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Securities fraud defendants will be heartened by a recent decision which makes it clear that a purchase-time value disparity allegation suffices only to establish transaction causation and that, instead, a plaintiff must plead a causal connection between alleged misstatements and the harm actually suffered. In Emergent Capital Investment Mgmt., LLC v. Stonepath Group, Inc., 2003 WL 22053957 (2d Cir. Sept. 4, 2003), the 2nd U.S. Circuit Court of Appeals clarified its prior holding in Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87 (2d Cir. 2001), which had suggested that loss causation could be pleaded with an allegation merely that the stock price was inflated at the time of purchase due to an alleged misrepresentation or omission. Emergent Capital concerned a private purchase by Emergent, an investment fund manager, of the stock of Net Value Holdings, a holding company that invested in Internet-based businesses. NETV’s chairman and chief executive officer was defendant Andrew Panzo. Following a personal solicitation by Panzo and another NETV officer, Emergent made a $2 million investment in the preferred stock of NETV pursuant to a stock purchase agreement. In its second amended complaint, Emergent complained of alleged oral misrepresentations concerning the size of NETV’s largest investment asset (Brightstreet) and of omissions to disclose facts about Panzo’s history of failed investment projects undertaken with Howard Appel, an individual who had been barred from the securities industry by the National Association of Securities Dealers and who effectively controlled NETV through affiliated individuals and entities. Panzo had a long history of collaborating with Appel in various investment projects, all of which involved the use of affiliated companies and complex corporate legal maneuvers to enable Appel to control and profit from companies that were nominally headed by Panzo. Appel and Panzo would sell large quantities of securities at relatively high prices, and the companies’ stock would later become worthless. The plaintiff alleged that these other Panzo-Appel ventures were “pump and dump” schemes and implied that NETV, too, was such a scheme. Within months after Emergent invested, NETV’s stock price declined precipitously. The District Court found sufficient allegations of loss causation with respect to both the misrepresentations concerning the Brightstreet investment and the failure to disclose information about Appel. Emergent Capital Investment Mgmt. LLC v. Stonepath Group, Inc., 195 F. Supp. 2d 551 (SDNY 2002). The court cited the two losses identified in Suez Equity: (1) the plaintiff’s loss at the time of purchase, due to the decreased “investment quality” of the stock; and (2) the eventual loss due to the group’s financial failure. The court concluded that, although Emergent had failed to allege facts to show the latter loss, it did make allegations sufficient for the former because the failure to disclose the Appel relationship and investment history created a disparity between the purchase price and the real value of the stock at that time. Nonetheless, the court dismissed the second amended complaint on the ground that Emergent could not establish reasonable reliance on the alleged misrepresentations and omissions because it had negotiated a detailed purchase agreement containing certain representations (not including those relating to the Brightstreet allegations) and a disclaimer by Emergent of reliance on any other representations. The 2nd Circuit agreed with the lower court’s conclusion as to the Brightstreet misrepresentations, observing that Emergent could have protected itself by insisting on having those representations included among the representations in the stock purchase agreement, and, given the size of the transaction and Emergent’s sophistication, its failure to do so precluded reasonable reliance as a matter of law. That reasoning did not apply to the omitted facts about Appel: since Emergent had no notice of the omitted facts, it could not have protected itself by insisting on contractual representations. Thus, it was necessary to determine whether the causation allegations were legally sufficient. Turning to the loss causation question, the court decided that, although it was a close question, the complaint did allege the required connection between the plaintiff’s economic loss and the defendants’ alleged omissions. Reading the allegations favorably to the plaintiff, the court found the complaint suggested that “the decline in NETV’s stock value was brought about by the same forces that caused the failures of the other Panzo-Appel ventures,” which were allegedly “pump and dump” schemes. CLARIFYING ‘SUEZ EQUITY’ Since both Emergent and the District Court had read Suez Equity to mean that alleging a disparity in investment value at the time of purchase could satisfy the loss causation pleading requirement, the 2nd Circuit took the opportunity to explain how that view misinterpreted Suez Equity. The court explained that a purchase-time value disparity allegation suffices only to establish transaction causation: By claiming that it incorrectly appraised the value of the securities and purchased them at an inflated price, Emergent alleged only that, had it known the omitted facts, it would not have agreed to buy the stock at the offering price, which is merely a paraphrased allegation of transaction causation. “While it may explain why plaintiff purchased NETV’s stock, it does not explain why it lost money on the purchase, the very question that the loss causation allegation must answer.” In Suez Equity, the plaintiffs had not merely alleged a disparity between the price paid and the securities’ true value at the time of purchase; rather they asserted a causal connection between the concealed information about the executive’s history [which suggested an inability to manage finances] and the ultimate failure of the venture following a liquidity crisis. The court acknowledged that in Suez Equity it had referred to a disparity between transaction price and true investment quality at the time of purchase and had said that the plaintiffs had “suffered a loss at the time of purchase since the value of the securities was less than that represented by defendants.” However the court went on to explain, “[w]e did not mean to suggest in Suez Equity that a purchase-time loss allegation alone could satisfy the loss causation pleading requirement.” In Suez Equity, that allegation did not stand alone but was accompanied by an allegation that the executive’s concealed lack of managerial ability induced the company’s failure, and the case was distinguished from one where the ultimate decline in the stock price was unrelated to the concealed negative history. The court concluded: “[we] do not think Suez Equity undermined our established requirement that securities fraud plaintiffs demonstrate a causal connection between the content of the alleged misstatements or omissions and ‘the harm actually suffered.’” DIFFERING CIRCUIT STANDARDS Whether Emergent Capital merely clarified, or actually altered, the 2nd Circuit’s standard for pleading loss causation is a debatable point. Either way, the 2nd Circuit has now plainly ruled that purchase-time price inflation is not enough and the plaintiff must in all cases plead a causal link between the complained-of omissions and the economic loss that was ultimately suffered. This ruling may contribute to a conflict among the circuits that may ultimately need to be addressed by the Supreme Court. In rejecting the sufficiency of price inflation for loss causation, the 2nd Circuit has joined the more stringent view of the 3rd and 11th circuits, which contrasts with the more lenient standard of the 8th and 9th circuits. The 9th Circuit has adopted, and recently reaffirmed, the theory that price inflation suffices to plead loss causation. See Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. 2003), and Knapp v. Ernst & Whinney, 90 F.3d 1431 (9th Cir. 1996). The 8th Circuit has seemingly taken the view that the loss causation pleading burden is not very stringent and causation may be presumed if there is a pleading of price inflation caused by misrepresentations. See Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824 (8th Cir. 2003), and In re Control Data Corp. Sec. Litig., 933 F.2d 616 (8th Cir. 1991). In contrast, the 11th Circuit has firmly rejected such a presumption, holding that the loss causation requirement is not satisfied merely by a showing of price inflation; rather, there must be proof of a causal connection between the misrepresentation and the investment’s subsequent decline in value. Robbins v. Koger Properties, Inc., 116 F.3d 1441 (11th Cir. 1997). And the 3rd Circuit, in a decision similar to the 2nd Circuit’s in Emergent Capital, issued an opinion in 2000 that clarified its prior holdings. In Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000), the 3rd Circuit made clear that, although its prior precedents had suggested that loss causation is adequately pleaded by alleging that the misrepresentation caused the purchase price to be inflated, those decisions all assumed “that the artificial inflation was actually ‘lost’ due to the alleged fraud. Where the value of the security does not actually decline as a result of an alleged misrepresentation, it cannot be said that there is in fact an economic loss attributable to that misrepresentation.” Therefore the “investor must also establish that the alleged misrepresentations proximately caused the decline in the security’s value to satisfy the element of loss causation.” In many cases, it may be that the same omission or misrepresentation that allegedly caused price inflation at the time of the transaction in fact also caused a subsequent decline in the securities’ market value when the misrepresentation becomes apparent or the undisclosed problem wreaks injury. But the lesson of Emergent Capital (and Semerenko in the 3rd Circuit) is that such a causal link cannot be presumed; it must be pleaded and proved. This clarification should be effective in weeding out cases where the causal link cannot be proved, since plaintiffs will now need to plead facts demonstrating a direct causal link between the alleged misrepresentation or omission and the economic loss suffered. Sarah S. Gold and Leon P. Gold authors are partners at Proskauer Rose (www.proskauer.com) of New York. Karen Clarke, an associate at the firm, assisted in the preparation of this article. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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