Securities Law - Second Circuit accepts Rule 10b-5 pleading of economic loss after share-price recovery.

• Author: Alexander, James M.
• Position: Case note

Securities Law--Second Circuit Accepts Rule 10b-5 Pleading of Economic Loss After Share-Price Recovery--Acticon AG v. China North East Petroleum Holdings Ltd., 692 F.3d 34 (2d Cir. 2012)

Securities and Exchange Commission (SEC) Rule 10b-5 (1) provides the principal remedy for private investors ensnared in fraudulent securities transactions. (2) A successful pleading of a fraud-on-the-market claim under Rule 10b-5 requires a showing of actual economic loss caused by a fraudulently inflated price of a security purchased by the plaintiff. (3) In Acticon AG v. China North East Petroleum Holdings Ltd., (4) the

Court of Appeals for the Second Circuit considered whether a defrauded investor's unrealized opportunity to sell securities at a profit precludes the ability to prove economic loss under Rule 10b-5's fraud-on-the-market theory. (5) The Second Circuit held that a recovery in share price after the fraud was disclosed to the purchasers does not automatically defeat an inference of economic loss at the pleading stage. (6)

Between January and May of 2010, Acticon AG (Acticon) acquired a total of 60,000 shares in China North East Petroleum Holdings Limited (NEP) at an average price of $7.25 per share. (7) Acticon alleged in its complaint that after each acquisition of stock, NEP disclosed corrections to financial statements that the company had filed with the SEC prior to Acticon's purchases. (8) NEP issued its first allegedly corrective disclosure on February 23, 2010, when the company announced it was withdrawing its 2008 and 2009 financial statements due to purported accounting errors. (9) According to the complaint, NEP made its final corrective disclosure on September 1, 2010, when it filed restated financial reports that eliminated its entire originally reported profit margin. (10) Although Acticon held its NEP stock for several months after NEP's final disclosure, the company ultimately sold a portion of its 60,000 NEP shares by May 2011 at prices ranging from $3.50 to $6.33 per share. (11) However, on twelve separate occasions during the period between NEP's final corrective disclosure and Acticon's sale of NEP stock, NEP stock traded and closed higher than Acticon's purchase price of $7.25 per share. (12)

Acticon filed suit against NEP in the United State District for the Court Southern District of New York, alleging securities fraud under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5. (13) In the complaint, Acticon claimed NEP misled investors as to its financial viability and anticipated profits, and caused Acticon significant economic losses by repeatedly issuing corrective disclosures that prompted declines in NEP's share price. (14) On March 22, 2011, NEP filed a motion to dismiss for failure to state a claim, asserting that Acticon repeatedly passed on opportunities to realize a profit and therefore suffered no loss. (15) The district court sided with NEP, dismissing the case on the grounds that Acticon's prolonged holding and subsequent sale of NEP stock at a loss, combined with several foregone opportunities to sell the shares at a profit, resulted in a failure to show the requisite economic-loss element of securities fraud. (16)

The Great Depression and the decade that preceded it--a period of unprecedented growth in securities speculation, issuance, underwriting and investment in the United States--provided the impetus for the federal legislation that is the basis of today's securities laws. (17) The Securities Act of 1933 ('33 Act) requires extensive financial disclosures prior to issuing stock for sale to the public, while the Exchange Act mandates continual periodic disclosures by publicly traded securities issuers after their initial public tender offer. (18) In 1942, after a brief deliberation, the SEC promulgated Rule 10b-5, which would unintentionally become the chief remedy for defrauded investors of private securities. (19) Because Rule 10b-5's private right of action arose from judicial construction, the development and refinement of its elements has taken considerable time and generated voluminous litigation. (20) By the early 1970s, the increasing role of Rule 10b-5 in abusive, meritless complaints prompted the United States Supreme Court to take action in a slew of decisions that dramatically curtailed the ability of private parties to sue under Rule 10b-5. (21) In 1988, however, the Court decided Basic Inc. v. Levinson, (22) signaling a significant departure from previous limitations on Rule 10b-5 liability by adopting a presumption of reliance under the fraud-on-the-market theory. (23)

After Basic, the sheer volume of Rule 10b-5 litigation and the damages alleged per lawsuit increased dramatically. (24) In the decade following Basic, the abundance of securities-fraud class actions engendered more scholarly and judicial criticism of Rule 10b-5's implied private remedy than ever before. (25) In 1995, Congress stepped in and passed the Private Securities Litigation Reform Act (PSLRA)--the first legislatively imposed limits on Rule 10b-5's judicially-created cause of action. (26) Among its many reforms, the PSLRA raised the pleading standards for Rule 10b-5 claims by requiring plaintiffs to demonstrate and prove loss causation. (27) Over several years following PSLRA's enactment, the circuits eventually developed two conflicting applications of the statutory requirements of well-pleaded loss causation. (28) In 2005, the Supreme Court addressed the circuit split head-on in Dura Pharmaceuticals, Inc. v. Broudo, (29) when the Court unanimously held that an allegation of an inflated purchase price does not alone constitute a sufficient pleading of loss causation in a fraud-on-the-market complaint. (30)

In Dura, the Court put to rest the issue of inflated purchase prices serving as a basis of private actions for securities fraud, but the Court's narrow holding led to confusion in the lower courts over the circumstances that may constitute a showing of actual economic loss under the PSLRA. (31) Indeed, the lower courts have cited Dura and its reasoning in widely divergent situations, including those in which a complainant failed to avoid significant financial loss by retaining its holdings in a company when an opportunity to sell the securities for a profit arose after the fraud on the market had been publicly disclosed. (32) These courts have equated their treatment of post-disclosure recoveries in share price with the Supreme Court's rejection of fraudulently inflated purchase prices as a complaint's sole allegation of economic loss. (33) Since the PSLRA embedded the element of loss causation in Rule 10b-5 claims, the Supreme Court's decision in Dura has served as the only interpretive precedent of the statute, leading to several district court rulings concluding that evidence of post-fraud-disclosure recovery in share price renders any allegation of economic loss insufficient in fraud-on-the-market suits under Rule 10b-5. (34)

In Acticon AG v. China North East Petroleum Holdings Ltd., the Second Circuit considered whether a Rule 10b-5 plaintiff that forgoes several post-disclosure opportunities to profit by selling its shares above the purchase price may allege legally sufficient economic loss. (35) The court framed its discussion of economic loss by reviewing the measure of damages applicable in Rule 10b-5 cases, which, according to the court, included both the judicially established out-of-pocket calculation method as well as the PSLRA's statutorily created limitations. (36) In Acticon, the court reasoned that neither the "bounce-back" provision in the PSLRA nor the Supreme Court's holding in Dura had altered the traditional out-of-pocket measure of damages and, as such, any pleading requirement based on damages--that is, economic loss--must also be consistent with the out-of-pocket framework. (37) In its declaration that the difference between a security's predisclosure "value" and its purchase price is recoverable under Rule 10b-5, the Second Circuit discussed the unique qualities of stock ownership and the inherently inequitable consequences of disallowing the entire class of Rule 10b-5 claims that involve post-disclosure recoveries in share price. (38) The appellate panel also characterized the district court's analysis as overly simplistic, arguing that offsetting post-fraud-disclosure gains in share price against the actual losses Acticon had experienced as a direct result of NEP's allegedly fraudulent activity would have placed Acticon in a worse position than if the fraud had never occurred. (39) The Second Circuit went on to hold that evidence of share price recovery does not necessarily negate an inference of economic loss at the pleading stage of Rule 10b-5 claims. (40)

The Acticon court correctly ruled that share price recovery does not preclude a successful demonstration of economic loss. (41) Nevertheless, by asserting that the district court's measure of damages is inconsistent with PSLRA's bounce-back provision, the court left its holding vulnerable to attack on precisely the same grounds. (42) On one hand, the Second Circuit stressed the possibility that stock prices may increase while the negative effects of corrective disclosures simultaneously run their course. (43) On the other hand, the court also stressed that day-to-day market volatility should not be used to skew the calculation of available damages by citing the PSLRA's use of the mean trading price over the ninety-day period as the benchmark for Rule 10b-5 damages to bolster its point. (44) The incongruity of these assertions is apparent if one considers the practical scenario in which public revelation of a securities fraud negatively impacts the stock's immediate closing price, yet entirely unrelated forces ultimately result in a mean trading price that is greater than the plaintiff's purchase price. (45) Here, the PSLRA's bounce-back provision would...