Part XI: Securities Class Actions: Current And Emerging Trends

Another theory of loss causation being utilized by the court’s following Dura is materialization. The court in Glover v. Deluca, 2006 WL 2850448 (W.D. Pa. Sept. 29, 2006) defined the requirements for using this theory, noting that “where the alleged misstatement conceals a condition or event which then occurs and causes the plaintiff’s loss, it is the materialization of the undisclosed condition or event that cause the loss.” To use this theory, the plaintiff must first identify the risk that is concealed. That specific risk must later “materialize” to establish loss causation.

If the concealed risk appears or materializes, loss causation is established. In Teamsters Local 445 v. Bombardier, 2005 WL 218919 (S.D.N.Y. Sept. 6, 2006), the complaint alleged that there were misrepresentations and omissions regarding the integrity of the underwriting standards for securitized interests in a pool of mortgages. Plaintiffs claimed that loss causation was adequately pled because the complaint alleged that the disclosure of any exceedingly high delinquency rate for the mortgage pool caused the price to drop. District Judge Scheindlin held this sufficient, noting that a corrective disclosure was not required where the concealed fact materializes.

Judge Kaplan came to a similar conclusion in In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 510 (S.D.N.Y. 2005). There, plaintiffs alleged sham transactions undertaken to aid Parmalat in concealing its true financial condition. The scheme involved the use of worthless invoices to conceal the fact that Parmalat could not pay its debt. The scheme emerged or materialized because of the increasing delinquency rate for the invoices.

In contrast, where sufficient facts do not materialize to reveal the truth to the markets, loss causation has not adequately been pled. In In re Initial IPO Sec. Litig., 399 F. Supp. 2d 261 (S.D.N.Y. May 6, 2006), the complaint alleged in part that the defendants discounted earnings estimates so that companies could beat the estimates. As a result, the share price became inflated. The scheme materialized, according to the complaint, when the companies failed to meet earnings and the financial statements became available. District Judge Scheindlin, who also wrote the opinion in Bombardier, rejected the claim holding: “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.” In a subsequent opinion, the court amplified its holding, noting: “Because plaintiffs do not allege that the scheme was ever disclosed, they fail to allege loss causation.”

In contrast, where the truth leaks out and its impact cannot be distinguished from other market events, the theory fails. Thus, in In re Williams Securities Litig., 496 F. Supp. 2d 1195 (N.D. Okla. July 6, 2007), the court held that a plaintiff relying on this theory “must provide proof that the market recognized a relationship between the event disclosed and the fraud.”

Other key loss causation questions concern how much truth must be revealed and the impact of other causes. In In re Retek Sec. Litig., 2005 WL 3059566 (D. Minn. Oct. 21, 2005), the court held that Dura is satisfied at the pleading stage if part of the truth emerges. There, a financial fraud compliant was held sufficient on a motion to dismiss where it alleged four interconnected schemes and the price dropped when a press release revealed one of the schemes. If, however, the complaint is based multiple, separate schemes, one of which is revealed, Dura is only satisfied as to the one. See, e.g., Marsden v. Select Medical Corp., 2007 WL 1725204 (E.D. Pa. June 12, 2007).

Finally, at the pleading stage it is not necessary to establish the sole cause of the loss to satisfy Dura. In In re Daou Systems, Inc., 411 F.3d 1006 (9th Cir. 2005), the complaint alleged a financial fraud in which revenues were overstated. By the third quarter the financial condition of the company was deteriorating. When the quarterly results were announced, the price of the stock dropped. An analyst report suggested that the company was “cooking the books.” The circuit court reversed a district court order dismissing the complaint. The court held that the plaintiff is not required to show that the misrepresentations are the sole cause. Rather, plaintiff is only required to demonstrate that it is “one substantial cause” of the decline. The fact that there are other contributing causes will not bar recovery, according to the court. See also In re Winstar Comm., 2006 WL 473885 (S.D.N.Y. Feb. 27, 2006) (the source of the information need not be the company; what is critical is that the truth emerges); see also In re Acterna Corp., Sec. Litig., 378 F. Supp. 2d 561 (D. Md. 2005) (general declining economic conditions not sufficient).

Next: Conclusions

Part X: Securities Class Actions: Current And Emerging Trends

One theory of Dura loss causation is the fraud on the market theory. Under this theory, the specific fraud must be revealed. This is the basic theory in Dura. The court applied this theory in Tricontinental Ind. v. PWC, 475 F.3d 824 (7th Cir. 2007). There, the complaint alleged that plaintiff sold assets to defendant for stock in reliance on the 1997 financial statements. In 2000, the defendant announced an investigation of possible accounting irregularities for the period 1998-1999. Following the announcement, the stock price dropped. The Seventh Circuit agreed with the district court that these allegations were inadequate: Dura “stresses that the complaint must ‘specify’ each misleading statement … and that there must be a causal connection … .” A general acknowledgement of “accounting irregularities” is not sufficient. See also In re Bristol-Myers Squibb Sec. Litig., 2005 WL 2007004 (S.D.N.Y. Aug. 17, 2005) (holding that it is the actual facts which are disclosed that is key, not the perception of the market).

It is critical to this theory that the truth be disclosed prior to the drop in the stop price. Conversely, it is not sufficient to plead facts demonstrating that the truth emerged after the share price drops. In Schleider v. Wendt, 2005 WL 1656871 (S.D. Ind. Jul 14, 2005), the complaint claimed that false statements were made about the operations during the class period. During the period the share price declined. After the class period, the company filed for bankruptcy and later still the truth emerged. The court held that there was a failure to plead loss causation: “The stock had long since hit bottom before these alleged misrepresentations became known.” See also In re Coca-Cola Enterprises, Inc., Sec. Litig., 2007 WL 472943 (N.D. Ga. Feb. 7, 2007) (same); Powell v. Ida Corp., Inc., 2007 WL 1498881 (D. Idaho May 21, 2007) (same).

Price inflation plus reliance on the integrity of the market also is not sufficient. Thus, the court in In re Business Objects, S.A., Sec. Litig., 2005 WL 1787806 (N.D. Cal Jul. 27, 2005) concluded that a complaint was insufficient because it alleged only that the class “suffered damages in reliance on the integrity of the market, [and that] they paid inflated prices for” the stock. See also Reding v. Goldman Sachs & Co., 382 F. Supp. 2d 1112 (E.D. Mo. 2005).

Likewise, a bankruptcy announcement has been held to be insufficient. In D.E. & J. Ltd. Partnership v. Conaway, 133 Fed. Appx. 994 (6th Cir. 2005), the stock price was alleged to have been inflated by concealing the true financial condition of the company. When the company filed for bankruptcy, the price dropped. The court rejected plaintiff’s claims that this was sufficient without more, concluding that an allegation that “a stock price dropped on a particular day, whether as a result of a bankruptcy or not, is not the same as an allegation that a defendant’s fraud caused the loss.” Indeed, under this theory, the complaint must specifically allege that the stock was sold at a loss. Knollenberg v. Harmonic, 152 Fed. Appx. 674 (9th Cir. 2005).

Next: Dura and the theory of materialization