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.

LIABILITY IN SECURITIES FRAUD ACTIONS: Part XX: Theories of Proof Under Dura.

Following Dura Pharmaceuticals, Inc., v. Broude, 544 U.S. 356 (2005), securities law plaintiffs can no longer simply plead “fraud on the market” to link the claimed fraud to the economic injury. While such an allegation continues to suffice as to transaction causation – sometimes called reliance or but for causation – it is not sufficient to establish transaction causation or proximate cause. Following Dura, a complaint which alleges that “Plaintiffs and the class have suffered damages in that, in reliance on the integrity of the market, they paid inflated pries for Business Objects’ publicly traded securities” will be dismissed for failing to plead loss causation. In re Business Objects S.A. Sec. Litig., 2005 WL 1787806 (N.D. Cal. July 27, 2005); see also Reding v. Goldman Sachs & Co., 382 F. Supp. 2d 1112, 1126 (E.D. Mo. 2005).

Equally clear is the proposition that the securities law plaintiff must now plead specific facts to link the fraud to the economic injury. The decision in Knollenberg v. Harmonic, 152 Fed. App. 674 (9^th Cir. 2005) illustrates this point. There, plaintiffs filed a securities fraud complaint predicated on a merger. The complaint alleged that the financial data furnished to investors was false. The court dismissed the complaint, however, because it failed to specifically allege that the stock was sold at a loss. See also, Glaser v. Enzo Biochem, Inc., 474 F.3d (4^th Cir. 2006) (following Dura in a common law fraud case).

Dura requires that the truth be revealed about the specific fraud. Thus, in a financial fraud case where plaintiffs alleged that they relied on the 1997 financial statements of the company, it was held insufficient that the company later admitted to accounting regularities for 1998 and 1999. While the stock price dropped following this revelation, the company did not admit that the financial statements for 1997 were incorrect. The court dismissed the complaint, concluding that Dura “stresses that the complaint must ‘specify’ each misleading statement … and that there must be a causal connection … .” General allegations of “accounting irregularities” are not sufficient. Tricontinental Ind. v. PWC, 475 F.3d 823 (7^th Cir. 2007).

Dura requires that the truth be revealed about the specific fraud. Thus, in a financial fraud case where plaintiffs alleged that they relied on the 1997 financial statements of the company, it was held insufficient that the company later admitted to accounting regularities for 1998 and 1999. While the stock price dropped following this revelation, the company did not admit that the financial statements for 1997 were incorrect. The court dismissed the complaint, concluding that “stresses that the complaint must ‘specify’ each misleading statement … and that there must be a causal connection … .” General allegations of “accounting irregularities” are not sufficient. Tricontinental Ind. v. PWC, 475 F.3d 823 (7 Cir. 2007).

Similarly, filing bankruptcy and the resulting stock drop is be insufficient under Dura absent disclosure of the specific facts about the fraud. In D.E. & J. Ltd. Partnership v. Conaway, 133 Fed. App. 994, 999-1000 (6^th Cir. 2005), the complaint alleged that the price of the stock was artificially inflated by concealing the true financial condition of the company. When the company filed for bankruptcy the stock price dropped. Nevertheless, the court found the complaint failed to adequately allege Dura causation. The court explained 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.”

Next: Materialization