The Inherent Ambiguity of Out-of-Pocket Damages in Securities Fraud Class Actions.

• Author: Booth, Richard A.

1. INTRODUCTION 319 II. DIRECT CLAIMS AND DERIVATIVE CLAIMS 326 III. ADVANTAGES (AND DISADVANTAGES) OF DERIVATIVE ACTIONS 328 IV. PRICE INFLATION REVISITED 333 V. IMPLICATIONS OF INVESTOR DIVERSIFICATION 333 VI. WHAT ABOUT DETERRENCE? 335 VII. ANOTHER THOUGHT 337 VIII. MARKET FAILURE AND THE PATH TO REFORM 338 IX. CONCLUSION 341 APPENDIX 343 I. INTRODUCTION

   To plead and prove a claim for securities fraud under federal law in connection with trading in publicly held securities, the plaintiff must show (among other things) (1) that investors were deceived by an agent of the defendant corporation who, in speaking to the market and acting with scienter, misrepresented or omitted a material fact, and (2) that such deception caused the claimed loss. (1)

   As the Supreme Court has ruled, it is not enough simply to prove (for example) that investors bought at a price inflated by deception. Rather, a plaintiff must show that market price reacted negatively to the revelation of the truth. (2) Thus, the law is clear that only the loss caused by deception--net of other causal factors--can be recovered by buyers. As the Supreme Court stated in Dura Pharmaceuticals, Inc. v. Broudo:

   [A]s 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. Moreover, the logical link between the inflated share purchase price and any later economic loss is not invariably strong.... When the purchaser subsequently resells such shares, even at a lower price, that lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price.... Given the tangle of factors affecting price, the most logic alone permits us to say is that the higher purchase price will sometimes play a role in bringing about a future loss. It may prove to be a necessary condition of any such loss, and in that sense one might say that the inflated purchase price suggests that the misrepresentation (using language the Ninth Circuit used) "touches upon" a later economic loss. But, even if that is so, it is insufficient. To "touch upon" a loss is not to cause a loss, and it is the latter that the law requires. (3) Thus, the law is quite clear that investors may recover only for the loss actually caused by deception. (4) Accordingly, the standard measure of recovery in a successful securities fraud class action (SFCA) under SEC Rule 10b-5 is often said to be one of out-of-pocket damages (OOP). (5) But few such cases have ever gone to trial. (6) Cases that survive a motion to dismiss almost always settle because of the threat of devastating liability. Thus, there is little case law about how to calculate OOPs.

   It could be argued that we do not really need to know how to calculate damages because few cases ever go to trial. Almost every case settles if it is not dismissed (or otherwise dispatched). (7) On the other hand, settlement negotiations are necessarily based on what the parties think they are likely to win or lose if a trial happens. Bargaining happens in the shadow of the law. Thus, the proper measure of damages matters. (8) The question is: What exactly do the courts mean by out-of-pocket damages?

   Intuitively, OOPs might seem to mean the difference between purchase price and market price after corrective disclosure. It seems only fair that buyers in a successful SFCA should be able to recover the difference between the too-high price they paid--because company agents had covered up negative information about the company (bad news)--and the price to which the stock fell when the truth came out. Indeed, Congress seems to have approved this measure of damages. Exchange Act [section]21D(a)(7)(b), which was adopted as part of the Private Securities Litigation Reform Act (PSLRA) of 1995, provides:

   [I]n any private action... in which the plaintiff seeks to establish damages by reference to the market price of a security, the award of damages to the plaintiff shall not exceed the difference between the purchase or sale price paid... by the plaintiff... 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. (9) Admittedly, this provision does not mandate that damages be measured by reference to market price following corrective disclosure. On the other hand, it clearly contemplates and permits the possibility of measuring damages so. But to measure investor loss in this way is fraught with problems.

   To be sure, when the truth comes out, stock price falls to reflect the new information. But this is not the end of the story. If there is reason to think that litigation will follow because company agents had earlier misrepresented the facts, then stock price will fall by some additional amount to reflect not only the new information but also the probable cost of fines, settlements, and added legal expenses. Moreover, stock price may fall by some additional amount because the market has lost trust in company management. In other words, the market may adjust the company's cost of capital upward to reflect the extra risk that information about the company may not be as reliable as it should be.

   There is no reason to think the market will wait to see if any of this comes to pass. Rather, there is every reason to think that market price will fall immediately upon corrective disclosure to reflect both the news that was covered up and the additional expenses attributable to the litigation that will follow--hereinafter collateral damage.

   Consider the following example:

   Acme Blasting Cap Corporation (ABC) generates earnings from operations of $1,000,000 per year. It has zero long-term debt and $2 million in cash in excess of the ordinary needs of the business. The company has 1,000,000 shares outstanding and a market capitalization of $12 million. Thus, the market assigns the company a 10% capitalization (discount) rate. In other words, the stock trades for $12 per share with EPS of $1.00 (ignoring any return from excess cash). A major customer cancels a big contract, and ABC management expects returns to fall to $800,000 for the year unless a new customer can be found in the meantime, which management thinks is a fifty-fifty possibility. If the cancellation is disclosed immediately, stock price should fall to $11 per share all other things equal, but ABC management does not disclose the bad news. Instead, the CEO in a regular conference call with investors and analysts reassures the market that the company expects to report earnings of $1.00 per share for the current year. Six months later the company reports earnings of $0.80 per share--having found no new customer. The market processes this earnings surprise quickly, concluding that it is likely that the company will be fined by the SEC and will be sued (successfully) by investors who bought during the six-month fraud period. As a result, the company will also suffer increased legal expenses. Thus, stock price falls not just to $10 but to $8 per share to reflect not only lower earnings but also the loss from the SEC enforcement action and private litigation likely to follow. It may also be that some of the additional decrease in price is due to the market assigning an increased cost of capital to the company because of a loss of trust in management. For example, a return of $1,000,000 per year at 10% COE is worth $10 million while the same return at 12% COE is worth $833,333. (10) So, what should be the measure of damages in this situation? Should a buyer who bought at $12 during the fraud period be able to recover the full $4 per share difference between the purchase price and the market price after corrective disclosure? Or should the buyer recovery be limited to the one dollar per share difference that would have resulted if management had told the truth in the first place?

   Some courts have been quite careful to describe the remedy as limited to the difference in price that should have been paid at the time of purchase. For example, as the Fifth Circuit has said:

   Congress has not specifically defined "economic loss" for purposes of a securities violation. It has provided an upper cap on damages. At the same time, the "out-of-pocket measure," sometimes called the "price inflation" metric, is often used. Under this theory, "a purchaser of securities may recover against a defendant... only the 'difference between the price paid and the "[true]" value of the security... at the time of the initial purchase by the defrauded buyer.'" (11) While our court has not held that this metric is the exclusive way to measure damages in [Rule] 10b-5 cases, we do insist that cognizable damage must be caused by the misstatements in question. That is, a loss does not constitute an "economic loss" for these purposes unless loss causation can be established. (12) Other courts have described the remedy as extending to the entire loss suffered by the buyer. For example, as the Second Circuit has said: Loss causation "is the causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff." (13) The PSLRA codified this judge-made requirement: "In any private action arising under this chapter, the plaintiff shall have the burden of proving that the act or omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff seeks to recover damages." (14) We have described loss causation in terms of the tort-law concept of proximate cause, i.e., "that the damages suffered by plaintiff must be a foreseeable consequence of any misrepresentation or material...