Saturday, August 9, 2014
The exact measure of damages in a fraud on the market 10(b) action has long been a bit of a muddle, because it raises many difficult evidentiary and legal issues. However, because most securities class actions are dismissed or settle, there actually are not many court decisions discussing the problem. The Supreme Court’s decision in Comcast Corp. v. Behrend (2013), an antitrust case, may have begun to change that – as the BP litigation demonstrates.
[More under the cut]
In a fraud on the market 10(b) action, the plaintiff alleges that the corporation inflated its stock price by making false statements about its business. The plaintiff further alleges that disclosure of the truth caused a price decline, creating recoverable damages.
The critical question then is – how much of that decline is recoverable?
Most courts state that the damages calculation in a 10(b) action is based on the difference between the “true” value of the stock and its “inflated” price at any given time. Class member A buys on Day X, and sells at a lower price on Day Y - she can collect damages to the extent that the lower price is due to artificial inflation leaving the stock price between Day X and Day Y.
To figure out the precise amount of artificial inflation in the stock's price on a given day, plaintiffs usually attempt to identify the “true” stock value by looking to the market reaction to the disclosure of the truth, controlling for factors unrelated to the fraud (confounding negative news, unrelated industry-wide developments, etc). Then, taking that as the unmanipulated price, they look backward to figure out what the price would have been on any given day, had the truth been told. The difference between the true value line, and the actual price line, represents the amount of artificial inflation in the stock, day by day, across the class period.
Anyway, as I’ve posted about before, the difficulty with this sort of methodology is that a disclosure at Time 2 is not the same thing as a misstatement at Time 1, and so identifying the “true value” of a stock by looking to its reaction to a corrective disclosure is fraught with difficulty. A company might have a 50/50 chance of having its FDA drug application approved, but lie and claim the chances are 80/20. As a result, its stock price is inflated. Then the drug application is denied, so the chances of approval go down to zero. The company’s stock price is now much lower than it would have been back when the lie was first told and the drug still had a 50/50 chance. Looking solely to the post-disclosure price does not reveal the "true value" of the stock back at the beginning.
That said, this exact scenario might not, in practical terms, be too hard to work with. For example, plaintiffs could use estimates of expected cash flows from the drug to develop a more nuanced analysis of the unmanipulated stock price at any given time. Other situations, however, are more difficult.
A related issue arises when the stock price drops not merely because of the simple economic value of the true information, but because the fraud calls the integrity and competence of management into question. These are real damages causally related to the fraud, but they create an impossible theoretical tangle to imagine whether they should be conceived as part of a stock’s artificial inflation. (If you imagine what the stock price would have been had they told the truth at an earlier time point, does that “truth” include the truth of their own malfeasance, or not? – more discussion by James Rutten and Bradford Cornell here and Barbara Black here.)
Making things even more complicated, many circuits – including the Second Circuit – have a definition of loss causation (a necessary element of a 10(b) claim) that does not correspond to the pure elimination of artificial inflation from the stock price. The Second Circuit allows plaintiffs to demonstrate loss causation if they show that lie concealed negative information that exposed investors to more risk, and that investors were damaged when those risks “materialized.” Thus, in the FDA example, the stock price drop would constitute loss causation. Or if a company lied about taking proper safety precautions at its oil wells, and then the “risk” created by the improper compliance materialized in the form of a disastrous explosion, the Second Circuit would say that loss causation exists.
The problem, of course, is that this definition of loss causation is not anchored to the usual definition of 10(b) damages. Or, to put it another way, had the oil company told the truth about its deficient safety procedures prior to the explosion, certainly the market would have downgraded its stock, but not nearly as much as it did when 62,000 barrels of oil per day were gushing into the ocean for nearly 3 months (yes, this is BP - we're talking about Deepwater Horizon). And it would be absurd to say that the stock price after the explosion represented the stock’s “true value” absent the lie about the safety protocols.
So this whole muddle creates two separate problems. The first is legal: Should investors in fact be permitted to recover for “materialization of the risk” damages (or even the reputational damages associated with disclosure of the fraud)? Jill Fisch has written extensively on this issue. As she puts it, “Securities fraud takes place in the context of an investment decision in which a plaintiff voluntarily enters into a transaction involving known and accepted risks. A plaintiff's assessment and pricing decision are based on an evaluation of those risks. By lying about the issuer and its financial condition, the defendant distorts the plaintiff’s ability to make an informed investment decision. The economic significance of the lie is in how it relates to the known risks at the time of investment, not the extent to which those risks materialize and result in harm. In a sense, the plaintiff's injury is akin to a failure to get true odds in a bet.”
The second issue is evidentiary: Assuming investors cannot recover for materialization damages, how can they possibly prove how the safety statements, standing alone, prior to the explosion, would likely have affected stock prices?
But until recently, courts usually managed to avoid making difficult decisions about this issue, because most cases settled. And when the Fifth Circuit tried to introduce that kind of inquiry into the class certification stage, the Supreme Court stopped it in the Halliburton cases.
But Comcast may represent a new way of reintroducing the issue back into class certification.
Comcast was an antitrust case. The plaintiffs alleged that the Comcast cable company monopolized the Philadelphia market for cable services. The district court held that in order to establish that common issues predominated over individual ones, and that a class should be certified, the plaintiffs would have to be able to prove antitrust injury on a class wide basis, and come up with a “common methodology” for calculating damages measurements. Ultimately, the district court was satisfied with the plaintiffs’ evidence, and certified the class. The Third Circuit affirmed.
The Supreme Court reversed, on the ground that the plaintiffs’ damages model was not tied to the theory of injury that plaintiffs intended to pursue. The opinion opened by stating that it was uncontested that the plaintiffs required a common damages methodology to win class certification. But later in the opinion, the Court made additional statements suggesting that a common damages methodology would definitely be necessary for class certification, regardless of the plaintiffs' concession. The dissent (unusually, jointly authored by Justices Ginsburg and Breyer) argued that because the issue had been conceded by the plaintiffs, it could not be part of the holding.
Prior to Comcast, it was generally accepted that plaintiffs could obtain class certification if the only differences among class members concerned damages calculations. Courts easily held that damages calculations could be shunted into individualized proceedings at the conclusion of litigation, especially since the plaintiffs would have to win on the merits before damages even became an issue.
Since Comcast, numerous courts have held that a damages methodology is required at class certification.
At first, it did not seem like Comcast would have much impact in securities litigation. Plaintiffs argued, and courts accepted, that they planned to reconstruct the stock’s true value, measure the difference between true value and artificial inflation, and reach a damages determination using the same methodology for every class member. Easy-peasy.
But in the BP litigation, the court demanded more.
The BP case is basically my oil well example – BP made a series of alleged misstatements about its safety protocols that were revealed to be false when the Deepwater Horizon exploded.
The court, relying on Comcast, refused to accept the plaintiffs’ summary explanation of how damages would be calculated, and instead demanded expert evidence of the proposed methodology. In that context, the plaintiffs argued that they should be legally entitled to “materialization of the risk” damages from the oil well explosion.
The court disagreed. As it explained:
[A] distinction must be drawn between the alleged misrepresentation and the subject matter allegedly misrepresented—in this case, between Defendants' public misstatements of their process safety reforms, and the underlying failure to institute process safety reforms. The Exchange Act provides compensation for losses caused by the former; losses caused by the latter are beyond the scope of the Act.
Plaintiffs argue that Defendants’ process safety misstatements were a proximate cause of all their post-explosion investment losses because Plaintiffs were deprived of the opportunity to avoid the increased risk by divesting prior to the explosion. But this articulation of the causal link between the alleged misstatements and the claimed losses injects individualized inquiries into what is supposed to be a classwide model of recovery. …
Plaintiffs' articulation of consequential damages is antithetical to the "fraud-on-the-market" theory which enables the classwide resolution of their claims. … If investors are not relying upon the integrity of the market price—if they are, as Plaintiffs suggest, determining their own risk thresholds specific to the company at issue—then Plaintiffs’ proposed measurement of damages cannot be deployed without an individualized inquiry into each investor's subjective motivations. Classwide treatment would be patently inappropriate in such a case.
See In re BP p.l.c. Sec. Litig., 2014 U.S. Dist. LEXIS 69900 (S.D. Tex. May 20, 2014). And the court only certified part of the class (based on a different set of representations and disclosures).
The decision is significant for several reasons. First, the court legally rejected materialization of the risk as a damages measure. Now, the Fifth Circuit – where the case was pending – does not recognize materialization of the risk theory for loss causation, so this was hardly surprising. Nonetheless, I expect future defendants to use this decision in other circuits, regardless of how those circuits define loss causation.
Second, I can only assume - though I don't know for sure, and some of the filings are redacted - that the plaintiffs made their "materialization of the risk" argument precisely because they could not develop a credible methodology that would segment out the impact of the safety statements, standing alone, prior to the explosion. Which simply demonstrates how hard that inquiry often will be.
Third, the court obviously believed that an individual investor who personally relied on the misstatements might be able to recover based on his or her own subjective valuations of the company, which was critical to its conclusion that plaintiffs' failure of proof created individualized issues. In fact, I'm not actually sure that individual investors would have a cause of action based on actual reliance that differs from the fraud on the market action (I have a theory on the implications of Amgen and Halliburton in that regard, which I'll eventually post). But the upshot is, at least for now, if other courts follow BP, it will introduce a whole new iteration of the causation fight into class certification, one that will force courts to confront the damages issues that they’ve previously been avoiding.