Event-driven securities suits – ones that arise after an issuer has experienced some kind of disaster – have become increasingly prevalent in recent years. These suits are based on the fraud on-the-market doctrine, a doctrine that ultimately gives rise to the bulk of the damages paid out in settlements and judgments pursuant to private litigation under the U.S. securities laws.
The theory behind fraud-on-the-market cases is that when an issuer’s share price has been inflated by a Rule-10b-5-violating misstatement, investors who purchased shares at the inflated price have suffered a compensable injury if they still hold the shares after the inflation is gone. Although these event-driven suits differ in important ways from their more traditional cousins based on the same doctrine, they constitute a kind of stress test for the overall doctrine. The growth of event-driven cases thus provides a unique opportunity to reconceptualize the overall system of adjudicating fraud-on-the-market suits more generally.
In this Article, we identify the basic logic behind this cause of action and consider what that logic implies as to when liability should and should not be imposed from a social welfare perspective. The result suggests ways we can both solve the challenges posed by event-driven litigation and improve fraud-on-the-market jurisprudence more generally.
In an event-driven case, the plaintiff points to a pre-disaster statement that allegedly underplayed the likelihood that the disaster would occur and argues that the disaster announcement was the corrective disclosure. But in these cases, the price drop on the day of the disaster announcement is almost never a reasonable measure of the misstatement’s share price inflation. By focusing on the price drop at the time of a corrective disclosure, as courts generally do in fraud-on-the-market suits, they have lost track of the real issue: whether the misstatement inflated the share price by a meaningful amount in the first place. More often, the answer to that question is better indicated by the price change back at the time of the misstatement.
For all fraud-on-the-market suits where the plaintiff can establish a misstatement made with scienter, we argue that liability should be imposed where the misstatement’s price impact appears to be at least as great as an inflation threshold chosen to trade off the costs and benefits of adjudicating securities class actions. Liability should not be imposed where both the misstatement’s price impact appears to be smaller than this inflation threshold, and the market would not have drawn negative inferences had the issuer stayed silent instead of making the misstatement. Where the misstatement’s price impact is less than the inflation threshold, but the market would have drawn negative inferences from issuer silence, liability should be imposed if and only if both the corrective disclosure’s price impact is a reliable proxy for how much the misstatement inflated the share price, and this impact appears to be at least as great as the inflation threshold.