Class Action Securities Fraud Cases Must Plead Economic Loss and Causal Connection Between Alleged Fraud and Loss
Class actions alleging securities fraud are commonplace. Whenever a publicly traded stock declines in value, an investor is ready to file a class action claiming that the stock price had been inflated or that he would not have invested in the company but for misleading representations made by the company. Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA) hoping, in part, to stem the “abusive” practice of “the routine filing of lawsuits . . . with only a faint hope that the discovery process might lead eventually to some plausible cause of action.” H.R. Conf. Rep. No. 104-369, p. 31 (1995), U.S. Code Cong. & Admin. News 1995, pp. 679, 730.
Class action defendants had high hopes for the PSLRA: it imposes limits on damages and attorney fees, imposes limits on the way lead plaintiffs are selected and the amounts they can be awarded, imposes sanctions for frivolous litigation, provides companies with a “safe harbor” for certain statements, and allows courts to issue stays of discovery pending motions by a defendant to have the case dismiss. See, 15 U.S.C. § 78u-4. Also, Section 21D(b)(2) of the PSLRA requires that a plaintiff alleging securities fraud “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.” SLUSA, discussed in a separate article, represents Congress’s attempt to fill in the loopholes in the PSLRA. Other holes, however, have been left to the judicial branch. The U.S. Supreme Court filled one such hole in Dura Pharmaceuticals v. Broudo, 544 U.S. 336, 125 S.Ct. 1627 (2005).
A class action alleging securities fraud was filed against Dura Pharmaceuticals in a California federal court. The complaint alleged that Dura falsely represented that a new product would secure FDA approval and that its drug sales would be profitable. The Supreme Court opinion sets forth the basic allegations of the complaint, which we do not repeat here. The Court stated at pages 339-40:
Most importantly, the complaint says the following (and nothing significantly more than the following) about economic losses attributable to the spray device misstatement: “In reliance on the integrity of the market, [the plaintiffs] … paid artificially inflated prices for Dura securities” and the plaintiffs suffered “damage[s]” thereby. [Citation.] (Italics added by court.)
The District Court granted defendant’s motion to dismiss holding, in part, that the complaint did not adequately allege “loss causation.” 544 U.S. at 340. The Ninth Circuit reversed, concluding that “‘[i]n a fraud-on-the-market case, plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation.’” Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933, 938 (9th Cir. 2003) (citation omitted, italics in original). The Ninth Circuit believed that “the injury occur[red] at the time of the transaction,” and that the complaint’s allegations were sufficient because they alleged “that the price at the time of purchase was overstated.” Id.
The Supreme Court noted that two of the basic elements for fraud claims involving publicly traded securities are “economic loss,” and “loss causation” – that is, “a causal connection between the material misrepresentation and the loss.” Dura Pharmaceuticals, 544 U.S. at 342. The Court held that “Normally, in cases such as this one (i.e., fraud-on-the-market cases), an inflated purchase price will not itself constitute or proximately cause the relevant economic loss.” Id. (italics added). The Court explained that the shares may not be sold for a loss even if they had been purchased at a time when the stock price was inflated. Alternatively, if the stock is sold at a loss, “that lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.” Id., at 343.
Dura Pharmaceuticals also recognized that securities fraud cases “resemble in many (but not all) respects common-law deceit and misrepresentation actions,” and that “a plaintiff in such a case [must] show not only that had he known the truth he would not have acted but also that he suffered actual economic loss.” Id., at 343-44 (citations omitted).
Finally, the Supreme Court held that the Ninth Circuit’s view undermined the purpose of the securities laws: private securities fraud actions are intended “not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause.” Id., at 345 (citation omitted). The Ninth Circuit’s approach would permit a securities fraud plaintiff to recover damages without proving economic loss or loss causation. Id., at 346.
The Supreme Court concluded, “Our holding about plaintiffs’ need to prove proximate causation and economic loss leads us also to conclude that the plaintiffs’ complaint here failed adequately to allege these requirements.” Id., at 346. To satisfy this pleading requirement, a securities fraud plaintiff “must provide the defendant with ‘fair notice of what the plaintiff’s claim is and the grounds upon which it rests.’” Id. (citation omitted). Because the complaint failed to meet this test, the Supreme Court reversed. Id.