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.

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?

The Fifth Circuit showed yesterday that it is possible to apply the PSLRA pleading standards without filling up dozens of pages of F.3d.  The plaintiff-appellant in Brunig v. Clark, — F.3d. — No. 08-20059, 2009 WL 376907 (Feb. 17, 2009), had been the defendant-respondent’s lawyer.  He had agreed to accept as his fee an interest in mineral leases, and later expected sale proceeds, from property owned by his client.  The dispute arose when the client sent the plaintiff a bill for operating expenses on the property and, when the bill wasn’t paid, a notice of default.

Brunig isn’t a class action, it has nothing to do with a drop in the price of any stock, and it isn’t the sort of case that Congress was was worried about when it enacted the PSLRA.  Although Brunig doesn’t say anything about congressional purpose, it does manage to keep a simple case simple, despite the statute.  The complaint, according to the court, is “prolix,” despite being, at fifty-six pages, on the slim side for a securities fraud complaint, at least in my experience.   By comparison with the Brunig court’s handiwork, however, the charge is justified.  In five paragraphs, the court states the elements of the Rule 10b-5 claim, assesses the complaint’s sufficiency as to both the PSLRA particularity requirements (misstatement/omission and scienter), and reverses the district court’s dismissal of the claim.  While it doesn’t break new legal ground, to my mind it doesn’t exclude anything important, either.  With equal efficiency, the court affirms the dismissal of a Securities Act claim and a RICO claim, and reverses a sanctions order.  Compliements to Judge Higginbotham, who wrote for the court.

Having misread the Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S. Ct. 2499 (2007), the Ninth Circuit has recently developed a new and nonsensical framework for analyzing securities fraud complaints.

The central issue in Tellabs was the meaning of the word “strong” in the provision of the Private Securities Litigation Reform Act of 1995 that requires plaintiffs to “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).  The Tellabs Court also cautioned judges applying the provision “not to scrutinize each allegation in isolation but to assess all the allegations holistically.”  127 S. Ct. at 2511.  “[T]he reviewing court must ask: When the allegations are accepted as true and taken collectively, would a reasonable person deem the inference of scienter at least as strong as any opposing inference?”  Id.

You might suppose that this “holistic” approach would be pretty uncontroversial, given the way human beings normally draw inferences.  An individual fact (an alleged fact) might be quite specific without strongly suggesting culpability, and yet, when viewed in conjunction with other specific and yet equally unsuggestive facts, might be strong evidence of guilt.  For example:

• Fact A:  The victim was run down by an orange Toyota at 9 pm on Feb. 2, three miles from Defendant’s home.
• Fact B:  Defendant’s neighbor owns an orange Toyota.
• Fact C:  Defendant does not own a car.
• Fact C:  Defendant’s neighbor’s orange Toyota was stolen at 8 pm on Feb. 2.
• Fact D:  Two of Defendant’s friends report that they were with Defendant at Defendant’s home in the late afternoon of Feb. 2, and that Defendant was drinking heavily and complaining about how much he hated his neighbor.
• Fact E:  At 9:15 pm on Feb. 2, Defendant was seen entering a bar, drunk and weeping, two blocks from where the victim was run down.

I could go on, but you get the idea.  Each fact individually is specific but innocuous, whereas taken together they give rise to an inference of guilt.  Although the facts don’t always fit together so neatly as this, it’s the norm that guilt is shown by an accumulation of evidence, not by a single fact.  This goes equally for allegations of scienter in a securities case.  A conversation might suggest that the defendant knew something particular about the operational aspect of the alleged fraud, an e-mail might show he was concealing something from the accountant, inconsistencies between a public statement and a private statement might suggest he was dissembling, and so on.

That looking at the whole complaint is the only approach that makes sense does not imply that the Court was wasting space saying it.  Divide and conquer is the defendant’s strategy in these cases.  Defendants address each allegation individually, explaining why it doesn’t give rise to a strong inference.  And they’re right:  merely alleging that the fraud was very large doesn’t raise a strong inference of scienter, merely alleging a SOx certification doesn’t support a strong inference, merely alleging that the defendant was present at such and such a meeting doesn’t support a strong inference, and so on.  The plaintiffs’ response is, “But we didn’t allege merely A or merely B or merely C.  We alleged A and B and C “!  For one reason or another, judges do sometimes seem to follow the defendant on this, although not expressly, perhaps in part because it’s easier to structure an opinion in this way.

Given the importance of this issue to the actual litigation of securities fraud cases, it’s not surprising that, even before Tellabs, most of the U.S. Courts of Appeals, including the Ninth Circuit, had expressly adopted the rule that a the court must look to the complaint as a whole in determining whether the plaintiff has satisfied  the PSLRA pleading requirement.  See, e.g., Gompper v. VISX, Inc., 298 F.3d 893, 896 (9th Cir. 2002) (“Under the PSLRA, the court ultimately reviews the complaint in its entirety to determine whether the totality of facts and inferences demonstrate a strong inference of scienter.”). Six such courts were identified in 2004 by the Eleventh Circuit, which joined them, summarizing the state of the law as follows:

Nothing in th[e] language [of the PSLRA] suggests that scienter may only be inferred from individual facts, each of which alone gives rise to a strong inference of scienter, rather than from an aggregation of particularized facts. We readily join the courts that have interpreted the PSLRA to permit the aggregation of facts to infer scienter. See  Broudo v. Dura Pharms., Inc., 339 F.3d 933, 940 (9th Cir.2003) (“This court has made clear that allegations of scienter must be collectively considered.”); In Re Cabletron Sys., 311 F.3d 11, 39 (1st Cir.2002) (“ ‘The plaintiff may combine various facts and circumstances indicating fraudulent intent’ … to satisfy the scienter requirement.”) (quoting Aldridge v. A.T. Cross Corp., 284 F.3d 72, 82 (1st Cir.2002)); Abrams v. Baker Hughes, Inc., 292 F.3d 424, 431 (5th Cir.2002) (“The appropriate analysis … is to consider whether all facts and circumstances ‘taken together’ are sufficient to support the necessary strong inference of scienter on the part of the plaintiffs.”); Fla. State Bd. of Admin. v. Green Tree Fin. Corp., 270 F.3d 645, 660 (8th Cir.2001) (“[U]nder the Reform Act, a securities fraud case cannot survive unless its allegations collectively add up to a strong inference of the required state of mind.”); Rothman v. Gregor, 220 F.3d 81, 92 (2nd Cir.2000) (“Taken together with the allegations of poor sales and the pleadings in various lawsuits filed by GT, the Appellants have alleged sufficient facts to support a strong inference of recklessness.”) . . . .

Phillips v. Scientific-Atlanta, Inc., 374 F.3d 1015, 1016-17 (11th Cir. 2004).  At least two more circuits had joined the group prior to Tellabs.  See Teachers’ Retirement System v. Hunter, 477 F.3d 162, 174 (4th Cir. 2007) (“Determining whether the complaint satisfies this standard necessarily entails a case-by-case assessment of the complaint as a whole.”); Fidel v. Farley, 392 F.3d 220, 233 (6th Cir. 2004) (“[T]his court employs a “totality of the circumstances analysis whereby the facts argued collectively must give rise to a strong inference of at least recklessness.” (internal quotation marks omitted)). As far as I know, no circuit has come out the opposite way, ruling that a plaintiff can satisfy the PSLRA standard only by alleging at least one fact that, all by itself, gives rise to a strong inference of scienter.

The Ninth Circuit, however, in two opinions authored by Judge Bybee, interpreted Tellabs‘ repetition of this well established principle as a substantial reformulation of the analysis under the PSLRA.  As a result of Tellabs, the court held in Rubke v. Capitol Bancorp, Inc., “we can no longer summarily dismiss a complaint whose individual allegations are insufficient under the PSLRA.”  551 F.3d 1156, 1165 (9th Cir. 2009).  Thus, according to Zucco Partners, LLC v. Digimarc Corp., Tellabs “calls into question” the Circuit’s prior “methodology that relies exclusively on a segmented analysis of scienter.” – F.3d –, No. 06-35758, 2009 WL 311070, at *6, (9th Cir. Feb. 10, 2009), amending 552 F.3d 981 (9th Cir. 2009).

To be fair, an intervening case, South Ferry LP, No. 2 v. Killinger, did rely on the “holistically” language in Tellabs to modify somewhat the Circuit’s analysis under the PSLRA. 542 F.3d 776, 785-86 (9th Cir. 2008). South Ferry, however, merely broadened the Circuit’s acceptance of “vague” allegations as support for specific allegations elsewhere in the complaint. 542 F.3d 776, 785-86 (9th Cir. 2008). Rubke and Zucco went much further, suggesting that the prior approach of the Circuit was simply to consider allegations in isolation.

Most perplexing, Rubke and Zucco imposed a new two-step analysis of scienter within the Circuit:

Thus, following Tellabs, we will conduct a dual inquiry: first, we will determine whether any of the plaintiff’s allegations, standing alone, are sufficient to create a strong inference of scienter; second, if no individual allegations are sufficient, we will conduct a “holistic” review of the same allegations to determine whether the insufficient allegations combine to create a strong inference of intentional conduct or deliberate recklessness.

Zucco, 2009 WL 311070, at *6; see also Rubke, 551 F.3d at 1165 (“[W]e must perform a second holistic analysis to determine whether the complaint contains an inference of scienter that is greater than the sum of its parts.”).  Contrary to the court’s assumption, it is the first of these two stages that is the innovation, not the second.  And, indeed, the first stage is without purpose, because allegations are generally meaningless out of context (and, in any event, are never more meaningful out of context than they are in context).

It will be interesting to see whether this pointless two-step analysis becomes the standard method for assessing scienter allegations within the Circuit.  While these decisions are binding on subsequent panels, there are other post-Tellabs decisions that do not apply this method.  Arguably there is therefore a conflict within the Circuit, which is one criterion for hearing a case en banc.  However, because this method doesn’t have any clear benefit to either side in these cases (or at least I don’t see any), it is unlikely to attract enough interest among the active judges to go en banc.  The issue is likely to remain unresolved, therefore, unless and until it arises in a case that is heard en banc for another reason.  In the meantime, panels may rely on the conflict as a basis for making their own choice as to whether to follow a two-step method.  Alternatively they may view a methodological issue of this nature as dictum (a term that not everyone defines in the same way) and therefore outside of the binding aspects of these decisions.

Readers (if you’re out there and have lasted this long), may be interested in Lyle Roberts’s post on this at the 10b-5 Daily.  I’m a regular reader and generally find his analysis astute.  I think he misses on this one, though.

Plaintiffs in private securities fraud litigation frequently point to insider trading as support for a “strong inference” that the defendant acted with scienter, as required to survive a motion to dismiss under the Private Securities Litigation Reform Act of 1995.  The defendant sold her stock, the plaintiff argues, because she knew that the price was inflated as a result of false information in the market.  Generally this argument works only if the trading was somehow suspicious, such as where the defendant sold an especially large percentage of her holdings. 

Last August, in Metzler Investment GMBH v. Corinthian Colleges, Inc., 540 F.3d 1049 (9th Cir. 2008), the Ninth Circuit rejected a plaintiff’s insider trading argument as to one of three defendants, in part on the ground that the other defendants’ sales weren’t suspicious.  Id. at 1067 (“Moore sold only 37% of his total stock holdings during the Class Period. We typically require larger sales amounts—and corroborative sales by other defendants—to allow insider trading to support scienter.” (emphasis added)).  One of the other defendants had sold no stock during the relevant period, “suggesting,” the court reasoned, “that there was no insider information from which to benefit.”  Id. The court cited two cases in support of this inference, neither of which does support it, although they do generally support the other point the court made in the same sentence.  See In re Silicon Graphics Inc. Sec. Litig., 183 F.3d 970, 987-88 (9th Cir. 1999); Tripp v. Indymac Fin., Inc., 2007 WL 4591930 at *4-5 (C.D. Cal. Nov.29, 2007).

Regardless of support, though, can this be the right rule—that if one defendant’s sales were not suspicious, then sales by a different defendant weren’t either?  There is some sense to it.  An insider’s failure to capitalize on the fraud through insider trading undermines allegations of his scienter.  And if one defendant didn’t know, then it’s certainly more likely that another didn’t, either.  While this sort of group-scienter argument is not available to plaintiffs, no one ever claimed that the PSLRA was intended to create reciprocal benefits to plaintiffs and defendants.

My view, though, is that without some affirmative reason for thinking that defendant B wouldn’t have known unless defendant A did, too, it’s an unreasonable inference in favor of the defendant.  (Unlike on most motions to dismiss, the court is supposed to consider defendant-favoring inferences.)  The same principle, moreover, could as easily be applied to any allegations bearing on scienter, not just to insider trading.  If it were applied broadly, it could affect plaintiffs’ decisions about whom to name as individual defendants.  I suppose it’s an open question whether the Metzler court would have considered in defendants’ favor the failure of the plaintiffs to allege insider trading by insiders who were not named—and/or documents offered by the defendants at the pleading stage to show the innocence of unnamed insiders’ trades.  Either way, a plaintiff could lower the likelihood that insider A’s comparatively innocent behavior would rub off on insider B by not naming A.  That a plaintiff might leave a less guilty-looking defendant off the complaint for this reason could be viewed as either a positive or a negative consequence of the rule, depending probably on how one views the balance of interests in the current system of enforcement.

I used to be a plaintiff’s lawyer, which presumably shapes my perspective on this to some degree at least.  Also, I’m an admirer of Judge Betty Fletcher, who authored the Metzler court’s opinion, and usually agree with her.  For these reasons, among others, I’m quite open to the possibility that I’m not weighing this right.  If anyone with a view on this is reading, please share it.

(For more on Metzler, see the Corporate Securities Blog and the 10b-5 Daily.)