United States: The Land Of The Loss: The Supreme Court Will Rule On Loss Causation

On January 12, 2005, the U.S. Supreme Court will hear oral argument in one of the most significant securities law cases to come before that Court in some time—a case concerning the parameters of "loss causation" (a key element of federal securities law claims) in "fraud-on-the-market" cases. The federal appeals courts have rendered conflicting decisions on this issue, and it was the Ninth Circuit’s ruling in Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9^th Cir. 2003) that prompted the Supreme Court to agree to step in and direct the courts as to the proper standard of loss causation.

All private plaintiffs alleging a securities fraud claim under § 10(b) or Rule 10b-5 must plead and prove that a defendant’s conduct caused their loss. There are two elements to causation: "transaction causation" and "loss causation." The first element, "transaction causation," requires that plaintiffs show that a defendant’s alleged misstatements caused them to enter into the transaction in question; that is, as one Court has put it, "but for the claimed misrepresentations or omissions, the plaintiff would not have entered into the detrimental securities transaction." E.g., Emergent Capital Investment Management, LLC v. Stonepath Group, Inc., 343 F.3d 189, 197 (2d Cir. 2003).

The second element, "loss causation," has been described as "the causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff." Emergent Capital, 343 F.3d at 197. Courts analogize loss causation to the general tort concept of proximate cause and the related notion of foreseeability. Id. The doctrine holds that "the damages suffered by plaintiff must be a foreseeable consequence of any misrepresentation or material omission." Id. (quoting Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 179 (2d Cir. 2001)). Congress codified loss causation as an essential element of a securities fraud case in the Private Securities Litigation Reform Act ("PSLRA"):

15 U.S.C.A. § 78u-4(b)(4).

The Dura case pending before the Supreme Court involves a class action asserting the fraud-on-the-market theory. In essence, that theory provides a mechanism by which class actions in securities fraud cases may be certified without each class member having to plead and prove individual reliance on a defendant’s alleged misrepresentations or omissions (transaction causation). Instead, in fraud-on-the-market cases plaintiffs are entitled to a rebuttable presumption that "(1) misrepresentations by an issuer affect the price of securities traded in the open market, and (2) investors rely on the market price of securities as an accurate measure of their intrinsic value." Hevesi v. Citigroup Inc., 336 F.3d 70, 77 (2d Cir. 2004) (citing Basic Inc. v. Levinson, 485 U.S. 224, 245-47 (1988)).

Underlying the doctrine is the efficient market theory: "the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business." Basic Inc. v. Levinson, 485 U.S. at 241-42 (quotation omitted). That is, "most publicly available information [about the company] is reflected in [the] market price [of its stock]." Id. at 247. Accordingly, an issuer’s material misrepresentation creating an unduly favorable view of the company, once publicly disseminated, typically will raise the company’s stock price, and "will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements." Id. at 241-42.

The question facing the Supreme Court is whether plaintiffs can use a fraud-on-the-market theory as a surrogate for loss causation as well as transaction causation. That is, if plaintiffs allege that they purchased stock at an artificially inflated price due to a fraud-on-the-market, can they "kill two birds with one stone" and adequately plead both transaction and loss causation? A brief description of the lower courts’ differing views on the question is set forth below.

In Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9^th Cir. 2003), the case the Supreme Court agreed to review, the Ninth Circuit held that plaintiffs can show loss causation if they allege that the defendant concealed damaging information and artificially inflated its stock price at the time of their stock purchase under a fraud-on-the-market theory, and did not need to plead that the subsequent fall in stock price was causally linked to the alleged fraud.

In Dura, defendant Dura Pharmaceuticals promoted (plaintiffs allege it did so fraudulently) the satisfactory development and testing of its asthma drug device Albuterol Spiros in a press release issued April 15, 1997. Id. at 935. On February 24, 1998, Dura reported lower than expected 1998 revenues and earnings, but its press release did not mention Albuterol Spiros at all. The next day, its stock price dropped from $39 1/8 to $20 3/4 per share, a 47% one-day loss. Id. at 936. Nine months later, in November 1998, Dura announced for the first time that the FDA had rejected Albuterol Spiros. Id.

A securities fraud class action was filed, in which plaintiffs claim that Dura deliberately misled the public into believing that the prospects for Abuterol Spiros were better than they in fact were. Plaintiffs set the class period between April 15 and February 24, the date of the poor earnings report, not the date nine months later on which Dura issued its corrective disclosure concerning Albuterol Spiros. Id. at 935-36. Plaintiffs assert that the purchase price of Dura’s stock on April 15 was artificially inflated due to Dura’s misstatements concerning the asthma device, and that as a result of that inflation they suffered cognizable losses when the stock price dropped the following February, even though the corrective disclosure concerning the FDA rejection did not occur for another nine months.

The Ninth Circuit reversed the district court’s dismissal of the complaint for failure to link the February stock price drop with the FDA rejection of Albuterol Spiros. The court held that "[i]n a fraud-on-the-market case, plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation." Id. at 938 (emphasis in original, citations omitted). The court explained that "loss causation does not require pleading a stock price drop following a corrective disclosure or otherwise. It merely requires pleading that the price at the time of purchase was overstated and sufficient identification of the cause." Id. Because this standard focuses the injury at the time of the transaction, damages are to be measured at the time of the stock purchase. Id. Under that standard, the Ninth Circuit held that plaintiffs adequately alleged loss causation because they alleged that "the price of the stock was overvalued in part due to the misrepresentations" concerning Albuterol Spiros on the date of purchase. Id. at 939.

Like the Ninth Circuit, the Eighth Circuit has ruled that loss causation properly is pled where plaintiffs allege overpayment for stock on the date of purchase due to a fraud-on-the-market theory, under what the Eighth Circuit has described as a "causation requirement for damages [that is] not very stringent." Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824, 831 (8^th Cir. 2003). In Gebhardt, the Eighth Circuit reversed the dismissal of a complaint alleging that investors had been injured as a result of losses stemming from a parent company’s announcement that it would restate its subsidiary’s earnings, which had been inflated due to certain accounting irregularities. Plaintiffs pled that "a decline in the value of their stock was related to accounting issues," and the court held that this was a sufficient causal link, although a "modest" one. The court permitted plaintiffs "to invoke the fraud-on-the-market theory and assume that the misrepresentations inflated the stock’s price. Paying more for something than it is worth is damaging. Thus, the plaintiffs adequately pleaded their case for damages." Id. at 831.

Other Circuits apply a stricter loss causation standard than that permitted by the Eighth and Ninth Circuits.

In Robbins v. Koger Properties, Inc., 116 F.3d 1441, 1448 (11^th Cir. 1997), class plaintiffs won a jury verdict for damages based on losses sustained as a result in a drop in stock price following a company’s cut in dividends. At trial plaintiffs had shown that the company’s accountants made fraudulent statements, which inflated the purchase price; however, defendants also had demonstrated that the dividend cut and drop in stock price occurred over a year before the alleged fraud was uncovered, and that the board of directors cut the dividend for reasons unrelated to the fraud. Plaintiffs argued that defendant’s false financial statements artificially inflated the company’s stock price at the time of purchase through the fraud-on-the-market theory, but did not allege that the drop in dividends that actually occurred were the result of discovery of errors in the financial statements. Id. at 1445-46.

The Eleventh Circuit reversed the jury verdict, holding that "proof that a plaintiff purchased securities at an artificially inflated price, without more" does not "satisf[y] the loss causation requirement." Instead, it explained, "[o]ur decisions explicitly require proof of a causal connection between the misrepresentation and the investment’s subsequent decline in value." Id. at 1448. No such connection existed in Robbins: "plaintiffs simply claim they paid too much. But there is no evidence that this price inflation was removed from the market price of [the company’s] stock, causing plaintiffs a loss." Id. The court refused to conflate transaction and loss causation: "the fraud on the market theory, as articulated by the Supreme Court, is used as a rebuttable presumption of reliance, not a presumption of causation." Id.

The Second Circuit in New York agrees with the loss causation standards applied by the Eleventh Circuit. In Emergent Capital Investment Management, LLC v. Stonepath Group, Inc., 343 F.3d 189 (2d Cir. 2003), the court held that a mere allegation that a fraudulent omission "‘induced a disparity between the price plaintiff paid for the . . . shares and their true investment quality’" at the time of their purchase "cannot satisfy the loss causation pleading requirement." Id. at 198. Instead, loss causation "require[s] that securities fraud plaintiffs demonstrate a causal connection between the content of the alleged misstatements or omissions and ‘the harm actually suffered."’ Id. (quoting Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87 (2d Cir. 2001)).

Although Emergent Capital was not a fraud-on-the-market class action, the Second Circuit rejected the Ninth’s Circuit approach in Dura: "Plaintiff’s allegation of a purchase-time disparity, standing alone, cannot satisfy the loss causation pleading requirement." Id. at 198. While the allegation that plaintiff would not have purchased the stock if it had known the truth "may explain why plaintiff purchased the [company’s] stock, it does not explain why it lost money on the purchase, the very question that the loss causation allegation must answer." Id. The Second Circuit confirmed that one of its earlier cases, Suez Equity, 250 F.3d 87, did not support a more lenient loss causation standard (as the Ninth Circuit had found, see Dura, 339 F.3d at 938).

The SEC also has criticized the Ninth Circuit’s approach. In an amicus brief in the Dura case, the SEC argues that the standard applied in Dura would "grant a windfall to investors who sold before the reduction or elimination of the artificial inflation, because they would recover the portion of the purchase price attributable to the fraud on resale, and then would be entitled to recover that same amount again in damages."

In summary, the Supreme Court’s decision in this case will have far-reaching implications for cases brought under the federal securities laws.

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