Price Inflation and Price Maintenance in Securities Fraud Class Actions

Most securities fraud class actions are based on allegations that the defendant company made some misrepresentation of material fact that had the effect of maintaining stock price at a level higher than what it would have been if the market had known the whole truth about the company. But some scholars have argued that this definition of fraud is inconsistent with the fact that there is no general duty under federal securities law requiring disclosure of information simply because it is material – because reasonable investors (like enquiring minds) would want to know: If the company can simply remain silent rather than voluntarily (mis)speaking to the market, it cannot be held liable simply because stock price would have fallen if investors had known the whole truth. How then can a company be liable if it does speak to the market in some way that merely confirms what the market already thinks? Thus, scholars who question the price maintenance theory argue that absent a duty to speak, a misrepresentation must cause stock price to increase to state a claim for fraud. Nevertheless, the courts have consistently upheld claims based on a theory of price maintenance without much explanation as to why they reject the argument that literal price inflation should be required to state a claim. Rather, the courts have relied on a general duty not to lie – at least in cases involving affirmative misrepresentations – together with a duty to update information that has become misleading and a duty to correct rumors (for example) that originate from sources within the company. SCOTUS has never opined on the price maintenance theory of fraud, although it has expressly recognized this gap in its securities fraud jurisprudence.

The implications of this debate extend far beyond the mere definition of fraud. Scholars who advocate for the price inflation requirement argue that the company should be held liable only to the extent of price inflation. In contrast, the price maintenance theory suggests that the remedy should be based on the price paid and the price at which the stock settles following corrective disclosure. Price inflation is clearly a more precise (albeit limited) measure of loss. But it excuses even outrageous lies that merely maintain stock price. In contrast, the price maintenance theory depends on corrective disclosure to reveal the effect of the fraud. And since corrective disclosure may be accompanied by other items of good (or bad) news that have the effect of muting (or magnifying) price change, the price decrease following corrective disclosure often reflects more than merely undoing the misrepresentation. Mostly, scholars have worried that savvy companies will wait until they have some good news to announce before they correct an earlier misstatement – and thus soften the effects of bad news. But the much more common scenario is that corrective disclosure will come with additional bad news, which often permits buyers to make much larger claims, especially when corrective disclosure comes in the form of a dramatic event that reveals the earlier (alleged) misrepresentation. To recognize such claims means that investors will be that much more encouraged to sue, and companies will be that much more deterred from voluntary disclosure. Indeed, the primary policy motivation for requiring literal price inflation seems to be to limit the potential for compensatory damages to investor loss based on mispricing at the time of purchase – to net out the consequential losses that flow from corrective disclosure.