The Importance Of A Causation 'Defense' In Post-Credit Crisis Investment Litigation

Nearly a decade ago, the United States Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 345 (2005), emphasized that a securities fraud suit is not an investor's insurance policy against market losses. As courts continue to address the fallout from the financial crisis that began in 2007, the Court's admonition is alive and well, and frequently appearing in decisions addressing claims under § 10(b) of the Securities Exchange Act of 1934 and common law claims involving structured products such as mortgage-backed securities. Just recently, two federal courts observed in the § 10(b) context that "[t]he securities laws are not an insurance policy for investments gone wrong, inexperience, bad luck, poor choices, or unexpected market events,i nor are they "a prophylaxis against the normal risks attendant to speculation and investment in the financial markets."ii

A key battleground where this maxim often comes into play involves an investor's attempt to demonstrate that investment losses were caused by the defendant's alleged misconduct. While there is nothing novel about the concept that a plaintiff may only recover losses actually caused by a defendant's misconduct,iii courts increasingly are citing a plaintiff's inability to plead or prove causation as the basis to reject claims involving alleged misconduct that occurred during or shortly after the credit crisis. This trend has important implications for defendants and their counsel. The stakes are quite high because, as the Second Circuit put it succinctly (in upholding a § 10(b) claim at the pleading stage), "ultimately, the [plaintiff may] recover nothing because defendants will prove that any diminution in value is attributable to, e.g., . . . (2) the global financial crisis[.]"iv

Nonetheless, causation is not a magic bullet, and defendants should be mindful of, among others, the following issues:

Prevailing on causation on a motion to dismiss remains difficult because courts do not uniformly require plaintiffs to disaggregate their alleged losses at the pleading stage. A defendant also may not be able to obtain summary judgment based on causation because plaintiffs are not always required to establish that all of their claimed losses were attributable to the defendant's alleged misconduct. Some courts require only that the plaintiff show that the defendant was responsible for a portion of those losses. Where the investments at issue are privately-offered structured securities, rather than publicly-traded stocks, a causation defense obviously is neither governed by Dura nor proven by reference to a concurrent drop in market price. In these cases, whether for claims of common law fraud, negligence, or breach of contract, traditional notions of causation typically apply and may represent a lower bar for a plaintiff to clear. This is important to keep in mind because of the prevalence of credit crisis cases based on common law claims as opposed to under § 10(b). If a motion to dismiss is denied, consideration should be given to obtaining discovery regarding, and ultimately putting on trial, the plaintiff's own investment activity. While courts are not always receptive to defendants' discovery requests into plaintiffs' investments, such evidence can be highly effective in undermining a plaintiff's attempts to prove causation (or, for that matter, any misconduct) where the plaintiff made investments comparable to those it claims in litigation were improper. I. CAUSATION DEFINED

The causation element of a claim under § 10(b) or at common law requires that a plaintiff plead and prove a "'[proximate] causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff.'"v Causation is typically shown in § 10(b) and common law fraud cases involving publicly-traded stock, at least in part, by pointing to a drop in the stock price following a corrective disclosure.vi Likewise, at common law, a plaintiff must show that his or her investment losses were proximately caused by the alleged misconduct.vii "[A] misstatement or omission is the 'proximate cause' of an investment loss if the risk that caused the loss was within the zone of risk concealed by the misrepresentations and omissions alleged by a disappointed investor."viii A defendant can defeat the plaintiff's attempts to show causation "if the loss was caused by an intervening event" or something other than the conduct at issue.ix Thus, it is the plaintiff's burden to "disaggregate those losses caused by 'changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events.'"x

2. RECENT DECISIONS

   A. Section 10(b) Cases

   1. Central States, Se. & Sw. Areas Pension Fund v. Federal Home Loan Mortg. Corp., No. 12-4353-cv, 2013 U.S. App. LEXIS 22413 (2d Cir. Nov. 5, 2013) In 2011, investors who purchased Federal Home Loan Mortgage Corp. ("Freddie Mac") securities issued in 2007-2008 brought a § 10(b) claim against Freddie Mac, alleging that the company misrepresented its exposure to subprime loans and the sufficiency of its internal controls. In affirming the district court's dismissal of the complaint at the pleading stage, including for failure to plead loss causation, the Second Circuit observed that "[w]here, as here, the plaintiff's stock purchases and losses coincided with a marketwide phenomenonthe housing bubble burst'the prospect that the plaintiff's loss was caused by the fraud decreases,' and therefore the plaintiff must plead facts sufficient to show 'that its loss was caused by the alleged misstatements as opposed to intervening events.'"xi The plaintiffs had not done so, the Second Circuit held, because their own allegations revealed that Freddie Mac's stock price had been falling gradually even prior to the release of the alleged corrective...