The Market Crisis, Fraudsters And The Regulators

There is at least one positive side to the on-going market crisis – it is sorting out the fraud in the market and leaving it to the regulators to clean up. In the beginning, there was Madoff with what appears to be a $50 billion Ponzi scheme. His undoing seems to have been his inability to continue raising money, apparently because of the credit crisis. It certainly did not have anything to do with his securities trades, since it now appears that Mr. Madoff has not purchased any securities in years. That revelation leads one to wonder just what Mr. Madoff was doing in the rooms were he supposedly ran the scheme alone and just where all the money went.

Following the Madoff scandal, the SEC stumbled onto a series of Ponzi cases, discussed here, in probability for the same reasons they found Madoff — the funds were out of cash because of the current market crisis. Then came “mini-Madoff,” that is the case against R. Allen Stanford, a one time banking mogul whose foreign assets are apparently being seized in the wake of the SEC’s case. Again, in probability a victim of market illiquidity. Apparently even the promise of remarkable returns is not enough to keep the investor funds coming in.

Last week, the market turmoil churned up another illiquid fund that once made unbelievable claims to lure investors. In a complaint filed in Minnesota, the Commission made allegations which seem echo those of Madoff, mini-Madoff and others. The complaint claims that “Defendant John W. Lawton holds himself out as the manager of a wildly successful hedge fund, Defendant Paramount Partners, LP. Paramount is a hedge fund in which approximately 50 to 60 persons have invested as much as $9 million … Lawton, Paramount and Crossroad [the investment advisor] … represented to existing and prospective investors that Paramount has produced annual returns ranging from 65% to 19% since 2001.”

The SEC’s complaint goes on to detail what appears to be another illiquid fraudulent hedge fund. From 2001 to 2008, investors put about $10.8 million into Paramount. Some individuals invested portions of their individual retirement accounts. During the same period they withdrew about $1.8 million. Although investors were told in January 2009 that the fund had about $17 million in assets, the four brokers who supposedly held those assets confirmed that Paramount has less than $2 million. The Commission obtained an order freezing the remnants of the fund. SEC v. Lawton, Civil Case No. 09-368 (D. Minn. Filed Feb. 20, 2009).

Lawton, like Madoff, mini-Madoff and the others appears to have run out of cash. The lure of impossible returns no longer attracted investors who probably had little to invest in view of current market conditions. Credit markets were far too tight to lend assistance. In the end, the market crisis churned these fraudsters up for the regulators to clean up. At least there is something good about this crisis.

Dura Causation: Expert Testimony Excluded

In Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 342 (2005), the Supreme Court held that a securities law plaintiff must prove loss causation — that is, a causal link between the claimed injury and loss — in order to recover damages. In reaching its conclusion, the court reversed a decision of the Ninth Circuit which held that purchasing stock at an inflated price was sufficient. Alleging that the share price had been inflated by misrepresentations is not sufficient, the Court held, even if the plaintiff has suffered a loss, unless there is proof of a causal connection between the misrepresentation and the loss.

Dura did not establish what is required to prove loss causation. Rather, the Court only discussed what is not adequate — price inflation standing alone. Following Dura, two primary theories of loss causation have emerged: 1) Fraud on the market (the standard theory used in Dura, which requires proof of an artificial price and a decline in value when the truth is revealed); and 2) Materialization of risk (under this theory, a plaintiff must prove that it was the very facts about which the defendant lied which caused the injuries). Under each theory, a key question involves the impact of other factors which may affect the price and make it difficult or impossible to tie the claimed fraud to the loss.

In In re Williams Sec. Litig. — WCG Subclass, No. 07-54119 (10th Cir. Feb. 18, 2009), the court considered the question of whether plaintiffs had demonstrated that the claimed losses were caused by a revelation of the fraud and not other causes. The court considered this question on an appeal from a grant of summary judgment in favor of defendants where the district court concluded that, although there were disputes of fact regarding certain issues, plaintiffs failed to establish loss causation. In reaching this conclusion, the district court excluded plaintiffs’ proffered expert testimony on loss causation on a Daubert challenge, concluding that the testimony could not reasonably link the claimed loses to the revelation of the claimed misrepresentations. The Tenth Circuit affirmed.

The case is based on the spin-off by Williams Companies, Inc. (“WMB”) of its telecommunications subsidiary, Williams Communication Group (“WCG”) in 2000. At the time of the transaction, the company claimed that it represented the best way to ensure that its energy and communications businesses would be efficient and have access to the capital necessary for growth. Two years later, WCG tumbled into bankruptcy as its stock dropped to $0.06 per share. These class actions followed.

Plaintiffs attempted to establish Dura causation by offering alternate theories through their expert, Dr. Nye. The first is a “leakage theory,” while the second is a “corrective disclosures” theory. Under the first, Dr. Nye opined that the fraud was not revealed to the market by a single corrective disclosure. Rather, the true financial condition of WCG which had been concealed materialized through a series of small leaks. Under this theory Dr. Nye began his damage calculation with the $0.06 price at the time of bankruptcy and incorporated all price movement back to the first day of the class period which is July 24, 2000. Through this method, he concluded that the true share price at the time of the spin- off was not the $28.50 sale price but $0.56.

The court rejected this method as inconsistent with Dura. It is essential under any theory of loss causation that plaintiff demonstrate that by some mechanism the truth came out and was revealed. Likewise, other factors which may have caused the price to decline must also be considered. Here however, there was no demonstration of how the truth came out and almost all of the price decline is attributed to the fraud. There was no real effort to sort out other possible events which may have impacted the price.

Dr. Nye’s alternate theory suffered from similar flaws the court concluded. This corrective disclosure theory is based on four specific public disclosures: 1) An announcement on February 4 that the release of earnings would be delayed; 2) A February 4 announcement that the company may be in default; 3) A February 25 announcement that it was considering bankruptcy; and 4) An April 25 bankruptcy filing.

This theory suffers from two key flaws, according to the court. First, it fails to show new, company specific, and fraud related information which became available to the market after January 29, 2002 when the first class action complaint. That lengthy complaint detailed the alleged fraud, claiming that the company actually spun-off the subsidiary not for the reasons disclosed, but because it was a cash drain. Nevertheless, plaintiffs attempt to claim the impact of the price decline after the filing of the complaint in their damage calculation.

Second, to be a corrective disclosure it must at least relate back to the misrepresentation and not to some other negative information about the company. While the disclosure does not have to be a “mirror image” of the fraud, it must be “within the zone of risk concealed by the misrepresentations and omissions …” claimed by plaintiffs. Here, the claimed press releases did not fall in the “zone of risk.” Rather, each could have resulted from other factors. Accordingly, Dr. Nye’s testimony failed to meet the Dura test.

Finally, the court rejected plaintiffs’ claim that there was a dispute of fact precluding summary judgment regarding causation as to whether the price drop and loss came from the revelation of the fraud or other factors. The court concluded that no jury could find for plaintiffs based on this record because any finding that there was Dura causation would be nothing but speculation.