April 20, 2005

KPMG Settles with SEC For $22 Million Over Xerox Audits

Yesterday, KPMG settled with the SEC over the financial fraud at Xerox, for which Xerox paid a record fine of $10 million in 2002. KPMG will pay $10 million in penalities itself, in addition to disgorging nearly $10 million in audit fees and another $2.7 million in interest. Another gatekeeper case; KPMG’s spokesperson stated that the settlement did not involve findings that KPMG’s conduct was fraudulent or reckless.

The SEC’s Order requires KPMG to undertake a series of reforms designed to prevent future violations of the securities laws, after finding that KPMG caused and willfully aided and abetted Xerox’s violations of the anti-fraud, reporting, recordkeeping and internal controls provisions of the federal securities laws. The Order also finds that KPMG violated its obligations to disclose to Xerox’s illegal acts that came to its attention during the Xerox audits. The SEC’s civil fraud injunctive action against the five KPMG partners involved in the Xerox audits during the period of fraud is ongoing.

Regulation FD Practices Survey

On the home page of, we have posted a new survey on Reg FD practices. Please participate – and also check out the running results. The final results will tie in well with the webcast – “The Latest Regulation FD Practices” – on May 2nd.

US Supreme Court Reverses 9th Circuit Decision in Dura Pharmaceuticals

Yesterday, the US Supreme Court issued this opinion in Dura Pharmaceuticals v. Broudo and overturned the 9th Circuit’s findings about loss causation. It is a unanimous decision authored by Justice Breyer.

Here is the analysis from Lyle Roberts, who blogs in “The10b-5 Daily“: As predicted, the court rejected the Ninth Circuit’s price inflation theory of loss causation. Instead, the court held that a plaintiff must prove that there was a causal connection between the alleged misrepresentations and the subsequent decline in the stock price.

Loss causation (i.e., a causal connection between the material misrepresentation and the loss) is an element of a securities fraud claim. In the Dura case, the Ninth Circuit had held that to satisfy this element a plaintiff only need prove that “the price at the time of purchase was inflated because of the misrepresentation.” (See this post for a full summary of the Ninth Circuit’s decision.)

On appeal, the Supreme Court made three key findings in rejecting the price inflation theory of loss causation. First, the court dismissed the idea that price inflation is the equivalent of an economic loss. The court noted that “as a matter of pure logic, at the moment the transaction takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value.” Moreover, it is not inevitable that an initially inflated purchase price will lead to a later loss. A subsequent resale of the stock at a lower price may result from “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.”

Second, the court found that the price inflation theory of loss causation has no support in the common law. The common law has “long insisted” that a plaintiff in a deceit or misrepresentation action “show not only that if had he known the truth he would not have acted but also that he suffered actual economic loss.” Accordingly, it was “not surprising that other courts of appeals have rejected the Ninth Circuit’s ‘inflated purchase price’ approach.”

Finally, the court noted that the price inflation theory of loss causation was arguably at odds with the objectives of the securities statutes, including the PSLRA. The statutes make private securities fraud actions available “not to provide investors with broad insurance against market losses, but to protect them against those economic losses that misrepresentations actually cause.” In particular, the PSLRA “makes clear Congress’ intent to permit private securities fraud actions for recovery where, but only where, plaintiffs adequately allege and prove the traditional elements of causation and loss.”

As clear as the opinion is on the issue of the price inflation theory, it fails to provide much guidance on what a plaintiff must allege on loss causation to survive a motion to dismiss. The court assumed, without deciding, “that neither the [Federal Rules of Civil Procedure] nor the securities statutes impose any special further requirements in respect to the pleading of proximate causation or economic loss.” Even under the notice pleading requirements, however, the complaint’s bare allegation of price inflation was deemed insufficient. As stated by the court, “it should not prove burdensome for a plaintiff who has suffered an economic loss to provide a defendant with some indication of the loss and the causal connection that the plaintiff has in mind.”

Holding: Reversed and remanded for proceedings consistent with opinion.

Addition: A few initial thoughts on the Dura opinion from Lyle:

(1) The case is a significant victory for defendants in the Eighth and Ninth Circuits, which were the only two courts to adopt the price inflation theory of loss causation.

(2) Although the Supreme Court has put the price inflation theory to rest, its opinion raises some complicated questions about recoverable loss. For example, the Supreme Court notes that many factors other than misrepresentations can cause a stock price decline, but does not provide any guidance on how plaintiffs can meet their burden of proof for loss causation in cases where some or all of these other factors are present.

(3) The opinion is unclear on an issue that was expressly raised on appeal: does the stock price decline need to be the result of a corrective disclosure that reveals the “truth” to the market? The Supreme Court makes some opaque references to when “the relevant truth begins to leak out” and “when the truth makes its way into the market place,” but does not squarely address whether there is any need for plaintiffs to establish the existence of a corrective disclosure.

(4) Finally, as noted above, the Supreme Court expressly leaves open the question of whether F.R.C.P. 9(b) or the PSLRA requires plaintiffs to plead loss causation with particularity. The lower courts will need to decide whether these statutes are applicable.