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Securities fraud complaint against CVS Corp. reinstated

A securities fraud complaint should not have been dismissed, as the allegations by the plaintiff investors were sufficient to show a causal connection between the defendants’ material misrepresentations and a 20 percent drop in share price that followed a chief executive officer’s earnings call, the 1st U.S. Circuit Court of Appeals has determined.

The plaintiffs argued that the defendants, in connection with the merger of CVS Corp. and Caremark Rx Inc., misrepresented the quality of customer service and the effectiveness of the integration of the merged corporations’ computer systems.

“The [plaintiffs]’ allegations indicate that the drop in CVS Caremark’s share price was causally related to its misstatements regarding the integration of CVS and Caremark, and these allegations are sufficiently plausible to foreclose dismissal,” Judge Jeffrey R. Howard wrote for the unanimous panel.

The 33-page decision is Massachusetts Retirement Systems, et al. v. CVS Caremark Corporation, et al.

Florida attorney Douglas Wilens argued the appeal on behalf of the plaintiff investors. He was opposed by Lawrence Portnoy of New York.

Call with investors

In November 2006, CVS and Caremark Rx Inc. announced that they would merge. At the time, CVS was the nation’s largest retail pharmacy chain, while Caremark was the second-largest prescription benefits manager, or PBM, in the country.

Defendant Thomas M. Ryan, the president and CEO of CVS, recognized that the combined company’s success would depend on its ability to deliver quality service. After the merger, Ryan claimed that CVS Caremark had integrated its computer systems, was providing excellent service, and was maintaining its client base.

The plaintiffs’ complaint alleged, however, that the merger was, in fact, a disaster. According to confidential witnesses, problems with the integration of computer systems following the merger caused mistakes that contributed to the loss of major clients worth $3 billion in annual revenue.

On Nov. 5, 2009, the same day that CVS Caremark reported its earnings for the third quarter of 2009, Ryan participated in a call with investors. The complaint alleged that Ryan’s statements during the call amounted to a disclosure of “the truth about [CVS Caremark’s] failure to integrate the merged-entity, which resulted in the loss of billions of dollars in PBM contracts, and that the CVS Caremark retail-PBM model had failed to gain acceptance by customers in the pharmaceutical benefit market.”

The complaint further alleged that “investors reacted severely, causing the share price of CVS Caremark stock to collapse,” dropping from $36.15 (the share price at the close of the market the previous day, Nov. 4, 2009) to $28.87 at the close of the market on the day of the earnings call (Nov. 5, 2009), a total of roughly 20 percent.

The complaint was brought by the retirement systems of the Massachusetts city of Brockton and counties of Plymouth and Norfolk.

The complaint eventually was dismissed in U.S. District Court in Rhode Island.

Loss causation

On appeal, Howard said the lower court focused on the element of “loss causation” — whether the retirement systems adequately alleged a causal connection between the defendants’ material misrepresentations and the drop in CVS Caremark’s share price that followed the Nov. 5, 2009, earnings call.

The complaint was based on claims that the Nov. 5 call revealed previous representations — that CVS Caremark could deliver quality service because it had fully integrated its back-end systems — to be false.

“After the call, analysts understood that CVS Caremark had mismanaged the acquisition and damaged the PBM business,” Howard said. “The market reacted accordingly, driving down CVS Caremark’s share price by twenty percent.”

The defendants argued that the Nov. 5 call could not have been a corrective disclosure because Ryan did not state on the call that CVS Caremark had failed to integrate its systems.

“But a defendant’s failure to admit to making a misrepresentation, or his denial that a misrepresentation was made, does not necessarily preclude loss causation. Instead, the appropriate inquiry is whether the November 5 call, as a whole, plausibly revealed to the market that CVS Caremark had problems with service and the integration of its systems,” Howard explained.

“[T]he alarm of the market following disclosure of the magnitude of CVS Caremark’s lost business likely reflected an understanding that something systemic had gone wrong,” he said. “Perhaps the market did not perceive every detail of CVS Caremark’s struggles, but it knew enough to drive down the price of CVS Caremark shares by 20%.”

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