Amicus Curiae Brief — Dura Pharmaceuticals, Inc. v. Broudo

03-932 Supreme Cour, US

= — ~-—

IN THE NOV 17 2004

,OFEICE CLERK

Supreme Court of the Uniter States

2> Pe

DURA PHARMACEUTICALS, INC. ET AL.,

Petitioners,

—V.—

MICHAEL BROUDO ET AL.,

Respondents.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOR THE NINTH CIRCUIT

BRIEF OF CITY OF NEW YORK PENSION FUNDS,

THE CALIFORNIA PUBLIC EMPLOYEES’ RETIREMENT

SYSTEM, THE CALIFORNIA STATE TEACHERS'

RETIREMENT SYSTEM, LOS ANGELES COUNTY

EMPLOYEES RETIREMENT ASSOCIATION AND

ALAN G. HEVESI, COMPTROLLER OF THE STATE OF

NEW YORK, AS TRUSTEE OF THE NEW YORK STATE

COMMON RETIREMENT FUND AND AS ADMINISTRATIVE

HEAD OF THE NEW YORK STATE AND LOCAL

RETIREMENT SYSTEMS AS AMICI CURIAE IN

SUPPORT OF RESPONDENTS

Leonard J. Koerner Jay W. Eisenhofer

Chief Assistant Counsel of Record

Corporation Counsel Geoffrey C. Jarvis

Law Department Grant & Eisenhofer P.A.

Corporation Counsel of Chase Manhattan Centre

the City of New York 1201 N. Market Street,

100 Church Street Suite 2100

New York, NY 10007-2601 Wilmington, DE 19801

(212) 788-0303 (302) 622-7000

(Counsel continued on inside front cover)

——[BEST AVAILABLE COPY [—

a

THA

Peter H. Mixon

General Counsel

California Public

Employees Retirement

System

Lincoln Plaza

400 P Street

Sacramento, CA 95814

(916) 795-3675

Alan P. Lebowitz

General Counsel to

Alan G. Hevesi,

Comptroller of the

State of New York

110 State Street

Albany, NY 12244

(866) 805-0990

David L. Muir

Chief Counsel

Los Angeles County

Employees Retirement

Association

300 N. Lake Avenue,

Suite 620

Pasadena, CA 91101

(626) 564-2348

Christopher W. Waddell

General Counsel

California State Teachers’

Retirement System

7919 Folsom Boulevard

Sacramento, CA 95826

(916) 229-3500

Counsel for Amici Curiae

November 17, 2004

TABLE OF CONTENTS

TABLE OF CITED AUTHORITIES.............. ili

INTEREST OF THE AMICI] CURIAE ............ I

SUMMARY OF ARGUMENT .................... 5

TT srbdbecdndsesesscocccoosccccccccececec: 9

I. The Court Should Adopt A Flexible

Siandard For Proving Loss Causation

And Should Not Adopt A Standard

That Would Require Plaintiffs To

Show A Decline In The Price Of A

Security After The Explicit Disclosure

That Fraud Has Occurred................ 9

A. Proof Of Loss Causation Is

Inherent In Any Proof Of

tl Pecedebeesesssececescoccccecs 14

B. A Flexible Loss Causation

Standard Is Consistent With

Principles Of Corporate Finance... 18

C. An Appropriate Standard For

Pleading And Proving Loss

Causation Should Be Based

Upon Sound Principles Of

Corporate Finance................... 21

TABLE OF CONTENTS — CONTINUED

Il. The Standard Of Loss Causation

Propounded By The Ninth Circuit

Or An Equivalent Standard Is

Appropriate At The Pleading Stage.....

CONCLUSION

PAGE

30

ee

ill

TABLE OF CITED AUTHORITIES

CASES PAGE

Anderson v. First Sec. Corp.,

249 F. Supp. 2d 1256 (D. Utah 2002)........ 10

Arduini/Messina Partnership v. National

Medical Finance Services Corp.,

74 F. Supp. 2d 352 (S.D.N.Y. 1999)......... 10

Bastian v. Petren Resources Corp., 892 F.2d 680

(7th Cir. 1990), cert. denied, 496 U.S. 906

Broudo v. Dura Pharmaceuticals, Inc.,

339 F.3d 933 (9th Cir. 2003), cert. granted,

Dura Pharmaceuticals, Inc. v. Broudo,

124 S. Ct. 2904 (U.S. June 28, 2004)

Ge, Gro ncccccecesesecsccesscccessecescses passim

Burstyn v. Worldwide Xceed Group, Inc.,

No. 01 Civ. 1125, 2002 WL 31191741

(S.D.N.Y. Sept. 30, 2002) ...........c-eeeeeee 22

Conley v. Gibson, 355 U.S. 41 (1957)............ 27

Danis v. USN Communications, Inc.,

73 F. Supp. 2d 923 (N.D. Ill. 1999).......... 21, 22

Emergent Capital Investment Memt.,

LLC, v. Stonepath Group, Inc.,

343 F.3d 189 (2d Cir. 2003) .................. 22

Esplin v. Hirschi, 402 F.2d 94 (10th Cir. 1968),

cert. denied, 394 U.S. 928 (1969) ........... 14

In re Executive Telecard, Ltd. Sec. Litig.,

979 F. Supp. 1021 (S.D.N.Y. 1997).......... 17

iV

CASES (CONT'D) PAGE

Gebhardt v. ConAgra Foods, Inc., 335 F.3d 824

(8th Cir. 2003), reh'g denied,

2003 U.S. App. LEXIS 17920

ee

Green v. Occidental Petroleum Corp..,

541 F.2d 1335 (9th Cir. 1976)................ 14, 15

Greenberg v. Crossroads Sys., Inc.,

364 F.3d 657 (Sth Cir. 2004) ................. 21

Harris v. American Investment Co..

$23 F.2d 220 (8th Cir. 1975), cert. denied,

Se : HEE cncbidcedcccsessocesonese 14

Hishon v. King & Spalding,

gE ne 27

Huddleston v. Herman & MacLean,

640 F.2d 534 (Sth Cir. 1981), aff'd in part

and rev'd in part, 459 U.S. 375 (1983)...... 22

In re Ikon Office Solutions, Inc. Sec. Litig.,

131 F. Supp. 2d 680 (E.D. Pa. 2001) ........ 2!

In the Matter of Genesis Health Ventures, Inc.,

266 B.R. 591 (Bankr. D. Del. 2001)......... 20

In re Merrill Lynch & Co., 273 F. Supp. 2d 351

EEE SUIT cicicdslaisnaniiaiseesiinncicimminnlinmeinlaiieiits 22

M.G. Bancorporation, Inc. v. LeBeau,

737 A.2d $13 (Del. 1999) .................... 7

Neal v. Alabama By-Products Corp., No. 8282,

1990 WL 109243 (Del. Ch. Aug. 1, 1990),

aff'd, 588 A.2d 255 (Del. 1991) ............. 19

ee ry

CASES (CONT'D) PAGE

No. 84 Employer-Teamster Joint Council

Pension Trust Fund v. America West

Holding Corp., 320 F.3d 920

I , Se icccutccesecceusseceseséseccsesce 22

In re Northern Telecom Sec. Litig.,

116 F. Supp. 2d 446 (S.D.N.Y. 2000)........ 16, 17

Onti, Inc. v. Integra Bank, 751 A.2d 904

Be rte 19

In re Oracle Sec. Litig., 829 F. Supp. 1176

ob Be rrr 15, 16, 17

RMED Int'l, Inc. v. Sloan's Supermarkets, Inc..,

No. 94-5587, 2000 WL 310352

(S.D.N.Y. Mar. 24, 2000).............-.-.045. 15

Robbins v. Koger Properties, Inc.,

116 F.3d 1441 (Lith Cir. 1997)............... 22

In re Sprint Corp. Sec. Litig..,

232 F. Supp. 2d 1193 (D. Kan. 2002)........ 10

U.S. v. Brown, No. 2004 WL 2242513

(M.D.Pa. Aug 17, 2004) ............ 6.0.00 eees 16

In re Valley-Vulcan Mold Co., No. 99-4129,

2001 WL 224066 (6th Cir. Feb. 26, 2001) .. 19

Wool v. Tandem Computers, Inc., 818 F.2d 1433

SBE Ga. GEG Pec cccccccncescsccocccccccsscseess 15

In re WorldCom, Inc. Sec. Litig.,

No. 02-3288, 2003 WL 22420467

(S.D.N.Y. Oct. 24, 2003) ...........eeceeeeees 17

—= - —_— 7 —_ —_—

vil

vi

PAGE OTHER AUTHORITIES (CONT'D) PAGE

RULES AND STATUTES Bradford Cornell & R. Gregory Morgan,

, Using Finance Theory to Measure

Fed. R. Civ. P. 8(a).......... .

IV. P. BC)... eee eee eeee eee ee eeee ees 26, 27, 28 Damages in Fraud on the Market Cases,

Fed. R. Civ. P. 9(b).......00cccccccceceuececceceees 28 37 UCLA L. Rev. 883, 887 ...........-.0++++. 15, 16

Pes Cs i GI io rictinctechaccevssaccecccs 28 Jay Eisenhofer, Geoffrey Jarvis & James Banko,

Securities Act of 1933 (“18 4 Securities Fraud, Stock Price Valuation

+4 np rs © Aang ("1933 Act”), and Loss Causation: Toward A Corporate

ee Oe WO EN cecnendsddcciaicinnicnne 4 Finance-Based Theory Of Loss Causation,

Securities Exchange Act of 1934 ("1934 Act”). 59 Bus. Law. 1419 (2004) TETTELELELELE LET 13

15 U.S.C. § 78a et SOG cccccccccccccccccceseces 4 Eugene Fama et al., The Adjustment of Stock

Private Securities Law Reform Act of 1995 Prices to New Information, \0 tat’! Econ.

(“PSLRA”), 15 U.S.C. § 78u-4............... 6 Bae. 8 CODER) cvccccccccccccecccecesccceccsccces 16

OS i 28 Daniel R. Fischel, Use of Modern Finance

Theory in Securities Fraud Cases

ae 28 | Involving Actively Traded Securities,

15 U.S.C. § 78u-4(b)(4) 0.2... .cccceeceeeeeeeeeees 6 | ne: ee © Neeee vespevernsneonvenssoees ”

oe | George Foster, Financial Statement Analysis

THER AUTHORITIES | (Prentice-Hall 1998) ............ccecceceeeeees 20

William Beaver, Financial Reporting: ) Jonathan Fuerbringer, Yesterday's Earnings

An Accounting Revolution (Prentice-Hall Don't Move Stocks. Tomorrow's Do,

SE, SE diinciieliuidibemdinniiet ten eeeian 20 N.Y. Times, Aug. 8, 2004, at 7............... 20

Richard Brealey & Stewart Myers, Capital Thomas Lee Hazen, The Short-Term/Long-Term

Investment and Valuation Dichotomy and Investment Theory:

FED DED cencccenccscccccscescscess 18 Implications for Securities Market

Tom Copeland, Tim Koller & Jack Murrin, Regulation and for Corporate Law, *

Valuation: Measuring and Managing the 70 N.C. L. Rev. 137 (1991).............000ee. 23

nna! of Companies (John Wiley & Sons, Jon Koslow, Estimating Aggregate Damages

Selle Se ndddudecddcncnsncedideseccauisendcsses 20 in Class-Action Litigation Under

Rule 10b-S5 for Purposes of Settlement,

59 Fordham L. Rev. 811 (1991).............. 15

Viii

OTHER AUTHORITIES (CONT’D) PAGE

Burton Malkiel, /s the Stock Market Efficient?

243 Sotenmes 1FEF (IDS) ..cccccsccccscceseoes 18

Brian E. Pastuszenski et al., Beyond

Materiality and Scienter: Strategies For

Successfully Defending Securities Class

Actions By Attacking Plaintiffs’ Loss

Causation and Damages Theories,

ALI-ABA Securities Litigation Planning

and Strategies 572-73 (2001)............545. 10

Shannon Pratt, Valuing a Business: The Analysis

and Appraisal of Closely Held Companies

CG, FOOD co cccnnccccotivaccscescossscenceses 19

Barry Reder, Measuring Buyers’ Damages in

10b-5 Cases, 31 Bus. Law. 1839 (1976)..... 14

Lynn A. Stout, The Unimportance of Being

Efficient: An Economic Analysis of Stock

Market Pricing and Securities Regulation,

87 Mich. L. Rev. 613 (1988) .............0065 18

David Tabak & Frederick Dunbar, Materiality

and Magnitude: Event Studies in the

Courtroom, NERA Working Paper No. 34

(AQT TSGS) a ccccccccccccesvccceccoccececcesees 16

INTEREST OF THE AMICI CURIAE

This amicus brief is filed on behalf of the pension

funds of the City of New York (“NYC Pension Funds”),

the California Public Employees’ Retirement System

(“CalPERS”), the California State Teachers’ Retirement

System (“CalSTRS”), Los Angeles County Employees

Retirement Association (“LACERA”) and Alan G.

Hevesi, Comptroller of the State of New York, as

Trustee of the New York State Common Retirement

Fund and as Administrative Head of the New York State

and Local Retirement Systems (“NYSCRF”) (collec-

tively, the “Public Pension Funds” or “Funds”). The Pub-

lic Pension Funds are comprised of four of the five

largest public pension systems in the United States.

The NYC Pension Funds comprise the actuarial pen-

sion systems of New York City and are among the

largest public pension systems in the United States.' The

NYC Pension Funds include the New York City Employ-

ees’ Retirement System, the Police Pension Fund, the

Fire Department Pension Fund, the Teachers’ Retirement

System, the Board of Education Retirement System, and

five variable supplement funds.’ As of June 30, 2003, the

' Pursuant to Supreme Court Rule 37.4, amicus the NYC Pension

Funds states that they are instrumentalities of the City of New York,

and this brief is being presented by Leonard J. Koerner, Chief Assis-

tant Corporation Counsel, Corporation Counsel of the City of New

York. In addition, amici state that no counsel for any party authored

this brief in whole or part, and no person or entity other than the amici

made a monetary contribution to the preparation or submission of the

brief. Pursuant to Rule 37.3, amici state that petitioners and respon-

dents have consented to the filing of this brief. Petitioners’ and

respondents’ letters of consent have been filed with the Clerk of the

Court.

> The variable supplement funds are: New York City Police Supe-

rior Officers’ Variable Supplements Fund, New York City Police Offi-

cers’ Variable Supplements Fund, New York City Fire Officers’

2

date of the most recent actuarial valuations for these

Funds, the NYC Pension Funds had approximately

253,000 retired members, 340,000 active members, and

aggregate assets of $73.971 billion.

CalPERS, the largest public pension fund in the

United States, manages pension and health benefits for

more than 1.4 million California public employees,

retirees, and their families. CalPERS’ membership is

divided approximately in thirds among current and

retired employees of the state, schools, and participating

public agencies. As of September 30, 2004, CalPERS

provided benefits for 1,014,360 active and inactive

members and 413,272 retirees. As of August 31, 2004,

CalPERS has $165.3 billion in total investments, of

which near!y $110 billion is in equities.

CalSTRS is the largest teachers’ retirement system in

the United States. CalSTRS* primary responsibility is to

provide retirement related benefits and services to teach-

ers in public schools from kindergarten through commu-

nity college. As of June 30, 2003, CalSTRS had a total

membership of approximately 734,963 (553,095 active/

inactive and 181,868 retired/benefit recipients) and, as

of June 30, 2004, had total assets of $116.1 billion.

LACERA is the largest county retirement system in

the United States. LACERA provides retirement, dis-

ability, and death benefits to eligible Los Angeles

County emplcyees and their beneficiaries. As of June 30,

2004, LACERA had a total membership of approxi-

mately 140,000 and total assets of nearly $30 billion.

NYSCRF is the second largest public pension fund in

the United States. NYSCRF provides pension, death and

Variable Supplements Fund, New York City Firefighters’ Variable

Supplements Fund, and New York City Teachers’ Retirement System

Variable Annuity A and B Programs.

3

disabi ity benefits for New York state and local gov-

ernment employees and employees of certain other par-

ticipating employers. As of March 31, 2004, NYSCRF

had over 970,000 members, beneficiaries and retirees,

and total net assets of approximately $120.8 billion.

The Public Pension Funds’ overriding responsibility is

to provide for the retirement and long-term security of

their more than 3.8 million active and retired members.

To satisfy that responsibility, the Public Pension Funds

invest in a wide variety of stocks, bonds and other

assets, through a variety of advisors, in order to maintain

the long-term growth and security of their members’

assets. As major investors with a long-term investment

outlook, the Public Pension Funds are vitally concerned

with the proper and efficient functioning of U.S. capital

markets, and are particularly concerned that investors

not be harmed by the improper and/or illegal conduct of

issuers and sellers of publicly traded securities.

Over the last five years, the Public Pension Funds

have become increasingly concerned that the pressure

for short-term profit maximization at a number of enor-

mous end well-respected U.S. (and foreign) corporations

has created an environment in which management, their

advisors (including outside advisors such as accountants

and lawyers), and others involved in the purchase and

sale of their securities (stock brokerage firms, invest-

ment banking firms, efc.) are willing to engage in uneth-

ical, illegal and improper behavior to manipulate stock

prices for their personal or institutional benefit. The

scandals at Enron, WorldCom, Global Crossing, Tyco,

Bristol-Myers, Xerox and others are now synonymous

with the culture of greed that has tarnished all U.S. cor-

porations and caused hundreds of billions, if not trillions

of dollars in losses to innocent investors. The Public

Pension Funds have lost billions of dollars in invest-

4

ments where the prices were inflated through accounting

fraud, market manipulation and other means.

The Public Pension Funds recognize that the oversight

of regulators such as the U.S. Securities and Exchange

Commission and the New York Attorney General's

Office is an important means of ensuring a level playing

field for all investors. The Funds strongly believe, how-

ever, that the ability of investors to seek to redress cor-

porate wrongdoing through class and individual actions

brought under the Securities Act of 1933 (“1933 Act”),

15 U.S.C. § 77a et seq. and the Securities Exchange Act

of 1934 (“1934 Act”), 15 U.S.C. § 78a ef seqg., is an

important mechanism to deter improper conduct and to

recoup losses that investors have suffered as a result of

fraud and other misconduct. Thus, the Public Pension

Funds have acted as lead plaintiffs in several significant

cases, including /n re Cendant Corporation Securities

Litigation, (D.N.J.) (NYC Pension Funds, NYSCRF and

CalPERS were co-lead plaintiffs), where the $3.2 billion

settlement remains the largest recovery in the history of

securities litigation. In addition, NYSCRF as lead plain-

tiff in the Jn re WorldCom, Inc. Securities Litigation

(S.D.N.Y.) has secured District Court approval of the

second largest settlement in history, nearly $2.6 billion

from Citigroup defendants, Citigroup, Inc., Citigroup

Global Markets, Inc. (formerly known as Salomon Smith

Barney, Inc.), Salomon Brothers International Limited,

and former securities analyst Jack Grubman. LACERA

has served as lead plaintiff in the Enterasys Networks,

Inc. Securities Litigation (D.N.H), and the King Phar-

maceuticals Securities Litigation (E.D.TN), and Cal-

STRS is serving as lead plaintiff in /n re Homestore

Securities Litigation (C.D. Cal.). Certain of the Public

Pension Funds also have brought individual actions

against Bristol-Myers Squibb, Inc., Qwest Communi-

cations, Inc., and others.

5

A key element of the legal regime governing the ini-

tiation, prosecution and resolution of claims under Sec-

tion 10(b) of the 1934 Act, and Rule 10b-5 promulgated

thereunder, is the issue of loss causation. While the Pub-

lic Pension Funds recognize that the federal securities

laws are not a form of “insurance” to protect investors

against market-based declines in the price of securities

and that companies should not be liable for declines in

their stock prices that do not result from their fraudulent

conduct, as investors who have been materially harmed

by entities that have resorted to fraudulent and improper

conduct, the Funds are vitally concerned that the legal

regime governing securities fraud litigation allows

investors who have been harmed to recover from those

entities that have engaged in fraud. At the same time, as

significant investors in thousands of corporations and

business entities that never have been touched with so

much as a taint of fraud, the Public Pension Funds have

a strong interest in ensuring that the rules governing

securities litigation do not unfairly harm companies that

have not engaged in wrong-doing. Because a failure

by a plaintiff to plead and ultimately prove loss causa-

tion will impair that plaintiff's ability to recover for

fraudulent conduct, the Public Pension Funds are sub-

mitting this brief as amici curiae to assist this Court in

developing rules that adequately protect honest compa-

nies and their investors, while permitting valid claims

against those companies that have engaged in fraudulent

conduct.

SUMMARY OF ARGUMENT

The Public Pension Funds support the Respondent and >

believe that the decision of the Ninth Circuit in Broudo

v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. 2003),

cert. granted, Dura Pharmaceuticals, Inc. v. Broudo,

6

124 S. Ct. 2904 (U.S. June 28, 2004) (No. 03-932),

which does nothing more than follow a notice pleading

standard for loss causation under Rule 8 of the Federal

Rules, should be affirmed. At the pleading stage, under

the liberal pleading requirements of Rule 8 of the Fed-

eral Rules of Civil Procedure, a plaintiff should be

required merely to allege a “short and plain statement”

that (i) the stock price was inflated by fraud and (ii) the

inflation, at least in part, has been removed. At the

pleading stage, a plaintiff should not be required to

demonstrate the negative impact on the share price of

each piece of information that may have revealed some

aspect of the defendants’ fraud. A plaintiff ultimately

should be required to demonstrate that he or she over-

paid for a security as a result of the dissemination of

fraudulent information about the company, and that the

price of the stock no longer is inflated due to fraud.

There should be no requirement, however, that a defen-

dant have made an explicit disclosure that fraud has

occurred nor should there be any requirement that there

be a stock price drop immediately following a specific

admission of fraud in order to state a claim as a matter

of law.

The issue of loss causation, as it has evolved over the

last thirty years, is codified in the Private Securities Law

Reform Act of 1995 (“PSLRA”), 15 U.S.C. § 781-4, and

is essentially a requirement that a plaintiff establish

“that the act or omission of the defendant alleged to vio-

late [the 1934 Act] caused the loss for which the plain-

tiff seeks to recover damages.” /d. at § 78u-4(b)(4). In

most securities fraud cases, the “loss” at issue is related

to a decline in the value of a stock or bond caused by the

disclosure of prior fraudulent statements by the issuer of

the security, the issuer's agent (usually an accountant) or

a third party that has an interest in manipulating the

price of the security. Thus, the proper goal of any test

-

for loss causation is to determine the legal responsi-

bility for changes in the price of stocks, bonds and/or

other securities that were impacted by materially false

Statements.

The entire discipline of corporate finance, a mainstay

of U.S. business schools over the last two to three decades,

has, as one of its primary goals, the development of

models to determine the true economic value of business

entities. The principles of corporate finance, while greatly

utilized in the business world to determine the value of

corporations and securities that reflect ownership in cor-

porations, as well the basis for changes in valuations, are

much less frequently used by courts in making legal

determinations regarding changes in the value of secu-

rities. Because a key issue in lawsuits brought under the

federal securities laws is the cause of the decline in the

value of securities, i.e., loss causation, an issue that is

subject to these well-understood principles of corporate

finance, the Public Pension Funds respectfully urge that

any legal determination as to what caused the decline in

the value of the security should generally be premised

upon such corporate finance principles.

The present case represents this Court's first oppor-

tunity to address directly the legal principles that will

govern the pleading and proof of loss causation in secu-

rities fraud litigation. In conducting its analysis, the

Court should be fully aware of, and should reach a deci-

sion consistent with, principles of corporate finance,

which generally equate the value of a corporation with

investors’ expectations of the “cash flows” that they ulti-

mately will receive from that corporation.’ Under sound

* A method other than cash flow expectations may need to be used

to value corporations in some circumstances. See M.G. Bancorpora-

tion, Inc. v. LeBeau, 737 A.24 513, 524 (Del. 1999) (“by recognizing

the discounted cash flow model as one proper valuation technique, the

8

principles of corporate finance, where expectations of

future cash flow have been artificially inflated because

of fraud, the resulting stock price also is artificially

inflated by fraud. Thus, as explained in detail below, the

Public Pension Funds propose that this Court adopt a test

for loss causation, based on fundamental principles of

corporate finance, that poses the following questions: (1)

did a defendant make a materially misleading statement

to the investing public that inflated the stock price of a

company, and (2) as the result of disclosures of infor-

mation by the company or others, is the stock price no

longer inflated because the fraud is no longer propping-

up the price? Where these questions are answered in the

affirmative, loss causation is established.

Any requirement, such as that implicit in Petitioner's

opening brief (Pet'r Br. at 21-22, 37), or as explicitly set

forth in the briefs of certain amicus curiae (Brief of

Chamber of Commerce of the United States as Amicus

Curiae in Support of Petitioners (“CC Br.”) at 13-14),

that there must be an explicit disclosure of fraud fol-

lowed by a stock price drop, would be inconsistent with

the law and basic corporate finance principles, and

would allow many frauds to fall outside the ambit of the

securities laws.

Finally, while a plaintiff ultimately should be required,

with the benefit of discovery and expert analysis, to

establish that the price of a stock was no longer inflated

due to fraud, no such strict linkage should be required at

the pleading stage. Plaintiffs are required to plead fraud

with particularity and to plead facts supporting a strong

inference of defendants’ scienter. Thus, any case that

survives a motion to dismiss, even using the Ninth Cir-

Court of Chancery was not required to use that methodology. . . .”).

However, using corporate finance principles will allow this Court to

establish an appropriate standard for loss causation.

9

cuit standard on loss causation for pleading purposes (or

a similar standard), will have adequately pled the exis-

tence of fraudulent statements that inflated the price of

the security at issue and strong support that such state-

ments were knowingly or recklessly made. Where these

facts canbe pled, it is not unduly onerous on defendants

if Plaintiffs are permitted to prosecute their action.

On the other hand, establishing a strict loss causation

requirement at the pleading stage is inconsistent with

federal pleading standards and will place unfair burdens

on securities plaintiffs. Any requirement that securities

plaintiffs be required to plead, other than in general

terms, a linkage between changes in the price of a stock

and specific disclosures could require a detailed expert

opinion demonstrating that revelation of the fraud had an

impact on the price of the securities at issue. Requiring

such an expert report at the pleading stage would effec-

tively preclude meritorious actions because of the enor-

mous expense of such reports (see infra Section I.A) and

the need (in many cases) for some discovery to produce

a rigorous report. Thus, the Court should affirm the deci-

sion of the Ninth Circuit for pleading purposes.

ARGUMENT

I. THE COURT SHOULD ADOPT A FLEXIBLE

STANDARD FOR PROVING LOSS CAUSA-

TION AND SHOULD NOT ADOPT A STAN-

DARD THAT WOULD REQUIRE PLAINTIFFS

TO SHOW A DECLINE IN THE PRICE OF A

SECURITY AFTER THE EXPLICIT DISCLO-

SURE THAT FRAUD HAS OCCURRED

The Court below in Broudo v. Dura Pharmaceuticals,

Inc., addressed a situation in which a defendant revealed

truthful information that corrected earlier, allegedly

10

fraudulent information, but the stock drop complained of

had occurred ten months prior to the truthful disclosure.

It held that:

“it is not necessary that a disclosure and subsequent

drop in the market price of the stock have actually

occurred, because the injury occurs at the time of

the transaction. . . . [L]oss causation does not

require pleading a stock price drop following a cor-

rective disclosure or otherwise. It merely requires

pleading that the price at the time of purchase was

overstated and sufficient identification of cause.”

339 F.3d at 938. In opposing the loss causation standard

adopted by the Ninth Circuit, Petitioner suggests (and cer-

tain amici specifically argue) that loss causation should

only be established where there is a price decline follow-

ing the explicit disclosure of fraud. (Pet'r Br. at 21-22, 37;

CC Br. at 13-14) Certain courts and commentators have

propounded such a rule and concluded that a stock drop

following the explicit disclosure of fraudulent activity is

essential to establish loss causation and, hence, is a sine

qua non for a plaintiff to prevail on the merits and ulti-

mately recover damages. See, e.g., Arduini/Messina P'ship

v. Nat'l Med. Fin. Servs. Corp., 74 F. Supp. 2d 352,

361-62 (S.D.N.Y. 1999); Anderson v. First Sec. Corp., 249

F. Supp. 2d 1256, 1268 (D. Utah 2002); Jn re Sprint Corp.

Sec. Litig., 232 F. Supp. 2d 1193, 1228 (D. Kan. 2002).*

An inflexible rule such as that proposed by Petition-

ers, some amici and certain commentators has the poten-

tial to create serious problems since it would effectively

eliminate a large number of meritorious actions at the

* See also Brian E. Pastuszenski et al.. Beyond Materiality and

Scienter: Strategies For Successfully Defending Securities Class

Actions By Attacking Plaintiffs’ Loss Causation and Damages The-

ories. ALI-ABA Securities Litigation Planning and Strategies 572-73

(2001).

pleading stage in order to address a very small subset of

securities cases. Three examples will illustrate the prob-

lem. The classic securities fraud case, where the stock

price collapses upon disclosure of fraud, typically does

not present a difficult loss causation issue. Assume that

the stock of Company A (with 100 million shares) is

priced at $10 per share at the beginning of a period and,

thereafter, Company A makes false statements that its

revenues were $1 billion last year and its profits were

$250 million. Based upon those favorable reports,

investors believe the Company will earn $300 million or

$3 per share going forward. As a result, the price of the

stock increases to $30 per share. Six months later, the

Company admits that its $1 billion in revenue and $250

million in profits were false because of the booking of

fictitious sales and that the correct numbers were $750

million in revenues and a $200 million loss. Investors

immediately understand that the Company will not be

earning $300 million ($3 per share) going forward. The

stock price immediately falls to $10 per share as investors

determine that the Company will probably just break-

even over the next year. In this case, under any theory,

there clearly is loss causation since the announcement of

the true information causes an immediate and substantial

decline in the cash flow expectations and share price.

The more difficult situation however, and one that is

common in financial fraud securities cases, is where

Company A does not explicitly label corrective infor-

mation as related to a fraud. Assume, as above, that

Company A releases false information that its revenues

were $1 billion and its profits were $250 million. As a

result, investors believe the Company will earn $300

million going forward, or $3 per share. However, the

actual undisclosed numbers were $750 million in rev-

enues and a $200 million loss. Over the next six months

the stock price increases to $30 per share. At the end of

12

the six months, the Company realizes it has a problem

and will not be able to keep booking the fictitious sates.

Rather than disclose the truth about its past practices,

over the next few months, the Company gradually dis-

closes that it will only break-even over the next year.

The stock price declines to $10 based upon those

deflated expectations. Investors do not know that the

deflation in the expectations is the result of a fraud.

Only after the price has declined to $10 does the Com-

pany admit inat its older financial information ($1 bil-

lion in revenue and $250 million in profits) was false,

that its true information for that year was $750 million

in revenue and a $200 million loss, and that its more

recent information is accurate. After this announcement, —

however, the share price does not decline further because

the market has already incorporated the decline in

expectations resulting from the cessation of the fraud in

the Company's stock price.

Under such circumstances, the Petitioner would take

the position, as would some of the amicus briefs, deci-

sions and commentators referenced above, that there is

no loss causation because the share price did not decline

after the disclosure of the existence of the fraud. Yet

investors in this scenario purchased a stock at an inflated

price due to fraud and lost money when the stock price

declined because truthful information was revealed

about the company’s actual performance and the fraud

no longer propped-up the price The only difference

between the second scenario and the first scenario is the

manner in which the fraud is disclosed. In the second

scenario the company manipulated the disclosure, clev-

erly revealing the truth without labeling it fraud.

The third scenario, which essentially is the one upon

which the Petitioner focuses, is where Company A releases

the same false information described above ($1 billion in

13

revenue, $250 million in profits) causing investors to

believe there will be $300 million in earnings and thus

the price increases to $30 per share. Thereafter, as the

result of some event wholly unrelated to the fraud (mar-

ket-shift, earthquake, fire, etc.), Company A becomes

essentially worthless. Thereafter, the fraud is disclosed

and a suit is brought for securities fraud. In such a case,

the plaintiff will be unable to prove that the fraud caused

the loss. Therefore, loss causation is absent.

The Public Pension Funds believe that an appropriate

standard of loss causation is one that does not eliminate

the meritorious cases that fall under example two above,

merely to ensure that the cases that conform to example

three do not result in the imposition of damages. Thus,

while the Public Pension Funds agree that, at trial, loss

causation requires some showing that the price of a stock

no longer was inflated as the result of the disclosure of

information correcting earlier fraudulent information,

the Court should not adopt a standard that requires a

plaintiff to prove the existence of a stock drop following

the explicit disclosure of fraud. Such a standard would

be inconsistent with the origins and development of the

loss causation doctrine and contrary to applicable prin-

ciples of corporate finance. Instead, this court should

adopt a flexible standard under which the issues are

whether the stock price was inflated by fraud and

whether that i .flation no longer is present because the

fraud no longer is impacting the price. If a plaintiff can

establish the existence of these two conditions, loss cau-

sation should be established.*

* See Jay Eisenhofer, Geoffrey Jarvis & James Banko, Securities

Fraud, Stock Price Valuation And Loss Causation: Toward A Cor-

porate Finance-Based Theory Of Loss Causation, 59 Bus. Law. 1419,

1441-45 (2004) (setting forth in detail a theory of loss causation based

upon corporate finance principles).

14

A. PROOF OF LOSS CAUSATION IS INHERENT

IN ANY PROOF OF DAMAGES

Proving loss causation often is inextricably linked to

the analysis of damages, since both :nquiries seek to

determine the links between a defendant's fraudulent

conduct and the consequent losses suffered by plaintiffs

from a decline in the price of a security. Many early

securities cases simply fixed the damages as the differ-

ence between the price paid for the securities and the

value ofthe securities determined as of the time of the

discovery of the fraud. See Esplin v. Hirschi, 402 F.2d

94, 104-05 (10th Cir. 1968), cert. denied, 394 U.S. 928

(1969) (court held the defrauded buyer is entitled to

recover the difference between the price paid for the

securities and the value of the securities determined as

of the time of the discovery of the fraud); Harris v.

American Inv. Co., 523 F.2d 220, 226-27 (8th Cir. 1975),

cert. denied, 423 U.S. 1054 (1976) (appropriate date for

ascertaining damages sustained to stockholder as result

of violation of securities laws prohibiting publishing of

false and misleading statements and filing of false and

misleading information was the date of public discovery

of fraud). This methodology was simple enough, but met

with opposition from defendants and commentators

because it ignored factors impacting stock price, such as

overall economic and industry factors, that were unre-

lated to any possible fraud. See, e.g., Barry Reder, Mea-

suring Buyers’ Damages in 10b-5 Cases, 31 Bus. Law.

1839, 1846-50 (1976).

In 1976, Judge Sneed of the United States Court of

Appeals for the Ninth Circuit, in a sconcurring opinion

in Green v. Occidental Petroleum Corp. set forth a the-

ory for measuring damages that proved to be a mile-

stone. Judge Sneed postulated that in a securities fraud

class action, the best way to measure the loss proxi-

15

mately caused by the misrepresentation of a defendant is

to create a chart containing a “price line” and a “value

line.” 541 F.2d 1335, 1341, 1344 (9th Cir. 1976) (Sneed,

J. concurring). Pursuant to Judge Sneed’s method, dam-

ages are calculated by subtracting the true value of the

stock on the date of purchase from the price actually

paid, with the spread between the price and value lines

varying over time. See Bradford Cornell & R. Gregory

Morgan, Using Finance Theory to Measure Damages in

Fraud on the Market Cases, 37 UCLA L. Rev. 883, 887

fig. 1 (1990).

As courts began to adopt Judge Sneed’s “value line”

concept, an issue arose as to the best methodology for

determining a stock's “true value,” i.e., value absent the

fraud. A methodology that began gaining some measure

of acceptance was the use of an “event study” to deter-

mine true value. See, e.g., Wool v. Tandem Computers,

Inc., 818 F.2d 1433, 1437 (9th Cir. 1987) (recognizing

the significance of fraud-related and non-fraud related

influences on the stock’s price behavior and stating “the

increment of artificial inflation caused by misrepresen-

tations may fluctuate ‘as a result of market forces oper-

ating on the misrepresentations.’ ”’); /n re Oracle Sec.

Litig., 829 F. Supp. 1176, 1181 (N.D. Cal. 1993) (requir-

ing use of an event study or similar analysis to more

accurately isolate the influences of information specific

to the Company which defendants allegedly distorted).

An event study is a statistical regression analysis that

examines the effect of an event on a dependent variable,

such as a corporation's stock price. RMED Int'l, Inc. v.

Sloan's Supermarkets, Inc., No. 94-5587, 2000 WL

310352, at *6 (S.D.N.Y. Mar. 24, 2000) (citing Jon

Koslow, Estimating Aggregate Damages in Class-Action

Litigation Under Rule 10b-5 for Purposes of Settlement,

59 Fordham L. Rev. 811, 822 & n.50 (1991)). This

approach assumes that the price and value of the security

16

move together except during days when disclosures of

company-specific information influence the price of the

stock. The analyst then looks at the days when the stock

moves differently than would be anticipated based upon

market and industry factors—so-called days of “abnor-

mal returns.” The analyst then determines whethe: inose

abnormal returns are due to fraud or non-fraud related

factors. See Cornell & Morgan, 37 UCLA L. Rev. at

899-900. This effectively is a determination of loss cau-

sation since it establishes the link between the fraud and

the loss.

Over time, the majority of courts have recognized the

utility of the event study methodology in the securities

context and have begun to require experts to include

event studies with their damages reports in order “to dis-

tinguish between the fraud-related and non-fraud related

influences on the stock's price behavior.” Oracle, 829 F.

Supp. at 1181. Courts have held that the event study

method is “an accepted method for the evaluation of

materiality damages to a class of stockholders in a

defendant corporation.” /n re Gaming Lottery Sec. Litig.,

96-5567, 2000 WL 193125, at *1 (S.D.N.Y. Feb. 16,

2000) (citing Eugene Fama et al., The Adjustment of

Stock Prices to New Information, 10 Int'l Econ. Rev. |

(1969)); David Tabak & Frederick Dunbar, Materiality

and Magnitude: Event Studies in the Courtroom, NERA

Working Paper No. 34 (April 1999). Indeed, a number of

courts have rejected or refused to admit into evidence

damages reports or testimony by damages experts in

securities cases that fail to include event studies or some

similar analysis.° See In re Northern Telecom Sec. Litig.,

® A method other than an event study may be used to determine

damages in a particular case. U.S. v. Brown, 2004 WL 2242513

(M.D.Pa. Aug 17, 2004) (applying methodology other than event

study in determining loss).

17

116 F. Supp. 2d 446, 460, 468 (S.D.N.Y. 2000) (court

granted defendants’ motion for summary judgment

where the defendants’ expert had conducted an event

study concluding that none of the allegedly fraudulent

statements resulted in inflation of defendant's stock

price and plaintiffs’ expert did not conduct such a

study); Oracle Sec. Litig., 829 F. Supp. at 1181 (court

found that the “[u]se of an event study or similar anal-

ysis is necessary more accurately to isolate the influ-

ences of information specific to Oracle. . .”). See also

In re Executive Telecard, Ltd. Sec. Litig., 979 F. Supp.

1021 (S.D.N.Y. 1997) (requiring an event study in a 10b-

5 damages case and setting forth standards for such a

study).

As a result of cases such as Executive Telecard, defen-

dants have created an environment in which plaintiffs’

damages analyses are required, in most cases, to comply

with basic principles of corporate finance and include as

damages only those factors that are related to the fraud.

See, e.g., In re WorldCom, Inc. Sec. Litig., No. 02-3288,

2003 WL 22420467, at *28 n.42 (S.D.N.Y. Oct. 24,

2003). Thus, an event study, a complex analysis often

comprising thousands of pages of analysis prepared by

an expert, is used to exclude factors from the overall

economy (such as an overall stock market price decline),

factors impacting the relevant industry, and factors

related to the specific company that are not fraud

related. Because of the detailed nature of these analyses,

they require that the expert have access to substantial

information regarding the fraud (often from discovery),

take many months to prepare, and frequently cost many

hundreds of thousands of dollars. Accordingly, as

explained below, the Court, in determining the appro-

priate pleading standard (as opposed to ultimate require-

ments of proof at trial), should not establish a pleading

standard that would effectively require plaintiffs to con-

18

duct event studies prior to the initiation of litigation. See

infra Section II.

B. A FLEXIBLE LOSS CAUSATION STANDARD IS

CONSISTENT WITH PRINCIPLES OF CORPO-

RATE FINANCE

Under well-accepted theories of corporate value, a

stock will be worth to investors what they ultimately can

obtain from it—dividends or an increase in value

through retained earnings. Richard Brealey & Stewart

Myers, Capital Investment and Valuation 77 (McGraw

Hill 2003). The best measure of what value a company

ultimately will provide to investors is the discounted

value of future cash flows, i.e., discounted value of-the

cash that comes in less the cash that goes out over time.

Thus, corporate finance theory holds that the stock price

of a company reflects the market's estimation of the

company’s future cash flows into infinity, discounted to

reflect the fact that money received in the future is less

valuable then money received today. Such “discounting”

is carried out through a “rate” that is equivalent to the

company’s cost of capital. /d. (“The value of a stock is

equal to the stream of cash payments discounted at the

rate of return that investors expect to receive on com-

parable securities”).’ This approach to valuation is

broadly agreed upon by financial economists and is the

” See also Lynn A. Stout, The Unimportance of Being Efficient:

An Economic Analysis of Stock Market Pricing and Securities Reg-

ulation, 87 Mich. L. Rev. 613, 616 n.11 (1988) (“Efficient market

prices which reflect all available information relevant to the value of

the stock are thought to measure rationally the ‘worth’ of stocks as

financial instruments in terms of the present value of their expected

future earnings. discounted for nondiversifiable risk.” ); Burton Malkiel,

Is the Stock Market Efficient? 243 Science 1313, 1316 (1989) (describ-

ing the standard “rational” model of share pricing as one of determin-

ing the present discounted value of the future stream of dividends).

19

basis for substantial portions of modern corporate

finance theory. /d.

Discounted cash flow (“DCF”) analysis is typically

used to determine the value of a company by calculating

the present value of its future cash flows. The DCF anal-

ysis is premised on the assumption that the value of all

of a corporation's assets is equal to the present value of

the expected cash flow from those assets while they are

held by the corporation. /d. at 52-54 (“the discounted-

cash-flow (DCF) formula for the present value of a stock

is just the same as it is for the present value of any other

asset. We just discount the cash flows by the return in

the capital market on securities of comparable risk.”’);

Neal v. Alabama By-Products Corp., No. 8282, 1990 WL

109243, at * 7 (Del. Ch. Aug. 1, 1990), aff’d, 588 A.2d

255 (Del. 1991) (noting that DCF analysis is considered

by valuation experts to be a “preeminent valuation

methodology”) (citing Shannon Pratt, Valuing a Busi-

ness: The Analysis and Appraisal of Closely Held Com-

panies (2d ed. 1989)).

The basic principle outlined above—that stock prices

are a reflection of future cash flows—has received judi-

cial acceptance by numerous courts in valuation and

bankruptcy settings. See Onti, Inc. v. Integra Bank, 75}

A.2d 904, 916 (Del. Ch. 1999) (in action for declaratory

judgment on fairness of cash-out merger court stated

“this Court has frequently employed the discounted cash

flow as at least one method of valuation”); Neal, 1990

WL 109243, at * 7 (noting that DCF analysis is consid-

ered by valuation experts to be “preeminent valuation

methodology”); see also In re Valley-Vulcan Mold Co.,

No. 99-4129, 2001 WL 224066 (6th Cir. Feb. 26, 2001)

(noting, with approval, that expert's “valuations were

based on discounted cash-flow valuation, a well-recog-

nized methodology for determining a business's going

20

concern values.”); /n the Matter of Genesis Health Ven-

tures, Inc., 266 B.R. 591, 613 (Bankr. D. Del. 2001)

(noting the use of the discounted cash flow method as

one method to support value of an enterprise).

Those principles have not, however, been widely

employed in securities litigation, even though this infor-

mation is relevant to the company’s stock price as an

indicator of the company’s future cash flows. This is a

mistake since these concepts have great relevance in that

area. When a company publicly discloses its present or

past financial performance, this information is relevant

to the company’s stock price as an indicator of the com-

pany’s future cash flows.* Thus, looking at cash flows

and at the information, whether correct or incorrect, that

* William Beaver, Financial Reporting: An Accounting Revolution

69 (Prentice-Hall 3d ed. 1998) (“A conceptual relationship can be

established between accounting earnings and the price of common

stock by introducing three critical links: (1) a link between security

price and future dividends, (2) a link between future dividends and

future earnings, and (3) a link between future earnings and current

earnings”); Tom Copeland, Tim Koller & Jack Murrin, Valuation:

Measuring and Managing the Value of Companies 154 (John Wiley &

Sons 3d ed. 2000) (“[t}he first step in valuing a business is analyzing

its historical performance. A sound understanding of the company’s

past performance provides an essential perspective for developing and

evaluating forecasts of future performance”); George Foster, Finan-

cial Statement Analysis 220-24 (Prentice-Hall 2d ed. 1986) (“[t}he

accounting literature contains many statements about what informa-

tion is (or should be) impounded into security prices. . . . A common

assumption is that there is a mechanistic relation between reported

accounting earnings and stock prices”) (emphasis in original); see

also Daniel R. Fischel, Use of Modern Finance Theory in Securities

Fraud Cases Involving Actively Traded Securities, 38 Bus. Law. |

(1982) (discussing use of current and historical data in determining

cash flows for valuation); Jonathan Fuerbringer, Yesterday's Earnings

Don't Move Stocks. Tomorrow's Do, N.Y. Times, Aug. 8, 2004, at 7

(citing analysis by Birinyi Associates demonstrating that expected

future earnings, not past earnings, are the driver of stock prices).

21

impacts such flows, can be of substantial value to courts

attempting to ascertain whether particular information

provided to the public by defendants has actually

impacted the price of a stock at issue in a particular case.

C. AN APPROPRIATE STANDARD FOR PLEADING

AND PROVING LOSS CAUSATION SHOULD BE

BASED UPON SOUND PRINCIPLES OF CoOR-

PORATE FINANCE

From the origins of the doctrine, courts have grappled

with the appropriate test for determining whether a spe-

cific set of facts establishes loss causation. Courts want

a standard that requires the defendant's fraud to have

caused the plaintiff's loss, but are struggling in those

increasingly frequent cases where there is not a disclo-

sure of fraudulent conduct followed immediately by a

material decline in the price of the company’s stock.

As shown above, some courts have effectively refused

to consider the issue at all, finding that there can be no

loss causation if a stock decline does not immediately

follow a disclosure of fraud. See, e.g., In re Ikon Office

Solutions, Inc. Sec. Litig., 131 F. Supp. 2d 680, 687

(E.D. Pa. 2001). This makes no sense because there are

clear cases of fraud where the stock declined substan-

tially prior to the formal announcement of the fraud and

thus there was little r_om for further decline after the

fraud was announced. See, e.g., Danis v. USN Commu-

nications, Inc., 73 F. Supp. 2d 923 (N.D. Ill. 1999);

Greenberg v. Crossroads Sys., Inc., 364 F.3d 657 (Sth

Cir. 2004).°

* It is not surprising that the stock price will decline prior to an

explicit admission that fraud has occurred since most corporations are

loath to admit that they have committed fraud and are strongly moti-

vated to manipulate their disclosures to make it appear as if no fraud

has occurred, even where fraud has taken place.

22

Other courts require that the plaintiff establish a link-

age between the defendants’ fraudulent statements and

the decline in the value of defendants* stock, but decline

to specify the nature of such a “linkage.” See Huddleston

v. Herman & MacLean, 640 F.2d 534 (Sth Cir. 1981),

aff'd in part and rev'd i». part, 459 U.S. 375 (1983);

Bastian v. Petren Resouress Corp., 892 F.2d 680 (7th

Cir. 1990), cert. denied, 496 U.S. 906 (1990); Robbins v.

Koger Properties, Inc., 116 F.3d 1441 (11th Cir. 1997).

A third group of courts (many in the Second Circuit) has

tried to impose the “foreseeability” test used for proxi-

mate cause in tort cases, (see Emergent Capital Invest-

ment Management, LLC, v. Stonepath Group, Inc., 343

F.3d 189 (2d Cir. 2003)), but that test has effectively

allowed courts to reach contrary results on equivalent

facts. Compare In re Merrill Lynch & Co., 273 F. Supp.

2d 351 (S.D.N.Y. 2003), with Burstyn v. Worldwide

Xceed Group, Inc., No. 01 Civ. 1125, 2002 WL

31191741 (S.D.N.Y. Sept. 30, 2002).

Finally, some courts have only required that a plain-

tiff, in order to establish loss causation, demonstrate that

the purchase price of a stock was inflated due to fraud,

and have not imposed any requirement that the ultimate

decline in the price be strictly linked to the fraud. See

No. 84 Employer-Teamster Joint Council Pension Trust

Fund v. America West Holding Corp., 320 F.3d 920, 934-

35 (9th Cir. 2003); Gebhardt v. ConAgra Foods, Inc.,

335 F.3d 824 (8th Cir. 2003), reh’g denied, 2003 U.S.

App. LEXIS 17920 (8th Cir. Aug. 27, 2003); Danis, 73

F. Supp. 2d at 923.

In order to make loss causation a predictable and log-

ically sound part of federal securities jurisprudence, the

Public Pension Funds propose that the test for estab-

lishing loss causation should be based upon the princi-

ples of corporate finance that govern stock prices and

23

that have increasingly been applied in other contexts.

Under basic principles of corporate finance theory, as

described above, the stock price of a company reflects

the market's estimation of the company’s future cash

flows, discounted back to the present. See supra Section

1.B. In other words, the market price of a publicly-traded

stock is based on the public's projections of how that

company is going to perform in the future. See Thomas

Lee Hazen, The Short-Term/Long-Term Dichotomy and

Investment Theory: Implications for Securities Market

Regulation and for Corporate Law, 70 N.C. L. Rev. 137,

147 (1991). Where a company publicly discloses its pre-

sent or past financial performance, the market will use

this information as an indicator of the company’s future

performance. See supra note 8. Thus, a disclosure

(whether of current performance or anticipated future

performance) that causes the market to believe that

future performance will fall short of expectations, will

deflate a stock price. If it is later revealed by the com-

pany or another source that the initial expectations upon

which investors relied were based upon fraudulent

reporting of past or present results, investors have been

victimized by the fraud, even if the admission that fraud

has occurred was subsequent to a stock price decline.

Accordingly, where a defendant makes a materially

misleading statement to the investing public that artifi-

cially inflates the stock price of a company, and the

plaintiff, in reliance on the market price of those secu-

rities as manipulated by the defendant, purchases the

company's stock at such artificially inflated prices, the

plaintiff should be deemed to have suffered a loss caused

by the defendant to the extent of the inflation so long as

the stock price no longer is being propped-up by the

fraud. Thus, loss causation should be found even where

the disclosures that contradict the earlier, fraudulent

statements appear, when made, merely to be the report-

24

ing of truthful information about the company. The ques-

tions are: (i) was the stock price inflated by fraud; and

(ii) has the inflation been removed?

The following hypothetical will demonstrate the appli-

cation of the proposed test. Assume that ABC, Inc. has

sufficient real cash flow for the present and future such

that its stock should properly be valued at $50 per share.

Assume further that management fraudulently reports

revenues by reporting sham sales to XYZ Corp. that

were not real transactions in quarters one to ten such

that, based upon the discounted future value of its (arti-

ficially inflated) cash flow, the market concludes the

company is worth $75 per share, even though, in reality,

it is worth only $50 per share. Our plaintiff purchases

stock at this point in time at $75 per share.

Finally, assume that X YZ Corp. files for bankruptcy at

the end of quarter ten. From that point in time forward,

ABC knows it will no longer be able to book the sham

transactions. It promptly discloses that its future per-

formance will be somewhat less than was previously

expected (but not why) and, over quarters eleven to six-

teen, releases revenue numbers, with attendant cash

flows, that result in a company with a value of only $40

per share. At the end of quarter sixteen, ABC announces

that the revenue and cash flow numbers from quarters

one to ten were fraudulent, but that its current numbers

are correct and, indeed, that its future numbers will be

improved due to a lucrative new contract. Its stock price

stays at $40 per share."”

Under the above facts, the plaintiff has been defrauded

and, under the test we postulate, should be able to prove

loss causation and recover damages for the difference

'© Of course, it is possible in this scenario that the stock price

would increase.

25

between the purchase price ($75 per share) and the true

value ($50 per share), but not for any decline in excess

of $25 per share, since any such decline would be unre-

lated to the fraud.

Utilizing this test for loss causation is fully consistent

with the vast majority of existing loss causation jurispru-

dence and is also consistent with basic principles of cor-

porate finance. So long as a plaintiff can show that the

fraud resulted in expectations of improved performance,

raising the stock price, and that the revelation of infor-

mation related to the fraud resulted in expectations of

reduced future performance, reducing the stock price,

plaintiff should be deemed to have established that the

fraud “caused” the loss at issue.

Il. THE STANDARD OF LOSS CAUSATION PRO-

POUNDED BY THE NINTH CIRCUIT OR AN

EQUIVALENT STANDARD IS APPROPRIATE

AT THE PLEADING STAGE

In its decision in Broudo, the Ninth Circuit addressed

a case in which a securities fraud lawsuit was brought as

the result of two allegedly fraudulent statements. Peti-

tioner Dura Pharmaceuticals, Inc. (Dura) developed and

marketed products for the treatment of allergies, asthma,

and other respiratory conditions. In 1995, it began devel-

oping a delivery device for asthma drugs called

Albuterol Spiros. The following year, it began selling a

respiratory antibiotic called Ceclor CD. In an April 15,

1997 press release announcing better-than-expected

results for the first quarter of 1997, Dura stated that

“strong progress” had been made in selling Ceclor CD,

and that certain testing had been completed that would

allow Dura to submit a new drug application (“NDA”)

for Albuterol Spiros to the Food and Drug Administra-

26

tion (“FDA”). Dura filed its application for Albuterol

Spiros in November 1997.

On February 24, 1998, Dura announced that, for a

number of reasons, including slower than expected sales

of Ceclor CD, it was anticipating lower revenues and

earnings per share in 1998 than had previously been

forecast. The next day, the price of Dura stock dropped

47 percent. The announcement did not mention Albuterol

Spiros. In November 1998, Dura announced that the

FDA had decided not to approve Albuterol Spiros, “due

to electro-mechanical reliability issues and chemistry,

manufacturing, and control concerns.” The complaint did

not allege any decline in Dura’s stock price after the

November 1998 disclosure.

In reversing a district court opinion that dismissed the

Albuterol Spiros allegations for failure to adequately

plead loss causation, the Ninth Circuit adopted a notice

pleading standard for loss causation. The Ninth Circuit

held that loss causation is satisfied where “the plaintiff

shows that the misrepresentation touches upon the rea-

sons for the investment’s decline in value.” 339 F.3d at

938. While the court also stated that “loss causation. . .

merely requires pleading that the price at the time of

purchase was overstated and sufficient identification of

cause,” that requirement is not inconsistent with notice

pleading, which would not require a discussion of the

specific disclosures that materially impacted the stock

price. /d. This is the appropriate pleading standard and,

as a result, the decision of the Ninth Circuit should be

affirmed.

Allegations regarding loss causation have been deter-

mined by the lower courts to be subject to the liberal

pleading requirements of Rule 8 of the Federal Rules of

Civil Procedure. See, e.g., Gebhardt, 335 F.3d at 830 n.3

(the PSLRA does not change the traditional pleading

27

rules for materiality and loss causation).'' Under Rule

8(a)(2), a complaint must include only “a short and plain

statement of the claim showing that the pleader is enti-

tled to relief.” Such a statement need only “give the

defendant fair notice of what the pleintiff's claim is and

the grounds upon which it rests.” Conley v. Gibson, 355

U.S. 41, 47 (1957). Other portions of Rule 8 reinforce

this notice pleading standard. Rule 8(e)(1) states that

“[njo technical forms of pleading or motions are

required,” and Rule 8(f) provides that “[a]ll pleadings

shall be so construed as to do substantial justicc.” Thus,

“[a] court may dismiss a complaint only if it is clear that

no relief could be granted under any set of facts that

could be proved consistent with the allegations.” Hishon

v. King & Spalding, 467 U.S. 69, 73 (1984).

Under this liberal pleading standard, and the standard

for loss causation proposed by the Public Pension Funds

above (see supra Section I.C), a plaintiff should be

required merely to allege a “short and plain statement”

that there is some potential linkage between a company’s

disclosures related to the fraud and the expectations of

reduced performance (and hence share price) on the part

of the securities at issue. Such a statement is not mate-

rially different from the standard adopted by the Ninth

Circuit in Broudo, since neither standard requires a plain-

tiff to state with any detail the specific factual statements

made by a defendant that are related to the fraud.

This Court should not adopt a more stringent standard

for pleading loss causation. Requiring a plaintiff to iden-

tify, with particularity, each statement made by a defendant

that had the effect, for cash flow purposes, of revealing

some aspect of the fraud is a complex, information-inten-

"' Petitioner has not argued, or even suggested, that a heightened

pleading standard is required for loss causation.

28

sive process that is not appropriate at the pleading stage

under Fed. R. Civ. P. 8(a). Such a standard would be

inconsistent with notice pleading, would necessitate dis-

covery and extensive expert analysis, and, inevitably,

would result in the dismissal of meritorious cases.

The determination of the pleading standard applicable

to loss causation requires the Court to balance the legit-

imate needs of defrauded investors in having access to a

legal remedy under the federal securities laws against

the needs of business to be protected from meritless lit-

igation. The test proposed by the Public Pension Funds,

with notice pleading required for loss causation, ade-

quately strikes that balance. Under Rule 9(b), “[iJn all

averments of fraud or mistake, the circumstances con-

stituting fraud or mistake shall be stated with particu-

larity.” Fed. R. Civ. P. 9(b). Further, the PSLRA requires

that a “complaint shall specify each statement alleged to

have been misleading, the reason or reasons why the

statement is misleading, and, if an allegation regarding

the statement or omission is made on information and

belief, [a] complaint shall state with particularity all

facts on which that belief is formed.” 15 U.S.C. § 78u-

4(b)(1). The PSLRA further mandates that a complaint

“state with particularity facts giving rise to a strong

inference that the defendant acted with the required state

of mind.” 15 U.S.C. § 78u-4(b)(2). Thus, every com-

plaint, in order to survive a motion under Rule 12(b)(6),

must identify, with particularity every fraudulent state-

ment, why it is false, and must set forth facts that

strongly infer that the false statements were made reck-

lessly or with knowledge of their falsity. A complaint

that has met these very high hurdles is not a frivolous

pleading and it is not burdensome for defendants to be

required to defend an action that avers in detail why they

29

knowingly or recklessly made fraudulent statements that

impacted the price of a stock.

Requiring, in pleading loss causation, anything more

than a basic averment that the fraud caused the loss, on

the other hand, would raise the pleading bar so high that

a large number of meritorious claims would be precluded

at the pleading stage. As described above, in order to

adequately plead loss causation in many complex cases

where the corrective statements are not labeled as such,

a heightened pleading standard would require an exten-

sive event study analysis to determine which corrective

statements impacted expectations of performance and,

hence, stock price, and the relationship of those cor-

rective statements to the fraud. In many cases, where

defrauders have sought to cover their tracks, it will be

impossible without detailed analysis like an event study

to plead the particular statements that corrected the fraud

and thus “caused” the loss. Accordingly, anything more

than a general averment that such corrective statements

exist, should not be required.

At the pleading stage, the test advocated by the Ninth

Circuit, which does not require any substantive link

between corrective disclosures and stock price declines,

strikes the correct balance between protecting investors

and securities fraud defendants. That decision should be

affirmed.

30

CONCLUSION

For the reasons set forth above, amici curiae the Pub-

lic Pension Funds respectfully request that the Court

affirm the judgment of the Ninth Circuit in Broudo v.

Dura Pharmaceuticals, Inc.

Respectfully submitted,

Leonard J. Koerner

Chief Assistant

Corporation Counsel

Law Department

Corporation Counsel of

the City of New York

100 Church Street

New York, NY 10007-2601

(212) 788-0303

Peter H. Mixon

General Counsel

California Public

Employees Retirement

System

Lincoln Plaza

400 P Street

Sacramento, CA 95814

(916) 795-3675

Jay W. Eisenhofer

Counsel of Record

Geoffrey C. Jarvis

Grant & Eisenhofer P.A.

Chase Manhattan Centre

1201 N. Market Street.

Suite 2100

Wilmington, DE 19801

(302) 622-7000

David L. Muir

Chief Counsel

Los Angeles County

Employees Retirement

Association

300 N. Lake Avenue,

Suite 620 |

Pasadena, CA 91101

(626) 564-2348

Alan P. Lebowitz

General Counsel to

Alan G. Hevesi,

Comptroller of the

State of New York

110 State Street

Albany, NY 12244

(866) 805-0990

Christopher W. Waddell

General Counsel

California State Teachers’

Retirement System

7919 Folsom Boulevard

Sacramento, CA 95826

(916) 229-3500

Counsel for Amici Curiae

November 17, 2004