A securities case now before the Supreme Court could have major implications for investors trying to recover money they lost in a stock fraud. A ruling in favor of the petitioners in Dura Pharmaceuticals Inc. v. Broudo could dampen shareholders' ability to successfully sue corporate wrongdoers and open a new escape route for bad business behavior. At issue is the theory of loss causation — in plain English, how strictly courts interpret what constitutes a financial loss due to fraudulent behavior.
Loss causation is a critical element of securities litigation, as shown by the heavy hitters who filed friend-of-the-court briefs in the case.
Filing amicus briefs in favor of the investors were some of the largest public pension funds in the country. Four funds joined to file one brief: the California Public Employees' Retirement System; the California State Teachers' Retirement System; the Los Angeles County Employees Retirement Association; and Alan G. Hevesi, New York state comptroller, on behalf of the New York State Common Retirement Fund. The New Jersey Division of Investment and the University of California Regents filed separate briefs.
Siding with the company were pro-business groups such as the U.S. Chamber of Commerce and, surprisingly, federal regulators.
Michael Broudo and a group of investors purchased Dura Pharmaceuticals stock following positive statements from the company about its Albuterol Spiros inhaler. Dura later revealed, however, that the Food and Drug Administration was not going to approve the device. The plaintiffs alleged that the company's top officers had misled investors, trumpeting the product when they knew it had reliability problems.
The district court dismissed the complaint brought under Section 10(b) of the Securities and Exchange Act, citing a failure to properly plead loss causation between the alleged fraud and the eventual stock drop.
At the heart of the case is the question of whether plaintiffs needed to show that the stock fell on the heels of a "corrective disclosure." The district court noted that while the stock price dropped following a disclosure made by Dura, the disclosure did not specifically refer to the FDA's refusal to approve the inhaler.
But the 9th Circuit Court of Appeals reversed the decision. Loss causation, the appeals court said, "merely requires pleading that the price at the time of purchase was overstated and sufficient identification of the cause."
The appeals court, in other words, said it was enough for the investors' case to proceed if they showed they lost money in Dura stock after buying shares at prices inflated by the company's misleading statements.
Dura has petitioned the Supreme Court to overturn the appeals court's decision in favor of the more stringent pleading requirement for loss causation applied by the district court. The justices heard arguments on Jan. 12 and are expected to rule by summer.
A more stringent pleading requirement would create a Catch-22 for investors and, in particular, for the public pension funds at the forefront of securities litigation. Thanks to the Private Securities Litigation Reform Act of 1995, plaintiffs in securities fraud cases already must meet stricter pleading requirements than those undertaking other litigation. Plaintiffs are also barred from gathering evidence from defendants — discovery, in civil court parlance — until the court has denied all motions to dismiss.
Requiring even stricter pleading standards for loss causation would be a radical departure from federal pleading rules, which merely require putting the defendants on notice about what the plaintiffs claim they did wrong. It would also force plaintiffs to articulate a damage theory at the time of pleading — before any discovery of company information that ordinarily has a bearing on how damages are computed.
Practically speaking, if the Supreme Court adopts the position advocated by Dura, its decision could make a significant number of securities fraud cases under Section 10(b) of the securities laws obsolete. Quite often, the price of an artificially inflated company stock declines prior to the formal corporate disclosure of fraud. In such instances, there is a causal connection between the fraud and the price drop, but the decline doesn't necessarily occur immediately after the disclosure.
In fact, some of the most notorious securities fraud cases of recent years — including Enron Corp., WorldCom Inc. and Sunbeam Corp. — arguably fall into that category. In each of these, the stock declined due to partial corrective disclosures that did not reveal the nature or extent of the fraud. By the time the full truth came out, the stocks' price already had declined substantially.
Very seldom do companies come completely clean when they reveal accounting flaws or other problems. They try to cover things up. Under the strict interpretation sought by petitioners in Dura, investors who can't prove a causal connection between the fraud and the stock drop caused by a corrective disclosure will be flat out of luck.
Let's think of it as the chicken-and-egg theory. It doesn't really matter which came first, the price drop or the corrective disclosure. As far as investors are concerned, the two are inextricably linked, and companies should be held liable for shareholder losses when fraud is ultimately to blame.
Investors have already lost billions of dollars thanks to the shenanigans of corporate wrongdoers. If the Supreme Court reverses the appeals court and adopts the stricter pleading standard in Dura, investors will lose yet again.