Earlier this week, the Eleventh Circuit Court of Appeals affirmed the granting of a post-trial judgment as a matter of law for the defendants in a private securities fraud-on-the-market action, Hubbard v. BankAtlantic Bancorp, Inc., 2012 WL 2985112 (11th Cir. July 23, 2012). The case is noteworthy for its treatment of the required element of loss causation, in particular the Court's lengthy evaluation of (without officially adopting) the alternative "materialization of concealed risk" form of proof that has developed in other circuit courts.

The plaintiffs alleged that BankAtlantic, a Florida-based community bank, had misrepresented the credit quality of its commercial real estate loan portfolio between October 2006 and October 2007 – a period of decline in the Florida real estate market. Allegedly BankAtlantic maintained an internal Loan Watch List, and officers had internal communications expressing concern about its commercial real estate portfolio. In April 2007, BankAtlantic began to disclose some of its concern with a certain segment of its particular portfolio. That disclosure was accompanied by discussions of signs of real estate slowdown, especially in Florida where its portfolio was concentrated.  

The end of the class period was defined by the release of BankAtlantic's 8-K, which disclosed dramatic increases in troubled loans. The stock dropped 38% that day, after having previously dropped an additional 40% earlier during the class period.

The plaintiffs' only evidence of loss causation was the testimony of an expert who performed an event study to measure how much of the decline in the price of BankAtlantic's stock was attributable to company-specific (as opposed to general market or industry) factors. The expert used broad indices (the S&P 500 Index and Nasdaq Bank Index) and analyst reports to conclude that the entire price decline was attributable to the concealed details of BankAtlantic's portfolio.

The Court then elaborated on what standards to assess this testimony for loss causation. In Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), the United States Supreme Court held that loss causation requires more than proof that the stock was purchased at a price artificially inflated by fraud. The plaintiff also must show that the decline in the stock price came “after the truth ma[de] its way into the market place,” and was not caused by such other factors as “changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions or other events.” Id. at 342-43.

The entry of truth into the marketplace is typically considered under the "corrective disclosure" theory – that is, the stock price declined upon a disclosure that reveals precisely the facts concealed by the fraud. The Eleventh Circuit also acknowledged "what some courts [including the Second Circuit and Seventh Circuit] have called a 'materialization of the concealed risk' theory." Under this theory, loss causation can be shown even absent a corrective disclosure if "the materialization of a fraudulently concealed risk caused the price inflation induced by the concealment of that risk to dissipate." In simpler terms, the disclosure need be only of a sufficient manifestation of the fraud, not the fraud itself, to satisfy this element of loss causation. Some examples are bond defaults, accounting irregularities, and officer and director resignations – the question remains whether the disclosed event is sufficiently related to the concealed fraud so that the fraud itself can be deemed to have led to the loss.

The Eleventh Circuit found that the plaintiffs did not satisfy either form of loss causation. First, the October 2007 disclosure was not "corrective" because it did not disclose the alleged concealed facts and otherwise discussed facts that did not exist at the time of the misstatements. Second, the risk of BankAtlantic's commercial real estate portfolio did not sufficiently materialize in October 2007 given the overall market deterioration. Specifically, the plaintiffs' expert "failed to adequately separate losses caused by fraud from those caused by the 2007 collapse of the Florida real estate market" – for example, the Nasdaq Bank Index contains few Florida banks. In effect, the material risk was the non-concealed general downturn of the Florida real estate market. Thus, without sufficient materialization of the concealed risk, the plaintiffs failed to prove loss causation.

Notably, the Eleventh Circuit undertook this lengthy analysis by merely assuming, without deciding, the validity of the "materialization of concealed risk" theory. Nonetheless, the Court's attention bestowed on this theory signifies that it should be given particular consideration by both plaintiffs and defendants as an alternative form of proof of loss causation in securities fraud-on-the-market actions.