United States: U.S. Supreme Court Decision on Securities Fraud Litigation May Deter Strike Suits

On April 19, the U.S. Supreme Court handed down a unanimous decision that may make it tougher for investors to recover compensation when companies make misleading disclosure. In Dura Pharmaceuticals v. Broudo, the Court held that a plaintiff in a U.S. securities fraud lawsuit must prove that the misrepresentation caused the plaintiff’s loss. It is not sufficient for the plaintiff simply to show that the misrepresentation caused the price of the stock to be inflated on the day he bought it. Rather, the plaintiff must demonstrate that a subsequent lowering of the stock price was caused by the misrepresentation. The decision is not a surprise, because it overturned a Ninth Circuit appeals court decision that had been widely criticized as a blow to a principal aim of the U.S.’s Private Securities Litigation Reform Act of 1995 (Reform Act)—namely, to deter strike suits. But the impact of the decision is expected to be magnified because it is the first time that the U.S. Supreme Court has considered this important statute.

The plaintiffs bought stock in Dura Pharmaceuticals between April 1997 and February 1998. In February 1998, Dura announced that its earnings would be lower than expected due to slow drug sales. The next day Dura’s stock lost nearly 50% of its value. Eight months later, in November 1998, Dura made another negative announcement informing the market that the FDA would not approve Dura’s new asthmatic spray device. Dura’s share price again fell, but mostly recovered within a week.

The plaintiffs alleged that Dura’s misrepresentations about its spray device caused them to suffer damages, even though they did not purchase Dura stock after February 1998 and the truth about the spray device was not revealed until months later, with little effect on Dura’s stock price. According to the plaintiffs, however, the spray device misrepresentations caused the price of Dura shares to be higher than they otherwise would have been on the day the plaintiffs purchased the stock. That "artificial inflation," argued the plaintiffs, caused their loss.

The U.S. Supreme Court disagreed, observing, "Given the tangle of factors affecting price, the most logic alone permits us to say is that the higher purchase price will sometimes play a role in bringing about a future loss." While the Court did not say what a plaintiff needs to do to establish causation and economic loss, it favourably cited literature stating that a purchaser sustains a loss when true facts become generally known and, as a result, share value depreciates.

Despite its relatively narrow holding, Dura has the potential to have far-reaching effects in deterring strike suits. The Reform Act was passed by Congress in 1995 to deter litigation in which plaintiffs’ lawyers seek quick, class-action settlements from public companies when their stock price drops. The Reform Act sought to achieve its goal, in part, by codifying a host of previously judge-made rules constituting the elements of a securities fraud lawsuit.

Following the dot-com bust of the 1990s and the subsequent string of Enron-type accounting frauds, the Reform Act’s goals have not been achieved as record numbers of securities lawsuits continue to be filed. Recent years have seen a trend in cases alleging hidden "fraudulent schemes," in which a defendant may not even have made misrepresentations to the market.

Although the Reform Act has been on the books for 10 years, Dura represents the first time the U.S. Supreme Court has considered it. The decision confirms the Reform Act’s purpose of reducing strike suits, and one can expect the securities defence bar and lower courts to rely on it to strengthen the Reform Act’s effects.

With respect to the narrow issue (loss causation) that was decided in Dura, the Court promoted the Reform Act’s purpose by emphasizing that a direct causal connection between the defendant’s fraud and the plaintiff’s loss is required. The Court based its conclusion on the observation that U.S. securities laws are not intended to protect a plaintiff from losses caused by factors unrelated to a defendant’s fraud—for example, changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events. The Court’s holding can be expected to significantly increase the burden on plaintiffs to prove "fraudulent scheme" cases in which all or much of a defendant’s alleged fraud does not come to light until after its stock price has collapsed, as in the cases of Enron and WorldCom.

In fact, the Court in Dura made clear that the availability of private securities fraud actions under U.S. securities laws is not intended to serve as an "insurance policy" to investors who lose money in the stock market. Rather, the purpose of these lawsuits is to deter fraud in an effort to maintain public confidence in the markets. The Court noted that in furthering that objective, the Reform Act "insists" that a plaintiff plead and prove each of the elements of its securities cause of action. The Court’s broader discussion of the Reform Act and Congress’s intent to limit securities fraud private actions can be expected to shore up the Reform Act’s eroding authority.

Provisions under Ontario securities law, once proclaimed, will permit investors to sue issuers and others for a misrepresentation in continuous disclosure. The U.S. and Canadian regimes are loosely comparable, although there are a sufficient number of differences to make a direct comparison difficult. One such difference is the loss causation issue dealt with in Dura. The Ontario law contains a complex formula for assessing damages, which is based on stock price, and the loss causation onus is reversed. That is, the damages that are assessed against a defendant will not include any amount that the defendant proves is attributable to a change in the market price of securities that is unrelated to the misrepresentation.