Securities Fraud Damages After Dura
by Warren R. Stern and Sarah E. McCallum

On April 19, 2005, the Supreme Court handed down an important opinion about pleading and proving federal securities fraud cases. Dura Pharmaceuticals, Inc. v. Broudo holds that an inflated purchase price is not a “relevant economic loss” for purposes of a claim under Rule 10b-5.¹ The case also emphasizes the heavy burden plaintiffs bear in proving their losses, and sets a baseline requirement for pleading loss causation.

The Origins of the Case

Dura Pharmaceuticals, Inc. began in 1995 to develop a device called Albuterol Spiros, which was intended to facilitate inhalation of asthma medication. The next year, Dura started selling a respiratory antibiotic called Ceclor CD. Between April 15, 1997, and February 24, 1998, Dura made several positive public statements about the robust sales of Ceclor CD and the prospect that Albuterol Spiros would swiftly gain FDA approval.

On February 24, 1998, the company announced that it expected lower revenues and earnings per share for 1998 than previously forecast, in part because of poor Ceclor CD sales. The announcement said nothing about Albuterol Spiros. Following the announcement, Dura’s stock price plunged from $39 1/8 to $20 3/4—a 47% drop in one day. In November 1998, the company announced that Albuterol Spiros had failed to gain FDA approval.²

Michael Broudo, on behalf of all persons who purchased Dura stock between April 15, 1997, and February 24, 1998, alleged that Dura inflated the price of its stock with its public statements during that period.³ Broudo filed his putative class action in January 1999, alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The only allegation plaintiffs made about their loss was that they had “paid artificially inflated prices for Dura securities” and had suffered “damage[s]” thereby.⁴ They alleged facts showing the price decline following the February announcement about Ceclor CD but did not allege any price reaction to the November announcement about Albuterol Spiros.

The district court dismissed the complaint for failure to meet the pleading standards of the Private Securities Litigation Reform Act of 1995 (the “PSLRA”), and, following the filing of an amended complaint, dismissed the action with prejudice. The court concluded that plaintiffs had failed to plead: (1) a strong inference of scienter in connection with the alleged misrepresentations about Ceclor CD; and (2) any connection between the alleged misrepresentations about Albuterol Spiros and the 47% stock price decline following the February announcement. The court characterized the second defect as a failure to plead “loss causation.”⁵

The Ninth Circuit held that both conclusions were erroneous. As to the Albutero Spiros allegations, the court of appeals stated that no connection between the misrepresentations and the February price decline needed to be alleged: “[L]oss causation does not require pleading a stock price drop following a corrective disclosure or otherwise.”⁶ Rather, it was enough, in the Ninth Circuit’s view, to plead “that the price at the time of purchase was overstated and sufficient identification of the cause.”⁷

Supreme Court Review

The Supreme Court granted certiorari to review the loss causation point. The question was ripe for resolution because at least three other circuits had held, contrary to the Ninth, that proof of purchase-time inflation was insufficient to prove loss causation.⁸

All circuits agreed that “loss causation” is an element of a private cause of action for securities fraud under Section 10(b) and Rule 10b-5. Indeed, the PSLRA mandates that a securities fraud plaintiff “shall have the burden of proving that the act or omission of the defendant alleged to have violated” those provisions “caused the loss for which the plaintiff seeks to recover damages.”⁹ But the circuits disagreed about what constituted the relevant “loss”; the Ninth defined it as purchase-time inflation and the others as the decline in value of the stock caused by revelation of the truth behind the misrepresentation or omission.

The Supreme Court, in an opinion by Justice Breyer, resolved the split against the Ninth Circuit. In unanimously reversing that court, the Justices rejected the notion that a duped investor suffers an actual loss at the time of purchase: “[A]s 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.”¹⁰ The point is illustrated by the case of the “in-and-out” trader. An investor who purchases a security at an inflated price and then re-sells before the lie is revealed has lost nothing. At the instant of the sale, the supposed misrepresentation or omission has not been corrected, so any inflation will be recouped in the market.

Dura thus implies that the only legally relevant loss to purchasers under Rule 10b-5 is the price drop following a corrective disclosure of the lie or omission. But even that loss is not necessarily recoverable:

If the purchaser sells later after the truth makes its way into the market place, an initially inflated purchase price might mean a later loss. But that is far from inevitably so. When the purchaser subsequently resells such shares, even at a lower price, that lower 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 taken separately or together account for some or all of that lower price.¹¹

The opinion does not consider the case of the investor who still holds shares throughout the duration of the lawsuit, or that of the investor who sells at a profit following the corrective disclosure but claims he or she would have made a greater profit absent the misrepresentation or omission.

Finally, Dura holds that loss causation has to be pled; a securities fraud complaint must, at the very least, put defendants on “notice of what the relevant economic loss might be [and] what the causal connection might be between that loss and the misrepresentation.”¹² Since the Dura plaintiffs had pled nothing more than purchase-time inflation, and had not even alleged that “Dura’s share price fell significantly after the truth [about Albuterol Spiros] became known” in November 1998, their claim concerning Albuterol Spiros had to be dismissed.¹³

Significantly, Dura leaves open the possibility that plaintiffs must plead even more than a general allegation of loss causation. The Court “assume[d], at least for argument’s sake, that neither the [Federal] Rules [of Civil Procedure] nor the securities statutes impose any special further requirement in respect of the pleading of proximate causation or economic loss,”¹⁴ but did not actually consider whether that assumption was valid.

Open Questions

Dura resolves the narrow question presented: whether a Rule 10b-5 plaintiff can prove loss causation without showing that he suffered economic loss caused by revelation of the truth. The decision rejects the idea that the relevant “loss” is the artificial inflation paid at the time of purchase. But it also raises a number of questions that will have to be tackled as Dura percolates through the lower courts.

What is “economic loss”?

What exactly is the “economic loss” that entitles a Rule 10b-5 plaintiff to damages? Can price inflation ever constitute such a loss? For example, can a plaintiff who bought shares at a price inflated by fraud but sold them (after the 90-day bounceback period¹⁵ ) for more than his purchase price show an “economic loss” because his profit could have been higher? Some case law suggests that the answer is yes,¹⁶ but the Supreme Court’s rejection of the purchase-time inflation theory of loss and its statement— borrowed from the Restatement (Second) of Torts—that the “loss” is the “depreciat[ion]” in the share price may suggest otherwise.17

How is “economic loss” measured?

How is the “economic loss” measured for purposes of calculating damages? By the dollar amount of the stock price decline following disclosure? By the percentage amount of the price decline? If the former, a plaintiff who purchased stock after the misstatement but prior to a substantial, non-fraud-related price increase may receive damages disproportionate to the inflationary effect of the misstatement. If the latter, a plaintiff who purchased stock prior to a substantial, non-fraud-related price decrease may likewise be over-compensated.

Alternatively, Justice Breyer’s emphasis on eliminating causal factors unrelated to the fraud may suggest that the amount (whether measured in dollars or a percentage) of the stock price decline is merely a starting point for the damage calculation. Under this approach, the calculation ultimately would require a complex regression analysis to estimate damages recoverable for a purchase at any particular point during the period of the fraud.

What is the requisite connection between the misrepresentation and the loss?

The Court makes clear that the connection between an alleged misrepresentation and corrective disclosure must be close; it is not enough that the two “touch upon” one another. As Justice Breyer explained, “[t]o ‘touch upon’ a loss is not to cause a loss, and it is the latter that the law requires.”¹⁸

But exactly how tight must be the connection between the information that resulted in the economic loss and the information misrepresented or concealed? Must the precise information that caused the loss have existed at the time of the alleged fraud, or is it enough that the defendant was aware of or recklessly ignored an undisclosed risk that the adverse event would occur?

Justice Breyer’s rejection of the “touching upon” test for loss and his emphasis on strict proof of causation suggest that the connection between the misrepresented or concealed information and the actual event must be very tight indeed. Of particular concern for plaintiffs will be those cases in which the stock falls as a result of a general announcement of bad news and the true corrective disclosure—the one that negates the alleged misrepresentation—follows later, with little price reaction.¹⁹

How can plaintiffs satisfy the burden of proof?

How can a plaintiff sustain the burden of demonstrating that the “economic loss” was “caused” by revelation of the allegedly concealed or misrepresented information, given that a wide variety of factors may affect stock price at any point in time? Specifically, how can a plaintiff prove with requisite certainty that any particular portion of a stock drop resulted from the revelation?

The burden of proving causation has always been a problem for plaintiffs, but Dura emphasizes just how tenuous the link between the misrepresentation and the alleged loss may be, especially when a long time has passed between the misrepresentation or omission and the corrective disclosure. Justice Breyer’s comments on causation suggest that, at a minimum, statistical “event studies” are required. In light of all the “confounding events” that affect stock price in an efficient market, however, do such studies have sufficient reliability and acceptance to satisfy Daubert v. Merrell Dow Pharmaceuticals, Inc.²⁰ and permit plaintiffs to carry their burden?

What must plaintiffs plead?

Justice Breyer made clear what kind of allegation is insufficient for pleading purposes, namely, a bare allegation that the plaintiff purchased stock at a price inflated by the fraud. But what kind of allegation is required? Must the plaintiff plead not only facts showing that an economic loss followed a revelatory announcement, but also facts sufficient to raise an inference that the loss resulted from the revelation rather than from any of the myriad other causes Justice Breyer suggested?

Some Things Settled; Others Wide Open

Dura will stand as an important clarification of the elements of a private right of action under Rule 10b-5 and will do much to end the uncertainties in cases, such as those involving research analysts, that complain of purchase-inducing fraudulent activity revealed after the collapse of the affected stock. There remains, however, much work to be done to develop clear and comprehensible standards for pleading, proving, and measuring damages in securities fraud cases.

Notes

1. 125 S. Ct. 1627, 1634 (2005).

2. See Broudo v. Dura Pharm., Inc., 339 F.3d 933, 935-37 (9th Cir. 2003).

3. See id.

4. Dura, 125 S. Ct. at 1630.

5. See Broudo, 339 F.3d at 936-37.

6. Id. at 938.

7. Id. For more on the Ninth Circuit decision and the background of the case, see Pamela S. Palmer and J. Christian Word, “The Errors in the Ninth Circuit’s Loss Causation Decision,” WALL STREET LAWYER, August 2004, at 1.

8. See Lentell v. Merrill Lynch & Co., 396 F.3d 161, 174 (2d Cir. 2005) (reaffirming Emergent Capital Inv. Mgmt., LLC v. Stonepath Group, Inc., 343 F.3d 189, 198 (2d Cir. 2003)); Semerenko v. Cendant Corp., 223 F.3d 165, 184-85 (3d Cir. 2000); Robbins v. Koger Properties, Inc., 116 F.3d 1441, 1447- 48 (11th Cir. 1997). The Eighth Circuit, by contrast, had sided with the Ninth. See Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824, 831 (8th Cir. 2003) (“Paying more for something than it is worth is damaging,” and “stockholders can be damaged in ways other than seeing their stocks decline.”).

9. 15 U.S.C. § 78u-4(b)(4).

10. Dura, 125 S. Ct. at 1631 (emphasis in original).

11. Id. at 1631-32 (emphasis in original).

12. Id. at 1634.

13. Id. Plaintiffs apparently focused on inflation at the time of purchase rather than the price drop at the time of the announcement because the “bounceback” provision of the PSLRA would have limited damages if calculated on the basis of the price drop. As revealed in submissions before the Supreme Court, Dura’s stock dropped by about 20% following the November announcement (the one about Albuterol Spiros specifically), from $12 3/8 to $9 3/4. Within twelve days, though, the price rebounded to nearly $12 1/2. See Respondents’ Brief, Dura Pharm. v. Broudo, No. 03-932, 2004 WL 2671450, at *5 n.4. The mean trading price during the 90 days following the announcement was $12.96. See id. Because the 90-day mean trading price exceeded the price on the eve of disclosure, any damages based on price decline following the announcement would have been minimal at best. See 15 U.S.C. § 78u-4(e).

14. Dura, 125 S. Ct. at 1634.

15. See note 13, supra.

16. See, e.g., Rand v. Monsanto Co., 926 F.2d 596, 597 (7th Cir. 1991) (Easterbrook, J.); Goldberg v. Household Bank, F.S.B., 890 F.2d 965, 966-67 (7th Cir. 1989) (Easterbrook, J.) (“[A] firm that lies about some assets cannot defeat liability by showing that other parts of its business did better than expected, counterbalancing the loss.”); Berkowitz v. Conrail, Inc., 1997 WL 611606, at *5 n.5 (E.D.Pa. Sept. 25, 1997); Sherman v. Widder, 1994 WL 159450, at *2 (N.D. Cal. Jan 6, 1994). But see Barrows v. Forest Laboratories, Inc., 742 F.2d 54, 60 (2d Cir. 1984); see also Carlisle Ventures, Inc. v. Banco Espanol de Credito, S.A., 176 F.3d 601, 605-06 (2d Cir. 1999).

17. See Dura, 125 S. Ct. at 1633.

18. Id. at 1632 (emphasis in original).

19. See, e.g., Robbins v. Koger Properties, Inc., 116 F.3d 1441 (11th Cir. 1997).

20. 509 U.S. 579 (1993).

About the Author

Warren Stern (WRStern@wlrk.com) is a partner, and Sarah McCallum (SEMcCallum@wlrk.com) is an associate, in the Litigation Department at Wachtell, Lipton, Rosen & Katz.