Monday, August 06, 2012

Price Recovery Did Not Negate Inference of Economic Loss

By Rodney F. Tonkovic and N. Peter Rasmussen

The 2nd Circuit concluded that that the price recovery of a stock soon after a drop did not defeat an inference of economic loss and loss causation at the pleading stage. In a class action suit against China North East Petroleum Holdings Limited (“NEP”), investors claimed the company misled investors about its earnings, oil reserves, and internal controls, and that these misrepresentations about its financial health and prospects artificially inflated the stock price. Acticon AG v. China North East Petroleum Holdings Ltd.

The truth was revealed through a series of corrective disclosures, and the stock price dropped in the trading days after each disclosure. NEP argued that the allegations were not sufficient to allege economic loss because its share price rebounded on certain days after the final disclosure to the point that the lead plaintiff could have sold its holdings and avoided a loss.

The district court granted NEP’s motion to dismiss for failure to plead economic loss based on a series of cases construing the Supreme Court’s Dura decision. The district court cited cases that “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.”

The district court relied in particular on a 2005 district court decision from Connecticut, Malin v. XL Capital Ltd. (DC Conn 2005, Civil No. 3:03cv2001 (PCD)). Initially, the appeals panel stated that the Malin court “correctly noted that the fact that the price rebounded does not, at the pleading stage, negate the plaintiff’s showing of loss causation.” The Malin court reasoned that determining why a stock’s price rebounded after an initial drop requires the court to consider factual issues of competing theories of causation which were not suitable for resolution on a motion to dismiss.”

Differing with the Malin court, however, the 2nd Circuit rejected the notion that under Dura, a rebound in stock price three months after the close of a class period negated an inference of economic loss. Initially, the appeals panel noted that the Dura holding “by its own terms, was quite limited,” and did not alter the traditional out-of-pocket measure for damages. Rather, stated the appellate court, Dura “merely clarified that a securities fraud plaintiff who purchased stock at an inflated purchase price must still prove that she suffered an economic loss, and that that loss was proximately caused by defendant’s misrepresentation.” In this case, the lead plaintiff “alleged something more than the mere fact that it purchased NEP shares at an inflated price; specifically, it alleges that the price of NEP stock dropped after the alleged fraud became known.”

The district court’s result would also be inconsistent, stated the court, with the PSLRA’s bounce-back damage provision, which refines the traditional measure by capping recovery based on the mean price over the look-back period. As described by the 2nd Circuit, Congress believed that calculating damages based on the date corrective information is disclosed “may substantially overestimate plaintiff’s actual damages." The statute was intended to limit damages to those losses caused by the fraud and not by other market forces. “Aside from imposing the `bounce back’ cap on recoverable damages, Congress did not otherwise disturb the traditional out-of-pocket method for calculating damages in the PSLRA,” concluded the 2nd Circuit.

The panel explained that “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,” because “it is improper to offset gains that the plaintiff recovers after the fraud becomes known against losses caused by the revelation of the fraud if the stock recovers value for completely unrelated reasons.” As described by the 2nd Circuit, this analysis takes two snapshots of the plaintiff’s economic situation and equates them without taking into account anything that happened in between. This approach assumes that if there are any intervening losses, they can be offset by intervening gains.

At this stage in the litigation, the panel was unable to determine whether the price rebounds represented the market’s reaction to the disclosure of the fraud or if they represented unrelated gains resulting from some other fact, condition, or event. The panel accordingly concluded that the recovery did not negate the inference that the investor suffered an economic loss.

The court found that it did not need to resolve what it described as an open question after Dura, whether plaintiffs must satisfy the “short and plain statement of the claim” standard under Federal Rule of Civil Procedure Rule 8(a)(2) or the more stringent heightened pleading requirements of Rule 9(b) in pleading economic loss. Because the court found that the price fluctuations in this case would not rebut an inference of economic loss under either standard, it was “unnecessary to resolve this issue at this time.”