Theories of Causal Nexus in Rule 10b-5 Claims: A Critical Reassessment

A Rule 10b-5 claim ‘resembles, but is not identical to, common law tort actions for deceit and misrepresentation.’

Dura Pharmaceuticals, Inc. v. Broudo, 544 US 336, 341 (2005).

[O]ne who fraudulently makes a material misrepresentation of fact, opinion, intention, or law, for the purpose of inducing another to act or refrain from acting, is subject to liability for economic loss caused by the other's justifiable reliance on the misrepresentation.

Restatement (Third) of Torts § 9 (Am. Law Inst. 1997).

Likewise, to establish a claim for damages under Rule 10b-5, a plaintiff must show: –

a material misrepresentation or omission

Where a material misrepresentation or omission is actionable as securities fraud if there is ‘a substantial likelihood that the disclosure of the misstated or omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.’

TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

Scienter indicates a wrongful state of mind (e.g. malice), which the Supreme Court defined as an ‘intent to deceive, manipulate, or defraud’, and several lower courts held that ‘a reckless disregard for the consequences of one's actions is enough to demonstrate scienter in an action under Rule 10b-5.’

SEC v. Falstaff Brewing Corp., 629 F.2d 62, 77 (D.C. Cir. 1980).

A connection with the purchase or sale of a security concerns a situation whereby a fraud ‘“touches’ or ‘coincides’ with a security transaction, that is, fraudulent practices (in this case, misrepresentation or omission) and securities transactions are not independent events. The US Supreme Court has interpreted this element very broadly in construing securities regulation, and the highest court has emphasised that ‘the rule must be read flexibly to effectuate its remedial purpose, not technically and restrictively.’

The highest court has hitherto considered the issue in following cases: Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6 (1971); United States v. O’Hagan, 521 U.S. 642 (1997); SEC v. Zandford, 535 U.S. 813 (2002). See Thomas J. Molony, “Making Solid Connection: A New Look at Rule 10b-5's Transactional Nexus Requirement.” Santa Clara Law Review 53, no. 3 (2014): 767, 780.

Reliance (also known as ‘transaction causation’) means that a defendant's wrongful conduct has caused a plaintiff to enter into the transaction at issue.

Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

Economic loss is commonly read as the pecuniary loss that a plaintiff suffers. Conceptually, economic loss is ‘interchangeably used in courts with adjacent terms such as injury, harm, and damages.’

Ryan S. Thorson, “Securities Law – The Artificially Inflation Purchase Price Theory: An Economically Sound Yet Legally Insufficient Method of Pleading and Proving Loss Causation, Dura Pharmaceuticals v. Broudo.” Wyoming Law Review 6, no. 2 (2006): 623, 635–636.

Loss causation indicates a causal connection between the alleged misrepresentation and economic loss, that is, an issuer's misstatement must constitute or proximately cause economic loss. Intuitively, graphing a historical price line and a (hypothetically) absent-fraud value line to calculate the difference helps the justices to measure the out-of-pocket losses that are proximately caused by the false or misleading statement of a defendant.

Judge Sneed of the US Court of Appeals for the Ninth District pioneered this concept in Green v. Occidental Petroleum Corp. 541 F.2d 1335, 1341 (9th Cir. 1976). See Jared T. Finkelstein, “Rule 10b-5 Damage Computation: Application of Finance Theory to Determine Net Economic Loss.” Fordham Law Review 51, no. 5 (1983): 838, 844.

The most common federal securities claim is based on Rule 10b-5, which was promulgated by the Securities and Exchange Commission (SEC) pursuant to Section 10(b) of the Exchange Act. However, there are actionable claims under other federal securities law provisions, including Section 11 and 12(a) of the Securities Act of 1933 (which is called the 1933 Act) and Section 18 of the Exchange Act.

Section 11 of the 1933 Act prohibits any material misrepresentations in the registration statement of securities. Covered persons with liability include the ‘issuer, directors or partners, accountants, underwriters and others named as experts’ whose profession gives authority to the filing statement.

15 U.S.C. § 77k.

Section 18 of the Exchange Act, likewise, provides an express cause of action for liability for misleading statements made in filings with the SEC. However, Section 18 is more rigorous in establishing the elements of the claims than Section 10(b) and Rule 10b-5 promulgated thereunder. Admittedly, it is more relaxed in terms of scienter but a showing of reliance is strictly required under Section 18 litigations.

Karmel, “When Should Investor Reliance be Presumed in Securities Class Actions?”, 33.

1. The role of economic theory in construing presumption of reliance

Requiring proof of reliance is purported to hinder Rule 10b-5 claims from being a scheme of investors’ insurance.

Note. “The Fraud-on-the-Market Theory.” Harvard Law Review 95, no. 5 (1982): 1,143, 1,144.

The fraud-on-the market doctrine has its origin with a notable economic theory called the efficient capital market hypothesis (ECMH). The ECMH presumes that ‘open and developed capital markets operate quickly to reflect new information in security prices’.

William J. Carney, “The Limits of the Fraud on the Market Doctrine.” The Business Lawyer 44, no. 4 (1989): 1,259, 1,266. There are three types of tests for market efficiency. First, in weak form tests, technical analysis relying on only past price movements is not a reliable strategy to earn a profit. Second, in semi-strong form tests, only inside information relevant for the formation of prices matters; neither technical analysis nor fundamental analysis is useful for generating excess returns under the assumption that any publicly available information is already incorporated into current prices. Finally, in strong-form tests, even corporate insiders fail to earn superior returns, because market prices would have already reflected all information (private as well as public) concerning the stock. See Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work.” Journal of Finance 25, no. 2 (1970): 383, 388.

In this respect, the ECMH persuasively argues for adoption of the fraud-on-the market presumption of reliance.

Out of three versions of ECMH, the fraud-on-the market doctrine rests upon the semi-strong form; that is, publicly released information is impounded in the securities price. See Schleicher v. Wendt, 618 F.3d 679, 685 (7th Cir. 2010).

2. The Basic ruling and the aftermath

In Basic (Basic Inc. v. Levinson, 1988) decision, the Supreme Court endorsed the fraud-on-the market theory (FOMT) as a basis for permitting a presumption of reliance on misrepresentation concerning stocks traded in public markets.

Basic Inc. v. Levinson, 485 U.S. 224 (1988). Notably enough, lower courts prior to Basic generally held that showing actual reliance would be anomalous in the public securities markets, and proof of materiality could sufficiently replace the requirement. See, e.g. Myzel v. Fields, 386 F.2d 718, 735–37 (8th Cir. 1967); Epstein v. Weiss, 50 F.R.D. 387, 392–95 (E.D. La. 1970).

In particular, criticism of the Basic decision and its underlying logic centres on the question of whether the securities market is truly efficient. This is in part because some notable theories and evidence challenging the ECMH came into the spotlight. The useful insights from findings of behavioural finance (e.g. bounded rationality and heuristics) and trading strategies based on technical analysis (e.g. momentum and rate of change) or fundamental analysis (e.g. dividend yield and price to earnings ratio) were most often cited as examples claiming that there are chances to generate excess returns and that the securities market is thus not entirely efficient.

maBurton G. Malkiel, “The Efficient Market Hypothesis and Its Critics.” Journal of Economic Perspectives 17, no. 1 (2003): 59, 61–63.

Testing market efficiency has indeed become a norm. Demonstrating that the market on which a stock at issue trades was less-developed and inefficient was deemed evidence to rebut the presumption.

The Basic court held that the presumption of reliance is rebuttable: ‘Rule 10b-5 defendants may attempt to show that (i) the price was not affected by their misrepresentation, or that (ii) the plaintiff did not trade in reliance on the integrity of the market price’. See Basic Inc. v. Levinson, 248–249.

Of course, this is not an exhaustive list, but other measures such as market capitalisation, bid/ask spread, and free-float percentage could be taken into consideration (e.g. Krogman v. Sterritt, 202 F. R. D. 467 [N. D. Tex. 2001]).

More recently, some of the Supreme Court Justices in Amgen (Amgen v. Connecticut Retirement, 2013) opined that ‘the Basic decision itself is questionable’.

Amgen Inc. v. CT Ret. Plans & Trust Funds, 568 U.S. 455 (2013).

The Supreme Court has recognised two (rebuttable) presumptions of reliance in private securities fraud lawsuits under Section 10(b) of the Exchange Act and Rule 10b-5: ‘(i) where there is an omission in the face of a duty to disclose (in Affiliated Ute Citizens v. United States, 1972), and (ii) where there is a fraud on the well-developed efficient secondary market (in Basic Inc. v. Levinson, 1988)’.

Kaufman and Wunderlich, “Fraud Created the Market.”, 281.

It is against this backdrop that investors devised an alternative idea, known as the fraud-created-the market theory, which posits that under Rule 10b-5, ‘the courts are allowed to presume reliance on condition that investors relied upon the market itself to prevent the entry of unmarketable securities’.

Peter J. Dennin, “Which Came First, the Fraud or the Market: Is the Fraud-Created-the-Market Theory Valid under Rule 10b-5.” Fordham Law Review 69, no. 6 (2001): 2,611, 2,613–2,614.

However, the fraud-created-the market theory was largely criticised for going contrary to the established purpose of securities law and regulations. Critics complain that reliance is unreasonable because the existence of a security being on the market does not warrant the veracity of disclosure. In truth, federal securities law does not embrace ‘merit-based’ regulation, and the SEC does not assess a company's valuation or exercise due diligence on behalf of investors.

Kaufman and Wunderlich, “Fraud Created the Market.” 286–287.

Of course, there are arguments against these criticisms that support the propriety of the fraud-created-the market theory as well. According to Langevoort, ‘investors rely on a security's integrity as well as its price’.

Donald C. Langevoort, “Basic at Twenty: Rethinking Fraud on the Market.” Wisconsin Law Review 2009, no. 2 (2009): 151, 159–161.

Some proponents of the theory argue that the fraud-created-the-market presumption, in particular, ‘protects a vulnerable group of investors and promotes market integrity’ by facilitating class-wide resolution of securities fraud claims in a broader sense. The advocates claim that investors in a thin and less developed market with low analyst coverage – as opposed to a sophisticated and secondary market with full market intelligence – are more at risk and hence in need of more protection.

Kaufman and Wunderlich, “Fraud Created the Market.” 310–311.

The current split among the federal circuit courts of appeals is evidence that judges are also divided by their own pros and cons, and the tension has not yet been resolved. In actuality, up to that time, while the Fifth (Shores v. Sklar, 647 F.2d 462 [5th Cir. 1981]), Tenth (T.J. Raney & Sons, Inc. v. Fort Cobb, Oklahoma Irrigation Fuel Authority, 717 F.2d 1330 [10th Cir. 1984]) and Eleventh Circuits (Ross v. Bank South, N.A., 885 F.2d 723 [11th Cir. 1989]) adopted the fraud-created-the-market presumption, the Sixth (Ockerman v. May Zima & Co., 27 F.3d 1,151 [6th Cir. 1994]), Seventh (Eckstein v. Balcor Film Investors, 8 F.3d 1,121 [7th Cir. 1993]), and Third Circuits (Malack v. BDO Seidman, LLP, 617 F.3d 743 [3d Cir. 2010]) precluded plaintiffs from turning to the theory in making out a Rule 10b-5 action.

Cassidy, “Validity of the Fraud-Created-the-Market Theory of Establishing Reliance in A Private Action for Damages Under Rule 10b-5.” 1030.

The chain of logic of the fraud-on-the market theory flows from the premise that a false or misleading statement made by a defendant must be incorporated into a security's price so that the conclusion that a plaintiff's reliance on that misrepresentation may be indirectly presumed by relying on the integrity of the market price. The precondition on which this logic operates is that the security trades on the well-developed efficient market. A presumption of reliance may be rebutted when the security price is not affected by misrepresentation at issue or the plaintiff did not trade in reliance on the integrity of the market price. Therefore, the fraud-on-the-market presumption is not logical and thus is inapplicable in the case of an indexed investor (broadly investing in the market) or a short seller (injured on her covering purchase), who clearly does not rely on the security's market price as reflecting its true value.

93 A.L.R. Fed. 444 (originally published in 1989).

In this context, the Basic court transformed the nature of proving transaction causation from a normative analysis to a market-oriented one, with judges generally having little expertise and thereby rendered the issue unwieldy and excessively complicated. Nevertheless, the greater problem in Basic's logic lies in its reliance on the ECMH to support the entirely valid idea that ‘when the market incorporates fraudulent information into price, a fraud on the market results’.

John C. Coffee Jr., “After The Fraud on the Market Doctrine: What Should Replace It?” (Columbia Law School's Blog on Corporations and the Capital Markets, 21 January 2014). https://clsbluesky.law.columbia.edu/2014/01/21/after-the-fraud-on-the-market-doctrine-what-should-replace-it/.

In this respect, the courts do not have to assess the validity or scientific standing on the ECMH in misrepresentation cases. Relatedly, some commentators, including Bebchuk, Ferrell, and Coffee, Jr., argue that justices should focus on the likelihood of fraudulent distortion of the market prices while obviating their long-running inquiry into the irrelevant issue of market efficiency. The price distortion is generally investigated and proven through event studies and other evidence, but today, such a showing is more pertinent to loss causation (as explained hereinafter) and is conducted at a trial stage pursuant to the Supreme Court's holding in Halliburton I decision (Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 [2011]).

Meanwhile, Langevoort used a normative approach to interpret the reliance requirement under Rule 10b-5 of the securities laws, which is in stark contrast with the market-based approach referred to above. Langevoort's duty-based analysis, as aforementioned, demonstrates that ‘investors rely on a security's integrity, implicitly assuming that the price has not been distorted by fraud, as well as its price’ and ‘imposing liability on those who appreciate the gravity of fraud in the marketplace and set out to facilitate a market fraud’ is justifiable.

Kaufman and Wunderlich, “Fraud Created the Market.” 303–305.

This normative perspective is in line with Karmel's argument that public companies should be liable when false or misleading statements are made in a way that bring about economic harm to investors, because they ‘impliedly represent that the statements they made in SEC filings and other required public utterances are truthful, whether or not investors can prove they read and relied upon such statements in purchasing or selling securities’.

Karmel, “When Should Investor Reliance be Presumed in Securities Class Actions?” 31–34.

The bottom line is that Karmel's standard is both reasonable and justifiable in that it allows the court to curb many frivolous litigations without necessitating overruling a long-established precedent. In addition, this normative approach is coherent with the securities law's purpose of encouraging fair and full disclosure. By permitting a presumption of reliance on SEC filings and other required public utterances, issuers and related gatekeepers are forced to pay more attention to providing complete and accurate information. In doing so, the courts deliver a clear message to the marketplace that the securities law protects investors by ‘penalizing defendants for shirking their disclosure obligations’, rather than by condemning plaintiffs for failing to scrutinise the stock at issue.

Kaufman and Wunderlich, “Fraud Created the Market” 314. Judge Easterbrook of the Seventh Circuit earlier opined that “[S]ecurities law seeks to impose on issuers duties to disclose, the better to obviate the need for buyers to investigate. The buyer's investigation of things already known to the seller is a wasteful duplication of effort” (Teamsters Local 282 Pension Tr. Fd. v Angelos, 762 F.2d 522, 528 [7th Cir. 1985]).

1. Traditional approach to loss calculation

Another key element for 10b-5 plaintiffs to be required to show is the causal link between the defendant's fraudulent misrepresentation and the damages. Earlier courts held that it can be ‘easily proven when a misrepresentation causes economic harm’ and the plaintiff must prove that the ‘untruth was in some reasonably way responsible for the loss’.

Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374 (2d Cir. 1974); Huddleston v. Herman & MacLean, 640 F.2d 534, 548 (5th Cir. Unit A 1981).

The House Banking Conference Committee clarified that showing loss causation would be

… for the plaintiffs to prove that the price at which they bought the stock was artificially inflated as the result of the misstatement or omission and the defendants are given the opportunity to prove any mitigating circumstances, or that factors other than the fraud contributed to the loss

Conspicuous here in its absence is any requirement for the stock prices to drop after corrective disclosures of a fraudulent scheme. This way of thinking is congruent with Judge Sneed's analysis of the out-of-pocket measure of damages. Judge Sneed computed the damages incurred by a plaintiff by subtracting the true value of the stock from the price actually paid on the date of purchase.

Jay W. Eisenhofer et al. “Securities Fraud, Stock Price Valuation, and Loss Causation: Toward a Corporate Finance-Based Theory of Loss Causation”, The Business Lawyer 59, no. 4 (2004): 1419, 1425.

The artificially inflated purchase price theory has a long and venerable tradition of jurisprudence. In the 1900 case of Sigafus, (Sigafus v. Porter, 1900), the Supreme Court set the damage standard to claims of fraudulent misrepresentation as follows.

[T]he plaintiffs' damage should equal the loss which the deceit, which the jury have found was practiced upon them, inflicted. The loss is the difference between the real value of the stock at the time of the sale, and the fictitious value at which the buyers were induced to purchase. Their actual loss does not include the extravagant dreams which prove illusory, but the money they have parted with without receiving an equivalent therefor.

Sigafus v. Porter, 179 U.S. 116 (1900).

This ruling is known as the first common law case of quantifying damages in a fraud context, which confirmed that the loss the defrauded buyer incurred was in overpaying at the time of procurement of the securities. In subsequent court decisions, judges reached the same conclusion that actual damages, under the federal rule of damages for fraud, is the out-of-pocket rule. In the federal courts, the measure of damages recoverable by one who through fraud or misrepresentation has been induced to purchase securities at issue is

… the difference between the contract price (or the price paid) and the real or actual value at the date of the sale, together with such outlays as are attributable to the defendant's (mis)conduct. Or in other words, the difference between the amount parted with and the value of the thing received.

Estate Counseling Service v. Merrill Lynch, 303 F.2d 527, 533 (10th Cir. 1962). See also Affiliated Ute Citizens of Utah v. United States., 154–155.

This out-of-pocket rule was commonly used in Rule 10b-5 cases, in the same spirit as the common law tradition. In the following cases, such as Scattergood (Scattergood v. Perelman, 1991), Hayes (Hayes v. Gross, 1992) of the Third Circuit, and Broudo (Broudo v. Dura Pharmaceuticals, 2003) of the Ninth Circuit, the appellate courts drew the contours of what constitutes damages in a securities fraud action and recognised the validity of artificially inflated purchase price theory.

See Scattergood v. Perelman, 945 F.2d 618 (3d Cir. 1991); Hayes v. Gross, 982 F.2d 104 (3d Cir. 1992); Broudo v. Dura Pharmaceuticals, Inc., 339 F.3d 933 (9th Cir. 2003).

2. The Supreme Court's Dura decision strikes back

Despite the common notion that an artificially inflated purchase price theory would sufficiently plead and prove loss causation, a split gradually developed amongst the circuits. Several more recent cases, such as Robbins (Robbins v. Koger, 1997) of the Eleventh Circuit and Semerenko (Semerenko v. Cendant, 2000) of the Third Circuit, took the opposite stance, holding that the out-of-pocket rule is legally insufficient to show the loss existence and its causality.

See Robbins v. Koger Properties, Inc., 116 F.3d 1441 (11th Cir. 1997); Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000).

The discrepancies of the court interpretations led to uncertainty and ambiguity in plotting the contours of the loss causation element in securities fraud claims. This is why the Supreme Court reviewed the lower court's ruling regarding the loss causation requirement in a Rule 10b-5 action. Specifically, the highest court granted certiorari in the Ninth Circuit's Broudo case and overturned the decision in Dura (Dura Pharmaceuticals v. Broudo, 2005).

Dura Pharmaceuticals v. Broudo refers to the Supreme Court's reversal of the Ninth Circuit's Broudo v. Dura Pharmaceuticals decision.

First, an artificially inflated purchase price does not, by itself, prove loss causation. The Court reasoned that ‘there is not any loss at the precise moment of transaction because the inflated price is offset by the ownership of a share that possesses equivalent value at that instant’.

See Dura Pharmaceuticals, Inc. v. Broudo, 336.

Second, although fraudulent misrepresentation might, in part, lead to a fall in the share price, other factors (e.g. macroeconomic conditions, investor sentiments, new industry or firm specific facts or events) could have played a greater role in bringing about a subsequent loss.

Dura Pharmaceuticals, Inc. v. Broudo, 343.

Third, the Ninth Circuit standard is inconsistent with judicial precedent.

Id.

Finally, whilst the primary objective of securities law and regulations is to maintain the public confidence in the marketplace and protect investors against securities fraud, the Ninth Circuit's permissive approach may put the enforcement regime at risk of ‘converting it to a generous insurance plan’ against market loss.

Helms, “The Supreme Court's Dura Decision.”

In addition to the above criticism of the artificially inflated purchase price theory, in Dura, the Supreme Court examined the issue of whether the securities fraud complaints adequately pled to survive dismissal. The highest court began by acknowledging that the Federal Rules of Civil Procedures (FRCP Rule 8) requires only ‘a short and plain statement of the claim showing that the pleader is entitled to relief’.

See Dura Pharmaceuticals, Inc. v. Broudo, 337.

3. Dura's legacy: the development of price impact theories

Since Dura's issuance, some prominent theories have attracted the court's attention through trial and appeal. In more recent cases, several lower courts took price dynamics more seriously and endorsed two types of price impact theories that elucidate the interrelationship between the price movements in the stock market and the revelation of fraud.

First, a notable development is the adoption of the price maintenance theory, which posits that a fraudulent misrepresentation ‘may cause inflation simply by maintaining existing market expectations, even if it does not actually cause the inflation in the stock price to increase at the time that statement is made’.

In Re Vivendi Universal, Sa Securities Litig., 765 F. Supp. 2d 512, 561 (S.D.N.Y. 2011), aff'd, 838 F.3d 223 (2nd Cir. 2016).

Second, the leakage theory reflects the reality that a drop in stock prices is not associated with a single official disclosure but rather through the gradual dissemination of news, typically before, but sometimes also after, a formal announcement. As the Tenth Circuit recognised, ‘loss causation is easiest to show when a corrective disclosure reveals the fraud to the public and the price subsequently drops’.

In re Subclass, 558 F.3d 1,130, 1,137 (10th Cir. 2009).

In Dura decision, the Supreme Court held that plaintiffs must allege that they bought a stock at an artificially inflated price owing to the defendant's false representation and that upon revelation of the truth, the share price dropped, consequently creating damages. As a seminal decision in the jurisprudence of the PSLRA, which codified the loss causation requirement for Rule 10b-5 claims, Dura Pharmaceuticals v. Broudo is often cited as one of the most important securities fraud cases.

Thorson, “Securities Law – The Artificially Inflation Purchase Price Theory: An Economically Sound Yet Legally Insufficient Method of Pleading and Proving Loss Causation, Dura Pharmaceuticals v. Broudo”, 623.

However, above all else, the Supreme Court made some errors from both historical and economic perspectives. It disregarded the legislative intent of the PSLRA, which expressly endorsed the artificially inflated purchase price theory (as addressed in the congressional committee interpretations). In other words, the highest court failed to read the statute's meaning properly. The Court also overlooked the fact that, in a Rule 10b-5 cause of action, the out-of-pocket rule has long been advocated that ‘damages in a securities fraud case is the difference between the (fair) value of all that sellers received and the fair value of what they would have received had there been no fraudulent conduct’.

See Affiliated Ute Citizens of Utah v. United States, 155.

Furthermore, the Dura court was wrong because it relied on faulty reasoning in calculating damages. More pertinent to our discussion as to damage calculations is to determine the date on which a misrepresentation proximately and directly caused economic loss. According to the artificially inflated purchase price theory, paying an unduly higher stock price on the date of purchase leads to damages, and questioning whether there were sales of the security and a price drop is essentially irrelevant. Economic loss must be defined as when an act or omission causes the damages, not at a later date, which is the most intuitive and economically sound approach.

Thorson, “Securities Law – The Artificially Inflation Purchase Price Theory: An Economically Sound Yet Legally Insufficient Method of Pleading and Proving

Consider the following hypothetical numerical example. One day, Company A lied to the market (e.g. window dressing in accounting) and its share price immediately rose from $10 to $15. On the same day, Investor B bought a share of stock at $15. One month later, the public became aware of the truth from an indirect source of information (e.g. an influential blogger), and Company A announced that a patent issuance on its innovative product was imminent. The information leakage (of misrepresentation) lowered the price by the $3 that it had been inflated while the breaking patent news spiked the price an additional $10. One month later, Company A made a corrective disclosure regarding the original misstatement. Assume that the official disclosure led to a fall in a price by $1; the reason for the incremental change in price is that the market already had the information and incorporated it into the stock price prior to the formal announcement. Overall, Investor B earned a profit of $6 per share, and accordingly, there were no actual monetary damages. However, calculating damages under the artificially inflated purchase price theory yields a different result. Under this approach, economic loss is measured by the difference between fair and fraudulent value at the time of purchase. Hence, Investor B suffered a loss of $5 [$15 (purchase price) – $10 (the fair price at the purchase date)]. On the contrary, under the approach advocated by Dura and its amici, damages are calculated by taking a price change surrounding a corrective disclosure date. Therefore, in this hypothetical situation, Investor B is only entitled to $1 in damages.

The bottom line is that the artificially inflated purchase price theory and its ex-ante focus is correct. As Fox stated,

[A] defendant's misstatement injures the plaintiffs not because it caused them to make a purchase that later, ex post, turned out to be a losing transaction, but because, ex ante, it caused them to pay a purchase price that is higher than it would have been but for the misrepresentation.

See Fox, “Understanding Dura”, 1548–1550.

An ex-ante perspective is appropriate especially for fraud-on-the-market cases, because in an efficient market, factors unrelated to the original misstatement may equally affect the security prices, rendering it extremely tough, if not impossible, to sift every scrap of evidence and separate out its causal effect. Therefore, the ex-ante approach of the artificially inflated purchase price theory is consistent with ‘efficiency-oriented economic thinking that has been the driving force behind the recent development of securities regulation’.

Fox, “Understanding Dura.”