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.

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.