The 10b-5 Daily

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.

Barred from taking discovery until after a motion to dismiss has been decided, plaintiffs frequently attempt to meet the PSLRA’s heightened pleading standards for securities fraud by citing statements from confidential sources (often former or current employees of the defendant corporation). In its seminal decision in Novak v. Kasaks, the Second Circuit found that it was not necessary to name these confidential sources “provided that they are described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.”

The Third Circuit has now weighed in on the issue. In California Public Employees’ Retirement System v. The Chubb Corp., 2004 WL 3015578 (3rd Cir. Dec. 30, 2004), the court adopted the Novak standard, but also stated that this standard requires “an examination of the detail provided by the confidential sources, the sources’ basis of knowledge, the reliability of the sources, the corrobative nature of other facts alleged, including from other sources, the coherence and plausibility of the allegations, and similar indicia.” After engaging in this rigorous examination, the court rejected most of the allegations based on confidential sources contained in the complaint. The opinion is notable for its in-depth discussion of different types of confidential sources, including former employees at various levels within Chubb’s corporate organization, and what knowledge reasonably can be imputed to them.

Holding: Dismissal affirmed.

Quote of note: “Citing to a large number of varied sources may in some instance help provide particularity, as when the accounts supplied by the sources corroborate and reinforce one another. In this case, however, the underlying prerequisite – that each source is described sufficiently to support the probability that the source possesses the information alleged – is not met with respect to the overwhelming majority of Plaintiffs’ sources. Cobbling together a litany of inadequate allegations does not render those allegations particularized in accordance with Rule 9(b) or the PSLRA.”