The Supreme Court recently announced its much-anticipated decision in Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627 (2005), addressing the pleading and proof burdens that private plaintiffs must carry on the issue of loss causation in actions under section 10(b) of the Securities Exchange Act of 1934 and S.E.C. Rule 10b-5. The narrow holding in Dura was not surprising. Unanimously reversing a decision by the United States Court of Appeals for the Ninth Circuit, the Dura Court concluded that plaintiffs seeking damages under section 10(b) and Rule 10b-5 cannot rely exclusively on the allegation that they purchased securities at a price artificially inflated by the defendant's false statement. Rather, the Court concluded, such plaintiffs must further plead (and, at trial, prove) that they suffered actual economic loss caused by the false statement. The Court strongly suggested that, in order to meet those requirements, plaintiffs must allege and prove that the price of the relevant security declined significantly in the wake of a corrective disclosure.
The Dura ruling will, in a number of important respects, assist defendants in federal securities litigation. Most obviously, Dura makes clear that plaintiffs must develop damage and causation theories before commencing suit, and bear the burden of pleading those theories in their complaints. Moreover, the Court's opinion emphasizes the role of the Private Securities Litigation Reform Act of 1995 ("PSLRA"), and particularly the provisions of that statute addressed to pleading standards, as a shield against meritless securities fraud claims. Thus, Dura will facilitate the disposition of securities cases by motion to dismiss - while the PSLRA stay provisions operate to spare defendants the cost and burden of discovery. The Court's opinion also signals more rigorous scrutiny in federal securities fraud actions of damages claims and evidence of causation.
The Dura Case
The facts underlying Dura are relatively straightforward. Plaintiffs asserted federal securities fraud claims on behalf of a purported class of investors who purchased common stock issued by Dura Pharmaceuticals, Inc. ("DPI") on the secondary market between April 15, 1997 and February 24, 1998. According to their amended complaint, DPI made false statements before and during the class period concerning (a) its anticipated sales of an asthma drug, and (b) its expectation that the Food and Drug Administration would approve the company's new spray device for the treatment of asthma. On February 24, 1998, DPI announced that its earnings would not meet earlier-stated expectations. The next day, the market price of DPI's stock fell by almost 50 percent, from about $39 per share to $21 per share. In November 1998 - about eight months later - DPI announced that the FDA would not approve the company's asthma treatment device. The market price of DPI's stock fell slightly on the day after that announcement, but recovered almost entirely within a week.
The district court dismissed plaintiffs' amended complaint, finding that, in the absence of any allegation of a causal relationship between the February 1998 price drop and DPI's supposed false statements concerning the expected approval of its asthma treatment device, they had failed to plead loss causation as to those statements. On appeal, the Ninth Circuit reversed. It reasoned that, in "fraud on the market" cases, a plaintiff who purchases a security at a price inflated by the defendant's misstatement or omission suffers loss that is measured at the time of the purchase. Accordingly, the Ninth Circuit concluded that the "loss causation" element under section 10(b) and Rule 10b-5 "does not require pleading a stock price drop following a corrective disclosure or otherwise," but rather "merely require[s] pleading that the price [of the security] at the time of purchase was overstated and sufficient identification of the cause." Broudo v. Dura Pharm., Inc., 339 F.3d 933, 938 (9th Cir. 2003).
The Ninth Circuit panel recognized that its decision in Dura was inconsistent with decisions on the loss causation issue by the Second, Third and Seventh Circuits. See, e.g., Emergent Capital Inv. Mgmt., LLC v. StonePath Group, Inc., 343 F.3d 189, 198 (2d Cir. 2003) (affirming dismissal of loss causation theory and holding that an "allegation of a purchase-time value disparity, standing alone, cannot satisfy the loss causation pleading requirement"); Semerenko v. Cendant Corp., 223 F.3d 165, 185 (3d Cir. 2000) ("Where the value of [a] security does not actually decline as a result of an alleged misrepresentation, it cannot be said that there is in fact an economic loss attributable to that misrepresentation"); Bastian v. Petren Res. Corp., 892 F.2d 680, 684 (7th Cir. 1990) (affirming dismissal of a Rule 10b-5 claim where plaintiffs alleged misrepresentations and omissions in offering memoranda but were unable to identify any reason for their investment loss).
Speaking through Justice Breyer, the Supreme Court unanimously reversed the Ninth Circuit's ruling, and rejected the notion that an investor suffers compensable injury simply by virtue of having purchased a security at a price inflated by a misstatement or omission. The Court reasoned that in many instances - such as where an investor purchases securities at an artificially inflated price but sells before any corrective disclosure - a misstatement or omission may inflate the price of a security but cause no loss at all. Thus, the Court held that, in "fraud on the market" cases, "an inflated purchase price will not itself constitute or proximately cause the relevant economic loss." Rather, the Court ruled that, under section 10(b) and Rule 10b-5, plaintiffs must plead and prove a pecuniary loss caused by the alleged misstatement or omission.
In support of its holding, the Court pointed out, among other things, that the policy underlying the private federal cause of action for securities fraud is "not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause." The Court further noted that the PSLRA, in addition to requiring that plaintiffs plead with particularity both the falsity of alleged misstatements and the defendant's scienter, "expressly imposes on plaintiffs 'the burden of proving' that the defendant's misrepresentations 'caused the loss for which plaintiff seeks to recover.'" Given those provisions, the Court concluded that Congress intended "to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss."
Applying those principles to the case before it, the Court found that the sole allegations in the amended complaint describing the loss caused by DPI's alleged misrepresentation - that plaintiffs "paid artificially inflated prices for [DPI's] securities" and suffered "damage[s]" - did not adequately plead either loss or causation. The Court noted that the absence of any allegation of a "significant" decline in DPI's stock price upon correction of the alleged misrepresentation "suggests that the plaintiffs considered the allegation of purchase price inflation alone sufficient." But price inflation alone, the Court repeated, is "not itself a relevant economic loss." Thus, the Court found plaintiffs' amended complaint defective in that it failed to "provide the defendants with notice of what the relevant economic loss might be or of what the causal connection might be between that loss and the [alleged] misrepresentation." Allowing a claim to proceed in the face of such defect would, the Court concluded, permit strike suits of the very sort that Congress sought to avoid when it enacted the PSLRA.
Beyond Pleading: Implications For Proof Of Damages
The Dura decision also may impact proof of causation and damages calculation at trial. Among other things, Dura emphasizes the importance of statistical methodolgy in establishing causation at trial. Similarly, the Court's opinion supports the proposition that a plaintiff who has both profitable and unprofitable transactions in an allegedly inflated security must "net" gains against losses in calculating recoverable damages.
Several courts have held that, in order to prove the element of loss causation, "[u]se of an event study or similar analysis is necessary more accurately to isolate the influences of information . . . which defendants allegedly have distorted." In re Executive Telecard, Ltd. Sec. Litig., 979 F. Supp. 1021, 1026 (S.D.N.Y. 1997) ( citing In re Oracle Sec. Litig., 829 F. Supp. 1176, 1181 (N.D.Cal.1993)). Under that case law, a plaintiff's failure to establish causation through reliable statistical methods can have dispositive consequences, regardless of the merits of other elements of the claim. For example, in In re Imperial Credit Indus. Sec. Litig., 252 F. Supp. 2d 1005 (C.D. Cal. 2003), the district court ruled that plaintiffs' expert testimony was "deficient for failure to provide an 'event study' or similar analysis." Noting the "importance and centrality of the event study methodology in determining damages in securities cases," the court granted summary judgment in favor of the defendant due to the resulting failure to make a sufficient showing of damages. Id. at 1014-15. By holding in Dura that evidence of price inflation cannot alone establish either damages or causation - and noting plaintiffs' failure to allege a "significant" price decline following correction of the alleged misstatements in that case - the Court keyed its loss causation analysis to the causal linkage between corrective disclosures and market price movements. Thus, Dura implicitly underscores the holdings in Executive Telecard, Oracle and Imperial Credit that statistical methodology is indispensable to establishing causation.1
Authority in the lower federal courts also supports the proposition - most frequently applied in non-class actions - that plaintiffs in a securities case must "net" losses against gains in determining recoverable damages. In the leading case on this point, Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1978), plaintiff sued under the Investment Advisers Act, alleging that defendants misrepresented the nature of the investment partnerships. Defendants obtained summary judgment based on the fact that plaintiffs actually made overall net profits on the investment partnership. The Second Circuit explained that although it did not agree with the ruling below that plaintiffs failed to prove damages, its holding "[was] not to say, however, that a plaintiff may recover for losses, but ignore his profits, where both result from a single wrong . " Id. at 878; see also Minpeco v. Conticommodity Servs., Inc., 676 F. Supp. 486, 488 (S.D.N.Y. 1987) ("Defendants' 'offset' argument has considerable force. Under most circumstances, it is clear that a plaintiff both injured and enriched by illegal activity cannot choose to recover for his injuries yet retain his windfall."); accord Apex Oil Co. v. Di Mauro, 744 F. Supp. 53, 55 (S.D.N.Y. 1990) ("[R]equiring each counterclaimant to net out its gains and losses will neither unjustly enrich Apex, nor shelter it from any appreciable liability, nor undermine the goal of deterrence. There is no unjust enrichment where a claimant has actually benefited from the alleged wrongdoing of another.") (emphasis in original). The analysis in Dura - permitting recovery only of actual pecuniary loss caused by a misstatement or omission - provides renewed support for the principle that a plaintiff's losses should be netted against gains in order to arrive at an appropriate damages calculation.
1 The Imperial Credit ruling is now on appeal before the Ninth Circuit. See Mortensen v. Snavely, No. 03-55547.
Stephen M. Sinaiko is a Partner, and Brendan M. Schulman is an Associate, at Kramer Levin Naftalis & Frankel LLP in New York City. The views expressed in this article are those of the authors, and are not necessarily those of their clients or the firm.