Court Permits Claim For Holding Stock based on Fraud

Court Permits Damage Claim for Holding Stock Based on Fraud 

California law recognizes a common law cause of action by persons wrongfully induced to hold stock instead of selling it.

Small v. Fritz Cos., Inc., No. S091297, 2003 Cal. App. LEXIS (Cal. Sup. Ct., 4/7/03). Pleading Requirements * Liability Issues (Buy & Hold; Public Policy) * Preemption, Federal * Class Actions, Effect of * PSLRA * SLUSA * Common Law Claims (Negligence; Negligent Misrepresentations; Fraud) * Reliance/Transaction Causation (Actual Reliance; Fraud on the Market; Efficient Market Theory) * Damages Calculations.

California law recognizes a common law cause of action by persons wrongfully induced to hold stock instead of selling it.

This is a buy-and-hold case or a “holder’s action,” as the Court terms it, on behalf of investors in the common stock of Fritz Companies who claim they were induced to retain their positions by a false quarterly financial report and were later damaged by a price decline when the results were restated and the truth disclosed. The question before the Court asks whether “the tort of common law fraud (including negligent misrepresentation) [should] be expanded to permit suits by those who claim the alleged misstatements by defendants induced them not to … sell securities….”

Inducing forbearance through misrepresentation has been previously recognized by California courts as giving rise to a cause of action for negligent misrepresentation or common law fraud, but “California has not yet applied this principle to lawsuits involving misrepresentations affecting corporate stock….” In addition, other state courts (citing CT, MA, NJ, and NY precedent) have concluded that “forbearance from selling stock” can support a cause of action. Federal law limits liability in securities fraud actions to persons who bought or sold securities in reliance on misrepresentations, but U.S. Supreme Court precedent makes clear that state actions that extend to holders are not preempted and, indeed, are contemplated in setting that restriction.

While Congress has enacted legislation in 1995 (PSLRA) and in 1998 (SLUSA) to discourage non-meritorious “strike suits” alleging securities fraud, the tide of public opinion today is concerned with corporate scandals and wrongdoing. Given the current state of affairs, “[e]liminating barriers that deny redress to actual victims of fraud now assumes an importance equal to that of deterring non-meritorious suits.”

Dealing with such concerns, though, does not require denying a cause of action to a class of victims, but rather limiting it. In that regard, the Court stresses the importance of actual reliance as an element to be pled and proved. “Because of the potential for false claims, we hold that a complaint for negligent misrepresentation in a holder’s action should be pled with the same specificity required in a holder’s action for fraud.” Reliance, in particular, must be specifically pled, the Court rules, and offers as an example that plaintiff, on remand, might plead “that if the plaintiff had read a truthful account of the corporation’s financial status the plaintiff would have sold the stock, how many shares the plaintiff would have sold, and when the sale would have taken place.

The plaintiff must allege actions, as distinguished from unspoken and unrecorded thoughts and decisions, that would indicate that the plaintiff actually relied on the misrepresentations.”

(ed: There are a lot of dimensions to this Opinion. The author of the majority Opinion (Kennard, J.) took the unusual step of writing a separate concurring Opinion in order to express her disagreement with concerns raised in two other concurrences (one is a partial dissent). Those concerns relate to the speculative nature of damages in these cases since stock held can regain value. Damages should not be calculated by deducting the post-disclosure price from the inflated pre-disclosure price, she agrees, because the bad news that was covered up by the fraud would have had an adverse price impact, even if it had been promptly disclosed. There is, though, a portion of the price decline that can be attributed to the market reaction to the existence of the possible cover-up and the distrust this engenders. That it may be difficult to assess does not render the exercise too speculative, writes Justice Kennard. Guidance is also offered on fixing the post-disclosure price for damage purposes, with the PSLRA 90-day average cited as a “workable rule” for holder’s actions. The mischief to be generated by this holding will certainly affect disputes between broker-dealers and their customers, particularly in the analyst conflict cases, but the emphasis on actual reliance should contain the scope of additional liability and the concern about speculative damages should focus attention on allowing only those damages “attributable to the fraud….”) (SAC Ref. No. 03-15-04)

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Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article. 


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Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page -, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.