'It Was The Economy, Stupid' — Loss Causation And ARS

As is well-known among securities lawyers, one of the elements a plaintiff must show in bringing a securities fraud claim under Rule 10b-5 is "loss causation."

In the typical 10b-5 case, the "loss causation" requirement means that the plaintiff must show that its injury (usually the decrease in market value of some security it owned) was proximately caused by the defendant's fraudulent conduct, and not by some other cause.

This requirement permits a securities fraud defendant to point to a variety of other causes — such as general, marketwide phenomena — as alternative explanations for any decrease in the security's market value.

But what does the "loss causation" requirement mean in the context of cases arising out of the collapse of the auction rate securities market? Such cases are prevalent in courts and Financial Industry Regulatory Authority arbitrations throughout the country.

After the collapse of the ARS market in February 2008 (which resulted in ARS becoming illiquid and unable to be sold at or near their par value), a slew of ARS investors brought claims against broker-dealers for allegedly defrauding investors about the liquidity risks associated with these relatively sophisticated securities.

Broker-dealers in turn have used the loss causation requirement to argue that, even assuming they misled investors about liquidity risks associated with ARS, their allegedly fraudulent acts did not actually cause the investors' securities to become illiquid — rather, the general deterioration in the credit markets did.

At first blush, the broker-dealers' argument can strangely sound at once logical and nonsensical. Will it prevail?

Loss causation was first recognized by the U.S. Supreme Court in 2005 in the case of Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005), although lower courts had required a showing of loss causation for decades.

In Dura, the Supreme Court reversed the Ninth Circuit's holding that a plaintiff could satisfy the loss causation requirement by alleging (and later proving) that the price at which it purchased securities was artificially inflated due to the defendant's misstatements.

The Supreme Court held that a plaintiff must also show a causal connection between a defendant's fraudulent acts and the plaintiff's loss, and that the plaintiff's loss does not occur when the security is initially purchased at an artificially inflated value, but rather when the plaintiff later tries to sell the security, presumably at some lesser price, after the truth finds its way into the marketplace.

Thus, the plaintiff must show that the price decline was caused by a correction of the earlier misrepresentation, and not by other events unrelated to the fraud (including such things as changed macroeconomic conditions).

Consistent with Dura, courts have held that "when the plaintiff's loss coincides with a marketwide phenomenon causing comparable losses to other investors, the prospect that the plaintiff's loss was caused by the fraud decreases, and a plaintiff's claim fails when it has not adequately pled facts which, if proven, would show that its loss was caused by the alleged misstatements as opposed to intervening market events." See, e.g., Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005).

Thus, the question becomes: Was the plaintiff's injury caused by the defendant's fraudulent conduct, or was it caused by some intervening market event?

How does this analysis apply to cases involving auction rate securities?

In the typical ARS case, the principal injury stems from the sudden, widespread auction failures in February 2008 due to insufficient investor demand for ARS.

In essence, there were not enough investors to buy up the available supply of ARS (once the broker-dealers who managed the auctions suddenly stopped buying up excess supply in February 2008, which they had allegedly been doing up until that point, as described below).

Under the rules of the auctions, the auctions were deemed to have "failed," and existing holders of the ARS have been forced to hold their ARS until the next successful auction (which, for many holders of ARS, has yet to occur) or attempt to sell them on the secondary market at a steep discount.

Plaintiff investors claim that broker-dealers defrauded investors about the liquidity risks associated with the ARS. They allege that broker-dealers pitched ARS as "highly liquid" investments and as "alternative to money markets."

Investors claims that such statements were allegedly false or misleading because, in fact, liquidity in this market had dried up sometime in mid-2007 (well before February 2008) as a result of waning investor demand.

Many of the claims focus on the conduct of the broker-dealers who also contracted with issuers to manage the auctions (i.e., to receive all buy and sell orders for a particular ARS and submit them to an auction agent), thereby having greater visibility to the fluctuations of supply and demand for the ARS.

Based in part on the findings of the U.S. Securities and Exchange Commission and a variety of state regulators upon investigations launched in 2008, plaintiff investors claim that these auction managers concealed the drying up of market liquidity by secretly purchasing excess supply at auction through "support bids," thereby preventing what would otherwise by auction failures.

While the auction managers' theoretical ability to place support bids was disclosed, investors allege that they were never informed that the actual practice had become so pervasive that, by mid-2007, any "liquidity" in the ARS market entirely depended upon the whim of the auction managers, who could choose to stop supporting the auctions at any time (which is exactly what happened in February 2008).

Meanwhile, investors allege, up until that point, the auction managers continued to recommend and purchase ARS for their brokerage clients.

Thus, the question becomes: Did the broker-dealers' alleged defrauding of investors as to the true state of the ARS market proximately cause the injury to the ARS investors as a result of the auction failures in February 2008?

Broker-dealers argue that it did not, because, they claim, it cannot be said that their conduct actually caused the auctions to fail. Rather, citing Dura and Lentell, they argue that the auction failures were caused by intervening macroeconomic phenomena — a decrease in ARS demand ultimately stemming from a global credit crisis, which had its roots in the subprime mortgage crisis.

This argument appears to have gotten at least some traction, as courts have dismissed suits against some broker-dealers in the auction rate securities context in part for failure to plead loss causation.

Last October, for example, a judge in the Southern District of New York dismissed allegations against Bank Leumi, a non-auction-manager broker-dealer who sold ARS to the plaintiff and allegedly represented them to be safe, cash equivalents.

The court held: "[Plaintiff has not plausibly alleged that the collapse of the auction rate securities market ... was caused by the revelation of the information that Bank Leumi had allegedly misrepresented or suppressed." Healthcare Finance Group Inc. v. Bank Leumi USA, No. 08-cv-11260 (VM), 2009 WL 3631036, *5 (S.D.N.Y. Oct. 26, 2009).

In recently filed briefing on a motion to dismiss an amended class action complaint, Citigroup — a broker-dealer and auction manager — cites Bank Leumi and argues a similar point:

"[T]here can be no dispute that the failure of ARS auctions was a marketwide phenomenon which unfolded in the midst of a global credit crisis. ... Because demand for ARS fell precipitously across the entire industry, Plaintiff fails to plead facts tying his purported loss to conduct by Citigroup, as opposed to market forces at large."

But it is not clear whether this argument will ultimately prevail in this context, particularly when offered by the auction managers.

At bottom, the case against the auction managers boils down to the allegation that they were representing to their brokerage clients that ARS were "highly liquid" and "alternatives to money market funds" while simultaneously concealing the impact that the changing macroeconomic conditions were having on liquidity and demand in the ARS market.

Meanwhile, the impact of changing macroeconomic conditions on the true state of ARS liquidity and demand were material facts, of which the investors were allegedly unaware.

Plaintiffs allege that, had they been told the role that the auction managers were actually playing in supporting the auctions, they would not have continued investing in the ARS.

Instead, they allege, they were led to believe that the ARS market was stable, until one day the rug was pulled out from under them, when the auction managers suddenly stopped supporting the auctions — resulting in widespread auction failures and leaving them with illiquid securities.

When framed as such, this scenario is arguably indistinguishable (at least in terms of loss causation) from one where, for example, a multinational public company fraudulently cooks its books in order to disguise the negative effect that macroeconomic conditions were having on its sales.

If the company later issues a restatement, and the price of its securities then immediately drops, it seems implausible that the company could effectively deny "loss causation" by arguing that it was in fact the macroeconomic conditions that caused the price of the security to drop, and not the fact that it had been cooking the books to disguise those conditions.

In this way, the actions by the auction managers in ending its support for the markets might be seen as a kind of "corrective disclosure," akin to a restatement in the public company context.

It remains to be seen whether courts and arbitration panels will ultimately agree with the loss causation argument offered by the auction managers, or whether they will conclude that the auction managers' allegedly-fraudulent conduct proximately caused investors' losses, notwithstanding the fact that the auction failures may also be said to be attributable to changing macroeconomic conditions.

In the meantime, the invocation of macroeconomic conditions adds an interesting layer of complexity to the loss causation analysis.

 

Originally published on Law360.com.