Most of the defense bar applauded the Supreme Court's April 2005 decision in Dura Pharmaceuticals Inc. v. Broudo because it significantly tightened the reins on securities fraud cases. Dura rejected the notion that simply alleging the stock price was inflated at the time of purchase due to misrepresentation gives rise to an action for fraud.
But the decision has created some unforeseen problems. The court left a vacuum in the jurisprudential landscape by failing to specify what allegations would meet the burden of pleading and proving that a misrepresentation caused the plaintiffs' economic loss. It remained unclear whether a plaintiff must show that the decline in stock price followed a corrective disclosure by the defendant. Dura also failed to establish what degree of connection was required between the corrective disclosure and the decline.
Judges around the nation have started tackling these issues with mixed results. "Lower court decisions are trickling in," says Bruce Ericson, a litigation partner at Pillsbury Winthrop Shaw Pittman. "They have provided some answers, with implications favorable both to defendants and plaintiffs."
Courts in the 2nd Circuit, however, had a head start on interpreting Dura thanks to the 2nd Circuit Court of Appeals' ruling in Lentell v. Merrill Lynch & Co. Inc. The case predated Dura by about four months, but formulated positive criteria for pleading and proving loss causation that turned out to be consistent with Dura.
Not surprisingly, Lentell has been influential in post-Dura decisions in 2nd Circuit district courts. As a result, the 2nd Circuit is emerging as a favorable jurisdiction for defendants seeking dismissal based on plaintiffs' failure to properly plead loss causation.
Setting The Standards
In any securities fraud action, plaintiffs must show that they not only suffered an economic loss, but also that the misrepresentation caused the loss. In Lentell the 2nd Circuit Court of Appeals ruled that in pleading loss causation, plaintiffs must allege "both that the loss be foreseeable and that the loss be caused by the materialization of the concealed risk." This standard has proved useful to defendants.
For instance, about two months after Dura's release, Judge Shira Scheindlin of the Southern District of New York dismissed Liu v. Credit Suisse First Boston because the plaintiff failed to properly allege loss causation.
The case centered on allegations that the defendant's issuers and underwriters had used a scam called "Pop and Performance" to inflate stock prices artificially by underestimating earnings. This ensured that actual revenue would exceed forecasts, thus creating the illusion of unforeseen profitability. The scheme collapsed when the issuer failed to meet even the understated projections and the stock price fell.
Scheindlin relied on Lentell in deciding that Dura did not change 2nd Circuit precedent on loss causation. As she saw it, the plaintiffs had failed to demonstrate that the statement or omission they relied upon "concealed something from the market that, when disclosed, negatively affected the value of the security." Indeed, she noted, what materialized (a shortfall of revenue) was exactly the opposite of what was concealed.
Just a few days later, Southern District Judge Robert Sweet granted defendants' motion to dismiss a federal securities action in Joffee v. Lehman Brothers Inc. Here, the complaint alleged only that defendants' misrepresentations artificially inflated the value of the company's shares--falling short of the Lentell standard.
Around the same time, another Southern District judge dismissed federal securities claims in Dresner v. Utility.com Inc. Judge Sidney Stein held that the complaint "contained no indication as to what loss was occasioned" by defendants' allegedly fraudulent conduct.
Despite the pro-defendant stance in these cases, Andy Beck, head of the securities practice in Torys' New York office, says a trend has not yet emerged. "It's just too early to tell," he says.
Indeed, district courts in the 2nd Circuit have not been uniform in their approach. In early July 2005, a Southern District judge refused to dismiss the action in Fraternity Fund Ltd. v. Beacon Hill Asset Management. Defendants had argued that there was no loss causation because multiple factors, including a drop in interest rates, caused the plaintiffs' losses.
But the court disagreed. Even if the drop in interest rates explained some of the losses, the court reasoned, it could not explain them all. The decision suggests that disclosure of alleged misconduct need only contribute to the plaintiffs' losses to satisfy the loss causation element of a 10b(5) claim; it need not be the primary cause.
What is clear, however, is that Dura gives defendants a broader scope for attacking plaintiffs' pleadings.
Even in jurisdictions such as the 2nd and 7th Circuits, where Dura has affected the least change to earlier jurisprudence, defendants are using the decision strategically.
"Dura is now a staple argument on motions to dismiss, with defendants using this case to challenge the sufficiency of plaintiffs' loss causation allegations," says Carol Gilden of Chicago, who heads Much Shelist Freed Denenberg Ament & Rubenstein's securities fraud class action practice. "And in cases where this issue was already decided pre-Dura, some defendants are trying to take second and third bites at the apple by filing motions to test plaintiffs' allegations again under Dura."
However that may be, that doesn't mean that the success rate of such motions--calculated on a nationwide basis--will change much.
"I don't expect to see a statistically significant change in successful summary motions," Ericson says.
Gilden agrees. "The Dura case just hasn't turned out to be the knockout punch defendants had hoped it would be," she says.
But at least defendants in the 2nd Circuit have a better idea than most about the rules of the match.