State High Court Limits Investors’ Ability to Win Punitive Damages : Law: It is not enough to prove that a company misrepresented its condition. Investors must show that they relied on the misstatements.

The California Supreme Court Thursday limited the ability of investors to recover damages from companies that misrepresent their financial health in selling stocks and bonds.

On a 5-2 vote, the court held that investors can sue for fraud under California common law and collect punitive damages only if they can demonstrate that they purchased the securities after actually relying on false representations from the company--something that is hard to prove.

It is not enough, the court said, for the investor to show that the company made false claims that artificially raised the price of the securities. Punitive damages, given by a jury to punish the defendant, can far exceed the actual losses suffered by the investor.

Investors will still be able to sue under federal and state securities laws, but those statutes limit damages to the amount lost by the investor. The laws also give investors less time to file a complaint after discovering the fraud than is provided by California common law.

The ruling came in a class-action case brought by investors Gerald Mirkin and Charles Miller, who charged that Los Angeles-based Maxicare Health Plans misrepresented its financial health from 1985 to 1988, prompting investors to buy stocks and bonds at inflated prices that later plummeted.

The investors could not demonstrate to the court’s satisfaction that they actually read or heard the alleged misrepresentations before buying the securities.

Instead, the investors argued that the market price of the securities reflected the misrepresentations and that by relying on the market price, they were indirectly relying on distortions.

The case had been closely watched by the accounting and securities industries, which had feared the California court might create a new avenue for fraud claims.

“This is a major case for the accounting industry and the securities industry,” said Todd E. Gordinier, a lawyer who represented one of the defendants, “and it was the focus of a lot of the plaintiffs bar’s attention--to open the California state system to these kinds of lawsuits.”

Justice Edward Panelli, writing the majority opinion, said it is not necessary to give investors the opportunity to win punitive damages from companies that misrepresent their performance.

Such damages can be justified only as a deterrent or retribution, Panelli wrote, and other laws already serve that purpose.

“Actual damages, alone, represent a potentially crushing liability in securities fraud cases,” Panelli wrote.

Neither are punitive damages needed as retribution, he wrote, because criminal sanctions are available to punish the offending companies, with prison terms ranging up to five years under state law and 10 years under federal law and fines of up to $2.5 million.

Justices Joyce Kennard and Stanley Mosk agreed that the investors must demonstrate that they had relied on the distorted representations to file a suit for negligent misrepresentation under California common law.

But they dissented on other grounds, saying that when investors can prove intentional fraud they should be entitled to recover money without also having to demonstrate that they actually read or heard the misrepresentations.

Donald Schmid, an attorney who represented the underwriters of Maxicare’s securities, said the decision may reduce the number of meritless lawsuits alleging securities fraud against companies every time their stock prices dip.

But William S. Lerach, an attorney for the investors, complained that most investors will not be able to demonstrate that they actually read a company’s distorted reports because they rely instead on advice from brokers and security analysts, who presumably have read them.

“The unfortunate truth of the matter is that this decision is just one more in a chain of decisions by the California Supreme Court to represent victories for corporate interests over the interests of individuals,” the San Diego attorney said.

A class-action lawsuit brought in federal court against officers of Maxicare was settled about a year ago for $8.5 million. As a condition of that settlement, Maxicare and its officers had been dropped from the California case.

The case before the California Supreme Court would have affected the accountants and underwriters for Maxicare, which were not part of the federal settlement.

“Now the underwriters who helped them sell these worthless securities are able to walk away scot-free,” Lerach said.

Maxicare declared bankruptcy shortly after the filing of the state class-action suit and was reorganized under Chapter 11 proceedings.