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Investors who blamed Merrill Lynch analysts for the collapse in the price of two Internet stocks failed to charge specifically how misleading reports and ratings caused their losses, properly leading to the dismissal of their lawsuits, the 2nd U.S. Circuit Court of Appeals ruled Thursday. In a decision experts say raises the bar high for suits based on analyst recommendations and jeopardizes dozens of such actions against Merrill Lynch, the circuit said the requirement for pleading “loss causation” demands a direct and tangible link between the analysts’ actions and an investor’s losses. It was not enough, the court said, for plaintiffs to broadly allege that fraudulent “buy” and “accumulate” ratings by Merrill on 24/7 Real Media Inc. and Interliant Inc. stocks helped artificially inflate their prices and perpetrate a “fraud on the market,” particularly where Merrill Lynch analyst reports consistently warned that the stock prices were volatile and were subject to implosion. Instead, said Judge Dennis Jacobs in upholding the dismissal of two class actions in Lentell v. Merrill Lynch & Co., 03-7948, investors in their pleadings have to show how the misrepresentations or omissions led to the actual decline in the stock or hid the risk that the stock would drop in price. “We are told that Merrill’s ‘buy’ and ‘accumulate’ recommendations were false and misleading, and that the Firm failed to disclose conflicts of interest, salary arrangements, and collusive agreements among analysts, bankers, and 24/7 Media and Interliant,” Jacobs wrote. “But plaintiffs nowhere explain how or to what extent those misrepresentations and omissions concealed the risk of a significant devaluation of 24/7 Media and Interliant securities.” Steve Thel, a securities law professor at Fordham Law School, said, “It really becomes very hard after this case to see how inflated recommendations can be held to cause losses without specific factual misrepresentations. “What does a plaintiff have to show to go after inflated analyst recommendations? The court says you have to say the damage came directly from the revelation of the falsehood.” Investors in 24/7 Media and Interliant alleged that they were relying on the integrity of the market for the two stocks — a market that was fed by fraudulent recommendations and omissions by Merrill. But Judge Jacobs wrote, “To plead loss causation, 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.” Professor John C. Coffee Jr. of Columbia University Law School, a New York Law Journal columnist, agreed that the court appeared to be making it “very hard” to seek damages based on analyst recommendations. “If the Second Circuit is now saying that loss causation requires you to demonstrate the market was responding not just to the incorrect nature of the revelation, but rather to the deliberately insincere nature of the recommendation, that’s going to be a very hard showing for any plaintiff to make,” he said. The ruling upheld a decision by the late Judge Milton Pollack dismissing claims against Merrill Lynch in connection with the consolidated class actions against 24/7 Media and Interliant. The cases also were part of a wave of some 140 class actions filed after New York Attorney General Eliot Spitzer sought broad discovery of documents from Merrill Lynch in his investigation into analysts who inflated their stock ratings to win investment banking business. The cases were consolidated by the Judicial Panel on Multidistrict Litigation before Pollack, who chose to proceed with 24/7 Media and Interliant first. Jay B. Kasner of Skadden, Arps, Slate, Meagher & Flom, who represented Merrill Lynch, called the ruling “a very significant decision for the securities litigation bar,” Pollack had recognized, Judge Jacobs said, that “plaintiffs fail to grapple in any meaningful way with the complexity of the reports that form the basis of their claims or, for that matter, to account for the price-volatility risk inherent in the stocks they chose to buy.” STATUTE OF LIMITATIONS The circuit reversed the part of Pollack’s ruling that garnered the most attention — that the cases should be dismissed because the statute of limitations had expired. Pollack had found that the clock had started running on the plaintiffs’ claims when they were placed on “inquiry notice” by several media reports about pervasive conflicts between investment banking and analyst sectors at Wall Street firms in general and Merrill Lynch in particular. Pollack had found that the media reports amounted to red flags or “storm warnings” that obligated potential stock buyers to inquire further about problems with the companies covered by Merrill Lynch. Not so, said the 2nd Circuit. “We do not mean to suggest that inquiry notice could never be established on the basis of non-specific public pronouncements, but the level of particularity in pleading required by the PSLRA [Private Securities Litigation Reform Act] … is such that inquiry notice can be established only where the triggering data ‘relates directly to the misrepresentations and omissions’ alleged,” Judge Jacobs said. And while the articles cited by Judge Pollack “describe the conflicted situation of Wall Street research analysts,” Jacobs said, “evidence of the outright falsity of Merrill Lynch’s investment recommendations is stray and indiscriminate at best, and is insufficient to put plaintiffs on inquiry notice of the specific frauds alleged.” LOSS CAUSATION Addressing the main issue, Judge Jacobs said, “Our precedents make it clear that loss causation has to do with the relationship between the plaintiff’s investment loss and the information misstated or concealed by the defendant.” “If that relationship is sufficiently direct, loss causation is established,” he said. Here, Jacobs said “There is no allegation that the market reacted negatively to a corrective disclosure regarding the falsity of Merrill’s ‘buy’ and ‘accumulate’ recommendations and no allegation that Merrill misstated or omitted risks that did lead to the loss. This is fatal under Second Circuit precedent.” Jacobs added, “We do not suggest that plaintiffs were required to allege the precise loss attributable to Merrill’s fraud, or that ‘systematically overly optimistic’ ratings of the type published by the Internet Group are categorically beyond the reach of the securities laws. “But where (as here) substantial indicia of risk that materialized are unambiguously apparent on the face of the disclosures alleged to conceal the very same risk,” a plaintiff must allege facts showing it was defendant’s fraud that caused the loss or “facts sufficient to apportion the losses between the disclosed and concealed portions of the risk that ultimately destroyed the investment.” Judge Jacobs was joined by Judges Sonia Sotomayor and Barrington D. Parker Jr. Herbert E. Milstein of Cohen, Milstein, Hausfeld & Toll, lead counsel for plaintiffs, could not be reached for comment.

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