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December 31, 2003.

In re: Initial Public Offering Securities Litigation This Document Relates To: All Cases

The opinion of the court was delivered by: SHIRA SCHEINDLIN, District Judge


In an Opinion and Order dated February 19, 2003, I decided defendants' motions to dismiss,*fn1 which they now renew in light of a recent Second Circuit case addressing the pleading of loss causation in securities fraud cases. For the reasons that follow, Underwriter defendants' motion for judgment on the pleadings is denied.


  The allegations in these actions were exhaustively described in the Court's February Opinion, familiarity with which is assumed.*fn2 In short, plaintiffs allege that defendants defrauded purchasers of securities of 309 technology stocks by manipulating the market for those securities.*fn3 The Underwriters allegedly required or induced their customers to buy shares of stock in the aftermarket as a condition of receiving initial public offering stock allocations. These prearranged purchases created an artificial market for the securities, and caused plaintiffs to purchase at an inflated price. In addition, the Underwriters allegedly received inflated commissions or other undisclosed compensation in exchange for IPO allocations. This conduct, collectively, gave rise to two claims against the Underwriters: (1) a claim for market manipulation pursuant to section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder, and (2) a claim for material misstatements and omissions, also under section 10(b) and Rule 10b-5.*fn4


  The issue raised here is whether bare allegations that a defendant artificially inflated the price of a security suffice to plead loss causation under a "fraud on the market" theory.*fn5 This question highlights an important circuit split in the pleading of securities fraud.

  A. Pleading Causation in a Securities Fraud Claim

  To maintain a claim for securities fraud, a plaintiff must plead, among other things, both (1) that it relied upon defendant's allegedly fraudulent conduct in purchasing or selling securities, and (ii) that defendant's conduct caused, at least in part, plaintiff's loss.*fn6 These two elements are known, respectively, as "transaction causation" and "loss causation."

  "Transaction causation is generally understood as reliance."*fn7 Under settled Supreme Court precedent, a rebuttable presumption of transaction causation may be established under the "fraud on the market" theory, even where a plaintiff was unaware of the fraudulent conduct at the time of the purchase or sale.

The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. . . . The causal connection between the defendants' fraud and the plaintiffs' purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations.*fn8
Pleading the applicability of the fraud on the market theory, therefore, fulfills a plaintiff's transaction causation pleading requirement.

  Loss causation, on the other hand, refers to the requirement that a plaintiff demonstrate that the fraudulent scheme caused her loss.*fn9 In the case of 10b-5 actions for material misstatements or omissions, loss causation generally requires a plaintiff to show that her investments would not have lost value if the facts that defendant misrepresented or omitted had been known.*fn10

  As noted above, the Supreme Court has explicitly approved the use of the fraud on the market theory to demonstrate transaction causation. More recently, courts have struggled with whether that theory can also be used to demonstrate loss causation. Those courts that have answered this question in the affirmative hold that, "[i]n a fraud-on-the-market case, plaintiffs establish loss causation if they have shown that the price on the date of purchase was inflated because of the misrepresentation."*fn11 If the plaintiff overpaid for the security because the fraudulent scheme inflated its price, these courts reason, then the discrepancy between the price of the security and its true investment quality are the measure of her loss.*fn12

  Those courts rejecting the fraud on the market theory as a sufficient allegation of loss causation reason that if a plaintiff purchases a security at an inflated price, she is only damaged if the sale price is not equally inflated.*fn13 To plead loss causation, therefore, a plaintiff must allege something more than mere price inflation — something that explains the plaintiff's loss. For example, courts have held that a disclosure correcting an earlier misstatement or omission can, coupled with allegations of artificial inflation, suffice to plead loss causation.*fn14

  The Courts of Appeals are deeply divided on this question. The Eighth and Ninth circuits have recently reaffirmed their holding that allegations of artificial inflation, alone, are sufficient.*fn15 ...

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