The Second Circuit's recent decision in Acticon AG v. China North East Petroleum Holdings Ltd.1appears to foreclose a defendant's ability, at the motion to dismiss stage, to use an increase in stock price following a corrective disclosure to refute a claim of economic loss, a required element for a damages claim under Section 10(b) of the Securities Exchange Act of 1934. The decision rejects reasoning previously applied by district courts, limiting the ability at the pleading stage to challenge allegations that a plaintiff has properly demonstrated loss causation.
Acticon AG (Acticon) brought a putative class action lawsuit in the United States District Court for the Southern District of New York against China North East Petroleum Holdings Limited (NEP), alleging violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. Acticon acquired shares in NEP between January and May of 2010. Acticon alleges that during that time NEP misrepresented information relating to reported earnings, internal controls, and oil reserves. A series of corrective disclosures relating to these alleged misrepresentations became public between February and September of 2010. Acticon sold some of its shares between December 2010 and May of 2011 at a loss. NEP moved to dismiss Acticon's claims, arguing, inter alia, a failure to demonstrate economic loss due to post-disclosure price recovery that caused the stock to close at a price higher than the average price Acticon spent acquiring NEP shares.
Section 10(b) and Rule 10b-5
Section 10(b) imposes civil liability against those individuals who, "use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange Commission] may prescribe as necessary or appropriate in the public interest or for the protection of investors."2 The SEC promulgated Rule 10b-5, implementing Section 10(b), and prohibiting "any untrue statement of a material fact or [. . . omission of] a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading."3 Pleading a claim under Section 10(b) and Rule 10b-5 requires factual allegations of "(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation."4
District Court's Ruling
NEP's motion to dismiss focused primarily on Acticon's alleged inability to demonstrate loss causation. In Dura Pharms., Inc. v. Broudo, the Supreme Court determined that loss causation requires proof of "the defendant's misrepresentation (or other fraudulent conduct) proximately caused the plaintiff's economic loss."5 Evidence that the share price "fell significantly after the truth became known" suffices at the pleading stage.6 As the district court noted, however, "[s]ince Dura, courts have held . . . that a purchaser suffers no economic loss if he holds stock whose post-disclosure price has risen above the purchase price €" even if that price had initially fallen after the corrective disclosure was made."7 The district court observed that Acticon could have sold its shares at a profit on twelve days between October and November 2010, a time when NEP's stock closed at a price higher than the average price at which Acticon purchased its NEP shares. As a result, the district court found Acticon's loss on sale of its NEP shares between December 2010 and May 2011 could not be attributed to any of NEP's alleged misrepresentations, despite the resulting loss, because "[a] plaintiff who forgoes a chance to sell at a profit following a corrective disclosure cannot logically ascribe a later loss to devaluation caused by the disclosure."8 Ultimately, the district court granted NEP's motion to dismiss after determining that the post-disclosure price increase negated Acticon's ability to demonstrate economic loss.
Second Circuit Decision
On appeal, the Second Circuit vacated the district court's ruling and remanded for further proceedings. The Court applied its understanding of the damages calculation in Section 10(b) cases to inform its reasoning.
Economic loss in Section 10(b) cases is determined through calculation of the "out of pocket" measure for damages. Using this mechanism, a purchaser is entitled to "the difference between the fair value of all that the [plaintiff] received and the fair value of what he would have received had there been no fraudulent conduct."9 As a further limitation, in the Private Securities Litigation Reform Act of 1995, Congress implemented a "bounce back" provision that caps available damages:
[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 for the subject security 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.10
This provision is intended to ensure that damages are reflective of the fraud, as opposed to events attributable to other market conditions.
The Second Circuit concluded that the district court's interpretation of loss causation was not in accord with either the "out of pocket" measure for damages, or the "bounce back" provision, thereby refuting the line of cases holding that a post-disclosure price rebound negates an inference of economic loss. The Court noted two problems with such reasoning. First, it found the reasoning employed in such cases unduly expanded upon Dura's analysis, leading to the erroneous belief that a "price fluctuation without any realization of an economic loss is functionally equivalent to the Supreme Court's rejection of an artificially inflated purchase price alone as economic loss."11 In the Second Circuit's view, such reasoning is inconsistent with the measure of damages employed for economic loss, which takes into account the impact of both price decrease and increase in its net calculation.
The Second Circuit also rejected the notion that a stock whose price increases after a period of decline is equivalent to an inflated share that has not lost value. According to the Court, such reasoning prevents the plaintiff from benefiting from an unrelated gain in stock price, and "it is improper to offset gains that the plaintiff recovers after the fraud becomes known against losses caused by the revelation of the fraud."12 Otherwise, according to the Second Circuit, a plaintiff would not benefit from "a second investment decision unrelated to his initial decision to purchase the stock" in the same manner as one who was not defrauded.13 In reaching its conclusion, the Court drew from the reasoning employed by the Eighth Circuit in Harris v. American Investment Company, which held a defrauded plaintiff is under no obligation to sell stock after learning of fraudulent conduct, even if that sale would result in a profit.14 Instead, the decision to retain the stock is a separate investment decision the plaintiff is entitled to make, a choice that should have no effect on the shareholder's ability to seek damages for economic loss.
As previously noted, the Supreme Court provided the framework for demonstrating loss causation in Dura Pharms., Inc. After Dura, it was evident that merely claiming price inflation at the time of purchase was insufficient to prove economic loss; the Court implied a need to show a causal connection through demonstration of a drop in share price following the corrective disclosure.
Therefore, one would not be remiss in thinking that a corresponding price increase following a corrective disclosure should also affect a court's analysis of economic loss. The Second Circuit's decision, however, limits the ability, at the motion to dismiss stage, to rebut an allegation of economic loss despite a price increase absent facts affirmatively demonstrating a price recovery that is not attributable to independent market factors. The decision shows that the Second Circuit is willing to consider gains to offset losses in limited circumstances.
Acticon may embolden plaintiffs to assert claims of loss causation despite evidence of a subsequent post-corrective disclosure stock price increase. But the Second Circuit's ruling does not mean that proof of price recovery following disclosure can never negate an inference of loss causation. A defendant who can demonstrate a causal relationship between the price recovery and the corrective disclosure may still obtain dismissal of the complaint. Furthermore, this defense may be more viable on a motion for summary judgment after further development of the record.
1. No. 11-4544-cv, 2012 WL 3104589 (2d Cir. Aug. 1, 2012).
2. 15 U.S.C. § 78j.
3. 17 C.F.R. § 240.10b-5(b).
4. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157 (2008
5. 544 U.S. 336, 346 (2005).
6. Id. at 347.
7. In re China North East Petroleum Holdings Ltd. Secs. Litig., 819 F. Supp. 2d 351 (S.D.N.Y. 2011); see also, Malin v. XL Capital Ltd., No. 03 Civ. 2001, 2005 WL 2146089 (D. Conn. Sept. 1, 2005).
8. In re China North East Petroleum Holdings Ltd., 819 F. Supp. 2d at 353.
9. Affiliated Ute Citizens v. U.S., 406 U.S. 128, 155 (1972).
10. 15 U.S.C. § 78u-4(e)(1).
11. Acticon AG, 2012 WL 3104589, at *6 (quoting Malin, 2005 WL 2146089, at *4).
13. Id. (quoting Harris v. Am. Inv. Co., 523 F.2d 220, 228 (8th Cir. 1975), cert. denied, 432 U.S. 1054 (1976)).
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