United States: Life After Dura—Courts Begin to Define Loss Causation in Securities Fraud Cases

The United States Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627 (2005), left many unanswered questions about securities fraud cases under Rule 10b-5: Must there be a corrective disclosure and a consequent decline in the stock’s price? How tightly must the decline be tied to the corrective disclosure? What if multiple factors cause the market to move? What need a plaintiff allege to sufficiently plead economic loss and loss causation? And when alleging loss causation, must a plaintiff satisfy the Private Securities Litigation Reform Act’s heightened pleading standard, or only the "short and plain" statement requirement of Fed. R. Civ. P. 8(a)(2)? Lower court decisions have begun to trickle in, providing many eagerly awaited answers, with implications favorable both to defendants and to plaintiffs alike.

The elements of a claim under Rule 10b-5 are: (1) a material statement (or omission); (2) scienter, meaning an intent to deceive; (3) a connection between the misstatement and the purchase or sale of a security; (4) reliance—often referred to as "transaction causation"; (5) economic loss; and (6) loss causation. Dura Pharmaceuticals, 125 S.Ct at 1631. Loss causation is the causal connection between the alleged misconduct or material misrepresentation and the loss or economic harm ultimately suffered by the plaintiff. Id.

On April 19, 2005, the Supreme Court rejected the "price inflation" theory of pleading loss causation. Under that theory, plaintiffs could satisfy their burden of pleading and proving that defendant’s fraud caused an economic loss merely by showing that plaintiffs had bought stock at an artificially inflated price. While Dura held that these allegations were not adequate, it did not say what types of allegations would meet the burden of pleading and proving loss causation.

The Second Circuit has begun to provide answers, finding that plaintiffs must show "both that the loss be foreseeable and that the loss be caused by the materialization of the concealed risk." Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 173 (2d Cir. 2005); Liu v. Credit Suisse First Boston, Inc., 2005 U.S. Dist. LEXIS 12845, at *15 (S.D.N.Y. June 27, 2005).

The Second Circuit’s ruling in Lentell, a harbinger of the Dura decision, predated the Supreme Court’s opinion by four months. In Lentell, the Court of Appeals held that to establish loss causation, plaintiffs must allege "that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security." 396 F.3d at 173.

In Liu, the Southern District of New York found that Dura did not disturb Second Circuit precedent on loss causation. After examining Lentell and other decisions handed down by the Second Circuit, Judge Scheindlin concluded that the Second Circuit requires "both that the loss be foreseeable and that the loss be caused by the materialization of the concealed risk." 2005 U.S. Dist. LEXIS 12845, at *15.

Plaintiffs in Liu alleged that defendant issuers and underwriters employed a scheme called "Pop and Performance" to inflate stock prices artificially. The alleged scheme, which involved defendants setting earnings estimates below their true estimates to ensure that actual revenue reports would exceed forecasts, was designed to drive up share prices by creating the illusion of unforeseen profitability. The alleged scheme failed, however, when the issuer failed to meet even the modest revenue projections and its stock price tumbled. Judge Scheindlin reasoned that: "the gulf between what was alleged to have been the concealed risk and the events that materialized is even more apparent [in this case than in Lentell]: what was concealed was the analysts’ belief that revenue would exceed forecasts, and what materialized was exactly the oppose. Accordingly, plaintiffs have never alleged any disclosure of the falsity of defendants’ opinions." The opinion thus suggests that a plaintiff, to survive a motion to dismiss, must allege both a corrective disclosure and a consequent decline in the stock’s price.

Just days after the Liu decision, another judge of the Southern District of New York found that plaintiffs adequately alleged loss causation where defendants allegedly concealed losses, causing plaintiffs to purchase securities at inflated prices, and plaintiffs were injured when the over-evaluation was revealed. Fraternity Fund Ltd. v. Beacon Hill Asset Management LLC, 2005 U.S. Dist. LEXIS 13094, at *44-45 (S.D.N.Y. July 5, 2005). Defendants argued that there could be no loss causation because multiple factors, including a drop in interest rates, caused the plaintiffs’ losses. But the court held otherwise, finding that even if the drop in interest rates explained some of the losses, it could not explain them all. Id. at *45. The opinion suggests that, to satisfy the loss causation element of a 10b-5 claim, the disclosure of alleged misconduct need only contribute to plaintiffs’ economic losses, and need not be the primary cause of such losses.

A recent Ninth Circuit opinion, In re Daou Systems, Inc., 411 F.3d 1006, 1025-27 (9th Cir. 2005), can arguably be read the same way. That appeal originally was decided before Dura came down, see 397 F.3d 704, but the opinion was substantially rewritten after Dura. The court, influenced by the drop in the price of Daou’s stock from $18.50 a share to $3.25 a share after corrective disclosures began, held that the allegations sufficed "‘to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind.’" Daou, 411 F.3d at 1026, quoting Dura, 125 S. Ct. at 1634. The court also held, however, that any loss suffered between $34.375 [the top of the market] and $18.50 was not causally related to the alleged fraud, because the loss occurred before the corrective disclosures began. Daou, 411 F.3d at 1027.

In In re Immune Response Sec. Litig., 2005 U.S. Dist. LEXIS 12602 (S.D. Cal. June 7, 2005), the court held that plaintiffs adequately alleged loss causation by separately claiming that defendants’ wrongdoing caused artificially inflated stock prices and that stock prices dropped when the alleged wrongdoing became public, without explicitly alleging that the disclosure had caused the stock drop. The court explained that the "conjunction" of the allegations made it clear that plaintiffs were claiming that the alleged wrongdoing was the cause of the drop in stock price. Immune Response, 2005 U.S. Dist. LEXIS 12602, at *95.

In re Cree, Inc. Sec. Litig., 2005 WL 1847004, at *11-*13 (M.D.N.C. Aug. 2, 2005) holds that, for loss causation purposes, a corrective disclosure must reveal new facts and not simply allege that facts already known amount to a fraud.

Dura assumed but did not decide that a plaintiff pleading loss causation need only allege it in accordance with the "short and plain statement" rule of Fed. R. Civ. P. 8(a)(2) and need not satisfy the higher pleadings standards imposed by the Private Securities Litigation Reform Act and Fed. R. Civ. P. 9(b). Thus far, the district courts that have ruled on the point have opted for Rule 8, holding that the heightened pleading requirements of the Private Securities Litigation Reform Act and Rule 9(b) do not apply to loss causation. In re Immune Response Sec. Litig., 2005 U.S. Dist. LEXIS 12602, at *94 (S.D. Cal. June 7, 2005); Greater Pa. Carpenters Pension Fund v. Whitehall Jewelers, Inc., 2005 U.S. Dist. LEXIS 12971, at *17 (N.D. Ill. June 30, 2005).

At least one commentator has read Daou, 411 F.3d at 1025-27, as requiring Rule 9(b) specificity in pleading loss causation. William F. Sullivan, et al., "’Daou II’ Reshapes Circuit’s Securities Litigation Picture," San Francisco Daily Journal, Aug. 2, 2005, at 9. This may be arguable, but Daou is far from explicit on the point.

While many issues remain unsettled, the courts are moving rapidly to resolve the questions left unanswered by Dura.

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