Saturday, October 11, 2014
One of the most complex issues in Section 10(b) litigation concerns loss causation, i.e., the question whether the fraud ultimately resulted in a loss to the plaintiffs.
The reason loss causation is so complex is because companies rarely simply admit to wrongdoing, out of the blue. Most of the time, the "truth" behind the fraud - whatever that truth may be - is revealed gradually or indirectly. The first revelations concerning an accounting fraud, for example, might simply be a drop in earnings, as the company tries to "make up" for past premature revenue recognition without admitting to wrongdoing. A company might announce a slowdown in product sales without ever admitting that it had previously lied about the product's features. A key officer might resign without explanation. And very often, the first rumblings of a problem come from the announcement of a government investigation - without any further details - that may or may not ultimately culminate in an enforcement action.
In response to any of these announcements, the company might experience a stock price drop, even though the market either is unaware of the possibility of fraud or uncertain as to whether a fraud exists and/or its scope. In such situations, can the fraud be said to have "caused" a loss?
In a pair of decisions by the Fifth and Ninth Circuits, it appears that whether such early warning signals constitute "loss causation" depends very much on what happened later.
[More under the cut]
In Loos v. Immersion Corp., 2014 U.S. App. LEXIS 17813 (9th Cir. Aug. 7, 2014), Immersion announced several profitable quarters before it began to report losses. Eventually, it announced an internal investigation into its own billing practices, and then it admitted that its financial statements could no longer be relied upon. Each disclosure of losses, as well as the disclosure of the internal investigation, resulted in a stock price drop, but the disclosure that the financial statements were unreliable did not - presumably because by then, the market had already figured that out.
The plaintiffs filed a lawsuit alleging that Immersion had "cooked its books," and defined the class period to end upon the announcement of the internal investigation. After the lawsuit was filed, Immersion formally announced the results of its internal investigation - it would in fact be required to restate its financials. Again, the stock price barely reacted (hardly surprising, since Immersion had already announced the previous year that its financial statements were unreliable).
The district court held, and the Ninth Circuit agreed, that neither the disclosure of the losses, nor the disclosure of the internal investigation, satisifed the plaintiffs' burden of showing loss causation, because none of these announcements necessarily revealed to the market that Immersion's financial statements were false. The Ninth Circuit elaborated that an investigation, standing alone, only gives rise to "speculation" regarding fraud, which is not sufficient to show that the fraud "caused" a loss. In so doing, the Ninth Circuit quoted Meyer v. Greene, 710 F.3d 1189 (11th Cir. 2013), that "the announcement of an investigation, 'standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.'"
The plaintiffs argued that in this case, there was subsequent disclosure of wrongdoing - the announcement that the financial statements were unreliable, and the restatement, both of which occurred after the class period. But the Ninth Circuit held that this argument was waived, because the plaintiffs had not raised it below, nor had the plaintiffs discussed the impact of these disclosures in their complaint.
In Public Emples. Ret. Sys. of Miss. v. Amedisys, Inc., 2014 U.S. App. LEXIS 18894 (5th Cir. La. Oct. 2, 2014), the plaintiffs alleged that Amedisys committed Medicare fraud by pressuring employees to provide unnecessary home healthcare services, and that this underlying fraud rendered a number of the company's public statements false. The plaintiffs claimed that losses were caused by a series of partial disclosures of the fraud. These disclosures were: a report published by Citron Research raising questions about Amedisys's billing; the resignation of the COO and CIO; a Wall Street Journal article that analyzed Amedisys's data and concluded that Amedisys was "taking advantage of the Medicare reimbursement system"; and the announcement of investigations by the DOJ, SEC, and the Senate Finance Committee. Each new disclosure was accompanied by a stock price drop.
The Fifth Circuit held that many of these disclosures, standing alone, would not satisfy the plaintiffs' burden to demonstrate loss causation - for example, the Citron report merely raised questions about Amedisys, but did not provide any definitive conclusions. Nonetheless, the Fifth Circuit held that the complaint as a whole was sufficient to allege loss causation, because the pattern of disclosures gradually revealed the fraud to the market.
Taken together, these cases - and the earlier Meyer decision on which the Ninth Circuit relied - hold that whether a disclosure "revealed" the fraud is gauged not by what the market understood at the time of the disclosure, but is instead gauged by what disclosures come after. So, for example, the announcement of an investigation does not "reveal" the fraud - unless, at some later time, there is an enforcement action, at which point, apparently, the earlier announcement becomes a revelation of fraud. Fraud has not "caused" a loss if the company's stock price drops in reaction to a report raising suspicions about fraudulent billing - unless the report is later confirmed by subsequent disclosures, in which case, it has.
These holdings do not make sense on their own terms. There is no way that a disclosure at Time 2 can change how the market understood, and reacted to, an earlier disclosure at Time 1.
The only way that these holdings can be understood is as an attempt to pack into loss causation a more substantive merits inquiry regarding the plaintiffs' claims. I think these courts fear that if the announcement of an investigation - without a subsequent definitive revelation of wrongdoing - qualifies as loss causation, plaintiffs will find it too easy to bring meritless claims where there wasn't any wrongdoing at all. Courts, I think, fear that there may be lots of reasons to launch an investigation that turns up empty, and they don't want companies that are taking reasonable steps to "clean house" to end up as targets of frivolous lawsuits.
The problem with this reasoning, of course, is that there are other elements to a Section 10(b) claim, and it is these other elements that are meant to protect against such a scenario. Plaintiffs still have to show that there were false statements; they still have to show that the statements were material; and they still have to show that the defendants acted intentionally. There is no need for loss causation to carry this entire burden, and forcing it to do so will only result in incoherence.