Issues
Oral argument:
January 12, 2005
Court below:
Dura Pharmaceuticals is a publicly traded company that developed and marketed prescription pharmaceuticals for the treatment of allergies and asthma. Investor plaintiffs brought a class action securities fraud action against Dura under §10(b) of the Securities Exchange Act, alleging that Dura knowingly misrepresented the success of the clinical trials for one of their asthma products, transferred the losses incurred from product development to subsidiary corporations in order to perpetuate the perception of high earnings for the parent company, and made repeated public statements regarding the success of its drug sales when sales were actually declining. The plaintiffs also claimed that Dura executives sold approximately $400 million of their personally-held Dura stock, actions which raise suspicions of insider trading.
The trial court dismissed the plaintiffs' complaint, ruling that the plaintiffs had failed to meet the pleading requirements of §10(b) and the Private Securities Litigation Reform Act. On appeal, the Ninth Circuit reversed, ruling that the lower court misinterpreted the loss causation element of §10(b) and that the lower court should have considered the plaintiffs' allegations collectively in order to determine whether the pleading requirements had been met. The Supreme Court granted certiorari in order to provide a clear standard on these two pleading requirement issues.
The Supreme Court will now resolve the question of whether or not plaintiff investors met the pleading requirements to bring a cause of action for federal securities fraud under §10(b) of the Securities Exchange Act against Dura Pharmaceuticals.
Questions as Framed for the Court by the Parties
Whether a securities fraud plaintiff invoking the fraud-on-the-market theory must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the investment's subsequent decline in price.
Facts
Defendant Dura Pharmaceuticals ("Dura") is a publicly traded company that develops and markets prescription pharmaceuticals for the treatment of allergies and asthma. The plaintiffs are investors who purchased Dura stock between April 15, 1997 and February 24, 1998. Broudo v. Dura Pharms., Inc., 339 F.3d 933, 935 (9th Cir., 2003). The present suit focuses specifically on two products that Dura developed and sold during this time period: (1) Albuterol Spiros, a mechanical inhaler designed to evenly administer asthma medication independent of the patient's ability to operate of the device; and (2) Ceclor CD, an asthma antibiotic.
Dura encountered problems during the development of the Spiros inhaler, which significantly increased the cost of product completion. Specifically, developers working to obtain FDA of approval of the device discovered during late-stage clinical trials that the aerosolizing device was unreliable and would need to be changed, which would render previous clinical trials invalid. Dura executives disguised these problems and cost overruns by creating subsidiary companies which incurred all of the expenses of Spiros product development in their names and allowed Dura to continue to report high earnings. Plaintiffs allege that these artificially high earning reports led investors to pay falsely inflated prices for Dura stock.
During the relevant time period, Dura also released a number of public statements in which, plaintiffs claim, Dura executives knowingly misrepresented the status of the company's Spiros product development and overall drug sales. Specifically, Dura released a statement claiming that the company had "completed the design of its Albuterol Spiros drug system and the patient dosing studies necessary for filing a New Drug Application with the FDA," despite the company's knowledge of the previously-described serious clinical defects and lack of FDA approval. In re Dura Pharm., Inc. Sec. Litig., No. 99cv0151-L(NLS) (S.D.Cal. 2000).
During this time period, Dura also repeatedly stated that it was pleased with Ceclor CD market reaction and sales, despite the fact that Ceclor sales actually began to decline in March, 1997 and continued to do so throughout the summer. To cover up the decrease in sales and maintain high earning reports, Dura engaged in "channel stuffing", whereby the corporation artificially inflated its reported sales by inducing drug distributors to purchase excess inventories in advance by offering discounts and favorable financing for Ceclor. Also during this time period, Dura executives sold nearly $400 million of personally-held Dura shares, which amounted to 34-61% of their total stock holdings. Id. The plaintiffs claim that these actions amounted to insider trading and serve as proof that Dura was knowingly misrepresenting its success to investors.
The plaintiffs allege that the combination of hiding the Spiros cost overruns and clinical problems with deceptive statements regarding positive sales and product development contributed to Dura's stock reaching an all-time high of $53 per share during the class period. The ensuing public revelation of these misrepresentations on the last day of the class period (February 24, 1998) led to an immediate 47% decline in Dura's stock price and prompted the present class action securities fraud lawsuit.
The plaintiffs brought their action primarily under §10(b) of the Securities Exchange Act. In order to properly plead a violation of §10(b), plaintiffs must state the following:
defendants made a false statement or omission with regard to a material fact;
in connection with the purchase or sale of a security;
with scienter;
upon which plaintiffs reasonably relied;
to their harm or detriment.
Id. Scienter is defined as the intent to deceive, manipulate or defraud. Id. To give courts clearer guidelines in determining whether plaintiffs met their pleading burdens in a §10(b) action, Congress enacted the Private Securities Litigation Reform Act ("PSLRA") in 1995, which requires that plaintiffs state with particularity all facts giving rise to an inference of scienter for each claim put forward in the complaint.
At trial, defendants Dura and the individually named Dura executives moved to dismiss the plaintiffs' complaint for failure to meet the above-described pleading standards. The trial court agreed, noting that plaintiffs had not met the requirement of setting forth the specific facts which allegedly gave rise to an inference of scienter. The court further ruled that none of the individual allegations rose to the level of being actionable under §10(b). It therefore dismissed the complaint with leave to amend. The plaintiffs subsequently amended their complaint and the court once again found that the plaintiffs failed to meet the pleading requirements as set forth in §10(b) and the PSLRA. This time, the court dismissed the complaint without leave to amend.
The plaintiffs subsequently brought an appeal in the Ninth Circuit, which reviewed the case anew and reversed the trial court's ruling. The appellate court ruled that the trial court erred in:
ruling that plaintiffs had not properly pled the loss causation element of §10(b), which requires plaintiffs to show that the misrepresentations at issue are related to the stock's decline in value;
failing to consider whether the complaint's allegations, when considered collectively, met the pleading requirements, instead of simply finding each individual allegation to be insufficient on its own;
ultimately dismissing the complaint with prejudice when the plaintiffs could reasonably have been expected to successfully amend the complaint.
Broudo, 339 F.3d at 941.
Regarding the issue of loss causation, the district court had construed this element as a requiring the existence of a corrective disclosure on the part of the company which preceded a drop in stock price. The Ninth Circuit noted that the loss causation element of §10(b) is ambiguous. Id. at 938. It then concluded that plaintiffs, in order to satisfy the loss causation element, merely had to show that the price of the stock at the time they purchased it was inflated, and to explain how the inflated price was related to the misrepresentations. Id. at 939. The court concluded that plaintiffs successfully met this requirement. Id. The court left open the issue of whether the allegations, when considered collectively, met the pleading requirements of the action.
On June 28, 2004, the U.S. Supreme Court granted the Ninth Circuit's petition for writ of certiorari to resolve the issues of (1) how the loss causation requirement of §10(b) is to be interpreted, and (2) whether individual allegations in a §10(b) action may be considered collectively in order to meet pleading requirements.
Analysis
Importance of the case
The Court's ruling on the above issues will provide needed clarity regarding §10(b) securities fraud pleading requirements. Regardless of what the Court ultimately decides, the ruling will no doubt aid potential plaintiffs in successfully crafting their complaints and in getting past the pleading stage when bringing a §10(b) securities fraud action.
Discussion
The Court will likely follow the Ninth Circuit's reasoning on both issues. It is important to keep in mind that at the heart of any securities action is a claim of scienter - willful deceit or manipulation. The Court will therefore interpret the loss causation element of §10(b) in manner that will most readily facilitate an accurate assessment of whether the defendants engaged in scienter. If plaintiffs can prove that the worth of their investment was overstated, and that this overstatement was directly connected to knowing misrepresentations on the part of the company, then this provides the court with evidence of scienter. Whether the company actually made corrective disclosures which led to a drop in stock price is less relevant in proving scienter; a company may make corrective disclosures in good faith at the first indication that prior projections are incorrect, leading to a drop in stock price -- yet the firm has engaged in no actionable conduct.
It is also likely that the Court will rule that courts should consider individual §10(b) allegations collectively in determining whether securities fraud pleading requirements have been met. Once again, if the ultimate goal of the court is to accurately determine whether the defendant company engaged in knowing deceit, then it is logical to evaluate the company's actions over time and in relation to one another.