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I would like to thank Mike for his willingness to publish his article on my site. I welcome guest post submissions from responsible authors on topics of interest to readers of this site. Please contact me directly if you are interested in submitting a guest post. Here is Michael’s guest post.
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Materialization-of-the-risk cases are a favorite of the securities class action plaintiffs’ bar. The basic theory of fraud in these cases is that a company misrepresented or withheld information, causing the market to miscalculate the company’s exposure to a particular risk. Every company is susceptible to risks, whether it be natural or man-made disasters, competition, labor disputes, technological obsolescence, currency fluctuations, supply-chain disruptions, etc. –the risks are endless. When a company’s stock price declines following a disclosure that you-name-the-risk has materialized – as every company must do on occasion – plaintiffs’ lawyers will scour the company’s prior disclosures concerning the risk and allege (with the benefit of hindsight) that the company and its executives did not accurately explain the company’s exposure to the risk. The damages in such cases are usually easy to calculate – plaintiffs say that the stock was inflated by the amount of the share price decline following the revelation of the risk. And if the case is certified as a class action, the damages typically run in the hundreds of millions, if not billions.
The securities class action filed against BP plc following the 2010 Deepwater Horizon explosion and oil spill is a classic materialization-of-the-risk case. Before the spill, according to plaintiffs, BP touted the company’s safety plans and procedures as being more advanced on paper than they were in practice. These pre-spill statements lulled the market into believing that BP was a safer company than it actually was. According to plaintiffs, BP thus understated the risk of the Deepwater Horizon catastrophe, and when that risk materialized, investors were damaged by the full value of the decline in BP stock caused by the materialization of the risk of the spill. The Fifth Circuit recently affirmed the district court’s order denying class certification of plaintiffs’ materialization-of-the-risk claims.[1] Ludlow v. BP, PLC, — F.3d —, 2015 WL 5235010 (5th Cir. Sept. 8, 2015). This opinion essentially removes the risk of materialization-of-the-risk cases in the Fifth Circuit.
The issue before the Fifth Circuit was whether plaintiffs satisfied the requisites of Federal Rule of Civil Procedure 23(b)(3), “that the questions of law or fact common to class members predominate over any questions affecting only individual members.” Id. at *6. The Fifth Circuit applied the Supreme Court’s recent mandate in Comcast Corp. v. Behrend, 133 S. Ct. 1426, 1433 (2013), that courts conduct a “rigorous analysis” to determine at the class-certification stage that plaintiffs’ damages model is susceptible to measurement across the entire class for purposes of Rule 23(b)(3). The Fifth Circuit determined that plaintiffs’ damages model, which purported to recover the bulk of the price decline following the disclosure of the Deepwater Horizon oil spill, was not capable of class-wide determination. “The theory hinges on a determination that each plaintiff would not have bought BP stock at all were it not for the alleged misrepresentations – a determination not derivable as a common question, but rather one requiring individualized inquiry.” Id. at *11.
The Fifth Circuit provided the following scenario to explain its reasoning: Assume the true risk to BP of a major spill was 2%, but BP’s statements improperly represented the risk as 0.5%. Some conservative investors would be entitled to the full recovery of the decline because they would not have invested in BP at all (e.g., a low-risk pension fund, whose investment policy forbids investments in companies for whom the risk of a catastrophic event is greater than 1%). But other, more risk-tolerant investors would not be entitled to recover the full amount of the stock decline because they still would have purchased BP stock even if they had known the “true” 2% risk. Such risk-tolerant investors would only be able to recover the price difference between the amount they paid (which assumed a 0.5% risk of a catastrophic spill) and a hypothetical price assuming the actual 2% risk. Although a damages model that provided for the full recovery of the decline in BP stock following disclosure of the oil spill would be a valid recovery of economic loss for the risk-averse investor, it would be an improper windfall to risk-tolerant investors who would have been willing to purchase BP stock based on the 2% true catastrophic risk profile. Plaintiffs’ damages model did not provide any mechanism for separating these two classes of plaintiffs. “And because it lacks the ability to do so, it cannot provide an adequate measure of class-wide damages under Comcast.” Id. at *11.
The Fifth Circuit rejected plaintiffs’ argument that this reasoning was inconsistent with the fraud-on-the-market presumption recognized by the Supreme Court in Basic, Inc. v. Levinson, 485 U.S. 224, 242 (1988). While Basic provides plaintiffs with a presumption that they relied upon BP’s misrepresentations in purchasing BP stock, it does not provide plaintiffs with a presumption that the misrepresentations were a cause-in-fact of their losses (i.e., loss causation). Id. In a materialization-of-the-risk case, a plaintiff’s economic loss depends on an assessment of the plaintiff’s risk tolerance, and thus loss causation and damages cannot be presumed nor found class-wide.
The Fifth Circuit also noted that the fraud-on-the-market theory was rebuttable at the class-certification stage and plaintiffs’ own damages model rebutted it. The efficient market theory assumes that all public information is incorporated into a company’s stock price, and investors make investment decisions “based on price and price alone.” Id. (Emphasis in original). Plaintiffs’ model asserts that BP investors relied on something other than price: risk. Plaintiffs’ damages model incorrectly assumed that all class members had an ultra-conservative risk profile – they would not have invested in BP stock had they known the true risk exposure, and thus were entitled to recover the full value of the decline in BP stock following the disclosure of the spill. Plaintiffs’ own model argues that plaintiffs’ investment decision was based on risk – a factor other than price.
The Fifth Circuit’s BP opinion takes the risk out of “materialization-of-the-risk” cases, which is a very common theory of fraud in securities class action cases. Because a valid damages model in a “materialization-of-the-risk” case requires an individualized assessment of each class member’s risk tolerance, such cases cannot satisfy the “predominance” requirement of Rule 23(b)(3). It will be interesting to see if the Fifth Circuit’s analysis is endorsed by other circuits or the Supreme Court. If it is, then “materialization-of-the-risk” class actions will be a thing of the past.
Mr. Biles is a partner in King & Spalding’s Securities Litigation practice group. The opinions expressed in this article are his alone and do not reflect the opinions of King & Spalding or its clients.
[1] There were actually two sub-classes in the case, a pre-spill class and a post-spill class. The Fifth Circuit affirmed class certification for the post-spill class, which did not concern a “materialization-of-the-risk” claim.