United States v. Schiff, 2010 WL 1338141 (C. A. 3 (N.J.))(April 7, 2010)
Since the U.S. Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, 544 U.S. 336 (2005), federal courts have required shareholders in civil securities litigation to use financial experts to prove loss causation. That is, the plaintiffs will likely need an expert event study or similar, statistical economic model to show that the alleged corporate fraud—and not a combination of industry and economic factors—caused a drop in share prices. (See, e.g., “Expert Event Study ‘Almost Obligatory’ in Securities Fraud Litigation,” In re Vivendi Securities Litigation, June 2009 Business Valuation Update.)
More recently, courts have started to impose the same evidentiary requirement on the government in criminal securities fraud cases. As this new case demonstrates, the government’s attempt to limit its own financial expert, and avoid comprehensive event studies, turned out to be a risky decision.
Expanding the reach of Dura. In 2005, a grand jury indicted two former, high-ranking Bristol-Meyers executives for orchestrating a massive securities fraud scheme related to the drug company’s wholesale distribution inventory during the early 2000’s. Three separate press releases were allegedly issued with the intent to cause a drop in the company’s market price. Before trial and based on precedent from civil securities fraud cases (most notably Dura), the U.S. District Court (New Jersey) ruled the government would need an expert to present the stock drop evidence:
Demonstrating that market reactions are caused by company press releases should not, however, be an exercise in post hoc, propter hoc [‘after this, therefore that’] logic. Many variables have the potential to and do affect a stock price-the daily market average; national, local and industry-specific economic news; competitors' activities; and on and on. The overall volatility of the stock price and the speed of its reaction to company news may also be significant. To this end, expert testimony may be helpful because of the utility of statistical event analysis for this inquiry. [citations omitted]
Accordingly, the government retained a “stock drop expert” whose report addressed the effect of all three company disclosures, but dealt only with exogenous (external) events beyond the company’s control, such as market, industry, and economy-wide effects. “The government did not ask him to address the potentially unrelated negative events disclosed in Bristol’s announcement[s] by statistically disaggregating the effect of those events,” the district court explained.
The defendants challenged the evidence under Rule 702 of the Federal Rules of Evidence and Daubert. Prior to the hearing, the government announced that it would limit the expert’s testimony to only one public disclosure, which took place on April 3, 2002 and was followed by the most substantial drop in stock price on April 4, 2002, of nearly 15%. The district court expressed its concern that there could be an “analytical gap in the expert’s testimony, such that it did not ‘fit’ the case.”
In particular, if in addition to disclosing a fraud-related event (regarding wholesale inventories), the press release announced a company event that could have triggered the stock drop, “then the expert’s testimony that viewed the announcement as a whole would not be probative of materiality (i.e., it would fail to fit),” the court said. Once again, it noted that the expert could have disaggregated the multiple confounding factors (i.e., simultaneously disclosed unrelated negative events), but declined to do so at the government’s request.
The district court had a second concern. If any portion of the April 3 disclosure repeated information in a prior press release (which did not cause a substantial drop in stock price), then a subsequent market drop might not be attributable to the fraud, but to some other factor. “By restricting [its expert’s] report and testimony to only the April 3 announcements and April 4 stock drop, he did not consider what inventory information announced on April 3 was new and what was already disclosed (and thereby incorporated into the market price of Bristol’s stock),” the court said.
The government still maintained that all of the negative company events disclosed on April 3 were new and related to the fraud, so statistical disaggregation of those events was unnecessary. The court permitted the Daubert hearing to proceed, but learned at the close of evidence that the government intended to call several unnamed (and previously undisclosed) fact witnesses to show that all the company announcements on April 3 related to the fraud. The court called this a “theory shift” in the case. The expert’s report did not assume this relationship of events and the defendants might not have time to evaluate the “skeletal factual proffer.” The court also wondered whether the intended fact evidence might not be more appropriate for an expert. Lastly, some of the disclosed events appeared “significant and unrelated to” any actionable fraud, the court said.
Government has taken a gamble. Nonetheless, the court gave the government a “substantial opening” to introduce factual evidence of the stock price drop at trial. If, at that point, the government believes it has laid sufficient support for its expert’s report regarding the April 3 disclosures, then it could move to admit the evidence (with its lack of certain assumptions and a disaggregating statistical study). If the government’s motion is unsuccessful, however, then its expert’s testimony would be “admissible only to refute an argument….that the market for [Bristol’s] stock is not efficient or that extrinsic market factors account for the observed stock price drop,” the court held.
The government appealed the Daubert ruling to the U.S. Court of Appeals for the Third Circuit. After reviewing the record, the appeals court found the district court allowed the government not only to present its fact witnesses at trial, but to petition the court for presentation of the expert stock drop evidence. If the fact witnesses failed to lay the proper foundation (and neither court could evaluate the intended evidence, given the government’s “bare-bones” description), then the district court properly precluded the expert evidence based on lack of analytical “fit.” (Note, the appellate court also found that there was “no question here about whether the market is efficient,” which would appear to limit the government’s expert to refuting arguments regarding external causation.)
Finally, the district court’s “generous” ruling also permits the government to renew its argument at trial that its expert evidence is material and provides the critical causal link. In this context, and given the broad discretion afforded federal courts to manage cases and their evidence, the Third Circuit affirmed the Daubert decision.