cornerstone reserach pdfBecause securities class action lawsuits under Section 10 of the Securities Exchange Act of 1934 and Rule 10b-5 so rarely go to trial (a topic I addressed in a recent post, here), questions about how damages are calculated are not often addressed directly. Section 28(a) of the ’34 Act specifies that no plaintiff shall “recover … a total amount in excess of [that person’s] actual damages.” However, the statute does not define “actual damages” and courts have adopted a variety of approaches to the question.


A November 19, 2014 paper published by Cornerstone Research and the Goodwin Proctor law firm entitled “Limiting Rule 10b-5 Damages Claims” (here) takes a look at the way that courts have addressed this issue. As discussed in the paper, the beginning point for analysis of the damages issues is the amount of “inflation” – that is, the difference between the defendant company’s actual stock price and what the price would have been absent the alleged fraud. The authors note that the administrative processes following a settlement, or more rarely, a verdict, involve several adjustments. These adjustments can reduce individual class members’ claims as well as plaintiffs’ estimates of classwide damages. However, the authors found, there are inconsistencies in the ways that courts apply these adjustments.


The authors suggest that the aggregate effect of these adjustments “can be quite large and may often be underestimated or overlooked by defendants.”  The authors contend that these adjustments can be inform defense strategies in settlement negotiations and could be influential on prospective settlement opt-outs on their decision whether or not to participate in class settlements.


In order to analyze these issues, the authors reviewed the plans of allocation reflected in publicly available settlement claims forms and notices for sixty-five Rule 10b-5 class action settlements occurring during 2012 and 2013. They also review the verdicts in the Vivendi and Household Financial cases, both of which cases resulted in jury trial verdicts. The authors also drew upon their own experience in the post-judgment proceedings in the Apollo Group securities litigation.


Based on this analysis, the authors identified three approaches to adjusting damages:


1. Offsetting recognized losses with gains from price inflation caused by the alleged fraud. (Inflation Gains Offset)

2.  Adjusting recognized losses with nominal gains. (Nominal Gains Offset)

3. Limited per-share recognized losses to nominal losses. (Nominal Loss Cap)


The starting point of the authors’ analysis is the recognition that an investor suffers a loss if he or she purchases a share at an inflated price and then later sells the share after a corrective disclosure eliminates the share price inflation. Say, for example, the investor purchases a share at a price of $27 with a $7 price inflation, and then after the corrective disclosure sells the share for $20, realizing a $7 dollar loss.


The authors suggest that this calculation should be adjusted to take other possible factors into account.


First, the investor’s losses on the sale of the share should be offset by any gains the investor realized as a result of the share inflation. Say, for example, the same investor purchased a share prior to the class period at $20 and then sold it during the class period at the price of $27 (reflecting the increased price due to the inflation.). The authors argue that the investor’s $7 loss on the post disclosure sale should be offset by the investor’s $7 gain during the class period, resulting in a conclusion that the investor suffered $0 in losses.


The authors contend that it is “economically rational” to subtract the gains from inflation from losses from inflation in calculating the harm to an investor. The authors found that the courts in the Household Finance case recognized the need to offset losses from gains from inflation. However, they also noted that “this seemingly well-recognized legal principle does not, however, explicitly appear in any of the sixty-five settlements the authors reviewed.” This offset can be calculated only when an individual investors’ purchase and sale information are available, as would usually be the case in opt-out litigation or sometimes for lead plaintiffs.


The gains from inflation cannot always be calculated accurately when performing plaintiff-style aggregate damages calculation. What can be calculated using publicly available information is the maximum adjustment to a plaintiff-style aggregate damages calculation. The “bank “of these available offsets is “often substantial and perhaps underestimated in the settlement negotiations.” The “economic logic and legal basis for this adjustment is strong and provides an argument for defendants negotiating smaller settlements.”


Second, the authors contend that recognized losses should be offset with nominal gains. In this example, the investor that experienced the $7 post disclosure loss also purchased a share during the class period at $27 dollars a share, reflecting the $7 price inflation, and sold the share during the class period at $28 per share, also reflecting the $7 per share price inflation. The authors contend the investors $1 gain on the class period transaction should be offset against the $7 loss, resulting in a net loss of $6. The authors note that a nominal gain offset was not mentioned in either the Household Finance or Vivendi verdicts, perhaps, the authors note, because “a nominal gains offset is likely to be smaller than a gain from inflation offset.”


The authors note that the while the nominal gains offset can be calculated when an investor’s trading data are available (for example with opt-outs or named plaintiffs), the adjustment cannot be determined reliably for the class using plaintiff-style aggregate damages models. The authors contend, however, that nominal gains from shares purchased during the class period are able to be offset against losses from inflation. While the nominal gains will not exceed losses from inflation, calculating the maximum reduction in damages due to nominal gains can “still be helpful for settlement discussion purposes.”


Third, the authors also contend that per-share recognized losses should be limited to nominal losses. This calculation takes in to account the PLSRA’s 90 day look-back period, which limits a plaintiff’s damages to the difference between the purchase price and the mean trading price of the security during the 90 days following a corrective disclosure. In this example, if the investor purchased a share with a $7 price inflation during the class period at $27 and sold the share after the corrective disclosure at $25, the damages are only $2, not $7. The 90-day rule creates what the authors call a “nominal loss cap.”


The nominal loss cap can be applied with respect to investors, such as opt-out claimants and named plaintiffs, where trading data are available. The authors also contend that “an estimate of the effect of nominal loss caps can and should also be applied to plaintiff-style damages estimates.”


The authors contend that all three of these adjustments can and should be applied in settlement negotiations to estimate recognized losses. The authors contend that the incorporation of these types of adjustments into class settlement could influence prospective opt-outs decision whether or not to remain in the settlement class.


In my view, the authors’ analysis should be of interest not only to defendants engaged in settlement negotiations, but also to the D&O Insurers whose financial interests could be affected by the negotiations. In the press release accompanying the report’s release, Dan Tyukody of the Goodwin Proctor law firm is quoted as saying “Besides lawyers and judges, these findings should definitely be of considerable interest to the insurance industry” – a statement that is clearly correct. I think that D&O insurers’ claims managers will want to review this report closely, to understand the authors’ analysis and to consider how this analysis could be incorporated into securities lawsuit settlement negotiations. The authors’ analysis clearly seems to suggest settlement negotiations approaches that could be used to argue for lower settlements reflecting the kinds of damages adjustments the report details.


Special thanks to Katie Galley of Cornerstone Research for sending me a copy of this report.