Phillips v. Scientific-Atlanta, Inc.: Proving Loss Causation in 10b-5 Violations
In Phillips v. Scientific-Atlanta, Inc., No. 10–15910, 2012 WL 3854795 (11th Cir. Sept. 6, 2012), the Eleventh Circuit affirmed the grant of the defendants’ motion for summary judgment because the plaintiffs failed to present sufficient evidence of loss causation as required in an alleged Rule 10b–5 violation.
Defendant Scientific–Atlanta, Inc. (“S–A”) manufactures and sells devices used in the cable television industry. Together with the company’s CFO and CEO (collectively with S–A, “the Defendants”), S-A was named in a class action by shareholders alleging violations of Rule 10b-5 based on loss of investments which occurred in the fourth fiscal quarter of 2001. The Defendants allegedly attempted to cover up decreasing demand for company products, issued materially false and misleading statements, and later issued “corrective disclosures” which caused the price of S–A securities to fall. The Complaint alleged that in 2001, S–A management became aware that sales were declining and the Defendants used various mechanisms to hide evidence of lower sales, including “discounts, warehousing credits, unusually liberal return policies, and extended repayment terms” thereby misleading investors.
The S-A shareholders also alleged the Defendants issued a series of materially false and misleading statements including: a press release of “record financial results” for the second fiscal quarter of 2001; a press release announcing an increase in manufacturing capacity “in response to the continuing acceleration in customer demand”; statements forecasting continued growth in several sectors; a press release noting a large year-over-year increase in third quarter sales; and interviews with the media describing rising demand and performance in the fourth fiscal quarter. The alleged fraud was revealed to the public in the fourth quarter of 2001 when corrective statements were made and S–A filed its Form 10-K with the SEC. S–A stock prices fell several times after issuance of the corrective statements.
To show a Rule 10b-5 violation, a plaintiff must show “(1) a material misrepresentation (or omission); (2) scienter, i.e., a wrongful state of mind; (3) a connection with the purchase or sale of a security; (4) reliance…; (5) economic loss; (6) and ‘loss causation’ i.e., a causal connection between the material misrepresentation and the loss.” The district court granted the Defendants’ motion for summary judgment, holding “the record evidence provide[d] no method by which a jury can determine how much, if any, of Plaintiffs' loss is attributable to Defendants' failure to disclose its [sic] alleged channel stuffing activities.”
The Eleventh Circuit upheld the finding that the plaintiffs had not sufficiently established loss causation.
According to the appellate court, a plaintiff attempting to use “corrective disclosure” and a “showing that the stock price dropped soon after the corrective disclosure,” to prove a 10b-5 violation, must also “eliminat[e] other possible explanations for this price drop…” in order to show loss causation. The Plaintiffs submitted an expert report in an attempt to eliminate other explanations for the drop in price. The Eleventh Circuit held the expert appropriately separated the statements made by management from general industry factors that could affect stock price. The expert, however, made no attempt to separate the impact of Defendants' truthful statements on the price of stock. The court pointed out that the negative statements regarding the industry-wide trends and the slowing of the economy specifically affected the fourth fiscal quarter performance. This truthful information confounded a finding that any false statement was the direct cause of a fall in stock price. The plaintiffs, therefore, failed to eliminate other possible explanations for the price drop. Without eliminating these other possibilities, no genuine issue of material fact exists regarding the loss causation element, which is a required element of the 10b-5 claim.
The Eleventh Circuit upheld the grant of summary judgment to the Defendants.
The primary materials for this case may be found on the DU Corporate Governance website.