6 August 2012
The failure to allege economic loss and loss causation—essential elements of a securities fraud claim—should be fatal to a Rule 10b-5 complaint. In Rosado v. China North East Petroleum Holdings Ltd., et al., the US District Court for the Southern District of New York dismissed a putative class action on the ground that the complaint failed to adequately allege an actual economic loss as a matter of law where the company’s stock price rebounded shortly after the alleged fraud. The rebound, in the district court’s view, showed that the plaintiffs had suffered no economic loss despite the disclosure of the alleged fraud. The Second Circuit disagreed, reversing the district court and holding that stockholders may sue to recover losses from a company’s fraud even if the company’s stock price recovered shortly after the fraud was exposed.
On August 1, 2012, the three-judge panel reversed a decision by the district court disposing of claims by shareholders of China North East Petroleum Holdings Ltd. (China North). China North had been delisted from the New York Stock Exchange in May 2010, after various accounting issues forced it to withdraw its financial statements from 2008 and 2009 and revise its prior earnings downwards; its stock price plunged when it was ultimately relisted in September 2010.
The district court had dismissed the consolidated securities fraud action against China North for failure to plead economic loss as a matter of law, after finding that the lead plaintiff Acticon AG (Acticon) had forgone a number of opportunities in October and November 2010 to sell its shares at a profit. In granting China North’s motion to dismiss, the district court relied on a series of cases in the wake of Dura Pharm., Inc. v. Broudo, a 2005 US Supreme Court decision that held that a securities fraud plaintiff cannot claim economic loss simply because it purchased stock at an inflated price; the district court reasoned that “[s]ince Dura, courts have held as a matter of law 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.”
In rejecting the district court’s analysis, the Second Circuit held “that the fact that the price of the stock recovered soon after the price dropped does not negate an inference of economic loss and loss causation at the pleading stage” because it was not clear “whether the price rebounds represent[ed] the market’s reactions to the disclosure of the alleged fraud or whether they represent[ed] unrelated gains.” In other words, the Second Circuit held that “price recovery does not defeat an inference of economic loss” because it was not clear why China North’s stock price rose after its initial fall, and the court, at the pleading stage of the litigation, must draw all reasonable inferences in favor of Acticon by assuming that the price rose for reasons unrelated to its initial drop.
The Second Circuit emphasized that the district court’s approach defied longstanding precedent requiring application of the ”out-of-pocket” measure for damages, which amounts to the difference between what the shareholder paid for the shares and their actual value at the time of purchase. The Second Circuit explained that “a share of stock that has regained its value after a period of decline” (i.e., experienced a post-disclosure price rebound) “is not functionally equivalent to an inflated share that has never lost value” (i.e., does not demonstrate that there was no difference between the shareholder’s purchase price and the stock’s value at the time of purchase).
The Second Circuit further ruled that the district court’s holding contravened the “bounce back” provision in the Private Securities Litigation Reform Act of 1995 (PSLRA). The bounce back provision caps the amount of recoverable damages in a federal securities fraud action by taking into account the mean trading price of the security over a 90-day period, commencing when the fraud is revealed. The purpose of the provision is to limit damages to those losses caused by the fraud, not by other market conditions. The Second Circuit ruled that, aside from this statutory cap, “Congress did not otherwise disturb the traditional out-of-pocket method for calculating damages.” Therefore, by failing to abide by the PSLRA’s provision, the district court erred. In rejecting the limitation upon damages imposed by the district court, the Second Circuit not only reversed the decision below, but also put an end to the line of cases misconstruing Dura.
The Rosado case highlights some of the key issues that apply to allegations of economic loss and loss causation in securities fraud cases. While it does not foreclose looking at post-disclosure stock price movements to defeat allegations of economic loss, Rosado does make it more difficult to show the absence of economic loss or loss causation as a matter of law.