By Lauren Goldman and Alexander Law
Earlier this year, a U.S. District Court for the Northern District of California jury found Tesla CEO Elon Musk not liable for losses incurred by investors who accused him of fraud based on his tweets in August 2018, in which he said he was thinking of taking the company private.
One of the most remarkable features of the case was not that the jury only deliberated for one hour, but that this securities fraud class action reached the trial stage with only a few narrow issues to be tried, including the amorphous element of loss causation.
In the last two decades, only 11 securities fraud class actions have been tried to verdict.
And of the cases that have even made it to a judge's pen, most fail to resolve critical questions surrounding loss causation standards beyond the specific facts in the cases before them. Indeed, even the U.S. Supreme Court, in its 1988 case Basic Inc. v. Levinson, expressly refused to "adopt any particular theory of how quickly and completely publicly available information is reflected in market price."
This has left practitioners without clear answers to critical questions that can result in a swing of tens of millions of dollars in value in the securities class action context. With the proliferation of charismatic CEOs frequently communicating without guardrails for extended periods of time, one such question promises to be top of mind in the near term: Can loss causation be proved through multiday window event studies in which a corrective disclosure spans several days?
While not directly at issue in the Tesla trial, U.S. District Judge Edward M. Chen explored unique questions related to loss causation, including the validity of the plaintiff's expert's reliance on the leakage theory of loss causation. The theory is exactly as it sounds: that the truth can be revealed, or "leak out" over the course of multiple days — 11 days to be exact in the Tesla case.
Judge Chen ultimately held that the plaintiff's expert could testify about this theory, observing that the U.S. Court of Appeals for the Ninth Circuit has taken a "flexible approach to loss causation that recognizes that there are an 'infinite variety of ways for a tort to cause a loss.'" Even more noteworthy was Judge Chen's holding that so long as the plaintiff's expert could show "that the alleged misrepresentations, as opposed to something else, foreseeably caused [the plaintiff's] loss, loss causation is satisfied."
Judge Chen's rulings, and the Tesla trial more broadly, shined a new spotlight on the unsettled frontier of loss causation in securities fraud class actions, as well as the varied situations in which a company may find itself facing securities fraud claims.
Corrective Disclosures and the Use of Multiday Window Event Studies
In securities fraud cases, loss causation resembles the tort law concept of proximate cause. As in tort law, plaintiffs must show a causal link between the alleged misconduct and the economic harm ultimately suffered. To do so, plaintiffs in securities fraud cases often rely on analysis of corrective disclosures, which are instances when information is disseminated to the market that corrects the misstatements or omissions by the company that are the basis for the action.
Corrective disclosures can take almost any form. Two common types of corrective disclosures are press releases and a company's release of its financial or settlement information.
In cases where a corrective disclosure is a press release or even a tweet, there is at least some consensus that an efficient market acts rapidly, such that the trading price for the defendant's public security will react the same day as the corrective disclosure to reflect the release of new information.
But even efficient markets do not instantaneously translate information into prices. According to the U.S. District Court for the Eastern District of Pennsylvania's 2022 ruling in Allegheny County Employees' Retirement System v. Energy Transfer, courts "acknowledge the difference between the hypothesis of efficient markets and the real world" by recognizing that an "efficient price is not set by an invisible hand that instantly reflects new information in a security's price, but [rather] through the dynamic, high-volume exchange of a security over an appropriate window of time."
Experts often use an event study to compare the price of a company's public security before and after the corrective disclosure.
The U.S. District Court for the Southern District of New York, in its 2016 opinion in Strougo v. Barclays has described an event study as an exercise akin to a medical experiment with a control group and a treatment group, saying,
[i]n a securities setting, the control group is established by modeling the normal relationship of a stock's price movements to movements of a market and/or industry index. The difference between the stock price movement we actually observe and the movement we expected to observe (i.e. the difference between the treatment and the control group) that occurs upon the release of a particular piece of information is called the excess price movement of the stock at the time of the event. This excess price movement is tested for statistical significance to see whether the result is unusual or unlikely to be explained by the normal random variations of the stock price.
This process, according to the Strougo court, has been broken down into four concise steps: "defining the event (e.g., an earnings announcement), establishing the announcement window (i.e., the period over which stock price changes are calculated), measuring the expected return of the stock, and computing the abnormal return (which is the actual return minus the expected return)."
Most event studies cover a single-day window because, as discussed above, the concept of an efficient market generally supports the notion that a company's stock price will react the same day as the corrective disclosure. However, courts, including the U.S. District Court for the Northern District of Georgia in Monroe County Employees' Retirement System v. Southern Co. have found that, "in accordance with the academic literature, ... when the particular facts and circumstances justify investigating multi-day event windows, such analysis is appropriate."
There are a variety of circumstances that courts have found justify using a multiday event window.
For example, courts in the Southern District of New York have allowed the use of multiday event windows to capture the day of a company's announcement and the day after, including in its 2015 decision in Carpenters Pension Trust Fund of St. Louis v. Barclays, in which it observed that "a two- to three-day window is common in event studies."
Three-day windows can be used "for instance as a result of a report being issued late in the day, a mis-classification of the date, or simply momentum trading by investors," or when the day before the event day is significant because "the information is released first to a select group of investors prior to being released to the public," per the Southern District of New York's 2009 ruling in Fogarazzo v. Lehman Bros. Such analysis is widely accepted across other circuits.
But what if the corrective disclosure does not fall neatly into one of those more well-trodden examples? What if the major price movement in a company's public security is several days after the speaker begins disclosing information that corrects the market?
An Invented but Realistic Example
Consider the following invented — but very possible — scenario, given the proliferation of congressional investigations in recent memory:
- Congress subpoenas a whistleblower to give testimony regarding their experience at their former employer, Company A, a prominent publicly traded company.
- Because of the importance of the whistleblower's testimony, the whistleblower is slated to speak at least over the course of three days, for four hours each day. Each political party has politicized the whistleblower, and it is expected that one party will attempt to develop the witness's testimony, and the other party will try to undercut it.
- On day one, the whistleblower gives testimony that implicates Company A in criminal activity. However, the public knows the whistleblower will come back to answer more questions for the next two days and will be cross-examined by the other political party on the same topic.
- After day one, Company A's stock price decreases slightly. After day two, the stock price again decreases slightly.
- On day three, the whistleblower is asked questions on an unrelated topic and does not discuss the alleged criminal activity again. The whistleblower's testimony concludes.
- After day three, Company A's stock price drops significantly.
- A law firm files a securities fraud class action against Company A, alleging that Company A made material misstatements and omissions to its shareholders when it failed to disclose its ongoing criminal activity thereby artificially inflating the stock price and causing losses to shareholders once the truth was revealed at the congressional hearing.
The law is unclear about whether plaintiffs can present evidence regarding damages that include the big price movement after day three of the whistleblower's testimony, which came two days after the whistleblower first discussed the criminal activity, or whether plaintiffs are restricted to the smaller price movements that can be more classically tied to the day of the disclosure.
Using the analogy from the Southern District of New York, such a scenario makes it hard to determine where the control group ends and the treatment group begins. If the whistleblower had spoken for only one day in our example, it would be a relatively simple exercise of determining when the market learned about the testimony and seeing how the price movement compared with how Company A's stock would have been expected to move that day.
However, in the scenario above, determining whether any of the changes to Company A's stock were actually the control group or treatment group is a really challenging, fact-intensive exercise that even highly trained economists might approach differently. Which expert the court decides to believe could determine hundreds of millions or even billions of dollars in damages. The lack of a firm rule to follow has created a gap in the law that presents unique challenges to practitioners.
When a speaker is captive, such as due to a legislative subpoena, that speaker is compelled to speak on a variety of topics for an indeterminate period. Therefore, a plaintiff's lawyer may argue that the markets cannot meaningfully react to any of the speaker's disclosures until the market knows the speech is over.
First, the market cannot evaluate the speaker's credibility until the speaker has been questioned by all parties. Second, the market does not know if the speaker will say more about the topic at issue until the speaker is finished. Third, the market may not have immediate or fulsome access to the speaker's testimony due to confidential portions of testimony or delays in receiving transcripts, for example.
On the other hand, a defense lawyer may contend that such an expansive use of a corrective disclosure flies in the face of an efficient market that would react immediately upon news that a company allegedly engaged in criminal activity.
This legal debate is at the center of numerous securities fraud class action cases, and experts play a large role. The Supreme Court declined to make a formal rule about event window length, deciding in its 2014 decision in Halliburton Co. v. Erica P. John Fund Inc. not to "enter the fray" of academic debates about the speed at which information is impounded into a stock price,leaving significant room for experts to debate the facts of each case.
In securities fraud class actions at the class certification stage, it is common for the court to discuss the merits and flaws of each side's experts and formulate a position based on a close reading of the expert positions. However, it is rare for cases that turn on the length of the event window to make it to final adjudication.
Therefore, whether loss causation can be established by the use of multiday window event studies remains a question that the Supreme Court has declined to answer and district courts rarely answer with finality beyond making narrow fact-based determinations before final adjudication. The uncertainty around event windows means greater risk for plaintiffs lawyers, but a potentially high reward if the battle of experts goes their way.
This article was first published by Law360 on July 14, 2023.