Alaska Elec. v. Flowserve: Loosening the Loss Causation Standard to Revive Investors’ Fraud Claims

With the help of a former Supreme Court justice, the Fifth Circuit entered an important opinion in the continuing controversy among federal circuits regarding the standard for loss causation in securities fraud cases, perhaps foreshadowing an issue that will ultimately head to the Supreme Court. In Alaska Electrical Pension Fund v. Flowserve Corp., ___ F.3d ____, 2009 WL 1740648, Nos. 07-11303 and 08-10071 (5th Cir. June 19, 2009), a per curiam opinion by a Fifth Circuit panel that included retired Justice Sandra Day O’Connor (sitting by designation) overturned the Northern District of Texas’ denial of class certification and grant of summary judgment for defendants, finding that the lower court had relied upon an erroneous loss causation standard. The opinion lowers the ever-increasing bar placed before securities class action that may be keeping even meritorious cases out of court.

BACKGROUND

The plaintiff, Alaska Electrical Pension Fund (“Alaska”), claimed that Flowserve Corp., along with its CEO, CFO, two stock offering underwriters, and its auditor (collectively “Flowserve”), deliberately and knowingly filed misleading financial reports and guidance reports. Specifically, the plaintiff claimed that primarily between 2001 and 2003, that Flowserve filed reports that included overstated current and expected earnings, understated costs, and other fraudulent misstatements designed to increase market expectations.

The plaintiffs point in particular to the company’s “overly optimistic” FY2002 earnings guidance released on Oct. 22, 2001 that was released the same day as inaccurate 3Q 2001 results – the combined result of those releases caused stock to rise 6.8%. The company repeated that FY2002 guidance with its inaccurate 4Q 2001 results, which included a 600% understatement of loss. Subsequently in 2002, the company downwardly revised its FY2002 guidance twice – causing significant drops in stock value – and both times, the company blamed the downward revisions on market forces instead of its internal company failures and previous financial misstatements. Ultimately, on Feb. 3, 2004, the company announced that it would downwardly restate its 200-2003 earnings by $11 million.

Plaintiff initially filed a putative class action suit in federal district court in the Northern District of Texas in 2003 (amending it once in 2004 and once in 2005), ultimately alleging violations of sections 10 and 20 of the Securities Exchange Act of 1934 and sections 11 and 15 of the Securities Act of 1933. The district court denied the plaintiff’s motion for class certification and granted the defendants’ summary judgment on all claims, and plaintiff appealed. Alaska Electrical Pension Fund v. Flowserve Corp., ___ F.3d ____, 2009 WL 1740648, Nos. 07-11303 and 08-10071 (5th Cir. June 19, 2009).

The District Court applied an improper loss causation standard

In order to obtain class certification, Alaska had to show that questions of law or fact common to the class members, such as the questions of class-wide reliance, predominated over questions affecting individual members of the class. Fed. R. Civ. P. Rule 23(b)(3)(c). “Alaska can ‘establish a class wide rebuttable presumption of reliance’ using ‘the fraud on the market theory’ of collective reliance.” Alaska Electrical Pension Fund v. Flowserve Corp., 2009 WL 1740648, * 4 (citing Unger v. Amedisys Inc., 401 F.3d 316, 322 (5th Cir. 2005)). As one element of establishing that rebuttable presumption, the plaintiff must “prove that the defendant’s non-disclosure materially affected the market price of the security” – also called “loss causation.” Nathenson v. Zonagen Inc., 267 F.3d 400, 414 (5th Cir. 2001).

“To establish loss causation, a plaintiff must prove ‘(1) that the negative ‘truthful’ information causing the decrease in price [was] 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.’” 2009 WL 1740648, *4 (citing Greenberg v. Crossroads Sys. Inc., 364 F.3d 657, 666 (5th Cir. 2004)).

The Fifth Circuit panel acknowledged that the plaintiff did have to prove loss causation by a preponderance of the evidence for Rule 23 purposes. 2009 WL 1740648, *5. However, the Court found that the district court applied the wrong standard for assessing plaintiff’s allegations of loss causation.

Flowserve argued that the plaintiff had to prove that the defendants made a “fact-for-fact” disclosure of information that fully corrected the prior misstatements, such that “fraud causes a loss only if the loss follows a corrective statement that specifically reveals the fraud.” 2009 WL 1740648, *6. Because the only revealing corrective statements were made in 2004, after which no major stock decline occurred (the major declines had occurred earlier), Alaska would not be able to establish loss causation under this theory. The District Court agreed with this argument, which was the primary basis of its denial of class certification and grant of summary judgment for Flowserve.

Alaska, on the other hand, had argued that loss causation can result when the “true financial condition” of the company is known, such that any disclosure of a company’s weakened financial condition relate to earlier misstatements, and any losses resulting from the revelation of the company’s true condition are the result of fraud. Id.

The Circuit Court rejected both positions, stating that “the true standard lies in the middle.” Id. The Court pointed out that if the defendants’ argument was correct, a defendant “could defeat liability by refusing to admit the falsity of its prior misstatements” or by making a “protracted series of partial disclosures” rather than a single “complete” disclosure. Id. The Court also rejected the plaintiff’s argument because undisclosed information cannot impact the market – “only information known to the market is relevant under the fraud-on-the-market theory of class wide reliance.” Id. at *7.

Instead, the Court determined that the “disclosed information must reflect part of the ‘relevant truth’ – the truth obscured by the fraudulent statements.” Id. In other words, the information of the company’s true condition can leak out over time and “fact-for-fact” disclosure is not necessary, but the plaintiff must show that “other negative information unrelated to the reduced FY2002 guidance did not cause the decline in Flowserve’s share price.” Id. at *8. The Court found that Flowserve’s alleged misrepresentation and the corrective disclosures were sufficiently related for purposes of class certification, but it remanded the matter to the District Court for determination of whether plaintiff sufficiently segregated its losses from the leaks of “relevant truth” from losses caused by unrelated factors. Id.

The Court expressed its frustration with developments in securities fraud law, stating: “To 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.” Id. at *12. Some practitioners interpret this as a warning that the Fifth Circuit – and perhaps other Circuits as well—has been too inhospitable to securities fraud claims.

The Court reversed the district court’s grant of summary judgment on the plaintiff’s 10b-5 claims, stating that the district court should not have allowed its Rule 23 loss causation finding to “govern the merits” of the plaintiff’s claim and affect its ruling on summary judgment. Id. at *11. Instead, the Court determined 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.

Finally, the Court vacated and remanded the District Court’s grant of summary judgment on the Section 11 claims. For Section 11 claims, loss causation is presumed once a plaintiff establishes a prima facie case. Id. The District Court had erroneously put the burden of proving loss causation on the plaintiff, when it should have instead required the defendants to prove “negative causation as an affirmative defense” before granting summary judgment – a much more difficult burden. Id.

CONCLUSION

The Fifth Circuit has generally been perceived as particularly favorable to defendants in securities class actions – the Flowserve opinion represents a small and unusual victory for plaintiffs in that Circuit, even though it still leaves the door open for the District Court to dismiss the case on remand.

More importantly, the case reflects the difficulties Circuit Courts are having in defining the proper standard for loss causation at the class certification stage in the wake of Dura Pharmaceuticals v. Broudo, 544 U.S. 336 (2005), which defined loss causation as requiring proof of a causal connection between a misstatement and a subsequent decline in stock price. There is no single consistent standard applied by the various circuit courts, and as a result, many practitioners predict that this issue will ultimately be decided by the U.S. Supreme Court.

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Josh Lawler

Joel B. Ginsberg

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