What Counts as Price Impact for Securities Fraud Purposes?

Abstract

The Supreme Court has ruled that in a securities fraud action arising under Rule 10b-5, class action status will be denied if the defendant can show that the alleged deception had no impact on market price. In a related development, the courts have also held that investors cannot recover for losses from materialization of risk – from occurrence of an event whose risk was misrepresented – but rather may recover only for the difference between the price paid and the price that would have obtained if the truth had been known about the risk when the investor bought or sold. Taken together, these developments will require the courts to address the component parts of any decrease in price that gives rise to a fraud claim. As shown here, a change in the market price of a particular stock may come from several different sources. A decrease (or increase) in price may result from new information as to expected return or cost of capital or one-time outflows (or inflows) of cash – including those attributable to materialization of risk. Moreover, changes in expected return or cost of capital may be attributable either to company-specific news (and clearly compensable) or more general economic conditions (and not clearly compensable). Once it is recognized that a price change may flow from any one of these sources or a combination thereof, it becomes apparent that some such claims are derivative in nature and should give rise to an action for the benefit of the corporation – and all of the stockholders – and not just for the buyers (or sellers). Moreover, after derivative recovery, stockholders will be in the same position they would have occupied in the absence of fraud. So there is no reason to compensate for the supposed direct claims that remain. This is especially so since most investors are diversified and since assessing damages against the company merely transfers the loss from one group of investors (buyers or sellers) to another (holders). The bottom line – and the implication of parsing the elements of damages in a claim for securities fraud – is that such claims should be litigated as derivative actions.