OOPs! The Inherent Ambiguity of Out-of-Pocket Damages in Securities Fraud Class Actions

Most securities fraud class actions under SEC Rule 10b-5 involve revelation of negative information about the defendant company that should have been disclosed earlier – bad news that (allegedly) has been covered up by company agents. The standard remedy in such cases is out-of-pocket damages (OOPs). But this measure of harm is inherently ambiguous. Some courts interpret it as price inflation at the time of purchase. Others interpret it as the difference between the price paid and the price at which a stock settles after corrective disclosure. Although it might seem that these formulations are synonymous, the latter includes not only the difference in price that would have obtained if the truth had been known at the time of purchase but also any additional difference that might be caused by revelation of the truth. For example, the market may conclude that the company is likely to become the target of an SEC enforcement action or private securities litigation. Either way, the company is likely to suffer increased legal expenses. In addition, the company may suffer an increased cost of capital because the market perceives added risk that information about the company may be unreliable. These additional factors and possibly others – herein dubbed collateral damage – will be reflected in the decrease in price that occurs immediately upon corrective disclosure. But such collateral damage is harm suffered by the company that should be the subject of a derivative action – for the benefit of all stockholders – and not a direct (class) action. The clear implication is that OOPs should be measured as price inflation at the time of purchase– that is, price inflation narrowly defined net of any collateral damage. Indeed, because FRCP Rule 23 – which governs class actions – requires that a class action for damages be superior to any other means of resolving a dispute, Rule 23 itself requires that collateral damage be addressed in a derivative action simply because it can be so addressed. As demonstrated here, state corporation law is perfectly congruent with federal securities law such that a derivative action for collateral damage will lie whenever a meritorious claim can be stated under Rule 10b-5. Aside from simplifying the litigation process by providing for unitary corporate recovery, derivative actions avoid the circularity inherent in class actions while also addressing the problem of excessive deterrence by providing a perfectly tailored action against individual wrongdoers. Finally, because derivative actions quite clearly address corporate internal affairs, a corporation can assure that claims for collateral damage will be so addressed by adopting a bylaw to that effect.