LIABILITY IN SECURITIES FRAUD ACTIONS: Part XXI: Theories of Proof Under Dura – Materialization

Materialization is another theory used to plead and prove loss causation. This theory is used “where the alleged misstatement conceals a condition or event which then occurs and causes the plaintiff’s loss, it is the materialization of the unclosed condition or event that causes the loss.” Glover v. Deluca, 2006 WL 2850448 (W.D. Pa. Sept. 29, 3006). As the Glover court explained, the key to this theory is that the risk is first concealed and then later that specific risk materializes. Under this theory, the securities law plaintiff “must provide proof that the market recognized a relationship between the event disclosed and the fraud.” In re Williams Securities Litig., 2007 WL 2007987 (N.D. Okla. July 6, 2007). If the truth gradually leaks out and the effects of the relevant truth – the facts which expose the fraud – cannot be differentiated from bad news unrelated to the fraud, the theory fails.

The key to materialization is that the concealed condition appears. In that instance, corrective disclosure is not required. In Teamsters Local 445 v. Bombardier, 2005 WL 218919 (S.D.N.Y. Sept. 6, 2006) for example, plaintiffs alleged that defendants made misrepresentations and omissions regarding the integrity of underwriting standards used in securitizing interests in a pool of mortgages. Subsequently, a high delinquency rate caused the price to drop. Judge Schendlin held that the plaintiffs correctly pled loss causation. A corrective disclosure was not required because the facts materialized.

Similarly, where a concealed scheme was revealed, the court held that loss causation was properly pled. In In re Parmalat Sec. Lit., 376 F. Supp. 2d 472, 510 (S.D. N.Y. 2005), defendants engaged in sham transactions to aid a defendant company in concealing its true financial condition. The scheme utilized worthless invoices to conceal the fact that the defendant could not pay its debts. Ultimately, the company could not pay its debts. Judge Kaplan held that loss causation was sufficiently pled.

In contrast, in In re Initial IPO Sec. Litig., 2005 WL 1162445 (S.D.N.Y. May 6, 2005), Judge Schendlin concluded that loss causation had not been properly pled. There, plaintiffs alleged that defendants engaged in a scheme to discount earnings estimates so that the companies could beat the estimates. As a result of the scheme, the share price became inflated. Plaintiffs claimed the truth materialized when the companies failed to meet earnings and the financial statements were published. The court rejected the claim: “The fact that an event – in this case a failure to meet earnings forecasts or a statement foreshadowing such a failure – disabused the market of the belief does not mean that the event disclosed the alleged scheme to the market.”

Next: How much truth and the impact of bad news.