9 October 2008

Purchase-Sale Matching in Securities Litigation: FIFO, LIFO, and Offsets

Raymund Wong, CPA, ABV, CFA*

Executive Summary

There is an ongoing debate in securities litigation regarding the proper way to match purchases

and sales in the calculation of damages for a single shareholder with multiple transactions. The

bounceback rule stipulated by the Private Securities Litigation Reform Act of 1995 (PSLRA) limits

damage claims based in part on the purchase and sale dates of a round trip transaction.1 This rule

alone implies that purchases must be matched with sales over the relevant period—otherwise, there

would be no way to calculate the damage limitation.

The manner in which purchases and sales are matched affects the calculation of gains and losses

over specified time periods. For example, if an investor buys one share of stock for $10 (the

investor’s “cost basis” in that share), and later sells it for $50, the realized gain is $40 (the sale price

of $50 less the investor’s basis of $10). However, if the investor buys one share for $10, then buys

another share at $50, and then sells one share for $50, the realized gain on the share sold can

range from $0 to $40, depending on the method used to calculate the basis of the sold share.

* Senior Consultant, NERA Economic Consulting. I would like to thank Lucy Allen, David Tabak, Marcia Mayer,

Stephanie Lee, Patrick Conroy, Robert Patton, Tom Porter, John Montgomery, and Jordan Milev for helpful

commentary on earlier drafts. I also thank Edward Fox for his help in reviewing and interpreting the relevant

case law.

1. In connection to damages claims under Rule 10b-5 of the Securities Exchange Act of 1934, the PSLRA states, in part,

that “in any private action arising under this chapter in which the plaintiff seeks to establish damages by reference

to the market price of a security, the award of damages to the plaintiff shall not exceed the difference between the

purchase or sale price paid or received, as appropriate, by the plaintiff for the subject security and the mean trading

price of that security during the 90-day period beginning on the date on which the information correcting the

misstatement or omission that is the basis for the action is disseminated to the market.”

Securities litigation brought under Sections 11 and 12 of the Securities Act of 1933 also limit damages claims to the

purchase price less the sale price.

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Different methods can be used to pair purchases and sales. In this example, pairing the $50 sale

with the first purchase at $10 is consistent with the First-In, First-Out methodology, or “FIFO,” and

yields a realized gain of $40. Pairing the $50 sale with the second purchase at $50 is consistent with

the Last-In, First-Out methodology, or “LIFO,” and yields a realized gain of $0.

As their names imply, FIFO treats sales as coming from the earliest unsold purchases

(i.e.,, the “first” purchases to come “in” are the “first” purchases to be sold, or go

“out”), while LIFO treats sales as coming from the latest unsold purchases (i.e., the

“last” purchases to come “in” are the first purchases to be sold, or go “out”).

In securities class action cases2, many court decisions have explicitly cited the LIFO method as being

more appropriate, while occasionally allowing the FIFO method in the absence of a LIFO analysis.

Many of the decisions which favor LIFO point to the importance of isolating the actual economic

impact of transactions over the period at issue.

Some of these decisions also explicitly or implicitly support the idea of offsetting a

particular investor’s gross damages with gains from other transactions where the same

investor directly benefits from the alleged fraud.

This paper explores the existing legal and theoretical support for FIFO and LIFO and examines

the implications for damages calculations. It also reviews the concept of offsets. In light of recent

legal events, the calculation of damages for a single shareholder with multiple transactions has

become more complex, and a thorough understanding of the interrelationship between inventory

assumptions, the treatment of offsets, and the legal limitations on damage claims is crucial.3

2. For the sake of simplicity, this paper specifically addresses common issues that arise in securities class action cases,

but most of the conclusions drawn may be applied to any securities litigation that involves alleged damages in

connection with multiple transactions in a single security.

3. The Supreme Court Decision in Dura Pharmaceuticals, Inc et al. v. Broudo et al, 544 US 336, 125 S. Ct. 1627 states

that “A private plaintiff who claims securities fraud must prove that the defendant’s fraud caused an economic loss,”

implying that when a share is purchased and sold will have a potential impact on alleged damages.

Several recent court decisions also appear to impose caps on 10b-5 damages based on purchase and sale dates,

highlighting the importance of assumptions regarding the timing of transactions. These decisions emphasize the legal

need to address the pairing of purchases and sales in securities litigation for any given investor who may

have a claim.

See, e.g., In re Estee Lauder Co. Sec. Litig., No. 06 Civ. 2505(LAK), 2007 WL 1522620 (S.D.N.Y. May 21, 2007) and

In re Veeco Instruments, Inc. Sec. Litig., 235 F.R.D. 220 (S.D.N.Y. 2006).

Purchase-Sale Matching Methods in Securities Class Action Litigations

At the core of the typical securities class action litigation is an allegation that, as a result of

misrepresentations or omissions by the defendant company, the company’s securities traded at

inflated prices over a certain period of time known as the class period. The damage calculation

begins with share purchases by investors at inflated prices. However, damages will also depend on

the existence or timing of share sales. If an investor buys one share at an inflated price during the

class period, and sells or continues to hold it after the end of the class period, damages are simple

to calculate. Damage calculations become more complex when an investor has holdings acquired

prior to the class period. The calculation becomes yet more complicated if the amount by which

prices are inflated changes from day to day and the investor has bought and sold shares numerous

times during the class period.

For example, assume that a hypothetical company has committed securities fraud, and that its

common stock is inflated by $1 per share on each day of the class period. An investor with no initial

holdings who purchases 1,000 shares at various points in the class period and sells no shares during

the class period has damages of $1,000.4 If the investor sold shares over the class period, these sales

must be from the 1,000 shares purchased during the class period.5 For example, if the investor sold

300 shares during the class period, damages would be $700.6

The situation potentially becomes complicated if this investor held 1,000 shares at the beginning

of the class period. If the investor only made purchases during the class period, there is no

complication: 1,000 shares purchased during the class period without any sales implies $1,000 in

damages. However, if sales were made during the class period, a question arises regarding which

shares (i.e., the pre-class period holdings or the class period purchases) were sold. The FIFO and

LIFO methods are two potential methods that may be used to resolve this issue.

Accounting Origins of FIFO and LIFO

The FIFO and LIFO methods originate from financial accounting practices. For example, consider

a retail firm that sells a single uniform product. The profit is equal to the sale price minus the cost.

Since costs change over time, the product held in inventory will include units obtained at different

costs. In calculating accounting profits as these units are sold off, one must make assumptions

regarding which units are sold when. This in turn requires an inventory method such as LIFO

or FIFO.7

Consider a company that manufactures and sells purses. This company manufactures purses in Year

One for $60 each and in Year Two for $70 each, before selling one year’s worth of production

in Year Three at $100 each. The question of how much accounting profit this company should

recognize depends on which purses were sold, and there is a trade-off between representing profits

made by the company as a forward-looking number and representing the remaining value of the

company’s inventory on its balance sheet at current values.

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4. Ignoring the impact of the PSLRA bounceback limitation, and assuming the investor has satisfied all other legal

requirements for a damages claim.

5. Assuming that the sales were not short sales.

6. Assuming that the investor has not benefited from transactions in the company’s other securities, and has satisfied all

other legal requirements for a damages claim.

7. Under certain circumstances, a company can also use alternative methods, such as specifically tracking each inventory

item. Using the average cost of items produced or obtained over a period of times is another possible method.

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Using a FIFO assumption, the first purses sold are assumed to have been manufactured in Year One.

Under this assumption, each purse would be sold at $100 and manufactured at $60, implying a

profit of $40 each. The company would also record purses remaining in its inventory at $70 each

on its balance sheet. While the inventory is represented at current values of production, the $40

profit per purse is higher than the future $30 profit per purse implied by the company’s current sale

price of $100 and current manufacturing costs of $70. This is because the FIFO method includes an

inventory holding gain in the calculation of accounting profits. Put another way, the company has

sold something for $100 that currently costs it $70 to manufacture, but by using outdated costs it

has recognized a higher accounting profit of $40 per purse.

In contrast, under a LIFO assumption, the first purses sold are assumed to have been manufactured

in Year Two. Under this assumption, each purse would be sold at $100 and manufactured at $70,

implying a profit of $30 per purse. The company would also record each purse remaining in its

inventory at $60. In this case, while the recognized profit seems to be consistent with the current

production costs of $70 per purse, the remaining inventory, which is recorded at $60 per purse, is

lower than current costs of production.

In actual practice, the LIFO method is generally used by companies based in the United States for

inventory cost assumptions, and it is understood that the company’s inventory may be undervalued

relative to current costs under this method.8 In an environment with rising costs, companies may

favor the LIFO method because it reduces accounting profits and therefore taxes.9 However, the

LIFO method also more accurately portrays the forward-looking performance of the company in the

current reporting period, which may be more important to many users of financial statements.

Purchase-Sale Matching Methods and the Tax Code

This section examines how purchase-sale matching methods are important to the calculation and

taxation of capital gains. Here, because capital gains (or losses) are defined as purchase price minus

sales price, multiple transactions over a tax year may lead to situations where it is unclear when a

particular sold share was purchased. If an investor sells all previously held shares during a tax year,

the capital gains calculation is unambiguous. This is because every share that was ever purchased

was sold, and regardless of how these purchases and sales are matched, the aggregate amount

spent on buying the shares and the aggregate amount received from selling the shares will yield the

same capital gain or loss.

However, when an investor has acquired shares of stock at different times in the past and sold some

(but not all) of those shares in the current year, an assumption about which shares were sold can

change the calculated capital gains for a given tax year. This is because it is unclear which shares

were sold and which shares were held as of the end of the year. As a simple example, consider an

investor who purchased one share of a company at $4, and subsequently purchased another share

at $10, before selling one share at $10 during the current tax year. Depending on whether the $4

purchase or the $10 purchase was assumed to be sold, the realized capital gains could be either

$6 or $0.

8. In fact, accountants recognize that the older layers of inventory have their value understated, and that liquidation

of these “LIFO layers” will result in artificially high accounting profits. It is also generally accepted in the accounting

literature that the LIFO method results in a more accurate portrayal of company profits, while the FIFO method biases

the portrayal of company profits through the inclusion of inventory holding gains and losses.

9. The IRS requires that companies utilize the same inventory method used in their financial accounting statements

when reporting taxable income.

The IRS allows two different methods for matching purchases to sales in calculating taxable

gains and losses for individual securities. The first method allows the investor to match sales with

purchases in whatever manner he/she chooses if the investor can show that the choice was made

at the time of sale (i.e., if specific shares were designated to be sold at the time of sale).10 In doing

this, the investor may choose to select particular shares for sale in an attempt to minimize the gain,

maximize the loss, or choose any other combination that fits in with his/her investment strategy

and the associated tax consequences. The second method is to default to FIFO. In either case, the

investor must match every sale with a purchase, and offset gross capital gains with any pairings that

result in losses.

Mutual fund investors may also choose to designate their transaction pairings, or default to FIFO.

However, mutual fund investors may also use the average cost basis of past purchases and apply

this to sales, which is called “average costing.” Regardless of the method used, gains and losses for

each purchase-sale pairing are aggregated before they are accorded their appropriate tax treatment.

Moreover, whether we are dealing with individual securities or mutual funds, a choice to customize

the pairing of transactions can only change the timing of losses or gains. Regardless of which

method is used, there are no transactions that are permanently ignored.11 Consider the same

investor previously described in this section, who purchased one share of a company at $4,

subsequently purchased another share at $10, and then sold one share at $10. An investor who

chooses to match the $10 sale with the $10 purchase will only defer the potential $6 gain that

would have occurred had the sale been matched to the $4 purchase. Similarly, an investor who

defaults to FIFO will recognize the $6 gain early by matching the $10 sale with the $4 purchase,

but will be able to match a future sale with a higher purchase price of $10, reducing future capital

gains by $6.

It is also worth noting that in general, an investor who bought a large number of shares of a

company many years ago, then purchases a smaller block of shares and almost immediately sells

that same block, would likely prefer to match his purchases and sales in a manner more consistent

with LIFO. If the shares have appreciated in value, this makes more sense from a tax perspective,

as it would reduce the current tax burden.12 The IRS, assuming that it wants to maximize current

tax revenue, has an interest in having this investor use FIFO. Further, the two new transactions may

more accurately reflect a reversed decision to add to the investor’s position rather than a purchase

of a new position and the liquidation of a portion of the old position. Even if we reverse the

timing of the two transactions and assume that a sale of the shares was followed by an immediate

purchase of the same amount, it may be more likely that this investor sold a part of his or her

holdings, but subsequently decided to reverse the transaction. In other words, pairing a recent

purchase and sale transaction, regardless of order of occurrence, often makes more economic

sense than pairing the sale with an older purchase.

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10. See 2007 IRS Publication 550, p. 43: “If you can adequately identify the shares of stock or the bonds you sold, their

basis is the cost or other basis of the particular shares of stock or bonds… If you have left the stock certificates with

your broker or other agent, you will make an adequate identification if you [t]ell your broker or other agent the

particular stock to be sold or transferred at the time of the sale or transfer, and [r]eceive a written confirmation of

this from your broker or other agent within a reasonable time.”

11. There are certain exceptions to this rule for estate taxes for a deceased individual.

12. As the stock market generally increases over the long term, it is likely that a sale of the older shares would trigger

greater taxable capital gains.

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In fact, an interesting feature in the US tax code alludes to this concept. In a situation where an

investor executes purchase and sale transactions within 30 days of each other, the investor is

prevented from pairing the sale transaction with a more than 30-day-old purchase in order to

recognize a loss. This is known as the “wash sale” rule.13 With it, the IRS prevents taxpayers from

deriving tax benefits from transactions that have no economic purpose. For example, if an investor

purchased 1,000 shares of a company five years ago that have since declined in value, the wash sale

rule prevents this investor from buying and selling 1,000 shares in close succession in order to gain a

tax benefit (by matching the older purchase with the recent sale).

Of course, there is no equivalent to the wash sale rule when a sale of securities acquired many

years ago results in an accounting profit; the IRS has no reason to prevent an investor from paying

taxes earlier than required. In fact, it is clear that FIFO is accepted by the IRS as a possible default

inventory method for the calculation of taxable profits in securities transactions because it would

generally lead to the collection of taxes sooner rather than later. Some court decisions in securities

class actions state exactly this—that FIFO is likely mandated as a default option by the IRS in order

to maximize tax revenues. We will review these cases below.

The Case for LIFO in Securities Class Action Litigation

Returning to the example at the beginning of Section II, let’s assume a securities class action case in

which the inflation in the stock price is a constant $1 per share. Let’s also assume that an investor

had holdings of 1,000 shares at the start of the class period, purchased 1,000 shares at various

points during the class period, and sold 300 shares at various points during the class period.

Plaintiffs’ counsel and experts commonly advocate the use of FIFO in such cases to allocate the sales

to initial holdings, after which they may claim damages on purchase-sale combinations that suffered

a loss due to the fraud. Typically, they would provide no offset for those purchase-sale combinations

that benefited from the fraud. When applied to this example, the FIFO method would assume that

sales are first matched with initial holdings. Thus, the 1,000 shares purchased during the class period

are assumed to be unsold, and damages for those shares would be $1,000. This approach ignores

the net benefit to the paired purchases from before the class period with the in-class period sales. In

other words, a share purchased at zero inflation and sold at a price inflated by $1 yields a benefit of

$1 to an investor—this benefit is generally ignored by plaintiffs using the FIFO methodology.

If 1,000 shares were purchased around the beginning of the class period, and 300 shares were

sold later in the class period, the FIFO method would still treat the 300 shares sold as coming from

initial holdings. A number of court decisions and opinions argue that a more logical allocation for

these shares would be obtained by the LIFO method.14 Using LIFO would mean that the 300 shares

sold would be matched with the 1,000 shares purchased around the beginning of the class period,

implying that only 700 shares are damaged, with a resulting claim of $700.

13. See 2007 IRS Publication 550, p. 55: “You cannot deduct losses from sales or trades of stock or securities in a wash

sale. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the

sale you [b]uy substantially identical stock or securities, [a]cquire substantially identical stock or securities in a fully

taxable trade, or [a]cquire a contract or option to buy substantially identical stock or securities.” The IRS has no such

rule in place for the recognition of gains. This is because the IRS has no incentive to disallow any tax payments.

14. See Appendix A: Selected Court Decision Excerpts Advocating the Use of LIFO.

Recall from the financial accounting inventory example above that FIFO will result in more currents

values for a company’s inventory on its balance sheet, but proves inferior in measuring current

period economic profits. For the purposes of calculating taxable gains and losses, FIFO may provide

a misleading picture of the actual economic impact of transactions in the current tax period—an

issue that the IRS obviously recognizes as evidenced by the wash sale rule. The example above

demonstrates that the application of the FIFO method in a securities class action damage calculation

results in similar problems.

Using FIFO for calculating damages in securities class action cases introduces bias into the

transaction analysis. It effectively provides a buffer to individuals who hold the security prior to

the class period when claiming damages even if such individuals sold a large number of shares at

inflated prices (and thus benefited greatly from the alleged fraud). Consider two investors who have

the following identical transactions during a class period: a purchase of 1,000 shares, followed

almost immediately by a sale of 1,000 shares. Assume that the first investor held 1,000 shares prior

to the class period, while the second investor did not hold any shares prior to the class period.

Under FIFO, the first investor would be assumed to have sold 1,000 shares of his pre-class period

holdings. This would imply that the 1,000 shares purchased during the class period would be

damaged. Conversely, the second investor would have no claim.

A comparison of this situation to the issues surrounding the calculation of recognized profits for

companies and the proper tax treatment for securities transactions is instructive. As previously

discussed, there are compelling arguments for the use of LIFO to measure the forward-looking

profits on the sale of old inventory, or to measure taxable capital gains on multiple transactions in

securities.15 In both cases, LIFO seems to more accurately represent the impact of transactions made

in the relevant period.

Conversely, the use of FIFO in either of these cases incorporates purchase prices from long ago. The

use of FIFO for calculating damages in securities class action cases can similarly bias the result—an

investor with large holdings prior to the class period can effectively ignore the benefits of any

class period sales and claim damages for all class period purchases, while another investor with no

holdings prior to the class period and who made identical transactions might have no claim at all.

For multiple transactions in the same security over any given period, the LIFO method stands out as

a more appropriate measure of the current-period net economic impact of these transactions.

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15. While some plaintiffs have relied on the US tax code’s default use of FIFO in the absence of custom matching as

support for this method, two court decisions have identified compelling reasons against this line of reasoning:

In re Comdisco Sec. Litig., 2004 WL 905938 (N.D. Ill.), Fed. Sec. L. Rep. P 92,809: “But the reasons

for that treatment for income tax purposes are readily apparent: In light of the long-term trend of

increasing values in stocks, plus the facts (1) that FIFO rather than LIFO therefore typically increases the

measurement of currently recordable gains and (2) that stocks held until death get a stepped-up basis

while at the same time escaping income taxation entirely, what other approach might be expected

from taxing authorities who are properly interested in maximizing the benefits to the fisc [sic]?”

Johnson v. Dana Corporation et al., 2006 WL 782746 (N.D. Ohio): “The IRS, therefore, adopts FIFO

not because it is necessarily more accurate than LIFO, but because it forces taxpayers to recognize

gains they would prefer--for tax purposes--to ignore. In this context, however, FIFO has the opposite

effect--allowing plaintiffs to cordon off their profits from the defendant’s misconduct. Using FIFO,

plaintiffs with significant pre-existing holdings of defendants’ securities can profit from substantially

from [sic] defendant’s misconduct and then turn around and show a loss for purposes of litigation.”

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Case Law that Appears to Allow For FIFO

Despite the compelling arguments for using a LIFO approach in matching purchases and sales in

securities class action lawsuits, there are court decisions that appear to prefer, or at least allow, the

FIFO methodology over LIFO.16 For example, the In re Schering-Plough Corp. Sec. Litigation, 2003

US Dist. LEXIS 26297 at *26 (D.N.J. Oct. 10, 2003) decision states:

Defendants’ argument that the FIFO calculation is irrelevant ... is somewhat perplexing.

[Plaintiff]’s Section 10(b) claim is based on losses that resulted from purchases of

Schering-Plough stock made during the Class Period. Any capital gains made with

respect to the sale of shares purchased before the Class Period are irrelevant.

Arguments for FIFO often emphasize capital gains and losses rather than the economic impact of

fraud. Class period capital gains from pre-class period purchases are indeed irrelevant to damage

calculations. Damages in securities class action lawsuits are not directly related to capital gains. The

theory stipulates that investors transacted at inflated prices during a class period. The issue is not

that an investor may have sold shares that were purchased prior to the class period, but whether

the investor sold at prices that were higher than they would have been in the absence of the alleged

fraud. It is not the capital gain or loss from these pairings of transactions that matters, but the fact

that the alleged fraud directly benefited the investor, potentially offsetting any loss that this same

investor may have suffered.

We see in the next section that while arguments in favor of FIFO often ignore the concept of offsets

entirely, arguments in favor of LIFO often allude to the logic behind considering an investor’s gains

as well as losses due to an alleged fraud when calculating the actual harm suffered.

16. See Appendix B: Selected Court Decision Excerpts That Appear to Allow FIFO.

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The Case for Offsets in Securities Class Action Litigation

A closer examination of the relevant court decisions and opinions reveals many instances of

language implying that losses claimed by plaintiffs in securities class action cases should be offset

by gains, even if these gains were from sales of shares purchased prior to the class period.17 For

example, the Court in In re eSpeed, Inc. Securities Litigation, 2005 WL 1653933 (S.D.N.Y.) July 13,

2005, found that:

An analysis of the Pension Fund’s loss as calculated by the Pension Fund demonstrates

why FIFO … is inferior to LIFO. … [FIFO] ignores that the Pension Fund also sold

shares of eSpeed stock during the class period, when the price was inflated. … LIFO

reflects offsetting “gains” that were attained through the sale of stock during the class

period. … Because this method contemplates the offsetting gains the parties collected

during the class period, it is a better measurement of the true damages sustained by

the plaintiffs.

It is telling that this decision emphasizes the “offsetting gains the parties collected during the class

period” in advocating the LIFO method over the FIFO method. Given this logic, an even better

measurement of true damages should include sales of shares purchased prior to the class period.

To see why this is so, let’s return to our example in which an investor held 1,000 shares before

the start of the class period, sold 300 shares during the class period, and purchased 1,000 shares

during the class period. Under FIFO, the 300 shares sold are matched with pre-class-period holdings,

resulting in damages of $1,000 from the shares purchased during the class period. Under LIFO,

if the 300 shares sold are sold after the 1,000 class period share purchases, then there are no

damages for those shares, and there is $700 in damages for the 700 class period purchases retained

to the end of the class period. But let’s assume that the 300 shares were sold toward the beginning

of the class period, and the 1,000 shares were purchased after the sale of the 300. A strict

interpretation of LIFO would technically not allow for matching the 300 shares sold with the class

period purchases, and would imply that damages are $1,000.

However, consider a second investor who engages in a short sale18 of 300 shares, followed by

a short cover of 300 shares and a purchase of 700 more shares. If we pair the short sale and the

short cover, this second investor could claim damages for only 700 shares, as the short sale and

immediate short cover of 300 shares would not result in any economic impact. In actuality, this

second investor has engaged in a set of transactions equivalent to the first investor. If we separate

the 1,000 shares purchased by the first investor into two pieces—a repurchase of the 300 shares

sold earlier, and a new purchase of 700 shares—we can see that the economic effect of these two

sets of transactions is identical. Consequently, we might ask a now familiar question—why does

an investor that simply happens to own shares prior to the class period have a larger claim than

an investor who does not, even if these two investors engage in identical transactions during the

class period?

17. This is true irrespective of the inventory method used to match sales to purchases.

18. A short sale is a transaction whereby an investor who does not own any shares in a security borrows these shares

and sells them on the open market. To close off this transaction, the investor must purchase equivalent shares on a

future date.

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We might view the matching of sales to subsequent purchases as described above as being

necessary in any fair calculation of true damages to a plaintiff. There is precedent for this in similar

types of litigation—short-swing profit cases (known as Section 16(b) cases), for example, employ a

profit-maximizing algorithm that allows for the pairing of purchases with sales on a prior date for

insiders that illegally sell shares after an offering.19 In addition, just as the tax code does not ignore

purchase-sale pairs with losses, neither do 16(b) calculations. This is because excluding pairings with

losses would tend to unfairly overstate the gains in both cases.

Recent court decisions allude to this logic, explicitly naming LIFO as more appropriate, but also

pointing out that benefits to investors strictly related to the alleged fraud should not be ignored. As

stated by the Court in Arenson v. Broadcom Corp., 2004 WL 3253646, *2 (C.D. Cal. Dec. 6, 2004):

The authority is clear: where a plaintiff engages in multiple purchases and sales during

the period in which the stock is inflated, the proper damages methodology is to take

all the inflation losses resulting from all purchases at the inflated price and reduce this

amount by all the inflation gain resulting from all sales at the inflated price.

The decision in Johnson v. Dana Corporation et al., 2006 WL 782746 (N.D. Ohio) similarly questions

the flawed logic behind allowing holdings from prior to the class period to increase damages to an

investor who has a transaction pattern that implies zero damages:

Consider an Investor A with accumulated holdings of 10,000 shares of XYZ Corporation

that were acquired when everything was on the up and up in terms of corporate

disclosures, and that represent the investor’s long-term commitment to the company’s

prospects. Assume further that unknown to Investor A but during what later turns out

to be a plaintiffs’ class period—a time when the nondisclosure of adverse information

caused the stock price to be too high in terms of real value—Investor A both buys

and sells an aggregate of 5,000 shares of XYZ stock in various transactions before the

stock price later falls out of bed, and that such class-period transactions leave Investor

A neither out of pocket nor in pocket when the expenditures for and the proceeds of

those transactions are aggregated.

19. “For the purpose of preventing the unfair use of information which may have been obtained by such beneficial

owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase

and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) or a

security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act) involving any such

equity security within any period of less than six months, unless such security or security-based swap agreement

was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by

the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into

such transaction of holding the security or security-based swap agreement purchased or of not repurchasing the

security or security-based swap agreement sold for a period exceeding six months. Suit to recover such profit may be

instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of

the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days

after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than

two years after the date such profit was realized. This subsection shall not be construed to cover any transaction

where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of

the security or security-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act) involved,

or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended

within the purpose of this subsection.” (http://www.sec.gov/about/laws/sea34.pdf).

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Is there any real question that Investor A, who has thus retained the same long-term

stake in XYZ that preceded the class period, has sustained neither gain nor loss from

the transactions during the class period?

In fact, some court decisions support the notion that simply “offsetting” gains from selling at

inflated prices against losses from purchasing at inflated prices is appropriate, without making direct

references to pairing up each and every transaction in a logical order. Some even go as far as to

support offsetting losses in one security with gains in another when both results derived from the

same actions, finding that “a plaintiff both injured and enriched by illegal activity cannot choose to

recover for his injuries yet retain his windfall.”20

20. See Appendix C: Selected Court Decision Excerpts Advocating the Use of Offsets: Minpeco v. Conticommodity

Services, Inc. 676 F. Supp. 486, 488-490 (S.D.N.Y. 1987).

12 www.nera.com

Case Law That Appears to Oppose Offsets

There are court decisions that do not appear to support the use of offsets for sales of shares

during the class period if those shares were purchased before the class period. These decisions

argue that an investor who is damaged on one transaction but benefited on another may claim

damages for the losing transaction without reducing the claim by the benefit received in the

winning transaction.21

What is notable is that unlike the strong statements in favor of the use of offsets,22 these decisions

generally do not claim that damages are a clear concept to be determined by the courts rather than

a jury or other trier of fact. These decisions therefore tend to allow but not mandate ignoring gains.

Moreover, of the decisions reviewed in this paper, none imply that a calculation ignoring gains

directly due to an alleged fraud is necessarily a more accurate estimate of economic harm. Instead,

the cases cite theories of deterrence or the particulars of statutory language as a justification for

the approach.

These cases also often rely on prior precedents rejecting the use of offsets that are not on point,

and thereby extend the nature of the proposed calculation beyond the scope found in those

precedents. For example, some arguments fall along the lines of claiming that a broker could not

have harmed a customer by charging excessive commissions if the customer’s overall portfolio rose

in value. Extending an argument like that to the securities fraud context results in an inappropriate

outcome, in part because it relies on incorrect assumptions regarding the nature of offsets and

securities class action damages in general. We explore these issues below.

Court Decisions That Appear to be Against Offsets Tend to Be Agnostic on the Definition of

Economic Harm Due to Fraud

Irrespective of their legal reasoning, court decisions that appear to be against the use of offsets

frequently acknowledge the fact that their interpretation of damages may conflict with actual

economic loss. Cigna notes that:

In many of these decisions, a frequently cited justification for adopting a transaction-

based methodology is that aggregation (i.e., offsetting) undermines a major goal of

the securities laws—namely, deterrence of fraud.23

21. See Appendix D: Selected Court Decision Excerpts That Appear to Be Against the Use of Offsets.

22. As cited in the previous section: Arenson v. Broadcom: “The authority is clear: where a plaintiff engages in multiple

purchases and sales during the period in which the stock is inflated, the proper damages methodology is to take all

the inflation losses resulting from all purchases at the inflated price and reduce this amount by all the inflation gain

resulting from all sales at the inflated price.”

23. In re Cigna Corp Securities Litigation, Civil Action No. 02-8088, Memorandum Regarding Economic Loss, August

2006, p. 21.

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Putting aside the fact that damages in securities fraud cases are not designed to be at optimal

deterrence levels,24 this establishes the fact that disallowing offsets is not based on an attempt to

measure actual economic harm. Consequently, the failure to use offsets results in damages that

exceed the economic harm due to an alleged fraud.

It is also interesting to note that Section 28 of the Securities Exchange Act of 1934 states:

Except as provided in subsection (f), the rights and remedies provided by this title shall

be in addition to any and all other rights and remedies that may exist at law or in

equity; but no person permitted to maintain a suit for damages under the provisions

of this title shall recover, through satisfaction of judgment in one or more actions, a

total amount in excess of his actual damages on account of the act complained of.25

One might argue in support of a legal definition of damages differing from net economic loss

directly connected to the alleged fraud, but the intent of the 1934 Act is often read as a prohibition

against exemplary damages for the purposes of deterrence.

Finally, some of these decisions merely refuse to establish a legal definition of damages that

requires offsets, instead ceding authority to the trier of fact. In this light, they do not argue against

considering offsets so much as they argue against the mandatory consideration of offsets in the

legal definition of damages. Cigna clearly acknowledges that damage calculations are the province

of the trier of fact:

The specific calculation of damages in this case should be resolved based on a

trial record, rather than at the summary judgment stage. The Court will not reject

the vitality of transaction-based methodologies on these facts on a motion for

summary judgment.26

Another set of decisions that argue against offsets are far less ambiguous—they directly state

that the appropriate damage measure should ignore offsets. However, these decisions also clearly

acknowledge a divide between the net economic impact of the alleged fraud and the legal

definition of damages. We examine these decisions in the next section.

24. That is, if Investor A buys stock from Investor B at an inflated price, the amount by which A overpaid B is merely the

measure of damages. For obvious reasons, the courts do not allow Investor A to collect from Investor B but rather

from the perpetrators of the fraud. Neither the actual harm to the integrity of the capital markets nor the appropriate

level of punishment to any guilty parties is meant to be addressed by this particular calculation. Even those who

come at this from different viewpoints generally agree that the securities laws are not designed to promote optimal

deterrence. See, for example, Frank H. Easterbrook and Daniel R. Fischel, “Optimal Damages in Securities Cases,”

University of Chicago Law Review 52:3 (1985), p. 611 and John C. Coffee Jr., “Reforming the Securities Class Action:

An Essay on Deterrence and Its Implementation,” Columbia Law Review, Vol. 106 (2006), p. 1534.

25. Available at http://www.sec.gov/about/laws/sea34.pdf

26. In re Cigna Corp Securities Litigation, Civil Action No. 02-8088, Memorandum Regarding Economic Loss, p. 28.

See, also, Argent Classic Convertible Arbitrage Fund L.P. v Rite Aid Corp., 315 F. Supp. 2d 666 (2004). “We also

prefer the transaction-based methodology because we see no principled limits to the aggregation implicit in a

cumulative methodology.” [Emphasis added].

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Many Decisions That Appear to Be Against Offsets Rely on a Legal Definition of Damages No

Longer Viable Given the Supreme Court’s Dura Pharmaceuticals v. Broudo Decision

One of the more difficult objections concerning the use of offsets to address from an economic

perspective would be one where the use of offsets is not allowed based on the particular language

of the law. Of course, as discussed above, there are cases that read the law and find that the use of

offsets is required.27 Argent Classic Convertible Arbitrage Fund L.P. v. Rite Aid Corp., 315 F. Supp.

2d 666, (2004) voices a contrary view:

The language of Section 10(b) and Rule 10b-5 is more consistent with a transaction-

based methodology than a cumulative one. Both provisions make it illegal for someone

to make materially misleading statements “in connection with the purchase or sale of

any security.” 15 U.S.C. § 78j(b) (2004); 17 C.F.R. § 240.10b-5 (2004). By using the

singular nouns “purchase” or “sale,” Congress and the SEC focus on each transaction

individually. Neither the statute nor the Rule authorize any sort of aggregation of

purchases or sales that could sanction the cumulative approach.

Yet, even the courts that cite this language do not actually limit the damages to “a purchase.” For

example, if the only transactions are a purchase of 100 shares and a sale of 100 shares, Argent

would in fact match those as a paired transaction and calculate damages as the net loss, if any, on

that pairing, based on its finding that “a plaintiff’s damages are equal to the difference between

what it paid to purchase securities and how much it received when it sold those securities.” Thus,

the singular noun “purchase” is interpreted to aggregate a purchase with a sale.

More notably, the definition of damages given by the Argent court is not the inflation-based

measure nearly universally used in securities fraud cases. It is not clear whether the reasoning from

that court would even apply to standard damages calculations. It may therefore be the case that

while denying the use of offsets may appear reasonable in the abstract, the way that damages are

calculated in securities fraud cases makes offsets not only relevant but necessary for a logical theory

of damages in that context.

We find a similar pattern in a number of court decisions that appear to be against the use of offsets

cited by the recent Cigna decision’s focus on language from Rule 10b-5 indicating that plaintiffs

may claim damages for alleged fraud “in connection with the purchase or sale of any security.”

For example, Plumbers & Pipefitters Local 572 Pension Fund, et al., v. Cisco Systems, Inc., NO. C

01-20418 JW, 2004 US Dist. LEXIS 27008 states:

[D]amages may be proved by simply showing that Plaintiffs purchased stock at an

inflated price. Broudo v. Dura Pharms. Inc., 339 F.3d 933, 938 (9th Cir. 2003) (“The

inquiry occurs at the time of the transaction. … It is at that time that damages are to

be measured.”) Therefore, every time Plaintiffs purchased stock at an allegedly inflated

price during the Class Period … they were arguably injured at the moment of the

purchase, notwithstanding earlier or later sales.28

27. See Appendix C: Selected Court Decision Excerpts Advocating the Use of Offsets.

28. See also Appendix E: Selected Court Decision Excerpts That Appear to Define Damages as Occurring at Time

of Purchase.

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Regardless, the Argent and Cigna-related decisions cited above are no longer viable given the

Supreme Court’s ruling in Dura Pharmaceuticals, Inc. v. Broudo. Dura states that “[a]n inflated

purchase price will not by itself constitute or proximately cause the relevant economic loss needed

to allege and prove ‘loss causation.’”

Further, Cisco appears to be off point in arguing for ignoring sales entirely. Cisco claims that

damages can be proven by virtue of a purchase, but also refers to FIFO as a possible method for

matching purchases and sales. Cisco thus implicitly accepts that damages on purchases should be

offset by later sales of those shares. But once it is recognized that damages on purchases should be

offset by other transactions, it becomes harder to justify limiting that offset to certain transactions—

those sales deemed to be matched to the purchases—but not others.

Many Decisions That Appear to be Against the Use of Offsets Refer to Profits Unrelated

to the Alleged Fraud

Cigna cites inapposite cases to support its conclusion against the use of offsets. In two separately

cited cases, it is clear that Cigna has incorporated decisions involving churning cases in which the

ultimate value of the plaintiffs’ account or portfolio does not demonstrate a loss.29 The churning

cases cited involved portfolios or accounts that involved many different transactions, some

profitable, others not, and in any case, many which may have been unrelated to the fraud alleged.

The decisions in those cases denied defendant brokers protection from damage claims by virtue of

an overall portfolio or account profit. This is a logical conclusion, to the extent that plaintiffs would

have enjoyed even greater gains in their overall portfolio had their account not been churned,

meaning that those portfolio gains were not a result of the brokers’ wrongful acts or evidence of

the benign quality of those acts.

In the case of a securities class action suit, the argument for considering losses due to the alleged

fraud as well as gains due to the alleged fraud is not comparable. Damages in a securities class

action are not typically calculated by subtracting raw dollar gains from losses in transactions.

Instead, the only gains and losses that enter into a damage calculation are those caused by the

fraud. Thus, an approach that considered offsets would not arbitrarily apply a plaintiff’s profits that

may have been unrelated to the alleged fraud against losses that are caused by the alleged fraud.

Rather, the approach applies plaintiff’s profits that were a proximate result of the alleged fraud

against his losses that were also a proximate result of the alleged fraud.

Thus, under the standard methods for calculating securities fraud damages, there is no merit to the

argument in Argent that says:

Shannon is entitled to recover his $50 loss of January 15 because that loss was

attributable to his purchase and sale of 50 identifiable shares. It would be inequitable

to deprive him of any recovery because his purchase and sale of 50 different shares

happened to be profitable. [Emphasis added.]

29. See Nesbit v. McNeil, 896 F.2d 380, 386 (9th Cir. 1990): “In the case at hand, the plaintiffs only suffered one of

those harms, but there is no reason to find that they should be denied a recovery because their portfolio increased in

value, either because of or in spite of the activities of the defendants.”

Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1218 (8th Cir. 1990). “We disagree with Merrill

Lynch’s argument that no actual damages were sustained because after deducting the unauthorized commissions,

the account nevertheless realized a cumulative net profit of over $53,000 during the period it was churned.”

16 www.nera.com

If Shannon had a transaction that happened to be profitable, those gains would not be considered

in the calculation of securities fraud damages; only if there was a gain due to the fraud at issue in

the case would that gain be considered.

Another case cited in Cigna, In re Blech Sec. Litigation, 2003 US Dist. LEXIS 4650 (S.D.N.Y. 2003),

similarly states that defendants should not “have any off-set against the class merely because there

were some purchasers fortunate enough not to have been injured.”

Here, Blech is arguing against offsetting losses to those investors who were damaged by the

inflation by gains to other investors who benefited from the inflation—this point is unrelated to

the definition of offsets as put forth in this paper, which deals only with offsetting inflation-related

losses with inflation-related gains enjoyed by the same investor.

Another case cited by Cigna makes a similar argument against offsets. In re Clinton Oil Company

Securities Litigation (1977 US Dist. LEXIS 16787; Fed. Sec. L. Rep. (CCH) P96,016) refers to the

inequity of depriving a plaintiff of profits made from another round-trip transaction:

… Mary d’O. Saurbrey purchased five hundred shares of Clinton Oil stock between

October, 1967, and February, 1968. In December, 1968, she sold two hundred of

these shares and disposed of the balance in January, 1969. She realized a profit on

these sales transaction … it appears that by good fortune Mrs. d’O. Saurbrey was able

to make a purchase and sale of Clinton Oil stock during a time when fraud allegedly

was affecting the market price of the stock. The profit she realized on this particular

transaction should not accrue to the benefit of anyone else but herself.

It appears that Clinton Oil is arguing against offsetting a plaintiff’s claimed losses with realized

capital gains that do not relate to the alleged fraud, which is a different concept than offsetting a

plaintiff’s losses with inflation gains that can be shown to be related to the alleged fraud.

Decisions against offsets which refer to “capital gains and/or losses,” or “profits” in the accounting

sense are unlikely to be directly addressing the generally accepted definition of fraud-caused gains

and losses which result from inflation. Argent and Clinton Oil, in particular, never mention the word

“inflation.” Many court decisions against offsetting losses with profits appear to emphasize that the

profits at issue are unrelated to any alleged fraud, which does nothing to undermine the reasoning

presented in court decisions advocating the offsetting of all of a claimant’s losses due to an alleged

fraud with all of that claimant’s gains due to the alleged fraud.30

30. See Appendix F: Selected Court Decision Excerpts Arguing Against the Use of Offsets for Profits Unrelated to Any

Alleged Fraud.

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Conclusion

In this examination of FIFO and LIFO and how these methods have been evaluated by the courts in

securities class action litigation, I conclude that the calculation of economic losses due to alleged

fraud in such cases is best done by netting all gains and losses, particularly in light of the Supreme

Court’s ruling in Broudo v. Dura. For situations in which matching purchases and sales is necessary,

using the LIFO method or, preferably, a variant of the LIFO method that allows for a sale to precede

a purchase, would be appropriate.

FIFO biases results for any entity that owns shares of a company at the start of the class period

and is also an active trader of those shares during the class period. For two investors with identical

transactions during a class period, equal damages are a fair outcome. However, if one of these

investors owns shares prior to the class period, FIFO will typically yield higher damages for that

investor. This is because any class period sales must first deplete the investor’s initial holdings prior

to being applied to class period purchases.

An approach that uses LIFO for matching class period purchases is more equitable. A number of

recent court decisions explicitly or implicitly support this approach. Analogous situations from

the tax treatment of transactions in securities and financial accounting show that LIFO is most

often used to more accurately measure the economic impact of transactions in the current period.

When applying this logic to securities class actions, LIFO is more appropriate than FIFO, as it better

measures actual economic loss in the class period.

An approach that incorporates direct gains due to the alleged fraud from class period sales of shares

purchased before the class period would be even better than either a LIFO or FIFO approach that

ignores such sales. Such an approach, in addition to being more logically sound, is supported by

many precedents in the case law for securities litigation and in areas such as the wash sale rule and

the legal treatment of short-swing profit damages.

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Appendices

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Appendix A: Selected Court Decision Excerpts Advocating the Use of LIFO

In re eSpeed, Inc. Securities Litigation, 2005 WL 1653933 (S.D.N.Y.) July 13, 2005.

“But more recently, courts have preferred LIFO and have “generally rejected FIFO as an appropriate

means of calculating losses in securities fraud cases.” Moreover, in a number of instances where

courts have used FIFO to calculate financial loss, they have done so reluctantly. LIFO, by contrast,

has been used not only for lead plaintiff calculations, but also to determine compensation amounts

for stockholders suffering losses due to securities fraud.”

“An analysis of the Pension Fund’s loss as calculated by the Pension Fund demonstrates why FIFO

… is inferior to LIFO. … [FIFO] ignores that the Pension Fund also sold shares of eSpeed stock

during the class period, when the price was inflated. … LIFO reflects offsetting ‘gains’ that were

attained through the sale of stock during the class period. … Because this method contemplates the

offsetting gains the parties collected during the class period, it is a better measurement of the true

damages sustained by the plaintiffs.”

In re Organogenesis Securities Litigation, Civil Action No. 04-10027-JLT (D. Mass.), Memo-

randum, March 15, 2007.

“The IRS uses FIFO to assess gain or loss for tax purposes as this method generally increases the

amount of gain reported. Plaintiff’s expert contends that FIFO is the appropriate method to use, and

explains that under this method gains or losses from shares sold during the Class Period that are

paired (for accounting purposes) with shares purchased before the Class Period are not considered

when computing total loss over the Class Period. Such an approach is incongruent with the goal of

understanding [Lead Plaintiff’s] actual loss caused by the alleged fraud occurring during the Class

Period. … Recognizing the inappropriateness of using FIFO in this context, a number of courts

compute gains and losses using the Last-in First-out methodology (“LIFO”) when choosing a Lead

Plaintiff. … One leading advocate of this approach has explained that LIFO is a superior accounting

method because, unlike FIFO, it more consistently reports profits or losses for investors who make

identical trades during the class period, but who had different initial holdings.”

Johnson v. Dana Corporation et al., 2006 WL 782746 (N.D. Ohio).

“Under FIFO, a plaintiff’s sales of defendant’s shares during the class period are matched first

against any pre-existing holdings of shares. The net gains or losses from those transactions are

excluded from damage calculations. In contrast, under LIFO a plaintiff’s sales of defendant’s share

during the class period are matched first against the plaintiff’s most recent purchase of defendant’s

shares and gains or losses from those transactions are considered in damage calculations.”

[Regarding prior cases that appear to support FIFO, Johnson states in a footnote: “Upon closer

examination, In re Veeco is less than compelling. Both cases that opinion relies on in support of

FIFO offer support for LIFO upon closer examination. see Thompson, 2004 WL 2988503, *5 (noting

competing methodologies suggested same result and stating that at later stages “FIFO may be

insufficiently accurate and jettisoned in favor of LIFO”); In re Cardinal, 226 F.R.D. at 304 (“Lead

Plaintiff candidates did not provide the Court with a breakdown of losses under LIFO ... designated

Lead Plaintiff is the same under either methodology ... the Court ‘resorts’ to the FIFO methodology

for the ‘immediate narrow purpose’ of evaluating the plaintiffs ... this use of FIFO in no way

demonstrates a modicum of approval of FIFO.”)”]

20 www.nera.com

Arenson v. Broadcom Corp., 2004 WL 3253646, (C.D. Cal. Dec. 6, 2004).

“A number of courts have spoken clearly on this issue, treating it as a pure question of law and

finding the FIFO methodology improper. See, e.g., In re Cable & Wireless, PLC, Sec. Litig., 217

F.R.D. 372, 378-79 (E.D.Va.2003) ( “[C]ourts have generally rejected FIFO as an appropriate means

of calculating losses in securities fraud cases.”) (internal quotation marks omitted); In re Clearly

Canadian Sec. Litig., Nos. C-93-1037-VRW, C-93-1278-VRW, C-93-4313- VRW, C-95-0699-VRW,

C-95-2295-VRW, 1999 WL 707737, at *4 (N.D. Cal. Sept.3, 1999) (“[U]se of the ‘first in, first out’

method ... will identify damages where in reality there may be none; the ‘FIFO’ assumption is in

no way based on actual trading practices in general, let alone the trades of actual claimants.”). …

Applying a LIFO methodology is supported by adequate authority, especially in light of the body

of case law rejecting FIFO.” [Note that the Court effectively rejected a declaration from plaintiffs’

expert arguing that FIFO is “customarily required in calculating damages.”]

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Appendix B: Selected Court Decisions That Appear to Allow FIFO

In re Schering-Plough Corporation Securities Litigation, 2003 US Dist. LEXIS 26297 at *26

(D.N.J. Oct. 10, 2003).

“Defendants’ argument that the FIFO calculation is irrelevant, because “irrespective of whether the

overall transaction would represent a profit or loss on an investment in a particular security ...,

an investor selling stock during a period when a stock price is artificially inflated will realize a

windfall by selling the stock at the inflated price.” (Def. Obj. at 19), is somewhat perplexing.

[Plaintiff]’s Section 10(b) claim is based on losses that resulted from purchases of Schering-Plough

stock made during the Class Period. Any capital gains made with respect to the sale of shares

purchased before the Class Period are irrelevant.” [Note that the argument is based, at least in part,

on the analysis of capital gains, which may be unrelated to an alleged fraud. Any gains due to sales

at an inflated price would be based on the same allegations that led to the losses on purchases

made during the Class Period.]

Plumbers & Pipefitters Local 572 Pension Fund, et al., v. Cisco Systems, Inc., NO. C 01-20418

JW, 2004 US Dist. LEXIS 27008.

“Plaintiffs seek damages consistent with the first-in-first-out (“FIFO”) accounting method, which

has been established as a legitimate method for computing losses or gains from stock purchases

or sales.”

The following cases accepting FIFO were reviewed in the Johnson and eSpeed decisions cited in

Appendix A, which found that they were either uncompelling or at best accepted FIFO reluctantly:

In re Cardinal Health, Inc. Sec. Litig., 226 F.R.D. 298, 303 (S.D. Ohio 2005). (“Lead

Plaintiff candidates did not provide the Court with a breakdown of losses under

LIFO ... designated Lead Plaintiff is the same under either methodology ... the Court

‘resorts’ to the FIFO methodology for the ‘immediate narrow purpose’ of evaluating

the plaintiffs ... this use of FIFO in no way demonstrates a modicum of approval

of FIFO.”)

Thompson, 2004 WL 2988503, at *2 n. 3. (“This figure is calculated under the ‘first-in/

first-out’ methodology (‘FIFO’) whose accuracy in measuring the genuine financial

interest is questionable.”)

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Appendix C: Selected Court Decision Excerpts Advocating the Use of Offsets

Arenson v. Broadcom Corp., 2004 WL 3253646, *2 (C.D. Cal. Dec. 6, 2004).

“The authority is clear: where a plaintiff engages in multiple purchases and sales during the period

in which the stock is inflated, the proper damages methodology is to take all the inflation losses

resulting from all purchases at the inflated price and reduce this amount by all the inflation gain

resulting from all sales at the inflated price. See Wool v. Tandem Computers Inc., 818 F.2d 1433,

1437 & n. 4 (9th Cir.1987); In re Seagate Tech. II Sec. Litig., 843 F. Supp. 1341, 1349 n. 7

(N.D. Cal. 1994).”

Harry Lax, et al., v First Merchants Acceptance Corporation, et al., 1997 WL 461036 (N.D. Ill.).

“Members of the Castillo Group purchased some 163,054 shares during the period January 25,

1996 to April 16, 1997. … the Castillo Group sold nearly 70% of its First Merchant holdings during

the class period at prices that were inflated by the alleged fraud, which would presumably diminish

their actual losses.”

In re Comdisco Sec. Litig., 150 F. Supp. 2d 943 (N.D. Ill. 2001).

“It turns out that when the Class Period of January 25 through October 3, 2000 (which is the proper

referent) is focused upon, PASERS’ claim that it suffered some $2.4 million in losses in connection

with its investment in Comdisco common stock is only a mirage created by PASERS’ adoption of

a FIFO (first-in-first-out) approach to its dealings in the stock. In fact PASERS was an active trader

during the Class Period, with 15 separate sales that more than matched its purchases during that

time frame: Its Class Period purchases of Comdisco common stock aggregated 213,800 shares,

while its sales during the same period totaled 218,400 shares. And when those transactions are

properly matched, rather than by the impermissible application of a FIFO methodology (which by

definition brings into play PASERS’ pre-Class-Period holdings as the purported measure of its claimed

loss), PASERS’ Class Period sales at inflated prices caused it to derive unwitting benefits rather

than true losses from the alleged securities fraud--so much so that [another movant] demonstrates

that PACERS [sic] derived a net gain of almost $300,000 (rather than any net loss at all) from its

purchases and sales during the Class Period.”

Johnson v. Dana Corporation et al., 2006 WL 782746 (N.D. Ohio).

“Consider an Investor A with accumulated holdings of 10,000 shares of XYZ Corporation that

were acquired when everything was on the up and up in terms of corporate disclosures, and

that represent the investor’s long-term commitment to the company’s prospects. Assume further

that unknown to Investor A but during what later turns out to be a plaintiffs’ class period-a time

when the nondisclosure of adverse information caused the stock price to be too high in terms

of real value-Investor A both buys and sells an aggregate of 5,000 shares of XYZ stock in various

transactions before the stock price later falls out of bed, and that such class-period transactions

leave Investor A neither out of pocket nor in pocket when the expenditures for and the proceeds of

those transactions are aggregated. Is there any real question that Investor A, who has thus retained

the same long-term stake in XYZ that preceded the class period, has sustained neither gain nor loss

from the transactions during the class period?” [Note that this passage does not specify whether the

sale of 5,000 shares must occur after the purchase of 5,000 shares.]

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Minpeco v. Conticommodity Services, Inc., 676 F.Supp. 486, 488-490 (S.DNY 1987).

“Under most circumstances, it is clear that a plaintiff both injured and enriched by illegal activity

cannot choose to recover for his injuries yet retain his windfall.”

“I conclude that Minpeco’s claimed damages on its silver futures positions must be offset by the

measure of the increase in value which accrued to its own physical silver holdings … as a result of

defendants’ allegedly manipulative behavior.” [Note that the Minpeco court offset plaintiff’s financial

loss in one asset with its gains in another because both were caused by the same illegal actions.]

24 www.nera.com

Appendix D: Selected Court Decision Excerpts That Appear to Be Against the Use of Offsets

In re Cigna Corp Securities Litigation, Civil Action No. 02-8088, Memorandum Regarding

Economic Loss, August 2006.

“…the Court finds that there is a significant amount of authority which would allow a jury to apply

a transaction-based methodology, if based on adequate evidence, to calculate economic loss and

damages, rather than requiring the jury to apply a cumulative approach that aggregates transactions

and off-sets gains and losses stemming from different transactions. The specific calculation of

damages in this case should be resolved based on a trial record, rather than at the summary

judgment stage. The Court will not reject the vitality of transaction-based methodologies on these

facts on a motion for summary judgment.” [Note that the court does not reject the use of offsets,

but refuses to reject a prohibition on the use of offsets.]

Argent Classic Convertible Arbitrage Fund L.P. v Rite Aid Corp., 315 F.Supp.2d 666 (2004).

“The language of Section 10(b) and Rule 10b-5 is more consistent with a transaction-based

methodology than a cumulative one. Both provisions make it illegal for someone to make materially

misleading statements ‘in connection with the purchase or sale of any security.’ 15 U.S.C. § 78j(b)

(2004); 17 C.F.R. § 240.10b-5 (2004). By using the singular nouns ‘purchase’ or ‘sale’, Congress and

the SEC focus on each transaction individually. Neither the statute nor the Rule authorize any sort of

aggregation of purchases or sales that could sanction the cumulative approach.”

“We also prefer the transaction-based methodology because we see no principled limits to

the aggregation implicit in a cumulative methodology. If we were to aggregate profitable and

unprofitable transactions, we would have to identify which transactions to aggregate.” [Note that

when damages and offsets are defined as relating to purchases and sales at inflated prices, there

are natural limits corresponding to those transactions that are made at inflated prices. Including any

additional transactions would have no effect since there would neither be a damage nor an offset

from transactions at prices that were not affected by a fraud. The Argent Court’s decision here only

makes sense because it defined damages as the difference between purchase and sale price with no

reference to inflation.]

In re Schering-Plough Corp. Sec. Litig., 2003 US Dist. LEXIS 26297 at *26 (D.N.J.

Oct. 10, 2003).

“[Plaintiff]’s Section 10(b) claim is based on losses that resulted from purchases of Schering-Plough

stock made during the Class Period. Any capital gains made with respect to the sale of shares

purchased before the Class Period are irrelevant.”

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Appendix E: Selected Court Decision Excerpts That Appear to Define Damages as Occurring at Time of Purchase

Plumbers & Pipefitters Local 572 Pension Fund, et al., v. Cisco Systems, Inc., NO. C 01-20418

JW, 2004 US Dist. LEXIS 27008.

“[D]amages may be proved by simply showing that Plaintiffs purchased stock at an inflated price.

Broudo v. Dura Pharms. Inc., 339 F.3d 933, 938 (9th Cir. 2003) (“The inquiry occurs at the time

of the transaction. . . . It is at that time that damages are to be measured.”). Therefore, every time

Plaintiffs purchased stock at an allegedly inflated price during the Class Period… they were arguably

injured at the moment of the purchase, notwithstanding earlier or later sales.”

In re Clinton Oil Company Securities Litigation, 1977 US Dist. LEXIS 16787; Fed. Sec. L. Rep.

(CCH) P96,016.

“Rule 10b-5, 17 C.F.R. § 240.10b-5, makes it unlawful for one to use interstate commerce to

defraud, mislead, or engage in activity which effectively would be a fraud on any person ‘in

connection with the purchase or sale of any security.” The implication of this language is that each

fraudulent act by which a person induces… another to purchase or sell stock to his detriment

creates an actionable wrong. Therefore, since fraud is in most cases a continuing wrong until

discovered, each purchase or sale transaction consummated by a buyer in reasonable reliance on

the fraudulent or misleading information provided by the wrongdoer would result in a separate

actionable wrong under the Rule.”

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Appendix F: Selected Court Decision Excerpts Arguing Against Offsets for Profits Unrelated to Any Alleged Fraud

Argent Classic Convertible Arbitrage Fund L.P. v Rite Aid Corp., 315 F.Supp.2d 666 (2004).

“Shannon is entitled to recover his $50 loss of January 15 because that loss was attributable to

his purchase and sale of 50 identifiable shares. It would be inequitable to deprive him of any

recovery because his purchase and sale of 50 different shares happened [emphasis added] to be

profitable.” [Note that standard damages analyses in securities fraud cases limit damages or offsets

to those proximately caused by a fraud, meaning that any shares that only happened to have been

profitable, as opposed to having a gain caused by the fraud, would not result in an offset.]

In re Blech Sec. Litig., 2003 US Dist. LEXIS 4650 at *72 (S.D.N.Y. 2003).

“Bear Stearns argues that [plaintiff expert]’s damage calculations are overstated because he failed

to account for “out-and-in” traders, or purchasers of Blech Securities who sold their shares prior to

the period. Defendants are not entitled to an offset, factoring in any gains made by these traders.

As the court explained in In re Crazy Eddie Sec. Litig., 948 F.Supp. 1154, 1172 (E.D.N.Y.1995):

While such an off-set may be appropriate for purposes of sentencing in a criminal case, [defendant]

presents no reason why he is entitled to this off-set here, let alone why a perpetrator of securities

fraud would generally have any off-set against the class merely because there were some purchasers

fortunate enough not to have been injured.” [Note that it is extremely rare for defendants to

attempt to claim an offset against the class for those class members that benefited from the fraud,

much less for those who simply were not injured.]

Nesbit v. McNeil, 896 F.2d 380, 386 (9th Cir. 1990).

“In the case at hand, the plaintiffs only suffered one of those harms, but there is no reason to find

that they should be denied a recovery because their portfolio increased in value, either because of or

in spite of the activities of the defendants.”

Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc. 906 F.2d 1206, 1218 (8th Cir. 1990).

“We disagree with Merrill Lynch’s argument that no actual damages were sustained because after

deducting the unauthorized commissions, the account nevertheless realized a cumulative net profit

of over $53,000 during the period it was churned.”

In re Clinton Oil Company Securities Litigation, 1977 US Dist. LEXIS 16787; Fed. Sec. L. Rep.

(CCH) P96,016.

“…Mary d’O. Saurbrey purchased five hundred shares of Clinton Oil stock between October, 1967,

and February, 1968. In December, 1968, she sold two hundred of these shares and disposed of the

balance in January, 1969. She realized a profit on these sales transaction… it appears that by good

fortune Mrs. d’O. Saurbrey was able to make a purchase and sale of Clinton Oil stock during a time

when fraud allegedly was affecting the market price of the stock. The profit she realized on this

particular transaction should not accrue to the benefit of anyone else but herself.”

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