United States: Supreme Court Rejects ´Price Inflation´ Theory of Pleading and Proving Loss Causation in Securities Fraud Cases Under Rule 10b-5

Resolving an issue that had divided the courts of appeals, the United States Supreme Court decided on April 19, 2005 that plaintiffs in federal securities fraud actions cannot satisfy their burden of pleading and proving that defendant’s fraud caused an economic loss merely by showing that plaintiffs had bought stock at a price inflated by the fraud. The unanimous opinion in Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627 (2005) rejects the "price inflation" theory followed by the Eighth and Ninth Circuits in favor of the more traditional common-law approach to loss causation followed by the Second, Third, Seventh and Eleventh Circuits. The Dura decision may limit the damages plaintiffs are able to claim and make it more difficult for plaintiffs to state a claim in cases where corrective disclosures did not promptly result in a significant and lasting drop in the stock’s price.

Dura involved the stock market’s reaction—or lack thereof—to two pieces of bad news. On the last day of the alleged class period, Dura Pharmaceuticals announced that earnings would be lower than expected; the next day Dura stock fell from $39 to $21. Eight months later Dura announced the FDA’s refusal to approve an asthmatic spray device that the company had predicted the FDA would approve; the next day Dura stock fell but almost fully recovered within the week. 125 S. Ct. at 1629-30.

Purchasers of stock in Dura Pharmaceuticals filed a securities fraud class action under section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The complaint alleged that the company and several of its managers had made false statements about drug profits and the likelihood of FDA approval of the asthmatic spray device. Regarding the spray device, the complaint alleged only that the plaintiffs had suffered damages by buying the stock at "artificially inflated prices." 125 S. Ct. at 1630.

The district court dismissed the lawsuit on several grounds. The Ninth Circuit reversed, but only as to the asthmatic spray device claim, holding that plaintiffs had satisfied the requirement of pleading loss causation by alleging that plaintiffs had purchased their Dura stock at artificially inflated prices. 339 F.3d 933, 938.

The Supreme Court reviewed the elements of a claim under Rule 10b-5, noting that a plaintiff must plead and prove "(1) a material statement (or omission)"; "(2) scienter, i.e., a wrongful state of mind"; "(3) a connection with the purchase or sale of a security"; (4) reliance, often referred to in cases involving public securities markets (fraud-on-the-market cases) as ‘transaction causation’"; "(5) economic loss"; and "(6) ‘loss causation, i.e., a causal connection between the material misrepresentation and the loss." 125 S. Ct. at 1631. Addressing elements (5) and (6), the Court spoke first to what a plaintiff must prove and then to what a plaintiff must plead.

The Supreme Court rejected the price inflation theory for three reasons: logic, precedent and policy.

First, the Supreme Court observed that paying too much for a stock does not create a loss at that moment, nor necessarily lead to a loss later. At the moment of purchase, cash is exchanged for stock that (then) has equivalent value. And the "logical link" between the inflated stock price and any later drop in price "is not invariably strong." As time passes, the price of a stock may drop for many reasons having nothing to do with the alleged fraud—e.g., changes in the issuer’s industry, a general economic downturn or erosion of investor expectations. The longer a shareholder holds stock, the more likely it is that factors other than a fraud at the time of purchase will be the real cause of any economic loss that the shareholder suffers. 125 S. Ct. at 1631-32.

Second, the Supreme Court traced the origins of private securities fraud actions. The Court said that such actions "resemble in many (but not all) respects common-law deceit and misrepresentation actions." In such cases, the common law has long required proof of actual economic loss. Similarly, most circuits and the Restatement of Torts have required proof of proximate causation. The price inflation theory requires no such showing, thus departing from this consensus. 125 S. Ct. at 1632-33.

Third, the Supreme Court said that the price inflation theory overlooks the purpose of the securities laws. Private actions operate to maintain investor confidence by deterring fraud and by protecting investors from the losses fraud actually causes. But such actions are not broad insurance against market losses. The Court also said that the Private Securities Litigation Reform Act of 1995, 109 Stat. 737 ("PSLRA"), expressly imposes on plaintiffs the burden of proving that defendant’s misrepresentation "caused the loss for which the plaintiff seeks recovery." 125 S. Ct. at 1633 (citing 15 U.S.C. § 78u-4(b)(4)).

Having held that a plaintiff must prove proximate causation and economic loss, the Court then addressed what a plaintiff must plead. The Court did not decide an issue that some had hoped it would address—whether economic loss and loss causation must be alleged with the particularity required by the PSLRA or Fed. R. Civ. P. 9(b) rather than the "short and plain statement" permitted by Fed. R. Civ. P. 8. Assuming rather than deciding that a short and plain statement under Rule 8 would suffice, the Court nonetheless held this complaint inadequate because it alleged nothing more than that the plaintiffs had bought Dura stock at artificially inflated prices. Noting the abuses than can flow from the assertion of groundless securities fraud claims, the Court said that plaintiffs should "provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind . . . allowing a plaintiff to forego giving any indication of the economic loss and proximate cause that the plaintiff has in mind would bring about harm of the very sort the statutes seek to avoid. Such a rule would tend to transform a private securities action into a partial downside insurance policy." 125 S. Ct. at 1634 (citations omitted).

Accordingly, the Supreme Court reversed the Ninth Circuit.

The Dura decision leaves unanswered a number of questions: 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? How does one plead and prove economic loss and loss causation? What need a plaintiff prove? What need a plaintiff allege? And when making allegations, how much detail is needed—the short and plain statement contemplated by Rule 8 or the particularity demanded by the PSLRA and Rule 9(b)? These questions remain for another day.

Nonetheless, the unanswered questions should not obscure the fact that Dura is very good news for defendants in the Eighth and Ninth Circuits.

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