(Article from Securities Law Alert, December 2015)
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Fifth Circuit: Damages Based on a “Materialization of the Risk” Theory Cannot Be Measured on a Class-Wide Basis for Rule 23(b)(3) Purposes, as Required Under the Supreme Court’s Decision in Comcast
On September 8, 2015, in connection with a securities fraud action against BP arising out of the Deepwater Horizon oil spill, the Fifth Circuit held that damages based on plaintiffs’ “materialization of the risk” theory could not be measured on a class-wide basis, as required under the Supreme Court’s decision in Comcast Corp. v. Behrend, 133 S. Ct. 1426 (2013), because plaintiffs’ damages model required an “individualized inquiry” into whether each investor would have purchased BP stock had that investor known of the true risk of a major spill. Ludlow v. BP, P.L.C., 800 F.3d 674 (5th Cir. 2015) (Higginbotham, J.).
Plaintiffs contended that “BP [had] allegedly misstated the efficacy of its safety procedures, creating an impression that the risk of a catastrophic failure was lower than it actually was.” According to plaintiffs, when the risk materialized in the form of the Deepwater spill, investors who were “defrauded into taking on that heightened risk” were entitled to recover their losses as damages.
The Fifth Circuit found that the district court had properly concluded that plaintiffs’ damages theory “was not capable of class-wide determination” under Comcast. In Comcast, the Supreme Court held that “a model purporting to serve as evidence of damages in [a] class action must measure only those damages attributable to that theory” and must “establish that damages are susceptible of measurement across the entire class for purposes of Rule 23(b)(3).” Rule 23(b)(3) provides, in relevant part, that “questions of law or fact common to class members [must] predominate over any questions affecting only individual members.” The Fifth Circuit reasoned that plaintiffs’ “materialization of the risk” “theory hinge[d] on a determination that each plaintiff would not have bought BP stock at all were it not for the alleged misrepresentations—a determination not derivable as a common question, but rather one requiring individualized inquiry” into the specific risk tolerance of each investor.
The Fifth Circuit also rejected plaintiffs’ claim that under the fraud-on-the-market theory, the court had to “presume[ ]” that plaintiffs had relied on BP’s misrepresentations in purchasing the stock and that “‘the misrepresentations were a cause-in-fact of their losses.’” The court explained that the fraud-on-the-market theory set forth in Basic Inc. v. Levinson, 485 U.S. 224 (1988) “does not provide any presumptions with regard to loss causation—whether the misstatement caused the loss.”
Finally, the Fifth Circuit noted that the fraud-on-the-market theory “presume[s] reliance because (a) all information in an efficient market is priced into a security and (b) investors typically make investment decisions based on price and price alone.” Here, however, “plaintiffs’ own model assert[ed] that they [had] relied on something other than price: risk.” The Fifth Circuit determined that “plaintiffs’ argument thus undercut[ ] one of the rationales for the Basic presumption of reliance.”
Seventh Circuit: Plaintiffs Must Eliminate Firm-Specific Nonfraud Factors from the Leakage Model for Quantifying Loss Causation in Securities Fraud Actions
On May 21, 2015, the Seventh Circuit vacated a jury verdict finding HSBC and several of its executives liable for $2.46 billion in damages for securities fraud. Glickenhaus & Co. v. Household Int’l, Inc., 787 F.3d 408 (7th Cir. 2015) (Sykes, J.). Relying on the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), the Seventh Circuit held that defendants were entitled to a new trial because plaintiffs’ leakage model of loss causation[1] “did not adequately account for the possibility that firm-specific, nonfraud related information may have affected the decline in [HSBC’s] stock price during the relevant time period.”
The Seventh Circuit found that “in order to prove loss causation” under Dura, “plaintiffs in securities-fraud cases need to isolate the extent to which a decline in stock price is due to fraud-related corrective disclosures and not other factors.” The court noted that in Dura, the Supreme Court recognized that a stock price decline “may reflect, not the earlier misrepresentation, but [also] 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” (quoting Dura, 544 U.S. 336) (emphasis added by the Seventh Circuit).
The Seventh Circuit held that plaintiffs’ “leakage theory . . . did not adequately account for the possibility that firm-specific, nonfraud related information may have affected the decline in [HSBC’s] stock price.” The court found that “[t]he model assume[d] that any changes in [HSBC’s] stock price—other than those that [could] be explained by general market and industry trends—[were] attributable to the fraud-related disclosures.” In the event that “there was significant negative information [during the class period] about [HSBC] unrelated to these corrective disclosures (and not attributable to market or industry trends),” then the court determined that “the model would [have] overstate[d] the effect of the disclosures and in turn of the false statements.” Conversely, if “there was significant positive information about [HSBC]” during the class period, “then the model would [have] understate[d] the effect of the disclosures” (emphasis in the original).
The Seventh Circuit rejected defendants’ contention that “any loss-causation model must itself account for, and perfectly exclude, any firm-specific, nonfraud related factors that may have contributed to the decline in a stock price.” The court reasoned that “[i]t may be very difficult, if not impossible, for any statistical model to do this.” The court found that “[a]ccepting the defendants’ position likely would doom the leakage theory as a method of quantifying loss causation.” However, the court also recognized that “if it’s enough for a loss-causation expert to offer a conclusory opinion that no firm-specific, nonfraud related information affected the stock price during the relevant time period, then it may be far too easy for plaintiffs to evade the loss-causation principles explained in Dura.”
Finding neither option perfect, the Seventh Circuit adopted a “middle ground” position. The court found that “[i]f the plaintiffs’ expert testifies that no firm-specific, nonfraud related information contributed to the decline in stock price during the relevant time period and explains in nonconclusory terms the basis for this opinion,” then defendants must “identify[ ] some significant, firm-specific, nonfraud related information that could have affected the stock price.” If defendants cannot do this, then “the leakage model can go to the jury.” If defendants can identify any firm-specific, nonfraud factors that may have impacted the stock price, however, then the burden “shifts back to the plaintiffs to account for that specific information or provide a loss-causation model that doesn’t suffer from the same problem, like the specific-disclosure model.” The court observed that “[o]ne possible way to address the issue is to simply exclude from the model’s calculation any days identified by the defendants on which significant, firm-specific, nonfraud related information was released.”
[1] The leakage model assumes that “the information contained in a major disclosure event often leaks out to some market participants before its release.” The leakage model factors in “every difference, both positive and negative, between the stock’s predicted returns … and the stock’s actual returns during the disclosure period.” Relying on the leakage model, plaintiffs’ expert assumed that the effect of defendants’ disclosures was equal to “[t]he total sum of these residual returns.”