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(Article from Securities Law Alert, May 2015)

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On May 21, 2015, the Seventh Circuit vacated a jury verdict finding Household International, Inc., now known as HSBC Finance Corp. (“HSBC”), and several of its executives liable for $2.46 billion in damages for securities fraud. Glickenhaus & Co. v. Household Int’l, Inc., 2015 WL 2408028 (7th Cir. 2015) (Sykes, J.). Relying on the Supreme Court’s decision in Dura Pharm., Inc. v. Broudo, 544 U.S. 336 (2005), the Seventh Circuit held that defendants were entitled to a new trial because plaintiffs’ leakage model of loss causation “did not adequately account for the possibility that firm-specific, nonfraud related information may have affected the decline in [HSBC’s] stock price during the relevant time period.”

Background

Plaintiffs brought suit “alleging that on numerous occasions [HSBC] and its executives [had] misrepresented [HSBC’s] lending practices, delinquency rates, and earnings from credit-card agreements.” The case proceeded to trial before a jury. During trial, plaintiffs’ expert presented two different models — the specific-disclosure model and the leakage model — for measuring the amount by which HSBC’s stock price was “overpriced” as a result of defendants’ alleged misrepresentations.

The specific-disclosure model measured the effect of each “major disclosure event” on HSBC’s stock price on the specific day of that event. Plaintiff’s expert determined “[t]he effect of a disclosure event” based on “the actual return on the day of the disclosure minus the predicted return (using [a] regression model and the broader market returns that day).” The leakage model accounted for the possibility that “the information contained in a major disclosure event often leaks out to some market participants before its release.” The leakage model factored in “every difference, both positive and negative, between the stock’s predicted returns . . . and the stock’s actual returns during the disclosure period.” Pursuant to the leakage model, plaintiffs’ expert assumed that the effect of defendants’ disclosures was equal to “[t]he total sum of these residual returns.”

During trial, the jurors were asked to determine “which model more accurately measured the effect of disclosures,” among other issues. The jury “adopted and applied the leakage model,” and found defendants liable for $2.46 billion in damages. Defendants appealed the jury verdict on the grounds that, inter alia, “the leakage model . . . did not account for firm-specific, nonfraud factors that may have affected the decline in [HSBC’s] stock price.”

Defendants also contended that the court had “incorrectly instructed” the jury “on what it means to ‘make’ a false statement in violation of the securities laws.” The district court had advised the jury that in order “[t]o prevail on their 10b-5 claim against any defendant, plaintiffs must prove . . . the defendant made, approved, or furnished information to be included in a false statement of fact.” Defendants moved for a new trial based on the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, 131 S. Ct. 2296 (2011), which was issued after the trial.[1] The Janus Court held that “[f]or purposes of Rule 10b-5, the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” The district court denied defendants’ motion, “reasoning that the [Janus] Court’s holding applied only to legally independent third parties (like the investment advisor in Janus itself), not corporate insiders like the individual defendants here, all top executives at [HSBC].” Defendants appealed.

Seventh Circuit Finds a New Trial Is Warranted on Loss Causation Grounds Because the Leakage Model Did Not Account for Firm-Specific, Nonfraud Factors

On appeal, the Seventh Circuit found that “in order to prove loss causation” under Dura, 544 U.S. 336,  “plaintiffs in securities-fraud cases need to isolate the extent to which a decline in stock price is due to fraud-related corrective disclosures and not other factors.” The court observed that in Dura, the Supreme Court recognized that a stock price decline “may reflect, not the earlier misrepresentation, but [also] 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” (quoting Dura, 544 U.S. 336) (emphasis added by the Seventh Circuit). 

The Seventh Circuit determined that plaintiffs’ “leakage theory . . . did not adequately account for the possibility that firm-specific, nonfraud related information  may have affected the decline in [HSBC’s] stock price.” The court found that “[t]he model assume[d] that any changes in [HSBC’s] stock price — other than those that [could] be explained by general market and industry trends  ― [were] attributable to the fraud-related disclosures.” In the event that “there was significant negative information [during the class period] about [HSBC] unrelated to these corrective disclosures (and not attributable to market or industry trends),” then the court determined that “the model would [have] overstate[d] the effect of the disclosures and in turn of the false statements.” Conversely, if “there was significant positive information about [HSBC]” during the class period, “then the model would [have] understate[d] the effect of the disclosures” (emphasis in the original).

The Seventh Circuit acknowledged that “[f]irm-specific, nonfraud factors were not entirely ignored” under plaintiffs’ leakage model. Plaintiffs’ expert “testified that he looked for company-specific factors during the relevant period and did not find any significant trend of positive or negative information apart from the fraud-related disclosures.” However, defendants argued that “this was not enough” under Dura because the “loss-causation model must itself account for, and perfectly exclude, any firm-specific, nonfraud related factors that may have contributed to the decline in a stock price.”

The Seventh Circuit observed that “[i]t may be very difficult, if not impossible, for any statistical model” to “perfectly exclude” nonfraud factors. The court found that “[a]ccepting the defendants’ position likely would doom the leakage theory as a method of quantifying loss causation.” However, the court also recognized that “if it’s enough for a loss-causation expert to offer a conclusory opinion that no firm-specific, nonfraud related information affected the stock price during the relevant time period, then it may be far too easy for plaintiffs to evade the loss-causation principles explained in Dura.”

Finding neither option perfect, the Seventh Circuit adopted a “middle ground” position. The court found that “[i]f the plaintiffs’ expert testifies that no firm-specific, nonfraud related information contributed to the decline in stock price during the relevant time period and explains in nonconclusory terms the basis for this opinion,” then defendants must “identify[ ] some significant, firm-specific, nonfraud related information that could have affected the stock price.” If defendants cannot do this, then “the leakage model can go to the jury.” If defendants can identify any firm-specific, nonfraud factors, however, then the burden “shifts back to the plaintiffs to account for that specific information or provide a loss-causation model that doesn’t suffer from the same problem, like the specific-disclosure model.” The court observed that “[o]ne possible way to address the issue is to simply exclude from the model’s calculation any days identified by the defendants on which significant, firm-specific, nonfraud related information was released.”

The Seventh Circuit vacated the jury verdict and remanded the action for a new trial on the loss causation issue “consistent with [this] approach.”

Seventh Circuit Holds the District Court Erred by Limiting the Janus Holding to Corporate Outsiders

The Seventh Circuit further held that the district court had erred in concluding that the Supreme Court’s decision in Janus “applie[s] only to legally independent third parties” and not “corporate insiders.” The Seventh Circuit found that “[n]othing in Janus limits its holding to legally independent third parties.” Rather, the Supreme Court’s interpretation of Rule 10b-5 “applies generally, not just to corporate outsiders.”

The Seventh Circuit determined that the district court’s jury instruction on what it means to “make” a statement for Rule 10b-5 purposes “directly contradict[ed] Janus.” The court had “instructed the jury that the plaintiffs could prevail on their Rule 10b-5 claim if they proved that the defendant ‘made, approved, or furnished information to be included in a false statement’” (emphasis in the original). The Seventh Circuit found that “[t]his goes well beyond the narrow interpretation [of Rule 10b-5] adopted in Janus” and “plainly misstated the law.”

The Seventh Circuit held that this instructional error did not prejudice HSBC itself, because “[t]he company stipulated that it [had] ‘made’ all statements in its SEC filings and press releases.” However, the court found that the error did prejudice the individual defendants, including HSBC’s CEO. For example, the Seventh Circuit found no basis for plaintiffs’ claim that the CEO had “‘made’ the statements in the [company’s] press releases.” The court noted that the CEO “had authority over the press releases in the sense that he could have exercised control over their content” (emphasis in the original). However, the Seventh Circuit explained that “if that were enough to satisfy Janus, then CEOs would be liable for any statements made by their employees acting within the scope of their employment.” The court found that such an approach “wouldn’t square with the Court’s reminder about ‘the narrow scope that we must give the implied private right of action’ under Rule 10b-5.” To satisfy Janus’s requirements, the Seventh Circuit explained that HSBC’s CEO “must have actually exercised control over the content of the press releases and whether and how they were communicated” (emphasis in the original).

The Seventh Circuit held that all three HSBC executives were entitled to a new trial on the issue of whether they had “made” the statements alleged within the meaning of Janus.