The Second Circuit recently held that, even if a stock recovers its value after dropping following a corrective disclosure, this does not necessarily negate a showing of loss causation at the pleading stage in a claim for securities fraud. See Acticon AG, et al. v. China North East Petroleum Holdings Ltd., et al., No. 11-4544-cv (2nd Cir., August 1, 2012). A copy of the decision is available here.
In Acticon, the plaintiffs filed a class action complaint for securities fraud against China North East Petroleum (“NEP”). Plaintiffs alleged that NEP inflated its oil reserves and engaged in improper accounting practices. They also alleged that NEP’s former CEO embezzled funds. The Complaint alleged that this information gradually became public: NEP announced withdrawal of its financial statements, temporary delisting from the NYSE, deficiencies in internal auditing controls, downward estimate of earnings, and finally, resignation of certain members of management for financial improprieties. When the stock resumed trading, its price dropped nearly 20% on very high volume.
However, the price subsequently recovered that value. On that basis, the District Court granted defendants’ motion to dismiss. The court cited previous district court decisions holding that “a purchaser suffers no economic loss if he holds stock whose post-disclosure price has risen above purchase price – even if that price had initially fallen after the corrective disclosure was made.”
The Second Circuit overturned the District Court’s ruling. At issue was application of the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). As the Second Circuit explained, Dura held that a plaintiff claiming securities fraud could not simply plead 1) that a misrepresentation was made; 2) that he purchased the stock at one price; and 3) that the price later fell. The fact that the price subsequently fell does not demonstrate that the plaintiff did not receive equivalent value at the time of purchase. The price may have fallen for other reasons, due to subsequent events, and not because it was artificially inflated at the time of purchase. The plaintiff must plead facts tying the price drop to the earlier misrepresentation – ordinarily, this is accomplished by showing a close temporal proximity between a “corrective disclosure” of the earlier misrepresentation and a drop in the stock price.
The Second Circuit noted that, in Acticon, the plaintiffs pled exactly that: various improprieties were disclosed, and then the stock immediately dropped steeply at its first opportunity following those disclosures. The subsequent rebound in the share price could mean that the market was ultimately unfazed by the disclosures; on the other hand, observed the Second Circuit, the stock could have subsequently risen for unrelated reasons. At the pleading stage, the court must construe all facts in the plaintiffs’ favor and presume the latter explanation.
The District Court had agreed on that point. But the District Court adopted a broader view of Dura to hold that even if the purchase price was presumed to be inflated, plaintiff could still not establish an economic loss if the price subsequently recovered its value. The District Court cited another decision reasoning that “[i]f the current value is commensurate to the purchase price, there is no loss, regardless of whether the purchase price was artificially inflated.” (emphasis added).
But the Second Circuit disagreed with this reasoning, noting that it is inconsistent with the basic concept of out-of-pocket damages, as limited only by the PSLRA’s “bounce-back” provision. The “bounce-back” provision states that if the company’s stock regains its value within 90 days after the information correcting the misrepresentation was disseminated to the market, the plaintiff has no damages. Here, that provision evidently did not apply, because the stock’s rebound occurred well after the 90-day window. But the District Court held that the plaintiffs had no damages, anyway, because if the stock ever recovered its value while the plaintiffs continued to hold it, then there would be no loss, as a matter of law. The Second Circuit first held that this holding was inconsistent with the statutory “bounce-back” provision, which expressly limited any “bounce-back” credits to a 90-day window.
But the Second Circuit also went on to note that the District Court’s holding and the line of cases on which it relied conflicted, more fundamentally, with the concept of out-of-pocket damages. The Second Circuit’s critique of the underlying line of cases is worth quoting at length:
[A] share of stock that has regained its value after a period of decline is not functionally equivalent to an inflated share that has never lost value. This analysis takes two snapshots of the plaintiff’s economic situation and equates them without taking into account anything that happened in between; it assumes that if there are any intervening losses, they can be offset by intervening gains. But it is improper to offset gains that the plaintiff recovers after the fraud becomes known against losses caused by revelation of the fraud if the stock recovers value for completely unrelated reasons. Such a holding would place the plaintiff in a worse position than he would have been absent the fraud. Subject to the bounce-back limitation imposed by the PSLRA, a securities fraud action attempts to make a plaintiff whole by allowing him to recover his out-of-pocket damages, that is, the difference between what he paid for a security and the uninflated price. In the absence of fraud, the plaintiff would have purchased the security at an uninflated price and would have also benefitted from the unrelated gain in stock price. If we credit an unrelated gain against the plaintiff’s recovery for the inflated purchase price, he has not been brought to the same position as a plaintiff who was not defrauded because he does not have the opportunity to profit (or suffer losses) from ‘a second investment decision unrelated to his initial decision to purchase the stock.’
In other words, the Second Circuit revealed this case to be another example of courts becoming bogged down in the formulaic elements of securities fraud claims and in the process losing track of the logic underlying those elements. The point of the “loss causation” element is to identify the loss plaintiff has suffered specifically because of the fraud committed by the defendant – the amount which, if recovered, would make the plaintiff whole. With that logic in mind, a subsequent, post-disclosure recovery of the stock price – presuming, as the court must at the pleading stage, that the recovery is for unrelated reasons – does not negate loss causation. If the defendant had not inflated the initial purchase price, the plaintiff would have paid less for the stock at the outset, and then still would have captured the benefit of the subsequent, unrelated rise.
The Second Circuit’s ruling in Acticon eliminates a weapon from the defendants’ arsenal on a motion to dismiss, and as such works against defendants. But a “long view” of Acticon may be more positive for defendants. While in this case, the district court’s formulaic decision worked in defendants’ favor, in many cases it is plaintiffs that use the formulas and theories of securities fraud to stretch liability. Keeping securities law grounded in first principles generally works in defendants’ favor. For example, suppose that instead of recovering, NEP’s stock dropped more over the ensuing months following the initial 20% drop. In that case, defendants would – rightly – argue that those drops were caused by unrelated market forces and are unrecoverable in the securities fraud action. The Second Circuit itself hinted at this scenario with the words “(or suffer losses)” in the quote above. Other examples are arguable over-extension of the “fraud-on-the-market” doctrine and accessory liability.