Shareholder damages in securities litigation
Securities litigation can prove costly to public companies, particularly when shareholders band together in class actions to accuse companies and their boards of directors of inflating their stock prices through material misrepresentations or omissions.
The calculation of damages in securities fraud cases can be complicated and vulnerable to attack by opposing parties.
Evaluate the options
The Securities Exchange Act of 1934 doesn’t directly address the issue of calculating damages. Case law, however, has established that shareholders generally can recover the least of:
Out-of-pocket damages: the difference between any price inflation when the share was purchased and any price inflation that remained when the share was sold. “Price inflation” is defined as the difference between the actual stock price and its “true value,” or the price it would have sold absent the alleged misrepresentation or omission.
Losses caused by the misrepresentation or omission: the actual decline in the price of shares purchased after an alleged misrepresentation or omission, resulting from corrective disclosure of the information previously misrepresented or omitted.
Statutory limit: The Private Securities Litigation Reform Act of 1995 specifically limits a plaintiff’s damages. Awards can’t exceed the “difference between the purchase or sale price paid or received, as appropriate, by the plaintiff for the subject security and the mean trading price … during the 90-day period beginning on the date on which the information correcting the [misrepresentation] that is the basis for the action is disseminated to the market.”
Regardless of the damages theory employed, a financial expert must establish loss causation. As the U.S. Supreme Court explained in Dura Pharmaceuticals, Inc. v. Broudo, an inflated purchase price alone normally doesn’t constitute or approximate the relevant economic loss. After all, if the purchaser sells the shares quickly, before the relevant truth begins to leak out, the alleged misrepresentation or omission won’t have led to any loss.
According to the Court, a loss can occur only after a corrective disclosure. Even then, the lower price could reflect not only the earlier misrepresentation or omission but also changed economic circumstances, investor expectations or other events. A plaintiff, therefore, must show that revelation of the truth caused the loss. In other words, recoverable damages are limited to the part of the price inflation that disappears after the corrective disclosure.
Measure price inflation
Financial experts generally use three approaches to determine price inflation: 1) constant dollar, 2) constant percentage, and 3) constant index methods. All assume the price after corrective disclosure represents the true value.
Under the constant dollar method, the expert uses the change in stock price after the corrective disclosure to calculate the price inflation for each day prior to the disclosure. This method is well suited for short damages periods with little expected fluctuation in the overall securities market.
With the constant percentage method, the expert uses the percentage change in stock price after the corrective disclosure as a percentage measure of the price inflation for each day prior to the disclosure. This method has been criticized after the Dura Pharmaceuticals decision for allowing damages for in-and-out traders who bought shares during the relevant period but sold before the disclosure, as well as for allowing different damages for shareholders with the same losses. Critics also point out that this method allows shareholders who sold after disclosure to recover for inflation that occurred before the disclosure.
The index method assumes that the true value from the time of the misrepresentation or omission through the corrective disclosure would have moved in the same proportion as a selected market index (for example, the S&P 500). This method has been subject to similar criticisms as the constant percentage method.
Not surprisingly, loss causation and stock price inflation are usually the targets of heated debate — and they aren’t the only contentious damages issue in securities litigation. In class actions, for example, you could also face thorny questions related to the estimation of aggregate damages. Your advisor can help you navigate these and other complexities related to shareholder damages.
Benchmarking against comparable stocks: The role of event studies
When computing shareholder damages in securities litigation, financial experts often use models that rely on event studies. An event study examines stock price movements at the time of the misrepresentation or omission, at the time of the corrective disclosures, or both.
The expert typically determines the point at which the misrepresentation or omission allegedly affected the stock price. He or she then establishes a performance benchmark based on the performance of a comparable security during the relevant period. The benchmark reflects the rate of return that the stock would have experienced but for the misrepresentation or omission. By comparing the stock’s performance with the benchmark for a given day, the expert can estimate the stock’s price inflation.
Further analysis is needed, though. The expert must isolate price movements caused by the misrepresentation from those caused by other influences, such as other additional negative news released at the time of the misrepresentation.