In a highly anticipated decision, the United States Supreme Court affirmed the decision of the Eighth Circuit dismissing claims under Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 against two third party customer/suppliers of an issuer who materially misrepresented its financial performance. Plaintiffs alleged that the issuer’s misleading disclosures were based upon transactions it entered into with the two third parties that had no economic substance and were designed, with the third parties’ knowledge, to enable the issuer to publish fraudulent financial statements that inflated its revenues and cash flow. Plaintiffs alleged that “but for” the third parties’ participation in the scheme, the issuer could not have defrauded them.

The Court rejected the claim, holding that the customer/suppliers could not be liable under Section 10(b) since their actions were not publicly disclosed and, therefore, were not relied on by the investors. The Court rejected the plaintiffs’ attempt to extend the efficient market theory beyond public statements relating to an issuer to also reach all transactions underlying those statements. In the Court’s view, adopting such a broad concept of reliance, which would include the realm of ordinary business operations, would result in the Section 10(b) implied cause of action “reach[ing] the whole marketplace in which the issuing company does business.”

The Court viewed this as unwarranted for multiple reasons, including the remoteness of the third parties’ actions – since nothing the customer/suppliers did made it “necessary or inevitable” that the issuer would record the transactions in a fraudulent manner. The Court also reasoned that extending the Section 10(b) implied right of action in the broad manner requested by plaintiff would amount to an end run around the limited circumstances in which Congress restored aider and abettor liability in the PSLRA following the Court’s Central Bank decision. (Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. --- S. Ct. ----, 2008 WL 123801 (Jan. 15, 2008))

Common Law Fraud Claim Adequately Alleged Loss Causation

The District Court denied defendants’ motion to dismiss, holding, among other things, that plaintiffs adequately pleaded loss causation to support their common law fraud claim based upon materially misleading statements allegedly made to inflate the defendant-company’s stock price. Defendants included the company, which was engaged in the research and development of treatments to fight HIV, and several of its officers and directors. Plaintiffs alleged that defendants’ misstatements and omissions concealed material risks which, when disclosed, caused a sharp decline in the stock price.

In January 2000 defendants made public statements which, plaintiffs alleged, led the market to anticipate the announcement of the imminent opening of multiple clinics and FDA approval of a drug that would cure HIV. Plaintiffs alleged that the dramatic stock price decline that occurred three months later resulted from defendants’ failure to make any follow up announcements of clinic openings or FDA approvals. According to plaintiffs, the absence of any such announcements constructively disclosed to the market that the defendant’s announced plans would not come to fruition, thereby causing the stock price decline.

After observing that not all stock declines are “caused” by constructive or actual corrective disclosures of prior misrepresentations – and finding that changed economic circumstances, investor expectations, industry-specific facts, etc. could account for such declines – the Court, nonetheless, ruled that plaintiffs had adequately pled the loss causation element of their fraud claim. The Court ruled that the risk of the clinics not being opened and of FDA approval not being granted “was ‘within the zone of risk’ concealed by defendants’ alleged misrepresentations.” The Court then concluded that it was reasonable to infer that defendants’ failure to make any follow up announcements regarding clinic openings or drug approval was, at least at the pleading stage, the cause of the plaintiffs’ investment loss. (Hunt v. Enzo Biochem, Inc., 2008 WL 111014 (S.D.N.Y. January 9, 2008))