The argument that loss causation must be plead by showing a stock price decline related to the alleged fraud, articulated in the Second Circuit by the Emergent Capital decision, is meeting with increased resistance by the S.D.N.Y. judges handling the research analyst cases. Judges have argued that the stock market crash that occured between the issuance of the allegedly biased research and the revelation of the analysts' conflicts of interest (and, therefore, arguably caused any loss) was irrelevant, either because of allegations that the research analyst directly participated in a fraudulent scheme perpetrated by the issuer of the underlying stock or because the revelation of the analysts' conduct caused a subsequent stock price drop. (See these posts on the WorldCom and Robertson Stephens cases).
In Fogarazzo v. Lehman Brothers, Inc., 2004 WL 1151542 (S.D.N.Y. May 21, 2004), however, the entire concept of the price decline approach to pleading loss causation comes under attack. The complaint, brought by shareholders of RSL Communications, Inc. (“RSL”), alleged that analysts at three firms had falsified their opinions of RSL. Specifically, while RSL issued a series of negative announcements in 1999 and 2000 – and its stock price dropped – the analysts continued to provide RSL with positive ratings. Ultimately, RSL’s stock declined to the point that it was delisted, and each of the three firms then dropped analyst coverage. The court was careful to note that there were no allegations that the defendants concealed any facts concerning RSL. Instead, the plaintiffs merely alleged that despite publicly available negative information, the analysts expressed falsely positive opinions.
Although the facts are similar to those in the Merrill Lynch cases, Judge Scheindlin appears to create a new loss causation standard and concludes that loss causation was adequately plead. The court explained that loss causation is shown when "(1) the misrepresentation artificially inflated the value of the security, or otherwise misrepresented its investment quality, and (2) the subject of the misrepresentation caused the decline in the value of the security." Here, the subject of the misrepresentations was "the financial health and future prospects of RSL," and though no facts were concealed, that subject still caused plaintiffs' losses. "[E]ven though the true facts were available to the world to see, by affirmatively opining on the meaning of those facts, the Banks obscured the logical conclusion that RSL was failing." This standard would appear to remove the need to draw any actual connection between the misrepresentations and the loss; the mere fact that the company's stock price declined creates liability for anyone who issued false statements about the company into the market.
Moreover, although Judge Scheindlin expressed uncertainty as to whether the Second Circuit’s price decline approach requires a corrective disclosure, the court concluded that dropping analyst coverage of RSL was a corrective disclosure. "[W]hen the Banks dropped coverage, they essentially conceded (in the eyes of the investing public) that their previous recommendations were mistaken." Even accepting this characterization of the banks' actions (and it is hard to see how dropping coverage can be equated with a disclosure about the previous recommendations), the court did not find that there was a price decline after coverage was dropped.
As noted previously, clarification of these issues may come in the near future. The Second Circuit is scheduled to hear the appeal of the first few Merrill Lynch decisions on August 12, 2004.
Holding: Motion to dismiss denied. (The 10b-5 Daily may do an additional post about the other holdings in the opinion.)