Brian Murray and Lee Albert ()
When an investment loses value, a common strategy is to buy additional shares of the stock at a lower price than the original purchase, in order to “average down” the blended cost of the stock. If the stock recovers, it need not rise all the way to the initial purchase price for the investor to break even. Courts have routinely recognized this investment technique on class certification motions and have held such purchases do not render an investor atypical or inadequate as a class representative. The investor/class representative is usually allowed to seek recovery for any damages caused by a fraud which led to the initial loss in value.
However, a court in the Southern District of New York has held an investor who “averaged down” was precluded from pursuing the case in court,1 in effect giving investors a choice: pursue an investing strategy which may help mitigate losses or sue to recover losses. Pursuing both options may no longer be possible.
Majority View, Second Circuit
“Averaging down” is a common investment technique used after an investment has fallen in value. Suppose Buyer purchases a share of stock for $20. If the stock falls in value to $10, it must rise 100 percent for Buyer to break even. If Buyer purchases an additional share at $10, the shares need only rise 50 percent (to $15) for Buyer to break even. In recognition of this, for almost 30 years, district courts in the U.S. Court of Appeals for the Second Circuit (with the notable exception of the late Judge John Sprizzo) have held that the subsequent purchase of stock by a plaintiff does not render his claim of securities fraud atypical from the proposed class, because the subsequent purchase is a common investment technique used to decrease the average cost of the investment.2
Absent evidence that the plaintiff purchased the additional shares with anything other than public information, averaging down is usually no bar to a finding of typicality on a class certification motion.3 Judge George Daniels in In re Moody’s Corp. Sec. Litig. summed it up as such: “the strategy of cost averaging down is a common investment strategy that decreases the average cost of an investment. It does not in any way implicate a shareholders’ initial decision to purchase stock.”4 These sentiments are echoed in cases outside the Second Circuit as well.5
The Minority View
There are, however, cases which hold that averaging down will preclude a finding of typicality and class certification, although there are usually other circumstances present. The leading case in the Southern District supporting a finding of atypicality if a plaintiff averages down is Rocco v. Nam Tai Elecs.6 The plaintiff in Rocco purchased stock four times after the class period ended. Sprizzo held, citing to two of his previous opinions (one from 2000 and one from 1992), that “this Court has consistently held that ‘a person that increases his holdings in a security after revelation of an alleged fraud involving that security is subject to a unique defense that precludes him from serving as a class representative’.”7 The most damning fact in Sprizzo’s mind was that the plaintiff had alleged an as yet undisclosed fraud in addition to a fraud which had been exposed, meaning the stock had yet to drop upon disclosure of the undisclosed fraud. Therefore, the plaintiff had purchased additional shares knowing the stock was still inflated by fraud.
In Berwecky v. Bear, Stearns & Co., Judge Sprizzo simply cites to his 1992 opinion in Kovaloff v. Piano8 to support his holding that a plaintiff who averages down is an inadequate class representative.9 Sprizzo could have, but did not, cite to Koenig v. Benson from the Eastern District of New York.10 In Koenig, a plaintiff who averaged down was found to be atypical, but there were additional factors such as purchasing shares after the defendant went bankrupt. Other courts have made similar findings. For instance, in In re Safeguard Scientifics, in the Eastern District of Pennsylvania, the plaintiff was a day trader “who typically focuses on technical price movements,” and this, coupled with the averaging down strategy, defeated class certification.11 Likewise, an Oregon district court in Rolex Employees Retirement Trust v. Mentor Graphics Corp. held that a trading pattern which includes averaging down after the fraud is revealed “acts to rebut the presumption that [the plaintiff] relied on the alleged misrepresentations in making his purchases.”12
China Automotive Decision
Last year Judge Katherine Forrest issued her opinion denying class certification in George v. China Automotive Systems.13 Defendants had challenged class certification on numerous grounds, including the lack of an efficient market and the typicality and adequacy of the class representatives because they averaged down and were “in and out” traders. One of the plaintiffs purchased additional shares five months, seven months, one year, and two years after the fraud was revealed. Another plaintiff made five additional purchases in the year following disclosure of the fraud. The third plaintiff made “several” additional purchases, beginning on the day the fraud was revealed. “Thus, each of the named plaintiffs increased their holdings of CAAS securities after each had allegedly learned of the fraud.” In other words, each followed the classic “average down” strategy.
Forrest found in defendants’ favor on all three issues. Most significant among the three was her holding that a plaintiff who makes purchases after the disclosure of the fraud and after the stock dropped in value (averaging down) would be “subject to the unique defense that the alleged misstatements or omissions were really not a factor in the purchasing decisions but rather that other investment considerations drove the decision.”14
Forrest held that “Defendants may assert that the disclosure of the fraud was irrelevant to the named plaintiffs as demonstrated by their pattern of continued purchasing” and that Defendants stated an intention to “aggressively pursue this line of inquiry.” Thus, the named plaintiffs would be expending “considerable time” on unique defenses.
There was no discussion of the cases either in the Southern District or elsewhere constituting the majority view described supra, but rather a mention of Nam Tai Electronics, Bear Stearns, and Greenspan. In addition, the court mentioned Gary Plastics Packaging Corp. v. Merrill Lynch Pierce Fenner & Smith.15 In Gary Plastics, however (upon which Judge Sprizzo referenced in his opinions), the plaintiff had continued to purchase the security with full knowledge that the fraud was still ongoing, which is inapposite to the averaging down scenario in which the plaintiff purchases additional securities after the fraud has been revealed and is completed.
China Automotive represents a significant departure from fairly well-established Southern District and other Second Circuit law that a defrauded investor can engage in an investment strategy designed to help it recover the losses caused by the fraud and still have a remedy at law for the fraud. While the China Automotive case remains an outlier for the time being, it is likely the Second Circuit will have to address the issue eventually.
Brian Murray and Lee Albert are partners in the New York office of Glancy, Binkow & Goldberg.
1. George v. China Automotive Systems, 2013 WL 3357170 (S.D.N.Y. July 3, 2013) (Forrest, J.).
2. Kronfeld v. Trans World Airlines, 104 F.R.D. 50, 53 n.4 (S.D.N.Y. 1984); Garfinkel v. Memory Metals, 695 F.Supp. 1397, 1404 (D. Conn. 1988); Wagner v. Barrick Gold Corp., 251 F.R.D. 112, 117 (S.D.N.Y. 2008); see also In re Monsters Worldwide Inc. Sec. Litig., 251 F.R.D. 132, 135 (S.D.N.Y. 2008) (“the fact that a putative class representative purchased additional shares in reliance on the integrity of the market after the disclosure of corrective information has no bearing on whether or not the representative relied on the integrity of the market before the information at issue was corrected or changed”).
3. In re American Int’l Group, Inc. Sec. Litig., 265 F.R.D. 157, 169 (S.D.N.Y. 2010) (Batts, J.), vacated on other grounds, 689 F.3d 229 (2d Cir. 2012).
4. In re Moody’s Corp. Sec. Litig., 274 F.R.D. 480, 488 (S.D.N.Y. 2011) (Daniels, J.); see also In re Salomon Analyst Metromedia Litig., 236 F.R.D. 208, 216 (S.D.N.Y. 2006) (Lynch, J.); In re Arakis Energy Corp. Sec. Litig., 1999 WL 1021819 (E.D.N.Y. April 27, 1999) (Ross, J.); Cosmas v.. DelGiorno, 1995 WL 62598 (E.D.N.Y. Feb. 8, 1995) (Glasser, J).
5. See South Ferry LP #2 v. Killinger, 271 F.R.D. 653, 659-60 (W.D. Wash. 2011); In re REMEC Inc. Sec. Litig., 702 F.Supp.2d 1202, 1263 (S.D. Cal. 2010) (summary judgment denied in favor of defendants on issue of reliance because “averaging down” doesn’t rebut fraud on the market presumption); In re Countrywide Fin. Corp. Sec. Litig., 273 F.R.D. 586, 602-03 (C.D. Cal. 2009); Rosen v. Textron, 369 F.Supp.2d 204, 209 (D.R.I. 2005); Yang v. Odom, 2005 WL 2000156, at *6 (D.N.J. Aug. 19, 2005); Cheney v. Cyberguard Corp., 213 F.R.D. 484, 494 (S.D. Fla. 2003); In re Select Comfort Corp. Sec. Litig., 202 F.R.D. 598, 607 n.12 (D. Minn. 2001); Feldman v. Motorola, 1993 WL 497228 (N.D. Ill. Oct. 14, 1993); Malone v. Microdyne, 148 F.R.D. 153, 158 (E.D. Va. 1993); In re Bally Mfs. Sec. Corp. Litig., 141 F.R.D. 262, 269 (N.D. Ill. 1992); In re Atlantic Fin. Fed. Sec. Litig., 1990 WL 188927 (E.D. Pa. Nov. 28, 1990).
6. 245 F.R.D. 131 (S.D.N.Y. 2007) (Sprizzo, J.).
7. Id. (quoting Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65, 69 (S.D.N.Y. 2000).
8. 142 F.R.D. 406 (S.D.N.Y. 1992).
9. Berwecky, 197 F.R.D. at 69-70.
10. 117 F.R.D. 330 (E.D.N.Y. 1987) (Bartels. J.).
11. In re Safeguard Scientifics, 216 F.R.D. 577, 582 (E.D. Pa. 2003); see also Epstein v. American Reserve Corp., 1988 WL 40500, at *4 (N.D. Ill. April 21, 1988) (averaging down vitiates typicality).
12. Rolex Employees Retirement Trust v. Mentor Graphics Corp., 136 F.R.D. 658, 664 (D. Or. 1991).
13. 2013 WL 3357170 (S.D.N.Y. July 3, 2013).
14. Id. at *6.
15. 903 F.2d 176 (2d Cir. 1980).