Loss causation is an essential element of a claim of securities fraud under section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. The idea is that fraud artificially inflates the stock price, and investors are damaged when the truth comes out, causing the price inflation to dissipate. But any bad news about a company usually causes the stock price to drop, and defendants cannot be held liable for losses caused by things other than fraud. Thus, for years, there has been a debate over what plaintiffs must plead and prove to establish that a stock price drop was caused by fraud. Did the market have to learn that a fraud occurred and react to that news? Or would other facts suffice? In Mineworkers’ Pension Scheme v. First Solar Inc., 881 F.3d 750 (9th Cir. 2018), the Ninth Circuit held that loss causation requires “no more than the familiar test for proximate cause.” This article discusses the implications of First Solar and the tools that are emerging to challenge loss causation in its wake.
In 2005, the U.S. Supreme Court held in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), that investors cannot plead loss causation by merely alleging that they bought their shares at an inflated price; rather, they must plead and prove that the “share price fell significantly after the truth became known.” Dura explained:
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. . . . To “touch upon” a loss is not to cause a loss, and it is the latter that the law requires.
Dura described loss causation as a “simple test” and, echoing now-defunct notice pleading standards, noted:
[I]t 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. At the same time, allowing a plaintiff to forgo giving any indication of the economic loss and proximate cause that the plaintiff has in mind would bring about harm of the very sort the statutes seek to avoid. . . . Such a rule would tend to transform a private securities action into a partial downside insurance policy.
Three major developments followed Dura. First, in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), and Ashcroft v. Iqbal, 556 U.S. 662 (2009), the Supreme Court held that courts must disregard conclusory allegations and unreasonable inferences, and must instead ask whether the factual allegations state a “plausible” theory of recovery. It is thus no longer enough to plead “some indication of the loss,” as the Court said in Dura. Rather, the facts alleged must raise a reasonable expectation that discovery will result in evidence that will support a viable theory of loss causation.
Second, the circuits split on what pleading standards applied to loss causation. The Second, Fourth, and Seventh Circuits indicated that loss causation, like other elements of fraud, is subject to heightened pleading requirements. In Oregon Public Employees Retirement Fund v. Apollo Group Inc., 774 F.3d 598 (9th Cir. 2014), the Ninth Circuit joined them, holding that loss causation must be pleaded with particularity under Rule 9(b) of the Federal Rules of Civil Procedure. All other circuits held that Rule 9(b) did not apply, or they dodged the issue by ruling, for example, that allegations fell short under either standard.
Third, the circuits also split on what facts could show loss causation. All circuits agreed that a “revelation of fraud”—a disclosure that the company misled the market in some material way—would suffice. Some courts drew the line there. Several Ninth Circuit cases expressed that view and rejected claims of loss causation because there was no revelation of fraud. Other circuits, concerned that companies might avoid liability by refusing to admit to fraud, allowed more permissive approaches. The Second Circuit, for example, held that plaintiffs could show loss causation by showing that the defendant’s misstatements concealed a foreseeable risk that materialized and caused the stock price to drop. Before First Solar, the Ninth Circuit had only discussed the materialization-of-the-risk approach but had not endorsed its use. That set the stage for First Solar.
First Solar was one of the world’s largest producers of photovoltaic solar panel modules. In early 2009, a customer complained that some of its sites were experiencing low power output. Within months, the company determined that the cause was a defective manufacturing process it had implemented the previous year, and it began remediation efforts. Investors first learned of the manufacturing defect and related remediation costs when the company released its financial statements for the second quarter of 2010. Over the following quarters, the company’s financial statements reported the continuing impact of the remediation efforts. A second product issue arose in April 2010, when data suggested that solar modules installed in hot climates were experiencing unusual power loss. The company undertook to mitigate those issues too. From early 2008 to early 2012, the company’s stock price plummeted from nearly $300 per share to less than $50 per share. The downturn coincided not only with the product issues but also with the 2008 recession and a change in leadership. Investors sued for securities fraud, alleging that the company and certain individuals had concealed the product defects and the cost and scope of the defects and had reported false information on financial statements.
After discovery, the defendants moved for summary judgment on loss causation, arguing that none of the alleged loss causation events revealed any fraud, which was required for loss causation. They cited one set of Ninth Circuit cases—Oregon Public Employees Retirement Fund v. Apollo Group Inc., 774 F.3d 598 (9th Cir. 2014), Loos v. Immersion Corp., 762 F.3d 880 (9th Cir. 2014), In re Oracle Corp. Securities Litigation, 627 F.3d 376 (9th Cir. 2010), and Metzler Investment GMBH v. Corinthian Colleges, Inc., 540 F.3d 1049 (9th Cir. 2008). The plaintiffs responded that they needed to show only that the misrepresented facts ultimately caused their loss, not that the market learned of and reacted to fraud. They cited a different set of Ninth Circuit cases—Nuveen Municipal High Income Opportunity Fund v. City of Alameda, 730 F.3d 1111 (9th Cir. 2013), Berson v. Applied Signal Technology, Inc., 527 F.3d 982 (9th Cir. 2008), and In re Daou Systems Inc. Securities Litigation, 411 F.3d 1006 (9th Cir. 2005). The district court denied the defendants’ summary judgment motion and certified the order for interlocutory appeal, explaining that it saw two “irreconcilable” lines of Ninth Circuit authority, one that would result in summary judgment for the defendants and one that would result in a lengthy and expensive trial.
On appeal, the Ninth Circuit rejected the defendants’ arguments that loss causation requires a revelation of fraud. Instead, it held that loss causation “requires no more than the familiar test for proximate cause.” It wrote:
To prove loss causation, plaintiffs need only show a “causal connection” between the fraud and the loss . . . by tracing the loss back to “the very facts about which the defendant lied”. . . . “Disclosure of the fraud is not a sine qua non of loss causation, which may be shown even where the alleged fraud is not necessarily revealed prior to the economic loss.” . . . A plaintiff may also prove loss causation by showing that the stock price fell upon the revelation of an earnings miss, even if the market was unaware at the time that fraud had concealed the miss.
Within days, First Solar was hailed as a “game-changer” that would have “far-reaching implications,” with one Law360 article reporting that First Solar “significantly alleviates the burden on plaintiffs to plead (and later show) that the fraud was disclosed to the market, and significantly raises the hurdle for defendants to challenge loss causation at the pleading stage.”
First Solar is significant for several reasons. The Ninth Circuit denied rehearing in May, a petition for certiorari is pending, and the solicitor general has been invited to weigh in. The Supreme Court may use the case as a vehicle to revisit and potentially redefine loss causation. It heard three securities cases last term, and the new conservative justices may be interested in further protecting businesses against the costs of litigating baseless fraud lawsuits. Justice Gorsuch, for example, filed an amicus brief in Dura on behalf of the U.S. Chamber of Commerce while he was in private practice, and he cowrote a paper proposing ways to curb abusive securities litigation, including by enforcing the loss-causation requirement of the Private Securities Litigation Reform Act. First Solar is also significant for those who litigate securities cases in Ninth Circuit and for the many high-tech, biotech, and new-economy companies headquartered there. Too often, those companies face baseless post hoc accusations of fraud when the new technology or the clinical trial results do not work out as expected. To the extent First Solar has made it harder to defend such claims, those companies and their insurers will pay the price in increased litigation and settlement costs.
First Solar is also dangerous, as it presents the risk of limitless liability. Its broad language suggests that it is enough to “trace” disappointing financial results back to some purported misrepresentation. Imagine, as in First Solar, that a company announces that it is remediating a product defect, then continues to report disappointing financial results for the next two years. Investors sue, claiming that the company misrepresented the cost and scope of the defect, so that each new financial report revealed “new” information about the true extent of the problem and its collateral effects, causing the stock price to drop. Such a theory is easy to allege and difficult to challenge, and should not support loss causation past the first disclosure. But who knows if that is what courts will do with it.
Several defenses are developing to address loss causation post–First Solar. Many are familiar. At the pleading stage, the emphasis is on pleading standards and on particularity and plausibility for all elements, including loss causation. Where there are factual gaps, any bridging inferences or conclusory allegations are susceptible to attack. One primary approach is to weaken other elements if possible, as they are the foundation for loss causation and any inferential leaps. At summary judgment and beyond, the plaintiff’s event studies—the typical method of proving loss causation in an efficient market—should fail if the method is unreliable or fails to adequately disentangle other market forces that also affected the stock price. Thoughtfully developed themes and counter-narratives are essential at all stages.
There is also a new focus on directness principles. The point is that proximate cause is supposed to limit liability, not extend it indefinitely. In the cases First Solar cited as examples of properly pleaded loss causation, there was a direct, one-step nexus between the subject of the alleged misrepresentation and the corrective disclosure. Two of the cases, Berson and Daou, involved alleged financial misrepresentations followed by financial disclosures. In a third case, Lloyd v. CVB Financial Corp., 811 F.3d 1200 (9th Cir. 2016), the company told investors there was no basis for serious doubt about its most significant borrower’s ability to repay loans, but then the Securities and Exchange Commission commenced an investigation on that subject, and the company wrote down millions of dollars in loans to that same borrower. In each case, the corrective disclosures amounted to a constructive revelation of fraud—nobody admitted that fraud occurred, but the facts contained in the disclosures said as much.
Unless there is a similar, direct nexus that essentially amounts to a constructive revelation of fraud, there is no reliable way to determine whether investors’ losses were caused by fraud as opposed to other market factors, and it is hard to say that any “truth became known,” as required by Dura. Presumably, that is what the “very facts” language means in First Solar, but how courts will receive these arguments remains to be seen.
Jeanne Detch is an associate with Cooley, LLP, in San Diego, California.
Copyright © 2018, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).