In a unanimous decision issued April 19, 2005, the United States Supreme Court issued an important decision that is likely to rein in class action lawsuits alleging violations of the federal securities laws.  In Broudo v. Dura Pharmaceuticals, Inc. ("Dura"),[1] the Supreme Court reversed a previous ruling from the Ninth Circuit Court of Appeals, which had held that that a plaintiff in a securities fraud class action under Section 10(b) of the Securities and Exchange Commission Act of 1934 can satisfy the "loss causation" requirement for suits brought under Section 10(b) merely by pleading that the price of the security on the date of purchase was inflated because of the alleged misrepresentations-without any showing that subsequent price declines and/or trading losses were actually caused by the allegedly false statements.  This decision had conflicted with those of a number of other Circuits, which required pleading and proof that the subsequent decline in price after purchase upon which the claim of loss was based was caused by the misrepresentation.  The issue has implications in many pending cases where large price declines occurred for market or other factors before any alleged fraud was disclosed to the market.  The Ninth Circuit standard potentially allowed recovery based solely on alleged artificial price inflation at the time of purchase, allowing plaintiffs to avoid addressing the difficult issues of loss causation. 

In Dura[2] the plaintiff-investors had sued defendant Dura Pharmaceuticals, ("Dura") under  Section 10(b), claiming that Dura had made allegedly misleading and untrue statements in its press releases concerning, among other things, the satisfactory testing and development of the Albuterol Spiros Device, a new asthma spray device.  The district court dismissed the Section 10(b) claim , holding that the plaintiffs had not properly pled the loss causation element of the claim.[3]  The Ninth Circuit Court of Appeals reversed as to loss causation, finding that "[i]n a fraud on the market case, plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation."[4]  The Court thus found that the plaintiffs properly pled loss causation by alleging that the price of the stock was overvalued at the time of purchase in part due to the misrepresentations made by the defendants.[5]  On June 28, 2004, the Supreme Court granted certiorari to resolve the question as to whether a securities fraud plaintiff must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the investment's subsequent decline in price.

In its decision reversing the Ninth Circuit, the Supreme Court held that in fraud on the market cases "an inflated purchase price will not itself constitute or proximately cause the relevant economic loss."[6]  Thus, while proof of an inflated stock price "may prove a necessary condition" to proving economic loss, it is insufficient to prove that the defendant's fraud or misleading statement "proximately caused the plaintiff's economic loss" under the securities laws.[7]  Although the Court did not specifically identify precisely how loss causation must be pled, it cited with approval various authorities requiring pleading and proof of a loss resulting from a stock price decline upon disclosure of the fraud.  The Court cited several reasons for its ruling. 

First, the Court rejected the underlying logic that merely alleging that a security had an inflated price on the date of purchase due to the misrepresentation was sufficient to show loss causation.  The Court recognized that no loss takes place at the moment of the transaction, because the "inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value."[8]  Moreover, the Court noted that the "logical link between the inflated purchase price and any later economic loss is not invariably strong," and thus would not itself constitute proof of loss causation.[9]  For example, if a purchaser later sells the shares before the news of the misrepresentation reached the market, no loss is suffered.  Further, the Court noted that even if a purchaser later sells stock at a lower price, that 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 which . . . account for some or all of that lower price."[10]  The longer the period between the purchase and the price decline, the "more likely that other factors caused the loss."[11]  Thus, the most "logic alone" would support was that the "higher purchase price will sometimes play a role in bringing about a future loss,"[12] but does not constitute the required proof of loss causation.  

Second, the Court found that the Ninth Circuit's rule "lacked support in precedent."[13]  The Court noted that common law deceit and misrepresentation claims, which securities fraud claims resemble, have long required the plaintiff to show that he suffered actual economic loss.[14]  Given this common-law background, the Court surmised, "it is not surprising that other courts of appeals have rejected the Ninth Circuit's 'inflated purchase price' approach to proving causation and loss."[15]

Finally, The Court noted that the Ninth Circuit's holding ignored an important objective of the securities laws, which is to "maintain public confidence in the marketplace" but not to serve as "broad insurance against market losses."[16]  Instead, the securities laws protect only against "those economic losses that misrepresentations actually cause."[17]   The Court relied on language in the Private Securities Litigation Reform Act of 1995 giving plaintiffs "the burden of proving" that the defendant's misrepresentations caused the loss, which showed Congress' intent to allow recovery for private securities fraud actions "only where plaintiffs adequately allege and prove the traditional elements of causation and loss."[18]  The Ninth Circuit approach undermined this rule by permitting recovery where a misrepresentation might lead to an inflated purchase price but did not proximately cause any economic loss.[19] 

Notwithstanding these helpful findings, the Dura decision includes a discussion of "notice pleading" standards that may soften the future impact of Dura Pharmaceuticals in connection with motions to dismiss cases at the pleadings stage.  In particular, the Court said that "we concede that ordinary pleading rules are not meant to impose a great burden upon the plaintiff," and that "it should not prove burdensome for a plaintiff...to provide a defendant with some indication [at the pleading stage] of the loss and the causal connection that the plaintiff has in mind."  The import of these observations will have to await future cases, where the pleading of "loss causation" is challenged in a motion to dismiss. 

In general, the Dura decision will have a significant impact on how loss causation and damages are now proven.  No longer will a plaintiff's damage expert be able to start from the premise that the entire amount of price inflation at the time of purchase constitutes "damages," subject only to how much of that inflation remains at the time of sale.  Instead, the loss causation requirements recognized by the Supreme Court will require damage calculations to be based on specific price declines, sufficiently connected to disclosure of the underlying alleged fraud to meet standards of proximate causation.  This will operate to reduce claimed damages, particularly in cases with multiple market, industry or firm specific factors causing large pre-disclosure declines.  This, in turn, will reduce both the overall risk of many securities class actions, and their settlement values. 

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Gibson, Dunn & Crutcher's lawyers are available to address questions regarding these issues.  For further information, please contact the attorney with whom you work or:

Jonathan C. Dickey (650-849-5324; jdickey@gibsondunn.com),
Robert F. Serio (212-351-3917; rserio@gibsondunn.com), or
Wayne W. Smith (949-451-4108; wsmith@gibsondunn.com).

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