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PIABA Bar Journal, Summer 2005 (Vol.12, #2)Lessons Learned in the Labyrinth of Loss Causation -- Finding Your Way in InfoSpace By Mark A. Tepper (written with Josh Katz) Florida Securities Fraud Attorneys Like the story in Greek mythology, respondents have devised what they think is the perfect labyrinth to ensnare claimants from any hope of escape loss causation. But there is hope! Like the Greek myth, the labyrinth is only a puzzle with a disguised solution. There are numerous paths through the labyrinth, but which one will lead to the promised land liability and damages? Courts have issued decisions in the last few months and years reformulating and reinterpreting prior decisions regarding loss causation, but the standard remains ambiguous (fn. 1). With multiple, apparently conflicting, standards in the Second Circuit alone, the labyrinth looks daunting. Respondents argue that claimants cannot prove loss causation, because their recommendations do not cause the prices of stocks to fall. This defense seems as ridiculous on its face as a conflicted research analyst's recommendation to buy. But there's just enough dicta in these decisions to give this defense a veneer of respectability. This article discusses the various twists and turns of the loss causation labyrinth. Don't let the Panel get confused. Loss causation does not bar recovery on an InfoSpace claim by a Merrill Lynch customer who relied on fraudulent research. The labyrinth can be successfully navigated.
Loss causation is "a causal connection between the material misrepresentation and the loss." (fn. 2). "If that relationship is sufficiently direct, loss causation is established." (fn. 3). "While loss causation is easily defined, its application to particular facts has often been challenging." (fn. 4). Courts have rendered "somewhat inconsistent precedents," which have "required numerous clarifications." (fn. 5). "Part of the problem lies in the continued expansion of the definition of 'securities fraud.'" (fn. 6). "Loss causation is a fact-based inquiry and the degree of difficulty in pleading will be affected by circumstances. . . ." (fn. 7). Respondents have latched onto two recent decisions to erroneously claim that they are now immune from liability Lentell v. Merrill Lynch and Dura Pharmaceuticals v. Broudo. As explained below, these cases have not announced new loss causation standards. Courts have likened loss causation "to the tort concept of proximate cause, meaning that in order for the plaintiff to recover it must prove the damages it suffered were a foreseeable consequence of the misrepresentation." (fn. 8). While an imperfect analogy,(fn. 9) recent decisions, including the Dura Pharmaceuticals decision by the Supreme Court, show a trend toward discussing loss causation in terms of common law torts, rather than statutory intent. In Dura Pharmaceuticals, the United States Supreme Court cited the Restatement (Second) of Torts (1977) with approval as the judicial consensus for proving loss causation: "One who fraudulently makes a representation of This standard is nothing new. In a claim for a Rule 10b-5 securities fraud, it is well established that a defrauded investor must plead that the defendant "(1) made misstatements or omissions of material fact; (2) with scienter; (3) in connection with the purchase or sale of securities; (4) upon which plaintiffs relied; and (5) that plaintiffs' reliance was the proximate cause of their injury." (fn. 11). Merrill Lynch consented to NASD findings that Respondent "issued research reports on GoTo.com and InfoSpace that were materially misleading because they were contrary to Merrill Lynch research analysts' privately expressed negative views." (fn. 12). Merrill Lynch told its customers "BUY," while omitting that it privately believed "SELL." Merrill Lynch's fraudulent BUY recommendation induced their customers to purchase InfoSpace in reliance upon Merrill Lynch's representation that the BUY rating was the product of Merrill Lynch's "world-class securities research team." (fn. 13). When the price of InfoSpace fell, Merrill Lynch reiterated its BUY recommendation, causing its customers' losses by "overcoming [Claimants'] misgivings prompted by the market behavior of the securities." (fn. 14). Customers' reliance on Merrill Lynch's allegedly independent and honest BUY recommendation, that InfoSpace was not overvalued, caused their injury. This detrimental reliance on Respondent's fraudulent BUY recommendation explains why ". . . the misstatements were the reason the transaction turned out to be a losing one." (fn. 15).
The Second Circuit has established that loss causation is proven when the misrepresentation or omission relates to the value of the stock. (fn. 16). Merrill Lynch, like Salomon Smith Barney and other firms, was "in the business of speaking to the public about stock values. [It] spoke forcefully and frequently about the value of [InfoSpace]." (fn. 17). "Having spoken, [Respondent] may be liable for any material omissions in those statements." (fn. 18). Research analysts review and analyze a company's essential economic indicators. "All of the information in a research report is distilled into a single recommendation, or 'rank.'" (fn. 19). "Critical to the value of these reports . . . [is that they were] held . . . out to be based on accurate information and to contain independent and unbiased recommendations on which the investing public could rely." (fn. 20). Merrill Lynch customers trusted Merrill Lynch's BUY recommendation that InfoSpace was not overvalued. Their trust in their broker was entirely reasonable. They maintained positions in InfoSpace as the stock fell believing that the stock would bounce back, as recommended by Merrill Lynch. Since the fraudulent BUY recommendation "induced the purchase (transaction causation) and related to the stock's value (loss causation), it was causally related to the loss."(fn. 21). Thus, customers' reliance on Merrill Lynch's BUY recommendation caused their losses.
"[O]ver time, the Second Circuit has advanced several different standards for pleading loss causation, including 'direct causation,' 'materialization of risk,' and 'corrective disclosure,' all of which are referenced in Lentell. . . ." (fn. 21). "However, the common thread is that, in each situation, "the loss be foreseeable and [ ] the loss be caused by the materialization of the concealed risk." (fn. 23). Merrill Lynch concealed the risk that InfoSpace was overvalued by recommending it as a BUY rated stock: 1. On March 1, 2000, Respondent's research analyst privately 2. In another exchange of emails in early April 2000, a 3. In June 2000, a research analyst admitted: "...I would 4. In July 2000, Blodget admitted that InfoSpace was a The concealed risk that InfoSpace was wildly overvalued materialized as the market learned the truth. Within the month of March 2000, the stock price had lost almost half of its value. Merrill Lynch alleges, without evidence, that the market caused its customers' losses, but the NASDAQ Index had lost only 6.9% of its value in March 2000. (fn. 24). The loss was clearly foreseeable. Foreseeability requires only that "the loss might reasonably be expected to result from the reliance." (fn. 25). Merrill Lynch knew that its customers would receive and rely upon its fraudulent BUY recommendation of InfoSpace. Merrill Lynch knew that the price of InfoSpace would fall to correct the overvaluation. Thus, it was foreseeable that Merrill Lynch's customers would incur losses by relying on Merrill Lynch's fraudulent BUY recommendation.
Merrill Lynch has argued that the Lentell and Dura Pharmaceuticals Courts hold that fraudulent buy recommendations are immune from liability because investors cannot prove loss causation. This argument is fatally flawed. First, the Lentell Court specifically rejected this myopic interpretation: "We do not suggest . . . that 'systematically Merrill Lynch's BUY recommendation of InfoSpace was not merely "overly optimistic," but was, as the NASD found, fraudulent. Merrill Lynch customers' reliance on the fraudulent BUY recommendation caused their losses. Unlike Merrill Lynch customers, the Lentell plaintiffs presented no facts supporting a finding that Merrill Lynch did not actually believe in its recommendations of 24/7 Media and Interliant. In re Merrill Lynch, 273 F.Supp.2d 351, 374-5 (S.D.N.Y. 2003)("Without the . . . emails concerning securities other than Interliant, the Interliant plaintiffs have no e-mails or other contemporaneous facts concerning Interliant to attempt to explain why any rating on Interliant was not actually and reasonably believed at the time it was issued"). Regarding InfoSpace, Merrill Lynch did not actually believe in its recommendation to purchase InfoSpace. Merrill Lynch issued research reports on InfoSpace that were materially misleading because they were contrary to Merrill Lynch research analysts' privately expressed negative views. Second, Merrill Lynch incorrectly assumes that, since the New York Attorney General publicly revealed Merrill Lynch's fraud in April 2002, its customers cannot prove loss causation for any prior damages. (fn. 27). Respondent's argument is erroneous and conflicts with Second Circuit precedent. The Lentell Court stated that "to establish loss causation, a plaintiff must allege. . . that the subject of the fraudulent statement or omission was the cause of the actual loss suffered, i.e., that the misstatement or omission concealed something from the market that, when disclosed, negatively affected the value of the security." (fn. 28). The "something" Merrill Lynch allegedly concealed was the fact that InfoSpace was overvalued. The market began discovering this concealed risk in March 2000, driving down the price of InfoSpace. As was the case in Demarco v. Lehman Bros. and In re Parmalat Sec. Litig., 2005 WL 1527674 (S.D.N.Y.), what matters here are the facts Merrill Lynch was allegedly concealing not merely the fact that Merrill Lynch was allegedly lying. (fn. 29). Third, respondents' affirmative defense that an intervening factor, such as a general market decline, caused their customers' losses requires evidence. Merely alleging that the market decline caused the customers' losses is nothing more than speculation. As long as the customer relied on the fraudulent research recommendation, the chain of causation is unbroken. As the price of InfoSpace declined, Merrill Lynch continued to publish its allegedly fraudulent recommendation to buy, overcoming customers misgivings and preventing its customers from discovering the fraud. (fn. 30). Fourth, Merrill Lynch has erroneously argued that its customers cannot assert that the allegedly false statements or omissions themselves caused them damage. This argument misstates the Court's test for proving loss causation. The United States Supreme Court made it clear that the test is whether "reliance was the proximate cause of their injury." (fn. 32). Merrill Lynch's argument applies only to pure fraud-on-the-market cases, such as Lentell v. Merrill Lynch. It does not apply to face-to-face transactions. (fn. 33). In Lentell, plaintiffs did not allege they were Merrill Lynch customers, that they bought securities through Merrill Lynch or that they relied on the allegedly fraudulent research. Lentell was a class action, not an individual arbitration claim. As Judge Kaplan pointed out on June 28, 2005, the Lentell Court "concluded that plaintiffs had failed to plead loss causation because they did 'not allege that the subject of those false recommendations (that investors should buy or accumulate 24/7 Media and Interliant stock), or any corrective disclosure regarding the falsity of those recommendations, is the cause of the decline in stock value that plaintiffs claim as their loss.' The use of the word 'or' indicates that a corrective disclosure is not necessary where, as here, plaintiffs allege that the subject of the misrepresentations and omissions caused their loss." (fn. 34). When claimants can allege that the subject of the fraudulent statements caused their losses, corrective disclosure is not required. The path through the labyrinth may be found by proving that the customer's reliance on the allegedly fraudulent research caused the customer's losses. Investors are not required to prove that the misrepresentation caused their losses. They only have to prove that their reliance did. ____________________________________________________________ 1. In re Initial Public Offering Sec. Litig. ("In re I.P.O."), 2005 WL 1529659 (S.D.N.Y. June 28, 2005). 2. Fraternity Fund Ltd. v. Beacon Hill Asset Mgmt., LLC, 2005 WL 1560506 (S.D.N.Y.), quoting Dura Pharmaceuticals v. Broudo, 126 S.Ct. 1627, 1631 (2005). 3. Lentell v. Merrill Lynch, 396 F.3d 161, 174 (2d Cir. 2005), citing Suez Equity, 250 F.3d at 96-98. 4. Castellano v. Young & Rubicam, 257 F.3d 171, 187 (2d Cir. 2001). 5. In re I.P.O., 2005 WL 1529659, *3, citing Suez Equity, 250 F.3d at 98 n.1. 6. Id.. 7. Lentell, 396 F.3d at 174 8. Suez Equity Investors v. Toronto-Dominion Bank, 250 F.3d 87, 96 (2d Cir. 2001). 9. AUSA Life Ins. Co. v. Enrst & Young, 206 F.3d 202, 233-35 (2d Cir. 2000)(Winter, J., dissenting). 10. Restatement (Second) of Torts 525 (1977); cited in Dura Pharmaceuticals v. Broudo, 125 S.Ct. at 1632. 11. In re IBM Sec. Litig., 163 F.3d 102, 106 (2d Cir. 1998)(emphasis added). 12. NASD Letter of Acceptance, Waiver & Consent, No. CAF030028, p. 24 (Apr. 24, 2003). 13. Merrill Lynch represented that customers should purchase its Unlimited Advantage trading platform to have "open access" to research from its "world-class securities research team," because "even the most sophisticated investor can find it difficult to sort through the wealth of available information and make the right choices." Merrill Lynch Unlimited Advantage Brochure, pp. 2, 4, 1. 14. Marbury Management v. Kohn, 629 F.2d 705, 708 (2d Cir. 1980); Suez Equities v. Toronto-Dominion Bank, 250 F.3d 87, 97 (2d Cir. 2001); AUSA Life Ins. v. Young & Rubicam, 206 F.3d 202, 227 (2d Cir. 2000)(Jacobs, J., concurring). 15. Lentell, 396 F.3d at 173, citing First National Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994). 16. Suez Equities, 250 F.3d at 97. 17. In re WorldCom Sec. Litig., 294 F.Supp.2d 392, 428 (S.D.N.Y. 2003)(Cote, J., discussing Salomon Smith Barney and Jack Grubman's research on WorldCom). 18. Id. 19. Fogarazzo v. Lehman Brothers, 341 F.Supp.2d 274, 278 (S.D.N.Y. 2004). 20. Id. 21. Suez Equity, 250 F.3d at 97; see Castellano v. Young & Rubicam, 257 F.3d 171, 187 (2d Cir. 2001); see also Lentell, 396 F.3d at 174 ("We follow the holdings of Emergent Capital, Castellano, and Suez Equity"). 22. In re Initial Public Offering Sec. Litig., 2005 WL 1529659, *3 (S.D.N.Y.), citing Lentell, 396 F.3d at 174. 25. Restatement (Second) of Torts 548A, cited in Dura Pharmaceuticals, 125 S.Ct. at 1633. 26. Lentell, 396 F.3d at 177. 27. Judge Winter called Respondent's argument "counterproductive indeed ranging from perverse to bizarre. . . ." AUSA Life, 206 F.3d at 238 (Winter, J., dissenting). Rather than promote full disclosure, it would encourage firms "to continue the fraud and make riskier gambles in the hope of salvation." Id. at 239. See also Demarco v. Lehman Bros., 309 F.Supp.2d at 636 (loss causation proven when the market discovers the facts concealed by a research analyst, not when the analyst's fraud becomes public); In re Initial Public Offering Sec. Litig., 297 F.Supp.2d at 673; Fogarazzo, 341 F.Supp.2d at 291-92. 28. Lentell, 396 F.3d at 175 (emphasis added; internal citations omitted), citing Suez Equity, 250 F.3d at 95. See Demarco v. Lehman Bros., 309 F.Supp.2d 631, 636-37 (S.D.N.Y. 2004). 29. Demarco v. Lehman Bros., 309 F.Supp.2d at 636-37 ("[T]he Complaint adequately alleges that in or around October, 2000 the market was finally apprised of the negative information concerning RealNetworks that had earlier led Stanek to take a secretly negative view of the stock and that, as the result of those revelations, the stock declined, causing the losses on 30. Fogarazzo, 341 F.Supp.2d at 290 (discussing Lehman Brothers' research). 31. Lentell, 396 F.3d at 174. 32. In re IBM Sec. Litig., 163 F.3d at 106. 33. In re Merrill Lynch, 273 F.Supp.2d at 366 (Pollack, J.) (distinguishing Suez Equity and Marbury Management as transactions involving face-to-face transactions, as opposed to fraud on the market cases). |
