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.

The “How” and “Who” Of Madoff: New Insights

Since the Madoff Ponzi scheme scandal emerged, key questions have been “how” and “who.” How did he bilk so many people for so long? Who else knew and helped him? Mr. Madoff, whose sentencing is scheduled for Monday, June 29, 2009, has said little about how it was done except to insist he acted alone. It’s fair to say that everyone wants to know how, and few believe Mr. Madoff about the who.

To date, the authorities have said little. Some insights came from the suit by the New York AG against Ezra Merkin and his feeder fund Gabriel Capital, discussed here. Other insights come from the actions by the SEC and DOJ against the auditors, SEC v. Friehling, Civil Action No. 09 cv 2467 (S.D.N.Y. Filed Mar. 18, 2009) and U.S. v. Friehling, Case No. 09-mj-00729 (S.D.N.Y. Filed Mar. 18, 2009), both of which are discussed here. Still, little is known about what has been called the Ponzi scheme of the ages.

More pieces are emerging however, with two new suits by the SEC, SEC v. Cohn, Civil Action No. 09 cv 5680 (S.D.N.Y. Filed June 22, 2009) and SEC v. Chais, Civil Action No. 09 cv 5681 (S.D.N.Y. Filed June 22, 2009). The Cohn case names as defendants New York broker dealer Cohmad Securities, its chairman Maurice Cohn and registered representative Robert Jaffee. The firm, located in the same building as Madoff’s securities operation, is owned by Maurice Cohn, Marcia Cohn, Bernard Madoff, Madoff’s brother, Maurice Cohn’s brother, Robert Jaffee and another Cohmad employee.

For more than two decades the defendants in Cohn facilitated Mr. Madoff’s fraudulent operations by aggressively marketing the Ponzi scheme. According to the complaint, defendants projected a “false aura of exclusivity and privilege that came to be associated with the opportunity to invest with the great Madoff. Madoff’s secret marketing operations were housed within the office of Bernard L Madoff Investment Securities Corporation LLC (“BMIS”) under the façade of a separately registered broker-dealer, defendant Cohmad.” The marketing targeted affluent, but financially unsophisticated investors, according to the SEC. The firm’s extensive dealings with Madoff were concealed from regulators by falsifying its filings with the SEC — acts which furthered Mr. Madoff’s efforts to evade detection. In fact, Mr. Madoff directed defendants to maintain secrecy about their arrangements.

During their years of marketing the Ponzi scheme king, the Cohmad defendants ignored numerous red flags suggesting the true nature of the fraudulent operation they were selling unsuspecting victims. Those included the fact that BMIS employees were generating false confirmation and statements that reflected backdated trades in Mr. Jaffe’s own personal accounts at the Madoff firm.

The Cohmad defendant faired far better than the investors they lured into the scheme. Their marketing efforts yielded them more than $100 million paid through Cohmad. Maurice Cohn and Robert Jaffee were paid, in addition, millions of dollars directly from Madoff’s brokerage firm.

The complaint alleges violations which include Section 17(a) and 10(b) of the Securities Act and the Exchange Act as well as Section 206 of he Advisers Act. The case is in litigation. See also Lit. Release No. 21095 (June 22, 2009).

The Chais defendants also fed the Madoff money abyss. The suit is against a California investment adviser who has funneled money to the Ponzi operation since the early 1970s. Mr. Chais, according to the SEC, held himself out as an “investing wizard, purporting to execute a complex trading strategy on behalf of hundreds of investors . . .” Mr. Chais claimed to operate three investment funds, Lambeth Company, the Brighton Company and the Popham Company.

Contrary to the representations he made to his investors, Mr. Chais lacked any real investment skills. The money he raised from investors was, unknown to them, simply turned over to Mr. Madoff for use in his fraudulent scheme. Despite clear indications of fraud, Mr. Chais continued to distribute account statements to the investors in his three funds based on the purported returns of the Madoff scam. By November 2008, Mr. Madoff claimed that the investors in the three funds had over $900 million invested, all of which has been wiped out.

Mr. Chais and his family however profited from the Madoff relationship. Through an array of accounts Mr. Chais and his family received about a half a billion dollars over a thirteen year period according to the SEC.

The complaint in Chais, alleges violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Section 206 of the Advisers Act. The case is in litigation. See also Lit. Release No. 21096 (June 22, 2009).

Two more Madoff complaints. More defendants who were paid handsomely to ignore the repeated warnings that those whose money they gave to Mr. Madoff were being defrauded. Slowly the “how” and the “who” is emerging. There undoubtedly will be more.