On March 9, 2010, the U.S. Court of Appeals for the Second Circuit issued a decision in In re Omnicom Group Inc. Securities Litigation, No. 08-612-cv, 2010 WL 774311 (2d Cir. March 9, 2010), in which the court continued to raise the bar for a securities fraud plaintiff to establish the “loss causation” element for Section 10(b) claims. The Second Circuit affirmed the decision, originally handed down by Judge William H. Pauley of the Southern District of New York, which dismissed the securities fraud case against advertising conglomerate Omnicom, Inc. and various members of its management. In so holding, the court made the following determinations on key loss causation issues prevalent in securities fraud cases:
- Negative news coverage suggesting fraudulent activity will likely not give rise to liability if the news is merely a characterization of facts previously disclosed to the public;
- Plaintiffs will have a more difficult burden in establishing investor reliance by fraud-on-the-market theory where the alleged fraud occurred some time before the stock price decline;
- Summary judgment is not precluded where there are conflicting expert reports if the plaintiff’s expert fails to draw the causal connection between the purported “new” information and the alleged fraud.
In Omnicom, the defendant sought to reduce losses from its subsidiary that invested in various internet marketing companies by transferring the subsidiary to Seneca, a newly created private holding company. Omnicom reported in its 2001 Form 10-K that it would not incur any gain or loss from the transaction. Several media outlets covered the transaction when it occurred in mid-2001, and beginning at the time of the transaction and continuing through early 2002, various news articles reported that Omnicom had completed the Seneca transaction in order to move losses associated with the internet companies off its books. Omnicom’s stock price did not experience any statistically significant drop in response to these news reports.
On June 5, 2002, Omnicom filed a Form 8-K stating that Robert Callander, an outside director and Chair of Omnicom's Audit Committee, had resigned. On June 6, 2002, Omnicom's stock price declined as rumors circulated that The Wall Street Journal would be publishing a negative article concerning accounting issues at Omnicom. A few days later, the Journal published a short article stating that Callander quit the Omnicom board over concerns relating to the creation and disclosure of the Seneca entity. The article also suggested Callander left due to broader corporate governance concerns.
On June 12, 2002, The Wall Street Journal ultimately published the rumored negative front-page story regarding the Seneca transaction and Callander’s resignation. The article stated that Callander resigned because of the questionable Seneca transaction and based on his concerns that Omnicom management had not consulted the board before engaging in transactions. The Journal article referred to the opinions of two accounting professors, who stated that the transaction “raise[d] a red flag.” The article also raised questions regarding Omnicom’s general accounting practices, suggested the company had cash flow problems, and discussed the substantial potential liability stemming from future earn-out payments relating to previous acquisitions. Over the next two days, amidst the fallout of the Journal article and subsequent negative analyst reports and news articles, Omnicom’s stock price dropped over 25 percent. Some analyst reports and news articles issued during this time, however, indicated that the Journal article did not raise any new factual issues and suggested that the market's negative reaction was due to the article's negative tone and innuendo in the post-Enron market.
On June 13, 2002, as Omnicom's closing price fell, plaintiffs filed a securities fraud class action pursuant to Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 against Omnicom alleging misrepresentation of the loss in value of the internet companies and improper accounting relating to the Seneca transaction. The action was granted class certification and survived a motion to dismiss. At summary judgment, plaintiffs offered a report by an expert who had conducted an event study and was prepared to testify that the stock price drop was caused by investors’ reaction to June 2002 corrective disclosures about inappropriate accounting for the Seneca transaction. The district court granted summary judgment for Omnicom and held that plaintiffs had failed to establish the requisite element of loss causation in a Section 10(b) claim. Specifically, Judge Pauley found that plaintiffs did not proffer sufficient evidence that the allegedly fraudulent Seneca transaction caused the precipitous drop in the stock price.
Second Circuit Analysis
The Second Circuit noted at the outset that plaintiffs faced the “difficult task” of seeking to establish investor reliance by their “fraud-on-the-market” theory. This was because the plaintiffs sought recovery for a stock price decline in 2002, despite the fact the Seneca transaction had been the subject of intense media scrutiny over the previous year. The Second Circuit than evaluated whether plaintiffs could establish a claim based on either of the theories set forth by the Second Circuit in Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005) by either proving (1) that the market reacted negatively to a “corrective disclosure,” or (2) that negative investor inferences drawn from Callander’s resignation and the news stories in June 2002 caused the loss and were a foreseeable materialization of the risk concealed by the fraudulent statement.
Corrective Disclosures. The court noted that loss causation could be established by a corrective disclosure to the market that reveals the falsity of prior recommendations. However, the court found that none of the matters in The Wall Street Journal article revealed any new and undisclosed facts with regard to the alleged misrepresentations concerning the Seneca transaction, and thus plaintiffs could not establish a corrective disclosure of the fraud. Although the Journal article had a “negative tone” and quoted the suspicions of academics, no “hard fact” in the article suggested that the Seneca transaction was improper. Accordingly, the court found that, at best, plaintiffs had shown that the market may have reacted as it did because of concerns of Callander’s resignation and the negative tone of the June 12 article that implied accounting or other problems in addition to the already-known Seneca transaction. The court concluded that a “negative journalistic characterization of previously disclosed facts does not constitute a corrective disclosure of anything but the journalists' opinions.” The court also found that although courts are “wary of granting summary judgment where there are conflicting expert reports,” a jury verdict could not be sustained on the basis of the expert’s testimony because it did not draw the causal connection between the information in the Journal article and the fraud alleged in the complaint.
Materialization of the Risk. Regarding the “materialization of the risk” theory, the court rejected plaintiffs’ argument that even if no new financial facts were revealed in June 2002, Callander's resignation and the ensuing negative media attention were foreseeable risks of the allegedly fraudulent Seneca transaction and caused the temporary share price decline in June 2002. Because the facts were known a year before his resignation, and the resignation did not add any new facts to the public’s knowledge, the court reasoned that plaintiffs had “at best shown that Callander’s resignation and negative press stirred investors’ concerns that other unknown problems were lurking in Omnicom’s past.” The investors’ negative reaction was “far too tenuously connected” to the Seneca transaction to support liability, and “[f]irms are not required by the securities laws to speculate about distant, ambiguous, and perhaps idiosyncratic reactions by the press or even by directors.” The court concluded that to “hold otherwise would expose companies and their shareholders to potentially expansive liabilities for events later alleged to be frauds, the facts of which were known to the investing public at the time but did not affect share price, and thus did no damage at that time to investors.”
Omnicom is significant for three reasons. First, negative news coverage suggesting fraudulent activity will likely not give rise to liability if the reports are merely a characterization of facts previously disclosed to the public which contain no new or undisclosed information. Plaintiffs cannot allege tenuous connections between the purported fraud and suspicions and statements contained in negative news articles to establish loss causation. Second, plaintiffs will have a more difficult burden to overcome in cases where the alleged fraud occurred some time before the stock price decline, since the investing public will have had time to digest the public information during the intervening period. Finally, conflicting expert reports on the subject of loss causation will not bear summary judgment. If the plaintiffs’ expert fails to establish the requisite causal relationship between the information discussed in the negative news article and the alleged fraud, then summary judgment is appropriate.