From Starr Foundation v. Am. Int’l Group, Inc., 2010 NY Slip Op 4526, 2010 N.Y. App. Div. LEXIS 4443 (1st Dep’t May 27, 2010):

At issue on this appeal is the legal sufficiency under New York law of a claim for fraudulent inducement to continue to hold, rather than sell, a large block of the common stock of defendant American International Group, Inc. (AIG), a publicly traded security. In a nutshell, the theory of the complaint (as amplified by affidavits and testimony offered in response to the motion to dismiss) is that plaintiff Starr Foundation (the Foundation), which was seeking to divest itself of most of the AIG stock that formed its original endowment, was induced to set an excessively high "floor price" ($ 65 per share) for the sale of the stock by public statements defendants made beginning in August 2007 that allegedly misrepresented (by minimizing) the degree of risk attached to AIG's large credit default swap (CDS) portfolio. Allegedly in reliance on these statements, the Foundation suspended its sales of the stock in October 2007, when AIG's share price fell below $ 65. But for defendants' misrepresentations, the Foundation claims, it would have set a lower floor price for selling its AIG stock and, as a result, would have accelerated its divestiture plan and sold all of its remaining AIG stock within two weeks. In fact, however, the Foundation ceased selling its AIG stock in October 2007, and therefore still held approximately 15.5 million AIG shares in February and March of 2008, when the value of AIG stock declined substantially as AIG reported billions in CDS losses due to the mounting number of defaults on real estate mortgages.

In this action, the Foundation apparently seeks to recover the value it hypothetically would have realized for its 15.5 million shares of AIG stock in the late summer or fall of 2007 had defendants at that time accurately disclosed the risk of AIG's CDS portfolio, less the stock's value after the alleged fraud ceased to be operative in early 2008. If the case were to go to trial, to establish liability and damages the Foundation would be required (in addition to proving the fraudulent nature of the statements complained of) somehow to come forward with a nonspeculative basis for determining how accurate disclosure of the risk of the CDS portfolio beginning in August 2007 — and such disclosure's hypothetical effect on the market at that time — would have affected the Foundation's decision to sell or retain its AIG stock and the amount it would have received for the stock it hypothetically would have sold. However, the Foundation's "holder" claim fails, as a matter of law, because it violates the "out-of-pocket" rule governing damages recoverable for fraud. ***

As should be evident from the foregoing summary of the allegations on which the claim is based, the Foundation is seeking to recover the value it would have realized by selling its AIG shares before the stock's price sharply declined in early 2008 due to the reporting of its CDS losses. Manifestly, such a recovery would violate New York's longstanding out-of-pocket rule, under which " [t]he true measure of damages [for fraud] is indemnity for the actual pecuniary loss sustained as the direct result of the wrong'" (Lama Holding Co. v Smith Barney, 88 NY2d 413, 421, 668 N.E.2d 1370, 646 N.Y.S.2d 76 [1996], quoting Reno v Bull, 226 NY 546, 553, 124 N.E. 144 [1919]). Such damages "are to be calculated to compensate plaintiffs for what they lost because of the fraud, not to compensate them for what they might have gained," and "there can be no recovery of profits which would have been realized in the absence of fraud" (Lama, 88 NY2d at 421; see also Reno v Bull, 226 NY at 553 ["The purpose of an action for deceit is to indemnify the party injured," and "(a)ll elements of profit are excluded"]).

This action is virtually the paradigm of the kind of claim that is barred by the out-of-pocket rule. As the Court of Appeals noted in Lama, under the out-of-pocket rule "the loss of an alternative contractual bargain . . . cannot serve as a basis for fraud or misrepresentation damages because the loss of the bargain was undeterminable and speculative'"***. Here, the Foundation seeks to recover the value it might have realized from selling its shares during a period when it chose to hold, under hypothetical market conditions for AIG stock (assuming disclosures different from those actually made) that never existed. A lost bargain more "undeterminable and speculative" than this is difficult to imagine.

[Footnote 3] It should be noted, however, that defendants go astray to the extent they may be arguing that a transaction in which a party realizes a profit can never form the basis for a fraud claim by that party. A plaintiff who is fraudulently induced to enter into a transaction in which he accepts something of less value than what he gives up can state a cause of action for fraud, even if that plaintiff happened to make a profit on the deal because what he received was of greater value than his cost basis in what he gave up. In the instant case, however, the Foundation seeks to recover the value it hypothetically might have received in a transaction that never took place.

The inconsistency of the Foundation's claim with the out-of-pocket rule emerges fully when one considers that the measure of damages under the rule is "the difference between the value of what was given up and what was received in exchange" ***. The Foundation does not allege any transaction in which it gave up anything in exchange for anything else. On the contrary, the Foundation complains that it was induced to continue holding its AIG stock for a certain period of time. In holding its stock, the Foundation did not lose or give up any value; rather, it remained in possession of the true value of the stock, whatever that value may have been at any given time. Thus, the Foundation did not suffer any out-of-pocket loss as a result of retaining its AIG stock. Further, the decline in AIG's share price for which recovery is sought was caused by the reporting of the company's massive CDS losses. Since the CDS losses would have been incurred regardless of any earlier misrepresentations AIG made concerning the risk of the CDS portfolio, such alleged misrepresentations could not have been the cause of the decline of AIG's stock price. In other words, the paper "loss" the Foundation seeks to recover in this action was caused by the underlying business decision of AIG's management to build up the CDS portfolio on which the losses reported in early 2008 were sustained, not by the earlier alleged misrepresentations forming the basis of the Foundation's complaint. ***

Notably, a federal district court applying Connecticut law dismissed a holder claim similar to that asserted by the Foundation on the ground that "the claims for damages based on the plaintiffs' failure to sell or hedge their stock are too speculative to be actionable" (Chanoff v United States Surgical Corp., 857 F Supp 1011, 1018 [D Conn 1994], aff’d 31 F3d 66 [2d Cir 1994], cert denied, 513 U.S. 1058, 115 S. Ct. 667, 130 L. Ed. 2d 601 [1994]). ***