Oscar Private Equity v. Allegiance Telecom

• Decision Date: 16 May 2007
• Docket Number: No. 05-10791.,05-10791.
• Citation: 487 F.3d 261
• Parties: OSCAR PRIVATE EQUITY INVESTMENTS, Individually and on behalf of all others similarly situated, Plaintiff-Appellee, Brett Messing and Marla Messing, Appellees, v. ALLEGIANCE TELECOM, INC., et al., Defendants, Royce J. Holland; Anthony NMI Parella, Defendants-Appellants.
• Court: U.S. Court of Appeals — Fifth Circuit

487 F.3d 261

OSCAR PRIVATE EQUITY INVESTMENTS, Individually and on behalf of all others similarly situated, Plaintiff-Appellee Brett Messing and Marla Messing, Appellees, v. ALLEGIANCE TELECOM, INC., et al., Defendants Royce J. Holland; Anthony NMI Parella, Defendants-Appellants.

No. 05-10791.

United States Court of Appeals, Fifth Circuit.

May 16, 2007.

Robin B. Howald (argued), Glancy, Binkow & Goldberg, New York City, Roger F. Claxton, Claxton & Hill, Dallas, TX, Lionel Z. Glancy, Kevin F. Ruf, Glancy, Binkow & Goldberg, Los Angeles, CA, for Plaintiff-Appellee and Appellees.

Timothy R. McCormick, G. Luke Ashley (argued), William Lowell Banowsky, Michael Warren Stockham, Thompson & Knight, Dallas, TX, for Defendants-Appellants.

Appeal from the United States District Court for the Northern District of Texas.

Before JOLLY, HIGGINBOTHAM and DENNIS, Circuit Judges.

PATRICK E. HIGGINBOTHAM, Circuit Judge:

This is a permissible interlocutory appeal from an order certifying a securities-fraud class action. Plaintiffs allege violations of section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 of the Securities Exchange Commission. Relying on the fraud-on-the-market theory, the district court certified the class. We vacate the certification order and remand, persuaded that the class certified fails for wont of any showing that the market reacted to the corrective disclosure. Given the lethal force of certifying a class of purchasers of securities enabled by the fraud-on-the-market doctrine, we now in fairness insist that such a certification be supported by a showing of loss causation that targets the corrective disclosure appearing among other negative disclosures made at the same time.

I

The class included all investors who purchased the common stock of Allegiance Telecom between April 24, 2001 and February 19, 2002. Three investors bring this suit, Oscar Private Equity Investments, its managing partner, Brett Messing, and his wife, Marla Messing. They sue Royce Holland, former chairman and CEO of Allegiance, and Anthony Parella, former executive vice president for sales. Allegiance Telecom was named in the suit, but filed for bankruptcy and is not now a party.

Allegiance was a national telecommunications provider based in Dallas, Texas. It sold local telephone service, long distance, broadband access, web hosting, and telecom equipment with maintenance to small and medium sized businesses. Founded in 1997, by February 2002 it was providing service in thirty-six U.S. markets. At the beginning of the class period April 24, 2001, there were over 112 million common shares of Allegiance stock trading on the NASDAQ. Institutional investors held approximately 68 percent of Allegiance's stock and over fifty active market makers traded it.

Plaintiffs allege that Holland and Parella fraudulently misrepresented Allegiance's line-installation count in the company's first three quarterly announcements of 2001, and that Allegiance's stock dropped after Holland and Parella ultimately restated the count in the 4Q01 announcement. Defendants explain that the restatement occurred because Allegiance installed a new billing system in 2001 and reported line-count information from the new billing system instead of from the order management system which it replaced. Defendants further argue that the 4Q01 restatement did not cause the stock price to drop.

The relevant announcement history is as follows. Allegiance's stock, like that of the rest of the telecom industry, was plunging during what is now the class period, losing nearly 90% of its value during 2001. On April 24, 2001, the first day of the class period, Allegiance announced its 1Q01 results, including (1) 126,200 new lines installed; (2) revenues of $105.9 million, an 11% increase over 4Q00; (3) positive sales force growth; and (4) improved gross margin. The following trading day Allegiance's stock rose 9%, from $14.90 to $16.20, but soon declined again.

On July 24, 2001, Allegiance announced its 2Q01 results, including (1) 135,800 new lines installed; (2) revenues of $124.1 million; (3) an earnings loss of $0.92 per share, $0.03 better than the analysts' consensus estimate; and (4) positive EBITDA¹ results in thirteen markets. The following trading day Allegiance's stock rose 20%, from $10.90 to $13.08 per share, but soon declined again.

On October 23, 2001, Allegiance announced its 3Q01 results, including (1) the installation of its one-millionth line; (2) revenues of $135 million; and (3) an earnings loss of $0.94 per share, $0.03 better than the analysts' consensus estimate. The next trading day Allegiance's stock rose 29%, from $5.21 to $6.74 per share, but remained volatile, falling to $3.70 per share by February 18, 2002, the day before the curative statements of the 4Q01 announcement.

On February 19, 2002, Allegiance announced its 4Q01 results, including (1) a restatement of the total installed-line count from 1,140,000 to 1,015,000, a difference of 125,000; (2) missed analysts' expectations on 4Q01 and 2001 earnings per share; (3) greater EBITDA loss than some analysts expected; and (4) a very thin margin of error for meeting revenue covenants for 2002. The next trading day Allegiance's stock continued its downward move, falling 28%, from $3.70 to $2.65 per share. Less than 90 days later, Allegiance missed its covenants putting its credit lines in default and on May 14, 2003, filed for bankruptcy.

Six months after Allegiance's bankruptcy, plaintiffs filed this class action, alleging that Allegiance's officers misrepresented the number of installed lines in their 1Q01, 2Q01, and 3Q01 announcements. Plaintiffs moved for class certification, relying on the fraud-on-the-market presumption for evidence of class-wide reliance. The district court certified the class,² and we granted interlocutory review.

II

The class certification determination rests within the sound discretion of the trial court, exercised within the constraints of Rule 23.³ A district court that premises its legal analysis on an erroneous understanding of the governing law has abused its discretion.⁴

III

This dispute turns on whether the certification order properly relied upon the fraud-on-the-market theory. This theory permits a trial court to presume that each class member has satisfied the reliance element of their 10b-5 claim.⁵ Without this presumption, questions of individual reliance would predominate, and the proposed class would fail.⁶

The Supreme Court in Basic adopted this presumption of reliance with respect to materially misleading statements or omissions concerning companies whose shares are traded in an efficient market.⁷ Reliance is presumed if the plaintiffs can show that "(1) the defendant made public material misrepresentations, (2) the defendant's shares were traded in an efficient market, and (3) the plaintiffs traded shares between the time the misrepresentations were made and the time the truth was revealed."⁸

We have observed that Basic "allows each of the circuits room to develop its own fraud-on-the-market rules."⁹ This court has used this room—in Finkel,¹⁰ Abell,¹¹ Nathenson,¹² and Greenberg¹³—to tighten the requirements for plaintiffs seeking a presumption of reliance. We now require more than proof of a material misstatement; we require proof that the misstatement actually moved the market.¹⁴ That is, "the plaintiff [may] recover under the fraud on the market theory if he [can] prove that the defendant's non-disclosure materially affected the market price of the security."¹⁵ Essentially, we require plaintiffs to establish loss causation in order to trigger the fraud-on-the-market presumption.¹⁶ Our most recent statement of this rule was in Greenberg, which held that "to trigger the presumption [of reliance] plaintiffs must demonstrate that ... the cause of the decline in price is due to the revelation of the truth and not the release of the unrelated negative information."¹⁷

This requirement was not plucked from the air. Basic plainly states that the presumption of reliance may be rebutted by "[a]ny showing that severs the link between the alleged misrepresentation and ... the price received (or paid) by the plaintiff."¹⁸ This would include "a showing that the market price would not have been affected by the alleged misrepresentations, as in such a case the basis for finding that the fraud had been transmitted through the market price would be gone."¹⁹

Quoting this very language, plaintiffs argue that our requirement improperly shifts the burden, from a defendant's right of rebuttal to a plaintiff's burden of proof. We disagree. As a matter of practice, the oft-chosen defensive move is to make "any showing that severs the link" between the misrepresentation and the plaintiff's loss; to do so rebuts on arrival the plaintiff's fraud-on-the-market theory. In Nathenson, the link was severed by publicly available information that the misrepresentation didn't move the stock price.²⁰ In Greenberg, it was severed by publicly available evidence that the corrective disclosure was buried in other bad news.²¹ Hence, in cases like this one, we have required plaintiffs invoking the fraud on the market theory to demonstrate loss causation.²²

The contours of this requirement—that the fraud affect the stock price—is the gist of this appeal. It is a requirement complicated here by the fact that multiple items of positive information were released together with the alleged line-count inflation, and further complicated by the fact that multiple items of negative information were released together with the corrective disclosure. In such multi-layered loss-causation inquiries, the legal standard, at least, is well established: Greenberg requires that plaintiffs prove "(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 is...