A recent u.s. supreme Court case may have dealt a blow to investor lawsuits based on allegations of fraud.

The court has set out what investors must do in order to sue an issuer when a stock price drops as a result of alleged misrepresentation. In an April decision in Dura Pharmaceuticals Inc. v. Broudo, the USSC ruled that investors must show in their statement of claim, and subsequently be able to prove, that a drop in stock price was caused by a misrepresentation and not other factors, such as economic conditions.

The decision could well influence Canadian courts, in which U.S. decisions are often cited as examples of how securities legislation should be interpreted. “Dura is one of the most important decisions made within the past 10 years,” says Jim Douglas, a Toronto securities lawyer and partner with national law firm Borden Ladner Gervais.
“You can’t just plead the price changed once the misrepresentation was clarified. You also have to show how the
misrepresentation caused the change in price.”

Neil Gross, a Toronto securities lawyer and partner with Carson Gross Christie Knudsen, is concerned that the Dura decision will mean “the death knell of the fraud-on-the-market theory.”

The fraud-on-the-market theory came out of 1988 USSC decision, Basic Inc. v. Levinson, in which the court stated that “in an open and developed market, the price of a company’s stock is determined by available information about the company and its business. Misleading statements, therefore, will defraud purchasers of stock even if the purchasers do not directly rely on the statements.”

Section 130 of the Ontario Securities Act is a codification of this theory, says Douglas. It states that when a prospectus contains a misrepresentation and an investor purchases a security during the distribution period, the purchaser “shall be deemed” to have relied on the misrepresentation.

However, says Douglas, the
fraud-on-the-market theory is not generally accepted in Canada. The only Sec. 130 decision made so far, he says, was Kerr v.
Danier Leather Inc., decided by the Ontario Superior Court of Justice in 2004.

In Danier, the court decided that a “forecast” made in a prospectus can be taken by investors as a “material fact.” Furthermore, the issuer has an obligation to disclose all material facts to ensure that a statement is not misleading.

As a result, the court decided, the plaintiff would get damages covering the drop between the offering price and the post-misrepresentation price unless the defendant can prove all or part of the drop is attributable to other factors.

If the Dura decision had been made before the Danier decision, says Douglas, the Ontario court might have decided differently.

However, there seems to be hope for issuers worried about the implications of the Danier decision. It is being appealed, and the Dura decision is sure to be a factor.

Gross hopes Canadian courts will take a closer look at the logic used in the Dura case, and not be as close-minded as the USSC.

He notes that one of the bases for the U.S.
decision was a federal statute called the Private Securities Litigation Reform Act, 1995. Passed before the Enron Corp.
debacle and the subsequent chain of corporate scandals that hit the markets, it was designed to dampen what are known as “strike suits” — class-action investor lawsuits brought immediately after a stock price drops. They are usually funded by plaintiff-side lawyers in return for a share of the eventual damages awarded. There was a lot of political sympathy for this legislation in the U.S. in the mid-1990s, says Gross.
But Enron has changed all that, and Gross is surprised the USSC seems to have returned to pre-Enron thinking.

The court seems to have been unwilling to accept the concept that damages can arise from an artificially inflated stock price, no matter what intervening events occurred.

The USSC decided the lower court’s
decision was “inconsistent with the [1995] law’s requirement that a plaintiff prove the defendant’s misrepresentation, or other fraudulent conduct, proximately caused the plaintiff’s economic loss.”

Instead, the USSC stated: “If the purchaser
sells later after the truth makes its way into the marketplace, an initially inflated purchase price might mean a later loss. But that is far from inevitably so. When the purchaser subsequently resells such shares, even at a lower price, that lower price may reflect, not the earlier
misrepresentation but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events, which taken separately or together account for some or all of that lower price.”