EXHIBIT 13 

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The Loss Causation Requirement for Rule 10b-5 

Causes of Action: The Implications of Dura 

Pharmaceuticals, Inc. v. Broudo 

By Allen Ferrell and Atanu Saha* 

In order to have recoverable damages in a Rule 10b-5 action, plaintiffs must establish 

loss causation, i.e., that the actionable misconduct was the cause of economic losses to the 

plaintiffs. The requirement of loss causation has come to the fore as a result of the U.S. Supreme Court's landmark decision in Dura Pharmaceuticals, Inc. v. Broudo. We address 

in this Article a number of loss causation issues in light of Dura, including the proper use 

of event studies to establish recoverable damages, the requirement that there be a corrective 

disclosure, what types of disclosure should count as a corrective disclosure, post-corrective 

disclosure stock price movements, the distinction between the class period and the damage 

period, collateral damage caused by a corrective disclosure, and forward-casting estimates 

of recoverable damages. 

I. INTRODUCTION: THE REQUIREMENT OF Loss CAUSATION 

In a Rule 10b-5 cause of action, plaintiffs have the burden of pleading and 

proving that the actionable misconduct, such as a reckless or intentional material 

misrepresentation upon which they relied., was responsible causally for damaging their shares. The requirement of establishing so-called "loss causation" has 

long been part of the common law.' It was at the very start of the development 

of Rule 10b-5 jurisprudence in Schlick v. Penn -Dixie Cement Corp. that a federal 

circuit court first mentioned the requirement of "loss causation" in a Rule 10b-5 

action? The requirement of loss causation for Rule 106-5 causes of action was 

* Allen Ferrell, Greenfield Professor of Securities Law, Harvard Law School, Cambridge, MA 02138; 

Ph.D. Massachusetts Institute of Technology; J.D. Harvard Law School. You may contact the author at 

(617) 495-8961 or at ffen-ell@law.harvard.edu . Professor Ferrell is grateful to the John M. Olin Center 

in Law, Economics, and Business and The Leeds Research Fund at Harvard Law School for financial 

support. 

Atanu Saha, Managing Director, AlixPartners LLP, 9 West 57th Street, Suite 3420, New York, NY 

10019. You may contact the author at (212) 297-6322 or at asaha@alixpartners.com . The opinions 

expressed in this Article are not necessarily those of AlixPartners. Dr. Saha gratefully acknowledges the 

invaluable research support provided by Alex Rinaudo. 

1. See Pasley v. Freeman, (1789) 100 Eng. Rep. 450,457 (KB.) (finding that if "no injury is occasioned 

by the lie, it is not actionable"); see also Dun Pharrns., Inc. v. Broudo, 544 U.S. 336, 344 (2005) (discussing 

how "loss causation" is a requirement in common law deceit and misrepresentation actions). 

2. 507 E2d 374, 380-82 (1974), cert denied, 421 U.S. 976 (1975). 

163 

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Date 

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Rptr. 

WWW.DEPOBOOK.COM 

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164 The Business Lawyer; Vol. 63, November 2007 

codified in the Private Securities Litigation Reform Act of 1995, which requires 

plaintiffs to "provlel that the act or omission of the defendant alleged to violate 

[section 10(3)] caused the loss for which the plaintiff seeks to recover damages." 3 

The requirement of loss causation has become increasingly emphasized by federal 

circuit courts, especially in light of the U.S. Supreme Court's recent landmark decision on loss causation in Dura Pharmaceuticals, Inc. v. Broudo.4 Perhaps the most 

notable decision in this regard is the U.S. Court of Appeals for the Fifth Circuit's 

recent opinion in Oscar Private Equity Investments v. Allegiance Telecom, Inc. 5 The 

court held that loss causation must be established before class-wide reliance can 

be presumed under a fraud-on-the-market theory at the class certification stage.' 

The Supreme Court's decision in Dura provided some much-needed clarification on what constitutes "loss causation." In that case, the defendant Dura Pharmaceuticals was alleged to have stated falsely on April 15, 1997 that it was likely 

to receive U.S. Food and Drug Administration ("FDA") approval of an asthmatic 

spray device! On February 24, 1998, Dura Pharmaceuticals lowered its earnings 

forecast citing slow drug sales. 8Finally, on November 4, 1998, Dura Pharmaceuticals announced the FDA's denial of its asthmatic spray device. 9Plaintiffs sued 

Dura Pharmaceuticals under Rule 10b-5 with the class period running from April 

15, 1997—the date of the alleged misrepresentation concerning the likelihood 

of approval—to February 24, 1998—the date of the lowered forecast being disseminated to the market." Dura's stock price over that time period is summarized 

in Figure 1. 11 

There are two aspects of the Court's analysis of plaintiffs' Rule 10b-5 action that 

are particularly noteworthy First, the Court held that even if Dura Pharmaceuticals' 

stock price was artificially inflated as a result of a fraudulent statement concerning 

the expectation of FDA approval of Dura's asthmatic inhaler, that was nevertheless 

insufficient to establish loss causation." In so doing, the Court rejected the position of the U.S. Court of Appeals for the Ninth Circuit that merely pleading price 

inflation was sufficient to state a claim under Rule 10b-5." Second, and equally 

important, the Court explained that the mere fact that Dura Pharmaceuticals' 

shareholders who purchased after Dura had made the purportedly false statement 

3. See Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, § 101(b), 109 Stat. 

737, 747 (codified at 15 U.S.C. § 78u-4(b)(4) (2000)) (hereinafter "PSLRA"l; see also PSLRA, § 105, 

109 Stat. at 757 (codified at 15 U.S.C. § 771(b) (2000)) (stating that loss causation means the "depreciation in value of the subject security" caused by the misrepresentation); PSLRA, § 101(b), 109 Stat. at 

748-49 (codified at 15 U.S.C. § 78u-4(e) (2000)) (limiting Rule 10b-5 recovery based on stock price 

movements following disclosure of "the misstatement or omission that is the basis for the action"). 

4. 544 U.S. 336. 

5. 487 E3d 261 (5th Cir. 2007). 

6. Id. at 268-69. 

7. See Respondents' Brief at la, Dura Phanns., Inc. v. Broudo, 544 U.S. 336 (2005) (No. 03-932). 

8. Id. at 4. 

9. See id. at la. 

10. Dura Pharms., Inc., 544 U.S. at 339. 

11. See Respondents' Brief at la, Dura Pharms., Inc. V. Broudo, 544 U.S. 336 (2005) (No. 03-932). 

12. Dura Pharms., Inc., 544 U.S. at 342-46. 

13. See id. at 342-47. 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 165 

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166 The Business Lawyer; Vol. 63, November 2007 

to the market, and hence arguably purchased at an inflated price, suffered a decline in the value of their stock between the time of purchase and the time of sale 

was likewise insufficient to establish loss causation." That conclusion was based 

on the observation that any number of factors could have caused shareholders' 

economic losses besides revelation of the misrepresentation (a so-called "corrective disclosure"), such as changing industry or market conditions." 

In short, the Supreme Court in Dura emphasized that the actionable misconduct must cause economic losses to shareholders who purchased shares at an 

inflated price. The method to calculate the portion (if any) of shareholders' losses 

attributable to the inflation caused by actionable misconduct raises a number of 

important issues. We begin by first outlining the basic analytical framework used 

in thinking about loss causation (as well as the related issue of materiality)—the 

event study—and then discuss several practically important damage issues that 

frequently come up in Rule 10b-5 securities litigation: the requirement that there 

be a "corrective disclosure"; what exactly constitutes a "corrective disclosure"; 

post-"corrective disclosure" stock market price movements; the allocation of inflation to different shares; collateral damage caused by revelation of the actionable 

misconduct; and back-casting versus forward-casting estimates of damages. 

II. ANALYTICAL FRAMEWORK FOR EVENT STUDY ANALYSIS 

Event study analysis is a ubiquitous tool in assessing claims of loss causation as 

well as the "materiality" of misstatements or fraudulently omitted information.' 6 

An event study is a regression analysis that measures the effect of an event, such as 

a firm's earnings announcement, on a firm's stock price.' 7In such an analysis, one 

must, of course, control for factors other than the event that may also simultaneously affect the stock price." 

A typical econometric model for measuring the effect of an alleged misrepresentation or a corrective disclosure on stock price is: 

= In PI )(30+PI M, + /32 /, + EctiD,+ e, 

1=1 

where r is the daily return (i.e., logarithmic percent change) of the stock price, M is 

the return on a market index, such as the S&P 500 Index or the Dow Jones Index, 

I is the return on an industry index (e.g., S&P Telecom Index), and the t subscript 

denotes the ti" day. D,. D, are k day-dummy variables—that is, they are binary 

14. Id. at 342-46. 

15. Id. at 343. 

16. See, e.g., Jonathan R. Macey, Geoffrey P Miller, Mark L. Mitchell & Jeffrey M. Netter, Lessons 

from Financial Economics: Materiality, Reliance, and Extending the Reach of Basic v. Levinson, 77 V. L. 

REv. 1017,1028-42 (1991). 

17. See generally JcniN Y. CAMPBELL, ANDREW W Lo & A. CRAIG MACKINLAY, THE ECONOMETRICS OF FINANCIAL MARKETS 149-80 (1997). 

18. Macey et al., supra note 16, at 1032,1036-37. 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 167 

variables, each taking the value of one for the day at issue and a value of zero for 

all other days.' 9These days may be the days of the alleged misrepresentations or 

days of the corrective disclosures. 

The estimated coefficient of the i-th day dummy, a, is a measure of the market 

and industry-adjusted return, in short the "abnormal return" on the i-th day." 

The t-statistics for ix; provide statistical evidence on whether the price move on the 

i-th day, after controlling for market and industry factors, is explained by random 

chance or by firm-specific news. A sufficiently large value of the t-statistics (generally greater than 1.96 in absolute value for a 95% level of confidence) allows the 

investigator to conclude that the estimated abnormal return on the i-th day cannot 

be explained by chance alone and is therefore attributable to firm-specific news. 21 

Thus, this analytical framework has obvious implications for both loss causation 

and materiality. 

There are a number of important generic issues that must be considered in undertaking a rigorous event study analysis: proper choice of an industry index; the 

length of the "event-window"; the possible "trickling" out to the market of the fact 

that there had been a misrepresentation; and confounding events. 

1. PROPER CHOICE OF AN INDUSTRY INDEX 

In selecting an appropriate industry index, it is important to pay particular attention to which firms are truly "comparable" in terms of their line of business and 

hence should be included in the industry index. The magnitude and the statistical 

significance of the 6,--s (i.e., the size and significance of the abnormal returns) can 

be highly sensitive to the choice of the industry comparables. The information 

source for the selection of firms to be used as industry comparables can include 

the firm's own financial filings (10-K, 10-Q), equity analysts' reports, and the constituents of widely-used industry indexes, such as the Dow Jones Internet Index 

or the S&P Telecom Index. 

2. THE LENGTH OF THE "EVENT WINDOW" 

The D1 ... Dkcan be single-day dummy variables, or two-day or three-day or even 

five-day dummy variables. It often makes sense to use multiple-day dummy variables 

because of possible "overreaction" in the market to a corrective disclosure. There 

is a substantial finance literature documenting that, in some circumstances, there 

appears to be market "overreaction" to certain disclosures and that it might take 

the market some time to "digest" fully and accurately the implications of a correc19. See, e.g., Nihat Aktas, Eric de Bodt, Jean-Gabriel Cousin, Event Studies with a Contaminated Estimation Period, 13J. CORP. FIN. 129-45 (2007). 

20. This framework is analytically equivalent to estimating the model 

ri= In P' j= 130 + 13,M,+ 132 1, + e, using all of the observations except the k-dummied days and 

A-1 

the forecast for these k days. 

21. See CAMPBELL ET AL., supra note 17, at 166. 

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168 The Business Lawyer; Vol. 63, November 2007 

tive disclosure, such as an accounting restatement. 22The market may correct for 

the "overreaction' over the course of several days, which would suggest the need 

to dummy out not only the day of the corrective disclosure but one or two days 

post-corrective disclosure as well. Alternatively, there can be "leakage" of news 

about the disclosure before the actual official corrective disclosure, suggesting, 

in some cases, the need to dummy the day or days prior to the actual corrective 

disclosure. 

3. POST-DISCLOSURE "TRICKLE" EFFECT 

Corrective disclosures can occur over a protracted period of time, i.e., the truth 

gradually "trickles" out into the market. As a result, while a single day's abnormal 

return may not be significant, the cumulative effect on the firm's stock over the 

entire corrective disclosure period may be. To examine such a hypothesis, one can 

test the significance of a , . am, assuming the disclosure period spans m days. 

4. CONFOUNDING EVENTS 

On a corrective disclosure day, there may be a disclosure event as well as firmspecific news unrelated to the alleged fraud. In that case, the estimated abnormal 

return on that day Cc, measures the combined effect of the disclosure and the unrelated firm-specific news. This confounding effect problem is exacerbated when 

using multi-day event windows as the longer the event window the more likely it 

is that confounding events occurred. Potential ways of dealing with this problem 

include (a) deletion of confounded days from the event study; and (b) the use of 

intra-day data. 

Deletion of confounded days from the event study, while sometimes necessary, 

incurs the cost of removing potentially relevant information. The use of intraday data can sometimes avoid this problem. In Figure 2 we illustrate the usage 

of intra-day data to disentangle the effects of two confounding events. The hypothetical data used in this figure is very similar to the actual NYSE TAQ data 

of a publicly traded firm; we call the firm ABC. Suppose in this litigation, the 

plaintiffs' class alleged that an investment bank's analyst artificially propped up 

the share prices of ABC by providing overly optimistic ratings and target prices. 

Also suppose the plaintiffs alleged that disclosure occurred over a series of days in 

which the analyst lowered the ratings of ABC. The share price movement on such 

a "disclosure" day, during which the analyst downgraded his recommendation of 

ABC, is depicted in Figure 2. 

In this example, ABC's prices moved down by 15.4%, falling from the previous 

day's close of $25.85 to $21.88 on that day. Event study analysis, based on closeto-close price change, shows that day's price drop to be statistically significant. 

22. See generally, i.e., Georgina Benou & Nivine Richie, The Reversal of Large Stock Price Declines: 

The Case of Large Firms, 27J. ECON. & FIN. 19 (2003);Navin Chopra, Josef Lakonishok & Ja yR. Ritter, 

Measuring Abnormal Performance: Do Stocks Overreact?, 31 J. FIN. ECON. 235 (1992);Marc Bremer & 

Richard J. Sweeney, The Reversal of Large Stock-Price Decreases, 46J. FIN. 747 (1991). 

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Figure 2 

Intra-Day Share Prices of ABC Inc. 

$26 

• Previous days 

closing price: $25.85 

$25 

$24 - 

ABC Inc. 

announces 

lower expected 

earnings 

$21 - 

Close-to-close 

price change: -$3.97 (15.4%) 

$20 - 

That day's closing 

price: $21.88 

$19 - 

$18 

9:30 AM 10:00 AM 10:30 AM 11:00 AM 11:30 AM 12:00 PM 12:30 PM 1:00 PM 1:30 PM 2:00 PM 2:30 PM 3:00 PM 3:30 PM 

$23 - 

$22 - 

Analyst 

• downgrades 

Loss 

Causation Requirement for Rule 1 0b-5 Causes of A ction 

CT, 

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170 The Business Lawyer; Vol. 63, November 2007 

Thus, based purely on daily price change one may erroneously conclude that the 

analyst's downgrade had a statistically significant negative impact on ABC's share 

price. 

However, examination of the intra-day data leads to a wholly different conclusion. As shown in Figure 2, the analyst did not downgrade ABC until 3:00 PM 

that day. At 10:15 AM on the very same day, ABC announced that it expected 

next quarter's and year's earnings to be lower. As is clear from the figure, the 

price reaction to that negative earnings news was sharp and immediate. By the 

time the analyst downgraded the stock later that afternoon, more than 14% of 

the total 15.4% price drop had already occurred. After the analyst's downgrade, 

ABC's prices moved by a statistically insignificant negative 1% for the rest of the 

trading day 

In this example, while the day's return is statistically significant, examination 

of the intra-day data allows one to disentangle the confounding effects of the two 

events, and conclude that the effect of the corrective disclosure was not significant. In contrast to the overreaction effect, consideration of confounding events 

emphasizes the advantage of using a shorter event window when possible. Thus, 

damages experts need to be judicious in choosing the length of the event window 

In the end this decision may well turn on a balancing act between capturing the 

full-impact of the disclosure (allowing for the correction for overreaction) and 

avoiding the contamination of confounding events. 

III. WHEN DOES A CORRECTIVE DISCLOSURE OCCUR? 

1. THE REQUIREMENT THAT THERE BE A CORRECTIVE DISCLOSURE 

The Dura court explained that the plaintiffs' failure to identify a fall in stock 

price "after the truth became known" to the market indicated a lack of loss causation.23The "truth" the Court is referring to is the revelation to the market of the 

actionable misconduct that forms the basis for the Rule 10b-5 cause of action." 

For example, if an investor, who purchases at an inflated price because of a misrepresentation, "sells the shares quickly before the relevant truth begins to leak 

out, the misrepresentation will not have led to any loss.' The Court noted that a 

price decline does not result in recoverable damages if the decline is due to changes 

in "economic circumstances, changed investor expectations, new industry-specific 

or firm-specific facts, conditions, or other events ...... 26 Some federal circuit courts 

have rightfully emphasized this language in Dura indicating the need for a corrective disclosure as a prerequisite to establishing loss causation. 27 

23. See Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 347 (2005). 

24. See id. 

25. See id. at 342. 

26. Id. at 343. 

27. See, e.g., Glaser v. Enzo Biochem, Inc., 464 E3d 474, 479 (4th Cir. 2006) ("It is only after the 

fraudulent conduct is disclosed to the investing public, followed by a drop in the value of the stock, 

that the hypothetical investor has suffered a "loss" that is actionable after the Supreme Court's decision 

in Dura."). 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 171 

Some commentators, plaintiffs' damage experts, and courts have argued that 

despite this language in Dura, in-and-out traders—investors who purchase and 

sell after the misrepresentation but prior to any "corrective disclosure" or the 

"truth" of the earlier misrepresentation becoming known—should still be able to 

recover damages in some circumstances. 28The basis for their conclusion is often 

what is called the "market forces operating on the fraud" theory. 29They believe 

that in-and-out traders can prove loss causation in certain circumstances. 

Consider the following situation. Suppose a widget manufacturer fraudulently 

states that it has spare capacity to build additional widgets so as to meet the 

market's demand for widgets in the event that demand for widgets increases. The 

stock price of the manufacturer increases, say from $80 to $100, as the market 

places a certain positive value on having spare capacity for producing widgets. 

Immediately after the fraudulent statement, an investor purchases shares in the 

widget manufacturer at $100. Subsequent to the purchase, the European Union 

imposes a tariff on widgets which substantially reduces the market's demand for 

widgets and thereby decreases the value of having spare capacity. As a result, the 

value of the investor's shares drops from $100 to $90 (in other words, the value 

of having spare capacity drops from $20 to $10). After the imposition of the tariff, 

the investor sells her shares. At no time does the market learn that the widget 

manufacturer's statement about having spare capacity is false. Did the fraudulent 

statement cause economic losses to the investor? More specifically, can the investor recover the amount of the disinflation—the difference between inflation at the 

time of purchase and inflation at the time of sale—which, in this example, is $10 

($20–$10)? 

Employing the "market forces operating on the fraud" theory some commentators would argue that this investor did suffer recoverable damages. The investor 

had to pay an inflated price for the shares initially as a result of the combined 

effect of the false statement concerning spare capacity and the market's value on 

having spare capacity at the-time of purchase, and had to sell the shares at a less 

inflated price as a result of the European Union's tariff lowering the market's value 

on having spare capacity at the time of sale. 3° 

28. See, e.g., Madge S. Thorsen, Richard A. Kaplan & Scott Hakala, Recovering the Economics of Loss 

Causation, 6J. Bus. & SEC. L. 93, 105-06 (2006) (finding that the theory is "rooted in thirty-year old 

legal precedent [and) sound economic theory" but recognizing that "it is controversial after Dural. 

The several district courts that have considered whether in-and-out traders can show loss causation 

have been divided on the issue. Compare In re Bally Total Fitness Sec. Litig., No. 04C3530, 2005 WL 

627960, at +5-6 (N.D. Ill. Mar. 15, 2005) (refusing to appoint as lead plaintiff an in-and-out trader 

who would need "to use considerable resources to establish" loss causation); Arduini/Messini P'ship 

v. Nat. Med. Fin. Servs. Corp., 74 E Supp. 2d 353, 360-61 (S.D.N.Y. 1999) (holding that in-and-out 

traders cannot establish loss causation), with Montoya v. Mamma.com Inc., No. 05 Civ. 2313(HB), 

2005 WL 1278097, at *2-3 (S.D.N.Y. May 31, 2005) (appointing a group that included in-and-out 

traders as lead plaintiff); In re Bearingpoint, Inc. Sec. Litig., 232 ER.D. 534, 544 (ED. Va. 2006) 

("Moreover, it is also conceivable that the inflationary effect of a misrepresentation might well diminish over time, even without a corrective disclosure, and thus in-and-out traders in this circumstance 

would be able to prove loss causation."). 

29. See, e.g., Wool v. Tandem Computers Inc., 818 E2d 1433, 1436-38 (9th Cir. 1986). 

30. See Thorsen, Kaplan & Hakala, supra note 28, at 105-06. 

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172 The Business Lawyer; Vol. 63, November 2007 

Several observations based on Dura in assessing this argument are in order. 

First, the "market forces operating on the fraud" theory ignores the language in 

Dura about the need for the truth concerning the misrepresentation to become 

known in order for there to be loss causation. Under the theory, there are recoverable damages even if the market never learns (as in the example), directly or indirectly, of the actionable misconduct that forms the basis for Rule 10b-5 liability. 

Second, the theory severely limits the language in Dura about how there is no loss 

causation in a situation in which an investor sells his or her shares after purchase 

but before disclosure of the truth. If one accepts the "market forces operating on 

the fraud" theory, then that language in Dura must be confined to the highly unusual situation of instantaneous purchases and sales. If any time elapses between 

the purchase and sale then, according to the "market forces operating on the 

fraud" theory, recoverable damages might well exist. Third, such an approach ignores the discussion in Dura about how price declines from market and industry 

changes do not give rise to recoverable damages. According to the "market forces 

operating on the fraud" theory, market and industry changes, such as a change 

in the value placed by the market on spare capacity, can quite readily give rise to 

recoverable damages even in the absence of a corrective disclosure concerning the 

actionable misconduct. 

Putting Dura aside, what about the economics of the situation described in the 

hypothetical? Has not such an investor suffered a loss, in an economic sense, from 

the fraudulent statement? The answer turns on whether one looks at the situation 

ex post or ex ante. Ex ante the investor is as likely to be the beneficiary of changes 

in the market's valuation placed on spare capacity as it is that the investor will 

incur losses as a result of a change. In the hypothetical, the investor would have 

gained if the market placed a greater value on having spare capacity (for whatever 

reason) between the time of purchase and sale. Indeed, an investor might have 

purchased the stock betting that this would happen. It is unclear why the securities laws should provide a put option for investors (i.e., bailing investors out when 

their bets turn out poorly) who speculate on changes in general market conditions 

when, as in the hypothetical, there has not even been a corrective disclosure to establish the necessary link between economic loss and the actionable misconduct. 

2. WHAT CONSTITUTES A "CORRECTIVE DISCLOSURE"? 

Consider another hypothetical. A company misstates its financial statements 

and subsequently issues a downward revision of its earnings projection. Many 

months after the dissemination of the lowered earnings projection the company 

discloses the need to restate its financials. When did a "corrective disclosure" 

occur? Did the "truth" about the financial misstatements become "known" at the 

time of the downward earnings projection or at the time of the disclosure of the 

need to restate? To raise the stakes, further suppose that there was a statistically 

significant negative abnormal stock return associated with the downward earnings projection but there was none associated with the disclosure of the need to 

restate the financials. Indeed, this hypothetical is not so different from the fact 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 173 

situation in Dura itself in which the class period ended on the day Dura Pharmaceuticals released lower than forecasted revenues and lower earnings per share estimates—a day on which Dura's stock price fell approximately 47%." In contrast, 

Dura Pharmaceuticals' price moved only modestly on the day that the FDA denied 

approval of the asthmatic spray device. 32 

The U.S. Court of Appeals for the Fifth Circuit in Greenberg v. Crossroads Systems, 

Inc. 33 addressed this issue most directly. The Fifth Circuit held that there was no 

loss causation in such a situation given that the earnings projection did "not report 

any concern that [the company's earlier earnings statements] may be incorrect."" 

But What about other circuits which have not squarely addressed when downward 

earnings projections can constitute the moment at which the "truth" about the earlier financial misstatements became, at least partially, revealed? What is the proper 

application of the loss causation requirement and Dura to this issue? • 

The issue of when negative stock price reactions to downward earnings projections can form the basis for establishing loss causation is often quite important 

both in its own right as well as for raising the general issue of whether a disclosure constitutes a "corrective disclosure" with respect to earlier misstatements 

when the disclosure does not directly indicate that the earlier statements were 

in fact false. One common claim is that a disclosure should be deemed a "corrective disclosure" when that disclosure reveals the "true financial condition" of 

the company that was being concealed by the earlier misstatement." According 

to this approach, the "fact that no wrongdoing or error has been identified is 

unimportant ... the company's true performance [ has entered the market and 

the market will react to that."" 

The "true financial condition" theory, like the "market forces operating on the 

fraud" theory is problematic. Any negative firm news, such as a downward earnings projection, can contain important information as to the true value of the 

firm and in that sense a downward-adjusted earnings projection can reveal the 

"true financial condition&' of the firm. 'However, without a concrete reason to link 

the negative stock market reaction associated with the earnings projection (or 

whatever the negative news happens to be) to the removal of the inflation in the 

stock price caused by the actionable misconduct, such as a misstatement of the 

financials, loss causation is lacking. In the downward-adjusted earnings projection hypothetical, for example, there is the possibility that if the timing of the 

intent to restate and the timing of the downward-adjusted earnings projection 

had been switched, we would have observed exactly the same stock price reactions 

(significant negative stock market reaction to the earnings projection and none to 

the intent to restate). This would suggest that the market's reaction to the earnings 

31. See Respondents' Brief at la, Dura Pharms., Inc. v. Broudo, 544 U.S. 336 (2005) (No. 03-932). 

32. See id. 

33. 364 E3d 657 (5th Cir. 2004), 

34. Id. at 668. 

35. See Thorsen, Kaplan & Hakala, supra note 28, at 102-03. 

36. See id. 

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174 The Business Lawyer; Vol. 63, November 2007 

projection was negative not because of the removal of inflation caused by the misrepresentation, but because of the implications of the earnings projection for the 

firm's future cash flows irrespective of the earlier misrepresentation. 

It is worth emphasizing that if the downward-adjusted earnings projection had 

in fact indicated a concern with the veracity of the earlier stated financials, then 

there would have been a concrete reason to connect the negative market reaction associated with the downwardLadjusted earnings projection to the removal of 

inflation caused by the misstated financials. Alternatively, if market analysts had 

called into question the earlier financials as a result of the earnings projection, 

then there likewise would have been a concrete reason to connect the negative 

stock market reaction to the removal of inflation caused by the misstated financials." Without the requirement of establishing such a concrete connection, the 

"true financial condition" theory removes much of the disciplining effect of the 

loss causation requirement. One could merely label the firm disclosure associated 

with the largest negative abnormal stock return reaction as the "corrective disclosure," as such disclosure reveals the "true financial condition" of the company, and 

thereby generate the largest possible securities damage estimates." It is interesting 

to note that the "market forces operating on the fraud" theory ensures that negative market changes are ready candidates for establishing loss causation, while the 

"true financial condition" theory ensures that disclosures of negative firm news are 

likewise ready candidates. 

The "true financial condition" theory sometimes arises in the context of the 

Second Circuit's "zone of risk" test for loss causation. In Lentell v. Merrill Lynch & 

Co. Inc., the Second Circuit explained that the loss causation question is whether 

"the loss was within the zone of risk concealed by the misrepresentations and 

omissions,....... If one characterizes the "zone of risk" that was concealed by a 

misrepresentation or omission, say a misstatement of the firm's financials, as the 

risk of investing in the company, then losses resulting from almost any subsequent 

negative news about the firm, such as a downward-adjusted earnings projection, 

can be said to be "caused" by the misrepresentation or omission under the "zone 

of risk" test. This characterization of the "zone of risk" is in reality just another 

version of the "true financial condition" theory of loss causation and therefore 

likewise also effectively vitiates the loss causation requirement. 

A proper interpretation of the Second Circuit's "zone of risk" test for loss causation, consistent with Dura, is to require that there be a corrective disclosure in 

the sense that new information reaches the market that unveils earlier actionable 

37. In In re Darn Systems, Inc. Securities Litigation, 411 E3d 1006, 1025-26 (9th Cir. 2005), cert. 

denied sub nom. Daou Systems, Inc. v. Sparling, 546 U.S. 1172 (2006), an analyst questioned the veracity of earlier statements by a firm, including its earlier financials, based on a quarterly earnings report 

that did not meet expectations. 

38. As the district court explained in In re Motorola Securities Litigation,---E Supp. 2d---, No. 03 C 

287, 2007 WL 487738, at *34 (N.D. III. Feb. 8, 2007), the standard for determining when a disclosure constitutes a corrective disclosure "cannot be so lax that every announcement of negative news 

becomes a potential 'corrective disclosure.'" 

39. 396 E3d 161, 173 (2d Cir.) (emphasis in original), cert. denied, 546 U.S. 935 (2005). 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 175 

misconduct. In the absence of such a corrective disclosure, the negative firm news, 

and the associated losses, should not be considered within the "zone of risk" 

concealed by the actionable misconduct. The reason for this is simple. Without 

imposing a requirement that there be a corrective disclosure in defining the "zone 

of risk," one runs the risk that the loss causation requirement would have been 

deemed satisfied even if there would have been the same negative price market 

reaction to the negative news without the conduct that ran afoul of Rule 10b-5. 

And it is the earlier misconduct, it must be remembered, that forms the basis for 

liability in the first place. 

3. POST-CORRECTIVE DISCLOSURE STOCK PRICE MOVEMENTS 

Class membership in a securities class action suit often covers purchasers of 

stock between the date of the alleged misrepresentation (or the date of the first 

alleged misrepresentation) and the date of the "corrective disclosure" on which 

the market learns the truth about the misrepresentation (or the earliest date by 

which the full truth about the fraud is revealed). 40Operationally, the "corrective 

disclosure" date identified by plaintiffs' counsel is often a date on which there is a 

large stock drop purportedly because of the market learning the truth about the 

earlier fraud. 4 ' 

An important issue that often arises in estimating securities damages concerns 

stock price movements in the period immediately following the corrective disclosure date identified by the plaintiffs. In a number of circumstances, the stock price 

of the firm recovers, at least partially, in the immediate post-corrective disclosure 

period. 42The question post-corrective disclosure stock price movements raise is 

what impact, if any, do these movements have on damages per share calculations 

in light of the Supreme Court's decision in Dura? It is important to.emphasize that 

this issue is analytically distinct from the "cap" on damages contained in section 

21D of the Securities Exchange Act of 1934, which limits damages to the average 

trading price of the security in the 90-day period following the corrective disclosure. 43The issue here is not what the applicable "cap" on damages is, but rather 

what are in fact the damages. 

If the stock price reaction in the days, weeks, and months following a corrective disclosure is a result of the market inferring additional information about the 

implications of a misrepresentation for the firm's valuation, then these stock price 

movements occurring after the corrective disclosure date identified by the plaintiffs should analytically be additional corrective disclosures. That is, the full truth 

40. See, e.g., Consolidated Amended Securities Class Action Complaint at 2, In re Royal Ahold 

N.V. Sec. & ERISA Litig., Civil No. 1:03-MD-01539 (D. Md. Feb. 18, 2004); Amended Class Action 

Complaint at 23, Ohio Pub. Employees Ret. Sys. v. Freddie Mac, Civil No. C2-03-711 (S.D. Ohio 

Jan. 15, 2004). 

41. See, e.g., id. 

42. See, e.g., id. See also infra Figure 3 for an illustration of Ahold share prices. 

43. See Section 21D of the Securities Exchange Act of 1934, ch. 404, 1 21D, 48 Stat. 881 (codified 

as amended at 15 U.S.C. § 78u-4(e) (2000)), as added by PSLRA, supra note 3, 1 101(b), 109 Stat. 

at 748-49. 

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176 The Business Lawyer; Vol. 63, November 2007 

concerning the misrepresentation was revealed to the market on a series of dates. 

This can have important implications for securities damages. 

Suppose, for instance, the market believes that an accounting restatement is 

indicative of deeper, as of yet undisclosed, problems at a firm. Then the market's 

reaction to a firm's restatement of its financials will reflect the expected negative 

effects of those undisclosed problems (perhaps, for instance, expected further accounting restatements) in addition to any negative implications for firm value of 

the initially misrepresented numbers. If no such problems are disclosed, then as 

time passes the market might view those hidden problems as less and less likely, 

resulting in positive stock price changes in the period following the disclosure of 

the financial restatement. In other words, the non-disclosure of additional problems itself can constitute new information to the market (no news is good news) 

that should be considered in evaluating the total harm caused by the initially 

misrepresented financials. Since nondisclosure of further bad news can itself constitute important positive information about the implications of misstated financials on firm value, the dissemination to the market of the full implications of the 

misrepresentation for firm value does not necessarily occur solely on the date of 

the disclosure of the true financials. 

On a similar note, the disclosure of the misrepresentation can be partial. For 

example, suppose a firm simply announces that it will restate its prior years' financials without quantifying the extent of the restatement. Often a firm's share 

price falls, in many cases quite sharply, merely in response to the announcement 

of a restatement. Typically, the class action plaintiffs end the class period on the 

day of the announcement of the intent to restate. That is, they argue that the share 

price on the day of the announcement reflects the "fair value" of the stock and 

should be used in calculating damages. However, in this example, the restatement announcement, although "corrective," is by no means a full disclosure. In 

the subsequent weeks and months the firm may provide further details about the 

extent of the restatement and full disclosure occurs only after the firm finalizes its 

restatement. Of course, whether the stock price reaction is negative or positive in 

response to the additional disclosures depends on the market's prior expectation 

of the probability and type of likely disclosures by the firm. 

In this context, the Ahold Securities litigation is illustrative. On February 24, 

2003, Ahold announced that it would restate its financials for the period 2000— 

2002. In response to that news, Ahold share prices 44fell by 61 percent—dropping from $10.69, the previous day's closing price, to $4.16 on the day of the 

announcement. 45In the ensuing Ahold securities litigation, the plaintiffs filed a 

complaint with the class period ending on February 24, 2003—the day of the 

restatement announcement. 46 

44. Ahold is traded as an ADR in the U.S. equity market. 

45. We believe that the large price impact reflects, in part, the market's "overreaction" to news about 

financial restatements in the post-Enron environment. 

46. See Consolidated Amended Securities Class Action Complaint at 2, In re Royal Ahold NN Sec. & 

ERISA Litig., Civil No. 1:03-MD-01539 (D. Md. Feb. 18, 2004). 

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Loss Causation Requirement for Rule 1Db-5 Causes of Action 177 

- £00Z/0141, 

• £00Z/OZI6 

- COWL C/8 

COOZ/1•148 

COOMM 

COO//L 

- SOOVEZig 

- £00VC/9 

£00Z/£ 

• £00Z/1,Z/£ 

£00Z/4/£ 

• MOM la 

- COOMZ/ 

ECOVC/i 

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69 CO 

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178 The Business Lawyer; Vol. 63, November 2007 

However, as is evident from Figure 3, Ahold share prices continued to rebound 

as the company provided more news about the extent of the restatement in the 

subsequent months: on August 8, 2003, it announced that the net income restatement amount for the years 1998 through 2002 would be $880 million; on July 1, 

it further revised the restatement estimate to $1.2 billion; finally, on October 17, 

2003, the company filed the restated financials with the U.S. Securities and Exchange Commission ("SEC") on a Form 20-F. 47On that day, Ahold shares closed 

at $9.56, only 11% or $1.13 lower than the price prior to the first restatement announcement:18Here the critical question is what is the impact of the curative disclosures? From the plaintiffs' point of view the impact is $6.53, which is the 61% 

drop on February 24, 2003. However, if one recognizes that the time frame of the 

corrective disclosures spans the entire period between February 24, 2003 through 

October 17, 2003, and that full disclosure did not take place until the latter date, 

then the corrective disclosure impact 49is only $1.13, the difference between the 

price on February 21, 2003 (the day before the first disclosure) and on October 

17, 2003. Needless to say, the difference in the quantification of the impact of the 

curative disclosures has nontrivial implications for class-wide damages. 

IV. ALLOCATION OF INFLATION TO DIFFERENT SHARES 

An important distinction to bear in mind in allocating the artificial inflation in 

stock price to shares purchased at different points in time within the class period 

is the difference between the class period and the damage period. This is a distinction that is frequently overlooked despite its often important implications for 

the measure of damages. The distinction is best conveyed through the use of an 

example. 

Suppose that a pharmaceutical company called Dura II truthfully announces 

that it expects that the FDA will soon grant approval to its new asthmatic spray 

device. Dura II learns several years later, however, that the FDA, after conducting 

an extensive examination of the device, is in fact unlikely to approve. When the 

firm learns of that fact it withholds the information but months later does announce the FDAs actual denial of the asthmatic spray device. Upon the announcement of the denial, Dura ll's share price drops substantially Plaintiffs' counsel, 

in such a situation, would typically extend the class period from the time of the 

negative announcement back to the day on which the firm had announced the 

prospects of likely approval. But, in the absence of a crystal ball, the firm could 

not have known on that day what it later learned. So despite the losses, perhaps 

considerable, for those shareholders who purchased upon the firm's announcement of likely approval, damages should exist only for those shareholders who 

purchased in the time period between when the firm had a legal duty to disclose 

47. See id. all13-57. The Ahold ADR price data used in Figure 3 is from Bloomberg LP 

48. See id. 

49. Here, in the interest of simplicity, we are discussing the "raw" price difference without accounting for market or industry factors. 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 179 

the FDA'.s likely denial (and hence arguably engaged in actionable misconduct 

because it did not promptly disclose) and the announcement of the denial. 

Drawing a distinction between the class period and the damage period is faithful to Dura's emphasis on focusing on whether actionable misconduct, such as a 

misrepresentation or a fraudulent nondisclosure, caused economic harm to shareholders. In the pharmaceutical company hypothetical, the economic loss suffered 

by shareholders who purchased upon the initial positive announcement was not 

caused by the actionable misconduct, which is the fraudulent nondisclosure of 

the FDA's likely denial. The actionable misconduct therefore cannot be said to 

have caused the loss suffered by shareholders who purchased upon the initial 

positive announcement which, after all, occurred earlier in time. Put slightly differently, there was no inflation in the pharmaceutical's stock price at the time of 

the positive announcement as the firm at that point had not engaged in fraudulent 

conduct that would have given rise to Rule 10b-5 liability. To allow the investors 

who purchased at that point to recover their economic losses would "effectively 

convert Rule 10b-5 into a scheme of investor's insurance."" 

Another important aspect of allocating the inflation, as proxied by the market's 

reaction to the corrective disclosure, to shares purchased at different times is the 

issue of apportionment of the harm resulting from multiple misrepresentations. 

Suppose that there is a substantial stock price drop in response to a firm announcing it will restate its financials for the prior years. Assume also the price 

drop can be attributed to the market removing the inflation in stock price because 

of a series of misrepresentations (i.e., prior years' financials) that had previously 

occurred. It is analytically obvious that one cannot use the entire price drop on 

the announcement day to measure inflation in stock price throughout the damage 

period because the price drop is the cumulative effect of the disclosure of a series 

of prior misrepresentations. To do so would result in a gross overestimation of 

damages. The critical challenge then becomes apportioning the cumulative inflation (as represented by the stock price drop in this example) to shares purchased - 

in different periods. Indeed, this problem is sufficiently serious that it suggests, in 

some circumstances, that damages experts should not use the stock price drop in 

reaction to a restatement announcement covering multiple years to approximate 

the price inflation during the damage period, but should "forward-cast" when 

feasible. We revisit this issue in greater detail in Part VI. 

V. COLLATERAL DAMAGE 

Dividing misrepresentations, such as accounting misstatements, into two categories is helpful in thinking about which types of representations can legally give 

rise to recoverable damages. In the first category are misstatements that have direct 

implications for the current and future cash flows of a firm or the rate at which 

50. Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 345 (2005) (internal quotation marks omitted) 

(quoting with approval Basic Inc. v. Levinson, 485 U.S. 224, 252 (1988) (White, J., concurring) (internal quotation marks and citation omitted)). 

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180 The Business Lawyer; Vol. 63, November 2007 

those cash flows will be discounted. For instance, if a firm overstates its cash-flow 

generating assets on its balance sheet, that might artificially inflate expectations 

about the future cash flows of the business. Given that share prices, in an efficient 

market, are the discounted cash flows of the firm," that overstatement would inflate the price of the stock all else being equal. There is, however, a second category 

of misstatements: those that do not have any bearing on the future cash flows of the 

firm or the discount rate that should apply to those cash flows when calculating the 

cash flows' present value. One possible example of such a misstatement might be 

an accounting statement by a firm that falsely states that the firm has $100 more in 

cash than it really does while falsely understating, in the same statement, the firm's 

corporate holdings of U.S. treasury bonds by an equivalent amount, $100. 

There are three different doctrinal categories under which to analyze the second type of misstatement: loss causation, reliance, and materiality. The reasoning, 

whatever doctrinal category is employed, consistently points to a lack of recoverable damages. Consider, first, whether there is loss causation. Section 21D of the 

Securities Exchange Act of 1934 requires that the "act or omission of the defendant alleged to violate [section 10(b)] caused the loss for which the plaintiff seeks 

to recover damages." 52This provision clearly indicates that the actionable Rule 

10b-5 misconduct, i.e., the misstatement of corporate holdings, must cause the 

economic loss alleged by plaintiffs. Or as the U.S. Court of Appeals for the Seventh Circuit put it, "[do plead loss causation, the plaintiff must allege that it was 

the very facts about which the defendant lied which caused its injuries.' Given 

the fact that the overstatement of cash reserves exactly equals the understatement 

of U.S. treasury bonds (a highly liquid asset), it is difficult to argue that the misstatement or the revelation of the truth had any implications for the future cash 

flows of the firm or the applicable discount rate. 

We can also analyze the issue, not in loss causation terms, but in terms of 

whether one can use the fraud-on-the-market theory to establish "reliance" (another necessary element for a Rule 10b-5 cause of action) on the misstatement. 

That was the approach adopted by the U.S. Court of Appeals for the Fifth Circuit. 

In Greenberg v Crossroads Systems, Inc., the Fifth Circuit explained that "plaintiffs 

cannot trigger the presumption of reliance by simply offering evidence of any 

decrease in price following the release of negative information. Such evidence 

does not raise an inference that the stock's price was actually affected by an earlier 

release of positive information."" The question in the cash reserve example is 

whether there is any reason to believe that the misstatement constituted "positive 

information" that increased the firm's stock price above what it otherwise would 

have been if the correct holdings had been provided to the market. To posit such 

51. See Maurice E. Stucke, Behavioral Economists at the Gate: Antitrust in the Twenty-First Century, 38 

Loy. U. CHI. U. 513, 534 (2007). 

52. See Section 21D of the Securities Exchange Act of 1934, ch. 404, § 21D, 48 Stat. 881 (codified 

as amended at 15 U.S.C. 1 78u-4(b)(4) (2000)), as added by PSLRA, supra note 3, § 101(b), 109 Stat. 

at 747. 

53. Caremark, Inc. v. Coram Healthcare Corp., 113 E3d 645, 648 (7th Cir. 1997). 

54. 364 F.3d 657, 665 (5th Cir. 2004). 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 181 

a reason one would have to explain, as was the case when considering loss causation, how knowing the truth would have affected the market's expectation of the 

firm's future cash flows or the appropriate discount rate. 

Finally, the same conclusion can be reached using instead the language of "materiality" (yet another necessary element for a Rule 10b-5 cause of action). Some 

circuits, such as the U.S. Court of Appeals for the Third Circuit in Oran v. Stafford," have taken the position that in the context of an efficient market, if a misstatement does not artificially inflate the price of a stock, then the statement is not 

"material." Again, in the absence of a reason to believe that the misstatement impacted the market's expectations of the firm's cash flows or the applicable discount 

rate, the misstatement is necessarily immaterial as it would not have affected the 

stock price as an initial matter. 

But suppose that the stock price dropped in reaction to a corrective disclosure 

that a firm had been misstating its holdings in the past. And further suppose that, 

using an event study, one concludes that the association of the negative stock 

reaction with the disclosure announcement is statistically significant. Does the 

mere fact of a price reaction to a disclosure announcement indicate that the misstatement (in the example, the misstatement concerning the corporate holdings) 

somehow affected expectations about cash flows and discount rates and is therefore in fact in the first category of statements which can give rise to recoverable 

damages? Such a conclusion would be premature. 

It is possible to account for a negative price reaction associated with the corrective disclosure without assuming that the misstatement artificially inflated the 

stock price. The corrective disclosure can create negative stock price reactions because of what we will label "collateral damage." The presence of "collateral damage" is entirely consistent with the' misstatement not inflating the price of the 

stock at the time the misstatement was made. By way of illustration we will consider two types of "collateral damage," both of which might well occur as a result 

of the disclosure of an accounting restatement necessitated by the misstatement of 

corporate holdings: reassessment of the quality of a firm's management or internal 

controls; and possible disruptive legal action. 

a. Reassessment of a Firm's Management or Internal Controls 

An example of collateral damage would be investors revaluing a firm not as a 

result of the information contained in the corrective disclosure contradicting the 

(false) representation made earlier, but rather as a result of a reassessment (perhaps only temporary) of how well the firm is run. Upon the announcement of the 

need for an accounting restatement, investors might infer that the quality of the 

firm's management and internal controls are lower than they had previously believed and revalue the firm downward accordingly. For example, investors might 

infer that the firm's internal controls are less rigorous than they had previously 

believed given the fact that false statements somehow made it into the firm's ac55. 226 F.3d 275, 282 (3d Gr. 2000). 

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182 The Business Lawyer; Vol. 63, November 2007 

counting statements. Such an inference could result, for example, in a reduction 

in firm value if investors placed some importance on the quality of the firm's internal controls in generating future cash flows. 

However, this explanation for the stock price decline associated with a corrective 

disclosure is consistent with the original misstatement not artificially increasing the 

stock price (and hence the misstatement not causing economic losses 6 la Caremark 

or not creating reliance by inflating stock prices a la Crossroads or not being material by inflating prices 6 la Oran). If the original fraudulent accounting statement 

only contained information, albeit false, about corporate holdings then there was 

no statement, let alone a misstatement, about the quality of the firm's management 

or its internal controls. And it is only the actionable fraudulent statement that gives 

rise to potential Rule 10b-5 liability, i.e., the misstatement of corporate holdings, 

and only if that statement caused the stock price to be artificially inflated. There 

is no general duty to disclose, for instance, that the management of a firm or the 

quality of the firm's internal controls are not the same as those expected by the market. The U.S. Supreme Court succinctly captured this point when it flatly stated, 

"Silence, absent a duty to disclose, is not misleading under Rule 10b-5."" 

The critical point is that the economic losses suffered by investors must be 

traceable to whatever misconduct is actionable under the federal securities laws, 

and not merely to the dissemination of information unrelated to the fraud. This 

later category includes information relating to conduct that might be actionable 

under other laws, such as state corporate law. The Court in Broudo v. Dura Pharmaceuticals, Inc. explained that loss causation only exists if a "plaintiff prove Es] 

that the defendant's misrepresentation (or other fraudulent conduct) proximately 

caused the plaintiff's economic loss." 57Indeed, the U.S. Court of Appeals for the 

Seventh Circuit, going one step beyond that, recently emphasized that plaintiffs 

must show that each actionable misrepresentation individually has a "causal connection" with plaintiffs' losses. 58As has been long established, it is simply not 

actionable misconduct under the federal securities laws for a firm to be poorly run 

nor does the fact that a firm's internal controls are weaker than those expected by 

the market give rise to a cause of action. The U.S. Supreme Court made this clear 

in Santa Fe Industries, Inc. v. Green when it explained that "Congress by 10(b) did 

not seek to regulate transactions which constitute no more than internal corporate mismanagement." 59On a similar note, the U.S. Supreme Court in Chiarella v. 

United States° reversed a conviction under Rule 10b-5 in a case in which the jury 

instructions tracked the text of Rule 10b-5 but did not mention that nondisclosure is only actionable when there is a duty to disclose. 

56. Basic Inc. v. Levinson, 485 U.S. 224, 239 n.17 (1988). 

57. Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 346 (2005) (emphasis added). 

58. Tricontinental Indus., Ltd. v. PricewaterhouseCoopers, LLP, 475 F.3d 824, 843 (7th Cir. 2007) 

(internal quotation marks omitted), cert. denied,---S. Ct.---, No. 06-1670, 2007 WI.. 2819761 (U.S. 

Oct. 1, 2007). 

59. 430 U.S. 462, 479 (1977) (internal quotation marks omitted) (quoting with approval Superintendent of Ins. v. Bankers Life & Gas. Co., 404 U.S. 6, 12 (1971)). 

60. 445 U.S. 222, 236 (1980). 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 183 

Nor is it obvious that such information about a firm's managerial quality or its internal controls would have reached the market earlier but for the 

misrepresentation. In other words, in the "but for" world, the hypothetical world 

in which the corporate holdings misstatement had not been made, it is not at 

all clear (or perhaps even plausible) that the firm would have disclosed to the 

market that its internal controls or the quality of its management was lower than 

the market's expectation. As a result, one could not plausibly claim that price 

declines resulting from investors' reassessment of managerial quality or the firm's 

internal controls were caused by the market learning the truth about the content 

of the misrepresentation concerning corporate holdings (returning to the earlier 

example) which is the purported basis for Rule 10b-5 liability in the first place. 

In this context of "collateral damage," the facts surrounding the Freddie Mac securities litigation provide useful insights. The class action lawsuit against Freddie 

Mac followed the company's announcement in January 2003 that it would restate 

its earnings for four prior years. However, unlike the vast majority of Rule 10b-5 

matters, here Freddie Mac had announced it would restate its earnings upward! 

Subsequently, on June 9, 2003, it announced that its top three officers would be 

replaced. On that day, Freddie Mac's share prices fell by 16%—from a previous 

close of $59.87 to $50.26—a $9.61 drop. However, over the subsequent weeks 

Freddie Mac continued to provide further information about its restatement, announcing, for example, on June 25 that the upward restatement could be as high 

as $4.5 billion. On November 21, 2003, Freddie Mac finally filed its restated financials with the SEC, and not unexpectedly, the share prices went up in response 

to the news. The share price movement for Freddie Mac over this relevant period 

is depicted in Figure 4. In the class action complaint, the plaintiffs chose to end 

the class period on June 9, 2003, the day of the announcement of the top officers 

being replaced. 6 ' 

The Freddie Mac securities litigation exemplifies a case in which collateral damages associated with the replacement of management had no bearing on the misstatement of the company's prior years' financial results. Likewise, there was not a 

direct link between the misstatement and an adverse impact on share prices. It is 

unclear how revision of prior years' earnings upward could have harmed the firm's 

value and its then-current share prices. Moreover, while the replacement of the 

top officers was associated with a price drop, it is equally unclear why that drop 

should lead to any recoverable damages based on Rule 10b-5 claims. 

b. Disruptive Legal Action 

Revisiting the corporate holdings misstatement example, suppose that the 

stock price decline was due to investors predicting that the company was likely 

to be subject to disruptive lawsuits, state attorneys general actions, and SEC en61. See Amended Class Action Complaint at 23, 157, Ohio Pub. Employees Ret. Sys. v. Freddie 

Mac, Civil No. C2-03-711 (S.D. Ohio Jan. 15, 2004). The Freddie Mac stock price data used in Figure 

4 is from Bloomberg LP. 

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184 The Business Lawyer; Vol. 63, November 2007 

(0 

69 

COOZ/Z/ 

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• £00Z/6/9 

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- £00Z/1-£/£ 

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Loss Causation Requirement for Rule 10b-5 Causes of Action 185 

forcement proceedings as a result of the accounting restatement. In particular, 

if investors valued the retention of the executives who were responsible for the 

misstatement, then expected legal action could well have the effect of these executives losing their jobs and thereby hurting the value of the firm. A company's 

stock price could decline for this reason even if investors placed absolutely no 

lower value on the firm as a result of the information contained in the accounting 

restatement. As the Supreme Court explained in Dura, price changes "may reflect, 

not the earlier misrepresentation, but changed economic circumstances, changed 

investor expectations, new industry-specific or firm-specific facts, conditions or 

other events...." 62The price decline in this situation would be due to new "firmspecific facts" as opposed to firm revaluation resulting from the market learning 

the truth about corporate holdings which was the subject of the earlier fraudulent 

representation. 

VI. CONFIRMATORY STATEMENTS AND FORWARD-CASTING 

ESTIMATES OF DAMAGES 

In estimating per-share damages, plaintiffs' experts typically adopt a "back-casting" approach.° That is, they use the price decline as a result of the curative disclosure to measure the inflation during the class period. 64In particular, they begin 

with the share prices at the end of the class period (which presumably reflect the 

fair market value of the security) and proceed backward in time to the beginning 

of the class period in constructing the but-for share price line.° The difference between the actual price and the 'back-casted' but-for price is purported to provide a 

measure of per-share damages on a given day within the class period. 

This 'back-casting' approach can suffer from some problems. As we discussed 

earlier, market overreaction, post-corrective disclosure price movement, collateral 

damage, and apportionment issues can render it difficult to estimate with any 

degree of reliability the inflation during the damage period using the price drop 

associated with the disclosure. 

A potential avenue for avoiding these problems is to use a "forward-casting" 

approach in creating the but-for price line. In forward-casting, one estimates the 

inflation in stock price associated with the misrepresentation announcement as 

opposed to inferring the extent of the inflation from the price decline associated 

with the curative disclosure. The doctrines of loss causation, reliance, and materiality, after all, all point to the inflation in stock price (and its subsequent removal 

via a corrective disclosure) as the potential harm to shareholders associated with 

a misrepresentation. 

62. Dura Pharms., Inc. v. Broudo, 544 U.S. 336, 343 (2005). 

63. See John Finnerty & George Pushner, An Improved Two -Trader Model for Measuring Damages in 

Securities Fraud Class Actions, 8 STAN. J.L. Bus. & FIN. 213, 220 (2003) (discussing the "basic plaintiffstyle approach" before critiquing it). 

64. See id. 

65. See id. 

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186 The Business Lawyer; Vol. 63, November 2007 

The application of the forward-casting approach is straightforward when the 

false information, which the market believes is true, was unanticipated by the 

market. In such an event, the stock price reaction (net of market, industry and 

other confounding effects) associated with the initial dissemination of the misrepresentation would represent the inflation in stock price which potentially harms 

shareholders by artificially inflating the purchase price. 

A number of misrepresentations, however, are motivated by the firm's desire to 

meet market expectations, such as a desire to meet the market's expectations of 

earnings. These so-called "confirmatory statements" pose some challenging issues 

in terms of estimating securities damages. As the U.S. Court of Appeals for the Fifth 

Circuit noted, " [C] onfirmatory information has already been digested by the market and will not cause a change in stock price.' It is still possible, nevertheless, to 

use a forward-casting approach even in a "confirmatory statement" situation. 

Suppose, for instance, that a firm overstates its earnings in order to meet the 

market's earnings expectations and there is, accordingly, no market reaction to the 

misrepresentation. In this case, the forward-casting approach would entail estimating what the market reaction would have been had the restated lower earnings 

been known on the misstated earnings announcement days. This estimation can 

be undertaken through an event study using the firm's prior earnings announcement days and quantifying the relationship between price response and earnings 

surprises or changes." This relationship could then be used to estimate the but-for 

stock returns in the earnings announcement days using the firm's restated earnings. These but-for returns when substituted for the actual returns on the earnings 

announcement days would generate the forward-casted but-for price line. The 

difference between the actual and the but-for price line would be a direct measure 

of the inflation caused by the overstated earnings. Our experience suggests that, 

typically, the back-casted and the forward-casted approaches yield substantially 

different but-for price lines, and hence vastly dissimilar estimates of damages. 

VII. CONCLUSION 

The Supreme Court's decision in Dura raises a host of important issues concerning the contours of the loss causation requirement for Rule 10b-5 actions. 

These important issues include the proper application of event study analysis, the 

requirement that there be a corrective disclosure, what constitutes a corrective 

disclosure, the proper treatment of post-corrective disclosure stock price movements, the allocation of inflation to different shares, the treatment of collateral 

damage from a corrective disclosure, and the use of forward-casted damage estimates. The proper resolution of these issues plays a critical role in ensuring that 

the loss causation requirement, a requirement emphasized by the Court's opinion 

in Dura, plays its important role in preventing Rule 10-b5 damages from becoming a costly insurance scheme for investors. 

66. Greenberg v. Crossroad Sys., Inc., 364 E3d 657, 665-66 (5th Cir. 2004). 

67. While this estimation can be undertaken using only the 'clean' period (i.e., the period preceding the misstatement) as long as market believed in the stated earnings, there is no reason necessarily 

to exclude the class period from this estimation. 

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