will rule in this case, a look at the legislative history suggests that
Congress intended a quite stringent pleading standard.
crsphpgw
23 H.Rept. 104-369 at 41 (1995).