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The free ride to fast riches enjoyed by securities class action attorneys in recent years appeared to hit a speed bump on Jan. 12, when the Supreme Court heard arguments in Dura Pharmaceuticals v. Broudo. The case gives the high court its first chance to explain the doctrine of loss causation in securities fraud litigation. The case is significant because it offers the Court an opportunity to curb frivolous fraud claims merely by enforcing the simple and straightforward causation requirement that Congress wrote into the Private Securities Litigation Reform Act more than a decade ago. NEW NAME, OLD PROBLEM The term loss causation is nothing more than a new name for a very old problem. Suppose an investor purchases $50 of stock in a corporation. The value of the investment later declines to $5. Some time after this decline, the corporation announces a restatement of an accounting error. The investor’s shares remain at $5. The investor sues, pointing to the sharp drop in the value of his stock and alleging that the company’s earlier accounting misstatement constituted fraud on the market. But can the plaintiff’s loss actually be attributed to the corporation’s alleged accounting fraud? In most circuits, the answer is no, and a securities fraud claim on these facts would be dismissed for a reason that any first-year law student could explain with ease: an absence of proximate causation. Whether couched in terms of the defendant’s “duty” to the plaintiff or in terms of the “foreseeability” of the particular harm as a result of the defendant’s conduct, the common law tort requirement of proximate causation sets limits on recovery as a matter of public policy. In the Private Securities Litigation Reform Act of 1995, Congress expressly adopted the then-prevailing view in the federal circuit courts that loss causation is a separate and unique element of any securities fraud claim. The PSLRA requires plaintiffs to prove that the defendant’s act or omission “caused the loss for which the plaintiff seeks to recover damages.” Congress added this requirement specifically to increase the plaintiff’s pleading burden in order to deter what legislators believed was an increasing trend in unmeritorious securities fraud claims. The 3rd, 7th, and 11th circuits have already read this simple and efficient pleading requirement to mean that the defendant’s conduct must be a proximate cause of the plaintiff’s loss. And that interpretation received a ringing endorsement from the U.S. Court of Appeals for the 2nd Circuit on Jan. 20 as the court affirmed the decision of the late Judge Milton Pollack in Lentell v. Merrill Lynch. In the Merrill Lynch case, a class of investors in once high-flying Internet startups brought suit for losses suffered after the “irrational exuberance” of the late 1990s diminished and the Internet bubble burst. Eager to find someone to blame for their losses, the plaintiffs filed suit against Merrill Lynch claiming the company deliberately issued falsely positive recommendations in its analyst reports (this despite the fact that the plaintiffs had not even seen a copy of Merrill’s reports). The 2nd Circuit rejected the plaintiffs’ construction of the loss causation requirement and held that they failed “to account for the price-volatility risk inherent in the stocks they chose to buy” or to plead any other facts showing that “it was defendant’s fraud � rather than other salient factors � that proximately caused [their] loss.” FRIVOLOUS CLAIMS The problem is that securities fraud litigation imposes an enormous toll on the economy, affecting virtually every public corporation in America at one time or another and costing businesses billions of dollars in settlements every year. Recent studies conclude that, over a five-year period, the average public corporation faces a 9 percent probability of facing at least one securities class action. Yet despite congressional efforts at reform (first in the PSLRA and then in the Securities Litigation Uniform Standards Act of 1998), the number of securities class actions has not declined. Quite the opposite, in fact, has occurred: In the first six years after the enactment of the PSLRA, the mean number of securities fraud suits rose by an astonishing 32 percent according to one law review article. Another study concluded that, since the enactment of the PSLRA, public companies face a nearly 60 percent greater chance of being sued by shareholders. And the dismissal rate of securities fraud suits between 1996 and 2003 averaged only 8.4 percent. As Rep. Anna Eshoo (D-Calif.) put it back in 1995, “Businesses in my region place themselves in one of two categories: those who have been sued for securities fraud and those that will be.” One explanation for this trend is that securities fraud class actions are fundamentally different from other types of commercial litigation: Because the amount of damages demanded can be so great, corporations confront the reality that one bad jury verdict could mean bankruptcy. That sobering prospect encourages many responsible corporate fiduciaries to forgo the adversarial process, settling even meritless suits to avoid the risk of financial oblivion. Since the PSLRA’s passage, more than 2,000 securities fraud cases have been filed in federal court, yet defendants have taken less than 1 percent to trial. So great is the pressure to settle that in 2004 one defendant agreed to settle a pending class action for $300 million even after the suit was dismissed by the trial court. The resulting drain on the American economy is substantial. In the last four years alone, securities class action settlements have exceeded $2 billion per year. LAWYER-DRIVEN MACHINATIONS? While plaintiffs attorneys have a strong financial incentive to bring even meritless suits if there’s a chance they will settle, and defendants have a strong incentive to settle them, neither has a particularly strong incentive to protect class members. Once the scope of the settlement fund is determined, defendants usually have no particular concern how that fund is allocated between shareholders and plaintiffs counsel. And with the threat of adversarial scrutiny from the defendant largely abated, plaintiffs counsel has free rein to seek (and little reason not to try to grab) as large a slice of the settlement fund as possible. The 3rd Circuit has put the problem this way: Settlement hearings frequently devolve into “pep rallies” in which no party questions the fairness of the settlement and “judges no longer have the full benefit of the adversarial process.” The result is that securities fraud class actions can end up not only harming the company but also failing to help the supposedly wronged shareholders. FROM BAD TO WORSE Given the plain meaning of the PSLRA, the legislative history, the scholarship, and the decisions of the 2nd, 3rd, 7th, and 11th circuits, Dura Pharmaceuticals v. Broudo seems like it should be an easy case for the Supreme Court. On Feb. 24, 1998, Dura announced a revenue shortfall. By the next day, shares in Dura had dropped from $39.125 to $20.75 for a one-day loss of 47 percent. More than eight months later, on Nov. 3, 1998, Dura announced for the first time that the Food and Drug Administration had declined to approve its Albuterol Spiros asthma device. Nonetheless, Dura shares fell only slightly after this announcement. Share prices initially dropped from $12.375 to $9.75, but, within 12 trading days, they had recovered to $12.438, ultimately climbing back to $14 within 90 days. A claim of fraud on the market was brought on behalf of Dura investors, who allege that Dura knew about the possibility that the FDA might not approve Albuterol Spiros in advance and failed to disclose it in Securities and Exchange Commission filings. Seeking to boost their recovery, the class action plaintiffs never alleged damages based on the brief $2.625 stock price dip after the Nov. 3 disclosure of the supposed fraud. Rather, they demanded recovery based on the much more significant Feb. 24 decline of almost $19. In other words, the plaintiffs sought damages based on a decline in share value that occurred nine months before the disclosure of the alleged fraud. The facts were as simple, and seemingly insufficient, as if the unfortunate Mrs. Palsgraf had filed suit for a headache she developed before ever leaving for the train station. The District Court agreed and dismissed the action. But the 9th Circuit saw things differently, finding the loss causation requirement satisfied where the plaintiffs “have shown that the price on the date of purchase was inflated because of the misrepresentation.” The economic implications of the 9th Circuit’s decision are staggering. Rather than holding companies liable for the damage they inflict on their shareholders as reflected by an actual market decline, the 9th Circuit’s rule permits liability to be found and damages to be awarded even when the plaintiff can point to no material market reaction to a disclosure of alleged fraud. The 9th Circuit decision would deny courts an important means for weeding out at the pleading stage lawsuits where the alleged fraud had no empirical effect on share price, and thus imposed no demonstrable harm on class members. The decision thus adds fuel to a fire in which virtually every case is settled, and only the lawyers truly win. A SKEPTICAL SUPREME COURT Accepting the request of the solicitor general, the Supreme Court granted certiorari to determine whether the 9th Circuit’s holding meets the standards established by the PSLRA. The questions posed by the justices at oral argument earlier this month suggest a fundamental disagreement with the 9th Circuit’s logic. Justice Ruth Bader Ginsburg asked: “How could you possibly hook up your loss to the news that comes out later? There is no loss until somehow the bad news comes out.” Justice David Souter commented that the plaintiffs’ argument “strikes me as an exercise in an inconsistent theory.” And Justice Sandra Day O’Connor summed up the problem: “The reason why loss causation is used is because a ‘loss’ experienced by the plaintiff is ’caused’ by the misrepresentation.” These observations demonstrate a sensitivity to the practical impact of the 9th Circuit’s decision. By allowing recovery where disclosures do not prompt any stock price decline, the lower court’s rule encourages, and in fact depends upon, a return to the use of “junk science”: Parties and courts, lacking any empirically verifiable proof of injury, will reach for a grab bag of speculative theories to estimate damages. Like Daubert v. Merrell Dow Pharmaceuticals Inc. (1993) and its progeny, the loss causation requirement arms courts with a tool to ensure that the legal system compensates fully for empirically confirmable losses, but not for phantom losses where cause-and-effect relationships have not been reliably proved and perhaps cannot be. Moreover, the 9th Circuit’s rule serves to chill investment advice and the free flow of information and the exchange of opinions critical to our capital markets. Without a requirement tying the disclosure of the alleged fraud to a timely market effect, dissatisfied investors will be encouraged to comb through the musings of television investment shows, Internet investment sites and, of course, investment banks, regardless of whether anyone actually listened to them, to find any investment advice proved mistaken by later events and then to sue for damages, claiming that the advice artificially inflated the value of the stock in question. Such dangers confirm that the 9th Circuit’s departure from the essential element of loss causation in claims for fraud is not only doctrinally inconsistent with basic common law tort pleading elements but also bad public policy. To be sure, the rising tide of meritless securities fraud claims won’t be stemmed in a single decision. The Supreme Court, however, has a unique opportunity to apply the undisputable principles of common law and the clear intent of the legislature to articulate a uniform standard for pleading securities fraud claims that will protect true investor loss due to fraud without damaging our national economy. Sometimes easy answers are the best solution to easy cases. Neil M. Gorsuch is a partner in D.C.’s Kellogg, Huber, Hansen, Todd, Evans & Figel. He is a former law clerk to Justices Byron White and Anthony Kennedy. Paul B. Matey is an associate at the firm. They filed an amicus brief in Dura Pharmaceuticals on behalf of the U.S. Chamber of Commerce.

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