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.
Pamela S. Palmer
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
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.
Jeff G. Hammel
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
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.