Second Circuit Holds That a Post-Disclosure Stock Price Rebound Does Not Per Se Preclude Damages for Alleged Federal Securities Fraud

Recently, the Second Circuit vacated a District Court’s dismissal of a securities fraud action brought by Acticon AG, shareholder of China North East Petroleum Holdings Ltd. (“NEP”), for failure to plead economic loss—a necessary element to maintain a private damages action under § 10(b) of the Securities Exchange Act of 1934 (“§10(b)”). Acticon had multiple opportunities to, but did not, sell its NEP shares at a profit after NEP’s disclosure of the alleged fraud. The Court held that economic loss is not conclusively negated at the pleadings stage where the price of a security recovers shortly after a disclosure of alleged fraud. Significantly, in drawing all reasonable inferences in favor of the plaintiff under NEP’s 12(b)(6) motion, the Court explained that a rise in the price of a stock following a corrective disclosure requires an inquiry into whether the security rose for “reasons unrelated to [the] initial drop,” and thus introduces factual questions and competing theories of causation that would be inappropriate to resolve on a motion to dismiss.

In support of its holding, the Second Circuit noted that §10(b) damages are traditionally determined by use of an “out-of-pocket” measure of damages. In other words, a defrauded buyer can only recover the excess of what was paid for a security over the true value of the security had there been no fraudulent conduct. For at least two reasons, the Court concluded that the lower court’s holding was at odds with the proper damages calculations for §10(b) securities fraud actions:

  • First, the limitation upon damages imposed by the lower court is inconsistent with the “out-of-pocket” measure of damages because it would “improper[ly] offset gains that a plaintiff recovers after the fraud bec[ame] known against losses cause[d] by the revelation of the fraud [even] if the stock recovers value for completely unrelated reasons.”
  • Second, based on legislative history of the “bounce back” provision of the Private Securities Litigation Reform Act (“PSLRA”), which caps the amount of damages in a securities fraud action to the difference between the price paid by the plaintiff and the average trading price of the security during the 90-day period following the fraud, the Second Circuit concluded that Congress intended to limit damages only to those losses caused by the alleged fraud. Thus, the lower court’s dismissal was inconsistent with the PSLRA’s “bounce back” provision because it would, effectively, credit an unrelated (post-disclosure) gain in the price of the security against the plaintiff’s recovery.

In sum, Acticon AGstands for the proposition that a stock’s rebound, subsequent to a corrective disclosure, without more, will not negate the inference that a plaintiff has suffered an economic loss as a matter of law. Instead, courts must determine whether a corrective disclosure is unrelated to the increase in value of a given security. At the same time, courts must also account for and deduct from a plaintiff’s alleged damages any relevant price increases of a security originating from corrective disclosures. Effectively, securities fraud plaintiffs must embrace all news and analysis following a corrective disclosure—both positive and negative—to properly account for their “out-of-pocket” damages.

Paul A. Saso is a Director in the Gibbons Business & Comemrcial Litigation Department.
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