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Stock Market Volatility: The Death Knell of Section 10(b) Securities Fraud Class Certifications

Jennifer N Huckleberry

Stock Market Volatility: The Death Knell of Section 10(b) Securities Fraud Class Certifications
Witthaya Prasongsin via Getty Images

The volatility of the stock market this past year effectively bars section 10(b) securities fraud class action lawsuits predicated on omissions or statements made in 2020. The turbulent financial climate that gave rise to these claims will simultaneously shield defendants from liability. Given the erratic and extreme stock market fluctuations in 2020, plaintiffs must show a truly exceptional price impact to prove that a price change was abnormal and outside the normal range of stock price fluctuations for the relevant period. These class actions will, as a whole, not survive class certification because plaintiffs likely cannot systematically show, with the requisite 5 percent statistical significance level, that the misrepresentation, omission, or corrective disclosure caused an abnormal price impact.

During 2020, private sector and class action 10(b) securities fraud lawsuits dominated the securities fraud landscape because the Securities and Exchange Commission has chosen not to bring COVID-related actions except where the misrepresentations and omissions were integral to the company’s core business. See Sec. & Exch. Comm’n v. Jason C. Nielsen, No. 5:20-cv-03788 (N.D. Cal. filed June 9, 2020) (company misrepresented that it had developed an approved COVID-19 test); Sec. & Exch. Comm’n v. Applied BioSciences Corp., No. 20-cv-03729 (S.D.N.Y. filed May 14, 2020) (company fraudulently represented it was offering products to combat COVID-19); Sec. & Exch. Comm’n v. Praxsyn Corp. and Frank J. Brady, No. 20-cv-80706 (S.D. Fla. filed Apr. 28, 2020) (company misrepresented that it was able to acquire large quantities of N95 masks).

Class Certification Determines the Course of 10b Litigation

Class action securities fraud lawsuits that are not dismissed at the pleading stage or denied class certification typically settle. See Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 163 (2008); Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258, 296 (2014). Therefore, the parties expend significant effort and resources to prosecute or defend these class actions at the class certification stage.

In the context of section 10(b) claims, one focus of class certification is whether common questions of law or fact predominate in the case, which often turns on the element of reliance. Halliburton Co., 573 U.S. at 258 (to prevail on a section 10(b) claim for securities fraud, a plaintiff must prove, among other things, reliance on the misrepresentation or omission). Under the judicially created “fraud-on-the market” theory, plaintiffs do not have to prove individualized reliance by each member of the proposed plaintiff class; instead, they may invoke a rebuttable presumption of reliance if they prove, inter alia, that the stock traded in an efficient market. Basic Inc. v. Levinson, 485 U.S. 224, 242 (1988).

Lack of Price Impact Bars Class Certification

The controlling determination of whether the market was efficient is whether the misrepresentation caused a price impact. Villella v. Chem. & Mining Co. of Chile Inc., 333 F.R.D. 39 (S.D.N.Y. 2019). An efficient market may be proven through indirect evidence vis-à-vis the fraud-on-the-market theory, or by direct evidence, through “event studies”—regression analyses that show whether the market price of the defendant’s stock tends to respond to relevant publicly reported events or information. Halliburton Co., 573 U.S. at 280. Event studies are superior evidence of reliance because while the fraud-on-the-market theory is an indirect proxy of price impact, event studies are direct, salient evidence that an alleged misrepresentation did or did not actually affect the stock price. Id. In fact, some courts have rejected outright testimony or reports from damage experts who did not conduct an event study. In re Imperial Credit Indus., Inc. Sec. Litig., 252 F. Supp. 2d 1005, 1015 (C.D. Cal. 2003); In re N. Telecom Ltd. Sec. Litig., 116 F. Supp. 446, 460 (S.D.N.Y. 2000); In re Exec. Telecard, Ltd. Sec. Litig., 979 F. Supp. 1021, 1025 (S.D.N.Y. 1997). Therefore, while plaintiffs and defendants are not required to prove or disprove reliance at class certification through direct evidence, plaintiffs and defendants often rely on event studies due to the credibility given them. Halliburton Co., 573 U.S. at 280 (before class certification, defendants are entitled the opportunity to defeat the presumption that the stock price reflected material misrepresentations by offering evidence of a lack of price impact to show market inefficiency).

Event Studies Prove Price Impact or Lack Thereof

Event studies, created by financial economists to measure the relationship between stock prices and various events, differentiate between price fluctuations that reflect the range of typical variation for the stock and a highly unusual price impact that occurs immediately after an event and has no other potential causes. Event studies are statistical regressions that model the normal distribution of a stock’s price from the date of the misrepresentation or omission to the date of the corrective disclosure, using historical data. After the regression establishes the normal distribution of the stock’s price changes for the relevant period, the regression applies a 95 percent confidence level, or 5 percent statistical significance level, to determine the range of normal stock price changes for the relevant period. Any stock price changes outside the 95 percent confidence interval are deemed “abnormal” and constitute a sufficient price impact for the purposes of section 10(b) securities fraud actions. See Erica P. John Fund, Inc. v. Halliburton Co., 309 F.R.D. 251, 260 (N.D. Tex. 2015). Conversely, stock price changes that fall within the 95 percent confidence interval are deemed insufficiently abnormal for purposes of section 10(b) and warrant denial of class certification because the plaintiffs failed to establish that the stock price incorporated the alleged misrepresentation or omission (and thus the market was inefficient). Id.

Stock Market Volatility Drives Event Studies Results

Ninety-five percent confidence intervals for normal distributions are derived by multiplying the applicable standard deviation (SD) by 1.96 and then adding this sum to the mean and subtracting this sum from the mean to produce the applicable range of normal values. Fluctuations in the company’s stock price, stock indexes, and comparable companies’ stock prices during the relevant period collectively determine the applicable standard deviation for the normal distribution. This standard deviation is then used to calculate the 5 percent statistical significance threshold for determining which stock price changes are sufficiently abnormal. Therefore, volatile markets yield a very high threshold for establishing an abnormal price impact, whereas stable markets yield a low threshold for establishing an abnormal price impact. Simply put, the ability to demonstrate abnormal price impact is highly dependent on stock market volatility. To see more, view this graph.

The Volatile Stock Market in 2020 Precludes Plaintiffs from Proving Price Impact

The COVID-19 pandemic, widespread protests for racial justice, and the presidential election precipitated an extremely volatile stock market this past year. For example, for the period from February 1, 2020, through October 31, 2020, the mean and standard deviation for the S&P 500 Index was $3,121.05 and $294.09, respectively. For the period from February 1, 2019, through October 31, 2019, the mean and standard deviation for the S&P 500 Index was $2,897.16 and $84.35, respectively. Year over year, the standard deviation of the S&P 500 multiplied almost threefold from 2019 to 2020. By way of a second example, the CBOE Volatility Index (VIX) is shown in these charts, for 2019 and 2020. VIX represents the market’s expectation of 30-day forward-looking volatility, which is the statistical measure of the degree of variation in the trading prices of stocks observed over a period of time.

The 2020 stock market volatility, as a practical matter, eradicates plaintiffs’ ability to prove price impact and survive challenges to class certification. Although plaintiffs may prove market efficiency, and thus reliance, indirectly through the fraud-on-the-market theory without producing event studies, defendants are permitted to rebut the presumption of reliance at the class certification stage by introducing direct or indirect evidence showing the market was inefficient during the relevant period. Halliburton Co., 573 U.S. at 258. Importantly, courts have held that while defendants have the burden of production and the burden of persuasion to rebut the presumption of reliance, defendants do not have to affirmatively disprove plaintiffs’ allegations significantly. Id. Rather, defendants have only to present evidence sufficient to persuade the court that their own evidence of the absence of price impact is more persuasive than the plaintiffs’ affirmative evidence of price impact. Id.; Erica P. John Fund, Inc., 309 F.R.D. at 262; IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 783 (8th Cir. 2016); In re Allstate Corp. Sec. Litig., 966 F.3d 595, 608–9 (7th Cir. 2020).

Plaintiffs in Pending Class Actions Implicitly Acknowledge This Insurmountable Hurdle

The plaintiffs who filed complaints in 2020 implicitly acknowledged this incredible hurdle to recovery in this unprecedented time. These plaintiffs have chosen to depart from common practice and omit event studies from their complaints altogether, instead alleging and relying solely on the fraud-on-the-market theory to indirectly prove reliance. Service Lamp Corp. Profit Sharing Plan v. Carnival Corp., No. 1:20-cv-22202 (S.D. Fla. filed May 27, 2020); Thomas Altomare v. Royal Caribbean Cruises Ltd., No. 1:20-cv-24407 (S.D. Fla. filed Oct. 27, 2020); John P. Elmensdorp v. Carnival Corp., No. 1:20-cv-22319 (S.D. Fla. filed June 3, 2020); Robert Lucas v. United States Oil Fund, LP, No. 1:20-cv-04740 (S.D.N.Y. filed June 19, 2020); Momo Wang v. United States Oil Fund, LP, No. 3:20-cv-04596 (N.D. Cal. filed July 10, 2020).

This shift in pleading strategy highlights the difficulty that securities fraud plaintiffs face in establishing the necessary elements for class certification. Except in extraordinary cases, these plaintiffs, like many to come, likely will be denied class certification, and the class allegations in these cases will be subject to dismissal.