Proving Fraud on the Market in the Fifth Circuit

Hamilton Lindley1

The Fifth Circuit recently issued two rulings concerning class certification in securities class actions.2 Both cases involved Basic Inc. v. Levinson’s fraud-on-the-market (FOM) presumption. These rulings will fundamentally change how securities fraud class actions are certified. In Basic the Supreme Court adopted the FOM theory for securities fraud class actions.3 By FOM, plaintiffs obtain a rebuttable presumption of reliance on a misrepresentation, if they can establish that the market for the security traded in an efficient market.4 The Fifth Circuit in Regents held that plaintiffs must show defendants owe a duty to investors in order to presume reliance, while Oscar held that plaintiffs must prove the market was efficient at the class certification stage.

I. No Scheme Liability Exists for Securities Fraud Class Actions

In Regents of University of California v. Credit Suisse First Boston (USA), Inc., the plaintiffs relied on scheme liability to certify a class of shareholders against several defendant banks.5 The district court certified the class. However, the Fifth Circuit reversed and remanded, stating that the conduct alleged were not acts on which an efficient market could presume reliance.6

Enron’s financial fraud is infamous. The defendant banks engaged in a series of transactions with Enron that allowed the Company to take liabilities off its books and to book revenue from the transactions, which, in actuality, caused it to incur debt. However, these acts did not permit Enron investors to take advantage of the fraud-on-the-market presumption, as set forth in the Supreme Court’s Basic decision, for purpose of class wide reliance and obtaining certification of a proposed investor class in their lawsuit against these banks. Because Enron is a judgment proof defendant, the banks were the main source of settlement revenue for the Enron investors. 7

Central Bank of Denver v. First Interstate Bank of Denver wasthe crux of the opinion.8 This ruling provides that plaintiffs “may not bring a 10b-5 suit against a defendant for acts not prohibited by the text of § 10b.”9 The Court held that Rule 10b-5 “does not include giving aid to a person who commits a manipulative or deceptive act.” 10 The Fifth Circuit in Regents focused on the meaning of the term “deceptive act” in § 10b, and found that the district court’s decision was premised on an overly broad conception of the term.11 The appellate court held that “an act cannot be deceptive… where the actor has no duty to disclose.”12 Scheme liability fails when defendants do not owe a duty to investors.13

Similarly, The Eighth Circuit recently ruled that there was no scheme liability in securities fraud class actions. The Supreme Court granted certiorari in that case.14 Enron plaintiffs have also appealed the Fifth Circuit opinion to the Supreme Court. Certiorari has not yet issued. The Federal criminal guidelines remained in place.

Scheme liability motivates third parties to reveal financial fraud before the deceit balloons to Enron-type proportions. The accuracy of financial statements is fundamental to a healthy securities market. Scheme liability would ensure that third parties would be watching over the companies in the market, thereby demanding accuracy in all statements. Additionally, it allows investors to obtain a separate source of settlement revenue from solvent defendants when the publicly traded company is otherwise judgment proof. However, scheme liability also poses the risk that banks would incur additional liability for knowing about a fraud without disclosing it to the market. Nevertheless, scheme liability would help curb future securities scandals such as Enron. If the securities markets wish for less regulation, it must begin to “self-police.” Scheme liability would stimulate that motivation.

II. Loss Causation Must be Proven at Class Certification

In another Fifth Circuit class certification case, Oscar Private Equity Investments v. Allegiance Telecom, Inc., the court ruled that plaintiffs must establish loss causation to trigger the FOM presumption.15 Further, when simultaneous negative disclosures are made, plaintiffs must prove that the specific disclosure complained of caused the stock to decline.16 Proximity between multiple negative statements and a stock loss will not suffice.17 Instead, plaintiffs must show that the specific misstatement they allege “actually moved the market.”18 The court noted that an event study19 is one way to show that a specific statement contained in a bundle of bad information caused the stock price to drop.20 The Fifth Circuit is the only appellate court to rule that plaintiffs must prove loss causation at class certification.21

Oscar is unique not because of what it requires, but when. Typically, plaintiffs are required to prove loss causation only at summary judgment. Loss causation and damages are issues of fact for the jury. However, this ruling makes loss causation a preliminary fact question for the judge to decide, instead of a question of fact for the jury to decide.

All evidence both for and against loss causation must be considered by the court at the class certification phase.22 This has taken “all evidence both for and against loss causation” from merits discovery and now places it squarely within class certification discovery. Therefore, plaintiff’s counsel may request more information during discovery concerning damages. For example, plaintiffs will request all documents concerning the specific disclosure, and how that disclosure affected the market. Additionally, plaintiffs will request all documents concerning damages.

In sum, this opinion is significant because it requires plaintiffs to prove loss causation at class certification instead of summary judgment. It will require plaintiffs to hire experts sooner and direct discovery to loss causation issues.

III. Conclusion

These two rulings show the Fifth Circuit requires atypical hurdles for investors to jump in order to obtain class certification. Class certification is now the battleground for expert discovery, instead of summary judgment. Additionally, investors cannot take advantage of scheme liability, even if banks were aware of the massive fraud, but chose not to tell anyone about it.

Cite as: Hamilton Lindley, Proving Fraud on the Market in the Fifth Circuit, TEXSUPP (2007), available at

  1. Hamilton Lindley is an associate at Provost Umphrey in Dallas, Texas, who has represented plaintiffs in approximately 50 securities class actions. J.D. 2004, Baylor University School of Law.[back]
  2. See generally Regents of Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372 (5th Cir. 2007); Oscar Private Equity Invs. v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007).[back]
  3. 485 U.S. 224, 241-43 (1988).[back]
  4. In an action under Rule 10b-5, the plaintiff must “allege, in connection with the purchase or sale of securities, (1) a misstatement or an omission; (2) of material fact; (3) made with scienter; (4) on which plaintiff relied; (5) that proximately caused [the plaintiffs'] [sic] injury.” Greenberg v. Crossroads Sys., Inc., 364 F.3d 657, 661 (5th Cir. 2004) (quoting Nathenson v. Zonagen, Inc., 267 F.3d 400, 406-07 (5th Cir. 2001)) (internal quotation mark omitted). Basic, 485 U.S. at 248 n.27 (requiring establishment of efficient markets).[3] See Basic, 485 U.S. at 248 n.27.[back]
  5. See In re Enron Corp. Sec., Derivative, & ERISA litig., 236 F.R.D. 313, 316-17 (S.D. Tex. 2006).[back]
  6. Regents of Univ. of Cal. v. Credit Suisse First Boston (USA), Inc., 482 F.3d 372, 390 (5th Cir. 2007).[back]
  7. Id. at 377.[back]
  8. 511 U.S. 164 (1994).[back]
  9. Id. at 173.[back]
  10. Id. at 177.[back]
  11. Regents, 482 F.3d at 382.[back]
  12. Id. at 386.[back]
  13. See Id.[back]
  14. In re Charter Communications, Inc., 443 F.3d 987 (8th Cir. 2006), petition for cert. filed, 75 U.S.L.W. 3034 (U.S. July 7, 2006) (No. 06-43).[back]
  15. 487F.3d 261, 265 (5th Cir. 2005).[back]
  16. 271.[back]
  17. Id.[back]
  18. Id. at 265.[back]
  19. An event study, in economics, finance, and accounting research, is an analysis of whether there was a statistically significant reaction in financial markets to past occurrences of a given type of event that is hypothesized to affect public company’s market values (Author’s note).[back]
  20. Oscar Private Equity Invs., 487F.3d at 270.[back]
  21. However, the First, Second, Fourth, Seventh and Eighth Circuits do require courts to resolve factual disputes at class certification even if they overlap with merits issues or involve conflicting expert opinions.The Ninth Circuit is alone in holding otherwise. See Dukes v. Wal-Mart, Inc., 474 F.3d 1214, 1230 (9th Cir. 2007). Prominently citing Eisen the Ninth Circuit reasoned that in analyzing “commonality” under Rule 23(a), the district court properly avoided resolving a “battle of the experts” and was not required to apply the full-blown Daubert “gatekeeping” standard. Id. In Miles, the Second Circuit decertified six class actions, on the ground that the plaintiffs failed to establish that common questions predominated over individual questions under Rule 23(b)(3). Miles v. Merrill Lynch & Co., 483 F.3d 70, 70-71 (2d Cir. 2007).[back]
  22. Oscar Private Equity Invs., 487 F.3d at270.[back]