When an issuer’s share price drops following a corrective disclosure and recovers shortly thereafter, such that the share price bounces back to the plaintiff’s purchase price but not to a level that eliminates damages under the Private Securities Litigation Reform Act (PSLRA), the Second Circuit has concluded that the complaint cannot be dismissed as a matter of law on grounds that a plaintiff who held shares through the bounce-back did not sustain an economic loss. Rosado v. China North East Petroleum Holdings Ltd., 692 F.3d 34 (2d Cir. 2012). In so doing, the court rejected the holdings of every district court to decide the question as well as that of another panel of the Second Circuit, and seems to put forth an expanded view of lost profits in a securities class action brought under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.
Traditional Damages in Securities Class Actions
Section 28(a) of the ‘34 Act limits recovery in a securities class action to “actual damages . . . from the act complained of.” Economic loss in such actions has, therefore, generally been interpreted to mean out-of-pocket damages; that is, the difference between the price paid and the value of what would have been received had there been no fraud. Affiliated Ute Citizens v. United States, 406 U.S. 128, 155 (1972).
Concerned that plaintiffs in securities class actions were recovering excessive damages, Congress placed a limitation on recoverable damages when it passed the PSLRA in 1995. S. Rep. No. 104-98, at 20 (1995), as reprinted in 1995 U.S.C.C.A.N. 679, 699. Congress recognized that from the time of the alleged misrepresentation through that of the corrective disclosure, the stock could fluctuate for many reasons unrelated to the alleged misrepresentation. As a result, Congress created a mechanism to provide an outside limit of the potential share-price inflation that could be attributable to the misstatement. The PSLRA provides, therefore, that damages cannot exceed “the difference between the purchase or sale price paid . . . and the mean trading price of that security during the 90-day period beginning on the date on which the information correcting the misstatement or omission that is the basis for the action is disseminated to the market.”
To recover those damages, a plaintiff must plead and prove, inter alia, an actual economic loss and a causal link between that loss and the alleged fraudulent misstatement. Dura Pharms, Inc. v. Brouda, 544 U.S. 336, 345 (2005). An inflated stock price alone will not suffice because “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.”
Complaints Dismissed When Share Price Recovers Following Corrective Disclosure
In the wake of the Supreme Court’s decision in Dura, defendants questioned whether, as a matter of law, where the share price dropped following a corrective disclosure but recovered shortly thereafter, a plaintiff who held its shares through the recovery could be said to have sustained “economic loss” under Dura. The district courts answered unequivocally in the negative and dismissed the complaints. In the first of those cases, Malin v. XL Capital Ltd., No. 3:03 CV 2001, 2005 U.S. Dist. LEXIS 27089, at *13–14 (D. Conn. Sept. 1, 2005), the court concluded that “a price fluctuation without any realization of an economic loss is functionally equivalent to the Supreme Court’s rejection of an artificially inflated stock price alone[. If] the current value is commensurate to the purchase prices, there is no loss, regardless of whether the purchase price was artificially inflated.” See In re Immucor, Inc. Sec. Litig., No. 09-CV-2351, 2011 U.S. Dist. LEXIS 97177 (N.D. Ga. Aug. 29, 2011); Ross v. Walton, 668 F. Supp. 2d 32 (D.D.C. 2009); cf. In re Veeco Instruments, Inc. Sec. Litig., No. 05-MC-01695, 2007 U.S. Dist. LEXIS 102363 (S.D.N.Y. June 28, 2007) (concluding on motion in limine that plaintiffs who held their shares past the point that the stock recovered could not recover damages). See also In re Estee Lauder Cos. Sec. Litig., No. 06-Civ-2505 (LAK), 2007 U.S. Dist. LEXIS 38491, at *5 (S.D.N.Y. May 21, 2007) (finding that the plaintiff failed to plead loss causation because the plaintiff could have profited had he sold when the stock rebounded).
Even a panel of the Second Circuit found that a stock-price recovery prevented a plaintiff from sufficiently pleading economic loss. In Masters v. GlaxoSmithKline, 271 Fed. Appx. 46, 51 (2d Cir. 2008), the relevant alleged misstatement involved negative findings in a drug study. The plaintiff bought the stock at $42.96. In re Glaxo Smithkline plc, 05 Civ. 3751 (LAP), slip op. at 7 (S.D.N.Y. Oct. 6, 2006). The stock price dropped on the corrective disclosure at the end of the class period from $42.77 to $41.39. Over six months after the close of the class period, the stock again dropped on a related announcement; this time from $45.08 to $44.82.
The district court concluded that because the share price before the corrective disclosure at the close of the class period was less than that after the later announcement, the plaintiff could not allege a loss even though the plaintiff’s purchase price was higher than the share price following the initial drop. Although the court did not address the question, the 90-day mean trading average appears to have been less than plaintiff’s purchase price. A panel of the Second Circuit affirmed in an unreported decision concluding that the plaintiff “[pled] no facts supporting a conclusion that he was . . . adversely affected.”
The Rosado Decision
In Rosado, the plaintiff,Acticon AG, purchased stock during the class period at prices ranging from $6.45 to $9.60 per share, and averaging $7.25 per share. In the 90 days following the alleged corrective disclosure, the stock price exceeded the plaintiff’s average purchase price on 12 days, the first of which was approximately a month into the 90-day period. The PSLRA 90-day average was $6.45, and thus lower than plaintiff’s average purchase price during the class period. (App. Reply Br. at 2, 2012 U.S. 2d Cir. Briefs LEXIS 55, at *3.) Acticon sold its stock at a loss in the months following the close of the 90-day period.
Acticon alleged a series of misrepresentations and corrective disclosures by the defendant. It further alleged that, in the trading days after each disclosure was made, the defendant’s stock price dropped as a result of the disclosure. The defendant moved to dismiss on the ground that Acticon could not allege economic loss as a matter of law because the share price exceeded the average purchase price on certain days after the final disclosure and as such, Acticon could have sold its holdings and avoided a loss. Following the reasoning of Malin and its progeny, the district court dismissed the complaint, concluding that “a purchaser suffers no economic loss if he holds stock whose post-disclosure price has risen above the purchase price—even if that price had initially fallen after the corrective disclosure was made.” In re China North East Petroleum Holdings Ltd. Sec. Litig., 819 F. Supp. 2d 351, 352 (S.D.N.Y. 2011), rev’d, Rosado, 692 F.3d 34 (2d Cir. 2012).
The Second Circuit reversed, holding that Acticon had satisfied the pleading requirements of Dura because “it has alleged something more than the mere fact that it purchased [defendant’s] shares at an inflated price; specifically, it alleges that the price of [defendant’s] stock dropped after the alleged fraud became known.” The court agreed with the Malin court’s conclusion that the fact that the share price recovered sometime after the corrective disclosure (in Malin, almost three months later) did not prevent the plaintiff from pleading loss causation as a matter of law, as loss causation is generally a question of fact. The court, however, rejected Malin’s conclusion that the recovery negates the inference of economic loss raised by the initial drop, concluding that such reasoning is inconsistent with the PSLRA’s damages limitation and the out-of-pocket damages measure. Thus, the court essentially concluded that as long as the purchase price exceeds the 90-day mean, fluctuations or increases in stock price following a corrective disclosure at the end of a class period will not defeat otherwise sufficient allegations of economic loss.
The PSLRA’s Damages Provision and Economic Loss
In each of the district-court cases and Masters, the share price bounced back from a decline following a corrective disclosure and the plaintiffs’ purchase price(s) exceeded the relevant mean 90-day trading price. None of those courts found a connection between the PSLRA’s limitations and the share-price recovery, let alone an inconsistency. The Second Circuit in Rosado appears to be the only court to have done so.
In the Second Circuit’s view, it would be inconsistent with the PSLRA to conclude that a plaintiff had suffered no economic loss when the stock returns to the purchase price on but a single day (or even 12 days, as was the case in Rosado), because the PSLRA only eliminates damages in their entirety if the mean trading price over the 90 days exceeds the purchase price, which necessarily means that the share price would exceed the purchase price on multiple days. The PSLRA’s limit is just that, however—an outside limit on damages that might be attributable to a particular misstatement. A plaintiff must still plead and prove economic loss and causation. In other words, before there can be a limit on damages, there must be damages; and once there are damages, the PSLRA serves to reduce them whenever the 90-day mean trading price exceeds the share price on the initial drop. Thus, had the court held that a price recovery negates the inference of economic loss as a matter of law, the PSLRA damages provision would not have been triggered. That the PSLRA damages limitation may never come into play in a case where all potential plaintiffs benefitted from the share-price recovery and thus did not suffer an economic loss is not inconsistent with either Congress’s intent or the provision itself.
Moreover, concluding that a plaintiff is not harmed when the stock price recovers would be more consistent with the views previously espoused by the Second Circuit regarding benefit of the bargain/lost profits in securities cases. The Second Circuit has historically denied plaintiffs the gain associated with a stock recovery where the plaintiff sold shares for more than the purchase price (albeit in non-class actions where there are actual sales of the securities). See, e.g., Barrows v. Forest Labs, Inc., 742 F.2d 54, 56 (2d Cir. 1984) (declining to award the plaintiff damages constituting the difference between the price paid and the “true value” of the stock at the time purchased where the plaintiff realized a profit from the sale of the security); see also Masters v. GlaxoSmithKline, 271 Fed. Appx. 46, 51 (2d Cir. 2008) (citing Dura and Veeco). The underpinning of these holdings is the speculative nature of the damages sought; that is, the question of whether the plaintiff would have made the investment in the first instance, had the truth of the issuer’s financial condition been known even at an uninflated price and whether the stock would have performed as it did absent the fraud. The Rosado court instead assumed that “in the absence of the fraud, plaintiff would have purchased the stock at an uninflated price and would also have benefitted from the unrelated gain in stock price.”
After Rosado, it will be far more difficult in the Second Circuit to obtain dismissal on grounds of a share-price recovery, see George v. China Auto Sys., 11 Civ. 7533, 2012 U.S. Dist. LEXIS 111730, at *35 (S.D.N.Y. Aug. 8, 2012), except where the mean 90-day trading price exceeds the plaintiff’s purchase price, see In re Nat’l Australia Bank Sec. Litig., No. 03 Civ. 6537 (BSJ), 2006 U.S. Dist. LEXIS 94162, at *26–28 (S.D.N.Y. Oct. 25, 2006), or where the stock recovers instantaneously such that loss causation can be determined as a matter of law, cf. Dura, 544 U.S. at 343 (recognizing that timing is relevant to causation). It is yet to be seen, however, whether other circuits will agree that a finding of no economic loss following a corrective disclosure, price drop, and recovery is inconsistent with the PSLRA and out-of-pocket damages.
Keywords: professional liability litigation, economic loss, lost profits, bounce back, securities class action, PSLRA
Tammy P. Bieber is a partner of Tannenbaum Helpern Syracuse & Hirschtritt, LLP in New York, New York. Sarah Mendola is an attorney in New York, New York.