Category Archives: Appellate Monitor

The U.S. Supreme Court has issued an opinion in the Dura Pharmaceuticals v. Broudo case. It is a unanimous decision authored by Justice Breyer. As predicted, the court rejected the Ninth Circuit’s price inflation theory of loss causation. Instead, the court held that a plaintiff must prove that there was a causal connection between the alleged misrepresentations and the subsequent decline in the stock price.

Loss causation (i.e., a causal connection between the material misrepresentation and the loss) is an element of a securities fraud claim. In the Dura case, the Ninth Circuit had held that to satisfy this element a plaintiff only need prove that “the price at the time of purchase was inflated because of the misrepresentation.” (See this post for a full summary of the Ninth Circuit’s decision.)

On appeal, the Supreme Court made three key findings in rejecting the price inflation theory of loss causation. First, the court dismissed the idea that price inflation is the equivalent of an economic loss. The court noted that “as a matter of pure logic, at the moment the transaction 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.” Moreover, it is not inevitable that an initially inflated purchase price will lead to a later loss. A subsequent resale of the stock at a lower price may result from “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.”

Second, the court found that the price inflation theory of loss causation has no support in the common law. The common law has “long insisted” that a plaintiff in a deceit or misrepresentation action “show not only that if had he known the truth he would not have acted but also that he suffered actual economic loss.” Accordingly, it was “not surprising that other courts of appeals have rejected the Ninth Circuit’s ‘inflated purchase price’ approach.”

Finally, the court noted that the price inflation theory of loss causation was arguably at odds with the objectives of the securities statutes, including the PSLRA. The statutes make private securities fraud actions available “not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause.” In particular, the PSLRA “makes clear Congress’ intent to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss.”

As clear as the opinion is on the issue of the price inflation theory, it fails to provide much guidance on what a plaintiff must allege on loss causation to survive a motion to dismiss. The court assumed, without deciding, “that neither the [Federal Rules of Civil Procedure] nor the securities statutes impose any special further requirements in respect to the pleading of proximate causation or economic loss.” Even under the notice pleading requirements, however, the complaint’s bare allegation of price inflation was deemed insufficient. As stated by the court, “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.”

Holding: Reversed and remanded for proceedings consistent with opinion.

Addition: A few initial thoughts on the Dura opinion:

(1) The case is a significant victory for defendants in the Eighth and Ninth Circuits, which were the only two courts to adopt the price inflation theory of loss causation.

(2) Although the Supreme Court has put the price inflation theory to rest, its opinion raises some complicated questions about recoverable loss. For example, the Supreme Court notes that many factors other than misrepresentations can cause a stock price decline, but does not provide any guidance on how plaintiffs can meet their burden of proof for loss causation in cases where some or all of these other factors are present.

(3) The opinion is unclear on an issue that was raised on appeal: does the stock price decline need to be the result of a corrective disclosure that reveals the “truth” to the market? The Supreme Court makes some opaque references to when “the relevant truth begins to leak out” and “when the truth makes its way into the market place,” but does not squarely address whether there is any need for plaintiffs to establish the existence of a corrective disclosure.

(4) Finally, as noted above, the Supreme Court expressly leaves open the question of whether F.R.C.P. 9(b) or the PSLRA requires plaintiffs to plead loss causation with particularity. The lower courts will need to decide whether these statutes are applicable.

News reports on the Dura opinion can be found in the New York Times, the Washington Post , and Reuters.

When Judge Easterbrook of the U.S. Court of Appeals for the Seventh Circuit writes a securities law opinion, it is invariably going to be worth talking about. His latest is no exception.

The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. The defendants are permitted to remove the case to federal district court for a determination on whether the case is preempted by the statute. If so, the district court must dismiss the case; if not, the district court must remand the case back to state court.

In an earlier opinion in the Putnam Fund cases, Judge Easterbrook found that the district court’s decision to remand the actions back to state court was appealable. This week’s opinion, Kircher v. Putnam Funds Trust, 2005 WL 757255 (7th Cir. April 5, 2005), addressed the merits of that remand decision. In particular, Judge Easterbrook grappled with the question that has confronted the Second and Third Circuits recently: what is the scope of SLUSA’s “in connection with the purchase or sale of securities” requirement?

In contrast to the Second Circuit, the Seventh Circuit found that SLUSA preemption is not limited to actions where the plaintiffs are purchasers or sellers of securities. One of the complaints filed in the Putnam Fund cases defined its class as “all investors who held the fund’s securities during a defined period and neither purchased or sold shares during that period.” The court held that the “in connection with” language in SLUSA merely “ensures that the fraud occurs in securities transactions rather than some other activity.” Although private actions under Rule 10b-5 (from which SLUSA adopted the “in connection with” requirement) can only be brought by purchasers or sellers, it “would be more than a little strange” if this judicially-created limitation on private actions “became the opening by which that very litigation could be pursued under state law, despite the judgment of Congress (reflected in SLUSA) that securities class actions must proceed under federal securities laws or not at all.” Accordingly, the complaint was subject to dismissal under SLUSA.

Holding: Cases remanded with instructions to undo the remand orders and dismiss plaintiffs’ state-law claims.

Quote of note: “[M]ost of the approximately 200 suits filed against mutual funds in the last two years alleging that the home-exchange-valuation rule can be exploited by arbitrageurs have been filed in federal court under Rule 10b-5. Our plaintiffs’ effort to define non-purchaser-non-seller classes is designed to evade PSLRA in order to litigate a securities class action in state court in the hope that a local judge or jury may produce an idiosyncratic award. It is the very sort of maneuver that SLUSA is designed to prevent.”

Two appellate decisions from earlier this year that are worth noting:

(1) In Barrie v. Intervoice-Brite, Inc., 2005 WL 57928 (5th Cir. Jan. 12, 2005), the Fifth Circuit considered a securities fraud claim based on revenue recognition issues at a software company. The defendants argued that a charge the company took against its revenues was caused by the SEC’s issuance of new revenue recognition guidance. To counter this argument, the plaintiffs apparently attached a sworn expert analysis to their amended complaint stating that “Intervoice’s reversal of revenue in the first quarter fiscal 2001 was not a result of SAB 101, but rather was required because Intervoice’s prior revenue recognition practice did not comply with GAAP, specifically SOP 97-2.” The Fifth Circuit reversed the dismissal of the revenue recognition claims, finding that the “accounting questions in this case are disputed” and that plaintiffs’ position “was adequately supported by expert opinion.”

(2) In In re Daou Systems, Inc. Sec. Litig., 2005 WL 237645 (9th Cir. Feb. 2, 2005), the Ninth Circuit clarified its position on confidential witnesses (by adopting the pleading standard used in the First and Second Circuits) and muddied its position on loss causation.

Confidential witnesses – The court held that “[n]aming sources is unnecessary so long as the sources are described ‘with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged’ and the complaint contained ‘adequate corroborating details.'”

Loss causation – The court found that “if the improper accounting did not lead to the decrease in Daou’s stock price, plaintiffs’ reliance on the improper accounting in acquiring the stock would not be sufficiently linked to their damages.” This position is the exact opposite of the one adopted by the Ninth Circuit in the Dura case and recently reviewed by the U.S. Supreme Court. Curious.

Although the U.S. Court of Appeals for the Fourth Circuit established its pleading standards for scienter (i.e., fraudulent intent) in securities fraud cases over a year ago, it has not had a subsequent opportunity to apply these standards. Moreover, the Hanger Orthopedic decision did not address the common scienter allegations of insider stock sales and violations of generally accepted accounting principles (“GAAP”).

The Fourth Circuit’s decision in In re PEC Solutions, Inc. Sec. Litig., 2005 WL 646070 (March 18, 2005), although unpublished, offers some guidance on how the court will evaluate the existence of a “strong inference” of scienter as required under the PSLRA. In PEC Solutions, plaintiffs alleged that scienter was demonstrated by, among other things, the stock trading of the individual defendants and a failure of the company to take a reserve against non-payment of a contract in violation of GAAP.

As to the stock sales, the court found that they were “nearly de minimus” given that the individual defendants only sold between 1.17% and 13% of their holdings during the class period. Moreover, the individual defendants exercised stock options during the class period, but did not sell the underlying stock, and actually lost hundreds of millions of dollars in stock value due to the price drop. The court concluded that “[i]f this all give rise to a ‘strong inference’ of anything, it is that no scienter exists.”

Turning to the alleged GAAP violation, the court noted that “it is certainly possible that some egregious GAAP violations may help support an inference of scienter for pleading purposes.” The supposed lack of a reserve, however, added “nothing new” to the scienter allegations because the complaint had failed to plead facts establishing that PEC believed it would not be paid for its work.

Holding: Dismissal affirmed.

Quote of note: “”But this alleged GAAP violation adds nothing new; rather it simply rides around in circles on the inadequate coattails of the scienter pleading. For if PEC was to take a reserve only when it believed non-payment was ‘probable’ . . . and that ‘the amount of the loss can be reasonably estimated,’ we are brought back to Appellants’ previous problem that they have not pled facts that give rise to a strong inference that PEC ever believed it would not get paid by Pearson while making the public statements that the [Complaint] challenges.”

Disclosure: The author of The 10b-5 Daily argued the case before the appellate court on behalf of the defendants. Note that the case has also received some attention for the results of the court’s spell-checking.

It may have been too much to expect that the U.S. Supreme Court would grant cert in two securities litigation cases within the span of a year. Having just addressed the issue of loss causation, the court has passed on the opportunity to interpret the PSLRA’s safe harbor for forward-looking statements.

The PSLRA created the safe harbor to encourage companies to provide investors with information about future plans and prospects. Under the first prong of the safe harbor, a defendant is not liable with respect to any forward-looking statement if it is identified as forward-looking and is accompanied by “meaningful cautionary statements” that alert investors to the factors that could cause actual results to differ.

As discussed in a post in The 10b-5 Daily from last August, entitled “The Safe Harbor May Just Be A Safe Puddle,” the U.S. Court of Appeals for the Seventh Circuit has weakened the protection afforded by the safe harbor. In Asher v. Baxter Int’l, the court found that it may be impossible, on a motion to dismiss, to determine whether a company’s cautionary statements are “meaningful.” Prior to this decision, however, numerous courts had dismissed cases pursuant to the first prong of the safe harbor. The defendants petitioned for a writ of certiorari to the Supreme Court to address the circuit split.

On Monday, however, the Supreme Court denied the cert petition. The Chicago Tribune has an article on the decision.

Quote of note: “Numerous business groups filed legal briefs in support of Baxter with the Supreme Court urging review of the case. The Business Roundtable, in its brief, argued that the 7th Circuit decision could affect how public companies across the country handle disclosures. ‘The ramifications of the decision below could be enormous,’ it wrote, adding that companies ‘may choose to avoid making forward-looking disclosures rather than risk lawsuits like this one.'”

Section 11 of the ’33 Act creates civil liability for misstatements in a registration statement. The class of persons who can sue under the statute, however, is limited to those who purchased shares issued pursuant to the registration statement in question. To have standing, an investor must have either acquired his shares in the offering or, if he purchased them in the aftermarket, be able to “trace” them back to the offering. As a general matter, the later introduction of non-offering shares into the market (e.g., via the sale of shares by insiders) generally defeats the ability of subsequent investors to trace their shares back to the offering because the intermingling of the shares makes it virtually impossible to establish that the purchased shares are offering shares.

In Krim v. pcOrder.com, 2005 WL 469618 (5th Cir. March 1, 2005), the plaintiffs tried a statistical approach to solving the problem of aftermarket standing for Section 11 claims. Although the plaintiffs conceded that they could not demonstrate that their shares were issued pursuant to the registration statement, they asserted the existence of standing based on expert testimony indicating that given the number of shares they owned and the percentage of offering stock in the market, the probability that they owned at least one share of offering stock was nearly 100%. The court rejected this statistical tracing theory, finding that “Congress conferred standing on those who actually purchased the tainted stock, not on the whole class of those who possibly purchased tainted shares – or, to put it another way, are at risk of having purchased tainted shares.”

Holding: Dismissal affirmed.

Quote of note: “The fallacy of Appellants position is demonstrated with the following analogy. Taking a United States resident at random, there is a 99.83% chance that she will be from somewhere other than Wyoming. Does this high statistical likelihood alone, assuming for whatever reason there is no other information available, mean that she can avail herself of diversity jurisdiction in a suit against a Wyoming resident? Surely not.”

The litigation arising out of the “research analyst” scandals (where major investment banks have been accused of disseminating overly optimistic research and investment recommendations to garner investment banking business) continues to raise interesting legal issues. Both the Second and Third Circuits, for example, have recently addressed whether the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) mandates the dismissal of class actions based upon state law seeking to recover various types of damages related to the allegedly biased research.

SLUSA preempts certain class actions based upon state law that allege a misrepresentation in connection with the purchase or sale of nationally traded securities. In Dabit v. Merrill Lynch, 2005 WL 44434 (2d Cir. Jan. 11, 2005), the Second Circuit addressed two state class actions (brought on behalf of Merrill Lynch brokers and brokerage customers respectively) alleging losses based on biased research. In both cases, the plaintiffs generally did not dispute that the lawsuits were “covered class actions” and concerned “covered securities.” The issue was whether Merrill Lynch’s alleged misrepresentations were “in connection with the purchase or sale” of those securities. The court held that to be prohibited under SLUSA “an action must allege a purchase or sale of covered securities made by the plaintiff or members of the alleged class.” As for the brokers, the court found that the proposed class of brokers who were injured by holding the recommended stocks included purchasers and therefore, in part, satisfied the “in connection with requirement.” Because the court could not “distinguish any non-preempted subclass, SLUSA requires that the claim be dismissed.” A separate claim regarding commissions lost by the brokers when their customers left Merrill Lynch due to the scandal, however, was allowed to proceed in state court.

The brokerage customers also received a mixed decision. The Second Circuit followed a number of other circuits in finding that the claims based on commissions paid to Merrill Lynch in reliance on the research were “preempted because they necessarily involve allegations of a purchase or sale ‘in connection with’ this alleged misconduct.” In contrast, the claims related to the annual fees paid by the customers were not preempted because the fees were “paid whether or not the customer transacts in the account, and the misrepresentations inherent in the alleged nonperformance and statutory violations therefore do not necessarily ‘coincide with’ a securities transaction.”

Last week, the Third Circuit addressed the same issues and came to similar conclusions. In Rowinski v. Salomon Smith Barney, Inc., 2005 WL 356810 (3rd Cir. Feb. 16, 2005) a putative class of Salomon brokerage customers brought a class action in Pennsylvania state court alleging that the company’s dissemination of biased investment research breached the parties’ service contract, unjustly enriched Salomon, and violated state consumer protection law. The plaintiffs sought “an amount equal to the amount of any and all fees and charges collected” from the class by Salomon. The court held that the “in connection with the purchase or sale” requirement under SLUSA must, as it is in the context of Rule 10b-5 actions, be broadly interpreted. Looking at a number of factors, including whether the fraudulent scheme coincided with the purchase or sale of securities and whether the nature of the parties’ relationship was such that it necessarily involved the purchase or sale of securities, the court found that the class action fell “well within the bounds of SLUSA” and upheld its dismissal.

Quote of note (Rowinski): “Plaintiff also contends that as master of his own complaint, he is entitled to plead around SLUSA. But SLUSA stands as an express exception to the well-pleaded complaint rule, and its preemptive force cannot be circumvented by artful drafting. In this context – where Congress had expressly preempted a particular class of state law claims – the question is not whether a plaintiff pleads or omits certain key words or legal theories, but rather whether a reasonable reading of the complaint evidences allegations of ‘a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.’”

Under the PSLRA, plaintiffs must plead facts creating a strong inference that the defendants acted with scienter (i.e., fraudulent intent) to survive a motion to dismiss. Several courts have found that the sheer size of an alleged financial fraud can support a finding of fraudulent intent. In a recent decision, however, the U.S. Court of Appeals for the Sixth Circuit has disagreed.

In Fidel v. Farley, 2004 WL 2901274 (6th Cir. Dec. 16, 2004), the plaintiffs argued that the magnitude of the financial fraud allegedly perpetrated by Fruit of the Loom, including a write-down of over $220 million of inventory in 1999, supported an inference that the company’s auditors had acted with scienter. The court found that “[a]llowing an inference of scienter based on the magnitude of fraud ‘would eviscerate the principle that accounting errors alone cannot justify a finding of scienter.'” Moreover, the fact that Fruit of the Loom took the write-offs in 1999, “in no way implied that [the auditors] acted with scienter while auditing the 1998 financial data.”

Holding: Dismissal affirmed.

Did The 10b-5 Daily’s summary of the Dura Pharmaceuticals v. Broudo oral argument get it right? Here’s a chance to find out: the U.S. Supreme Court has posted the transcript. Thanks to Richard Zelichov for pointing out the link.

The general theme of the research analyst cases is straightforward: the defendants allegedly committed fraud by disseminating research reports that they knew to be overly optimistic. A key question, however, has been whether the subsequent decline in the company’s stock price was caused by the research reports. In an important decision, the U.S. Court of Appeals for the Second Circuit has affirmed the dismissal of two research analyst cases based on the plaintiffs’ failure to adequately plead loss causation.

The appeal was from Judge Pollack’s seminal decision in June 2003 dismissing the securities class actions brought against Merrill Lynch based on allegedly biased research reports concerning 24/7 Real Media, Inc. and Interliant, Inc. Judge Pollack found that the plaintiffs had failed to adequately allege loss causation because there was no alleged connection between the analyst reports and the companies’ financial troubles or the collapse of the overall market. (See this post, among others, for a discussion of the decision.)

In Lentell v. Merrill Lynch & Co., 2005 WL 107044 (2d Cir. Jan. 20, 2005), the Second Circuit affirmed Judge Pollack’s ruling. The court held that to establish loss causation, a plaintiff must allege that the subject of the misrepresentation was the cause of the actual loss suffered. In other words, the misrepresentation must have “concealed something from the market that, when disclosed, negatively affected the value of the security.” In these cases, however, the court found there was “no allegation that the market reacted negatively to a corrective disclosure regarding the falsity of Merrill’s ‘buy’ and ‘accumulate’ recommendations and no allegation that Merrill misstated or omitted risks that did lead to the loss.” Accordingly, the plaintiffs failed to adequately plead loss causation.

The Second Circuit’s decision would appear to have two potential impacts. First, it will make it difficult for the numerous other research analyst cases to go forward. The plaintiffs will need to adequately allege that either: (1) the disclosure of the false recommendations caused a stock price decline; or (2) the recommendations concealed risks about the stocks that later lead to a loss. Certain complaints, however, may satisfy these requirements (see the roundup of cases in this post). Second, the decision could affect the Supreme Court’s pending ruling in the Dura loss causation case. Although the Second Circuit does not alter its previous position on loss causation (rejecting the price inflation theory), the case illustrates the serious impact that loss causation standards can have on securities fraud litigation.

Quote of note: “We are told that Merrill’s ‘buy’ and ‘accumulate’ recommendations were false and misleading, and that the Firm failed to disclose conflicts of interest, salary arrangements, and collusive agreements among analysts, bankers, and 24/7 Media and Interliant. But plaintiffs nowhere explain how or to what extent those misrepresentations and omissions concealed the risk of a significant devaluation of 24/7 Media and Interliant securities. The reports indicate that 24/7 Media and Interliant were high-risk investments, a designation that specifies, inter alia, a ‘high potential for price volatility,’ and ‘no proven track record of earnings.’ And the unchallenged financial analyses presented (e.g., negative EPS ratios and consistent quarterly losses) certainly indicate weakness.”

Addition: The New York Law Journal has an article (via law.com – free regist. req’d) on the decision. Thanks to all of the The 10b-5 Daily’s readers who sent in the opinion.