Justices Raise the Bar on Stock Fraud Cases

The Supreme Court made it harder Tuesday for investors and pension funds to sue and win back the money they lost after the bursting of the stock market bubble of the late 1990s, ruling that the nation’s antifraud laws were not “insurance against market losses.”

The justices used a failed suit against a small San Diego pharmaceutical company to issue a warning against open-ended lawsuits claiming stock fraud.

A plunge in a stock’s prices does not show there has been a fraud, even if investors were lured to buy the stock because of the company’s inflated claims, the justices said. Sometimes a steep drop in a stock’s price “may reflect changed economic circumstances, changed investor expectations, new industry-specific ... facts, conditions or other events,” Justice Stephen G. Breyer said.

To sue for stock fraud, the investors and their lawyers must show that a company’s false statements caused the plunge in the stock price and caused the investors to lose money, Breyer said.

The 9-0 ruling set a strict standard for bringing into court lawsuits claiming a stock fraud. It applied the Private Securities Litigation Reform Act of 1995, a measure designed to curb lawsuits that alleged stock fraud.

Tuesday’s decision reversed a more lenient standard set by the U.S. 9th Circuit Court of Appeals in San Francisco that allowed investors to sue based on the claim that a company’s overly optimistic statements had inflated its stock price.

Experts in securities law feared that if the 9th Circuit ruling were upheld, companies could be held liable for the billions of dollars in losses that followed the bursting of the Internet bubble five years ago.

“This sends the strong message that the Supreme Court will not allow losses caused by economic conditions to be swept into a cause for lawsuits. Market bubbles are not fraud,” said Richard Bernstein, a Washington lawyer for the Securities Industry Assn.

The San Diego lawyer who defended the pharmaceutical firm said the court made it harder to bring suits that lack clear evidence of fraud.

“This is a pretty powerful opinion by Justice Breyer,” said William F. Sullivan, the lawyer for Dura Pharmaceuticals Inc. of San Diego. “It rejects the idea that an inflation in a stock price is enough to go forward. But if you have evidence that someone cooked the books ... then you can [sue], because the misrepresentation caused the loss.”

In the fall of 1997, Dura’s stock price rose steadily after the company announced that its sales were increasing and that it was making good progress on developing a device for inhaling an asthma medication. The stock price reached $53 a share late in the year but plunged to $20 in February 1998 after the company announced disappointing sales.

The stock price fell further that summer after Dura said its inhaler had not won the approval of the Food and Drug Administration.

A group of investors sued Dura, alleging that company executives had deceived them by issuing false claims that inflated the stock price. A federal judge in San Diego dismissed the suit before trial on the grounds that the lawyers had not pointed to a revealed fraud or a “corrective disclosure” that caused the investors to lose money.

But the 9th Circuit revived the suit, saying investors needed only to show that they were misled into paying too much for the stock in 1997.

The high court reversed that decision Tuesday in Dura Pharmaceuticals vs. Broudo.

Breyer said the 9th Circuit’s open-ended approach would permit a plaintiff “with a largely groundless claim” to sue and demand money to cover losses.

Breyer’s opinion was brief -- 11 pages -- and he did not spell out what kind of evidence was needed to move forward with a lawsuit. However, most legal experts read the decision as seeking to block such suits.

The U.S. Chamber of Commerce and other business groups told the justices that the growing number of securities lawsuits takes “an enormous toll on the national economy.” Sometimes companies settle these open-ended lawsuits because they are too costly to fight, they said.

Deborah Zuckerman, a lawyer for AARP, called Tuesday’s decision a setback for older Americans who were hurt by losses in the stock market.

“This means people who have experienced losses in the market because of misrepresentations will not be able to recoup their losses,” she said. “It also opens the door for companies to get away with representation that results in losses to investors.”