LAWFUEL – The Law News Network – On January 20, in one of the most significant securities laws decisions in recent years, the Court of Appeals for the Second Circuit affirmed dismissal of two cases brought against Merrill Lynch and one of its research analysts seeking losses for investments in internet stocks based on allegedly false research reports. Lentell v. Merrill Lynch & Co., Docket No. 03-7948.
The Second Circuit held that the flaws in plaintiffs’ allegations of loss causation were “fatal.” The cases on appeal had been dismissed by the Honorable Milton Pollack (now deceased) of the Southern District of New York in June 2003. In dismissing the cases, Judge Pollack described plaintiffs as “high-risk speculators who, knowing full well or being properly chargeable with appreciation of the unjustifiable risks they were undertaking in the extremely volatile and highly untested stocks at issue, . . . hope[d] to twist the federal securities laws into a scheme of cost-free speculators’ insurance.” In re Merrill Lynch Research Reports Securities Litigation, 273 F. Supp. 2d 351 (S.D.N.Y. 2003). At the time of the dismissal, The Wall Street Journal described it as a “landmark victory” and a “breakthrough victory for Wall Street.”
Loss causation focuses on the nexus between the alleged fraud and the reason the security at issue declined in value.
Judge Dennis Jacobs, writing for the Court, held that plaintiffs had failed to allege that the subject of the fraudulent statement was the cause of the actual loss suffered. In doing so, the Court delineated a standard requiring plaintiffs to plead that the loss resulted from the “materialization of a concealed risk,” finding that language to the contrary in an earlier decision, Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F. 3d 87, 95 (2d Cir. 2001), was not controlling. The Court also held that the loss must be “sufficiently direct,” not too “attenuated” and foreseeable. The Second Circuit emphasized that the concept of loss causation “is intended to fix a legal limit on a person’s responsibility even for wrongful acts.” In particular, the Court found that plaintiffs had alleged “no loss resulting from the market’s realization that the [allegedly overly optimistic ratings] were false or that Merrill concealed any risk that could plausibly (let alone foreseeably) have caused plaintiff’s loss.” The Court explained that plaintiffs “did not challenge the detailed financial information and investment analysis published alongside the [allegedly] fraudulent recommendations” and held that it was “incontestible that the risk . . . of implosion [of the stock prices] is apparent on the face of every report challenged.”
The Court rejected plaintiffs’ argument that the decline in the price of the stocks on the day they were downgraded adequately pleaded loss causation, holding that downgrades are not “corrective disclosures” because “they do not reveal to the market the falsity of the prior recommendations.” And with respect to plaintiffs’ allegations concerning allegedly undisclosed conflicts of interest, the Court noted that such alleged conflicts “do not, standing alone, evidence fraud,” and found that plaintiffs had simply made no attempt to connect these alleged omissions with any “concealed risk of a significant devaluation of 24/7 and Interliant.”
Finally, the Court also rejected an attempt by plaintiffs to re-cast their claims as “market manipulation” so as to circumvent the Private Securities Litigation Reform Act’s heightened pleading requirements, holding that the heightened requirements apply where the sole basis for a “market manipulation” claim is a misrepresentation or omission.