Measuring Insider Trading Damages for a Private Plaintiff

This article discusses various measures of the damages of a private plaintiff who sues a stock market insider trading defendant. The measures are: “pure” out of pocket, “expedient” out of pocket, rescissory, and cover. The “pure” out of pocket measure is the difference between the transaction price and the real or actual share value. Implicitly, this measure assumes that but-for the defendant’s fraud, the plaintiff would have traded at the same time anyway, but at a better price. The so-called “expedient” out of pocket measure accepts the “pure” out of pocket measure in principle. Nevertheless, to avoid the practical difficulty of determining the real value of the stock at the time of the plaintiff’s trade, the “expedient” out of pocket measure substitutes for this “true value” the market price after dissemination of the correct or previously nonpublic information. A variant of the “expedient” out of pocket measure looks to either the dollar or percentage price change at curative dissemination and uses this change as a measure of the damages to the plaintiff. The price change at dissemination could be applied to the plaintiff’s transaction price to estimate the true value at the time of the plaintiff’s trade. More complex variations exist to correct for the effects of extraneous factors. The rescissory measure attempts to undo the fraudulent transaction and return the defrauded party to her position before the fraudulent inducement caused her to enter into the trade. In other words, rescissory damages award a plaintiff the dollar amount at the time of judgment necessary to put her back in her original position prior to the fraudulent transaction. This measure implicitly assumes that the plaintiff would not have traded but-for the defendant’s fraud. For the rescissory measure, courts usually require the plaintiff to prove a contractual relationship with the defendant. Most stock market insider * Professor, University of California, Hastings College of the Law. The author wishes to thank Ms. Robin Krutzsch for her valuable research assistance. This article draws on William K.S. Wang & Marc I. Steinberg, Insider Trading (PLI 2d ed. 2008) § 4:8.2 and on William K.S. Wang & Marc I. Steinberg, Insider Trading (Oxford Univ. Press 3d ed. forthcoming 2010). Professor Steinberg initially wrote § 4:8.2’s discussion of “disgorgement of windfall profits” and “benefit of the bargain.” WANG MACROED2.DOCX (DO NOT DELETE) 9/3/2010 12:59 PM 2 UC Davis Business Law Journal [Vol. 10 trading plaintiffs are not in contractual privity with the defendant. The rescissory measure would give such plaintiffs an unjustified “free ride” to gain speculative profits from stock price changes until the date of judgment without risking any money. Nevertheless, rescissory damages might conceivably be available to a plaintiff in contractual privity with an insider trading defendant, especially one liable under the classical relationship theory. Like the rescissory measure, the cover measure implicitly presumes that the plaintiff would not have traded but-for the defendant’s fraud. This approach also implicitly assumes that the plaintiff is entitled to a rescissory measure of damages. Nevertheless, the cover measure imposes on the plaintiff the obligation to mitigate damages by reversing her trade within a “reasonable” time after curative disclosure. Although this article briefly discusses two additional damage measures, “disgorgement of windfall profits” and “benefit of the bargain,” these two measures are not appropriate in stock market insider trading cases. To select a “fair” measure of damages, one must know what the plaintiff would have done absent the defendant’s fraud. When the plaintiff bought or sold a publicly traded security, she had an almost infinite number of alternatives. If the plaintiff would have traded at the same time anyway, but at a different price, the “pure” out of pocket or “expedient” out of pocket measures would be appropriate. If the plaintiff would not have traded and would have maintained that position until the time of judgment, the rescissory measure might be proper; but fairness might require the plaintiff to mitigate damages, in which case the cover measure would be appropriate. Knowing what the plaintiff would have done is difficult because any plaintiff testimony may be self-serving. With class actions, the members of the plaintiff class are not even available to give self-serving testimony and, in any event, are not uniform and would have pursued different courses of action absent the fraud. Therefore, no one measure of damages is “fair.” INTRODUCTION 3 I. VARIOUS MEASURES OF ACTUAL DAMAGES 3 A. “Pure” Out of Pocket 5 B. “Expedient” Out of Pocket 9 C. Rescissory 19 D. Cover 21 E. Distinction Between the “Expedient” Out of Pocket and Cover Measures 24 F. Disgorgement of Windfall Profits 25 G. Benefit of the Bargain 27 II. SUMMARY AND CONCLUSION: THE DIFFICULTY OF DETERMINING A “FAIR” MEASURE OF DAMAGES 30 WANG MACROED2.DOCX (DO NOT DELETE) 9/3/2010 12:59 PM Ed. 1] Measuring Insider Trading Damages for a Private Plaintiff 3