Rather than attempting to prove that they themselves actually relied on misstatements or omissions by the defendant, investors bringing 10b-5 claims frequently employ a fraud-on-the-market theory, whereby they can win a presumption of reliance by showing that they reasonably relied on the integrity of an efficient market for the security they purchased.  The success of class actions in particular generally depends on a fraud-on-the-market argument, because showing actual reliance by each individual plaintiff would tend to raise so many individual factual issues as to render the class uncertifiable under Rule 23.

There is a circuit split as to the showing that a plaintiff must make to support a fraud-on-the-market presumption for the purpose of class certification.  In The Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton, the Fifth Circuit required “plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption . . . at the class certification stage by a preponderance of all admissible evidence.”  597 F.3d 330, 335 (5th Cir. 2010).  The Seventh Circuit rejects that rule.  Schleicher v. Wendt, 618 F.3d 679, 685–86 (7th Cir. 2010).  On Friday the Supreme Court granted cert in the Fifth Circuit case to address the issue.

More documents at SCOTUSblog.  Also see 10b-5 Daily.  Following the links in the paragraph above, other than to the cases themselves, will give you a sense of how Spindle Law handles splits.

Just a follow-up up on my post last night about pleading plausibility (as discussed there, it’s not specifically a securities law issue and is probably less relevant to securities fraud complaints than it is to complaints in most other civil actions in federal court):  Three House Democrats plan to introduce a bill next week that would undo the new standard, says WSJ Law Blog.

While the Supreme Court’s decisions in Bell Atlantic v. Twombly and Ashcroft v. Iqbal have left Rule 8 pleading in a state of flux and uncertainty, it hasn’t been obvious whether the “plausible on its face” standard of those cases will have much effect on securities cases governed by the already (expressly) heightened pleading requirements of the Private Securities Litigation Reform Act.  Kevin LaCroix of D & O Diary has a good discussion of this issue, including of last week’s McAdams v. McCord, in which the Eighth Circuit affirmed a dismissal for failure to satisfy the new plausibility requirement as to loss causation.  I recommend reading it in full if you’re interested in this issue.

He does draw a conclusion I don’t agree with, namely that by affirming without deciding whether the complaint satisfied the scienter pleading requirement of the PSLRA, the McAdams court implied “that Iqbal’s generalized pleading requirements must be considered analytically prior to the PSLRA’s more particularized requirements.”  That would probably be correct if the court had applied Twombly/Iqbal in analyzing the complaint’s scienter or misstatement allegations, because the PSLRA’s heightened standard applies to those elements.  By applying it to loss causation, though — to which the PSLRA standard does not apply (rule on Spindle) — I think the court simply asserted its authority to affirm on any legally sufficient basis and to pass on other issues.  (Whether there is any special specificity required in pleading loss causation is an issue as to which there has been some disagreement.)  Although there are issues that courts feel they ought to address first (e.g., jursidiction) or avoid if possible (e.g., undecided constitutional issues), the court here faced no such special-priority issues, just a choice among elements to analyze.  (It is notable that the court chose to decide the loss causation issue, because the district court did not reach that issue.  Assuming that loss causation was argued on appeal, though, it’s pretty much your basic affirmed-on-other-grounds.)

I also have a quibble with the rhetorical question that Mr. LaCroix, who supports the plausibility standard, poses to the standard’s opponents:  “are they suggesting that complaints that are not facially plausible should be allowed to go forward?” he asks.  The right question, I think, is whether enough meritorious cases appear implausible to judges prior to discovery to justify letting a case move forward if the complaint satisfies a notice pleading standard.  Reasonable people can disagree.

Those interested in the Twombly/Iqbal pleading standard in general might want to check out several posts and columns on the subject by Mike Dorf, who opposes the standard (and to whose blog I sometimes contribute).  You can find links from his post on strategies for overruling it.

Standards of review on appeal have sometimes appeared to me to be mostly for show. Certainly they are pliable, often seeming to depend on whether the reviewing judges would have had a tough time deciding the issue themselves if they’d been deciding it below. For many appellate judges, there aren’t that many close calls, especially on issues they’ve thought about many times before.

For the judges on a Ninth Circuit panel that recently reviewed a denial of class certification in an investors’ action, however, the standard of review was worth fighting over even though they agreed as to the result for the parties. In Desai v. Deutsche Bank Securities Ltd., 573 F.3d 931 (2009), no judge dissented from the per curiam opinion holding that the district court did not abuse its discretion in denying certification because individual issues did not predominate under Federal Rule of Civil Procedure 23(b)(3).  (Rule of the decision on Spindle.)   In competing concurrences, though, Judges O’Scannlain and Graber disputed whether the Court of Appeals was required to decide that the denial was required as a matter of law.  (Topic on Spindle.)

The underlying issue was plaintiffs’ theory that in a manipulation claim under Rule 10b-5 reliance can be presumed on the ground that investors typically rely on the integrity of the market, which was undermined by the alleged manipulative conduct. In other words, the plaintiffs proposed an analog to the fraud-on-the-market presumption of reliance in actions based on misstatements or omissions. (They also argued, and the district court and appellate court rejected, a presumption of reliance theory based on material omissions under Affiliated Ute Citizens v. United States, 406 U.S. 128, 153–54 (1972).  (Rule on Spindle.) Judge O’Scannlain, who wanted to decide the issue as a matter of law, argued that the theory was either legally valid or not, regardless of the facts weighing for or against predominance. Judge Graber’s retort was that the question before the court was only whether the district court was required to recognize the novel presumption.  Judge Noonan, who didn’t express himself personally, evidently agreed with Judge Graber. As a result, another district court may yet recognize the presumption, and another panel may yet hold that the presumption is not legally invalid.

In February I discussed the Ninth Circuit’s curious new two-step method for analyzing scienter under the Private Securities Litigation Reform Act of 1995, which the court believed had been mandated by the Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S. Ct. 2499 (2007). It turns out that another court of appeals reads the same Supreme Court decision to require not two, but three steps.

The Fifth Circuit adopted its competing “three step approach” last July in Indiana Elec. Workers’ Pension Trust Fund IBEW v. Shaw Group, Inc., 537 F.3d 527 (5th Cir. 2008), and reaffirmed it last week in Flaherty & Crumrine Preferred Income Fund, Inc. v. TXU Corp.:

“First, the allegations must, as in federal pleadings generally, be taken as true. Second, courts may consider documents incorporated in the complaint by reference and matters subject to judicial notice. The facts must be evaluated collectively, not in isolation, to determine whether a strong inference of scienter has been pled. Third, a court must take into account plausible inferences opposing as well as supporting a strong inference of scienter. The inference of scienter must ultimately be ‘cogent and compelling,’ not merely ‘reasonable’ or ‘permissible.’”

— F.3d —, 2009 WL 930055, at *5 (5th Cir. Apr. 8, 2009) (quoting Ind. Elec., 537 F.3d at 533 (citing Tellabs, 127 S.Ct. at 2509-10)).

It’s always nice to be able to break a difficult task down into steps.  If you’re writing for a federal circuit court, it would be terrific if a recent Supreme Court decision already broke it down for you.  Tellabs, perhaps unfortunately, didn’t do that.  Rather, it “establish[ed]” three “prescriptions”:  1) “accept all factual allegations in the complaint as true“; 2) “consider the complaint in its entirety, as well as other sources courts ordinarily examine when ruling on Rule 12(b)(6) motions to dismiss”; and 3) when determining whether the facts give rise to a strong inference of scienter, “take into account plausible opposing inferences.” Tellabs, 127 S.Ct. at 2509-10.  The first of these prescriptions must be applied concurrently with, not prior to, the second, so they certainly aren’t “steps.”

The Fifth Circuit version leaves out the first part of prescription number two—”consider the complaint”—thus allowing a possible sequential interpretation:  look at allegations, look at documents, draw inferences.  Even if that reading were possible, though, it could as well apply to any area of federal civil litigation.    Everything special to the PSLRA pleading standard would be contained within a subset of the third step.  (Indeed, the first two prescriptions of Tellabs just affirm that, as to those two issues, the PSLRA did not alter the law.)

Judge Benavides, who authored last week’s decision in Flaherty & Crumrine, seemed a bit half-hearted about the three step approach, pointing out that the circuit had “recently interpreted Tellabs” this way—i.e., don’t blame me—and never mentioning any of the steps after their first dutiful recitation.  Like the Ninth Circuit’s “dual method, ” it’s not clear whether this approach has the potential to affect outcomes of cases, or if so, how.  If not, it’s not likely to be undone by an en banc court or by the Supreme Court, even through there is, in some sense, a circuit split.  If it can’t affect outcomes, perhaps it will be viewed as non-binding precedent by subsequent panels and will fade away.

One more point I should have made in introducing this blog:  I plan to continue to express my views on securities law issues on this blog and hope I might be joined eventually by other contributors who will express views that I won’t agree with.  Whatever views are expressed on this blog, whether by me or by another contributor, they do not represent the views of the company.  The company, in fact, doesn’t have any views on securities law at all.  If it ever forms any and states them, they will be explicitly characterized as the views of the company—and not on this blog.  In fact, I don’t plan to express company views on any topic on this blog.

Disclaimers unfortunately didn’t work very well for William Patry, but I’m hopeful that the many obvious differences between his situation and mine will make the difference here.

This is a new blog about securities law, associated with our developing securities law module.  For now, I am the only blogger here, and the subject is primarily securities fraud case law, since that’s what the module is mostly about so far. The posts prior to this one have been copied here from my personal blog, which consequently finds itself, at too young an age, suffering from doubts as to its reason for existence.

Like the rest of Spindle Law, this blog is an experiment.  Our little securities sub-module on SEC Rule 10b-5—built to a great extent by me, but with many important contributions from others—has been our test and demonstration piece for some time.   Although other, more knowledgable chief editors are now developing modules in their areas of expertise, I am, for the time being, at least, continuing to oversee and contribute regularly to the 10b-5 section.  Staying on as a kind of interim chief editor keeps me involved with the actual functioning of the research system, including new features as we add them, and helps me to maintain a lawyer’s perspective on it.  It’s also interesting and fun for me (as is most of what I do at Spindle).

I decided to start blogging about securities material, because I had the feeling that some of what I was learning by working with these fraud cases might be of interest or use to others (at least to the kind of people who love to curl up at night with a good SEC order).  Since just about everything I’m blogging about here is connected with something in the securities module, I’ve been adding comments within the module with links to the blog, and vice versa.  (I’m also adding comments within the module with links to other people’s blogs and to other relevant material online.)  This way, it will be easily accessible to researchers of particular legal issues on the research system as well as to followers of the blog (and, either way, through search engines, once we’re out of private alpha).  In this way, I hope this blog will be a good test of how or how not to connect what we’re doing inside the research system with what’s happening elsewhere.

Depending on how this all develops, we may add other bloggers here, or I may turn the whole blog over to others.  We’ll see.

It’s controversial whether Federal Rule of Civil Procedure 9(b), which applies where a party is “allegating fraud,” sometimes applies to securities claims that do not have scienter as an element and therefore do not necessarily sound in fraud.  Many courts, perhaps most, have held that Rule 9(b) does apply where the alleged facts on which the claim is based entail fraud, as is often the case where a plaintiff brings a rule 10b-5 claim (that is, a basic federal securities fraud claim, to enforce section 10(b) of the Securities Exchange Act of 1934) and also, based on a subset of the same allegations, a claim for violation of section 11 of the Securities Act of 1933 (for a not-necessarily-intentional material misstatement in a registration statement).

Every now and again, however, a court takes an additional, erroneous step, and applies the particularity requirements of the Private Securities Litigation Reform Act of 1995 to one of these semi-fraud situations.  The Ninth Circuit did this last month, without discussion of the point, in Rubke v. Capitol Bancorp, Inc., 551 F.3d 1156, 1162 (9th Cir. 2009), which I have previously criticized for a different misstatement of the law.  (It’s only fair to note that both of these misstatements were apparently made without scienter.)

The pleading standards of the PSLRA that require the plaintiff to plead with particularity all alleged misstatements or omissions and facts supporting a strong inference of scienter fall within section (b) of the PSLRA, which amends the Securites Exchange Act of 1934 and is codified as 15 U.S.C. § 78u–4.  These pleading provisions, as codified at § 78u–4(b)(1) & (2), both expressly define the extent of their reach as “any private action arising under this chapter,” that is, chapter 2B of of title 15,  which codifies the 1934 Act, as amended.  See 15 U.S.C. § 78a (“This chapter may be cited as the ‘Securities Exchange Act of 1934.’ “).  Section 10(b) is codified within that chapter as § 78j(b).  The PSLRA does contain a section amending the 1933 Act as well, but that section, section (a), does not contain an analogous section on pleading falsity or scienter.  (The 1933 Act is codified as chapter 2A, 15 U.S.C. §77a et seq.)  Thus there really isn’t any plausible argument that the particularity requirements apply to 1933 Act claims.

Last Thursday, in In re Williams Securities Litigation – WCG Subclass, — F.3d –, 2009 WL 388048 (10th Cir. Feb. 18, 2009), the Tenth Circuit affirmed the district court’s exclusion, under Federal Rule of Evidence 702 and Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 589 (1993), of testimony of plaintiffs’ expert witness as to loss causation.  It therefore also affirmed a summary judgment order against the plaintiffs on the ground that they had failed to offer evidence raising a reasonable inference of loss causation.

Loss causation, an element of a Rule 10b-5 claim, is the causal connection between the defendant’s material misrepresentation or omission and the plaintiff’s loss.   In Williams, the Williams Companies had allegedly misled the market as to the reasons for spinning off a subsidiary, calling it “the best way to ensure that both our energy and communications businesses have the efficient and effective access to the capital necessary to pursue the substantial growth that each enjoys.”  Within two years, the former subsidiary had filed for bankruptcy protection, its stock price having fallen from a peak of $61.81 to $0.06.

The slide in the stock price, however, began well before the alleged misrepresentations, and at no point was there a sharp fall in price immediately following any alleged misstatement.  The plaintiffs therefore relied on testimony of an expert witness, Blaine Nye, a professional expert consultant in these kinds of cases, to explain how the revelation of the truth caused the price drop and plaintiffs’ loss.

Nye offered two theories, neither of which impressed the district court or the Circuit.  The first was that the truth slowly leaked into the market, causing a gradual fall in the stock price.  While plaintiffs are, in principle, free to show loss causation through a “truth leaked out” kind of theory, the Circuit disallowed it here, because, it held, they were required, regardless of the theory, “to show some mechanism for how the truth was revealed,” and they had not done so here.  The second theory was that four specific corrective disclosures caused specific drops in the price.  The court, however, held that Nye had been unable to “tie these four particular disclosures to any of the alleged misrepresentations or describe why they should be considered ‘corrective.’”

Having held that the district court had not abused its discretion by excluding the expert testimony, the Circuit then rejected the plaintiffs’ argument that the jury should be permitted to reach its own inference that the misstatements caused plaintiffs’ loss, based on one of the same two theories.

Earlier this month I questioned the Ninth Circuit’s conclusion in Metzler Investment GMBH v. Corinthian Colleges, Inc., that one defendant’s unsuspicious behavior undercuts an inference of scienter arising from the suspicious behavior of a different defendant. I’d like to add to that a thought on Metzler’s unusual, and I believe erroneous, application of the rule that courts look to the whole complaint in determining whether the plaintiff has satisfied the scienter pleading standard under the PSLRA.

As I discussed the week before last, the point of requiring the court to evaluate the whole complaint is that generally one reasonably draws an inference of guilt from accumulated evidence (or, in evaluating a complaint, from allegations assumed to be true), rather than from one isolated piece of evidence. That doesn’t mean that the rule benefits only the plaintiff, however. Because all of the allegations in the complaint are assumed to be true, the court must evaluate all the allegations and weigh against one another the strength of competing inferences, for and against the defendant. Thus, as the Metzler court noted, “the directive that a complaint must be read in its entirety cuts both ways.” 540 F.3d at 1069.

For the Metzler court, though, cutting both ways meant something more: “Although a defendant cannot gain dismissal by de-contextualizing every statement in a complaint that goes to scienter, a plaintiff cannot avoid dismissal by reliance on an isolated statement that stands in contrast to a host of other insufficient allegations. 540 F.3d at 1069. In other words, not only allegations that affirmatively support an inference that the defendant lacked scienter, but also allegations that are merely “insufficient” to support scienter, weigh in defendant’s favor.

To be clear, the Metzler court’s innovation is in its view of allegations that raise no inference, either for or against scienter. Including a great deal of such neutral allegations, the court holds, actually undermines allegations that would otherwise support scienter. It is uncontroversial that allegations that affirmatively suggest innocence (the defendant suggested to his daughter that she buy stock in the company a day before the share price crashed) do undermine allegations that otherwise suggest scienter. Under Metzler, however, allegations that the court rejects as too weak to support an inference of scienter but do not suggest innocence, either (the CEO had a hands on management style, there were errors in the financial statements, etc.), can undermine the plaintiff’s more effective allegations.

The court did, in fact, apply its new rule. Conceding that an alleged statement by the defendant was “susceptible to [the plaintiff's] characterization that it was intended as a winking suggestion that [the company's employees] should perpetrate fraud,” the court nonetheless rejected the plaintiff’s inference. The statement, the court reasoned, was “equally susceptible to an interpretation . . . that [the defendant] was simply making a broader exhortation to improve business” and was “not so indicative of fraudulent intent that it carries the weight of the entire 181-page complaint for purposes of establishing a ’strong inference’ of scienter.” Id.

The rule of Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S. Ct. 2499 (2007), is that the plaintiff can satisfy the PSLRA standard by pleading facts that support an inference of scienter that is at least as compelling as an inference supporting non-culpable behavior. That appears to be exactly what the plaintiff did in Metzler by alleging a statement that, in the court’s words, was “equally susceptible” to interepretations for and against scienter.

What knocked this allegation out, then, was that the plaintiff said too much other stuff that didn’t support scienter—181 pages of it, to be specific. Now, 181 is a lot of pages, and, although I have not read the Metzler complaint (and hope to keep it that way), I can attest that reading one of these monsters generally is a punishing experience, requiring roughly a quarter ounce of coffee per page. As my post last week indicated, I’m also an admirer of concise legal writing (and shorter blog posts than this one).

One ought not to forget the reason for the bloated complaints, however. These complaints are big because the PSLRA requires the plaintiff to plead the specific facts supporting the misstatement/omission and scienter elements. Given that it’s impossible to know in advance precisely which allegations will impress the judge, the plaintiff can hardly be expected to omit allegations that arguably support these elements.

Even if the plaintiff includes allegations that no reasonable person would think support the claims, moreover, it’s not clear why that should count against the other allegations. When a party makes seven legal arguments and the court rejects six of them, it doesn’t reject the seventh, too, just because the party wasted so much space on the losers. Indeed, useless factual arguments in a complaint also don’t generally count against the plaintiff. Why should they here?