Loss Causation Under Rule 10b-5: Separating Fraud From Bad News

In Fener v. Belo Corp., 2009 WL 2450674 (5th Cir. Aug. 12, 2009), the Fifth Circuit Court of Appeals affirmed the district court’s decision to deny class certification to shareholders of Belo Corporation.  The court held that the shareholders’ motion for class certification failed to show the loss causation element required to establish securities fraud-on-the-market theory.

Belo Corporation (“Belo”) is a media company that owns various media outlets, including the Dallas Morning News (“DMN”).  Approximately 60% of Belo’s publishing revenue and 30% of its total revenue comes from DMN, and advertising sales make up about 90% of DMN’s revenue.  Plaintiffs alleged that Belo paid bonuses for achieving circulation targets, rigged audits of DMN’s circulation, and implemented a no-return policy that eliminated any incentive for distributors to return unsold newspapers.  The plaintiffs claimed that, as a result of these practices, the defendants artificially increased circulation numbers, which led to improperly inflated revenues for DMN and overstated profits for Belo.

On March 9, 2004, Belo announced that DMN’s circulation would decrease 2.5% on daily papers and 3.5% on Sunday papers.  On August 5, 2004, Belo issued a press release that stated that an internal investigation revealed questionable circulation practices.  Correcting these fraudulent practices resulted in an additional 1.5% daily paper circulation decline and a 5% Sunday decline.  The following day, Belo’s stock price dropped substantially and several analysts downgraded the stock. 

Plaintiffs brought a class action and requested that the district court certify the litigation as a class action.  Defendants objected, arguing that plaintiffs could not demonstrate that fraudulent disclosure in the press release was the primary cause of the stock decline.  The district court agreed with the defendants and denied class certification.

In its decision, the court stated that in a securities fraud case, a plaintiff must prove, inter alia, the causal connection between the material misrepresentation and the loss.  To make that connection, the plaintiff must show “(1) that the negative truthful information causing the decrease in price is related to an allegedly false, non-confirmatory positive statement made earlier and (2) that it was more probable than not that it was this negative statement, and not other unrelated negative statements, that cause a significant amount of the decline.”  In this case, the primary issue was whether plaintiffs submitted enough information to demonstrate loss causation. 

In their motion, the plaintiffs submitted about one hundred pages of support, including excerpts from Belo’s SEC Form 10-k for two years, historical stock prices, SEC S-3 forms from 1996 to 2006, financial data from Yahoo! Finance, and a daily share price chart.  Plaintiffs did not, however, submit expert testimony.  Defendant’s answer included expert testimony, claiming that the press release contained three separate pieces of information: “DMN’s circulation decrease resulted from (1) fraudulent overstatements; (2) changes in DMN’s methodology;  and (3) industry-wide decline in newspaper circulation.”  The expert concluded that the stock price decline was related to the non-fraudulent disclosures and not the fraudulent one.  Plaintiffs responded with expert testimony that the press release should be examined as one disclosure and that the market already absorbed the non-fraudulent information. 

In reaching its decision, the court looked to the holding in Oscar Private Equity Investments v. Allegiance Telecom Inc., 487 F.3d 261 (5th Cir. 2007), and concluded that where multiple items are released the plaintiffs must prove that the fraudulent disclosure caused a significant amount of the decline.  Furthermore, the court examined the plain language of the press release and concluded that it did consist of three separate pieces of information.   As a result, the court held that the plaintiffs failed to demonstrate loss causation.  The court stated that, “conceivably, DMN’s fraudulent practices could have resulted in 90% of the circulation decline, but if the stock price fell because the market was concerned only with the reason for the other 10%, loss causation could not be proven.”  

The court further explained that long term investors could have been more concerned with the overall trend of declining newspaper sales.  The court stated that “[i]f the fraud did not cause the price of the stock to increase, and its disclosure does not cause the price to go down, no injury has occurred.”  As a result, the court affirmed the district court’s decision.

The primary materials for this post are available on the DU Corporate Governance website.