Legal Forum: Loss Causation

The Supreme Court finds that investors can't sue based on alleged price inflation alone.
Jul 01, 2005

Pamela S. Palmer
Dura Pharmaceuticals recently found itself in the same position as many other companies in today's business and legal environment: Its share price had declined after it reported lower-than-expected revenue and earnings. Subsequently, the company was sued by investors who claimed Dura had engaged in securities fraud.

But there was something that made this case unusual. Normally, when a company discloses "bad news" (such as missed-earnings guidance or a restatement of financial information) and its stock-price declines, investors and their lawyers claim that the company had engaged in fraud prior to that announcement, and the stock decline provides an apparent link between the alleged misconduct and investors' losses. This linkage is known in the law as "loss causation," and is a required element of a securities fraud claim.

Jeff G. Hammel
In Dura's situation, however, plaintiffs did not attempt to draw a link between any share price decline and the investors' losses. Instead, their theory was that because of alleged misconduct at the company, the share price was artificially inflated. The investors argued they had paid too much for the stock—not that the decline had anything to do with misconduct.

Case History Plaintiffs alleged that Dura artificially boosted the price of its stock by making misrepresentations about the prospects of an FDA approval of an asthma-spray device called Albuterol Spiros, and about future drug sales. As a result, plaintiffs could not—and did not try—to establish a link between the purported misconduct concerning the FDA approval and the decline in share price, which had occurred months beforehand. Plaintiffs' sole allegation regarding their economic loss was that they had paid artificially inflated prices for Dura securities.

After initially being dismissed by a federal district court in San Diego, the United States Court of Appeals for the Ninth Circuit (which encompasses nine western states, including California) permitted the case to proceed. In accepting this "price inflation" theory of loss causation, the Ninth Circuit set itself apart from most other federal courts—and created a significant potential liability for companies headquartered or sued in the states encompassed by the Ninth Circuit. In April 2005, in Dura Pharmaceuticals v. Broudo, the US Supreme Court rejected the Ninth Circuit's ruling, and established the law of the land on the issue of loss causation.

Loss from Misrepresentations The Private Securities Litigation Reform Act of 1995 (PSLRA) codified a longstanding judicial interpretation of Rule 10b-5, requiring plaintiffs to prove that their investment losses were caused by the defendant's misrepresentations. This causation requirement has two components:
» transaction causation (the plaintiff relied on the defendant's alleged misrepresentations in making the investment decision)
» loss causation (the alleged misrepresentation caused the plaintiff's investment loss).

These requirements ensure that defendants are only held liable for investment losses resulting from their misrepresentations—and not for stock-price declines attributable to other factors, such as changes in market conditions or other negative business developments.

In 1988, based on its ruling in the case of Basic v. Levinson, the US Supreme Court enabled so-called "stock drop" class actions by allowing plaintiffs to plead transaction causation based on a fraud-on-the-market theory. The Court held that all investors who trade stock in an efficient market (such as the New York Stock Exchange or the NASDAQ) rely on the integrity of the market price because that price should rapidly reflect all available material information. This principle enables many securities claims to be brought as class actions by permitting investors to allege that they relied on a supposed misrepresentation (whether they were actually aware of it or not) merely by purchasing stock at an inflated price, since that price incorporates all material information. Similarly, in an efficiently operating market, when the truth is disclosed, the stock price quickly declines to reflect the corrected information.

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