The authors do not hide their underlying concern that the present regime has “exposed misstatement-making issuers to a much larger chance of needing to pay out substantial sums.” Among other things, they believe that focusing on the significant price drops following corrective disclosures results in over-estimating the price impact of the misstatements when they were first made, especially in cases arising from sudden disasters. Recognizing that the EDS model may curtail some potentially actionable claims, the authors suggest the gap can be filled by “SEC enforcement . . . or criminal prosecution.”
This article critiques the EDS model. Part I focuses on its lynchpin: the default to a “silent” counterfactual. The authors argue that, at least in cases where defendants have volunteered information not otherwise mandated by statute, stock-price inflation should be measured by hypothesizing how analysts would have reacted if the information had not been volunteered, and that the company had been “silent.” The authors challenge application of the “half-truth” doctrine, which the authors assert that courts have “sleepwalked” in applying to many cases.
In so doing, the EDS model departs from case law that has consistently held that price impact should be measured by looking at what would have happened if the company had been truthful, not just abstained from lying. The model also fails to account for claims asserted under Rule 10b-5(c), which creates liability for engaging in a deceptive scheme. Indeed, section 10(b) of the Exchange Act does not focus on misleading statements per se, but rather on “manipulative contrivance[s].” As such, if defendants choose to deceive investors, why should price impact (and other elements) be determined as if defendants had not acted deceptively (and thereby “maintained” the price of the stock)?
Part II focuses on several cases analyzed by the authors using the EDS model. Claims in those cases arose not from inflated financial results, but rather from exposure of illegal activities or disasters, despite assurances that sufficient regulatory compliance or safety measures had been adopted beforehand. The authors assert that, under their “stripped-down” analytical model, motions to dismiss should have been granted at the outset of each case because it was unlikely that the statements themselves were material, or that analysts would have reacted adversely in the absence of any affirmative representations. As discussed herein, the authors could be faulted for considering the alleged misstatements in isolation, rather than contextually, given a prior pattern of misconduct. In each situation, the misleading statements were part of an effort to restore the company’s reputation for reliability, and thus deemed material to investors by the courts.
Part III expands on the theme developed in Part II, the impact on stock prices of a company’s reputation for reliability and trustworthiness. The EDS authors acknowledge this factor, but then marginalize it, asserting that it is too remote from securities fraud. In so doing, the authors ignore the generally accepted fact that a company’s reputation is not a hollow image, but an asset into which considerable resources are invested with the intent of boosting future cash flows and stock prices. According to famed corporate attorney Martin Lipton, reputation accounts for over 50 percent of market capitalization. It is not surprising that empirical studies have shown that, when a company corrects prior misrepresentations and its stock price plummets, over 50 percent of that price decline represents reputational damages. This reputational factor warrants consideration when determining price impact, materiality, and recoverable damages. Indeed, the Second Circuit acknowledged the importance of reputation in a recent decision involving Goldman Sachs, noting that, had the investment bank truthfully disclosed significant client conflicts in several transactions, such a revelation “would have harmed Goldman’s reputation, causing at least some of its clients and potential clients to seriously reconsider trusting Goldman with their money. This lost revenue would have reduced Goldman’s bottom line and caused the market to devalue its share price accordingly.”
The EDS authors do not dispute these empirical studies, but deem them irrelevant, other than perhaps in a derivative action. Thus, the EDS model substantially shortchanges defrauded investors, given that, at the time they purchased the company’s stock, they had no reason to believe that management was untrustworthy when it spoke. There is no dispute that, if management had remained silent, investors would not have a basis for asserting they were misled—but neither would investors have a basis for suing for management’s misrepresentations. Were investors likely to have purchased the stock if they knew management was not truthful? Given that management chose to speak, investors should not be limited to a scenario as if management had not spoken deceptively.
Part I
The Silent Counterfactual
It is well-accepted that damages in securities fraud cases (which are a function of price impact) are measured by the “out-of-pocket” rule—“the difference between the fair value of all that the [investor] received and the fair value of what he would have received had there been no fraudulent conduct.” That difference requires determining how much the stock price was inflated at the time of purchase due to the company’s misstatements or omissions. That determination, in turn, involves looking at both price reactions (if any) at the time any misstatement was made and when the truth was revealed, perhaps by the company’s corrective disclosure.
The critical question for this calculation is: “Inflated compared to what?” Experts and philosophers define the “what” as the “counterfactual.” One might argue that the counterfactual should be based upon the defendant having spoken the truth; alternatively, one might argue that the counterfactual should be based upon the defendant having remained silent. The distinction is not merely linguistic. A price-impact/damages model based upon the defendant having spoken truthfully measures inflation utilizing a “back-end” analysis, by focusing on the price reaction to a corrective disclosure, and then determining what portion of the decline was due to revelations of the truth, and what portion was due to general market conditions or news unrelated to the fraud. As synthesized by one court:
The best way to determine the impact of a false statement is to observe what happens when the truth is finally disclosed and use that to work backward, on the assumption that the lie’s positive effect on the share price is equal to the additive inverse of the truth’s negative effect. (Put more simply: what goes up, must come down.)
An alternative price-impact model is based on the company having remained silent. This is far more complicated, because it requires a “front-end” analysis—a determination whether the price artificially increased at the time of the misstatement, or would not have been “maintained” but would have declined but for the misstatement. In large part, such a front-end analysis requires estimating, if not speculating, how the market would have reacted to mere silence. Any such estimate requires quantifying the materiality of the omitted information at the time of its omission.
As noted above, the EDS model adopts the silent counterfactual. The EDS authors set out impressive mathematical formulae demonstrating how this calculation can be made using event-study protocols. In so doing however, the authors overlook criticisms of such event studies, which were designed to analyze hundreds of events, rather than just a handful—as is the case in typical securities fraud actions. Moreover, some of these calculations appear to be more inferential leaps regarding how much weight analysts would assign to silence. Regardless, this article will focus on the legal rationale underlying the EDS model.
First and foremost, in championing the silent counterfactual, the EDS authors first emphasize that defendants are not obliged to volunteer information (other than that periodically mandated by Congress and the SEC). As noted in Basic Inc. v. Levinson, “Silence, absent a duty to disclose, is not misleading under Rule 10b-5.” But courts have consistently recognized that, once management chooses to speak, it must not lie or omit information that would render voluntary statements not misleading. “Having chosen to speak about their base of customers, Defendants had a duty to speak accurately, giving all material facts in addressing those issues to permit investors to evaluate the potential risks.” This “half-truth” doctrine has been summarized by Professor Donald Langevoort: “[O]nce the issuer speaks, it must tell both the literal truth and the whole truth, including any hidden facts necessary to make what is said not misleading.”
The EDS authors question whether, in those cases where defendants have spoken (regardless of whether being required to do so), the appropriate counterfactual should be that the defendant spoke truthfully or that the defendant remained silent. The authors assert that, in such cases, the courts have failed to:
engage[] in any analysis as to why [the former] is the more appropriate of the two possible counterfactuals; indeed they have not even recognized that there is an issue here. In our view, these courts have in essence sleepwalked into this position without any apparent recognition that they were making a choice.
The EDS article goes further, boldly asserting that, upon closer examination:
[T]he case law lacks any well-reasoned rationale for the proposition that if one violates Rule 10b-5 by making a materially untrue or misleading statement, one commits a violation for failing to disclose the truth. This is not surprising because such a proposition has no foundation in the language of section 10(b) of the Exchange Act or Rule 10b-5(b). Rule 10b-5(b) creates no duty to speak truthfully. It just prohibits speaking untruthfully or misleadingly. . . . Put another way, it is correct that there are two ways of avoiding illegality under Rule 10b-5(b): one is staying silent and the other is to speak but do so in a way that is true and not misleading. There is, however, no duty to avoid liability in this second way because there is no duty to speak in the first place. Hence, there is no foundation in the language of the statute or the rule for using truth telling rather than silence as the counterfactual.
This seems tautological: Given that defendants had the option to say nothing, but chose to speak, should they get the benefit of an illusory counterfactual premised on the notion that they said and did nothing wrong? Having actively deceived investors, shouldn’t all elements of liability be based on what actually occurred—not what might have occurred had the defendants not chosen to deceive?
The EDS authors are not the first to assert that price impact and/or damages might be computed differently in cases involving statutorily mandated disclosures, rather than volunteered disclosures, which trigger the judicially created “half-truth” doctrine. The distinction between compelled and volunteered speech echoes a concern raised by Professor Langevoort: “Damages in no-duty cases are considerably larger under the truth-telling counterfactual than under the alternative [of silence]—well above what the compensatory goal strictly requires. Whether automatically applying that [truth-telling] counterfactual is good policy or not is debatable.” With all due respect to these leading scholars, is this observation based on empirical analysis? The four largest securities-fraud class-action recoveries involved mandated disclosure of financial information: Enron ($7.2B), WorldCom ($6.1B), Tyco ($3.2B), and Cendant ($3.1B). The fifth largest (Petrobras $3.0B) was a blend of mandated quantitative financial data and volunteered qualitative misrepresentations. Thus, it remains to be seen whether damages in mandated-disclosure cases in fact routinely exceed those in volunteered-disclosure cases.
Moreover, the line between mandated/volunteered information becomes fuzzy when considering the risk factors required to be disclosed by Item 105 and the known trends and uncertainties required to be disclosed by Item 303. To the extent that the disclosures of risk factors and known trends are mandated, it is unclear which counterfactual the EDS model would apply.
Regardless, the EDS authors ultimately recommend discarding the distinction between mandated and volunteered disclosures by noting that, unlike section 13, section 10(b) does not mandate specific disclosures, and that, unlike section 13, section 10(b) is privately enforceable. The authors thereupon argue that stock price inflation for a mandated-disclosure claim should also be measured as if the company had been silent. In so doing, the authors appear to be arguing that section 13 sets the boundary lines of actionable deception for section 10(b) claims, which is certainly questionable.
The EDS model also challenges application of the “inflation-maintenance” theory that the Supreme Court recently addressed in Goldman Sachs. The Supreme Court described “inflation maintenance” or “price maintenance” as making a “misrepresentation [that] causes a stock price ‘to remain inflated by preventing preexisting inflation from dissipating from the stock price.’” The EDS model urges courts to examine more carefully whether the inflation would have dissipated if the defendant had remained silent. But consideration of price impact was endorsed by the Supreme Court only in the context of class certification regarding a fraud-on-the-market claim (and after the plaintiff demonstrated that the market was efficient). Halliburton previously made clear that the burden, with respect to price impact, was placed on the defendant to disprove any impact and thereby rebut the presumption that the market had been misled. By framing price impact as a pleading issue, the EDS model places this burden on the plaintiff, which the Halliburton Court expressly refused to do:
Halliburton argues that since the Basic presumption hinges on price impact, plaintiffs should be required to prove it directly in order to invoke the presumption. Proving the presumption’s prerequisites, which are at best an imperfect proxy for price impact, should not suffice.
Far from a modest refinement of the Basic presumption, this proposal would radically alter the required showing for the reliance element of the Rule 10b-5 cause of action. [T]he Basic presumption . . . incorporates [a] constituent presumption[]: [I]f a plaintiff shows that the defendant’s misrepresentation was public and material and that the stock traded in a generally efficient market, he is entitled to a presumption that the misrepresentation affected the stock price.
The EDS authors effectively ignore Halliburton’s determination that plaintiffs need not prove price impact at the class-certification stage to satisfy the element of reliance. They circumvent this problem by recasting the price-impact issue as proof of materiality at the pleading stage. They double down by positing a radically different measure of price impact and inflation. As evidenced by application to several cases discussed below, it remains to be seen whether this radical change is warranted.
Part II
Contextual Materiality: Application of the EDS Model to Cases involving Systemic Regulatory Violations and Disasters
The jurisprudential problems with the EDS model become more evident when applied to specific cases in which companies volunteered information as part of a campaign to reassure investors that prior regulatory or safety-related problems had been remedied, when in fact the problems had persisted, if not metastasized. Examinations of Barclays and Wells Fargo expose flaws in the EDS paradigm. Cases involving mining and oil-exploration catastrophes raise similar concerns.
Barclays
The claims in Strougo v. Barclays PLC arose not from a typical catastrophic event but, as characterized by the EDS authors, the “disastrous” filing of a lawsuit by the Attorney General of the State of New York (NYAG) charging improper conduct (and customer conflicts) in the investment bank’s operation of its LX dark-pool trading platform. Barclays permitted high-frequency “predatory” traders to participate in the dark pool, despite statements to the contrary. Plaintiff asserted investors were misled by assurances that “attribute[ed] ‘LX’s success to Barclays’ commitment to being transparent regarding [its] operations, . . . and the kinds of counterparties traders expect to deal with when trading in the dark pool.” The bank also claimed that LX had systems to monitor clients’ trading behaviors which precluded access by those engaged in “toxic” trading strategies. Following revelation of the NYAG charges to the contrary, Barclays stock fell more than 7 percent.
The EDS authors assert that the district court’s decision denying the motion to dismiss was ill-considered, questioning—as did defendants in the case—the quantitative materiality of the misstatements. “The problem for plaintiffs . . . is LX contributed only about 0.1 percent to Barclays revenues.” The EDS authors insist that, even if revelation of the truth had led to the collapse of the LX operations, “it would be difficult to characterize the possibility of such a result as ‘material’ to someone considering buying or selling Barclays’ stock.” Under the EDS model, it is “very unlikely” that the market would have drawn any “negative inferences from Barclays’ silence on the matter.”
The authors also question the court’s qualitative analysis of statements regarding Barclays’ operation of its LX dark-pool trading platform:
In essence, the allegation is that management, by making these statements, undertook an act that, through the risk it created, made the company less valuable, and then stayed silent about what it had done. If management had instead made some operational decision that risked future damage and stayed silent about it, the risky act plus silence would not have given rise to a valid fraud-on-the-market claim.
Had the investigation of the LX trading operations been an isolated incident, the objections regarding quantitative and qualitative materiality might have been more persuasive. But in Barclays, the NYAG’s investigation was déjà vu all over again. As the court noted, plaintiff asserted that Barclays’ volunteered assurances were important to investors in the context of repercussions from prior scandals, and the bank’s need to remediate reputational losses incurred as a result: “Investors were concerned with lack of management honesty and control because, as had happened in the past following the LIBOR scandal, such problems could result in considerable costs related to defending a regulatory action and, ultimately, in the imposition of substantial fines.” Other courts have consistently interpreted materiality not in isolation, but in context. As noted by the Supreme Court in Omnicare, “The reasonable investor understands a statement . . . in its full context . . . .” This was echoed in Judge Jed A. Rakoff ’s denial of a motion to dismiss in Petrobras where the alleged misstatements included qualitative characterizations of efforts to improve corporate governance of a state-run enterprise with a history of corruption:
Whether a representation is “mere puffery” depends, in part, on the context in which it is made. While some of the alleged statements, viewed in isolation, may be mere puffery, nonetheless, when (as here alleged) the statements were made repeatedly in an effort to reassure the investing public about the Company’s integrity, a reasonable investor could rely on them as reflective of the true state of affairs at the Company. Accordingly, the Court cannot find that all of Petrobras’ alleged statements regarding its general integrity and ethical soundness were immaterial as a matter of law.
Thus, the EDS authors’ insistence that Barclays’ statements had no impact on investors, nor the price of the bank’s stock, is highly questionable.
Wells Fargo
The EDS model arguably collapses altogether with the Wells Fargo cases. At the beginning of September 2016, Wells Fargo’s stock market capitalization was the highest of all U.S. banks. Wells Fargo had consistently distinguished itself from competitors by touting its “cross-selling” practices, whereby bank officers marketed a menu of products (for example, savings accounts and insurances policies) to checking account customers, thereby creating synergies. How much the cross-selling practice translated into bottom line financial benefits was not disclosed. Clearly, this was a matter about which the bank could have remained silent, but chose instead to burnish its competitive reputation.
On September 8, 2016, investors learned that Wells Fargo had engaged in abusive cross-selling practices. Senior management had pressured branch bank officers to meet “goals,” and bank officers thereupon pushed the envelope to generate fees by, for example, withdrawing monies from customers’ checking accounts near the end of a quarter, depositing the monies in newly opened unauthorized savings accounts, and then reversing the transaction immediately after the next quarter began. Bank officers met their goals, while customers, unaware of surreptitious transfers, paid overdraft fees. Senior Wells Fargo officials were well-aware of the illegal practices, having fired over 5,000 bank officers caught performing such machinations. Nonetheless, management not only continued to press cross-selling goals, but awarded multi-million-dollar bonuses to Carrie Tolstedt, the Executive Vice President responsible for supervising the practice.
The illegal practices resulted in only a few million dollars of additional revenues over a multi-year period. As such, they were hardly material to financial results. Wells Fargo was fined only $185 million to settle state consumer regulatory claims—a drop in the bucket because the bank’s assets exceeded $1.9 trillion. Most telling, none of the previously reported financial results or cross-selling metrics had been materially inaccurate; they were simply infected by a culture of misconduct.
Under the EDS rationale, this case could have been dismissed at the pleading stage. The financial impact was immaterial. It remains to be seen how much Wells Fargo’s stock price would have declined (or risen less) had it remained silent about cross-selling. Materiality, though, is more apparent when viewed through the prism of a back-end analysis. Within days of September 8, 2016, when the first regulatory settlement was disclosed, Wells Fargo’s stock price tumbled 6 percent, and continued falling as pressure mounted for CEO John Stumpf to resign. Within a week, Wells Fargo’s stock price fell 16 percent, its market cap ultimately plummeting over $30 billion—a significant portion of which was clearly related to reputational concerns. A year later, Wells Fargo market value was still $4.5 billion below its pre-September 2016 level, compared to an $82 billion gain by Bank of America over the same period.
Investors filed a class action alleging securities fraud that focused on qualitative representations attributing the bank earnings to “achiev[ing] record cross-sell across the Company”; that “[cross-selling] of our products is an important part of our strategy to achieve our vision to satisfy all our customers’ financial needs”; and that “[o]ur ‘cross-selling’ efforts to increase the number of products our customers buy from us . . . is a key part of our growth strategy.” In denying the motion to dismiss, the district court held that the statements were materially misleading both because the cross-selling metrics had been illegally inflated, and because contextually, the bank had characterized cross-selling as “the core of [its] vision-based strategy.” The case was settled for $480 million.
The stock market’s 2016 recalibration of the reliability of Wells Fargo’s management proved prescient. Not long thereafter, additional illegal conduct was revealed regarding the bank’s auto loan practices. As financial reporter Gretchen Morgenson noted, this represented “the latest blow to the reputation of Wells Fargo, America’s third-largest bank and one that was once regarded as among the best run in the country.”
But this was not the end of the story. Given the breadth of systemic abuse of customers, Wells Fargo was compelled to enter into a consent decree with federal regulators in 2018 intended to improve governance and internal controls. Among other things, the decree required the bank to file a comprehensive “remediation plan” by April 3, 2018. When submitted to the regulators, the plan was rejected as insufficient. Nonetheless, when asked by Congress about progress in resolving matters with the regulators, bank representatives consistently provided generalized responses without disclosing the outright rejection, a de facto default to silence.
In 2020, federal regulators sued the bank for violating the 2018 consent decree, precipitating yet another blow to the stock price. The stock market’s reaction to this disclosure proved prescient once again. Between February 2020 and December 2022, government agencies fined Wells Fargo a total of $7.2 billion. In March 2023, Tolstedt pled guilty to criminal charges and is facing a jail sentence. A second investor class action was filed on the heels of the February 2020 revelations, this time asserting that the bank failed to disclose, among other things, the initial rejection of the proposed remedial plan. After certain claims survived motions to dismiss, this second class action case was settled in May 2023 for $1 billion.
Barclays and Wells Fargo call into question whether the EDS model should be applied to systemic regulatory misconduct cases. In such cases, where materiality is far more contextual, why should courts require investors to demonstrate how a company’s stock would have responded at the time of the misstatements if the company had simply remained silent without regard to how the stock reacted upon subsequent revelation that investors had been misled?
That said, the EDS model arguably raises questions for cases in which a one-time calamitous event causes significant stock price declines. Massey Energy and BP are prime examples of such catastrophic cases.
Massey Energy
Massey Energy operates fifty-six coal mines in West Virginia, Virginia, and Kentucky. In 2006, a fire at one mine killed two workers, leading the FBI to investigate regulatory violations. Thereafter, the company embarked on a campaign to “restore the company’s reputation” by making “a strong company commitment to the safety of its miners” and implementing “safety improvement initiatives.” In an effort to rebuild “investor confidence and goodwill with regulators,” the company consistently and voluntarily affirmed in SEC filings its prioritization of “the safety of its miners before its production.” For instance, in its 2007 Annual Report, Massey declared that “a safe mine is a productive mine” and explained its “formula for success [as] S-1 + P-2 + M-3 = shareholder value.” At an analyst conference, Massey’s CEO stated, “The main thing about Massey is, we have a better safety performance than the industry, whether you’re looking at underground, surface or total. And we have S1 and safety programs in place that far exceed the law . . . .” Despite these representations, on April 5, 2010, twenty-nine miners died in an explosion and fire at Massey’s Upper Big Branch Mine, one of the deadliest coal mining accidents in the United States in forty years. It was subsequently revealed that the company had been charged with, but had not disclosed, several hundred safety violations in the prior years. Investors filed a class action asserting that Massey’s consistent touting of its safety policy and record was materially misleading, given its failure to disclose the significant number of violations that occurred after 2006. The court denied a motion to dismiss, noting that it “appreciates that Section 10(b) ‘do[es] not create an affirmative duty to disclose any and all material information.’ However, disclosure of a balanced view of Massey’s safety record is required ‘to make . . . statements made [respecting NFDL rates], in the light of the circumstances under which they were made, not misleading.’” Plaintiffs also asserted that investors were misled by representations regarding Massey’s “commitment to safety.” The court upheld these claims as well, noting that:
“While opinion or puffery will often not be actionable, in particular contexts when it is both factual and material, it may be actionable.” As the Court stated above, the truth or falsity of Defendants’ statements can be determined. They are not stated in a context of a future prediction, but generally recognize the company’s past achievements and current goals. Additionally, Defendants closely aligned their statements of commitment to safety to their productivity and success as a company, thereby lending credence to the materiality of their statements.
As in Barclays and Wells Fargo, the Massey Energy court determined that qualitative statements concerning corporate conduct could be contextually material, regardless of any measurable impact on bottom line results, something for which the EDS model fails to account.
BP
In re BP p.l.c. Securities Litigation concerned the devastating 2010 explosion at the Deepwater Horizon exploration rig that killed eleven workers and led to billions in damages from massive oil leaks. Like Massey Energy, it is more typical of an event-driven case than Barclays or Wells Fargo. On the other hand, like Massey Energy, BP shares characteristics with all three cases, given that alleged misleading statements were issued as part of a campaign to demonstrate that the company had been remediating past misconduct. In BP’s case, the company had previously suffered several oil well blow-outs in the early 2000s, and then sustained two catastrophic disasters—first, an explosion at a Texas refinery in 2005 that killed fifteen and injured nearly two hundred people and then, in 2006, the largest Alaskan oil pipeline leak, which caused billions in damages to the environment.
A blue-ribbon panel headed by former Secretary of State James Baker concluded that these earlier disasters were attributable to a corporate culture that placed profits over safety. The 2007 Baker Report recommended significant changes to operations, including high-risk oil drilling operations. Unbeknownst to investors, BP failed to implement the recommended reforms for even higher-risk offshore drilling operations. Fundamental deficiencies in the well-sealing process at the Deepwater Horizon rig—consistent with the prior practice of prioritizing profits over safety—led to an undetected gas leak in the exploratory pipeline, resulting in a build-up that ultimately blew up the entire drilling platform. BP’s stock price plummeted, resulting in class action lawsuits.
The court in BP denied the motion to dismiss, finding that statements regarding the purported refocus on safety and the implementation of the recommendations set forth in the Baker Report were misleading, including the statement: “[W]e have continuously reported progress against a response plan and against an independent external report.” As the court noted, “This was a disaster so similar to prior disasters—the culmination of corner-cutting, overlooked and disregarded warnings, a lack of oversight, a failure to train employees properly, and long overdue maintenance—that it raises a genuine question as to whether BP was truly making the progress it claimed.” Thus, once again, the volunteered statements regarding remedial efforts do not readily fit the EDS paradigm.
Goldman Sachs and EDS
After publication of the EDS article, the Second Circuit issued an opinion that decertified the class in the previously discussed suit against Goldman Sachs. In that case, the Second Circuit applied a different, arguably more linguistic, model for analyzing inflationary price impact. When the Supreme Court remanded the case for further consideration of class certification, it focused on the degree of relatedness between the precise language of the alleged misstatements and that of the corrective disclosures. This approach is arguably more skewed to loss causation than quantitative price impact, but it is certainly far afield from the silent counterfactual model advocated by the EDS authors, which is primarily, if not exclusively, focused on the front-end statements. The case nonetheless warrants discussion in the context of the issues raised by the EDS model.
The case arose out of Goldman Sachs structuring both the short and long sides of collateralized debt obligation (CDO) transactions in 2007, without informing the long side that the short side selected the constituent securities. The nondisclosure of that information clearly violated client-conflict standards. Following disclosure of Goldman’s breach of duty to its long-side clients, and a 16 percent stock price drop, investors sued, claiming that they had been misled by Goldman’s assurances that it had taken adequate measures to preclude such conflict-ladened transactions.
Goldman moved to dismiss on grounds that its statements regarding client conflicts were too generic to be relied upon by investors, and thus per se immaterial. The district court denied the motion and granted class certification, after which a decade of appeals ensued, including one to the Supreme Court, which held that the generic nature of a statement does not render it per se immaterial, but rather should be weighed with other evidence in determining whether or not the statements had an inflationary price impact. The case was remanded to the district court to further consider inflationary price impact, but the Supreme Court cautioned that the “inference [] that the back-end price drop equals front-end inflation [] starts to break down” when the earlier misrepresentation is generic and the later corrective disclosure is specific, and that, “[u]nder those circumstances, it is less likely that the specific disclosure actually corrected the generic misrepresentation. . . .”
On remand from the Supreme Court, the district court reaffirmed class certification, but, for a third time, the Second Circuit granted an interlocutory appeal. Despite having previously upheld class certification, the Second Circuit reversed the district court on grounds that the alleged misstatements regarding client conflicts were not sufficiently related to the alleged revelations of specific conflicts of the CDO transactions. The Second Circuit deemed the respective statements a “mismatch.” While the Second Circuit agreed that the “subject matter” of the front- and back-end statements “match[ed],” it held that this failed to demonstrate sufficient relatedness. The Second Circuit stressed that the front-end statements were in “separately disseminated” documents unrelated to the subject matter at issue. Significantly though, the Second Circuit endorsed a contextual reading of the front-end statements:
[A] statement can be materially misleading when “the defendants’ representations, taken together and in context, would have mislead a reasonable investor.” . . . So, for example, a company’s statement that its distribution market is “highly competitive,” might be actionable when considered within the context that the company did not actually operate in a competitive market and instead colluded with its competitors to fix prices. Or, a company’s statement that it has “demonstrated successful acquisition and integration capabilities” might be actionable when, at the time the statement was made, the company had already fired key integration staff and was dealing with a poor integration of a newly acquired company.
Using this contextual framework, the Second Circuit distinguished its prior decision upholding class certification in the aforementioned Barclays case. Unlike Goldman Sachs, Barclays had previously engaged in regulatory misconduct, and had acknowledged that it was engaged in another specific high-risk trading practice. Referencing its own decision in Waggoner, the Goldman court acknowledged:
[I]n order to quell “concerns that high-frequency traders may have been front running” other traders on a specific Barclays trading platform, Barclays’ officers made numerous statements to assure investors the platform was “safe from” aggressive trading practices, and that it “was taking steps to protect” institutional investors on those platforms by monitoring and removing aggressive traders who violated the platforms’ special protections. In the end, upon the filing of a complaint by the New York Attorney General (the “NYAG Complaint”) alleging securities fraud under state law, investors learned that those representations were allegedly false because, according to the State, no special protections existed, and, in fact, Barclays favored rather than removed aggressive traders.
Waggoner is particularly illuminating given the similarity between the corrective disclosure there and here; both took the form of an enforcement action. Unlike here, however, Waggoner presented a tight fit between corrective disclosure and misrepresentation: the NYAG Complaint targeted the same trading platform discussed by Barclays in their misleading statements, and took aim at the same or similar statements underlying the claims subsequently pressed by plaintiffs in Waggoner, alleging that those statements were false or misleading.
This analysis is also consistent with the aforementioned cases of BP and Massey, and contrary to the conclusions reached by the EDS model. Nonetheless, one might ask why, in determining price impact for class certification purposes, the Second Circuit focused only on the linguistic relationship of the alleged misstatements regarding conflict controls to the back-end corrective statements, rather than to counterfactual statements Goldman should have made in order not to mislead investors. As noted above, the Second Circuit previously recognized that Goldman Sachs’ failure to be truthful effectively maintained its stock price by avoiding disclosure of facts that “would have harmed Goldman’s reputation, causing at least some of its clients and potential clients to seriously reconsider trusting Goldman with their money. This lost revenue would have reduced Goldman’s bottom line and caused the market to devalue its share price accordingly.” One might also ask whether the degree of relatedness must be binary—all or nothing. As discussed below, there are other possible solutions to determine whether there was some or sufficient price impact, which could be sorted out at the damages stage. Regardless, it remains to be seen what, if any, support the EDS model received from the Goldman Sachs decision.
What Portion of a Back-End Corrective Disclosures’ Price Drop “Relates” to the Front-End Misstatements?
The harder question raised by the EDS model and cases involving catastrophic disasters is, presuming a sufficient relationship exists between the front- and back-end statements in order to demonstrate some “price impact” at the time of the misstatements, what portion of the price decline at the back end should be recoverable damages. For instance, does the amount by which BP stock price fell after the explosion reflect the degree to which it had been inflated by the alleged misstatements issued during the class period? In this respect, the EDS model is correct—the degree of undisclosed risk of a specific disaster (say, 20 percent) will always be smaller than the risk when the same disaster actually occurs (100 percent). Indeed, this was the reason that the court in BP subsequently denied class certification of the pre-explosion class of investors, holding that the degree of risk tolerance for possible catastrophes would likely differ significantly among class members, thereby rendering individual questions predominant over common questions.
The EDS authors frame this as a “loss causation” issue—whether the revelation/corrective disclosure included elements arguably unrelated to the misstatements. The challenge is to identify the portion of the stock price drop that would not have occurred had the company been truthful in the first instance rather than deceptive. There are two possible solutions to this problem. First, mathematical models could demonstrate the degree to which the understated risk contributed to stock price inflation. David Tabak of National Economic Research Associates proposed such a formula:
[T]he analysis can be broken down into four steps: (1) Determine which risks were required to be disclosed; (2) Measure the price decline on disclosure of the realization of the risk; (3) Estimate the probability at earlier dates that the risk would eventually be realized; and (4) Use the probability to estimate the artificial inflation in the security’s price.
This formula facilitates measurement of the inflation leading to out-of-pocket damages, which, for a specific risk, will be less than the actual price decline upon the realization of the risk. Notably, that analysis would not address alleged differences in “risk tolerance” of reasonable investors sufficient to satisfy class certification requirements for plaintiffs seeking to obtain the entire price decline upon the realization of the risk, as the BP court recognized.
A second solution draws lessons from empirical studies discussed below showing that a significant portion of post-revelation stock price declines are caused by loss of management credibility and reputation. While investors may have different thresholds for investment risk, it is highly unlikely that they differ in their tolerance of deception. As noted in Judge Winter’s famous dissent in AUSA Life Insurance Co. v. Ernst & Young:
If aware of those facts, a reasonable lender would have inferred that JWP had a management quite willing to lie systematically to investors and an auditor willing to certify the lies. A reasonable lender would then have discounted JWP’s creditworthiness not only because of its less favorable financial condition but also, far more devastatingly, because of the questionable quality of its management and auditor. Reasonable investors surely view firms with an untrustworthy management and auditor far more negatively than they view financially identical firms with honest management and a watch-dog auditor.
The full implication of this common-sense observation regarding reputation and stock price inflation is explored below.
Part III
Reputational Capital and Stock Prices in the Context of Event-Driven Suits
As the Bible says, “A good name is better than fragrant oil.” Though King Solomon was referencing olive oil—not petroleum oil—the adage still holds. Reputation Matters! Corporations invest billions to burnish their image, which translates into brand loyalty, increased sales, and enhanced investor confidence. According to Martin Lipton, a “focal point of investors has been the importance of corporate culture and the ways in which that is tied to the preservation and creation of value.” In support thereof, Lipton quoted a State Street study that found that “‘intangible assets’ (e.g., human capital and culture) comprise an average of 52% of a company’s market value.” Lipton added, “particularly in times of uncertainty, corporate culture can not only provide reputational capital and help mitigate compliance risks, but also enhance business resiliency.”
So what is this thing called “reputation”? Economists define reputation as:
the present value of the cash flows earned when an individual or firm eschews opportunism and performs as promised on explicit and implicit contracts. Stated differently, reputation is the value of the quasi-rent stream that accrues when counterparties offer favorable terms of contract because they believe the firm will not act opportunistically toward them.
Given its contribution to bottom line results, corporations actively cultivate reputation. As Jonathan Macey noted, companies “find it profitable, and therefore rational, to invest money immediately in developing a reputation for honesty, integrity, and probity, because doing so allows the company or firm to charge higher prices, and thus earn superior returns in later periods.” Reputation is valuable not only in the commercial product market, but in financial markets as well. As Professor Langevoort has noted, “There is ample evidence that credibility is a variable in the fundamental valuation calculus; over time, investors form impressions of how reliable managers are and act accordingly.” The value of a company’s reputational capital is reflected in its stock market price. As scholars have noted:
[R]eputational capital often constitutes a significant fraction of a company’s market value. In addition to brands, reputational value can be associated with perceptions regarding the honesty, integrity and skill of management, the internal controls of the company, and the company’s quality control, among other things. Because reputational value depends on the perception of investors and other stakeholders, it is highly sensitive to negative information regarding the company, its management or its products.
Significantly, the Second Circuit recognized the importance of reputation to companies and their stock price:
Although it is possible that Goldman’s price declined in part because the market feared that Goldman would be fined, this is not enough to rebut the Basic presumption. Moreover, there are good reasons to believe that the corrective disclosures were more significant than Goldman makes them out to be. . . . It is therefore reasonable to assume that this disclosure [regarding customer conflicts] would have harmed Goldman’s reputation, causing at least some of its clients and potential clients to seriously reconsider trusting Goldman with their money. This lost revenue would have reduced Goldman’s bottom line and caused the market to devalue its share price accordingly.
Quantifying the Impact of Reputational Damages on Stock Prices
Because reputation accounts for a significant portion of a company’s market value, “hits” to reputation often cause significant stock price declines. Stated otherwise, if a company has materially misstated its true operating condition or risks, thereby maintaining or increasing its stock market valuation, revelation of the truth will cause its “reputational premium” to significantly deflate. As Professor Langevoort observed:
Of course, reasonable investors do assess the credibility of management in making decisions and an investor’s willingness to rely no doubt varies from issuer to issuer depending on its reputation for candor. The stock-price drop that ensues upon discovery of fraud is partly the product of learning the truth about the company’s situation and partly the product of loss of credibility.
The adverse impact of reputational losses on stock prices following corrective disclosures (and hence the degree to which stock prices were inflated by the original misstatements) has been empirically quantified by Jonathan M. Karpoff, D. Scott Lee and Gerald S. Martin (collectively, Karpoff ). The landmark study concluded that: “For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to expected legal penalties and $2.71 is due to lost reputation.”
In other words, this study found that nearly 66 percent of a stock price decline following revelation of the truth is caused by the market’s reassessment of management’s reliability, not just immediate changes in financial metrics. Such empirical findings are consistent with Professor Langevoort’s observation that “stock price drops in the aftermath of disaster . . . seem to exceed the fundamental value of the bad news in question—they reflect a downward revision of credibility as well, calling into question other value assumptions.” But as discussed below, such outsized stock price reactions are not limited to the typical disaster scenario, but rather occur across the board.
To illustrate “reputational losses,” Karpoff examined Xerox Corp.’s manipulation of its reported earnings. Xerox revolutionized office copy machines in the 1960s and was promptly anointed one of the stock market’s “Nifty Fifty.” By the late 1990s, however, Xerox’s earnings had slowed to a crawl. To reverse this decline and re-ignite its stock price, the company embarked on a scheme to accelerate revenue recognition for copiers leased for extended periods. Xerox improperly front-loaded most of the contract price, rather than amortizing the price over the duration of the lease. The resulting inflated earnings skyrocketed Xerox shares from $22 in January 1997 to over $56 by May 1999. However, the scheme was sustainable only so long as the volume of new equipment leases exceeded that of expiring leases. The ratio of new-to-expired leases reversed as the decade ended, and the company was compelled to announce lower projections in late 1999. When it became clear that past profits had been artificially inflated, the SEC investigated, and securities fraud class actions were filed. By October 2002, Xerox shares had tumbled to $4.
Karpoff calculated that Xerox’s inflated earnings had boosted its market capitalization by over $1 billion. However, the company’s market value had declined over $5 billion following the corrective disclosures. In response to the question, “Why did the share price fall so far?,” Karpoff noted that $1 billion (20 percent) was due to reversal of the artificial price inflation, and $0.5 billion (10 percent) was due to regulatory fines and settlement of the class action lawsuit. “The rest of the loss—$3.44 billion—is due to something else. The most plausible explanation is that most of the $3.44 billion is due to impaired operations because of the revelation of misconduct—what I call ‘the reputational loss.’” Other studies buttress Karpoff ’s conclusions. A critical take-away from these studies is that merely revaluing financial results without the inflated earnings does not capture the full impact of defendants’ deception of investors. The act of lying has additional deleterious consequences.
Should reputation matter when calculating inflated price impact caused by deception at the time misstatements were made? If 66 percent of the stock price decline following disclosure of the deception is caused by the loss of credibility, then presumably that portion of the decline was reflected in the stock price prior to revelation—what goes in must come out. It is also reasonable to presume that, as Judge Winter observed in AUSA Life Insurance Co. v. Ernst & Young, “[r]easonable investors surely view firms with an untrustworthy management . . . far more negatively than they view financially identical firms with honest management.” While tolerance for the risk of disasters may differ among investors, tolerance for untrustworthy corporations presumably does not. Stock price reactions reveal that investors punish companies that betray that trust with relative proportional consistency, making the computation of inflation both manageable and material.
Application of Reputation Factor to Cases
So if reputation matters and impacts stock prices, how should it be incorporated into securities fraud lawsuits, especially those that are “event-driven”? A good example would be the aforementioned BP class action case. First off, consideration of reputation would enable plaintiffs to argue that common questions of law predominate with regard to investor risk tolerances. While people may differ in their aversion to investing in companies with higher operational risk profiles, it is unlikely that they significantly differ regarding a presumption of management’s integrity. If management is known to be untrustworthy, then it is more likely than not that the company’s stock premium will be lower (per Langevoort et al.). As such, class wide reliance could be presumed in cases like BP.
The computation of damages will also be impacted. As Karpoff’s studies demonstrated, revelation of fraudulent behavior itself consistently causes significant stock price declines. Applied to the BP case, 66 percent of the stock price decline following the explosion and disastrous oil spill could be recovered as class-wide damages. This is far higher than the damages calculated under the Tabak model.
Exclusion of Reputational Damages from the EDS Model
The EDS authors do not dispute that disclosure of management misconduct directly impacts stock prices. Nor do they dispute Karpoff ’s computation that 66 percent of the resultant price decline “is due to lost reputation.” The authors also acknowledge that, as Professor Langevoort asserted, such stock price declines reflect not only “truth with respect to the specific facts misrepresented or omitted[,] but also a readjustment in expectations regarding other matters on which management was previously thought credible.” Nonetheless, the EDS authors insist that post-revelation reputational losses have little or no bearing in determining pre-revelation inflation: Regarding “[t]he market’s loss of confidence with respect to other statements made by the company, that portion of the share-price decline is not a proxy for the misstatement’s inflationary effect.” It is not clear what “other statements” the authors have in mind. Granted that any confounding information unrelated to the misstatements must be factored out of the inflation/damage computation. If the authors mean that generalized statements regarding a firm’s honesty should be discounted, this is irrelevant to such a computation of inflation. Courts have consistently held that such generalized statements of integrity are “puffery” upon which no reasonable investors relied, and thus for which there can be resultant inflation—and no actionable claim. If those puffery statements had no price impact, per se they cannot account for the additional 66 percent decline in the stock price after the corrective disclosure. But, as examination of the foregoing cases indicates, even qualitative reputational statements can contextually mislead investors, and can cause an inflationary impact on a stock price.
The EDS authors offer an alternative argument for eliminating any reputational impact from the computation of inflation. They first distinguish the decision to lie from the contents of the lie itself. They insist that the decision to lie (which contributed to the initial inflation) is not a recoverable fraud under the federal securities laws, but is rather a “bad decision” that might be “serious enough to be a fiduciary duty breach.” In other words, the conduct of lying is a breach of fiduciary duty (for which a derivative action is appropriate), while only the content of the lie itself constitutes actionable deception recoverable under the securities laws.
One might dismiss this distinction between a lie and lying as linguistic gymnastics. Regardless, it is contrary to law. In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., the Supreme Court expressly rejected the position taken by the Eighth Circuit that “there must be a specific oral or written statement before there could be liability under § 10(b) or Rule 10b-5.” Consistent with Rule 10b-5(c), the Court held, “Conduct itself can be deceptive . . . .” One may argue about the precise contours of “scheme liability,” and the degree to which it should be limited to misstatements issued by an identified party. However framed, the EDS article marginalizes reputation based on an alleged distinction between the content of a deceptive statement and the deceptive conduct itself, which distinction fails to account for the import of Rule 10b-5(a) and (c).
Alternatively, one might consider the EDS authors’ insistence on ignoring reputational damages as consistent with their objective to limit, if not eliminate, recoveries for many claims under the federal securities laws. Whether the need for such a limitation is warranted, or amounts to good policy, can be debated. But siloing such claims to derivative lawsuits hardly serves the interests of those investors who were defrauded, and sold their shares after revelation, particularly given the significant hurdles erected by Delaware courts to demonstrate “demand futility.” As long as the SEC is constrained to pursue only the most egregious cases, and only recover fines payable to the agency, the EDS authors proposed cure will more likely leave investors out in the proverbial cold.
Putting aside the ideological/policy concerns underlying the EDS model, two common sense concerns raised by the article remain. If the company’s stock price fails to move upward in reaction to its statements, why should one assume there was an inflationary impact? This is a particularly thorny problem when measuring something intangible, like reputation. Point taken. But courts, statisticians, and scientists have routinely measured intangibles by observing what happens when they are untangled or taken away. This is the generally accepted back-end calculation that Karpoff and many other economists utilize. If something is lost (that is, a portion of the stock price), it must have been there all along.
The harder question is ascertaining just when reputation became a measurable part of a company’s stock price. To some degree, this article assumes that the stock price always reflected a company’s reputation. Reputation may be enhanced over time by continued evidence of reliability and trustworthiness, but we may lack the tools to measure how much Barclays’ deceptive remedial statements moved the needle. Perhaps the issue is semantic in event-driven lawsuits. The Supreme Court described “inflation maintenance” or “price maintenance” as a “misrepresentation [that] causes a stock price ‘to remain inflated by preventing preexisting inflation from dissipating from the stock price.’” Why should one focus on when reputation first inflated a company’s stock price? After all, any reputation premium was always there; but for the deception, the reputation premium would have dissipated as the stock price declined. Because the fraud prevented such dissipation, the stock price was inflated. In other words, the deceptive act and the inflation are inextricably linked.
Bottom line, the EDS authors fail to offer a better explanation than Karpoff as to why stock prices fall so precipitously following revelation of management’s unreliability. Reputation Matters!
Conclusion
Regardless of whether the duty to disclose was pre-existing, or triggered by volunteered information, corporations maintain, burnish, if not boost, their reputations regarding managements’ trustworthiness. These are not casually made remarks. Perhaps investors should not give much credence to statements of the sort examined in this article, but that is a question of materiality, one that is far more subjective by definition and less precise than the hypothetical price impact model championed by the EDS authors.
It has long been accepted that investors are entitled to presume the “integrity of the market.” As Justice Blackmun wrote in Basic, “[I]t is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?” By the same token, why shouldn’t investors be entitled to presume that, when management makes pronouncements, it is acting consistent with a reputation for “integrity” and not acting deceptively?
