SAN FRANCISCO (HedgeWorld.com)–California’s highest court held that corporations may be liable to investors for misleading statements in earnings reports if those statements induce the stockholders to hold on to shares they would otherwise have sold.
So-called “holders’ lawsuits” have been barred from federal courts since 1975. In the Blue Chip Stamps Co. decision that year, the U.S. Supreme Court held that only the actual purchasers and sellers of securities have standing to bring private lawsuits for damages enforcing section 10(b) of the Securities Exchange Act of 1934.
The plaintiff in the California case, investor Harvey Greenfield (and subsequently his estate’s administrator, Marietta Small, substituted as the plaintiff after Mr. Greenfield’s death), alleged fraudulent misrepresentations by Fritz Cos. Inc., an import/export concern, and three of its officers: improper accounting for merger and acquisition costs, improper classification of ordinary operating expenses as capital expenditures, failure to allow for uncollectable accounts receivable, etc. Mr. Greenfield alleged that in 1996 he read an earnings statement containing such improper numbers and in reliance thereon decided against selling his stock in Fritz. On July 24 that year, when the defendant corporation restated its previously reported revenues earnings, the value of its stock fell by more than 55%.
Although the four-justice majority decision April 7 allowed the lawsuit to proceed, it also indicated that the complaint had not specified crucial elements in such a claim, so the complaint will have to be revised when the matter is remanded to the trial court. Specifically, the complaint in such a case must state specific words and actions indicating plaintiff’s reliance upon the corporation’s inaccurate earnings report.
The court also declined to answer some of the other questions its opinion raises: whether it would also allow relief for someone who declined to buy a stock as a result of excessively pessimistic statements by the corporation or its officers (which had been the precise issue before the U.S. Supreme Court in the Blue Stamp Case) and whether this or similar cases might properly be certified as class actions or might be brought as a derivative action on behalf of the corporation against its officers.
Even on the relatively narrow issue it did decide, the decisions in Small vs. Fritz reveal important differences among California’s justices. Justice Joyce L. Kennard wrote for the four-justice majority. Justice Marvin R. Baxter agreed with the four-justice bloc that there should be such a holders’ right of action, but he would have given the trial court different instructions on remand–instructions that might have made any plaintiff’s recovery in a wide range of cases (including this one) very unlikely. Specifically, Justice Baxter was unhappy about the complaint’s failure to state that Mr. Greenfield sustained any realized loss as a result of the earnings restatement.
“In a holder’s action,” he wrote, “the plaintiff presumably bought the shares at their fair prefraud value,” prior to the misrepresentations made in April 1966. “If he did not sell them when the fraud was disclosed [in July], at a price influenced by the disclosure, but instead retained them for a substantial period thereafter, their value, subject to the daily fluctuations of an efficient securities market, may have risen or fallen during that time for reasons and in an amount, unrelated to the fraud.” Justice Baxter would have allowed for holders lawsuits only with the caveat of a sell-to-sue rule, in order to eliminate the speculative nature of the damages into which courts must otherwise inquire. Although this is a concurring opinion, not the view of the court, we can expect to hear more on this point in continuing litigation of this matter and others.
Justice Janice R. Brown’s dissent went further, arguing that the plaintiff had, as a matter of law, sustained no damages. The price of Fritz stock after the April 2 misrepresentation was “unlawfully inflated,” and the bursting of that balloon after the admission of error in July merely returned the share price to where it would have been had the accounting been accurate all along.
“Thus, the price of Fritz stock on July 24 was, by definition, the same price the stock would have had on that date if the defendants had reported Fritz’ true third quarter results on April 2,” so anybody who purchased stock before April and did not sell until after July merely saw a nominal windfall erased by an equally nominal loss, Judge Brown asserted.
United Parcel Service Inc. purchased Fritz in 2001.