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Trial Evidence Committee

Supreme Court Reverses Trend on Loss Causation

By Kara Altenbaumer-Price – September 15, 2011

Loss causation is continuing to prove an important consideration for securities lawyers who defend securities class actions in the Fifth Circuit. Until this summer’s U.S. Supreme Court decision in Erica P. John Fund v. Halliburton, 131 S. Ct. 2179 (2011), the Fifth Circuit was the most difficult venue for plaintiffs to maintain a securities class action. Even with a new, relaxed standard on certifying a securities class in the Fifth Circuit, proving loss causation is still a difficult needle for Fifth Circuit plaintiffs to thread.

Loss Causation and Class Certification
As recently as last year, the Fifth Circuit was still actively narrowing the ability of a plaintiff to maintain a securities class action in the Fifth Circuit, issuing opinions that required proof of loss causation at class certification. The U.S. Supreme Court, however, eased the class-action certification burden on securities-fraud plaintiffs in the Fifth Circuit (and elsewhere) this summer when it ruled plaintiffs are not required to prove that a company’s misrepresentation caused their particular loss before having their class certified under a fraud-on-the-market theory of causation. The Court’s ruling in Erica P. John Fund v. Halliburton resolved a conflict throughout the circuits as to the burden of proving loss causation before certifying a securities class action.

The Halliburton case arose from a corrective disclosure related to the company’s exposure to asbestos-related liability. Id. at 2183. The Fifth Circuit affirmed a denial of class certification in the case because the plaintiffs failed to prove “that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in losses.” Id. at 2184. In other words, the court had required plaintiffs to prove that the decline in value of the stock could not be caused by other factors before certifying the class. Id. The Supreme Court disagreed.

The Supreme Court harkened back to its ruling in Basic v. Levinson, 485 U.S. 224 (1988), holding that invoking a fraud-on-the-market theory of reliance allows the presumption that “the market price of shares on well-developed markets reflects all publicly available information, and hence, any material misrepresentations.” See Halliburton, 131 S. Ct. at 2181. As the high court wrote, “The fact that a subsequent loss may have been caused by factors other than the revelation of a misrepresentation has nothing to do with whether an investor relied on the misrepresentation in the first place, either directly or presumptively, through the fraud-on-the-market theory.” Id. at 2186. The Court held that, while reliance is required to prove predominance under Federal Rule of Civil Procedure 23(b)(3), loss causation is not a component of reliance and therefore irrelevant at the class-certification stage. Id. Instead, loss causation becomes relevant as the case proceeds forward. Id. at 2186–87.

The impact of this decision is twofold. First, it reverses the high burden required by potential plaintiffs seeking to establish a class action in the Fifth Circuit—which had a stricter certification requirement than any other circuit—and may cause an increase in class actions filed in the circuit. Second, it marks an uncharacteristically “plaintiff-friendly ruling” by the Supreme Court. The Court shed some light on this latter impact in a footnote in Walmart Stores, Inc. v. Dukes, 131 S. Ct. 2541, n.6 (2011), when it noted that its ruling arose, in part, from the “insuperable barrier” to pursing securities-fraud class actions that would exist if each plaintiff was required to prove particularized reliance in order to achieve certification.

Proving Loss Causation in the Fifth Circuit
While some of the ultimate rulings in the cases discussed in this section have since been overruled, they provide insight into the Fifth Circuit’s view of the elements of proof required for loss causation at other stages in litigation, as well as some of the confusion the court seems to have internally on the matter. Although the burden on plaintiffs has eased with respect to proving loss causation at the class-certification stage, the Fifth Circuit still requires plaintiffs to jump a high hurdle in other stages of proving loss causation.

With Oscar Private Equity, Inv. v. Allegiance Telecom Inc., the Fifth Circuit began requiring plaintiffs to prove a direct causal link between defendants’ alleged misrepresentations and plaintiffs’ losses to trigger the general fraud-on-the-market presumption of reliance and qualify for class certification. See 487 F.3d 261 (5th Cir. 2007), abrogated by Erica P. John Fund v. Halliburton Co., 131 S. Ct. 2179 (2011). In Oscar, the Fifth Circuit required the district court to look beyond the pleadings to the merits of the claims at the class certification stage. Specifically, the court required that when multiple pieces of negative information are revealed at the same time as a corrective disclosure, plaintiffs must prove by a preponderance of the evidence that a particular corrective disclosure, and not other negative statements, caused their loss.

Less than two years after Oscar, in another class certification case, the Fifth Circuit vacated a district court’s denial of class certification, holding that the lower court applied too strict a standard for proving loss causation at the class certification stage. See Alaska Elec. Pension Fund v. Flowserve Corp., 572 F.3d 221, 228 (5th Cir. June 19, 2009). The panel in Alaska Electric Pension Fund held that the district court used the wrong standard to determine loss causation at the class certification stage by requiring a fact-for-fact disclosure that completely corrects prior misstatements. Id.

The court held that such a rule would do away with the fraud-on-the-market theory of reliance: “If a fact-for-fact disclosure were required to establish loss causation, a defendant could defeat liability by refusing to admit the falsity of its prior misstatements. And if a ‘complete’ corrective disclosure were required, defendants could ‘immunize themselves with a protracted series of partial disclosures.’” Id. at 230(internal citations omitted). Instead, the test lies somewhere in the middle. The panel held that on remand, the plaintiffs must “prove by a preponderance of the evidence that the market learned more than that [defendant’s] earnings guidance was lower and so its business seemed less valuable” to establish that the losses were caused by prior misstatements. Id. at 232.

Flowserve also addressed loss causation proof at the summary judgment stage, with the Fifth Circuit reversing the district court’s grant of summary judgment on the investors’ Exchange Act claims because the district court failed to conduct a loss causation analysis for summary judgment independent of its loss causation analysis for class certification. Id. at 221. The court held that the two have no relation to one another.

The court rejected arguments by the plaintiffs that the district court required a higher loss causation standard for class certification than for summary judgment, holding that the argument improperly “conflates the issue of loss causation for purposes of establishing predominance under Rule 23 with the issue of loss causation on the merits.” Id. at 229. “As a matter of law,” the court ruled, “a district court’s findings in connection with a holding on class certification do not resolve loss-causation issues on the merits, even when—as here—the two issues are practically identical.” Id. at 233. The court pointed out that a party could lose its bid for class certification and still prevail on the merits in its individual claims as to loss causation. Id. at 229.

Just two months after Flowserve was issued, the Fifth Circuit upheld the denial of another class certification because the plaintiff’s expert looked at how the “stock reacted to the entire bundle of negative information,” rather than considering the “evidence linking the culpable disclosure to the stock-price movement.” See Fener v. Operating Eng’rs Constr. Indus. & Misc. Pension Fund (Local 66), 579 F.3d 401 (5th Cir. Aug. 12, 2009) (Belo). In Fener, the court ultimately held that when there are multiple sources of negative information, plaintiffs must establish by a preponderance of the evidence that it was the negative truthful statement—and not other sources of negative information—that caused the decline in share price. Id.

Despite recitation of the Oscar standard by both courts as well as the standard from Greenberg v. Crossroads Systems, Inc., 364 F.3d 657 (5th Cir. 2004), that a plaintiff must prove “(1) that the negative ‘truthful’ information causing the decrease in price [was] related to an allegedly false, nonconfirmatory 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,” Flowserve holds that a plaintiff does not have to compare fact for fact between the omission and the later disclosure, while Belo holds that a plaintiff must show a statement-for-statement analysis of proof or at least disprove other potential information as the source of the decline in value. Belo favorably cites Flowserve but offers no explanation for the arguably inconsistent results.

Then in February 2010, the Fifth Circuit again rejected a class certification, holding in Archdiocese of Milwaukee Supporting Fund v. Halliburton that plaintiffs could not use revised earnings guidance to prove that earlier earnings estimates were untrue. See 597 F.3d 330 (5th Cir. 2010), vacated and remanded by Erica P. John Fund v. Halliburton Co., 131 S. Ct. 2179 (2011). Clarifying its opinion in Flowserve, the court held instead that to prove loss causation, plaintiffs must prove that the alleged “corrective” disclosure “shows the misleading or deceptive nature of the prior positive statements.” Subsequent disclosures that do not “correct” earlier statements and “reveal the truth” of the earlier misstatement are insufficient to prove loss causation. Id. at 336. The court stated that “a company is allowed to be proven wrong in its estimates” without being liable for fraud. Id. at 340. That ruling, discussed at the beginning of this article, was ultimately overturned by the U.S. Supreme Court.

The court made an important point in Flowserve—the burden for proving loss causation at the class certification stage is on the plaintiff, while the burden for proving a lack of loss causation at the summary judgment stage is an affirmative defense. See Flowserve, 572 F.3d at 234. While the Supreme Court decision in Halliburton overrules or negates some elements of these cases, they still provide valuable insight into the Fifth Circuit’s high standards for proving loss causation.

Loss Causation and Pleadings
As in the seeming contradiction between Flowserve and Belo, the court is also creating confusion on the issue of the pleading standard for loss causation. In Lormand v. U.S. Unwired, Inc., 565 F.3d 228 (5th Cir. 2009), which was decided in April 2009, the court held that notice pleading is sufficient for loss causation. The court looked to Federal Rule of Civil Procedure 8(a)(2) to hold that a plaintiff must allege “in respect to loss causation, a facially ‘plausible’ causal relationship between the fraudulent statements or omissions and plaintiff’s economic loss.” Id. at 258. Or, the court phrased it another way, “the complaint must allege enough facts to give rise to a reasonable hope or expectation that discovery will reveal evidence of the foregoing elements of loss causation.” Id.

Just seven months earlier, in September 2008, the court appeared to use Federal Rule of Civil Procedure 9(b)’s more stringent pleading standard for loss causation in its unpublished opinion in Catogas v. Cyberonics, Inc., 28 F. App’x 311 (5th Cir. 2008). There, the court directly quoted the heightened pleading requirements found in Rule 9(b), holding that “plaintiffs failed to plead loss causation with the requisite particularity.” Lormand makes no mention of the Cyberonics opinion, citing for support the Supreme Court opinions Dura Pharmaceuticals., Inc. v. Broudo, 544 U.S. 336 (2005), and Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007). And, unlike the Belo and Flowserve panels, the Lormand and Cyberonics panels have an important similarity; Judge Barksdale served on both panels.

The Fifth Circuit acknowledged the ever-increasing burden it is placing on plaintiffs in securities class actions when it wrote in Flowserve 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.” See Flowserve, 572 F.3d at 235. What is also clear from these recent cases is that loss causation is an important and evolving issue in the Fifth Circuit. And for securities class-action defendants, the “higher hurdle” created by the court’s loss-causation analysis is proving an important defense tool. Finally, as the Belo court noted, it is a tool at all stages of litigation—pleadings, summary judgment, and trial on the merits. See Fener, 579 F.3d at 407.

Keywords: litigation, trial evidence, loss causation, securities class actions, Fifth Circuit, Supreme Court

Kara Altenbaumer-Price, J.D., is director of complex claims and consulting for USI Southwest’s Management & Professional Services Group.

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