These are not the best of times for law firms that specialize in bringing class action securities suits against public companies. The shareholder suits, which often follow sharp declines in a company’s stock price due to a missed earnings projection or other unfavorable news, generally allege that some fraud or misstatement by the company caused the stock price to plummet.
Known as “strike suits,” these shareholder claims have become a cottage industry for some law firms, especially in times of high-profile corporate fraud cases. Corporate defendants consider the vast majority of these shareholder suits baseless, if not outright frivolous. Still, companies settle most of these claims that survive pretrial dismissal motions as business decisions that spare the expense and risk involved with an actual trial. Often in these settlements, individual investors recover only pennies on the dollar of their losses, but the law firms bringing the claims may gain multimillion dollar legal fees.
Yet the powerful New York-based law firm that has epitomized the class action shareholder suit, Milberg Weiss Bershad & Schulman, was indicted in May on federal charges of mail fraud and racketeering conspiracy for allegedly paying kickbacks to investors to serve as the “lead plaintiff” in these suits. Although the law firm has pleaded not guilty and vehemently denies the allegations, there is little doubt that the criminal charges will hinder the firm in pursuing or bringing new suits while the case is pending.
Corporations that have been the target of class action suits brought by Milberg Weiss might find some satisfaction from the firm’s own legal troubles. Yet there is no shortage of other law firms ready to fill any gap left by Milberg Weiss, and that firm’s indictment certainly will not mean the end of strike suits. Rather, of greater significance to public companies, and of greater concern to lawyers representing investors, are two recent Supreme Court decisions making it more difficult to bring class action shareholder suits.
Did the Misstatement Actually Cause the Loss?
In Dura Pharmaceuticals, Inc. v. Broudo, the Supreme Court said that shareholders cannot base a securities fraud suit merely on the theory that they bought their shares at an artificially inflated price due to a company misstatement. Rather, they must show some clear link between the misrepresentation and the actual decline in the stock price.
Dura Pharmaceuticals was a San Diego company that made products to treat asthma and allergies (before the company was purchased by the Elan Corporation in 2000). The class action suit was brought by shareholders who had bought Dura stock between April 1997 and February 1998 a time when both Dura’s stock and the stock market as a whole were rising. The shareholders contended that Dura made a number of positive, but false, statements during that time about the prospects for one of its products and about the company’s sales.
Then, in February 1998, Dura significantly lowered its revenue projections for 1998, but without correcting or retracting any of its prior statements. Dura’s stock fell 47 percent the day after that announcement, prompting the securities fraud suit. The Supreme Court decision turned on the legal issue of causation whether the shareholders could prove that their losses were caused by any misstatements by the company. At this pretrial stage, the issue was not whether the statements were actually false.
Securities fraud suits against a public company or its officials usually are based on the Securities and Exchange Commission’s Rule 10b-5. To win a Rule 10b-5 claim, the plaintiff shareholders need to prove that the defendant company or its officials, acting with intent to defraud, made a material misstatement or omitted stating some important information. The shareholders must have reasonably relied on the statement and must have suffered some economic loss.
Finally, the misstatement or omission must have “caused” the plaintiff shareholders’ loss. This causation requirement includes two components. First, the plaintiffs need to show “transaction causation” meaning that the misstatements or omissions prompted the plaintiffs to enter into the specific stock transaction. Second, plaintiffs must also prove “loss causation” that the alleged securities law violations caused the actual harm by directly impacting the stock’s price.
The outcome of the Dura case depended on the precise meaning of “loss causation” whether the buyers of the company’s stock between April 1997 and February 1998 could prove loss causation based on the inflated purchase price theory alone. Or, by contrast, did they need to show a specific misrepresentation that directly precipitated the stock’s drastic fall?
A federal district court judge initially dismissed the suit, saying that the plaintiffs had not adequately alleged the connection between any purported misstatements and the February 1998 decline in the stock price. On appeal, the U.S. Ninth Circuit Court of Appeals reversed the trial court and reinstated the class action claim, finding that an allegation of loss causation based on an inflated purchase price was sufficient to entitle the plaintiffs to a trial.
The Ninth Circuit treated this as a “fraud-on-the-market” case meaning that an efficient stock market properly sets a stock’s price, but that any misstatements or omissions about a company can defraud the market as a whole and distort the stock price. In these fraud-on-the-market cases, the Ninth Circuit had previously ruled that “plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation.” As a result, the appellate court ruled, “it is not necessary that a disclosure and subsequent drop in the market price of the stock have actually occurred, because the injury occurs at the time of the transaction.”
Considered one of the most liberal federal appellate courts, the Ninth Circuit recognized that other circuit courts “are less favorable to plaintiffs and do require demonstration of a corrective disclosure followed by a stock price drop to be alleged in the complaint.” The Ninth Circuit’s more generous approach to loss causation, if followed nationwide, would make it harder for public company defendants to have shareholder suits dismissed before trial perhaps thereby prompting even more settlements of dubious class action claims.
The Supreme Court’s Narrower Approach
The Supreme Court in 2005 unanimously rejected the Ninth Circuit’s approach to loss causation. On the appellate court’s conclusion that a shareholder must show only an artificially inflated purchase price to establish loss causation, Justice Stephen Breyer’s opinion responded: “In our view, this statement of the law is wrong. Normally, in cases such as this one (i.e., fraud-on-the-market cases), an inflated purchase price will not itself constitute or proximately cause the relevant economic loss.”
The Court explained that general market and economic conditions, or many other factors, might be the true cause of the stock’s decline, rather than any misrepresentation by the company. Justice Breyer added: “Given the tangle of factors affecting price, the most logic alone permits us to say is that the higher purchase price will sometimes play a role in bringing about a future loss.…But, even if that is so, it is insufficient.”
In support of its decision, the Supreme Court considered the intent of the Private Securities Litigation Reform Act of 1995 (PSLRA). Aimed at law firms such as Milberg Weiss, the PSLRA was an attempt by Congress to make it more difficult to bring shareholder suits.
One provision of the PSLRA requires that plaintiffs in securities fraud suits “have the burden of proving that the act or omission of the defendant…caused the loss for which the plaintiff seeks to recover damages.” The Supreme Court found that statement to be important, saying: “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.” Based on that and other reasons, the Supreme Court said that the Dura shareholders did not adequately allege loss causation and reversed the Ninth Circuit’s decision.
More important than the outcome in the Dura case, what does this ruling mean for other public companies that might face shareholder suits? It is difficult to know exactly how to interpret the case’s impact on other suits, as the Supreme Court’s brief opinion left many unanswered questions.
One plausible view would be that the Supreme Court ruling was a fairly narrow one addressing only fraud-on-the-market cases based on an inflated purchase price theory and not affecting different types of shareholder suits. One might also argue that the Dura opinion was primarily a rejection of a Ninth Circuit decision that conflicted with established law from several other courts. In fact, the Supreme Court did not provide extensive new guidance on how to prove loss causation in a shareholder suit.
Even if that is all that the Supreme Court intended, the Dura ruling is still significant because a contrary decision one accepting the Ninth Circuit view that an inflated purchase price alone can prove loss causation could have opened the floodgates to new and seemingly countless shareholder suits. Stretched to the extreme, such a ruling might have allowed almost any public company, at one time or another, to be sued by unhappy shareholders alleging an artificially inflated purchase price when they bought the company’s stock. Even if those claims were eventually rejected, they would severely burden both the courts and corporate defendants because more shareholder suits would survive pretrial dismissal motions.
However, it is equally plausible, and perhaps even more likely in light of the second Supreme Court decision, that the Court’s ruling should be viewed more broadly than as being a narrow rejection of the Ninth Circuit’s opinion. The Court may have been signaling a skeptical view of shareholder suits in general. The justices clearly recognized that stock prices often fluctuate greatly and due to many different causes. That statement alone could be useful to a corporation being sued after its stock price has fallen. More importantly, the Supreme Court endorsed the general principle that a shareholder suit must prove some definite connection between a company’s alleged misstatement and the specific decline in the stock price.
Shareholder Class Actions Based on State Law
These class action shareholder suits are usually based on federal securities law, rather than on the potentially inconsistent laws of 50 different states. However, once the PSLRA made it harder to bring these claims under federal law, some plaintiffs began to sue under various state law provisions instead.
Congress responded with another statute, the Securities Litigation Uniform Standards Act of 1998 (SLUSA). SLUSA prohibited state-law suits brought by more than 50 shareholders if the suit alleges some misrepresentation or omission “in connection with the purchase or sale” of stock that is subject to federal securities regulation.
In the second Supreme Court case, a group of plaintiffs claimed that this federal preemption under SLUSA applied only to buyers or sellers of stock not to shareholders who held onto the stock or delayed selling it because of allegedly false statements. If the plaintiffs’ argument had succeeded, “holders” of stock could still bring large class action securities fraud suits based on state law.
In early 2006, the Supreme Court rejected that interpretation in Merrill Lynch v. Dabit. In another unanimous decision, the Court held that the phrase “in connection with the purchase or sale” of stock applied not only to buyers or sellers, but also to these holders of stock. The opinion by Justice John Paul Stevens noted that suits “brought by holders pose a special risk of vexatious litigation,” and that a contrary ruling “would give rise to wasteful, duplicative litigation.”
The practical effect of the decision is that state-law class actions brought by more than 50 holders of stock are also preempted by SLUSA. Because prior court cases had decided that only buyers or sellers of stock may sue under Rule 10b-5 of federal securities law, these holders of stock are not able to bring a large class action shareholder suit under either state or federal law. While it is still possible to bring an individual claim based on state law, or a class action representing 50 or fewer shareholders, those claims often are not economically viable based on the smaller amount of damages involved.
Both Supreme Court decisions were more important for what they did not do allow or encourage even more class action shareholder suits than for what they actually said or did. Still, both cases resulted in a victory for corporate defendants and a defeat for shareholders and plaintiffs’ lawyers seeking to bring these claims. In two unanimous rulings, the Supreme Court acted to enforce the intent of congressional legislation specifically designed to narrow the availability of these suits. Together, these rulings will likely have a more lasting effect than even the criminal prosecution of the law firm that has come to symbolize class action shareholder suits.
 John R. Wilke, Nathan Koppel, and Peter Sanders, Milberg Indicted on Charges Firm Paid Kickbacks, Wall St. J., May 19, 2006, at A1.
 Dura Pharm., Inc v. Broudo, 544 U.S. 336 (2005).
 17 C.F.R. § 240.10b-5.
 In re Dura Pharm., Inc. Sec. Litig., 2001 U.S. Dist. LEXIS 25907 (S.D. Cal. 2001).
 Broudo v. Dura Pharm., Inc., 339 F.3d 933 (9th Cir. 2003).
 Id. at 938.
 Id. n.4.
 Dura Pharm., 544 U.S. at 342.
 Id. at 343.
 Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified in various sections of 15 U.S.C.).
 15 U.S.C. § 78u-4(b)(1) (2005).
 Dura Pharm., 544 U.S. at 346.
 Securities Litigation Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat. 3227 (codified in various sections of 15 U.S.C.).
 15 U.S.C. § 78bb(f)(1)(A) (2005).
 Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 126 S. Ct. 1503 (2006).
 Id. at 1514.