False Statements Confirming Misinformation Already in Market Are Actionable under 10b-5 — Circuit Split

Findwhat Investor Group v. Findwhat.com, 2011 U.S. App. LEXIS 19887 (11th Cir. Sept. 30, 2011):

In opposing summary judgment, the Plaintiffs relied on the expert report of Dr. Hakala as evidentiary support for both loss causation and damages. The Defendants expressly assumed the admissibility of Dr. Hakala's report for purposes of their summary judgment motion..... Dr. Hakala conducted an "event study" to demonstrate loss causation and to estimate damages.... "An event study . . . is a statistical regression analysis that examines the effect of an event[, such as the release of information,] on a dependent variable, such as a corporation's stock price." United States v. Schiff, 602 F.3d 152, 173 n.29 (3d Cir. 2010) (internal quotation marks and alteration omitted). As acknowledged by the Defendants' expert, event studies are a "common method" of establishing loss causation, "used routinely in the academic literature to determine whether the release of particular information has a significant effect on a company's stock price." ***

Footnote 31. Event studies can be used to determine retrospectively the cause of a stock price movement. The analyst first estimates a "predicted return," based on the firm's average return during a control period as well as on market and industry factors. If the actual stock price moves differently than the predicted return, the analyst then determines whether such "abnormal returns" are the result of chance or are instead statistically attributable to the information release. See In re Williams Sec. Litig., 496 F. Supp. 2d 1195, 1272 (N.D. Okla. 2007); Allen Ferrell & Atanu Saha, The Loss Causation Requirement for Rule 10b-5 Causes of Action: The Implications of Dura Pharmaceuticals, Inc. v. Broudo, 63 Bus. Law. 163, 167 (2007). The methodology of event studies has been sustained by many circuits. See, e.g., Archdiocese of Milwaukee, 597 F.3d at 341 (noting that event studies "demonstrate[] a linkage between the culpable disclosure and the stock-price movement"); Schiff, 602 F.3d at 173-74 & nn.29-31 (accepting as reliable under Daubert, 509 U.S. 579, an event study that linked a stock price drop with the revelation of fraud, for purposes of establishing materiality); Schleicher, 618 F.3d at 684 (affirming class certification based on expert's event study).

Through his event study, Dr. Hakala concluded that MIVA's stock price was inflated by 26.44 percent before and throughout the Class Period due to the false information in the marketplace that MIVA did not rely on click fraud to boost revenues. Dr. Hakala also concluded through his event study that immediately after the Company finally revealed the truth about its heavy reliance on click fraud on May 5, 2005 — admitting in an investor conference call that "a couple" of MIVA's distribution partners had been employing "capabilities . . . to get additional traffic that just simply don't adhere to our standards" *** — the inflation in MIVA's stock price dissipated, causing substantial losses to Class Period investors. *** Dr. Hakala excluded other possible explanations for the price drop following the May 5, 2005 disclosure, concluding that "the primary if not exclusive reason for the [price] drop [on May 5-9, 2005] was related to . . . the subject matter of the fraud . . . . [T]he confounding information in my analysis could not account for the drop -- did not account for the drop . . . ." *** Reasoning that Class Period investors would not have suffered those losses if the Company had disclosed the truth at the beginning of the Class Period instead of at the end, Dr. Hakala estimated total Class Period damages to be $22.24 million. ***

Even though the Plaintiffs purported to demonstrate that the market substantially devalued MIVA stock upon learning the truth about the Company's click fraud woes on May 5, 2005 — a devaluation that the Plaintiffs claim would have occurred at the start of the Class Period if only the truth had been revealed then — the district court concluded that the Plaintiffs' evidence was insufficient as a matter of law to demonstrate loss causation and damages. The district court explained its reasoning this way: "Dr. Hakala testified that the full amount of the alleged price inflation of the stock — 26.44% — existed . . . more than a year before either of the[se] statements . . . , and remained at that level after the statements at issue. Thus, the evidence from plaintiff establishes that the inflation in the stock price was caused by statements made prior to the class period in this case." In re MIVA, 2009 WL 3821146, at *5. In other words, the basic logic underlying the district court's grant of summary judgment is that, because the inflation in MIVA's stock price predated the Class Period, the statements made by the Defendants during the Class Period — even if knowingly and materially false or misleading — could not have "caused" the inflation, and therefore could not have "caused" the Plaintiffs' losses. This reasoning misapprehends the nature of market fraud.

Footnote 32. The analysis also appears to conflate the concepts of reliance and loss causation — two distinct elements of a Rule 10b-5 claim. As noted above, reliance polices the front-end causation question of whether the defendant's fraud in fact inflated the plaintiff's purchase price, while loss causation polices the back-end causation question of whether the fraud-induced inflation in the plaintiff's purchase price ultimately caused financial losses. To the extent the district court concluded that the Defendants' fraud did not affect the purchase price the Plaintiffs paid — because the inflation in the price predated the fraudulent statements — this appears to be a conclusion drawn about reliance, not loss causation. Indeed, the Court in Basic presaged the Defendants' argument here and expressly placed it under the rubric of reliance, saying that fraud-on-the-market defendants may rebut the presumption of reliance by showing that "the misrepresentation in fact did not lead to a distortion of price." 485 U.S. at 248. This appears to be essentially what the Defendants argued and the district court accepted, albeit using the language of loss causation. On remand, the parties should clarify their causation arguments, and specify whether their dispute actually goes to reliance or loss causation.

The district court erroneously assumed that simply because confirmatory false statements have no immediate effect on an already inflated stock price in an efficient market, these statements cannot cause harm. But the inflation level need not change for new investors to be injured by a false statement. Fraudulent statements that prevent a stock price from falling can cause harm by prolonging the period during which the stock is traded at inflated prices. We therefore hold that confirmatory information that wrongfully prolongs a period of inflation — even without increasing the level of inflation — may be actionable under the securities laws. That is, defendants can be liable for knowingly and intentionally causing a stock price to remain inflated by preventing preexisting inflation from dissipating from the stock price. See Schleicher, 618 F.3d at 683-84 ("[Defendants are liable for securities fraud regardless of whether their] false statements (or . . . material omissions) propel the stock's price upward . . . [or] were designed to slow the rate of fall.").

Footnote 33. The Fifth Circuit appears to have rejected this view, holding that confirmatory information cannot be actionable. See Greenberg, 364 F.3d at 665 (stating that "confirmatory information cannot be the basis for a fraud-on-the-market claim"); see also Archdiocese of Milwaukee, 597 F.3d at 337 (explaining Greenberg as holding that confirmatory statements are not actionable because "[c]onfirmatory information is already known to the market and, having been previously digested by the market, will not affect the stock price"), cert. granted sub nom. Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 856 (2011) (addressing different issue). No other circuit has embraced this view. The rule also appears to conflict with the Fifth Circuit's own recognition in Nathenson v. Zonagen Inc., 267 F.3d 400 (5th Cir. 2001), that fraudulent information that confirms what the market already believes is actionable if it prevents the stock price from dropping to the level the market would set if the truth were revealed. ***

While we agree with the Fifth Circuit that confirmatory information will not likely move the market price at the time of its release — because the market already digested the information when it was first released — we do not agree that such confirmatory information can therefore never be actionable. If a company knowingly makes materially false representations with the purpose and effect of preventing the stock price from falling to the level that the truth would yield, the company is responsible for perpetuating inflation within the stock price. See Schleicher, 618 F.3d at 683 (holding that companies are liable for "stop[ping] a price from declining" because, "the fraud lies in an intentionally false or misleading statement, and the loss is realized when the truth turns out to be worse than the statement implied"); In re Cooper Sec. Litig., 691 F. Supp. 2d 1105, 1116 (C.D. Cal. 2010) (holding that a company can be liable for "caus[ing] artificial inflation to continue to be incorporated into the stock price, as opposed to revealing the truth, which allegedly would have caused the stock price to fall").

At bottom, it is irrelevant to securities fraud liability that the stock price was already inflated before a defendant's first actionable misrepresentation; fraudulent misstatements that prolong inflation can be just as harmful to subsequent investors as statements that create inflation in the first instance. Inflation creates an ongoing risk of harm. Every investor who purchases at an inflated price — whether at the beginning, middle, or end of the inflationary period — is at risk of losing the inflationary component of his investment when the truth underlying the misrepresentation comes to light. Investors who quickly resell their stock during the inflationary period generally will not suffer any economic loss from the fraud, because, although they overpaid for their stock, they can recoup the amount they overpaid by selling at the same inflated price. See Dura, 544 U.S. at 342 ("[I]f . . . [a] purchaser sells the shares . . . before the relevant truth begins to leak out, the misrepresentation will not have led to any loss."). When the truth underlying the falsehood is finally revealed, however, the market will digest the new information and cease attributing the artificial inflation to the price. At that time, investors who purchased at inflated prices (and who still hold their stock) will suffer economic loss, because they will no longer be able to recoup the inflationary component of their purchase price by reselling their stock in the newly calibrated marketplace. See Schleicher, 618 F.3d at 684 ("People who buy the stock after the [fraudulent] announcement, and before the truth comes out, pay too much; they will lose money when the [concealed] bad news emerges.").

Because thousands of shares of stock are purchased each day, the longer that inflation remains within a stock price, the more shares that are purchased at inflated prices, and the more shares that stand to lose when the inflation subsequently dissipates from the price. Clearly then, a falsehood that endures within the marketplace for a longer period of time, all else being equal, will cause greater harm than one that endures for a shorter period of time. There is no reason to draw any legal distinction between fraudulent statements that wrongfully prolong the presence of inflation in a stock price and fraudulent statements that initially introduce that inflation. See In re Cooper, 691 F. Supp. 2d at 1116 (denying summary judgment to defendants on loss causation grounds on the basis that "it [was] disputed as to whether the [defendants'] statements caused artificial inflation to continue to be incorporated into the stock price, as opposed to revealing the truth, which allegedly would have caused the stock price to fall" (emphasis added)); In re Scientific Atlanta, Inc. Sec. Litig., 754 F. Supp. 2d 1339, 1380 n.12 (N.D. Ga. 2010) ("Plaintiffs argue persuasively that the class period inflation includes . . . the pre-class period inflation that would have been removed from the stock price had [the company] accurately provided information about [the relevant truth at the start of the class period]."); In re Bristol-Myers Squibb Sec. Litig., No. Civ.A. 00-1990(SRC), 2005 WL 2007004, at *17 (D.N.J. Aug. 17, 2005) (stating, in the materiality context, that "it is conceivable that [an affirmative] misstatement could serve to maintain the stock price at an artificially inflated level without also causing the price to increase further").

Footnote 34. Cf. Matrixx Initiatives, 131 S. Ct. at 1313-16 (holding that plaintiffs had adequately pled a Rule 10b-5 claim — where defendant had disputed the sufficiency of the allegations with respect to the elements of scienter and materiality — by alleging that defendant had forestalled a stock price drop by making affirmative statements confirming the market's impression that defendant's leading product was safe, despite defendant's awareness of evidence suggesting a significant risk that the nasal spray led to loss of sense of smell; when the risk was finally (belatedly) disclosed, the stock price plummeted).

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