The Fifth Circuit Court of Appeals – the federal appeals court covering Texas, Louisiana, and Mississippi – is not known for being a particularly friendly forum for investor-plaintiffs.  But perhaps that reputation is unwarranted, in particular when it comes to the issue of proving “loss causation” under the federal securities law. 

Loss causation is one of the elements that a defrauded investor must prove under Rule 10b-5.  Under the Private Securities Litigation Reform Act, an investor must show that the defendants’ misrepresentations caused the investment losses – and were not the result of some other factor unrelated to the fraud, such as a decline in the market or industry as a whole. The most common way to establish loss causation is for the investor to show (usually through an event study conducted by an expert) that the issuer’s stock price declined in connection with the release of information relating to the fraud.  Most courts have rejected the notion that news causing the stock price drop must actually use the word “fraud” or admit conscious wrong-doing.  Indeed, fraud can be revealed (and harm investors) via a series of partial-but-incomplete disclosures of the underlying truth or by the gradual materialization of a previously concealed risk. 

However, recently, a few stray courts have adopted a much higher standard for loss causation, requiring that the corrective information directly reveal the fraud itself, as opposed to the truth the fraud concealed.  This more-exacting standard would suggest it is nearly impossible to establish loss causation except in the extremely rare case where an issuer who commits securities fraud confesses to conscious wrongdoing.  In fact, issuers often take steps to prevent the truth from coming out in a clear and conspicuous manner, such as by burying the revelation of fraud-related information with the disclosure of other news – a process known as information bundling that has been discussed by the SEC and commentators.

Given its reputation as a judicially conservative forum, one might expect the Fifth Circuit Court of Appeals to be among the courts adopting this heightened standard for loss causation.  But that is not the case.  In fact, the Fifth Circuit has adopted a practical approach for assessing loss causation that is grounded in economic reality and acknowledges that the revelation of the truth can take various forms. 

For example, In Spitzberg v. Houston American Energy Corp., 758 F.3d 676 (5th Cir. 2014), the Fifth Circuit held that the disclosure causing the stock price drop need not “squarely and directly contradict the earlier misrepresentations.”  In another case, Public Employees Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014), the Fifth Circuit explained that “[a] corrective disclosure can come from any source, and can take any form from which the market can absorb the information and react.”  The Amedisys court further found that sometimes there will be multiple partial disclosures, which, taken collectively, reveal the defendant’s fraud to the market – even though none of them standing alone directly discloses the truth (not that there was conscious misconduct).  The Fifth Circuit has expressly declined to adopt a standard that a corrective event must precisely mirror the alleged misrepresentation because doing so would allow “a defendant [to] defeat liability by refusing to admit the falsity of its prior misstatements.”  Alaska Elec. Pension Fund v. Flowserve Corp., 572 F.3d 221 (5th Cir. 2009).

The Fifth Circuit’s approach to loss causation is consistent with the salutary purpose of the federal securities laws.   It does not allow investors to recover losses that were not caused by the defendant’s fraud.  At the same time, however, it protects investors by prohibiting a crafty defendant from evading liability for wrongdoing through concealment or obfuscation of the truth.  In that sense, the Fifth Circuit provides a forum that is perhaps more investor-friendly than some might anticipate.