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Two recent interrelated trends have had a significant impact on federal securities litigation: (1) the marked decline in the number of securities fraud class action cases filed in 2005 and 2006; (2) the more stringent "loss causation" standard adopted by the U.S. Supreme Court in the Dura Pharmaceuticals, Inc. v. Broudo case, 544 U.S. 336 (1995). Both of these trends will have far-reach effects on public companies and their director and officer insurers.
I. In Spite of a New Wave of Corporate Scandals, the Number of New Securities Fraud Class Action Filings Has Fallen to an All Time Low
According to the Stanford law School Securities Class Action Clearinghouse, the leading source for data and analysis regarding the financial and economic characteristics of federal securities fraud class action litigation, the number of securities fraud class actions filed in 2006 was the lowest ever recorded in a calendar year since the adoption of the PSLRA. Securities fraud class actions decreased by 38 percent since 2005, falling from 178 filings to just 110. This is 43 percent lower than the ten-year historical average of 193. 2006 followed the trend evidenced in 2005. Class action filings decreased in 2005 to 178 from 213 in 2004.
The decline in 2006 class action filing is even more striking when filings alleging options backdating are excluded. To date, there have been 22 securities class actions filed related to options backdating allegations, 20 of which were filed in 2006. Excluding the options backdating cases from the list, there were only 90 securities fraud class action cases filed in 2006, a decline of 53% from the historic average. Of the cases filed in 2006, most focused on specific accounting and reporting irregularities.
The Clearinghouse attributes the record low number of class action filings in 2006 to a number of factors. First, the SEC and Department of Justice now often bring intense pressure on corporations to conduct internal investigations that implicate individual executives allegedly responsible for fraud. Second, the strong stock market combined with lower stock price volatility typically reduces the number of cases filed. Third, the Sarbanes-Oxley Act of 2002 and increased focus on responsible corporate governance have given the private class action bar less to complain about.
II. The Effect of Dura Pharmaceuticals
The US Supreme Court's decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) has substantially affected how federal securities class actions are litigated, and may have played a role in limiting class action filings in 2006. In Dura, plaintiffs alleged that the defendant pharmaceutical company made false and misleading statements, touting sales of its antibiotic drug as well as its asthma delivery device. On 24th February, 1998, the last day of the class period, Dura announced lower than forecast revenues and earnings due to lower than forecast sales of the antibiotic. The stock fell by 47 per cent. Nearly nine months after the class period ended, Dura announced that the FDA found the asthma device not approvable. Class action complaints were filed. The district court dismissed the case and held that the complaint failed to plead "loss causation", an essential element of a securities fraud claim, because the complaint did not plead that the FDA's non-approval of the device had any relationship to the stock price drop at the end of the class period. The Ninth Circuit reversed, holding that loss causation is satisfied if plaintiffs establish "that the price on the date of purchase was inflated because of the misrepresentation". 339 F.3d 933, 938 (9th Cir. 2003). The Ninth Circuit held that loss causation does not require pleading a stock price drop following a corrective disclosure or otherwise.
The Supreme Court reversed the Ninth Circuit's holding in a unanimous decision authored by Justice Breyer. The Court emphasized the requirement in the Reform Act that the misrepresentation at issue caused the loss. The Court stated:
The statute thereby makes clear Congress' intent to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss. By way of contrast, the Ninth Circuit's approach would allow recovery where a misrepresentation leads to an inflated purchase price but nonetheless does not proximately cause any economic loss. That is to say, it would permit recovery where these two traditional elements in fact are missing.
Post-Dura, plaintiffs must plead that their loss is related to the misrepresentations at issue in the complaint and to the subject of the corrective statement that caused the stock to drop. Applying Dura, federal courts throughout the country have been tightening the standards for pleadings and proving "loss causation."
For example, in D.E. & J. Limited Partnership v. Conway, 133 Fed.Appx. 994 (6th Cir. 2006) relying on Dura, the Sixth Circuit affirmed the District Court's dismissal with prejudice for failure to plead loss causation. Kmart filed for bankruptcy protection on 22nd January, 2002, and attributed its bankruptcy filing to a 'combination of factors, including a rapid decline in its liquidity resulting from Kmart's below-plan sales and earnings performance in the fourth quarter'. On this announcement, Kmart's stock price fell from $1.74 to $0.70. Three days later, the company announced that it had received an anonymous whistleblower letter expressing concerns about the company's accounting and financial results. The letter implicated Kmart's President and Chief Operating Officer and its auditor. Kmart announced that it would conduct an internal investigation. Kmart subsequently received three additional letters. Plaintiffs filed their lawsuit several weeks later.
On 15th May, 2002, three months after the lawsuit was filed, Kmart filed its 10-K and "announced that, due to the bankruptcy and resulting inability to estimate vendor purchases and associated allowances, it had changed its policy of estimating and recording vendor allowances on an interim basis." The result was to restate its financial statements to lower its vendor rebates for the first three quarters of the year at issue by $311m, $211m, and $32m, respectively. On this announcement, Kmart's stock price fell from $1.22 to $1.17. On 15th August, 2002, the plaintiffs filed an amended complaint to add additional parties, incorporate the whistleblower letters, and to extend the class period through the date of the restatement announcement. For their loss causation allegation, the plaintiffs alleged that "they paid artificially inflated prices for Kmart publicly traded securities" and "[a]s a direct and proximate result of defendants' wrongful conduct, plaintiffs and the other members of the Class suffered damages in connection with their purchases."
The Sixth Circuit found that the plaintiffs' loss causation allegation "does not differ in any material respect" from the allegation in Dura: 'D.E. & J. did not plead that the alleged fraud became known to the market on any particular day, did not estimate the damages that the alleged fraud caused, and did not connect the alleged fraud with the ultimate disclosure and loss." D.E. & J, 133 Fed.App. 999-1000. The court rejected the plaintiffs' contention that Kmart's disclosures of its bankruptcy filing and restatement were sufficient to plead loss causation. As to the bankruptcy filing, the court held that the filing did not "disclose any prior misrepresentations to the market"; rather, it attributed the bankruptcy to factors such as poor business performance and a lack of liquidity. Thus, 'D.E. & J. has done nothing more than note that a stock price dropped after a bankruptcy announcement, never alleging that the market's acknowledgement of prior misrepresentations caused the drop. But the observation 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." Id. at 1000-10001. As to the restatement, the
court held that the plaintiffs failed to plead or to argue before the district court that the stock-price drop on the restatement announcement (slightly more than 4 per cent) caused their loss.
As in D.E. & J, in In re Cree, Inc. Securities Litigation, 2005 WL 1847004 (M.D.N.C. 2005), the U.S, District Court for the Middle District of North Carolina held that the plaintiffs failed to adequately allege loss causation. Plaintiffs filed the action shortly after Eric Hunter, Cree's co-founder and former CEO, filed a securities fraud action against Cree and his brother, also a co-founder of Cree. On the announcement of the suit, Cree's stock price dropped 18.5 per cent, and 19 securities fraud lawsuits were filed against the company. The plaintiffs in the consolidated action alleged that Cree engaged in fraudulent transactions with a number of companies, only one of which was mentioned in the Hunter complaint that caused Cree's stock price to drop and precipitated the securities class actions. As to the transactions with that company, the court found that Cree had disclosed the transactions in its SEC filings at the time they were executed and that Hunter's complaint merely attributed to the defendants an improper motive for entering into them - in other words, "Hunter's complaint discloses
nothing new, but merely attributes an improper purpose to the previously disclosed facts." Id. at *12. The court held that the plaintiffs thus could not plead loss causation. Instead, to plead loss causation, "[a] disclosure must reveal new facts; a bald assertion of fraud is not sufficient."
The development, post-Dura, of loss causation pleading standards will have a significant effect on the types of cases plaintiffs file. If applied strictly, as in D.E. & J. and Cree, Dura will curtail a type of filing that is not uncommon - those that couple a negative disclosure with a random collection of allegedly false statements made in the preceding year or two. Given the trend in class action filings, Dura may already be having that affect.
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