Most securities fraud class actions under SEC Rule 10b-5 involve revelation of negative information about the defendant company that should have been disclosed earlier – bad news that (allegedly) has been covered up by company agents. The standard remedy in such cases is out-of-pocket damages (OOPs). But this measure of harm is inherently ambiguous. Some courts interpret it as price inflation at the time of purchase.[1] Others interpret it as the difference between the price paid and the price at which a stock settles after corrective disclosure.[2]
Although it might seem that these formulations are synonymous, the latter includes not only the difference in price that would have been paid if the truth had been known at the time of purchase, but also any additional difference that might be caused by the disclosure of the truth. For example, the market may conclude that the company is likely to become the target of an enforcement action or private securities litigation, and thus that the company is likely to suffer increased legal expenses (including possible fines and settlements). In addition, the company may suffer an increased cost of capital because the market perceives added risk that information about the company may be unreliable. These additional factors and possibly others – what I call collateral damage – will also be reflected in the decrease in price that occurs immediately upon corrective disclosure.
The U.S. Supreme Court quite clearly ruled in Dura Pharmaceuticals, Inc. v. Broudo that price inflation alone is not enough to establish loss causation, holding that a plaintiff must show that market price reacted to disclosure of the truth.[3] But that answer begs the question of how much of the loss can be said to be caused by the misrepresentation.
The question of how to calculate OOPs has become even more important with the growth in event-driven securities fraud class actions. For example, following the Deepwater Horizon explosion and spill, investors who had bought BP stock during the run-up to the event argued that BP (as operator of the rig) had misrepresented its safety practices and thus had deceived the market into underestimating the risk inherent in its business. When the explosion and spill occurred, the market allegedly discovered that BP had covered up some of the risk. Stock price fell, and plaintiffs sued to recover their losses. When the smoke cleared (so to speak), BP stock had lost about half of its value. Market capitalization had declined from about $120 billion to about $60 billion. In the end, BP paid out about $60 billion in direct expenses relating to the event. In other words, it could be argued that the entire decrease in BP stock price was attributable to collateral damage. While ordinarily the business judgment rule (in possible combination with an exculpatory charter provision) would preclude corporate recovery for such loss, fraud-period buyers would undoubtedly argue that their losses flowed from price inflation – even though subsumed within the $60 billion loss suffered by the company. In short, it matters a lot how we measure damages in a securities fraud class action.
As I show in a forthcoming piece, it is quite clear that collateral damage is harm suffered by the company that should be the subject of a derivative action – for the benefit of all stockholders – and not a direct (class) action.[4] The clear implication is that OOPs should be measured as price inflation at the time of purchase; that is, price inflation narrowly defined net of any collateral damage.
Indeed, because FRCP Rule 23 – which governs class actions – requires that a class action for damages be superior to any other means of resolving a dispute, Rule 23 itself requires that collateral damage be addressed in a derivative action simply because it can be so addressed.
Although there is little doubt that the law requires collateral damage to be litigated in a derivative action, there is no doubt that this result is a radical departure from the prevailing practice. In a securities fraud class action, the company pays and buyers recover. In a derivative action, the company recovers from the individuals responsible for the loss – presumably directors and officers. It is equivalent to a pick-six in football. Indeed, in the Deepwater Horizon case, it could be that investors who bought BP stock during the alleged fraud period would have little or no claim remaining since it appears that the entire loss is derivative in nature, if actionable at all.
Arguably, the problem with a derivative remedy is that the defendant directors and officers are likely to hide behind the almost bullet-proof business judgment rule and thus to avoid any liability. Nevertheless, it turns out that a derivative action for collateral damage will lie whenever a meritorious claim can be stated under Rule 10b-5. In other words, it appears that state corporation law is perfectly congruent with federal securities law.
Two developments in the state law of fiduciary duty have coalesced to provide a state law remedy in any case in which a claim will lie under Rule 10b-5.
The first such development is the recognition that fiduciary duty includes a duty of candor that applies even in the absence of a request for stockholder action (such as ratification).[5] That is, the duty of candor extends beyond the well-recognized state law duty of disclosure that applies in the context of a stockholder vote.[6] It applies whenever management speaks: If management speaks, it must speak the truth. To do otherwise is a breach of fiduciary duty and is actionable under state law.
In order to state a claim for breach of the duty of candor, a stockholder-plaintiff must plausibly allege that the corporation suffered harm as a result and that management acted with scienter. Neither of these requirements is problematic. If the company has suffered no harm, there is no need for a derivative action. And because scienter is required to state a federal claim for fraud under Rule 10b-5, the need to plead scienter to maintain a state law claim for breach of fiduciary duty merely matches the federal pleading hurdle.
The second such development is the recognition that in cases alleging a breach of fiduciary duty, a fiduciary who acts contrary to the interests of the corporation – and does so with scienter – loses the protection of any exculpatory charter provision under DGCL 102(b)(7), which extends only to actions taken in good faith, because scienter implies bad faith.[7] Moreover, the same standard applies to establish demand futility in the context of a derivative action.[8]
The upshot is that a state law derivative action can be maintained in any case in which a securities fraud class action can be maintained under Rule 10b-5. In other words, whenever a claim will lie under Rule 10b-5, it will also lie under the state law of fiduciary duty so long as some sort of harm to the corporation can be pleaded.
Admittedly, this congruity assumes that the definition of scienter is the same under state corporation law and federal securities law. But scienter is scienter is scienter – as Gertrude Stein might put it – whether one is in federal court or state court. Indeed, the federal courts borrowed the scienter standard from the common law of fraud as developed by state courts.[9] Moreover, since a state law claim for breach of fiduciary duty in this context will arise under the duty of candor, the issue of scienter arises in connection with speech by corporate agents. Whatever scienter might mean in other situations, it is difficult to see how the definition of scienter could possibly differ as between state law and federal law as applied to corporate speech.[10]
To be sure, the quantum of the remedy in a derivative action will be different from that of a securities fraud class action even though the same facts are involved. On the one hand, a derivative award will not include a decrease in stock price from the correction of price inflation as narrowly defined. The corporation itself has no claim for price inflation. On the other hand, the award will reflect the loss suffered by all of the stockholders and not just those who bought during the fraud period. Moreover, it seems likely that the calculation of damages will be based on the actual costs of fraud suffered by the company. But this difference militates further for a derivative remedy: It is much easier to quantify the cost of fraud by reference to fines, legal bills, and such than by reference to the stock price, which can be affected by all sorts of extraneous factors.
Finally, aside from simplifying the litigation process by providing for unitary corporate recovery, derivative actions avoid the circularity inherent in class actions while also addressing the problem of excessive deterrence by providing a perfectly tailored action against individual wrongdoers.[11]
[1] See, e.g., Ludlow v. BP, PLC, 800 F.3d 674 (5th Cir. 2015).
[2] See, e.g., Lentell v. Merrill Lynch & Co., 396 F.3d 161 (2d Cir. 2005).
[3] Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005).
[4] Richard A. Booth, OOPs! The Inherent Ambiguity of Out-of-Pocket Damages in Securities Fraud Class Actions, European Corporate Governance Institute – Law Working Paper 508/2020. Available here or here forthcoming, 46 J. Corp. L.
[5] See Malone v. Brincat, 722 A.2d 5 (Del. 1998).
[6] See, e.g., Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983).
[7] See Stone v. Ritter, 911 A.2d 362 (Del. 2006). Although the Stone court does not use the word scienter, the court cites Guttman v. Huang, which does so with gusto. See Stone, 911 A.2d 362, 369-70 (quoting Guttman v. Huang, 823 A.2d 492, 506 (note 34) (Del. Ch. 2003)). See also Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007); American International Group, Inc. v. Greenberg, 965 A.2d 763 (Del. Ch. 2009).
[8] See Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006) (noting that it is critical in a case of BOD inaction to overcome an exculpatory charter provision in order to excuse demand). See also Rattner v. Bidzos, No. 19700, 2003 Del. Ch. LEXIS 103 (Sept. 30, 2003); In re Tyson Foods, Inc. Consolidated Shareholder Litigation, 919 A.2d 563 (Del. Ch. 2007); Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007) (all stating that a showing of scienter will suffice to overcome the presumption of propriety as to unconflicted directors).
[9] See Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). See also Aaron v. SEC, 446 U.S. 680 (1980) (requiring scienter also in SEC enforcement actions).
[10] See generally Richard A. Booth, Scienter in State Law Securities Litigation (forthcoming).
[11] See Richard A. Booth, Sense and Nonsense About Securities Litigation, 21 U. Penn. J. Bus. L. 1 (2018).
This post comes to us from Professor Richard A. Booth, the Martin G. McGuinn Chair in Business Law at Villanova University’s Charles Widger School of Law. It is based on his recent article, “OOPs! The Inherent Ambiguity of Out-of-Pocket Damages in Securities Fraud Class Actions,” available here.