The U.S. Court of Appeals for the Second Circuit recently handed down a decision underscoring the increasing importance of evidence and factual determinations at the class-certification stage. See In re Flag Telecom Holdings, Ltd. Securities Litigation, Docket Nos. 07-4017-cv, 07-4025-cv (2d Cir. Jul. 22, 2009).

Shareholders of Flag Telecom Holdings, a company that provides fiber optic network access to other telecommunications companies, sued Flag’s officers, directors, and lead underwriter, alleging false statements in the company’s prospectus and SEC filings, both before and after its IPO. According to the shareholders, Flag sent misleading signals of strong demand for its network services both in its IPO—in the form of representations regarding presales of fiber optic services—and in subsequent statements—by improperly inflating its sales figures by swapping unused cable capacity with its competitors, thereby creating the appearance of active sales.

Shareholders brought suit under both the Securities Act of 1933 and the Securities and Exchange Act of 1934 after Flag's corrective disclosures depressed its share price to near zero and the company had filed for Chapter 11 protection. The district court certified a broad class encompassing purchasers in the original IPO, who asserted claims under the '33 Act based on allegedly misleading statements in the prospectus; subsequent open market purchasers, who asserted claims under the '34 Act based on allegedly misleading statements regarding reciprocal sales; and "in-and-out traders," those who sold their shares before the corrective and debilitating disclosures. The defendants appealed.

The Second Circuit handed the defendants a defeat on the first of their arguments, concluding that no "disabling intra-class conflict" existed between the '33 Act plaintiffs, who predicated their claims on alleged misstatements in the IPO purchasers, and the '34 Act plaintiffs, who based their claims on subsequent statements. Defendants had argued that "success for the '34 Act plaintiffs" on loss causation, which required a finding attributing causation to post-IPO statements, "necessarily precludes recovery by the '33 Act plaintiffs," who predicated causation on statements in the IPO, and vice versa. Rejecting this contention in affirming the district court’s ruling, the Second Circuit reasoned that the decline in value of Flag stock might have been attributable to both sets of misstatements.

But the Second Circuit reversed the district court's ruling that permitted an in-and-out trader to serve as class representative and included others like him in the certified class. The Second Circuit held that the in-and-out traders, who sold before Flag’s corrective disclosures, could not meet their burden of demonstrating loss causation by reference to those disclosures. Instead, it fell to them to identify "leakage" of truthful information that found its way to the marketplace and depressed Flag's share price before the corrective disclosures. But because the in-and-out plaintiffs failed to present evidence of such disclosures, the court declared them unable to show loss causation and struck them from the class.

Flag Telecom highlights the increasingly difficult factual burden federal courts have placed on plaintiffs seeking to certify a class. In its decision, the Second Circuit underscored that, to obtain class certification, plaintiffs must satisfy each of Rule 23's requirements by a preponderance of the evidence, even if this requires a judge to resolve merits issues at the certification stage. In Flag Telecom, the in-and-out traders did not qualify as class representatives, or even as members of the class, because they failed to produce evidence sufficient to show their eventual success on the loss-causation question. Although this issue would typically not be resolved on a class certification motion, plaintiffs' effort to include an in-and-out trader as a class representative brought the issue to the forefront and required its disposition (despite its overlap with the merits) to determine the representative’s adequacy.

For more information on the Flag Telecom opinion, please contact Edward D. Rogers ( or 215.864.8144), M. Norman Goldberger ( or 215.864.8850), or Stephen J. Kastenberg at ( or 215.864.8122).

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