Over the last 25 years, calculating damages in securities class actions has developed into an increasingly sophisticated and highly complex undertaking. While public pension fund fiduciaries don’t need to know all the nitty-gritty details behind damages calculations, understanding the basics can be instructive, particularly for funds contemplating lead plaintiff roles.
Damages calculations are critical at several stages of securities litigation. In the very earliest phases of a case, they can help pension funds weigh the significance of potential damages before deciding whether to actively participate in a class action.
At the outset, funds should ask themselves a few key questions. How large are the damages in this case? $100 million? $1 billion? How many shares are outstanding? Did the stock drop $1 or $10? Was there a triggering event? Were there any external market influences?
The amount a stock’s price declines is only the beginning of this analysis. A fund may initially appear to have lost large sums due to an alleged fraud, but the case is ultimately only worth pursuing if the price drop can be directly attributed to the fraudulent activities. Without that causal connection, the case won’t hold up in court.
The damages calculations employed to select a lead plaintiff are by necessity preliminary estimates; they cannot be as detailed as those used in later stages of a case. This helps explain why case evaluations can differ substantially from one law firm to the next. Where one firm sees a worthy class action, another sees a claim that could be hamstrung by challenges to plaintiffs’ damages calculations.
Defendants have long sought to require plaintiffs to provide damages models, also known as event studies, to demonstrate how an alleged fraud directly affected the movement of a company’s stock price. The U.S. Supreme Court answered their pleas in its 2005 Dura Pharmaceuticals decision.
In Dura, the high court ruled that plaintiffs must show that a defendant’s material misrepresentation or omission caused a stock’s decline, rather than an intervening event. It is no longer enough for a plaintiff to merely allege that the price was artificially inflated by a defendant’s misrepresentation.
According to Dura, plaintiffs must now provide comprehensive analyses to meet the burden of establishing damages in securities fraud class actions. The evidence must show that a plaintiff’s losses resulted from stock price inflation that was caused by the defendant’s misstatements or omissions.
Calculating Damages
A plaintiff’s damages in a securities fraud case are usually calculated as out-of-pocket losses. These losses are expressed as the difference between the price at which the stock sold and the price at which the stock would have sold absent any artificial inflation caused by a defendant’s alleged misrepresentations or omissions.
For many years, the courts defined damages as the difference between the price paid for the securities and the value of the securities at the time the fraud was discovered. Defendants opposed this method because it ignored outside elements impacting stock price, such as overall economic and sector factors that may have been unrelated to the fraud.
In 1976, a federal appeals court judge set forth a landmark theory for measuring damages, suggesting that the best way to measure the loss caused by a defendant’s misrepresentation was through a chart showing a “price line” and a “value line.” Damages would be calculated by subtracting the true value of the stock on the date of the purchase from the price actually paid, with the spread between the price and the value lines varying over time.
To determine the true value, lawyers began to employ the use of event studies – statistical regression analyses that examined the effect of an event on a dependent variable, such as a corporation’s stock price. This approach assumes that the price and value of the security move in tandem, except during the days when disclosures of company-specific information influence the price of the stock.
A damages expert looks at the days when the stock price moves differently than anticipated solely based upon market and industry factors – so-called days of “abnormal returns.” The damages expert then determines whether those abnormal returns are due to fraud or non-fraud related factors.
Over time, courts began to view event studies as an accepted way to distinguish between fraud-related and non fraud-related influences on the stock. In recent years, courts have even rejected or refused to admit into evidence damages reports or testimony by damages experts that fail to include event studies. Courts have also rejected event studies that do not comply with basic principles of corporate finance and will recognize as damages only those factors that are related to the fraud.
In the end, there is no one-size-fits-all approach to evaluating potential securities cases, particularly where damages calculations are concerned. Potential damages themselves are only one factor to weigh when considering whether to file for lead plaintiff. The opportunity to make corporate governance improvements may also influence that decision, for example. The best advice for fund fiduciaries is to approach each case individually when pondering whether to get actively involved.
Editor’s Note: This article was adapted from a paper written by Berman DeValerio partners Kathleen M. Donovan-Maher and Jeffrey C. Block and associate Kyle G. DeValerio. The paper was presented to Law Seminars International this spring.
*In August 2017, our firm name changed to Berman Tabacco. Case references and content published before that date may refer to the firm under our prior name, Berman DeValerio.