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If an investor’s purchase of stock was prompted by a fraud and that stock later crashes and burns, the investor has a claim under � 10(b) of the Securities Exchange Act, right? Actually, the answer at the moment is “maybe.” The U.S. Supreme Court, however, will have the opportunity to address which losses are compensable under the securities laws in deciding Dura Pharmaceuticals Inc. v. Broudo, 124 S. Ct. 2904 (2004). To prevail in a claim of securities fraud under � 10(b), a plaintiff has the burden of showing, among other things, that the defendant’s misrepresentation or omission “caused the loss for which the plaintiff seeks to recover damages.” 15 U.S.C. 78u-4(b)(4). At issue in Dura Pharmaceuticals is whether “a securities fraud plaintiff invoking the fraud-on-the-market theory must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the investment’s subsequent decline in price.” Dura Pharmaceuticals Inc. v. Broudo, No. 03-932, 2004 WL 2075752, at 1 (U.S. 2004) (Brief for Petitioners). The 2d U.S. Circuit Court of Appeals recently had an opportunity to weigh in on the debate in deciding Lentell v. Merrill Lynch & Co., No. 03-7948, 2005 WL 107044 (2d Cir. Jan. 20, 2005). In Lentell, the plaintiff investors alleged that Merrill Lynch published false and misleading research and investment recommendations concerning publicly traded Internet companies. According to the plaintiffs, Merrill Lynch analysts issued positive reports that they did not truly believe to “drive . . . up the market prices of [those] companies” and cultivate Merrill Lynch’s investment banking clients. Id. at 2. The consolidated complaints challenged approximately 80 reports issued during a combined class period of May 12, 1999, through Feb. 20, 2001. In granting the defendants’ motion to dismiss, the district court held that the plaintiffs had failed to plead that Merrill Lynch’s misstatements and omissions in the analyst reports caused their investment losses. The 2d Circuit affirmed that ruling, noting that, although the plaintiffs alleged that the recommendations artificially inflated the value of the stocks at issue, the plaintiffs did not allege that the false recommendations, or any corrective disclosure regarding the falsity of the recommendations, were the cause of the decline in value of the stock that the plaintiffs claimed as their loss. Id. at 12. The court held that “the complaints must allege facts that support an inference that Merrill’s misstatements and omissions concealed the circumstances that bear upon the loss suffered such that plaintiffs would have been spared all or an ascertainable portion of that loss absent the fraud,” and that, because they failed to do so, were subject to dismissal. Id. The 2d Circuit, thus, sided with the defense bar’s view on the standard for loss causation. Of course, the Supreme Court will have the last word on loss causation when it decides Dura Pharmaceuticals. The plaintiff investors in that case alleged misstatements made by Dura, a pharmaceutical development and marketing company, and others regarding the development of a delivery device for asthma medication. Throughout 1997, Dura made several statements reporting the progress of this device. On Feb. 24, 1998, Dura announced a revenue shortfall. Following this announcement, the company’s stock price dropped. In November 1998, Dura announced that the Food and Drug Administration (FDA) had not approved the device. The plaintiffs, a class of investors who purchased shares of Dura’s securities between April 15, 1997 and Feb. 24, 1998, alleged that the defendants violated � 10(b) by making false statements and omissions concerning the device. Moving to dismiss, the defendants argued that the plaintiffs had not properly pleaded loss causation because the complaint did not contain any allegations that there was a relationship between the FDA’s rejection of the device in November 1998 and the decline in the stock price that occurred nine months earlier. The 9th Circuit, however, held that the plaintiffs had satisfied the loss causation element by pleading that the price at the time of purchase was inflated due to misrepresentations. Broudo v. Dura Pharmaceuticals Inc., 339 F.3d 933, 939 (9th Cir. 2003). The 9th Circuit’s view is at odds with the standard applied by other circuits. The Supreme Court’s decision in the Dura Pharmaceuticals case should settle this conflict by establishing whether loss causation may be sufficiently alleged when the plaintiff identifies a material misrepresentation as the cause of inflation in stock price or whether the plaintiff must plead a nexus between stock price drop and statements that are “corrective” of a prior alleged misstatement or omission. What is loss causation? Section 10(b) of the Exchange Act prohibits fraudulent conduct “in connection with the purchase or sale of any security.” Id. � 78j(b). To succeed on a claim under this section, a plaintiff must establish (1) that the defendant made a false statement or omission of material fact (2) with scienter (3) upon which the plaintiff justifiably relied that (4) proximately caused the plaintiff’s injury. See, e.g., Robbins v. Koger Props. Inc., 116 F.3d 1441, 1447 (11th Cir. 1997). With respect to the fourth element, the plaintiff has the burden of showing that the misrepresentation made by the defendant “caused the loss for which the plaintiff seeks to recover damages.” 15 U.S.C. 78u-4(b)(4). To satisfy the causation element, the plaintiff must establish both transaction causation and loss causation. See, e.g., Bruschi v. Brown, 876 F.2d 1526, 1530 (11th Cir. 1989). Transaction causation is akin to the common law fraud element of reliance. Transaction causation requires a showing that the defendant’s misrepresentations caused the plaintiff to make the investment. See, e.g., id. In a securities fraud class action alleging damages on behalf of a class based on the defendant’s misstatements, a plaintiff can attempt to invoke the “fraud-on-the-market” presumption to establish transaction causation. Under the fraud-on-the-market presumption, when the market for a particular stock is shown to be sufficiently efficient, the effects of a defendant’s statement are presumed to be reflected in the stock price, entitling the plaintiff to a presumption that he relied on the integrity of the marketplace as reflecting all material information about a company. Basic v. Levinson, 485 U.S. 224, 247 (1988). When applicable, this theory relieves a class of the need to establish specific reliance by each class member individually. A similar presumption is employed for alleged omissions of material fact. See Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1972). To establish loss causation, the plaintiff must show that the misrepresentation was “in some reasonably direct, or proximate, way responsible for his loss.” Bruschi, 876 F.2d at 1530. The loss causation inquiry examines “how directly the subject of the fraudulent statement caused the loss, and whether the resulting loss was a foreseeable outcome of the fraudulent statement.” Suez Equity Investors L.P. v. The Toronto-Dominion Bank, 250 F.3d 87, 96 (2d Cir. 2001). The loss causation element is intended to ensure that investors recover only for losses caused by fraud and not by other events. It is useful to consider an example. Suppose the stock of New Age Radio, a publicly traded satellite radio company, soars on the announcement that it has signed Smutty Sam, a “shock jock,” to a five-year contract commencing in 2007. Four months later, the stock price plummets 25% when New Age’s founder and chief executive officer announces that he has just been diagnosed with a fatal disease. One month later, the stock falls another 2% when it is disclosed that Smutty Sam never signed the contract. Would plaintiffs have a claim for that first drop in stock price? Not under the defendants’ proposed rule because that stock price drop could not be linked to the disclosure of any alleged fraud. The standard for pleading loss causation had not been litigated extensively until the passage of the Private Securities Litigation Reform Act in 1995, 15 U.S.C. 78u-4. Congress passed the Reform Act to discourage meritless lawsuits, such as those in which plaintiffs seek to recover the decline in the value of their securities despite the fact that it was not caused by the defendant’s acts or omissions. See H.R. Conf. Rep. No. 104-369, at 32 (1995). Among other things, the Reform Act codified the requirement that the misrepresentation at issue “caused the loss for which the plaintiff seeks to recover damages” and established fairly stringent pleading requirements for claims of securities fraud. 15 U.S.C. 78u-4(b)(4). The 9th Circuit’s ruling The 9th Circuit’s decision in Dura Pharmaceuticals reaffirmed its prior precedent establishing a low pleading standard for the loss causation element in securities fraud cases. According to the 9th Circuit’s longstanding view, “plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation.” See, e.g., Knapp v. Ernst & Whinney, 90 F.3d 1431, 1438 (9th Cir. 1996). The 8th Circuit also accepts the presumption of loss causation in a fraud-on-the-market case. See Gebhardt v. Conagra Foods Inc., 335 F.3d 824, 831 (8th Cir. 2003). Although the 9th Circuit states that “loss causation does not require pleading a stock price drop following a corrective disclosure,” other circuits have imposed such requirements on plaintiffs. See, e.g., Emergent Capital Inv. Mgmt. LLC v. Stonepath Group Inc., 343 F.3d 189, 198-99 (2d Cir. 2003); Semerenko v. Cendant Corp., 223 F.3d 165, 184-87 (3d Cir. 2000); Robbins, 116 F.3d at 1447-49; Bastian v. Petren Res. Corp., 892 F.2d 680, 684-86 (7th Cir. 1990). In Bastian, for example, the 7th Circuit stated as follows: ” ‘Loss causation’ is an exotic name-perhaps an unhappy one . . . -for the standard rule of tort law that the plaintiff must allege and prove that, but for the defendant’s wrongdoing, the plaintiff would not have incurred the harm of which he complains . . . .Defrauders are a bad lot and should be punished, but Rule 10b-5 does not make them insurers against national economic calamities. If the defendants’ oil and gas ventures failed not because of the personal shortcomings that the defendants concealed but because of industry-wide phenomena that destroyed all or most such ventures, then the plaintiffs, given their demonstrated desire to invest in such ventures, lost nothing by reason of the defendants’ fraud and have no claim to damages.” Id. at 685. Private securities litigation In Dura Pharmaceuticals, the plaintiff investors argued that being required to link corrective disclosures to a drop in stock price would be an “insurmountable” hurdle, in part because those committing fraud that inflates the stock price over its actual value can “undo” the inflation by lowering market expectations. According to the Dura plaintiffs, “Market valuations are based upon expected future cash flows discounted by the cost of capital, commonly referred to as discounted cash flows. Open-market frauds manipulate stock-market prices by artificially raising cash-flow expectations. Sophisticated individuals who would commit market manipulation and fraud are likely to be adept at concealing it. Expectations can be lowered, thereby reducing fraud-induced inflation without disclosure of the fraud, by further false statements.” See Dura Pharmaceuticals Inc. v. Broudo, No. 03-932, 2004 WL 2671450, at 10 (2004) (Respondents’ Brief). The Dura plaintiff investors’ argument suggests that, if the loss causation standard is too rigorous, the purpose underlying private securities litigation would be undermined because it would become too difficult for plaintiff investors to plead sufficient facts to meet this standard. See id. at 9-10. As to scienter, plaintiffs had a colorable argument in favor of less rigorous pleading standards-that is, until discovery commences, plaintiffs do not have access to specific facts relating to the defendants’ states of mind. (Congress, of course, rejected that argument in enacting the elevated pleading standards as to scienter). Corporate defendants would argue that there is no similar argument with respect to loss causation. Plaintiffs should have all of the required information at the time of initial complaints. Before filing a complaint, a plaintiff will know what the alleged misstatements were and whether the alleged losses were prompted by a related disclosure. The Dura investors’ argument also appears to be contrary to the provisions of the private securities litigation regulatory scheme, which was established to provide the channels by which private investors may recover the actual damages suffered as a result of securities fraud. First, as noted above, loss causation is a statutory element of a securities fraud claim. Second, under the Exchange Act, the measure of damages is clearly defined: Recovery is limited in private securities actions to investors’ actual damages. 15 U.S.C. 78u-4(e)(1). The statutory “actual damages” requirement “makes no sense unless loss causation requires that a corrective disclosure of the alleged misrepresentation or omission caused such a decline.” Brief for Petitioners, 2004 WL2075752, at 16. Further, petitioners could well argue that the more rigorous standard promotes the Reform Act’s intended effect of discouraging meritless lawsuits. As the 7th Circuit has explained “no ‘social purpose’ would be served by encouraging everyone who suffers an investment loss because of an unanticipated change in market conditions to pick through offering memoranda with a fine-tooth comb in the hope of uncovering a misrepresentation.” Bastian, 892 F.2d at 684-86. Although the respondents argue that a low loss causation standard is needed to deter fraud, that argument focuses solely on one aspect of securities law enforcement. Private rights of action are limited to cases involving actual damages, as explained above. But the government has no such limitation in its civil and criminal enforcement. The SEC does not need to prove investor reliance, loss causation or damages in an action under � 10(b) of the Exchange Act. See, e.g., SEC v. Credit Bancorp Ltd., 195 F. Supp. 2d 475, 490-91 (S.D.N.Y. 2002). Reliance, loss causation and damages are not requirements for government action because “[t]he Commission’s duty is to enforce the remedial and preventive terms of the statute in the public interest, and not merely to police those whose plain violations have already caused demonstrable loss or injury.” Berko v. SEC, 316 F.2d 137, 143 (2d Cir. 1963). In sum, the debate over when a loss is a loss recognized by the securities laws has created substantial uncertainty in the lower courts. The Dura decision should end that debate, and the result should profoundly affect the viability of scores of securities cases for years to come. Todd David is a partner, and Irene Baker is an associate, in the securities litigation group at Atlanta’s Alston & Bird.

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