To Invoke Presumption of Reliance in Securities Fraud Class Action Based on Fraud on the Market Doctrine, Plaintiff must Establish Loss Causation at Time of Motion to Certify Class Action Fifth Circuit Holds
Plaintiffs filed a securities fraud class action against telecommunications provider Allegiance Telecom and others alleging violations of section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 based on an inaccurate statement concerning the number of line installations during the first three quarters of 2001 and a drop in stock price following a restated line count announced during the fourth quarter of that year. Oscar Private Equity Inv. v. Allegiance Telecom, Inc., 487 F.3d 261, 2007 WL 1430225, *1 (5th Cir. May 16, 2007). Plaintiffs’ lawyer moved to certify the litigation as a class action, advancing a “fraud on the market” theory to establish reliance by class members; defense attorneys objected to class action treatment, arguing that the restatement was not the cause of a drop in the stock price, id. The district court relied on the “fraud on the market” theory, rejected defense arguments, and certified a class action as requested. Id. The Fifth Circuit granted the defense leave to file an interlocutory appeal and reversed. The Circuit Court summarized its holding as follows: “We vacate the certification order and remand, persuaded that the class certified fails for wont of any showing that the market reacted to the corrective disclosure. Given the lethal force of certifying a class of purchasers of securities enabled by the fraud-on-the-market doctrine, we now in fairness insist that such a certification be supported by a showing of loss causation that targets the corrective disclosure appearing among other negative disclosures made at the same time.” Id. (italics added).
The details of the events that precipitated the filing of the class action complaint are set forth in the Note, below. The Fifth Circuit explained: “This dispute turns on whether the certification order properly relied upon the fraud-on-the-market theory. This theory permits a trial court to presume that each class member has satisfied the reliance element of their 10b-5 claim. Without this presumption, questions of individual reliance would predominate, and the proposed class would fail. Oscar, at *2 (footnotes omitted) (italics added). Under the fraud on the market theory, “Reliance is presumed if the plaintiffs can show that ‘(1) the defendant made public material misrepresentations, (2) the defendant’s shares were traded in an efficient market, and (3) the plaintiffs traded shares between the time the misrepresentations were made and the time the truth was revealed.’” Id. (citation omitted). In the Fifth Circuit, it is insufficient for a plaintiff to show that defendant made a material misstatement; rather, “proof that the misstatement actually moved the market” is required, id., at *3. The Circuit Court explained at page *3:
Essentially, we require plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption. Our most recent statement of this rule was in Greenberg, which held that “to trigger the presumption [of reliance] plaintiffs must demonstrate that … the cause of the decline in price is due to the revelation of the truth and not the release of the unrelated negative information.” (Italics added and footnotes omitted.)
The Fifth Circuit was confronted with two questions. First, does the loss causation test apply at the class action certification stage? And second, if so, did plaintiffs sufficiently establish loss causation? Oscar, at *4. As to the first question, the Circuit Court recognized “widespread confusion” on whether loss causation should be considered in connection with a motion to certify a securities fraud class action. Id. The district court concluded that it should not consider loss causation; on appeal, plaintiffs argued that to consider loss causation as part of a class certification motion “improperly combines the market efficiency standard with actual proof of loss causation.” Id. The Court of Appeals disagreed, holding at page *6 that “loss causation must be established at the class certification stage by a preponderance of all admissible evidence.” A significant factor in this decision was the Court’s criticism of the “efficient market” assumption that underlies the fraud on the market theory: In the words of the Court, “The assumption that every material misrepresentation will move a stock in an efficient market is unfounded, at least as market efficiency is presently measured.” Id., at *7 (italics added).
With respect to the second inquiry, the Court of Appeals explained that determining loss causation in this case was “complicated here by the fact that multiple items of positive information were released together with the alleged line-count inflation, and further complicated by the fact that multiple items of negative information were released together with the corrective disclosure.” Oscar, at *3. The Fifth Circuit explained that in such cases, the plaintiff must prove “‘(1) that the negative “truthful” information causing the decrease in price is related to an allegedly false, non-confirmatory positive statement made earlier and (2) that it is more probable than not that it was this negative statement, and not other unrelated negative statements, that caused a significant amount of the decline.’” Id. (citation omitted). The appellate court ultimately concluded that plaintiffs’ evidence amounted to “little more than well-informed speculation” and held that more was required, id., at *8. As the Circuit Court explained at page *8, “When multiple negative items are announced contemporaneously, mere proximity between the announcement and the stock loss is insufficient to establish loss causation.”
At bottom, the Fifth Circuit concluded that plaintiffs’ evidence failed to establish the foundational facts necessary to invoke the fraud on the market presumption of reliance; accordingly, the district court erred in certifying a class action. Oscar, at *9.
NOTE: The Fifth Circuit summarized the factual history underlying the proposed class action as follows: “On April 24, 2001, the first day of the class period, Allegiance announced its 1Q01 results, including (1) 126,200 new lines installed; (2) revenues of $105.9 million, an 11% increase over 4Q00; (3) positive sales force growth; and (4) improved gross margin. The following trading day Allegiance’s stock rose 9%, from $14.90 to $16.20, but soon declined again. [¶] On July 24, 2001, Allegiance announced its 2Q01 results, including (1) 135,800 new lines installed; (2) revenues of $124.1 million; (3) an earnings loss of $0.92 per share, $0.03 better than the analysts’ consensus estimate; and (4) positive EBITDA results in thirteen markets. The following trading day Allegiance’s stock rose 20%, from $10.90 to $13.08 per share, but soon declined again. [¶] On October 23, 2001, Allegiance announced its 3Q01 results, including (1) the installation of its one-millionth line; (2) revenues of $135 million; and (3) an earnings loss of $0.94 per share, $0.03 better than the analysts’ consensus estimate. The next trading day Allegiance’s stock rose 29%, from $5.21 to $6.74 per share, but remained volatile, falling to $3.70 per share by February 18, 2002, the day before the curative statements of the 4Q01 announcement. [¶] On February 19, 2002, Allegiance announced its 4Q01 results, including (1) a restatement of the total installed-line count from 1,140,000 to 1,015,000, a difference of 125,000; (2) missed analysts’ expectations on 4Q01 and 2001 earnings per share; (3) greater EBITDA loss than some analysts expected; and (4) a very thin margin of error for meeting revenue covenants for 2002. The next trading day Allegiance’s stock continued its downward move, falling -, from $3.70 to $2.65 per share. Less than 90 days later, Allegiance missed its covenants putting its credit lines in default and on May 14, 2003, filed for bankruptcy.” Oscar, at *1-*2 (footnote omitted).