Loss Causation and the Materialization of Risk Doctrine in Securities Fraud Class Actions

Abstract

In the context of a claim for securities fraud under SEC Rule 10b-5, most federal circuit courts have ruled or recognized that loss causation can be proven by an event that demonstrates an earlier statement by a defendant company to be false. In other words, corrective disclosure need not take the form of speech. Rather, a statement can be shown to be false by the materialization of a risk that was concealed by the company, and investors can be compensated for any losses they suffer as a result. Although this materialization doctrine is well established, it is the thesis here that its ultimate effect is to over-compensate investors, thus encouraging excessive securities litigation and chilling voluntary disclosure.

The point is graphically illustrated by the securities litigation that followed the Deepwater Horizon explosion and spill. There, plaintiffs argued that BP (the operator of the rig) had misrepresented its safety practices. Assuming the allegations to be true, the pre-event market price of BP stock would have been a bit lower, reflecting additional risk. If plaintiffs had paid that lower price, they would have had no claim as a result of the explosion and spill. So if plaintiffs recover an amount equal to pre-spill price inflation, they will be in exactly the same financial position as if they had bought knowing the truth. But most of the price decline following the event came from the prospect of cash outflows resulting from clean-up, repairs, fines, settlements, and possibly an increase in the cost of capital. To compensate buyers for these consequential losses is excessive. The risk of such losses is one that can be diversified away by investors. Moreover, if these consequential losses are actionable at all, they constitute a claim of mismanagement belonging to the company that should be pursued in a derivative action.

To generalize: In cases in which loss causation can be shown only by materialization, the bulk of the claim is almost always more properly characterized as one on behalf of the company that should be resolved by a derivative action instead of by a class action on behalf of individual investors. Moreover, to recharacterize such claims as derivative carries significant collateral benefits: Because the company stands to recover (rather than to pay), derivative actions avoid the circularity problem endemic in class actions while providing a remedy that is perfectly tailored to the true (undiversifiable) loss suffered by investors. It is difficult to overstate the significance of this insight: It implies that much of securities litigation, as we know it must be recast as derivative rather than direct.

Keywords: securities fraud class action, Rule 10b-5, loss causation, misrepresentation, corrective disclosure, materialization of risk, derivative action, price inflation, consequential damages, mismanagement, fiduciary duty, deterrence, compensation, superiority

JEL Classification: G32, K22, K41