On August 1, 2012, the Second Circuit “consider[ed] whether the fact that a stock’s share price recovered soon after the fraud became known defeats an inference of economic loss in a securities fraud suit.” Acticon AG v. China North East Petroleum Holdings Ltd., 2012 WL 3104589, at *1 (2d Cir. Aug. 1, 2012) (Straub, J.). Holding that “price recovery does not defeat an inference of economic loss[,]” the Second Circuit vacated dismissal of a securities fraud suit against China North Petroleum Holdings Limited (“NEP”) where NEP’s stock price had rebounded after the final alleged corrective disclosure.

Background

The plaintiffs contended that “beginning on May 15, 2008, NEP [had] misled investors regarding the financial health and prospects of the company.” Id. Specifically, the plaintiffs alleged that “NEP [had] inflated its proven oil reserves and did not account for certain warrants … in accordance with Generally Accepted Accounting Principles (‘GAAP’).” Id. In addition, the plaintiffs claimed that “NEP’s former CEO and his mother [had] transferred funds from the company’s corporate coffers into their own accounts.” Id. The plaintiffs alleged that “this information gradually became public [through a number of corrective disclosures] as NEP was required to withdraw its financial statements and revise its prior earnings downwards.” Id. “NEP’s stock price fell sharply in the days following each of these disclosures.” Id.  

The lead plaintiff had purchased a total of 60,000 NEP shares at an average price of $7.25 per share, and “held all 60,000 shares for months after the final allegedly corrective disclosure was made on September 1, 2010.” In re China North East Petroleum Holdings Ltd. Sec. Litig., 819 F. Supp. 2d 351, 353 (S.D.N.Y. 2011) (Cedarbaum, J.) (China North I). “On twelve days between October and November 2010, NEP stock closed at a price higher than $7.25.” Id. “Had [the lead plaintiff] chosen to sell on those post-disclosure dates, it would have turned a profit.” Id. However, the lead plaintiff instead sold a portion of its NEP stock between December 2010 and May 2011, at prices ranging from $3.50 to $6.33.  

On October 6, 2011, the Southern District of New York dismissed the plaintiffs’ claims for failure adequately to allege economic loss. Id. at 354. The China North I court explained that since the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005) (Breyer, J.), “courts have held as a matter of law that a purchaser suffers no economic loss if he holds stock whose post-disclosure price has risen above the purchase price—even if that price had initially fallen after the corrective disclosure was made.” Id. at 352. The plaintiffs appealed.

The Second Circuit Holds That A Plaintiff Can Suffer Economic Loss Even If the Stock Price Later Rebounds to the Plaintiff’s Purchase Price

At the outset of its analysis, the Second Circuit emphasized that the Supreme Court’s holding in Dura was “by its own terms … quite limited.” China North II, 2012 WL 3104589, at *5. The Dura Court did “not alter or abandon the traditional out-of-pocket measure for damages.” China North II, 2012 WL 3104589, at *6. “Rather, the Court merely clarified that a securities fraud plaintiff who purchased stock at an inflated price must still prove that she suffered an economic loss, and that that loss was proximately caused by [the] defendant’s misrepresentation.” Id. The Dura Court explained that “as a matter of pure logic, at the moment the transaction takes place, the plaintiff has suffered no loss; the inflated purchase payment is offset by ownership of a share that at that instant possesses equivalent value.” Dura, 544 U.S. at 342.  

In a line of cases beginning with Malin v. XL Capital Ltd., 2005 WL 2146089 (D. Conn. Sept. 1, 2005) (Dorsey, J.), courts have relied on Dura to hold that “a securities fraud plaintiff suffers no economic loss if the price of the stock rebounds to the plaintiff’s purchase price at some point after the final alleged corrective disclosure.” China North II, 2012 WL 3104589, at *4. The Malin court reasoned that “a price fluctuation without any realization of an economic loss is functionally equivalent to the Supreme Court’s rejection of an artificially inflated purchase price alone as economic loss.” Malin, 2005 WL 214608, at *4.  

The Second Circuit found the Malin court’s rationale to be “inconsistent with [both] the traditional out-of-pocket measure of damages, which calculates economic loss based on the value of the security at the time that the fraud became known,” and the “bounceback provision” set forth in the Private Securities Litigation Reform Act (“PSLRA”), “which refines the traditional measure by capping recovery based on the mean [share] price over [a 90-day] look-back period.”China North, 2012 WL 3104589, at *6.  

Moreover, the Second Circuit observed that “a share of stock that has regained its value over a period of decline is not functionally equivalent to an inflated share that has never lost value.” Id. “This analysis takes two snapshots of the plaintiff’s economic situation and equates them without taking into account anything that happened in between; it assumes that if there are any intervening losses, they can be offset by intervening gains.” Id. The Second Circuit found that “it is improper to offset gains that the plaintiff recovers after the fraud becomes known against losses caused by the revelation of the fraud if the stock recovers value for completely unrelated reasons.” Id. “Such a holding would place the plaintiff in a worse position than he would have been absent the fraud.” Id.  

The Second Circuit explained that “[i]n the absence of fraud, the plaintiff would have purchased the security at an uninflated price and would also have benefited from the unrelated gain in stock price.” Id. “If we credit an unrelated gain against the plaintiff’s recovery for the inflated purchase price, he has not been brought to the same position as a plaintiff who was not defrauded because he does not have the opportunity to profit (or suffer losses) from ‘a second investment decision unrelated to his initial decision to purchase the stock.’” Id. (quoting Harris v. Am. Inv. Co., 523 F.2d 220, 228 (8th Cir. 1975) (Bright, J.), cert. denied, 423 U.S. 1054 (1976)).  

Finally, the Second Circuit noted that it was “aware of no circuit court or Supreme Court decision imposing the economic-loss rule embraced by Malin.” Id. The court also found it “significant” that the PSLRA “did not impose the limitation on damages favored by Malin.” Id.  

The Court Finds The Complaint Adequately Pleads Economic Loss

On appeal, NEP contended that the plaintiffs had “failed to plead economic loss as a matter of law” because NEP’s “stock price rose higher than [the lead plaintiff’s] average purchase price on various dates in the months following the close of the class period[.]” Id. at *2. NEP argued that “the rebound in share price demonstrate[d] that the market was so unfazed by the alleged corrective disclosures, so the disclosures were unrelated to [the lead plaintiff’s] ultimate loss.” Id. at *5.  

The Second Circuit found that “[a]t this stage in the litigation,” it could not determine “whether the price rebounds represent[ed] the market’s reactions to the disclosure of the alleged fraud or whether they represent[ed] unrelated gains.” Id. at *7. “[D]rawing all reasonable inferences in favor of [the lead plaintiff],” the Second Circuit “assume[d] that the price rose for reasons unrelated to its initial drop.” Id. at *5. “Accordingly,” the Second Circuit held that “the recovery [did] not negate the inference that [the lead plaintiff] ha[d] suffered an economic loss.” Id. at *7.  

The Second Circuit Did Not Rule on the Applicable Pleading Standard for Allegations of Economic Loss

The Second Circuit noted that the “Circuits have split in the wake of Dura as to which [pleading standard] applies to loss causation.” Id. at *3. “The Fourth Circuit has held that heightened pleading requirements of Rule 9(b) apply to the element of loss causation because it is ‘among the circumstances constituting fraud.’” Id. (quoting Katyle v. Penn Nat’l Gaming, Inc., 637 F.3d 462, 471 & n. 5 (4th Cir. 2011) (Baldock, J.)). “The Fifth Circuit, in contrast, has held that only the requirements of Rule 8(a)(2) apply[.]” Id. (citing Lormand v. U.S. Unwired, Inc., 565 F.3d 228, 256-58 (5th Cir. 2009) (Dennis, J.)). “And the Ninth Circuit has recognized that ambiguity exists regarding which pleading standard applies, but has found it unnecessary to resolve which standard applies because in each case where it could address the issue, either pleading standard was satisfied.” Id. (citing WPP Lux. Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1053-1054 (9th Cir. 2011) (Gwin, J.); In re Gilead Scis. Sec. Litig., 536 F.3d 1049, 1056 (9th Cir. 2008) (Hawkins, J.)).  

Finding that “the price fluctuations here would not rebut an inference of economic loss under either standard,” the Second Circuit determined that it was “unnecessary to resolve” the question of which pleading standard applies to allegations of economic loss. Id.