The U.S. Supreme Court will soon decide what investors have to plead and prove in order to recover for securities fraud on a “fraud on the market” theory.
The case, which was argued on Jan. 12, represents the first major securities issue to go before the justices in a decade.
The plaintiffs want the court to uphold a 9th Circuit Court of Appeals decision finding that investors only need to demonstrate that the purchase price of a stock was inflated due to fraud, without showing any connection between the fraud and a subsequent decline in stock price.
But the defendant, Dura Pharmaceuticals, claims that standard makes it far too easy for companies to face costly securities fraud lawsuits. It wants the Supreme Court to adopt a test forcing investors to show that a decline in price was caused by the alleged fraud.
Jarvis
Geoffrey Jarvis, who co-authored a friend-of-the-court brief on behalf of several pension funds, said the tone at the oral arguments suggest that the court “certainly is going to reverse the 9th Circuit. The idea [that plaintiffs only have to show price inflation] did not seem to have the favor of any of the justices.”
But it is unclear whether the court will go so far as to require “an explicit mea culpa admission of fraud and then a stock drop,” said Jarvis, who practices with Grant & Eisenhofer in Wilmington, Del.
Such a result “would essentially eviscerate” many securities lawsuits, such as those brought against WorldCom and Enron, said Jarvis, whose brief opposes the 9th Circuit decision but is arguing for a causation standard that falls short of what Dura Pharmaceuticals is seeking.
‘Extortionate Settlements’
The Dura Pharmaceuticals lawsuit was filed by a group of investors who claim they purchased the company’s stock after a series of positive statements about its development of Albuterol Spiros, a delivery device for asthma medication. Ultimately, the Food & Drug Administration did not approve the device, citing concerns about reliability.
SECTION 10(b)
The following excerpt is from Section 10 of the Securities Exchange Act of 1934, titled Manipulative and Deceptive Devices:
"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange ...
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors..."
Source: University of Cincinnati's Securities Lawyer's Deskbook
The investors sued under Section 10(b) of the Securities Exchange Act, arguing that Dura had indicated satisfactory development and testing of the device despite knowledge of significant reliability issues (see box at left for details). A federal judge in California dismissed the suit on the ground that the complaint failed to allege a causal connection between any fraud and a subsequent decline in stock price.
But the 9th Circuit reinstated the lawsuit, holding that Section 10(b) does not require a causal connection between the fraud and a stock price decline. Instead, the plaintiffs merely had to show that the “price on the date of the purchase was inflated because of the misrepresentation,” the court said.
Sullivan
“The 9th Circuit, in its ill-conceived opinion, gave [the plaintiffs] a wide-open version of loss causation [under section 10(b)] and the plaintiffs are doing their darndest to keep that alive,” said Dura’s counsel, William Sullivan, of Paul, Hastings, Janofsky & Walker in San Diego.
The fact that the plaintiffs have invoked Enron underscores the strength of Dura’s argument, Sullivan said. “The sooner and more often you hear Enron, that’s a pretty good measure of how weak the plaintiffs’ case is.”
Requiring securities plaintiffs to prove a price drop caused by fraud “is consistent with the [Private Securities Law Reform Act of 1995],” Sullivan said, noting that Congress wanted there to be a “meaningful screen” at the motion to dismiss stage to weed out baseless suits. “These are very expensive and risky cases for defendants. Companies need some protection against the kinds of extortionate settlements that can occur.”
Coughlin
However, the plaintiffs’ attorney, Patrick Coughlin of Lerach Coughlin Stoia Geller Rudman & Robbins in San Francisco, argued in his brief that the 9th Circuit’s decision represents “the traditional rule that loss causation is established by paying an inflated price.”
A ruling in favor of Dura Pharmaceuticals “would give those who choose to commit fraud many opportunities to game the system, and to avoid liability with manipulative disclosures,” Couglin wrote in his brief.
Walking Down Price
Jarvis at Grant & Eisenhofer, who filed an amicus brief largely supporting Dura Pharmaceuticals, nevertheless agreed with the plaintiffs that the bar for showing causation shouldn’t be so high as to preclude legitimate lawsuits against companies that drive down the stock price before formally disclosing fraud. Jarvis sited the Xerox case from several years ago as an example of where the price actually went up after disclosure because reduced revenue expectations had earlier sent the stock down.
“What we’re saying to the court is to be sophisticated, understand what’s going on and adopt a flexible test,” said Jarvis.
His brief argues that “where a defendant makes a materially misleading statement to the investing public that artificially inflates the stock price of a company, and the plaintiff, in reliance on the market price of those securities as manipulated by the defendant, purchases the company’s stock at such artificially inflated prices, the plaintiff should be deemed to have suffered a loss caused by the defendant to the extent of the inflation so long as the stock price no longer is being propped-up by the fraud.”
But Sullivan at Paul Hastings said the test urged by his client would still allow lawsuits in situations where an inflated price was lowered prior to formal disclosure.
“If they do walk down the stock price, they’re making a disclosure as to what’s happening,” he said. “They’re making disclosures that are tied to misrepresentations.”
A decision in the case, Dura Pharmaceuticals vs. Broudo, is expected by the end of the court’s term in June. Compliance Week will keep subscribers up-to-date on developments.
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