Legal Forum: Loss Causation - Pharmaceutical Executive

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Legal Forum: Loss Causation
The Supreme Court finds that investors can't sue based on alleged price inflation alone.


Pharmaceutical Executive


As the Supreme Court in Dura held, no economic loss is caused by alleged misrepresentations until the truth is disclosed and absorbed by the efficient market, causing the stock price to drop. It logically follows that any adverse price movement prior to a corrective disclosure is caused by events other than the alleged misrepresentation because the negative truth is not yet known and, therefore, not reflected in the stock price. The problem with the Ninth Circuit's Dura decision was that it did not require plaintiffs to plead any loss in stock value due to the defendant's alleged fraud, such as a price drop following a corrective disclosure.

Ruling and Reversal The Ninth Circuit's price inflation theory was highly controversial because it had the effect of collapsing the separate requirements of transaction causation and loss causation. In so doing, the Ninth Circuit's decision threatened to expand securities fraud liability dramatically by making defendants "insurers" against investment losses when the stock price declines—but for some reason other than corrective disclosure. As a result, not only Dura, but the SEC, the Department of Justice, and the Securities Industry Association all submitted briefs urging the Supreme Court to reject the Ninth Circuit's approach.

The Supreme Court, in a short and unanimous opinion authored by Justice Breyer, held that in fraud-on-the-market cases such as Dura, "an inflated purchase price will not itself constitute or proximately cause the relevant economic loss." The decision rests on three points:

Price inflation doesn't equal economic loss First, the Court rejected the notion that mere price inflation means investors have suffered an economic loss. "For one thing," the Court observed, "as a matter of pure logic, at the moment the [stock purchase] takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value." If the owner then sells the share before the "relevant truth" is learned by the market, the investor will not have suffered any loss due to the alleged misrepresentation. Moreover, even if the stock is sold at a price below the purchase price, the "lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events." Thus, at most, "an initially inflated purchase price might mean a later loss." As a result, demonstrating that the purchase price was inflated due to a misrepresentation only gives rise to the potential for loss causation.

No historical support Second, the Court concluded that the price inflation theory of loss causation has no historical support in the common law of fraud and deceit on which the federal anti-fraud securities statutes are based. "[T]he common law has long insisted that a plaintiff... show not only that had he known the truth he would not have acted, but also that he suffered actual economic loss." The judicial consensus, as reflected in the Restatement of Torts, is that a person who "misrepresents the financial condition of a corporation in order to sell its stock" is liable "for the loss" sustained by the purchaser "when the facts... become generally known" and, as a result, share value depreciates.

No broad insurance against market losses Lastly, the Court found that the price inflation theory was inconsistent with the purpose of the federal securities statutes. These statutes "seek to maintain public confidence in the marketplace;" they are "not to provide investors with broad insurance against market losses" that are not caused by defendants' misrepresentations. The Ninth Circuit's approach "would allow recoveries where a misrepresentation leads to an inflated purchase price but nonetheless does not proximately cause" an investor's economic loss.


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