A recent well-reasoned decision from the Ninth Circuit Court of Appeals underscores the importance of the loss causation requirement for any claim brought under Section 10(b) of the Securities Exchange Act of 1934. See Metzler Inv. GMBH v. Corinthian Colleges, Inc., No. 06-55826, 2008 WL 2853402 (9th Cir. July 25, 2008). In Metzler, the Ninth Circuit affirmed the lower court’s dismissal of a complaint due to the plaintiff’s inability to plead loss causation in addition to other critical pleading deficiencies.
As the Metzler Court explained, loss causation establishes the “causal connection between the [defendant’s] material misrepresentation and the [plaintiff’s] loss.” Id. at *8. To survive a motion to dismiss, the complaint must “set forth allegations that, if assumed true, are sufficient to provide [the defendant] with some indication that the drop in [the company’s] stock price was causally related to [the defendant’s] financial misstatements.” Id. In other words, “the complaint must allege that the practices that the plaintiff contends are fraudulent were revealed to the market and caused the resulting losses.” Id. at *9.
The plaintiff in Metzler alleged that the defendant, Corinthian Colleges, employed fraudulent practices at its colleges designed to (i) maximize the amount of Federal Title IV funding the schools received and (ii) inflate the company’s stock price. See id. Plaintiff relied on a June 24, 2004 Financial Times story that described a Department of Education investigation at one of defendant’s campuses and on an August 2, 2004 press release issued by the defendant disclosing reduced earnings and earning projections and a meeting with the California Attorney General’s office. Plaintiff pointed to these public statements, and the drop in defendant’s stock price which followed, as evidence that the market had learned of and reacted to the news of defendant’s alleged fraud. See id.
The complaint, however, “[did] not allege that the June 24 or August 2 announcements disclosed – or even suggested – to the market that [the defendant] was manipulating student enrollment figures company-wide in order to procure excess federal funding, which is the fraudulent activity that [plaintiff] contends . . . caused its losses.” Id. In addition, neither the June 24 or August 2 announcement could be “reasonably read to reveal widespread financial manipulation by [the defendant]….” Id. Thus, the Circuit Court concluded that plaintiff had failed to plead loss causation by reference to any stock price drops in the wake of these two announcements. Id.
Also of significance was the fact that both the June 24 announcement and the complaint made reference to other statements that actually undercut the notion that the allegedly improper conduct was company-wide. The June 24 Financial Times story expressly stated that the Department of Education’s investigation “[did] not affect the status of [the defendant’s] other . . . schools.” Id. The complaint similarly “discredits the notion that the June 24 disclosure revealed company-wide manipulation of student enrollment, by describing the June 24 disclosure as revealing to investors ‘the potential but real risk of all 88 colleges being placed on reimbursement status….’” Id. (emphasis in original). The court concluded that its prior decisions on loss causation did not “support the notion that loss causation is pled where a defendant’s disclosure reveals a ‘risk’ or ‘potential’ for widespread fraudulent conduct.” Id. Rather, the plaintiff must allege that the market learned of and reacted to the specific alleged fraudulent conduct – here, the company-wide manipulation of enrollment figures – as opposed to the market merely reacting to reports of a defendant’s poor financial health or disclosure of a risk that the defendant’s financial performance might decline. See id.
Plaintiff had also argued that the reference in the company’s August 2 press release to “higher than anticipated attrition” was understood by the market as a “euphemism” for defendant’s wide-spread financial misconduct. The Court of Appeals rejected this speculation as insufficient to plead loss causation. Id. at *10. The law does not “allow a plaintiff to plead loss causation through ‘euphemism’ and thereby avoid alleging the necessary connection between defendant’s fraud and the actual loss.” Id. Moreover, the court “is not required to indulge unwarranted inferences in order to save a complaint from dismissal.” Id. Although the defendant’s stock price dropped 10% following the June 24 announcement, it rebounded within three trading days and exceeded the June 24 price within five trading days. See id. at *5, 9. Plaintiff’s inferences were undercut by this quick stock price recovery as well as the fact that the August 2 press release “contain[ed] a far more plausible reason for the resulting [45%] drop in Defendant’s stock price – the company failed to hit prior earnings estimates.” Id.