The precise impact of Dura continues to be controversial. While the Dura Court held that loss causation is a requirement and what it is not — price inflation alone — the decision does not dictate how the element is to be plead and proved. That loss causation is required is not a new since the passage of the PSLRA. Determining precisely what it is had proven to be more difficult, however. For this reason, while most commentators agree that the case is significant, many argue its importance is difficult to assess in view of the open questions left by the decision. See, e.g., Tom Baer and Sean J. Griffith, How The Merits Matter: D&O Insurance and Securities Settlements, 157 U. Pa. L. Rev. 755 (2009).

Following the Supreme Court’s decision, two basic approaches have been utilized to plead loss causation. The first is the fraud on the market theory. The second is materialization. See, e.g., Ray v. Citigroup Global Markets, 482 F.3d 991 (7th Cir. 2007).

The fraud on the market theory is discussed in Dura and keyed to the Supreme Court’s decision in Basic regarding the efficient market theory. Under this theory, the price drop must result from a corrective disclosure. The disclosure must actually reveal the fraud to the market.

A good example of this approach is the seventh circuit’s decision in Tricontinental Industries, Ltd. v. PriceWaterhouseCoopers, LLP, 475 F.3d 824 (7th. Cir. 2007) which affirmed the dismissal of a securities fraud complaint because the specific fraud was not revealed. In this case, the 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 court found these allegations to be inadequate to establish Dura loss causation: Dura “stresses that the complaint must ‘specify’ each misleading statement . . . and that there must be a causal connection . . .” Id. at 843. Likewise, a general acknowledgement of “accounting irregularities in not sufficient.” See, e.g., Metzler, Inv. GmbH v. Corinthian Col., 540 F. 3d1049 (9th Cir. 2008) (announcement that caused the stock drop did not disclose the truth); Catogas v. Cyberonics, Inc., 292 Fed. Appx. 311 (5th Cir. 2008) (press release mentioning the subject of the fraud but not revealing it not sufficient).

Materialization is a second theory of loss causation frequently used following Dura. The court in Glover v. Deluca, No. 03-0288, 2006 WL 2850448 (W.D. Pa. Sept. 29, 2006) stated that 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 undisclosed condition or event that causes the loss.” To use this theory, plaintiff must first identify the risk that is concealed. Later, that risk “materializes” to establish the loss.

Two examples of the application of this theory are In re Parmalat Sec. Litig., 376 F. Supp. 2d 472 (S.D.N.Y. 2005) and In re Initial IPO Sec. Litig., 399 F. Supp. 2d 261 (S.D.N.Y. May 12, 2005). In the former, the court found a complaint using a materialization theory sufficient at the pleading stage. In Parmalat, there were 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 fraud emerged or materialized because of the increasing delinquency rate for the invoices.

In the latter, the court found that loss causation had not been adequately pleaded because the facts did not materialize to reveal the truth to the markets. In IPO the complaint alleged in part that the defendants discounted earnings estimates so that companies could beat 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. The court rejected this theory concluding that the fact that the companies failed to meet earnings forecasts did not disclose the alleged scheme to the market. In a subsequent opinion, the court reiterated this holding. See In re Initial IPO Sec. Litig., 399 F. Supp. 2d 298 (S.D.N.Y. 2005).

A recent significant decision on loss causation is In re Williams Sec. Litig. — WCG Subclass, 558 F.3d 1130 (10th Cir. 2009). Here, the court considered the question of whether plaintiffs had demonstrated that the claimed losses were in fact caused by a revelation of the fraud and not other causes. The district court granted summary judgment in favor of the defendants after excluding plaintiff’s proffered expert testimony on a Daubert motion. The Tenth Circuit affirmed.

Williams is based on the spin-off by Williams Companies of its telecommunications operations in 2000. At the time of the deal, the company claimed the transaction represented the best way to ensure the success of both businesses. Two years later however the unit spun off, WCG tumbled into bankruptcy with a share price of $0.06.

Plaintiffs offered two theories of loss causation — a leakage theory and a corrective disclosure theory, through their expert Dr. Nye. Under the leakage theory, Dr. Nye opined that the fraud leaked out to the market in a series of small leaks. Under this theory Dr. Nye concluded that the true share price at the time of the spin off was $0.56, not the offering price of $28.50 and used the date of the bankruptcy filing and calculating back to the start of the class period on July 24, 2000 to estimate damages. The court rejected this theory concluding that there was no demonstration of how the truth emerged and because almost of the price decline was attributed to the claimed fraud with no effort to sort out other causes.

The corrective disclosure theory was based on four specific public disclosures: 1) an announcement that the earnings release would be delayed; 2) an announcement that the company may be in default; 3) a subsequent announcement that it was considering bankruptcy; and 4) the bankruptcy filing.

The court rejected this theory for two reasons. First it failed to show new, company specific, and fraud related information which became available to the market after the date the first class action complaint was filed on January 29, 2002. Second, to be a corrective disclosure, it must at least relate back to the misrepresentation and not to some other negative information. While the disclosure does not have to be a “mirror image” of the fraud, it must be “within the zone of risk concealed by the misrepresentations and omissions . . .” claimed by plaintiffs. Here, the claimed press releases did not fall in the zone of risk.

Next: Pleading requirements for loss causation — a split in the circuits.