In a recent decision, the Second Circuit Court of Appeals considered the issue of stock price rebounds in reviving a securities fraud class action suit that had been dismissed by the district court for failure to adequately allege an economic loss as a matter of law. In Rosado v. China North East Petroleum Holdings Ltd., No. 11-4554-cv (2d Cir. Aug. 1, 2012), the Second Circuit found that the plaintiff shareholder had adequately pleaded economic loss even though the plaintiff had foregone several opportunities to sell its stock at a profit after disclosure of the alleged misrepresentations. The court reasoned that, because the subsequent price rebound may have been unrelated to the alleged misrepresentations, it was improper to credit those gains against the plaintiff’s losses. In jurisdictions that follow the China North East Petroleum decision, it will be harder for defendants in securities fraud class actions to rely on subsequent price rebounds at the motion to dismiss stage.
Background Facts and Procedural History
The plaintiff, suing on behalf of a putative class of shareholders of China North East Petroleum Holdings (NEP), alleged that the company misled investors about its reported earnings, oil reserves, and internal controls. The plaintiff further alleged that this information gradually became public starting with disclosures in February 2010 when the company withdrew its financial statements and revised its prior earnings downwards. NEP subsequently announced in April 2007 that there would be delays in its SEC filings, that it faced possible de-listing by the New York Stock Exchange (“NYSE”) and that there were certain deficiencies in its internal controls. NEP’s stock price fell sharply in the days following these disclosures. In May 2010, NEP announced that the NYSE had stopped trading of the company’s stock. The same release also announced the resignation of certain members of management for financial improprieties. Over the summer, the chairman of NEP’s audit committee resigned over concerns whether the company’s financial statements were properly prepared in accordance with GAAP and whether the company had bribed foreign government officials. When NEP’s stock resumed trading in September 2010, its price dropped almost 20 percent on high trading volume.
Citing a line of cases applying Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), the district court noted that “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.” The district court observed that NEP’s stock price had traded above the plaintiff’s average purchase price on twelve days in October and November 2010 after NEP was relisted on the stock exchange. The district court therefore dismissed the complaint, concluding that because the plaintiff had foregone multiple opportunities to sell its shares at a profit, it had not suffered an economic loss. The plaintiff subsequently appealed.
Pleading Economic Loss in the Context of Price Rebounds
The Second Circuit vacated the district court’s dismissal and, in doing so, rejected the line of lower court decisions (relied upon by the district court) that held that a securities fraud plaintiff suffers no economic loss where the stock price rebounds above the plaintiff’s purchase price after the final alleged corrective disclosure. In reversing the district court, the Second Circuit found that the lower court’s analysis was inconsistent with the traditional out-of-pocket measure of damages which permits a plaintiff to recover damages for economic loss based upon the difference between the price paid for the stock and the value of the stock when bought. The Second Circuit also held that the district court’s reasoning did not comport with the “bounce back” provision in the Private Securities Litigation Reform Act of 1995 (PSLRA). This statutory provision caps the amount of damages available in a securities fraud action to the difference between the purchase price paid and the mean trading price of the stock during a 90-day period after the corrective disclosure is disseminated to the market. The court further explained it would be 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 because such a holding would place the plaintiff in a worse position than it would have been in absent the fraud.
The Second Circuit found that the plaintiff had satisfied the pleading requirements of Dura because it alleged something more than the mere fact that it had purchased NEP shares at an inflated price; specifically, the plaintiff alleged that the price of NEP stock dropped after the alleged fraud became known. Although it was undisputed that the NEP stock price recovered above the plaintiff’s average purchase price, the court stated that it did not know at the pleading stage whether those price rebounds represented the market’s reaction to the alleged corrective disclosure or whether they represented unrelated gains in the company’s stock price. Drawing all favorable inferences in favor of the plaintiff for purposes of evaluating a motion to dismiss, the court assumed that the price rose for reasons unrelated to the initial drop. Consequently, the court held that at this stage of the litigation, the subsequent price recovery did not negate the inference that the plaintiff had suffered an economic loss. Accordingly, the Second Circuit concluded that dismissal as a matter of law on economic loss grounds was inappropriate.
The Second Circuit’s decision in China North East Petroleum is important because it holds that a stock price rebound following a corrective disclosure does not necessarily mean that a plaintiff cannot prove economic loss or loss causation. In jurisdictions that follow this decision, it will be more difficult to obtain dismissal on the pleadings due to the absence of economic loss or loss causation as a matter of law. Instead, in such jurisdictions, defendants will need to develop evidence at the class certification and/or summary judgment stage to link the subsequent price recovery to the alleged corrective disclosure.