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.

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?