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VOLUME 230—NO. 82 FRIDAY, OCTOBER 24, 2003 OUTSIDE COUNSEL

BY DAVID M. BRODSKY AND JEFF G. HAMMEL The Fraud on the Market Theory and Securities Fraud Claims o maintain a claim for securities Now codified in the PSLRA, 15 U.S.C. fraud, it is well established that a §78u-4(b)(4), loss causation is distinct from plaintiff must plead and prove both transaction causation as an element of proof (i) that it relied upon defendant’s in securities fraud claims. Thus, even in T circumstances where “the investment decision allegedly fraudulent conduct in purchasing or selling securities, and (ii) that defendant’s is induced by misstatements or omissions that conduct caused, at least in part, plaintiff’s loss. were material and relied upon by plaintiff” These two elements are generally known, (in other words, where the existence of respectively, as “transaction causation” and transaction causation is evident), if those “loss causation.” David M. Brodsky Jeff G. Hammel misstatements or omissions “are not the prox- The “fraud on the market theory,” also well imate reason for his pecuniary loss, recovery ... established, entitles plaintiffs to a rebuttable is not permitted.”6 presumption of the existence of transaction causation is “two-pronged: a plaintiff must causation (e.g., that they relied upon allegedly allege both transaction causation ... and Expanding Fraud on Market fraudulent information) even where they were loss causation.”3 unaware of the fraudulent conduct at the time Transaction causation is “another way of Although the fraud on the market theory of their purchase or sale. has traditionally been applied to transaction ------Some plaintiffs, however, have sought to causation, there is, increasingly, some question extend the fraud on the market theory to also The fraud on the market concerning whether that theory can also be enable them to establish loss causation — theory should not be applied to loss causation. effectively relying upon the theory for “double Those seeking to apply the fraud on the duty” to satisfy both causation elements. expanded to enable plaintiffs market theory to loss causation utilize This approach has received greater atten- to establish an approach sometimes called the “price tion following two recent decisions reaching both transaction inflation” or “price disparity” theory. opposite conclusions: the much-publicized They contend that, because fraudulent Merrill Lynch & Co. Research Reports Securities and loss causation. information disseminated on an efficient Litig. decision,1 in which a prominent district ------market leads to an artificially inflated price of court rejected such an expansive application the stock at issue, loss causation exists because of the fraud on the market theory, and the plaintiffs would not have purchased the stock Broudo v. Dura Pharmaceuticals, Inc. decision,2 describing reliance,” and is established when if they had known it was falsely inflated or in which the U.S. Court of Appeals for the the misrepresentations or omissions at issue because they paid too much for it. There is, Ninth Circuit embraced this approach. cause the plaintiff to engage in the purchase or however, no consensus among courts on Merrill Lynch got it right and Broudo got it sale of the securities in question.4 this issue. wrong. The fraud on the market theory should Transaction causation may be established A number of decisions suggest that the not be expanded to enable plaintiffs to through the fraud on the market theory. Based fraud on the market theory can be applied to establish both transaction and loss causation. largely on the U.S. Supreme Court’s decision establish loss causation. The most recent court in Basic v. Levinson, that theory holds that, to do so is the Ninth Circuit in Broudo. “[b]ecause most publicly available information That case was brought on behalf of Causation in Securities Fraud Cases is reflected in market price, an investor’s investors in Dura Pharmaceuticals who Causation is a necessary element of securi- reliance on any public misrepresentation, claimed that the company issued material ties fraud claims. In the securities context, therefore, may be presumed for purposes of a misstatements concerning the development of Rule 10b-5 action.” a new device for delivering asthma medica- Loss causation, on the other hand, general- tion. When the company announced that it David M. Brodsky is a partner in the New ly refers to the requirement that plaintiffs expected lower revenues than it had previous- York office of Latham & Watkins, where he is co- demonstrate that their investments would not ly forecast, its stock suffered a single-day 47 chair of the firm’s worldwide Securities Litigation have lost value if the facts that defendants percent drop. The announcement said and Professional Liability Practice Group. Jeff misrepresented or omitted had actually been nothing about the asthma device. However, G. Hammel, an associate at the firm, is a true, and, thus, that the misrepresentation or after the close of the class period, the member of that practice group. omission caused the loss.5 company disclosed that the FDA had denied NEW YORK LAW JOURNAL FRIDAY, OCTOBER 24, 2003 its application for the asthma device. Judge Pollack agreed, stating that he market theory can be used to create a In dismissing plaintiffs’ claim, the district was “utterly unconvinced” that fraud had rebuttable presumption of reliance (e.g., court focused on the fact that the disclosure occurred. In so doing, he rejected plaintiffs’ transaction causation), not loss causation. that caused the sharp share price decline did effort to rely upon the fraud on the Second, if the fraud on the market theory not mention the asthma device, and reasoned market theory to satisfy the loss causation can serve double duty in this way, then the that “any omission or misleading statements pleading requirement. distinction between these two forms of about this device could not be said to have Specifically, he found that “[t]o permit causation will have collapsed. This is caused the decline in price.” As a result, it plaintiffs to allege artificial inflation through inappropriate. The PSLRA expressly codifies held that “the loss causation element was the fraud on the market theory to satisfy loss loss causation as a separate, free-standing not met.” causation would improperly conflate both the element of a Section 10(b) claim. It should The Ninth Circuit reversed. It accepted, ... transaction causation and the loss causation be treated as such. without comment, the premise that, “[i]n a elements into one.” The effect of such a ruling Moreover, transaction causation and fraud on the market case, plaintiffs establish would be to convert the securities laws into a loss causation are conceptually different: loss causation if they have shown that the transaction causation embodies an investor’s ------price on the date of purchase was inflated reliance on fraudulent information in electing because of the misrepresentation.” While the courts may sort out to engage in a purchase or sale, while loss It also noted, again without elaboration, this issue over time, there are causation reflects the fraudulent information’s that “for a cause of action to accrue, it is not impact on the stock price. Using fraud on the necessary that a disclosure and subsequent several reasons why permitting market theory for both elements renders this drop in the market price of the stock have loss causation to be satisfied distinction meaningless. actually occurred, because the injury occurs at through the fraud on the Third, conflating transaction causation the time of the transaction.” and loss causation leads to a troubling and Based on these principles, it held that market theory is inappropriate.- unworkable result. Loss causation ensures the pleading loss causation in securities fraud ------existence of an identifiable causal nexus claims “merely requires pleading that the price between a defendant’s alleged misconduct and at the time of purchase was overstated and “scheme of cost-free speculators’ insurance” plaintiffs’ claimed loss. It therefore enables sufficient identification of the cause [of the policy, indemnifying plaintiffs against all courts to take account of intervening causes, overstatement].” the downside risks of their investment— such as recessions, wars or other external The Ninth Circuit therefore reversed the regardless of whether those risks were events which may be responsible for plaintiffs’ district court’s dismissal because plaintiffs attributable to defendants. losses, and for which a particular defendant “ha[d] pled that the price of the stock was This the court would not do, explaining in should not be held liable. overvalued in part due to the misrepresenta- no uncertain terms what it believed plaintiffs As Judge Pollack explained in Merrill Lynch, tions.” The Eighth Circuit adopted a similar were up to: without a requirement of proof of loss approach 12 years earlier in In re Control Data Seeking to lay the blame for the enormous causation, the securities laws become a Corp. Securities Litig.7 Internet Bubble solely at the feet of a cost-free form of insurance against stock price Other courts have rejected the double duty single actor, Merrill Lynch, plaintiffs drops, whether attributable to defendant or approach. The Eleventh Circuit did so in 1997 would have this Court conclude that the not. It is, therefore, critical to maintain in Robbins v. Koger Properties, Inc.8 federal securities laws were meant to loss causation as a separate element of a Most recently, Judge Milton Pollack did so underwrite, subsidize, and encourage their securities fraud claim. in the Merrill Lynch case, a decision containing rash speculation in joining a freewheeling perhaps the most cogent analysis rejecting the casino that lured thousands obsessed with •••••••••••••• •••••••••••••• application of the fraud on the market theory ••• the fantasy of Olympian riches but which (1) Merrill Lynch & Co. Research Reports Securities Litig., to satisfy both transaction and loss causation. delivered such riches to only a scant --- F. Supp. 2d ---, 2003 WL 21500293 (S.D.N.Y. June 30, Plaintiffs had purchased Internet stocks handful of lucky winners. Those few lucky 2003), reconsideration denied, 2003 WL 21920386 during the height of the “internet bubble” and (S.D.N.Y. Aug. 12, 2003). winners, who are not before the Court, (2) Broudo v. Dura Pharmaceuticals, Inc., --- F.3d ---, 2003 subsequently lost money. In an effort to recoup now hold the monies that the unlucky WL 21789028 (9th Cir. Aug. 5, 2003). their money, they brought claims for securities plaintiffs have lost fair and square and (3) Suez Equity Investors, L.P. v. Toronto-Dominion Bank, fraud under Section 10(b), alleging that the they will never return those monies to 250 F.3d 87, 95 (2d Cir. 2001). financial projections and investment ratings (4) See Currie v. Cayman Resources Corp., 835 F.2d 780, plaintiffs. Had plaintiffs themselves won 785 (11th Cir. 1988) (citing Schlick v. Penn-Dixie Cement contained in Merrill Lynch’s analyst reports the game instead of losing, they would Corp., 507 F.2d 374, 380 (2d Cir. 1974)). concerning those companies’ stocks were have owed not a single penny of their (5) See, e.g., Suez Equity, 250 F.3d at 96. materially inaccurate and caused their losses. (6) Huddleston v. Herman & MacLean, 640 F.2d 534, 549 winnings to those they left to hold the bag (5th Cir. 1981), aff’d in part and rev’d in part on other Employing a “fraud on the market theory,” (or to defendants). grounds, 459 U.S. 375 (1983) (citing Marbury Mgt., Inc. v. plaintiffs contended that they relied on the Accordingly, plaintiffs’ claims were Kohn, 629 F.2d 705, 718 (2d Cir. 1980) (Meskill, J., dissent- analyst reports even though none of them was dismissed. ing)). (7) 933 F.2d 616 (8th Cir. 1991). alleged actually to have seen or read any of While the courts may sort out this issue (8) 116 F.3d 1441 (11th Cir. 1997). the reports. over time, there are several reasons why Defendants also contended that any permitting loss causation to be satisfied reduction in the price of the shares held by through the fraud on the market theory This article is reprinted with permission from the plaintiffs was caused by the bursting of the is inappropriate. October 24, 2003 edition of the NEW YORK LAW “Internet bubble” and the resultant general First, this approach is not faithful to the JOURNAL. © 2003 ALM Properties, Inc. All rights stock market drop (for which defendants reserved. Further duplication without permission is U.S. Supreme Court’s reasoning in adopting prohibited. For information, contact American were not responsible), not the contents of the fraud on the market theory in Basic. That Lawyer Media, Reprint Department at 800-888-8300 analyst reports. decision makes plain that the fraud on the x6111. #070-10-03-0036