Using Loss Causation to Repeal Rule 10b-5: In re: Williams Securities Litigation (Part 4)

We are discussing the loss causation analysis in In re Williams Securities Litigation.

This case involved a spin off by The Williams Companies, Inc. (“WMB”) of its Communications Subsidiary (Subsidiary).  Plaintiff essentially alleged that WMB had misrepresented the adequacy of the Subsidiary's capital at the time of the spin off. 

In a post-Dura era, loss causation is a relatively straight forward process.  In most cases, plaintiffs pinpoint the moment at which the market became aware of the fraud, usually when the company discloses the truth, and shows a resulting drop in share prices.  In some cases, the truth makes its way into the market over several days or through several announcements. Either way, the market learns about the fraud in a relatively identifiable fashion. Nothing in Dura prevents the use of this type of information in showing loss causation.

With respect to Williams, however, the loss causation issue was more complex.  The issue was the inadequacy of the Subsidiary's capitalization.  There was not one day or one moment where the market learned of the misstatements.  Instead, the market would likely learn gradually (as evidence of a company's financial problems slowly surface) and would likely only learn the extent of the misstatement over time.  Moreover, to the extent the Subsidiary raised any capital during the relevant period, it would postpone the day of reckoning.

The court in Williams, however, made it clear that the plaintiffs could not just allege that share prices had fallen as a result of the fraud.  Instead, they had to identify the ways in which the truth was revealed.

• To satisfy the requirements of Dura, however, any theory--even a leakage theory that posits a gradual exposure of the fraud rather than a full and immediate disclosure--will have to show some mechanism for how the truth was revealed. A plaintiff cannot simply state that the market had learned the truth by a certain date and, because the learning was a gradual process, attribute all prior losses to the revelation of the fraud. The inability to point to a single corrective disclosure does not relieve the plaintiff of showing how the truth was revealed; he cannot say, "Well, the market must have known." (citation omitted)

Somehow, in other words, the truth had to get into the market.  To meet this burden, the expert selected by plaintiffs presented a series of scenarios that could explain the losses attributable to the disclosure of the fraud.  The strongest was labeled the "leakage" scenario.  The theory posited that no single disclosure resulted in the market learning about the fraud but instead it occurred as the market gradually became aware of the true financial condition and prospects of the Subsidiary during the Class Period.

As part of that scenario, the expert submitted 1300 pages of articles, reports, and filings that he used to show the gradual disclosure of the corrective information to the market.  Moreover, the expert testified that "tiny corrective disclosures occurred each and every day of the class period."

The court characterized most of the articles as news of general applicability to the entire industry or "an upbeat rather than negative statement about WCG."  Nonetheless, the court conceded that the reports contained negative information.  In a relatively dismissive fashion, the court concluded that the negative information was not enough to show that corrective disclosure had leaked into the market.

• As it would be difficult to characterize an announcement that contained no negative information about WCG as revelatory of the truth about WCG's grim prospects, we cannot say that the district court abused its discretion in rejecting the theory that these disclosures leaked the truth to the market.

The sentence is not analysis.  There are no examples of the negative information given in the opinion.  To the extent the negative information shows that the market is figuring out the inadequate capitalisation of the Subsidiary, it demonstrates the validity of the leakage approach.  Instead, the court simply ignored the information. 

The court tried to circumvent the approach by focusing on one sentence in the expert report stating that "Plaintiffs’ losses were caused by the materialization of the concealed risks, specifically that WCG’s assets were overstated, that WCG was in default of its debt covenants, and that there was significant uncertainty about WCG’s ability to continue as a going concern.”  To the court, this meant that the losses didn't result from leakage at all but from the actual materialization of the concealed risk (in the form of things like the default on debt covenants, and so on).  But in fact, this is a backdoor attempt by the court to require that the plaintiff identify a specific event and a specific drop in share prices.  As the court reasoned:

• While the truth could be revealed by the actual materialization of the concealed risk rather than by a public disclosure that the risk exists, see Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 173 (2d Cir. 2005) (loss can be caused by “materialization of the concealed risk”), any theory of loss causation would still have to identify when the materialization occurred and link it to a  corresponding loss.

But the notion of leakage is built around gradual disclosure, gradual revelation.  The market may know at some point that the earlier, optimistic statements were not entirely true, but for the truth to be fully reflected in share prices, the market must know the extent to which the false statements misrepresented the company's capital position.  Short of the company coming out with a blunt announcement about its deplorable financial condition, this is the type of information that the market will only gradually figure out and only gradually reflect in share prices.

Indeed, later in the opinion, the court all but admitted that the information had already leaked to the market.  In dismissing the claim that the corrective information made it into the market on specified days (an alternative scenario) such as the date the Subsidiary announced that it would delay filing its periodic reports.  As the court noted:

• While an announcement that WCG could be in default on its debt obligations might fall within the zone of risk obfuscated by the alleged misrepresentations, the district court questioned whether Dr. Nye had any basis for saying that the January 29 announcement revealed new information to the market such that the disclosure can be said to have caused that day’s loss. The fact that Milberg Weiss was able to assemble a complaint that very day and identify the very misrepresentations in question would suggest that the marketalready had at least some knowledge of the fraud.

In other words, the market knew.  Presumably, one way or another, the Subsidiary told it, through each statement that indicated a problem paying bills or raising capital.  In other words, that comment, in another part of the opinion, more or less confirmed the leakage scenario. 

In the end, the real objection to the expert appears to be his failure to factor out, to the satisfaction of the court, the other events that may have resulted in a drop in share prices. 

• WCG’s share price fell from $28.50 to $1.63 during that period, and while Dr. Nye could not explain how the market learned of the fraud over that year-and-a-half, he claimed that the decline must have resulted from its revelation and not from the “tangle of factors” that affect a company’s stock price—despite the fact that the same period witnessed the bankruptcies of WCG competitors, a decline in the telecommunications industry as a whole, and the overall market declines that followed the 9/11 terrorist attacks.

But this issue is dealt with through cross examination and rebuttal experts, not through dismissal.  Dura imposed a bar, requiring some pleading of evidence that the fraud caused a drop in share prices, but did not require, at the summary judgement stage, that the plaintiffs rule out the effects of other factors. 

We have some primary materials posted on the DU Corporate Governance web site. Oddly, the briefs are not available but are under seal.