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United States District Court, S.D. New York

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 The Third and the Eleventh circuits have held otherwise.*fn16

  B. Suez Equity and Emergent Capital

  In Suez Equity, the Second Circuit held that plaintiffs could plead causation in securities fraud cases by alleging:

both that [Plaintiffs] would not have entered the transaction but for the misrepresentations [i.e., transaction causation] and that the defendants' misrepresentations induced a disparity between the transaction price and the true "investment quality" of the securities at the time of transaction [i.e., loss causation].*fn17
Thus, as recently as 2001, this circuit seemed clearly to have joined with the Eighth and Ninth circuits in holding that allegations of artificial inflation, alone, are sufficient to plead transaction causation.

  Earlier this year, however, the Second Circuit decided Emergent Capital Investment Management, LLC v. Stonepath Group, Inc.,*fn18 which purported to "clarify" the rule of Suez Equity.*fn19 The Emergent Capital court held:

We did not mean to suggest in Suez Equity that a purchase-time loss allegation alone could satisfy the loss causation pleading requirement. To the contrary, we emphasized that the plaintiffs had "also adequately alleged a second, related loss. . . . [T]herefore, we do not think Suez Equity undermined our established requirement that securities fraud plaintiffs demonstrate a causal connection between the content of the alleged misstatements or omissions and "the harm actually suffered."*fn20
After Emergent Capital, this Circuit appears to have switched camps, now siding with the Third and Eleventh circuits.*fn21 However, because the court took pains to insist that Suez Equity is still good law, the sweep of Emergent Capital is not entirely clear.


  It is now clear that allegations of artificial inflation, without more, do not suffice to plead loss causation in securities fraud cases involving material misstatements and omissions. In the February Opinion, I found that plaintiffs had sufficiently alleged loss causation, under the rule of Suez Equity, by alleging a scheme that "`had the effect of inflating the price of the Issuer's common stock above the price that would have otherwise prevailed in a fair and open market.'"*fn22 In light of Emergent Capital, Underwriter defendants renew their objections to plaintiffs' allegations of loss causation.*fn23

  A. Understanding Emergent Capital

  The Third Circuit's rationale for its holding in Semerenko v. Cendant Corp. sheds light on the reach and meaning of Emergent Capital. Semerenko involved alleged misrepresentations in connection with a tender offer.*fn24 The Court held:

Where the value of a security does not actually decline as a result of an alleged misrepresentation, it cannot be said that there is in fact an economic loss attributable to that misrepresentation. In the absence of a correction in the market price, the cost of the alleged misrepresentation is still incorporated into the value of the security and may be recovered at any time simply by reselling the security at the inflated price.*fn25
In other words, if the artificial inflation is maintained from the buy to the sell, there is no loss. If a customer buys a security at the inflated price of $12 a share and sells it at the inflated price of $2 a share, that customer suffers the same loss as one who buys at the true price of $11 and sells at the true price of $1. The difference between the inflated prices ($2-$12) and the "true" prices ($1-$11) is the same, and the customer suffered the same loss. So long as the amount of inflation is constant, artificial inflation causes no loss for customers who buy and sell at inflated prices.

  This rationale suggests that inflated stock prices can lead to a loss in one of two ways. First, there can be an external correction to the market, such as a corrective disclosure. Once the fraud is revealed, it no longer taints the stock price and the artificial inflation disappears. The result is a sale at true value, causing a loss based on the inflated price at the time of purchase. Second, there can be a market correction, where ordinary market forces affect the rate of artificial inflation. If, for example, the normal functioning of the securities market causes the inflationary effect to dissipate over time, a customer who buys and sells at inflated prices will still suffer a loss based on the inflated price at the time of purchase so long as the price was less inflated at the time of sale.

  Semerenko suggests that, in material misstatement and omission cases,*fn26 a court cannot presume dissipation of the inflationary effect; a plaintiff must explicitly allege a disclosure or some other corrective event. Indeed, Emergent Capital is limited to material misstatement and omission cases: it is a misrepresentation case, and its recitation of the law consistently refers to misstatements, rather than to the more generic "scheme to defraud." Indeed, all of the previously-cited cases discussing the application of the fraud on the market theory to allegations of loss causation (on both sides of the circuit split) were material misstatement and omission cases. Material misstatements and omissions, however, do not cover all of the proscribed activity under Rule 10b-5. Rule 10b-5 makes it unlawful:

(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.*fn27
Material misstatements and omissions are prohibited by Rule lOb-5(b); Rules 10b-5(a) and (c) apply to what are commonly called "market manipulation" cases.

  B. Market Manipulation Claim

  The IPO litigation involves claims of market manipulation. Plaintiffs allege that the banks' laddering of securities created artificial demand in the aftermarket of hot IPOs, thereby artificially inflating the price of those securities. Thus, the question arises: for loss causation purposes, are market manipulation cases different from misstatement cases?

  As noted earlier, the fraud on the market theory is premised on the idea that, in an efficient market, stock prices reflect all the information available to the market.*fn28 Once a misstatement or omission infects the pool of available information, it continues to affect the stock price until contradictory information becomes available. The inflationary effect of misstatements or omissions, therefore, should be constant.*fn29

  Manipulative conduct is different. A market manipulation is a discrete act that influences stock price.*fn30 Once the manipulation ceases, however, the information available to the market is the same as before, and the stock price gradually returns to its true value. For example, suppose that a bank manipulates the market for a stock by engaging in "wash sales," fictitious trading for the purpose of creating a false appearance of activity. By creating an appearance of increased trading volume, wash sales may drive up the price of a security. Once the wash sales cease, ordinary trading resumes. The spectre of wash sales may continue to affect the stock price for some time as investors recall the recent increased activity and observe the higher price; over time, however, the security will fall back to its true investment value.

  In market manipulation cases, therefore, it may be permissible to infer that the artificial inflation will inevitably dissipate.*fn31 That being so, plaintiffs' allegations of artificial inflation are sufficient to plead loss causation because it is fair to infer that the inflationary effect must inevitably diminish over time. It is that dissipation — and not the inflation itself — that caused plaintiffs' loss.

  It is important not to lose sight of why loss causation is a requirement of a securities fraud claim. At base, loss causation is nothing more than a securities fraud analog to the tort concept of proximate causation, "meaning that the damages suffered by plaintiff must be a foreseeable consequence of any" scheme to defraud.*fn32 The gravamen of plaintiffs' complaint is that the Underwriters manipulated the IPO market to drive up the price of securities, knowing that they were causing the securities to be overvalued and that the stock prices would eventually recede to reflect the actual value of the securities, thereby injuring innocent investors. That is loss causation.*fn33 C. Material Misstatement and Omission Claim

  For the same reasons that plaintiffs' allegations of artificial inflation plead loss causation in their market manipulation claims, they also plead loss causation in the material misstatement and omission claims. It is true that Emergent Capital ordinarily forbids courts from inferring a dissipation in the inflationary effect of misstatements. In this case, however, the misstatements and omissions did nothing more than conceal the Underwriters' alleged market manipulation.*fn34

  Emergent Capital requires allegations of a "causal connection between the content of the alleged misstatements and `the harm actually suffered.'"*fn35 The content of Underwriters' misstatements was, in essence: "this is a fair, efficient market, unaffected by manipulation." In fact (according to plaintiffs), the market was manipulated. For the reasons discussed in Part III.B above, that market manipulation was a cause of plaintiffs' loss. Therefore, the misstatements that concealed that manipulation also were a cause of plaintiffs' loss.


  For the foregoing reasons, plaintiffs have alleged loss causation. Underwriters' motion for judgment on the pleadings is denied. The Clerk is directed to close this motion.


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