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The pleading standard for loss causation in the 2nd Circuit requires plaintiffs in a securities fraud case to allege a concealment of risk and to show that this concealment, which was later exposed, caused the plaintiff’s loss, a federal judge has ruled. In Amy Liu v. Credit Suisse First Boston, 04 Civ 3757, Southern District of New York Judge Shira Scheindlin reviewed the history of loss causation cases in the 2nd U.S. Circuit Court of Appeals. In seeking to define a standard from a half-dozen decisions handed down since 1986, she wrote that, on their face, the rulings appeared to create an “ambiguous” precedent. The decision comes on the heels of the U.S. Supreme Court’s April decision in Dura Pharmaceuticals v. Broudo, which also involved loss causation. In Dura, the Court ruled that to prove fraud, plaintiffs must provide a direct link between a fall in a company’s stock price and the alleged fraud or misrepresentation. Loss causation often comes into play in the earliest parts of a securities class action, when plaintiffs must show during the pleadings stage that the defendant’s actions caused the alleged losses. The unanimous Supreme Court opinion rejected the looser standard applied by the 9th U.S. Circuit Court of Appeals, which allowed plaintiffs to prove loss causation without showing a direct link between a plunge in a company’s stock price and misrepresentation or fraud. Under that standard, plaintiffs could fulfill their obligations at the pleading stage by making allegations that a stock price was inflated without the need for a direct link to a loss. The Supreme Court also tacitly sided with the stricter standard for loss causation established by the 2nd Circuit, Scheindlin said. However, that tacit approval failed to offer the final word on the boundaries of loss causation. “ Dura did not establish what would be a sufficient loss causation pleading standard,” Scheindlin wrote, “it merely established what was not.” The 2nd Circuit’s decisions on the issue — what one appellate panel described as “somewhat inconsistent” — led Scheindlin to attempt to reconcile the circuit’s loss causation standard. EARLIER RULING In January, a circuit panel that included Judges Dennis Jacobs, Sonia Sotomayor and Barrington D. Parker Jr. ruled on loss causation in Lentell v. Merrill Lynch & Co., and acknowledged that “different formulations of the loss causation standard” existed. “[O]ver time, the Second Circuit has advanced several different standards for pleading loss causation,” Scheindlin wrote, “including ‘direct causation,’ ‘materialization of risk,’ and ‘corrective disclosure,’ all of which are referenced in Lentell.” Despite the apparent confusion, “a close look at the recent discussion of loss causation by the Second Circuit reveals that the loss causation pleading standard, although murky, is not internally inconsistent,” the judge held. The expansion of what constitutes securities fraud was partly to blame for this proliferation of loss causation theories, Scheindlin wrote. She explained that securities fraud claims now include instances in which brokers make excessive trades on behalf of clients to increase commissions or invest a client’s money in riskier investments than they had agreed upon. “All of these examples of securities fraud cause a loss to the injured party,” Scheindlin held. “The mechanisms for such losses vary widely. However, the common thread is that, in each situation, ‘the loss be foreseeable and the loss be caused by the materialization of the concealed risk.’” Scheindlin concluded that the key to the circuit’s thinking involved the “concealment of a risk and the materialization of that risk.” She found that the circuit required “both that the loss be foreseeable and that the loss be caused by the materialization of the concealed risk.” The case before Scheindlin involved Amy Liu, an investor, and a class of plaintiffs that alleged that defendants, which included issuers and Credit Suisse First Boston, the lead underwriter involved in several IPOs, defrauded investors by setting their earnings estimates below their true estimates to dramatically drive up the prices of the IPOs once they went public. In her opinion, Scheindlin said her analysis led her to reject the looser “proximate cause” theory advocated by the plaintiffs. She also rejected plaintiffs’ motion for reconsideration of her previous dismissal of their claims. John Watts of Yearout & Traylor, an Alabama firm, represented the plaintiffs. Kristin Linsey Myles of Munger, Tolles & Olson’s San Francisco office, Randall Clement of Sheppard, Mullin, Richter & Hampton’s Costa Mesa office, Mitchell Herr of Holland & Knight’s Miami office, and Michael Hirschfeld of Milbank, Tweed, Hadley & McCloy’s New York office represented issuer defendants. Peter Vigeland of Wilmer, Cutler & Pickering’s New York office represented Credit Suisse First Boston.

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