Fifth Circuit: Proof Of Loss Causation Requires “Some” Truth To Emerge

A key question in pleading loss causation under the Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, 544 S.Ct. 336 (2005) (discussed here) is how much truth must emerge. The Fifth Circuit held that at least part of the truth must emerge in Alaska Electrical Pension Fund v. Flowerserve Corporation, Case No. 07-11303 c/w 08-10071 (5th Cir. Filed June 19, 2009), a per curiam opinion joined by retired Supreme Court Justice O’Connor. The decision is consistent those of other circuits. See, e.g., In re Williams Sec. Litig. — WCG Subclass, 558 F.3d 1130 (10th Cir. 2009).

This action against Flowerserve, a manufacture of pumps and related equipment, focuses on three claimed misstatements: 1) a February 6, 2001 release claiming $13.2 million in earnings for FY 2000 when in fact they were $5.4 million, a fact revealed in a 2004 restatement; 2) an April 24, 2001 announcement of positive first quarter 2001 earnings that overstated those earnings; and 3) an October 22, 2001 release which contained overly optimistic FY 2002 earnings guidance. The statements followed acquisitions in 2000 and 2002 undertaken to bolster sagging earnings.

In 2002, the share price of the company declined dramatically twice. Once in July 2002 by over 37% when guidance was lowered. A second time in September by over 38% when the announcement that guidance would be lowered was repeated. Expert testimony established that a significant portion of each decline related to company specific rather than general market factors. It was not until February 2004 however, that Flowerserve announced it would restate 2000-2003 earnings by $11 million. There was no significant impact on the share price at the time of the announcement, however.

To establish Dura loss causation, plaintiff must prove a causal connection between a misstatement and a subsequent decline in the stock price according to the court. Plaintiff is also required to establish that “after the purchase and before the loss there was a disclosure of negative ‘truthful’ information . . . ” that is related to the earlier false statement.

Here, the district court applied the wrong standard. It required, as defendants argued, that plaintiff show a fact-for-fact disclosure of information that fully corrected prior misstatements. The only statements here that meet this requirement are the 2004 restatements which had no share price impact. This standard, the Circuit Court concluded, is wrong because it does away with the fraud on the market theory of reliance. In addition, “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 statements . . . And if a ‘complete’ corrective disclosure were required, defendants could ‘immunize themselves with a protracted series of partial disclosures'” quoting Freeland v. Iridium World Commc’ns, Ltd., 233 F.R.D. 40, 47 (D.D.C. 2006).

The court also rejected the plaintiff’s theory of loss causation. That theory posited that loss causation may result when the true financial condition of a company becomes known regardless of whether the disclosure of that financial condition corrects past misstatements. Under this theory, if the difference between the market’s erroneous perception of the financial condition of the company and the true financial condition is a consequence of the fraud, a loss that results from the revelation of the true condition is sufficient. This theory is flawed, the court held, because undisclosed information cannot drive down the market price of the stock.

While the market may never learn the relevant truth about Flowerserve’s claimed fraudulent statements, it clearly understood there was some problem when guidance was dropped in 2002 according to the court. But a loss caused by a general impression that something is wrong is not sufficient. If “Alaska cannot prove . . . that the market learned more than that Flowerserve’s earnings guidance was lower and so its business seemed less valuable, it cannot establish that its loss was caused by Flowerserve’s misstatements pertaining to past financials.” Rather, to establish loss causation, the “disclosed information must reflect part of the ‘relevant truth’ — the truth obscured by the fraudulent statements.” The case was remanded to the district court for reconsideration based on these principles.