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February 25, 2016

Securities 101: A Circuit Split in the Standard for Pleading Loss Causation in Securities Fraud Cases

How the split came to be and why the Supreme Court should resolve it

Jonathan Schwartz

Most securities fraud cases are brought under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated by the Securities and Exchange Commission (SEC). Section 10(b) makes it unlawful to “use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe. . . .” Rule 10b-5 prohibits any person from

mak[ing] any untrue statement of a material fact or . . . omit[ting] to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading . . . in connection with the purchase or sale of any security.

It is well settled that, to state a claim for securities fraud under section 10(b) and Rule 10b-5, a plaintiff must adequately allege (1) a material misrepresentation or omission; (2) made with scienter; (3) in connection with the purchase or sale of a security; (4) reliance on the misstatement or omission; (5) economic loss; and (6) a causal connection between the material misrepresentation or omission and the loss, commonly called “loss causation.” Dura Pharm., Inc. v. Broudo, 544 U.S. 336, 341–42 (2005).

What remains uncertain, however, is the degree to which a securities fraud plaintiff must plead loss causation. For more than a decade, federal circuits have disagreed over which Federal Rule of Civil Procedure pleading standard to apply in determining the sufficiency of a plaintiff’s pleading of loss causation in a securities fraud complaint: Rule 8(a)’s “short and plain statement” standard or Rule 9(b)’s “particularity” standard. With more and more federal circuit courts aligning themselves in one camp or the other, a practitioner handling securities fraud cases should understand where the circuit split began and how to handle it until the United States Supreme Court wades into the fray and conclusively decides the matter. Until then, best practices seem to suggest that the safest bet is to plead loss causation in accordance with Rule 9(b).

The Historical Backdrop: Proving Loss Causation
Since the 1980s (or earlier), federal courts have lacked consensus on what plaintiffs need to prove in order to prevail on section 10(b) and Rule 10b-5 claims. Some courts, for example, required an investor to prove loss causation, or that the defendant’s misrepresentation or omission proximately caused the plaintiff’s loss (i.e., that the misrepresentation or omission related to the reason for the decline in the value of the security). See, e.g., Huddleston v. Herman & MacLean, 640 F.2d 534, 549 (5th Cir. 1981). Other courts, however, used the “transaction causation” theory and required a plaintiff to simply show that the defendant’s misrepresentation or omission caused the plaintiff to purchase a security that subsequently declined, even if the cause of the decline was unrelated to the misrepresentation or omission. See, e.g., Lubin v. Sybedon Corp., 688 F. Supp. 1425 (S.D. Cal. 1988). One court illustrated these differences when it explained that

an investor might purchase stock in a shipping venture involving a single vessel in reliance on a misrepresentation that the vessel had a certain capacity when in fact it had less capacity than was represented in the prospectus. However, the prospectus does disclose truthfully that the vessel will not be insured. One week after the investment the vessel sinks as a result of a casualty and the stock becomes worthless.

Huddleston, 640 F.2d at 549 n.25.

In this example, an investor could not prove loss causation (i.e., that the misrepresentation caused the investor’s loss) because the loss was not caused by the misrepresentation about the vessel’s capacity, but rather by the lack of insurance. Conversely, under the “transaction causation” theory, an investor could potentially prevail by demonstrating that the misrepresentation about the vessel’s capacity induced the investor to purchase the stock.

To settle the disagreement, Congress enacted the Private Securities Litigation Reform Act (PSLRA) in 1995. In addition to requiring proof that the investor relied on the defendant’s misrepresentation or omission in purchasing the security, the PSLRA specifically requires that the investor prove that the defendant’s act or omission caused the loss for which the investor seeks damages. Thus, since 1995, plaintiffs have been required to prove reliance and loss causation in order to prevail in a securities fraud case.

The Historical Backdrop: Pleading Loss Causation
Although the requirement to prove loss causation became clear with the enactment of the PSLRA, the standard for pleading it under the Federal Rules of Civil Procedure did not. As a general matter, to properly plead a claim brought under section 10(b) or Rule 10b-5, a complaint must satisfy the federal notice pleading requirements found in Rule 8(a)(2), special fraud pleading requirements found in Rule 9(b), and the additional pleading requirements imposed by the PSLRA.

Under the federal notice pleading standards of Rule 8(a), a complaint must contain “a short and plain statement of the claim showing that the pleader is entitled to relief.” In addition, Rule 9(b) requires that, for complaints alleging fraud or mistake, “a party must state with particularity the circumstances constituting fraud or mistake,” although “[m]alice, intent, knowledge, and other conditions of a person’s mind may be alleged generally.” In addition to Rule 9(b), the PSLRA imposes additional heightened pleading requirements for securities fraud claims, mandating that “the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” None of the foregoing, however, specifically addresses whether the loss causation element of a securities fraud claim also is subject to this heightened pleading standard.

In 2005, the U.S. Supreme Court muddied the waters when it took on the issue in Dura Pharmaceuticals and held that plaintiffs bringing 10(b) claims must allege some causal connection between the alleged misrepresentation and the loss suffered. In discussing the pleading standard for such allegations, the Supreme Court did not expressly resolve the issue of whether Rule 8(a) or Rule 9(b) applied to pleading loss causation. Instead, the Court explained that, consistent with Rule 8(a)(2), a complaint need only provide a defendant with “fair notice of what the plaintiff’s claim is and the grounds upon which it rests.” 544 U.S. at 346. While the complaint in Dura Pharmaceuticals was deemed insufficiently pled because it only generally alleged damages resulting from the plaintiffs’ purchase of Dura Pharmaceuticals stock at artificially inflated prices, the Supreme Court indicated that the complaint would have been sufficient had it alleged that Dura Pharmaceuticals’ stock price fell after the alleged misrepresentations were revealed. The Supreme Court also noted that the standard for pleading loss causation was a “simple test” and that “it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind.” Id. at 346–47.

Thus, even though Rule 9(b) and the PSLRA imposed a heightened pleading standard for other securities fraud elements, the Supreme Court indicated that Rule 8(a)’s “short and plain” statement standard may apply to the loss causation element of a securities fraud claim. Consequently, courts have since applied the pleading requirements of both Rules 8(a) and 9(b) to different individual elements of securities fraud claims.

The Current Circuit Split
Without clear guidance from the Supreme Court, courts throughout the federal circuits have continued reaching different conclusions with respect to which pleading requirement applies to loss causation in securities fraud cases. The Seventh Circuit was the first to decide the matter when it held in 2007 that the heightened pleading standard of Rule 9(b) applies to all elements of a securities fraud action, including loss causation. Tricontinental Indus. Ltd. v. PricewaterhouseCoopers, LLP, 475 F.3d 824, 842 (7th Cir. 2007). The Fourth Circuit joined the Seventh Circuit in 2011, and the Ninth Circuit also agreed with this approach at the end of 2014. Katyle v. Penn Nat’l Gaming, Inc., 637 F.3d 462, 471 (4th Cir. 2011); Or. Pub. Emps. Ret. Fund v. Apollo Grp. Inc., 774 F.3d 598 (9th Cir. 2014).

The Ninth Circuit rationalized its holding based on three main reasons. First, Rule 9(b) applies to all circumstances of common-law fraud, from which securities fraud law is derived. Consequently, it makes sense to apply the same pleading standard to common-law fraud claims and securities fraud claims. Second, Rule 9(b) specifically requires plaintiffs to “state with particularity the circumstances constituting fraud or mistake.” Given that loss causation is one of the elements of a securities fraud claim, it is a “circumstance” constituting the fraud. Finally, applying Rule 9(b) to the loss causation element would create a uniform standard for evaluating pleadings in securities fraud cases, thereby removing the piecemeal standard that uses both Rules 8(a) and 9(b).

The Fifth Circuit, on the other hand, reached the opposite conclusion in 2009 and held that the heightened pleading standard does not apply to loss causation. Lormand v. US Unwired, Inc., 565 F.3d 228 (5th Cir. 2009). The court based its ruling on the U.S. Supreme Court’s decision in Bell Atl. Corp. v. Twombly, 127 S. Ct. 1955 (2007), which held that Rule 8(a) requires that a complaint include facts giving rise to a “plausible” (as opposed to “conceivable”) entitlement to relief. As stated by the Fifth Circuit in reiterating Twombly, the “plausibility” standard was not a heightened pleading standard; rather, it was the standard always required by the Federal Rules of Civil Procedure. Lormand, 565 at 258 n.29.

Other circuits have not addressed the issue or have declined to decide it. The Second Circuit even appears to have compounded the confusion further by creating its own standard that applies neither Rule 8(a) nor Rule 9(b) but instead requires a plaintiff to “plead that the loss was foreseeable and caused by the materialization of the risk concealed by the fraudulent statement.” ATSI Commc’ns Inc. v. Shaar Fund, 493 F.3d 87, 106 (2d Cir. 2007). In turn, district courts within the Second Circuit have applied both Rules 8(a) and 9(b) when evaluating whether a complaint has met the Second Circuit standard. Perhaps the most accurate assessment of the state of the issue is the First Circuit’s recent statement that the law is “unclear.” Mass. Ret. Sys. v. CVS Caremark Corp., 716 F.3d 229, 239 n.6 (1st Cir. 2013).

Since Dura Pharmaceuticals, the majority of federal circuit courts that have considered the issue have held that loss causation in securities fraud cases must be plead with particularity under Rule 9(b). Certainly, this will make pleading securities fraud more difficult for plaintiffs, as they will need to allege sufficiently particularized facts averring that the defendant’s conduct was a substantial cause of their injury. Yet, Congress enacted the PSLRA in the first instance and required plaintiffs to prove these elements in order to counter the abusive class action strike suits brought by plaintiffs’ attorneys anytime a stock price declined. Thus, requiring plaintiffs to plead these facts does not impose a burden beyond what they would have to show at trial anyway.

Until there is a uniform approach to pleading loss causation, practitioners would be best served by pleading securities fraud claims in conformity with Rule 9(b)’s heightened standard. While there may be additional labor in doing so at the pleading stage, including these particularized allegations in the complaint would reduce the risk of dismissal and, moreover, the costs associated with unnecessary motion practice.

Ultimately, however, without the Supreme Court’s intervention, courts will undoubtedly continue applying different pleading standards to securities fraud claims. Yet, given the growing circuit split on this issue, the current prominence and prevalence of securities fraud cases, and the Supreme Court’s newfound willingness to hear such cases, this issue may be decided sooner rather than later.

Keywords: litigation, securities, loss causation, transaction causation, heightened pleading, PSLRA