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IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

IN RE: 

CHARLES SCHWAB CORPORATION

SECURITIES LITIGATION.

This Document Relates

To All Cases.

 /

No. C 08-01510 WHA

ORDER REGARDING

SECTION 12 DAMAGES

UNDER THE 1933 ACT

The 1940 Act governance issues, the 1933 Act disclosure issues, and the loss-causation

motion have all been addressed by prior orders. This order focuses on the measure of damages

recoverable under Section 12 of the 1933 Act, as amended by the Private Securities Litigation

Reform Act.

* * *

As amended, Section 12 provides:

(a) In general 

Any person who— 

(1) offers or sells a security in violation of section 77e of

this title, or 

(2) offers or sells a security (whether or not exempted by

the provisions of section 77c of this title, other than

paragraphs (2) and (14) of subsection (a) of said section),

by the use of any means or instruments of transportation or

communication in interstate commerce or of the mails, by

means of a prospectus or oral communication, which

includes an untrue statement of a material fact or omits to

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state a material fact necessary in order to make the

statements, in the light of the circumstances under which

they were made, not misleading (the purchaser not knowing

of such untruth or omission), and who shall not sustain the

burden of proof that he did not know, and in the exercise of

reasonable care could not have known, of such untruth or

omission, 

shall be liable, subject to subsection (b) of this section, to the

person purchasing such security from him, who may sue either at

law or in equity in any court of competent jurisdiction, to recover

the consideration paid for such security with interest thereon, less

the amount of any income received thereon, upon the tender of

such security, or for damages if he no longer owns the security. 

(b) Loss causation 

In an action described in subsection (a)(2) of this section, if the

person who offered or sold such security proves that any portion or

all of the amount recoverable under subsection (a)(2) of this

section represents other than the depreciation in value of the

subject security resulting from such part of the prospectus or oral

communication, with respect to which the liability of that person is

asserted, not being true or omitting to state a material fact

required to be stated therein or necessary to make the statement

not misleading, then such portion or amount, as the case may be,

shall not be recoverable.

15 U.S.C. 77l (emphasis added). 

The caselaw is inconsistent as to whether plaintiffs who continue to hold their shares

after the filing of a complaint are “locked in” to the market value of those shares at the time the

complaint was filed. See Goldkrantz v. Griffin, 1999 WL 191540, at * 6 (S.D.N.Y. 1999)

(“With respect to those who continue to hold the shares, their ‘amount recoverable’ is the

difference between the consideration they originally paid for the shares and the value of the

shares at the time of filing the complaint, minus any income received.”); Wigand v. Flo-Tek, Inc.,

609 F.2d 1028, 1036 (2d Cir. 1979) (“The value of the stock itself is irrelevant insofar as relief

under section 12(2) is concerned. If the consideration passing from plaintiff to defendant is

money, the amount to be awarded is simple to calculate”).

This order, however, finds the 1995 legislative history and wording of Section 12(b)

compelling. The situation before the amendment was explained by the Supreme Court in

Randall v. Loftsgaarden, 478 U.S. 647, 659 (1986) (emphasis added):

[T]he 1933 Act is intended to do more than ensure that defrauded

investors will be compensated: the Act also “aim[s] . . . to prevent

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further exploitation of the public by the sale of unsound,

fraudulent, and worthless securities through misrepresentation

[and] to place adequate and true information before the investor.”

S.Rep. No. 47, 73d Cong., 1st Sess., 1 (1933). See also United

States v. Naftalin, 441 U.S. 768, 775–776 (1979). We may

therefore infer that Congress chose a rescissory remedy when it

enacted § 12(2) in order to deter prospectus fraud and encourage

full disclosure as well as to make investors whole. Indeed, by

enabling the victims of prospectus fraud to demand rescission upon

tender of the security, Congress shifted the risk of an intervening

decline in the value of the security to defendants, whether or not

that decline was actually caused by the fraud. See Thompson,

THE MEASURE OF RECOVERY UNDER RULE 10B-5: A RESTITUTION

ALTERNATIVE TO TORT DAMAGES, 37 VAND.L.REV. 349, 369

(1984) (hereinafter Thompson); Loss, at 1133. Thus, rescission

adds an additional measure of deterrence as compared to a purely

compensatory measure of damages.

In other words, prior to the amendment, Section 12 seemed to require defendants to bear the risk

of a market decline — whether or not that decline was actually caused by the alleged

misrepresentation — when the remedy of rescission was elected under Section 12.

The potential “unfairness” of this rule was noted in the Thompson law review article

cited by the Supreme Court in the above passage:

The concern that rescission will redistribute market risks that have

nothing to do with the fraud has influenced courts in securities

cases to adopt the restrictions on rescission developed by equity

courts, particularly the requirement that plaintiffs file suits for

rescission promptly after notice of the fraud. Courts show

particular concern that plaintiffs not be permitted to delay a choice

of the rescission remedy while speculating on the fluctuating value

of the property in question.

Thompson, THE MEASURE OF RECOVERY UNDER RULE 10B-5: A RESTITUTION ALTERNATIVE TO

TORT DAMAGES, 37 VAND. L. REV. 349, 369–370 (1984); see also Loftsgaarden, 478 U.S. at 666

(noting that “some courts have barred plaintiffs from electing rescission, or a rescissory measure

of damages, where they delayed tender or suit in order to increase their expected recovery should

the market decline”).

Thereafter, Congress added the “loss causation” defense set forth in Section 12(b), a

direct response to the concerns mentioned in the Thompson article, as well as in Loftsgaarden. 

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The following excerpt from the Senate Report on the 1995 amendments to Section 12 is

illustrative:

Congress adopted Section 12(2) of the 1933 Act to deter material

misrepresentations and omissions in the purchase or sale of

securities. Some courts have held that a plaintiff suing under

Section 12(2) need not prove that the misstatement or omission

caused the loss. As a result, issuers have been put in the position

of insuring shareholders and purchasers against normal market

risk. An issuer that makes a material misstatement or omission in

its prospectus can be liable for losses to shareholders — even if the

losses have nothing to do with the misstatement or omission.

This interpretation of Section 12(2) provides an unfair windfall to

shareholders who have not in any way been harmed by the

misstatement or omission.

* * *

The Committee amends Section 12(2) to clarify that defendants

may raise the absence of “loss causation” as an affirmative

defense. If a defendant in a Section 12(2) action demonstrates that

part or all of the decline in the value of the security was caused by

factors other than the misstatement or omission alleged in the

complaint, the plaintiff may not recover damages based on that

portion of the decline. The defendant must bear the burden of

affirmatively demonstrating the absence of loss causation.

This provision does not place any additional burden on plaintiffs

to demonstrate that loss causation existed, nor does it deprive

investors of Section 12(2) remedies when they have incurred losses

caused by inadequate disclosure. The amendment to Section 12(2)

is modeled after Section 11 of the Securities Act, which provides

for a similar affirmative defense.

S. Rep. No. 104-98, 23 (1995) (emphasis added). In other words, the affirmative defense of loss

causation was added by Congress to provide defendants with a mechanism to combat unfair

overcompensation in the rescission remedy where the overcompensation was due to normal

market risk.

* * *

With respect to a mutual fund that materially misrepresents its investment strategy, this

order holds that the combined effect of Sections 12(a) and (b) is that a new investment decision

must be deemed made by investors once they learn or should learn, in the exercise of reasonable

diligence, the fund’s true investment strategy. At that time, investors have the clear choice to

redeem versus to accept the actual investment strategy and remain with the fund. Any further

decline in the NAV is for the account of the investors, just as any subsequent gains would be. 

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The legislative history of Section 12(b) is clear that Congress intended to subtract from

recovery any losses attributable to normal market risk, which would include losses due to market

declines after the truth is revealed and investors have a fair opportunity to make a new

investment decision. The measure of damages is the difference between what each investor paid

minus the NAV at the time investors knew or should have known the concealed information

(plus the statutory adjustments for interest and income). 

The burden is on mutual fund defendant(s) to prove when the investors knew or should

have known the truth — with the outside defaults being the commencement of the action in the

case of the named plaintiffs and the date of class notice in the case of absent class members. 

For example, if early on a fund sends a clarifying letter to all investors, clearly explaining

everything, then investors are in a position to make a new investment decision and to remain

with the fund or to redeem. The date of receipt of the clarification locks in the damage price. 

Likewise, if the concealed strategy is discovered and so prominently publicized in news accounts

(without dispute) such that a reasonable investor would then know the true investment strategy,

a new investment decision must be deemed to have occurred. That date would lock in the

damages price. In contrast, if the truth begins to leak out but the mutual fund releases

misleading denials, the investors should not necessarily be expected to believe press rumors. 

(If, of course, an investor redeems before the date of discovery, then damages would be

measured as of redemption.)

The reason that absent class members are not held to the lawsuit commencement date

is that they do not join in the lawsuit until class notice is provided. More to the point, in the

absence of proof of an earlier date, they only learn about the misrepresentation via the notice and

then discover the truth. The sellers and promoters may try to prove an earlier date. Perhaps it

can be proven that news of the lawsuit was so pervasive that all investors surely should have

known of the true facts, but this would be a matter of proof and its burden would be on the

defense.

Under this holding, it is true that an investor who stays with the fund, after learning the

truth and a new investment decision is made, may recover damages even if the fund price

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eventually recovers to its subscription price. The new investment decision is akin to the investor

selling the shares at the then NAV (and locking in the damages), and in the next moment

purchasing the same number of shares at the same NAV (for the new investment). By the same

token, the new investment may crater and the subsequent decline must be for the investor’s

account.

Although the instant case involves a mutual fund, Section 12 covers common stocks as

well. In the case of a publicly traded common stock, the principle should be the same. 

Damages are fixed at the point investors knew or should have known of the actual concealed

or misrepresented facts. At that point, they can sell on the open market or remain invested as

they elect. At this point they must be deemed to have made a new investment decision. 

The burden is on the seller to prove the date by which investors must be deemed to have made

a new investment decision based on the corrected information and thus subjected themselves to

normal market risk. One difference between a publicly traded common stock and a mutual fund

is, in the case of publicly traded common stock, that the correction will tend to be almost

universally and instantly known. This is due to the near instantaneous effect of public

information on the market price. All investors presumably follow the market price. In contrast,

given that it is based on the portfolio’s underlying market prices, the NAV for a mutual fund

will not necessarily transmit “bad news” instantly about cover-ups in the true investment plan. 

So, for common stocks, it may be easier to isolate when all investors should be deemed to have

known the truth and to have made a new investment decision.

To be sure, this holding introduces a slight divergence between the named plaintiffs

and absent class members. This should not be fatal to class treatment under Rule 23. Before the

amendment, Section 12 already recognized a dichotomy between those who sold and those who

held. That distinction was not fatal to class treatment. Since the main liability issue of

misrepresentation will usually predominate, this small deviation in recovery will not prevent

classes from being certified, at least in the run of cases.

Counsel have expounded at length over the meaning of “tender” and when it occurs. 

The practical fact of Section 12(b) in litigated class actions is to deem all class members to

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have made a new investment decision, i.e., to have sold and re-purchased, no later than the class

notice, so there will be no rescission at the end of the case, only a damage award. The tender

requirement was mainly a way to make sure that those who recover under Section 12 gave back

their shares if they had not already sold. One huge effect of Section 12(b) and the PSLRA is

to shift the normal market risks to the investor. Once the investor is armed with corrected

information, the investor must decide to stay in or to redeem and if he or she stays in the fund,

then the subsequent normal market risks are for the investor’s account. The date of tender is

really now just a relic of the older version of Section 12. 

* * *

Schwab’s motion is therefore DENIED. 

IT IS SO ORDERED.

Dated: April 14, 2010. WILLIAM ALSUP

UNITED STATES DISTRICT JUDGE

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