The Higher Regional Court of Stuttgart ruled on April 12, 2022 on a claim made by US hedge funds against Porsche Automobil Holding SE (court case number 1 U 205/18). The decisive question was whether or not gains from short sales have to be deducted from losses in purchases of shares.

Below, we not only summarize the decision, but we also provide an outlook on what impact this ruling may have (or not have) on related issues within the German securities litigation landscape and on the ongoing VW and Porsche model case proceedings pursuant to the Capital Markets Model Case Act (Kapitalanlegermusterverfahrensgesetz – KapMuG).

The plaintiffs, US hedge funds, acquired shares of defendant Porsche Automobil Holding SE (Porsche) in the years 2013 to 2015. They suffered losses in Porsche preferred shares after the “emissions scandal” became known and, against this background, demanded compensation from Porsche (out-of-pocket damages) due to the breach of ad-hoc disclosure obligations.

At the same time, the plaintiffs engaged in short selling with regard to preferred shares of Volkswagen AG (VW). VW was Porsche’s main asset during the period under review, which is why there was a close correlation between the share price performance of both issuers Porsche and VW. With the purchases of Porsche shares and the corresponding short sales of VW shares, the plaintiffs pursued a so-called pair trading strategy: with the pair trade the plaintiffs hedged against general market risks and VW-related risks on the one hand. On the other hand, they could speculate on arbitrage opportunities, since pursuant to their analysis of the fundamentals there was an unjustified difference in value (spread) between the preferred shares of the issuers.

The Stuttgart Regional Court (by judgment of Oct. 24, 2018 – 22 O 348/16) partially upheld the claim and ordered the defendant Porsche to pay the plaintiffs around €44 million plus interest. The plaintiffs and the defendant appealed against this judgment.

For more details on the claims asserted and on a few peculiarities of German securities law read further:

The hedge funds asserted only out-of-pocket damage claims for their long positions – for very good reasons.

Investors can in fact choose if they want to claim out-of-pocket damages or rescissionary damages. So, when investors constrain themselves and pursue only out-of-pocket damages (as has happened here), one may want to ask why that is the case. Rescissionary damages (Transaktionsschaden) mean the difference between the purchase price and the sales price or – if the shares are still held – the purchase price in exchange for the shares. So, investors will be put in the financial position as if they had never purchased the shares. A major disadvantage with rescissionary damages is that investors have to prove transaction causation, i.e. the investors must prove that their decisions to purchase the securities were based on the issuer’s failure to disclose the inside information, i.e that they would not have purchased the shares if they had known about the undisclosed information.

Regarding out-of-pocket damage claims (Kursdifferenzschaden) the threshold is considerably lower and hence much more investor friendly: investors only have to prove loss causation, i.e. investors only have to establish causation between the harmful event and the economic loss. In other words: An investor’s reliance does not play a role under German securities law when it comes to out-of-pocket damages.

In the present case and in view of their investment strategy the claimants would not have been succesful in proving transaction causation. Insofar the claimants’ decision to claim the “lower hanging fruits” of out-of-pocket damages (only) was logical and reasonable.

The Stuttgart Higher Regional Court dismissed the action as unfounded. Also, the appeal on points of law to the Federal Court of Justice was not admitted. The last resort for the plaintiffs is hence a complaint against denial of leave to appeal. In practice, such a complaint is rarely succesful and to date it is unknown if such a complaint has been filed in this matter.

Summarized, the Higher Regional Court of Stuttgart ruled based on the following arguments:

In the case of possible out-of-pocket damages due to the purchases of Porsche shares, any benefits from the short sales of VW shares made at the same time are to be taken into account. This leads to a deduction of losses by offsetting gains as the entire action is based on breaches of duty in connection with the “emissions scandal” and related risks were hedged by the short sales of VW shares (so-called “full hedging”).

The prerequisites for offsetting gains were met. There was an adequate causal connection with the damaging event (1.). The offsetting is also in line with the purpose of the compensation (2.), i.e. the injured party is neither unreasonably burdened nor the injuring party unfairly relieved: the Federal Court of Justice has ruled that if an investor has subscribed to two different investment models on the basis of investment advice and has thereby made a uniform investment decision based on the same wrong investment advice, benefits from the positive transaction are to be credited if he wants to unwind the loss-making transaction. Since the purchases and short sales had been part of a uniform investment concept and had been based on a uniform investment decision, the connection was even closer here than in the aforementioned judgment of the Federal Court of Justice regarding an investment advice. Also, the benefits from the short sales of VW shares were neither legally nor functionally comparable to insurance benefits [where offsetting benefits would not apply under German law].

With the short sales, the plaintiffs had not hedged against price losses of the Porsche shares against payment of a premium in the sense of an insurance policy, as is the case, for example, with a put option. Rather, they had deliberately eliminated the general market risk and the VW-specific risk.

First of all, it should be noted that the first instance, the Stuttgart Regional Court, was unable to take into account the defendant’s objection of offsetting gains. The defendant only obtained documents on the plaintiffs’ investment strategy later, i.e. after the judgment, in the course of parallel discovery proceedings in the USA pursuant to 28 U.S. Code § 1782. Thus, the objection regarding offsetting gains did not play a role until the appeal before the Higher Regional Court of Stuttgart. This illustrates: the US discovery can be a sharp sword not only for plaintiffs to obtain information. It can prove very useful for defendants, too.

The fact that the Higher Regional Court of Stuttgart did not grant leave to appeal is quite surprising – and wrong

Applying the case law of the Federal Court of Justice on the combination of two transactions in actions for damages due to wrong investment advice to the pair trade in the present case raises considerable concerns.

An investment advisor owes disclosure and correct advice with regard to all investments where advice is given. The issuer instead owes disclosure of information (and not advice) solely with regard to the financial instruments it has issued. The issuer does not have to pay damages for any other financial instruments, whereas the investment advisor does have to pay damages for another product on which he is advising. In this respect, in the case of investment advice, there is a synchronism between offsetting gains on the one hand and the obligation to pay for damages on the other; in the case at issue, though, the circumstances are different. Therefore, the Higher Regional Court of Stuttgart should have granted leave to appeal.

In the case of the acquisition of put options, for which an (insurance-like) premium is to be paid, the Higher Regional Court of Stuttgart indicated, it would possibly have decided differently. But whether this legal “hair-splitting” makes sense may be doubted – at the very least from the point of view of market participants who do not distinguish between “insurance-like” and “non insurance-like” investments.

Also supporting arguments are questionable

Also further arguments put forward by the Stuttgart Higher Regional Court in support of its judgment raise further doubts. Pursuant to section 97 of the German Securities Trading Act, investors cannot assert out-of-pocket damage claims for shares that have been sold within the disinformation period and not within the disinformation period. This is the case because pursuant to section 97 of the German Securities Trading Act the shares must have been held until the disclosure (put more simply: when the stock drop occurs). The court explained that this decision of the legislator is comparable to offsetting gains, which is why, the court concluded, its opinion of offseting the short sale gains from the losses in the VW trades in the case at issue should be in line with the law and the legislator’s concept.

This conclusion of the court is also not convincing:  the legislator had certainly not in mind how to cope with pair trades when the law was enacted. The legislator did not even – as well as large parts of German legal literature by the way – have any awareness of the fact that out-of-pocket damages can also exist if an investor sells before the inside information is disclosed to the markets. The legislator obviously believed that when an investor sells shares within the disinformation period the loss in terms of an inflated purchase price will be completely transferred to the next investor. From an economic perspective, this simplified view cannot be upheld. Out-of-pocket damages can exist for transactions made within the disinformation period. The delta of inflation can change over time, i.e. the inflation at the time of the purchase can be higher than the inflation at the time of the sale – even when a share is sold before the disclosure.

In addition, regarding the damage calculation the use fo the constant percentage method may be more feasible in certain cases than the constant dollar method, with the consequence of a dynamization of the out-of-pocket damages across the (sub-)periods. There is therefore little to be gained from the court’s argument. It is all the more unsuccessful with regard to claims under section 826 of the German Civil Code (which is the German “catch-all” tort statute). Here, there is no such “holding requirement” as in section 97 of the German Securities Trading Act (Wertpapierhandelsgesetz – WpHG), i.e. under section 826 of the German Civil Code (Bürgerliches Gesetzbuch – BGB) investors can assert out-of-pocket damages claims stemming from shares that have been sold within the disinformation period. Unfortunately, these and other considerations have not been taken into account by the court in its decision.

The ruling presumably marks the beginning of a series of decisions in the coming years where the objection of offsetting gains will play a central role, not only when it comes to shares but also when it comes to bonds (credit default swaps). For example, under German law it is unclear, if one has to deduct gains from transactions in a financial instrument where other transactions in the same financial instrument generated losses. This question is a different one from the one decided, as it is about the same financial instrument and about long positions only. And this question is quite relevant as it affects thousands of investors in pending cases. What makes it even more complicated is the fact that it is undecided yet under German law, whether the FIFO method (first in first out) or the LIFO method (last in first out) applies. So, it is not even clear what exactly the (closed) transaction is. Even the method of calculating damages (constant dollar vs. constant percentage method) is unclear to date under German law. The Federal Court of Justice only decided  back in 2005 (by judgment of May 9, 2005 – II ZR 287/02) that a so-called backward induction is appropriate to calculate (or at least estimate) damages.

The Higher Regional Court’s decision has marked the beginning of shaping the law regarding offsetting gains in securities cases. But it will not sketch out the further development. First of all, the pair trade in the present case was rather unique. It neither represents the trading strategy of ordinary small investors, nor the strategy of the vast majority of institutional investors. Secondly, the reasoning was flawed and questionable. It will not serve as a trend-setting decision.

The claimants belonged to just a few who have not become part of the two model cases against Porsche and VW. As the claimants lost in a separate lawsuit and only based on – the in our view wrong application of  – the principle of offsetting gains for specific and highly sophisticated trades, the judgment has no impact on the proceedings under the German Capital Markets Model Case Act against VW and Porsche where around EUR 10 bn are at stake.

The landmark judgments in this matter are yet to come.

For further read see:

– Maximilian Weiss, Securities Litigation against VW and Porsche – The 10 Billion Euro Marathon Walk, in: Beate Gsell/Thomas M.J. Möllers (eds.), Enforcing Consumer and Capital Markets Law – The Diesel Emissions Scandal, Intersentia, Cambridge/Antwerp/Chicago, 2020, pp. 449 et seqq.

– Maximilian Weiss, Comment on OLG Stuttgart, judgment of 12.04.2022 – 1 U 205/18 – (on the prerequisites for offsetting gains when claiming out-of-pocket damages due to the breach of ad hoc disclosure obligations in the case of a “pair trade”, ie the purchase of shares and simultaneous short sales), in: EWiR – Entscheidungen zum Wirtschaftsrecht, 2022, pp. 421 et seqq.