In Tellabs v. Makor Issues & Rights Ltd., 127 U.S. 2499 (2007) the U.S. Supreme Court ruled that pleading facts indicating a "plausible inference of scienter" was insufficient. To establish a "strong inference" of scienter, the inference drawn from the plaintiff's allegations "must be cogent and at least as compelling as any opposing inference of non-fraudulent conduct." According to the Supreme Court, the "strength of inference" inquiry is "inherently comparative," which means that the court must analyze the alleged wrongful conduct in the context of all of the factual allegations made in the complaint and then take into account plausible opposing inferences. If the inferences are equal, the tie favors the plaintiff.

Two recent cases, both involving financial professionals as defendants before the same district court judge, illustrate how you can come to different results in cases that are facially similar. In both Top Tanker Securities Litigation, 2007 WL 4563930 (S.D.N.Y. Dec. 18, 2007) and City of Brockton Retirement System v. The Shaw Group, Inc., 06 CIV 8245 (decided March 18, 2008), the only issue was whether the complaint adequately alleged facts "giving rise to a strong inference" of scienter.

Ernst & Young was the outside auditor in both cases. The Top Tanker complaint alleged that E&Y and Top Tanker had significant differences over a proposed accounting treatment of a seller's credit. E&Y took the position that the seller's credit should not have been included in book value, but should be treated as a residual value guarantee. The plaintiff contended that the defendants were reckless in choosing to recognize this as current gain from the sale of vessels, and that doing this in the face of E&Y's contrary position established a strong inference of scienter. Since Top Tanker was a foreign issuer, E&Y was not required to file a resigning auditor's letter with the SEC pursuant to Item 304 of Regulation S-K. Nothing in the record clarified why E&Y resigned. In Top Tanker, the complaint was deemed sufficient.

In contrast, in City of Brockton Retirement System v. The Shaw Group, Inc. the amended complaint quoted from a Form 8-K in which the company stated that E&Y resigned, but "conveniently" failed to note that E&Y filed an Item 304 letter, as required by Regulation S-K. The Item 304 letter was attached to the Form 8-K. In that letter, E&Y specifically agreed with the Company's statement that there were no disagreements between the Company and the outside auditor on any matter of accounting principles or practices, financial statement disclosure or auditing scope or procedure in the relevant fiscal years. The court held that this disclaimer was an important factor indicating that the plaintiff was unable to allege a strong inference of fraud.

Also, the plaintiff's case cited five other independent factors, which in the aggregate constituted strong circumstantial evidence of conscious misbehavior or recklessness raising a strong inference of fraud. The court pointed out that each of these five factors cited by the plaintiff, standing alone, did not raise a strong inference of fraud. It therefore rejected the plaintiff's argument that aggregating disparate factors, none of which by themselves raise a strong inference of fraud, could create the strong inference.

Certain principles were enunciated in both cases: (i) knowledge of GAAP accounting principles cannot be attributed to an individual officer defendant simply because of his position at the company; (ii) neither the mere fact of an earnings restatement, nor the purportedly inaccurate Sarbanes-Oxley certification supports a strong inference that the company was reckless in issuing its original financial statements; and (iii) knowledge of accounting improprieties that may be legally imputed to a company's officers and directors who are involved in the day-to-day operations do not by themselves give rise to any inference of scienter by the individuals.

Although the plaintiff's class action counsel are taking the position that Tellabs does not change the law, see "Tellabs and SDNY: Plaintiff's Prospective," NYLJ, March 25, 2008, alleging facts evidencing a strong inference of scienter, rather than a plausible inference of scienter, is obviously a higher pleading hurdle. In my opinion, Tellabs strengthens the defendants and will result in more dismissals at the pleading stage.

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CHARLES HECHT has been a principal of his own law firm specializing in securities law since 1971. He was previously on the staff of the Division of Corporate Finance of the Securities and Exchange Commission at its headquarters in Washington, DC. Contact him at 212.490.3232 or visit www.securitiescounselors.com