Leakage Loss Causation Model Fails to Meet Admissibility Standards
Reprinted with permission from the September 3, 2016 issue of The Legal Intelligencer. © 2016 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
In July, U.S. District Judge Robert W. Sweet of the Southern District of New York issued a comprehensive opinion in the federal securities action, Sherman v. Bear Stearns, Master File No. 08 MDL 1963, Index No. 09 Civ. 8161, 2016 U.S. Dist. LEXIS 97784, at *18-35 (S.D.N.Y. July 25, 2016), explaining why the plaintiff's expert report purporting to prove loss causation under a "leakage" theory should be excluded. The plaintiff, Bruce S. Sherman, who is the former chief executive officer and chief investment officer of Private Capital Management, sued Bear Stearns Companies Inc., and two of the company's former executive officers (the defendants) for alleged violations of Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5, promulgated thereunder (10b-5 claim).
To establish the loss causation element of his 10b-5 claim, Sherman proffered the expert report of John D. Finnerty, which purported to show that information concerning Bear's "true" financial condition "leaked" into the market between Dec. 20, 2007, and March 13, 2008, causing the price of Bear's stock to decline before the March 14, 2008, public disclosure of the company's deteriorating liquidity, and the March 16, 2008, announcement that JPMorgan would acquire Bear for $2 per share. The defendants moved to exclude Finnerty's report and testimony under Federal Rule of Evidence 702 and Daubert v. Merrell Dow Pharmaceuticals, 509 U.S. 579 (1993). Sweet granted the defendants' motion, holding that Finnerty's report failed to qualify under Rule 702 for its lack of general acceptance and not having been subject to peer review and its failure to control for nonfraud factors.
Proving Loss Causation
To establish a 10b-5 claim, a plaintiff must prove, among other things, the essential element of loss causation—a causal connection between the alleged material misrepresentation or omission and the plaintiff's economic loss, i.e., as in Dura Pharmaceuticals v. Broudo, 544 U.S. 336, 341-44 (2005). To meet this burden, the plaintiff must "establish that the price of the securities she purchased was 'inflated'—that is, it was higher than it would have been without the false statements—and that it declined once the truth was revealed." In addition, the plaintiff must show that the stock-price decline resulted from the alleged fraud, not from other factors that affect price: "When the purchaser subsequently resells such shares, even at a lower price, that lower price may reflect, not the earlier misrepresentation, but changed economic circumstances, changed investor expectations, new industry-specific or firm-specific facts, conditions, or other events, which taken separately or together account for some or all of that lower price."
Typically, plaintiffs attempt to meet the loss causation requirement by showing that the defendant company's stock price dropped in reaction to a "corrective disclosure" revealing the allegedly misrepresented or undisclosed fact. Alternatively, some plaintiffs allege a "materialization of the risk" theory of loss causation, "whereby a concealed risk—such as a liquidity crisis—comes to light in a series of revealing events that negatively affect stock price over time."
On occasion, a plaintiff will proffer a third method for proving loss causation—the so-called "leakage theory"—which "posits a gradual exposure of the fraud rather than a full and immediate disclosure," as in In re Williams Securities Litigation, 558 F.3d 1130, 1138 (10th Circ. 2009). To date, only two U.S. circuit courts—the Tenth and the Seventh—have considered the leakage theory. In each case, the court found that the plaintiff's expert's leakage analysis was deficient, as in Glickenhaus & Cos. v. Household International, 787 F.3d 408, 423 (7th Cir. 2015).
In Williams, the U.S. Court of Appeals for the Tenth Circuit explained that "even a leakage theory ... will have to show some mechanism for how the truth was revealed. A plaintiff cannot simply state that the market had learned the truth by a certain date and, because the learning was a gradual process, attribute all prior losses to the revelation of the fraud. The inability to point to a single corrective disclosure does not relieve the plaintiff of showing how the truth was revealed; he cannot say, 'Well, the market must have known.'"
Accordingly, the court affirmed the district court's rejection of the plaintiffs' expert's leakage analysis, agreeing with the lower court that the expert's "failure to explain how the truth was revealed to the market and failure to then link the revelation of truth to a corresponding loss made his theory unreliable." In Glickenhaus, the Seventh Circuit remanded the case for a new trial on the issue of loss causation because evidence presented at trial in support of the plaintiff's expert's leakage model "did not adequately account for the possibility that firm-specific, nonfraud related information may have affected the decline in the defendant company's stock price during the relevant time period."
The Court's Rejection of the Leakage Model in 'Sherman'
In Sherman, the plaintiff alleged that the defendants misrepresented various aspects of Bear's financial condition and that their alleged misrepresentations led him to purchase a large block of Bear stock between June 25, 2007, and March 13, 2008, at prices ranging from $53.77 to $140.76 per share. On March 19, 2008, after the March 14, 2008, and March 16, 2008, disclosures of Bear's deteriorating financial condition, Sherman sold 229,150 shares of his Bear stock at $5.23 per share.
To prove loss causation, Sherman proffered Finnerty's expert report. According to that report, Bear's stock price not only dropped after the alleged March 14, 2008, and March 16, 2008, corrective disclosures, but it also declined between December 20, 2007, and March 13, 2008 (the alleged leakage period), when the facts of the company's financial condition allegedly "leaked" into the market. The court granted the defendants' motion to exclude Finnerty's report on the following grounds: First, the court determined that the Finnerty report was inadmissible because it failed to qualify under Federal Rule of Evidence 702 for lack of general acceptance and for not having been subject to peer review. Rule 702, which codifies the holdings of Daubert and its progeny, provides that a qualified expert may testify if "her scientific, technical, or other specialized knowledge will help the trier of fact to understand the evidence or to determine a fact in issue; the testimony is based on sufficient facts or data; the testimony is the product of reliable principles and methods; and the expert has reliably applied the principles and methods to the facts of the case." Following the guidance of Daubert in evaluating the reliability and validity of the Finnerty report, the court concluded that "Finnerty's leakage methodology must be excluded" because the Second Circuit "has not endorsed the leakage theory" and because "Finnerty's leakage model has not achieved 'general acceptance' within the relevant scientific community or 'been subjected to peer review and publication.'"
Second, the court further concluded that Finnerty's report failed to qualify under Rule 702 because it did not control for nonfraud factors. After conducting a lengthy analysis of Finnerty's leakage model, the court held that the methodology "failed to adequately account for the impact of nonfraud related information and effects, including market and industry effects." In explaining its reasoning, the court focused specifically on the "fundamental flaw" of Finnerty's "backwardation method": "Finnerty's 'backwardation method' estimates Bear's 'true value' on each day of the purported leakage period by taking his estimate of the true value of Bear's stock at the close of the last day of the period [March 17, 2008] and then back-casting this price to previous days based on either Bear's actual return (for non-fraud related news days) or the return due to market and industry factors (on all other days). Because Finnerty purports to find that the true value of Bear's stock was such a small fraction of Bear's stock price at the end of the leakage period ($10.41 when the stock price was $57), the change in the model's estimated 'true value' is minimal on each day of the leakage period. In turn, this has the mechanical result in his model of attributing almost all of the actual declines in Bear's stock price to the alleged fraud, despite the actual effects on Bear's stock price of market and industry factors and company-specific nonfraud related news."
Consequently, Finnerty's backwardation method "posits that the alleged fraud caused Bear's stock price to decline during the leakage period regardless of whether there was any identifiable leakage." Thus, the court concluded that "there is simply no evidence that any of the stock price declines between Dec. 20, 2007, and March 7, 2008, were due to leakage rather than other factors, and plaintiff will not be permitted to use the results during the week of March 10, 2008, to create the impression of an abnormal return where there was none."
Notably, the court also granted the defendants' motion for summary judgment to the extent Sherman's claims were based on Finnerty's leakage report, holding that the report failed to meet the loss causation requirement. Because few courts have assessed the admissibility of an expert's leakage model, Sweet's detailed opinion provides helpful guidance for parties litigating the loss causation issue in 10b-5 cases, particularly at the expert discovery and summary judgment stages.
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