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The U.S. Supreme Court is set to mend a circuit split involving “loss causation,” a key ingredient in securities fraud cases. The appeal arises from Broudo v. Dura Pharmaceuticals, in which the 9th U.S. Circuit Court of Appeals held that injured shareholders need to show that the defendant concealed damaging information and artificially inflated its stock price, regardless of whether the fall in price was a result of the disclosure of the company’s true financial standing. Other circuits apply a different standard, under which plaintiffs must show that their losses arose when a misrepresentation was revealed. The difference between the standards is often subtle, because most cases applying the 9th Circuit or competing standard arise from a similar scenario. A company announces that a promising technology has failed, and its stock drops. Plaintiffs sue claiming the company lied about its fortunes. The difference between the circuits comes in the level of proof they demand from plaintiffs. The 9th Circuit applies a standard less strict than its sister courts. The Supreme Court’s decision could have a profound impact on the 190 or so loss causation cases filed each year, particularly at the pleadings stage where plaintiffs’ face a heavy burden of proof. THE BACKGROUND The case centered on an asthma drug device that San Diego, Calif.’s Dura Pharmaceuticals, now part of Dublin-based Elan Corp., promoted in a financial press release in April 15, 1997. On Feb. 24, 1998, Dura reported poor earnings. Its stock dropped from $53 to $20.75 a share in one day. Nine months later, it announced for the first time that the U.S. Food and Drug Administration had rejected its once promising asthma drug device, Albuterol Spiros. The stock dropped again but soon climbed to original levels. Plaintiffs’ lawyers cried foul, arguing that Dura concealed information about the rejected drug device. They filed a class action suit and set the class period — the time span in which shareholders bought shares of Dura — between April 15 and Feb. 24 of that year. The lower court agreed with defendants that because Dura’s February announcement did not mention Albuterol Spiros, plaintiffs could not argue that the stock’s decline had any connection to the drug device’s rejection by federal authorities. The 9th Circuit overturned the dismissal. Plaintiffs must prove two elements of causation in a securities fraud case, said the court. They must first show that defendants’ violations caused them to purchase the stock and also prove loss causation — that the misrepresentation caused the harm. The appellate panel held that plaintiffs could “establish loss causation if they have shown that the price on the date of the purchase was inflated because of the misrepresentation.” It is unnecessary for “a disclosure and subsequent drop in the market price of the stock [to] have actually occurred because the injury occurs at the time of the transaction.” Damages are thereby measured at the time of the purchase, the court continued. This theory rests upon the belief that “fraudulent information disseminated on an efficient market leads to an artificially inflated price of the stock … loss causation exists because plaintiffs would not have purchased the stock if they had known it was falsely inflated or because they paid too much for it,” David Brodsky of Latham & Watkins wrote in a column for the New York Law Journal last October. THE SPLIT Not every court agreed with the 9th Circuit’s position. The 3rd and 11th circuits followed an alternative approach requiring evidence of a corrective disclosure followed by a drop in the stock. A 2003 decision in the Southern District of New York by Judge Milton Pollack also used this approach. But the 8th Circuit is in agreement with the 9th, according to Brodsky. To add to the mix, the Securities and Exchange Commission and Department of Justice filed an amicus brief asking the Supreme Court to reject the 9th Circuit. In its brief, the government argued that the 9th Circuit’s decision was inconsistent with the 1995 Private Securities Litigation Reform Act, claiming the legislation required shareholders to show that an omission caused the loss. In this case, said the SEC, the class period ended before the announcement of the drug device’s failure. Omission of that information did not lead to the drop in price, said the commission. The Dura decision would reward uninjured investors, the SEC said. The 9th Circuit approach would “grant a windfall to investors who sold before the reduction or elimination of the artificial inflation, because they would recover the portion of the purchase price attributable to the fraud on resale, and then would be entitled to recover that same amount again in damages,” said the government. The decision will make it easier for plaintiffs to prove a loss, said William Sullivan of the San Diego office of Paul, Hastings, Janofsky & Walker. He will lead oral arguments for Dura before the Supreme Court in December or January. The primary benefit will come at the pleadings stage. The 1995 Reform Act placed a higher burden of proof at this stage. The 9th Circuit decision reduces that burden to some degree. In pleadings, plaintiffs do not need to show that a stock tumbled “following a corrective disclosure,” the 9th Circuit held. They only need to plead “that the price at the time of purchase was overstated and sufficient identification of the cause.” “It’s going to muddy the waters,” said Pamela Palmer of the Los Angeles office of Latham & Watkins, by making it more difficult for defendants to win pre-trial motions. But in order to prove damages, she said, plaintiffs will likely revert to the approach used in other circuits. Without pointing to a misrepresentation causing the price of the stock to drop, plaintiffs will not be able to show damages, she said. Otherwise, as the SEC explained in its brief, shareholders who sold the stock at a profit before it dropped can recover damages whether or not they paid an inflated price for the stock. Even those who profited could legitimately claim that they overpaid for the stock, counter those in favor of the 9th Circuit decision. In other words, these investors lost money by making less than they otherwise would have made. But Sullivan said that under the 1995 Act, plaintiffs cannot “imagine or assume a loss.” They must show actual losses, he said. Lawyers representing the class could not be reached for comment.

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