The Errors in the Ninth Circuit’s Loss Causation Decision by Pamela S. Palmer and J. Christian Word

The Supreme Court has agreed to review a highly controversial decision by the Ninth Circuit Court of Appeals in Broudo v. Dura Pharmaceuticals, Inc.,¹ that has important implications for defendants in fraud-on-themarket securities class actions. In Dura, the Ninth Circuit held that plaintiff investors satisfy the securities laws’ “loss causation” requirement merely by alleging that they paid too much for a company’s stock due to alleged misrepresentations, and need not show that their stock actually lost value when the truth was revealed.

It has been sixteen years since the Supreme Court endorsed the efficient market theory underpinning the “transaction causation” or reliance element of a fraud on-themarket claim under Section 10(b) of the Securities Exchange Act of 1934.² In Dura, the Supreme Court is poised to resolve a circuit split over how the efficient market theory operates on plaintiffs’ obligation to prove the separate “loss causation” element of a Section 10(b) claim.

The Ninth Circuit’s Dura decision is unpopular with more than just the Dura defendants; the Department of Justice, the Securities and Exchange Commission, and the Securities Industry Association all urged the Supreme Court to review and reverse the decision. The root of the controversy lies in the Ninth Circuit’s failure to give full effect to the efficient market theory— the economic concept that the price of a security in an efficient market reflects all publicly known information—as it pertains to plaintiffs’ obligation to prove loss causation. Plaintiffs have long been permitted to use the efficient market theory to establish a presumption of reliance, which satisfies the element of transaction causation and enables Section 10(b) claims to be brought as class actions. Dura is anomalous because the court permitted plaintiffs to rely on the efficient market theory to establish class-wide reliance on an alleged misrepresentation, and then allowed plaintiffs to escape the efficient market theory when it came to proof that their stock lost value when the truth was revealed. In so holding, the Ninth Circuit placed itself squarely in conflict with several other federal courts of appeals and with loss causation and damages limitations codified in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”).

At stake in the Supreme Court’s review of Dura is whether companies—not only in the Ninth Circuit but nationwide—may be forced to defend class action lawsuits prosecuted by investors who cannot plead or prove that their stock lost value due to the defendant’s alleged misrepresentations.

Background

This securities class action was brought on behalf of investors who purchased stock in Dura Pharmaceuticals Inc. between April 15, 1997, and February 24, 1998. At the start of the class period, Dura issued a press release describing its financial results for the first quarter of 1997. The company reported both “strong progress” in selling its respiratory antibiotic product, Ceclor CD, and completion of a “[p]atient dosing” milestone necessary to submit a new drug application to the FDA for its asthma product, Albuterol Spiros. The plaintiffs closed the alleged class period on February 24, 1998, when Dura announced that it expected to fall short of its forecasted revenues and earnings per share for 1998, in part due to slower than expected sales of Ceclor CD. Dura’s February announcement did not mention Albuterol Spiros.

The day following Dura’s unfavorable press release, the price of the stock fell 47%. Approximately nine months later—after the close of the class period—Dura announced that the FDA had declined to approve the Albuterol Spiros device; Dura’s stock price dropped again. The plaintiffs alleged that statements made during the class period about both Ceclor CD and Albuterol Spiros were false and misleading in violation of Section 10(b) and Rule 10b-5 and fraudulently inflated the price of Dura stock.

The defendants moved to dismiss the claims based on the alleged misstatements about Albuterol Spiros because the plaintiffs did not, and could not, plead that the decline in the stock price at the close of the class period was related to any alleged misrepresentations about that product.³ The district court agreed and granted the motion to dismiss, holding that the plaintiffs failed to plead the requisite element of “loss causation” since the disclosure that triggered the price drop during the class period did not mention Albuterol Spiros. The district court reasoned that the decline in stock price on which plaintiffs sought to recover their losses was not caused by the alleged misrepresentations about Albuterol Spiros, but was solely attributed to the unexpected revenue decline including slower sales of Ceclor CD.

The Ninth Circuit disagreed. The court of appeals reiterated a principle from its prior decisions that the element of loss causation is satisfied by allegations that the “misrepresentation touches upon the reasons for the investment’s decline in value.” The Ninth Circuit recognized the ambiguity inherent in this standard, however, and elaborated: “in a fraud-onthe- market case, plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation.” On that basis, the court concluded, “it is not necessary that a disclosure and subsequent drop in the market price of the stock have actually occurred.” The Ninth Circuit thus held that the plaintiffs’ allegations of price inflation satisfied the loss causation requirement and reversed the district court’s decision.

Loss Causation Without Causing the Loss?

The Ninth Circuit’s decision is fundamentally at odds with the Reform Act and with the efficient market theory underpinning all fraud-onthe- market securities class actions. The Reform Act codified the long-standing judicial interpretation of Rule 10b-5 requiring plaintiffs to prove that their loss was caused by the defendants’ misrepresentations. Under the Reform Act and preexisting case law, this causation requirement consists of two components: transaction causation (the plaintiff relied on the defendant’s misrepresentations when making investment decisions); and loss causation (the misrepresentations caused the plaintiff ’s loss).⁴

Considering the first of these components, the Supreme Court recognized in Basic v. Levinson,⁵ that investors could not satisfy the “commonality” requirement necessary to maintain a class action if each investor were required to prove transaction causation (or reliance). Dissatisfied with that outcome, the Supreme Court decided that plaintiffs could invoke a fraud-on-the-market presumption of reliance— i.e., a presumption that all investors rely on the integrity of a stock’s market price as a proxy for all available material information about the company. The economic foundation supporting that presumption is the efficient market theory, which holds that all material information about a company is rapidly reflected in the company’s stock price. Together, these concepts allow a shareholder class to demonstrate transaction causation by claiming that a material misrepresentation artificially inflated the stock price (the efficient market theory) and that shareholders purchasing at the market price thereby relied on the misrepresentation (the fraud-on-the-market presumption).

The Ninth Circuit’s decision is fundamentally at odds with the Reform Act and with the efficient market theory underpinning all fraud-on-the-market securities class actions.

The efficient market theory likewise has implications for the loss causation requirement. Known as the “truth-on-the-market” presumption of causation, the theory is that an artificially inflated stock price remains inflated until the misrepresentations are corrected. Investors who buy stock at the fraudulently inflated price but sell the stock before the inflation is eliminated by way of a corrective disclosure (sometimes called “in and out” class members) do not incur a compensable loss. In other words, recoverable economic loss is not caused by the alleged price inflating misrepresentations until the “truth” is disclosed and absorbed by the efficient market causing the stock price to drop (deflate). Any adverse price movement occurring prior to a corrective disclosure is necessarily caused by facts or market conditions other than the alleged misrepresentation since the falsity is not yet known and, therefore, is not reflected in the price of the stock.⁶

Since plaintiffs have the benefit of the efficient market theory to obtain a presumption of transaction causation (or reliance)—as they do in virtually every securities class action—they should not be permitted to sidestep the attendant consequences of that theory when it comes to their obligation to prove loss causation. But, this is precisely what the Ninth Circuit has allowed. Its decision that loss causation requires nothing more than proof of price inflation incorrectly collapses the separate elements of transaction causation and loss causation by ignoring the truth-on-the-market presumption. This means, for example, that “in and out” investors in the Ninth Circuit can seek to claim compensable injury under Dura, even though their losses were not actually caused by the alleged misrepresentation.

The Ninth Circuit Alone Among the Courts of Appeals

The Ninth Circuit’s interpretation of loss causation is at odds with decisions from the Second, Third, Seventh, and Eleventh Circuits that uniformly require plaintiffs to demonstrate that the price drop giving rise to their losses was caused by the alleged misrepresentation (i.e., that the drop followed a corrective disclosure revealing the previously undisclosed or misrepresented information). Thus, the Second and Eleventh Circuits have stated what, prior to Dura, appeared obvious: the loss causation requirement requires proof of a “causal connection” between the loss and the corrective disclosure.⁷ Each rejected the notion adopted in Dura that inflation alone is sufficient.⁸ Likewise, the Third Circuit held in Semerenko v. Cendant Corp. that “an investor must also establish that the alleged misrepresentations proximately caused the decline in the security’s value to satisfy the element of loss causation.” ⁹

The Seventh Circuit reached the same conclusion in Bastian v. Petren Resources Corp., where Judge Posner, a widely regarded expert on the intersection of law and economics, rejected as inadequate a claim for which the investors “alleged the cause of their entering into the transaction in which they lost money but not the cause of the transaction’s turning out to be a losing one.”¹⁰ Judge Posner concluded that plaintiffs must plead facts showing that “but for the circumstances that the fraud concealed, the investment that they were induced by the fraud to make would not have lost its value.” Absent this requirement, Judge Posner said, plaintiffs whose investments lose value as a result of any other market factors would receive an undeserved windfall.¹¹

Together, these cases from four of the nation’s courts of appeals set forth the majority, and better reasoned, view that the loss causation requirement is meaningful and is not subsumed in the determination of transaction causation or reliance. The Ninth Circuit’s decision in Dura stands alone in reaching the opposite conclusion. ¹²

The Statutory Conflict

The Dura decision also conflicts with the Reform Act, which requires plaintiffs to prove causation to recover under Section 10(b) and Rule 10b-5.¹³ Moreover, Congress incorporated the principles of loss causation into the Reform Act’s damages calculation provision.¹⁴ The Reform Act caps damages at the difference between the price paid and the mean trading price during the 90-day period “beginning on the date which the information correcting the misstatement or omission that is the basis for the action is disseminated to the market.” Congress explained in the House Conference Report the purpose behind this so-called “bounce back” provision:

“Typically, in an action involving a fraudulent misstatement or omission, the investor’s damages are presumed to be the difference between the price the investor paid for the security and the price of the security on the day the corrective information gets disseminated to the market. . . . The Conference Committee intends to rectify the uncertainty in calculating damages . . . by providing a ‘look back’ period, thereby limiting damages to those losses caused by the fraud and not by other market conditions.”¹⁵

Together, the statutory language and the legislative history leave no doubt that Congress intended for plaintiffs to prove a causal link between the stock price decline and the alleged misrepresentations.

The Ninth Circuit’s decision that this causal link is not required obviously cannot be reconciled with that Congressional intent. Indeed, the Reform Act’s “bounce back” damages calculation is inoperable under Dura. In Dura, the Ninth Circuit concluded that the plaintiffs could recover for the price decline even though the “information correcting the misstatement or omission that [was] the basis for the action” was not yet disclosed. As a result, the 90-day “bounce back” period was not (and, indeed, need not ever be) triggered. How then can the damages cap be calculated?

Indeed, for precisely this reason, the plaintiffs in Dura apparently made a strategic decision to cut off the class period approximately nine months before Dura disclosed that the FDA would not approve Albuterol Spiros and the resulting decline in the stock price. Following the announcement of FDA non-approval, the company’s stock fell from $12 3/8 to $9 3/4, but quickly rebounded and was trading near $12 1/2 twelve days later. Under the Reform Act damages cap, this “bounce back” would reduce (and possibly eliminate) the amount recoverable by the plaintiffs.

What is at Stake in Dura?

In the typical securities class action, the end of the class period coincides with the corrective disclosure that triggers the decline in stock price for which the plaintiffs hope to recover. In Dura, there was no corrective disclosure during the class period. Assuming arguendo that the plaintiffs suffered any loss of stock value based on alleged misrepresentations during the class period, those losses were not due to the misrepresentations about Albuterol Spriros.

If the Supreme Court affirms Dura, that decision will open the door to fraud-on-themarket securities class actions when a company’s stock price has not declined in response to a corrective disclosure. It is not hard to imagine that plaintiffs will seek to exploit such an opening by alleging that the stock price was inflated by categories of alleged misstatements unrelated to any corrective disclosure, and then pursuing discovery on those categories. Such practice would open up defendants to the very fishing expeditions the Reform Act sought to eliminate. On the other hand, there is reason for optimism: the bedrock economic principles of the efficient market theory (articulated in the better reasoned case law from other federal courts of appeals) and the requirements of the Reform Act strongly indicate that the Supreme Court should reverse the Ninth Circuit.

Notes

1. 339 F.3d 933 (9th Cir. 2003).

2. Basic v. Levinson, 485 U.S. 224 (1988).

3. The defendants also argued that claims based on the Ceclor CD statements should be dismissed because the plaintiffs failed to plead the requisite particularized facts giving rise to a strong inference of scienter.

4. The Ninth Circuit did not disagree that causation requires both transaction and loss causation.

5. 485 U.S. 224 (1988).

6. A plaintiff could also satisfy the loss causation element by showing that the stock price did not fully appreciate following the disclosure of positive news due to the dampening effect of a simultaneous corrective disclosure.

7. See Emergent Capital Investment Mngmt., LLC v. Stonepath Group, Inc., 343 F.3d 189, 199 (2d Cir. 2003) (loss causation “require[s] that securities fraud plaintiffs demonstrate a causal connection between the content of the alleged misstatements or omissions and the harm actually suffered.”); Robbins v. Koger Props., Inc., 116 F.3d 1441, 1448 (11th Cir. 1997) (requiring “proof of a causal connection between the misrepresentation and the investment’s subsequent decline in value.”).

8. Emergent, 343 F.3d at 198 (“Plaintiff ’s allegation of a purchasetime value disparity, standing alone, cannot satisfy the loss causation pleading requirement.”); Robbins, 116 F.3d at 1448 (“Our cases do not hold that proof that a plaintiff purchased securities at an artificially inflated price, without more, satisfies the loss causation requirement.”).

9. 223 F.3d 165, 185 (3d Cir. 2000).

10. 892 F.2d 680, 684 (7th Cir. 1990).

11. Id.

12. Some commentators have suggested that the Eighth Circuit is aligned with the Ninth Circuit on this issue. However, the Eighth Circuit’s decisions appear to be more consistent with the majority view. See Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003); In re Control Data Corp. Sec. Litig., 933 F.2d 616 (8th Cir. 1991). Although in both of these cases the Eighth Circuit states that loss causation is satisfied by demonstrating an inflationary misstatement, the court asserted, at the same time, that loss causation also requires a causal connection between the loss in value and the alleged misstatements. Gebhardt, 335 F.3d at 831 (loss causation requirement met by allegation that losses were caused by “the company’s misbehavior”); Control Data, 933 F.2d at 621 (plaintiffs demonstrated “causal nexus” between misstatements and drop in stock price).

13. 15 U.S.C. § 78u-4(b)(4).

14. 15 U.S.C. § 78u-4(e).

15. H.R Conf. Rep. No. 104-369, at 42 (emphasis added).

About the Authors

Pamela Palmer (pamela.palmer@lw.com) is a litigation partner in Latham & Watkins’ Los Angeles office. She specializes in securities class action litigation, professional liability defense, financial accounting disputes, and other complex business disputes. Ms. Palmer Co-Chairs the American Bar Association’s Professional Liability Subcommittee of the Committee on Class Actions & Derivative Suits. Christian Word (Christian.Word@LW.com) is a senior litigation associate in Latham & Watkins’ Northern Virginia office. He specializes in securities class action litigation and professional liability defense.