Appeal from the United States District Court for the Northern District of Illinois, Eastern Division. No. 02 C 4356-Amy J. St. Eve, Judge.
The opinion of the court was delivered by: Posner, Circuit Judge.
Before POSNER, WOOD, and SYKES, Circuit Judges.
This appeal is before the court a second time, after our previous decision, 437 F.3d 588 (7th Cir. 2006), reversing the dismissal of the suit by the district court on the defendants' motion to dismiss, was itself reversed by the Supreme Court. 127 S.Ct. 2499 (2007). The Court remanded the case to us with directions to consider whether the plaintiffs' allegations of securities fraud in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, create the "strong inference" of scienter, as defined by the Supreme Court in its opinion, that the Private Securities Litigation Reform Act of 1995 requires for the complaint to survive a motion to dismiss.
Rule 10b-5 forbids a company or an individual "to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." 17 C.F.R. § 240.10b-5(b). But liability requires proof of the defendant's "scienter," which is to say proof that he either knew the statement was false or was reckless in disregarding a substantial risk that it was false. Higginbotham v. Baxter International, Inc., 495 F.3d 753, 756 (7th Cir. 2007). A popular definition of recklessness in this context is "an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." In re Scholastic Corp. Securities Litigation, 252 F.3d 63, 76 (2d Cir. 2001), quoting Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978). This looks like two criteria- knowledge of the risk and how big the risk is-but as a practical matter it is only one because knowledge is inferable from gravity ("the danger was either known to the defendant or so obvious that the defendant must have been aware of it"). When the facts known to a person place him on notice of a risk, he cannot ignore the facts and plead ignorance of the risk. AMPAT/Midwest, Inc. v. Illinois Tool Works Inc., 896 F.2d 1035, 1042 (7th Cir. 1990); SEC v. Jakubowski, 150 F.3d 675, 681 (7th Cir. 1998).
A complication introduced by the Private Securities Litigation Reform Act is that "actual knowledge" of falsity, not merely indifference to the danger that a statement is false, is required for liability for "forward-looking" statements-predictions or speculations about the future.
15 U.S.C. § 78u-5(c)(1)(B)(ii); see Helwig v. Vencor, Inc., 251 F.3d 540, 554-55 (6th Cir. 2001). This has implications for pleading, since the "strong inference" that must be drawn to avoid dismissal cannot be an inference merely of recklessness if predictions are challenged as fraudulent. The fact that all the statements challenged in this case that we found in our earlier opinion to be materially false are in the present tense is not decisive on the question whether the statements include predictions: "Our earnings are certain to double" is in the present tense, but is a prediction. But a mixed present/future statement is not entitled to the safe harbor with respect to the part of the statement that refers to the present. When Tellabs told the world that sales of its 5500 system were "still going strong," it was saying both that current sales were strong and that they would continue to be so, at least for a time, since the statement would be misleading if Tellabs knew that its sales were about to collapse. The element of prediction in saying that sales are "still going strong" does not entitle Tellabs to a safe harbor with regard to the statement's representation concerning current sales.
Section 21D(b)(2) of the Reform Act requires that the plaintiff's complaint "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), that is, with scienter. But except with regard to "forward-looking" statements, the Act does not specify "the required state of mind," so it remains the concept of scienter developed before the Act. Nathenson v. Zonagen Inc., 267 F.3d 400, 407-09 (5th Cir. 2001); Helwig v. Vencor, Inc., supra, 251 F.3d at 550. In our previous opinion, we ruled that the plaintiffs had adequately pleaded not only that the defendants had made materially false statements but also that they had acted with the required scienter. The first ruling was not disturbed by the Supreme Court and is the law of the case, controlling our present consideration. The second ruling was not reversed, but the Supreme Court disagreed with this court's interpretation of "strong inference" of scienter and directed us to dismiss the complaint unless "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." 127 S.Ct. at 2510 (footnote omitted). The plaintiff "must plead facts rendering an inference of scienter at least as likely as any plausible opposing inference." Id. at 2513 (emphasis in original). So first the inference must be cogent, and second it must be as cogent as the opposing inference, that is, the inference of lack of scienter.
To judges raised on notice pleading, the idea of drawing a "strong inference" from factual allegations is mysterious. Even when a plaintiff is required by Rule 9(b) to plead facts (such as the when and where of an alleged fraudulent statement), the court must treat the pleaded facts as true and "draw all reasonable inferences in favor of the plaintiff." Borsellino v. Goldman Sachs Group, Inc., 477 F.3d 502, 506-07 (7th Cir. 2007). To draw a "strong inference" in favor of the plaintiff might seem to imply that the defendant had pleaded facts or presented evidence that would, by comparison with the plaintiff's allegations, enable a conclusion that the plaintiff had the stronger case; and therefore that a judge could not draw a strong inference in the plaintiff's favor before hearing from the defendant. But comparison is not essential, and obviously is not contemplated by the Reform Act, which requires dismissal in advance of the defendant's answer unless the complaint itself gives rise to a strong inference of scienter. For a defendant will usually have evidence to present in his defense; and so a complaint that on its face, and without reference to the defendant's case, creates only a weak or bare inference of scienter, suggesting that the plaintiff would prevail only if there were no defense case at all, would be quite likely to fail eventually when the defendant had a chance to put on his case, which would normally be after pretrial discovery. Apparently Congress does not believe that weak complaints should put a defendant to the expense of discovery in a securities-fraud case, which is likely to be complex-as this case is.
The complaint alleges the following: The corporate defendant, Tellabs, manufactures equipment used in fiber optic cable networks; its principal customers are telephone companies. In December 2000, the beginning of the period of alleged violations of Rule 10b-5, Tellabs's principal product, accounting for more than half its sales, was a switching system called TITAN 5500. The product was almost 10 years old when on December 11 Tellabs announced that the 5500's successor product, TITAN 6500, was "available now" and that Sprint had signed a multi-year, $100 million contract to buy the 6500, though in fact no sales pursuant to the contract closed until after the period covered by the complaint. The same announcement added that despite the advent of the 6500, sales of the 5500 would continue to grow. (Most of these and other announcements quoted in the complaint were made by Richard Notebaert, who was Tellabs's chief executive officer and, along with Tellabs, is the principal defendant.)
The following month, Tellabs announced that "customers are buying more and more Tellabs equipment" and that Tellabs had "set the stage for sustained growth" with the successful launch of several products. In February, the company told its stockholders that its growth was "robust" and that "customers are embracing" the 6500. In response to a question frequently asked by investors-whether sales of the 5500 had peaked-the company declared that "although we introduced this product nearly 10 years ago, it's still going strong." In March the company reduced its sales estimates slightly but said it was doing so because of lower than expected growth in a part of its business unrelated to the 5500 and 6500 systems, and that "interest in and demand for the 6500 continues to grow" and "we are satisfying very strong demand and growing customer demand [for the 6500, and] we are as confident as ever-that may be an understatement-about the 6500." And in response to a securities analyst's question whether Tellabs was experiencing "any weakness at all" in demand for the 5500, Notebaert responded: "No, we're not . . . . We're still seeing that product continue to maintain its growth rate; it's still experiencing strong acceptance." Yet from the outset of the period covered by the complaint Tellabs had been flooding its customers with tens of millions of dollars worth of 5500s that the customers had not requested, in order to create an illusion of demand. The company had to lease extra storage space in January and February to accommodate the large number of returns.
Just weeks after these statements Tellabs reduced its sales projections significantly because its customers were "exercising a high degree of prudence over every dollar spent." But it reiterated that the demand for the 6500 was "very strong." In April it said "we should hit our full manufacturing capacity [for the 6500] in May or June to accommodate the demand we are seeing. Every- thing we can build, we are building and shipping. The demand is very strong."
In June, however, at the end of the period covered by the complaint, Tellabs announced a major drop in revenues, and its share price, which at its peak during the period had been $67 and in the middle of the period had varied between $30 and $38, fell to just under $16. (It currently is below $7.00.) But the deterioration had been well under way by December as a result of the bursting of the fiber-optics bubble in the middle of the year. The market for the 5500 was evaporating; the next month (January 2001), Tellabs's largest customer, Verizon, reduced its orders for the 5500 by 50 percent-having already, the previous June, reduced them by 25 percent. And not a single 6500 system was shipped during the complaint period.
Tellabs's revenues in 2001 were 35 percent lower than the year before and its profits 125 percent lower. The drop in the second quarter (most of which was within the period covered by the complaint) over the year before was even ...