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Does Fraud Equal Loss?

When fraud occurs and investors lose, how do you prove the link between the two?

3Sep

It's as predictable as anything about the stock market: when a company's share price plunges, shareholders sue. But launching a successful shareholder suit — that is, one that gets settled — may soon become harder.


The U.S. Supreme Court has agreed to review a decision in a case that pits shareholders against Dura Pharmaceuticals Inc., a drug firm now owned by Ireland-based Elan Corp. At issue is a fundamental question: When fraud occurs and investors lose, how do you prove the link between fraud and loss?


Currently, courts in the United States use two competing standards. Under the first, the plaintiff needs to show that disclosure of the fraud caused the price to fall. The idea is that when a company fakes the numbers, its share price will be artificially high. When the lie is exposed, the price should come down. "It's not perfect — economists will argue about the factors behind a price drop — but it addresses the need for a plaintiff to prove that wrongdoing was the cause of the loss," says Michael Gass, partner with Boston law firm Palmer & Dodge LLP.


The second standard is looser. This approach — at issue in the Dura case — says it's enough to show that the stock price was inflated due to fraud. Then, any loss that occurred during that time is fair game for a lawsuit.


Not surprisingly, public companies hope the Supreme Court strikes down the more lenient standard, a move that could make it easier to have suits dismissed. "Companies spend a lot of time and money on cases that end up getting thrown out," says David J. Elliott, a partner with Day, Berry and Howard in Hartford. "I'm not troubled by putting plaintiffs to a higher burden of proof."


Is there a risk that such a decision could set the bar too high? After all, such suits are weapons for combating corporate wrongdoing. Elaine Buckberg, an economist with NERA, doesn't think so. "If you have a big case involving material fraud, the market will have a statistically significant reaction when the truth comes out."


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