Supreme Court Makes It More Difficult To Bring A Securities Fraud Claim

In today's fast-paced, ever-changing business world, many companies make statements that later turn out to be incorrect. Such comments could range from statements about earnings, to statements about whether an important piece of business will be won, to statements about whether the government will approve a new drug. When the market learns "the truth," because a company has to restate its earning or because it announces that a key piece of business was not obtained, companies often worry that they are prime targets for a securities fraud lawsuit.

But what about the case where the negative facts are revealed, and the market does not react negatively and a company's stock price does not decline? Until recently, some courts allowed plaintiffs to bring a claim for securities fraud in this situation, even though there was not a subsequent stock decline. The United States Supreme Court, however, recently put an end to such cases in its opinion in Dura Pharmaceuticals v. Broudo.

The Issue

In order to bring a claim for securities fraud, a plaintiff has to allege and ultimately prove that the defendant's fraud caused plaintiff to suffer an economic loss. In legal terms, this is called loss causation. The issue in Dura was whether a plaintiff can satisfy the loss causation requirement simply by alleging that the price of the security that plaintiff bought was inflated on the day of purchase because of the defendant's misrepresentation.

The Dura Decision

Dura Pharmaceuticals, Inc. is a drug and medical device manufacturer. The plaintiffs alleged that during their class period of April 15, 1997 to February 24, 1998, Dura made misrepresentations about future FDA approval of a new asthmatic spray device. Eight months after the end of the class period, in November 1998, Dura announced that the Food and Drug Administration had not approved the device. The next day, Dura's share price fell temporarily, but it almost fully recovered in one week.

With respect to loss causation, the plaintiffs, in a very long complaint, made only one allegation. The plaintiffs merely claimed that in reliance on the integrity of the market, they paid artificially inflated prices for Dura securities and suffered damages thereby. The Court of Appeals for the Ninth Circuit found that the plaintiffs had adequately pled loss causation.

The Supreme Court in Dura resoundingly rejected the Ninth Circuit's holding and ruled that a plaintiff cannot adequately plead loss causation simply by alleging that he or she paid an inflated price for a security because of the defendant's alleged misrepresentation. Instead, the Supreme Court ruled that a plaintiff must allege and prove that he or she suffered an actual economic loss and that the defendant's alleged misrepresentations proximately caused that loss.

The Supreme Court based its decision in Dura on a number of things. First, it noted that the Ninth Circuit's opinion misstated the law. The Supreme Court noted that in typical securities fraud cases, an inflated purchase price cannot itself constitute or proximately cause the relevant economic loss. As a matter of pure logic, at the moment a plaintiff buys the stock, he or she has not suffered any loss because he or she owns a share with an inflated value. And, the Supreme Court reasoned, even if a plaintiff sells the shares after the truth makes its way into the market place, an initially inflated stock price could, but not must, mean a later loss. Such a causal link is not inevitable because a whole host of other factors, such as changed economic circumstances or changed investor expectations, could account for some or all of the lower stock price. Thus, while the Ninth Circuit was correct in noting that an initially inflate stock price might "touch upon" a later economic loss, the Supreme Court ruled that federal securities statutes require more. They require that a loss be caused by a misrepresentation.

Second, the Supreme Court found that the Ninth Circuit's decision was not supported by precedent. The Supreme Court noted that several other circuit courts had rejected the Ninth Circuit's position that an inflated stock price alone was enough to support a finding of loss causation in a securities fraud case. In addition, the Supreme Court pointed out that common law fraud claims, which federal statutory securities fraud claims resemble in many ways, require a plaintiff to prove that he or she suffered a loss when the facts underlying the fraud become generally known and, as a result, the share value declined.

Finally, the Supreme Court found that there is a great danger to allowing plaintiffs to bring securities fraud claims based only upon an artificially inflated stock price at the time of purchase. The Supreme Court pointed out:

It should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind. At the same time, allowing a plaintiff to forgo 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 [securities] statutes seek to avoid. It would permit a plaintiff with a largely groundless claim to simply take up the time of a number of other people, with the right to do so representing an in terrorem increment of the settlement value, rather than a reasonably founded hope that the discovery process will reveal relevant evidence. Such a rule would transform a private securities action into a partial downside insurance policy.

What The Dura Decision Did Not Do

While the Dura decision rejected the Ninth Circuit's permissive pleading standard for loss causation, the Supreme Court did not clearly articulate what constitutes a sufficient loss causation pleading standard. And there are differences between the lower courts on this issue. For example, the Eighth Circuit has ruled that in order to satisfy loss causation, a plaintiff does not need to plead or prove direct causation. Instead, a plaintiff need only allege some causal connection between the fraud and the loss, and the Eighth Circuit has indicated that proximate cause standards from tort cases are appropriate places to find loss causation standards for securities fraud cases. At the same time, the United States District Court for the Southern District of New York recently ruled that the Second Circuit requires a plaintiff to plead and prove more than proximate cause in order to adequately plead loss causation.

Thus, the Dura decision did not resolve all issues related to loss causation. Lower courts will be left to determine if a plaintiff who has alleged more than an artificially inflated stock price at the time of purchase has adequately pled loss causation.