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Plantiffs did not try to establish a link between the purported misconduct and the decline in share price. Rather, their sole allegation was that they had paid artificially inflated prices for Dura securities.
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 fraud claim.
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.
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.
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.
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.
The Supreme Court's rejection of the price inflation theory of loss causation may have the most effect in the West and Midwest, in the Ninth and Eighth Circuits, where the
decision closes the door to a speculative genre of "stock drop" class actions in which plaintiffs need not plead any loss in stock value due to a defendant's alleged fraud. In all jurisdictions, however, the decision's impact will depend on how courts interpret the Supreme Court's reasoning.
The Supreme Court's embrace of the logical consequences of the efficient market theory strongly supports certain defense arguments in fraud-on-the-market cases. It supports, for instance, the principle that defendants are not liable for the portion of a drop in stock price attributable to factors unrelated to an alleged corrective disclosure. The Court's reasoning also supports the defense argument that the absence of any negative market reaction to disclosure of the truth establishes that the alleged misrepresentation was not material and, therefore, not actionable.
Although courts are still wrestling with the implications of Dura, it is a victory for companies and others named as defendants in securities fraud cases.
Pamela S. Palmer is a litigation partner at Latham & Watkins. She can be reached at email@example.com
Jeff G. Hammel is a litigation partner at Latham & Watkins. He can be reached at firstname.lastname@example.org