Timing is Everything: The Supreme Court Tightens the Rules for Proving Harm in Securities Fraud Suits

Securities fraud seems to be in the air. From notorious corporate collapses like Enron, and high-profile prosecutions of alleged fraudsters like Bernie Ebbers and Kenneth Lay, to new statutes like the Sarbanes-Oxley Act of 2002, securities law is making more front-page news than at almost any time since the stock market crash of 1929.

In this environment, one might expect to see civil liability for securities violations expanding rather than contracting. On April 19, however, when the Supreme Court issued its decision in Dura Pharmaceuticals v. Broudo, it restricted civil liability for securities fraud.

In Dura, a lower court had established a very low threshold for proving economic harm under the federal securities laws. But the Court unanimously and resoundingly rejected that standard--and, in so doing, preempted what might have been a wave of new securities lawsuits.

The Competing Theories of Harm at Issue in Dura

A plaintiff needs to prove a number of things in order to recover under the federal securities laws for an alleged fraud:

First, the plaintiff must show that the defendant made a material representation (or omitted to disclose a material fact) in connection with the purchase or sale of a security. Second, he or she must show that the defendant intended to defraud. Third, the plaintiff must show that he or she relied on the representation or omission.

And fourth, the plaintiff must show that he or she suffered the kind of economic harm for which the securities laws allow recovery. (Generally speaking, "recoverable" economic harm means that the fraud in question, as opposed to general market forces, was the source of the plaintiff's injuries.) This was the element at issue in Dura.

In particular, Dura concerned an important question of how economic harm must be proved. Lower courts had been using two different standards that had dramatically different implications for stock fraud suits, and the Supreme Court granted review to resolve this difference.

The U.S. Court of Appeals for the Ninth Circuit--the court that had initially decided Dura--held that harm was established if the plaintiff proved that, at the moment he or she purchased the stock, its price was inflated over its "true" value by fraud. It was unnecessary, the Ninth Circuit said, to prove any subsequent price drop associated with discovery of the fraud, since the "harm" had already occurred at the instant of purchase.

But other lower courts explicitly disagreed with the Ninth Circuit. They held that harm does not occur until the stock price actually drops (usually after the fraud is discovered). Merely purchasing a stock with a fraudulently inflated price was itself not a recoverable loss. According to these courts, only when the market learns of the fraud and corrects for the inflation, and the plaintiff therefore loses money, is the legally relevant harm suffered.

Why the Supreme Court's Rejection of the Ninth Circuit's Lower Standard Matters

In Dura, the Supreme Court rejected the Ninth Circuit's theory. It sided with the other lower courts, holding that mere price inflation at the time of purchase was not sufficient to establish harm to investors. This ruling will have a significant effect on federal securities litigation.

In theory, the choice of standards for measuring this kind of harm should make little difference. Assuming that the experts valuing the stock are doing their jobs correctly, the amount of price inflation attributable to a fraud at the time of purchase should be equivalent to the amount that the price falls once the fraud is discovered. Thus, it shouldn't matter if one evaluates harm at the time of purchase or at the time the price dropped: the difference in stock price should be the same and the compensation to the injured plaintiff identical under both standards.

In practice, however, proving harm at the time of purchase is much simpler than proving harm at the time the fraud is discovered. To prove the former, all one needs is a financial expert who would testify that the purchase price was inflated by some amount as a result of an alleged fraud. And the reality of modern litigation (fortunately or unfortunately) is that there is always some academically qualified expert who can provide that testimony.

Under the price-drop standard, by contrast, one has to wait until the stock price actually drops--often months or years later--and then prove why it dropped, which includes filtering out price fluctuations caused by factors other than the alleged fraud. Given the innumerable factors that can affect stock prices, this can be a daunting prospect.

There are even cases in which it is difficult to determine whether discovery of the alleged fraud affected the stock price at all, given intervening market developments. In Dura itself, for example, correction of one of the alleged misrepresentations led to a 20% drop in stock price. The stock rebounded, however, to its original, pre-disclosure price within a matter of days. This quick recovery suggests that, at least by the time of the corrective announcement, the alleged fraud was not inflating the stock price at all.

Moreover, the constraints on the critical expert testimony about stock value are not equal as between the two tests. Requiring the experts to focus on the actual evidence of whether disclosure of the fraud affected the stock price provides a reality-based limitation on the scope of possible expert opinion. In contrast, as noted above, experts have a comparatively free hand when it comes to testimony about initial price inflation caused by the fraud.

The Bottom Line: The Supreme Court's Decision Makes It Harder for Plaintiffs

In sum, though the two standards at issue in Dura are equivalent in theory, they are not equivalent in practice. In practice, plaintiffs would have a much easier time proving harm if they could focus simply an alleged price inflation at the time of purchase. Now that, after Dura, plaintiffs cannot rely on that approach, they will have a much harder time proving the necessary harm. Inevitably, that means fewer successful securities suits in the future.