Securities Litigation Update

Fifth Circuit Issues Important Opinion in Securities Fraud Class Action

The Fifth Circuit recently issued an important opinion in a securities fraud class action, Alaska Electrical Pension Fund v. Flowserve Corporation, -- F.3d -- (5th Cir. 2009). The plaintiff alleged that Flowserve and its directors, underwriters and auditor violated Rule 10b-5 of the Securities Exchange Act of 1934 and Section 11 of the Securities Act of 1933 by issuing fraudulent earnings guidance and a defective registration statement. The district court denied the plaintiff’s motion to certify the case as a class action and granted defendants summary judgment on all claims because the plaintiff had failed to prove loss causation—a causal connection between an alleged misstatement and the plaintiff’s losses. In a per curiam opinion, a Fifth Circuit panel that included Hon. Sandra Day O’Connor sitting by designation reversed and remanded the case.

The court observed that “[t]o be successful, a securities class-action plaintiff must thread the eye of a needle made smaller and smaller over the years by judicial decree and congressional action. Those ever higher hurdles are not, however, intended to prevent viable securities actions from being brought.” Op. at 17. Coming from a panel with a former Supreme Court justice, those words are being interpreted by some practitioners as a warning that the Fifth Circuit has perhaps been too inhospitable to securities fraud claims.

The issue before the court was how the plaintiff establishes that the decline in the defendant’s stock price was caused by the truth leaking out regarding the alleged fraud and not by some other factor. Must the plaintiff show that negative news at the time of the stock price decline fully and specifically revealed the fraud? The court rejected both parties’ arguments concerning the type of evidence sufficient for proving loss causation.

On one hand, the court refused to adopt a standard requiring a plaintiff to show that at the time of the stock price decline the defendant made a “‘fact-for-fact’ disclosure of information that fully corrected prior misstatements” and “specifically reveal[ed] the fraud.” Id. at 9. Such a causation requirement, the court noted, would allow issuers to immunize themselves from securities suits merely by making a protracted series of partial disclosures. On the other hand, the court rejected the plaintiff’s “true financial condition” theory, under which any disclosure of the defendant’s “weakening financial condition would relate to its earlier misstatements.” Id. A “loss caused solely by a general impression in the market that ‘something is wrong’ is insufficient to establish causation.” Id. at 11. Thus, a plaintiff may rely on a disclosure that reveals only “part of the ‘relevant truth’” that was “obscured by the fraudulent statements.” Id. at 10 (emphasis added). But such a disclosure is no proof of loss causation unless “the market learned more” than that the defendant’s “business seemed less valuable.” Id. at 11.

Applying these principles, the court first vacated the district court’s ruling that the plaintiff failed to prove loss causation by a preponderance of the evidence for purposes of class certification, as required in Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007), and remanded for a new certification hearing. The focus was on Flowserve’s July and September 2002 announcements that it was downwardly revising previous earnings guidance for fiscal year 2002. Although the district court held that these announcements did not reveal the relevant truth concerning the inaccuracy of the company’s October 2001 earnings guidance for fiscal year 2002, the Fifth Circuit disagreed. It was not necessary for the July and September 2002 announcements “directly to reveal that the October 2001 guidance was fraudulent,” Op. at 11, in order for the announcements to constitute “a disclosure of negative ‘truthful’ information that was ‘related to [an] allegedly false non-confirmatory, positive statement made earlier,’” Id. at 9 (quoting Oscar, 487 F.3d at 266). Instead, “it was enough that the market learned that the October guidance was wrong.” Id. at 11. Although the Fifth Circuit held that the alleged misrepresentation and the corrective disclosures were sufficiently related, the court did not decide whether the plaintiff had satisfied its additional burden to prove that “other negative information unrelated to the reduced FY2002 guidance did not cause the decline in Flowserve’s share price.” Id. The court instructed that on remand the plaintiff must segregate the “loss caused by the ‘relevant truth’ leaking out” from any “loss caused by unrelated factors.” Id. at 11.

The court next reversed the district court’s summary judgment in favor of Flowserve and two individual defendants on the 10b-5 claims. The court held that “a genuine fact issue exists on the material element of loss causation under the [10b-5 claim] because a reasonable trier of fact could at the least conclude that the October 2001 statement concerning Flowserve’s FY2002 earnings caused some portion of [the plaintiff’s] loss after the ‘relevant truth’ began to leak out in July and September 2002.” Id. at 14. The court instructed, however, that its summary judgment ruling “does not hamstring the district court during the class certification proceedings on remand.” Id. Likewise, although the court held that the preponderance-of-the-evidence standard is proper and constitutionally allowable at the class certification stage, it noted that a district court’s “loss causation holdings under Rule 23’s preponderance requirement [do] not govern the merits of [the plaintiff’s] claims” and should not have affected the district court’s summary judgment ruling. Id.

Finally, the court vacated and remanded the district court’s summary judgment in favor of Flowserve and individual defendants on the Section 11 claims. Unlike with the 10b-5 claims, loss causation is presumed once a plaintiff establishes a prima facie case under Section 11. The court held that the district court erroneously placed the burden of proving loss causation on the plaintiff when it should have required the defendants to prove “negative causation as an affirmative defense.” Id. at 17. The court remanded for the district court to determine whether any defendant could “shoulder the burden” of proving “that no reasonable juror could believe that any portion of [the] July and September 2002 losses was caused by the defendants’ alleged misrepresentations . . . , i.e., the losses were caused by another factor.” Id. at 17.