How finely does an expert’s loss-causation model have to filter out non-fraud-related factors? This was the question at the heart of an unusual financial case.
Big award challenged: Securities fraud cases rarely make it to trial, but this one did. The plaintiffs (investors in Household International Inc.) filed suit alleging misrepresentation of the company’s lending practices, delinquency rates, and earnings from credit-card agreements. The jury found the defendants liable and, based on expert testimony, awarded them $2.46 billion—one of the largest judgments to date. In appealing the verdict to the 7th Circuit, the defendants essentially claimed the plaintiffs failed to prove loss causation, a critical element of a securities fraud claim. The plaintiffs must show that they bought the stock at an “inflated” price—a price higher than it would have been without the false statements—and that the stock price declined once the market learned of the deception.
As the 7th Circuit observed, calculating how much stock price inflation a false statement causes requires “sophisticated expert testimony,” Here, the plaintiffs hired “one of the best in the field.” At trial, the expert proposed two loss causation models. Under the specific-disclosure model, he identified each major disclosure event and then measured the disclosure's effect on the stock price on that specific day. He found the net effect of the disclosures was a decline of $7.97 in the stock price. Under the leakage model, he sought to account for the fact that some of the information in a major disclosure often leaks out to participants in the market before it is made public. The price impact based on this model was $23.94 per share.
Fly in the ointment: The crux was that, while both models adjusted for market-related factors, they did not account for the effect of company-specific, non-fraud-related information. When asked at trial, the expert testified that he carefully had looked for that kind of information. There were disclosures that “dealt with something other [than that which] was fraud related,” he acknowledged. But he did not find any significant trend of positive or negative information. The jury adopted the leakage model for its damages determination.
The defendants contended that, “to be legally sufficient, any loss-causation model must itself account for, and perfectly exclude, any firm-specific, non-fraud-related factors that may have contributed to the decline in stock price.”
Middle ground: The 7th Circuit considered that standard too high—it likely would doom the leakage model as a way to quantify loss causation. On the other hand, said the court, simply allowing an expert to make a conclusory statement would make it too easy for plaintiffs. There was a “middle ground.” If a plaintiff’s expert explains in nonconclusory terms that no firm-specific, non-fraud-related information contributed to the decline in stock price, the burden shifts to the defendant to identify contrary information that could have affected the stock price. If it can, then the burden shifts again to the plaintiff to account for the effect of that information.
Ultimately, the 7th Circuit remanded for a new trial to explore the issue of loss causation in accordance with its instructions.
Takeaway: While the court acknowledged flaws in the plaintiffs’ loss-causation model, it declined to throw out the baby with the bathwater. In this case, its burden-shifting approach may lower the award but likely won’t reduce damages to zero.
Find an extended discussion of Glickenhaus & Co. v. Household International, Inc., 2015 U.S. App. LEXIS 8424 (June 3, 2015), in the September issue of Business Valuation Update; the court’s opinion will appear soon at BVLaw.