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Current events in Law & Finance:
Do plaintiffs settle for a song or are damages estimates inflated?
In October, AT&T announced that it settled a private securities class-action lawsuit for a gross payment (before legal fees and expenses) of $100 million, or 4 percent of the $2.4 billion in shareholder damages claimed by the plaintiffs. This is a typical settlement percentage. Atypically, in August, Judge Barbara G. Lynn declined to accept as fair a settlement by Halliburton of a private securities class-action lawsuit calling for a gross payment of $6 million, where an economist had supplied a shareholder damages estimate in the range of $799 million to $4.036 billion. Ruling Halliburton’s private settlement followed its agreement to pay a penalty of $7.5 million in a settlement with the SEC. SEC Release Combined, the two Halliburton payments would have amounted to less than 2 percent of the low end of purported damages.
Are investors damaged by the misstatement or by the corrective disclosure?
The Supreme Court will decide this term whether a corrective disclosure and sudden stock price drop is required to establish “loss causation,” which in turn is a legal requirement for any private securities class-action lawsuit. The quesiton is whether stock-price inflation can be established reliably absent a visible deflation in the price. Shareholders of Dura Pharmaceuticals bought stock at a price allegedly inflated by a false statement, and the stock price subsquently did fall substantially, but plaintiffs apparently cannot tie the price decline to a press release explicitly correcting the alleged misstatement. The Court of Appeals for the 9’th Circuit ruled that a stock-price drop on a corrective disclosure was not required. The United States has weighed in with an amicus brief saying that legal consistency argues for making an identifiable (same-company) stock-price drop a requirement. 9’th Circuit Ruling and Amicus Brief Faced with a similar fact pattern in SEC v Boren, I used the average stock-price decline in a representative sample of comparable corrective disclosures by other companies to estimate the ill-gotten gains of an insider who sold shares when his company’s market price was falsely inflated by an omission. Ruling in SEC v Boren
SEC accuses Siebel Systems of a repeat violation of Regulation FD
In June, the SEC filed a complaint against Siebel Systems and several of its employees alleging that the company’s CFO made selective forward-looking disclosures at two private dinners with institutional investors, that these disclosure materially contradicted recent public statements, that these selective disclosures caused some dinner attendees to convert a 108,200 share short position to a 114,200 share long position, and that the company did not make a public disclosure to counter subsequent unusual trading activity and rumors. Complaint
The OTC Bulletin Board is far from efficient
In May, the Court of Appeals for the 4’th Circuit reviewed a pretrial decision in a lawsuit by purchasers of First National Bank of Keystone common stock. The trial court accepted at face value plaintiffs’ claim that the trading market for the stock was an efficient market, offering only a “brief allusion” to the drop in the company’s stock price when bank regulators declared the bank insolvent. The Court of Appeals found this single piece of information insufficient in light of the fact that the stock was quoted on the OTC Bulletin Board, at best,with only 2.5 trades on an average day, and that the bid-ask spread sometimes reached 30%. In its Basic decision, the Supreme Court contemplated as efficient “modern securities markets, literally involving millions of shares changing hands daily.” While the OTC Bulletin Board may qualify as modern, it falls far short of qualifying as an efficient market. Ruling
“Hello. I’m from the government and I’m here to help you”
Back in March, the SEC proposed a rule to require that mutual funds charge a 2% redemption fee to eliminate too-rapid trading. The feedback from the public on this one-size-fits-all mandate has fallen short of the accolades the SEC may have expected, but is consistent with the paucity of economic evidence showing a need for limits on private contracting in this area. The economic evidence the SEC could muster is cited in Footnote 3 of its rule proposal, as follows:
See Jason Greene & Charles Hodges, The Dilution Impact of Daily Fund Flows on Open-end Mutual Funds: Evidence and Policy Solutions, 65 J. Fin. Econ., 131-158 (2002) (estimating annualized dilution from frequent trading, based on market timing, of 0.48% in international funds: "the dilution impact has brought about a net wealth transfer from passive shareholders to active traders in international funds in excess of $420 million over a 26-month period."). See also Roger M. Edelen, Investor Flows and the Assessed Performance of Open-end Mutual Funds," 53 J. Fin. Econ. 439, 457 (1999) (quantifying the costs of liquidity in mutual funds as $0.017 to $0.022 per dollar of liquidity-motivated trading). See also Ken Hoover, Why mutual funds discourage timers; Two forms of practice; They increase expenses, can disrupt portfolios and rob other investors, Investor's Business Daily, Sept. 17, 2003, at AO9. SEC Proposal
Can opinion be material in an efficient market?
In April, the SEC filed an amicus curiae brief with the Appeals Court for the 2’nd Circuit regarding the court’s review of Citigroup’s claim that it was not Jack Grubman’s opinion that caused investors to overpay for WorldCom stock. The SEC brief formally addresses “whether the fraud-on-the-market presumption of reliance applies to material misrepresentations by analysts” [emphasis added], but the threshold question would seem to be whether opinion can be material if it is based on facts known to an efficient market. Although Regulation FD rendered much historical data obsolete, the SEC cites historical evidence from large-sample event studies by financial economists to establish the general proposition that analyst opinion matters. With few exceptions, however, studies have found only small average stock-price impacts for changes in analyst opinion. Statistical significance can arise as a consequence of sample size alone, and the samples in these event studies tend to be very large. SEC Brief [I filed a Declaration in this matter on behalf of Citigroup.]
Implications of market efficiency
In April, the Court of Appeals for the 5’th Circuit reviewed a pretrial decision in a lawsuit by purchasers of Crossroads Systems common stock. Plaintiffs had the “burden in a fraud-on-the-market case to show that a stock’s price was actually affected by an allegedly false statement.” The evidence for this was a stock-price drop on a curative disclosure. The appeals court conducted a detailed analysis of the extent to which the new information that caused the stock-price drop was curative of the alleged misrepresentations. Ruling Coincidentally, also in April, Judge Vaughn Walker of the Northern District of California issued a pretrial ruling in a lawsuit by purchasers of Copper Mountain common stock, advising: “So a plaintiff seeking to allege open market securities fraud does well to begin the analysis with the ‘truth,’ stack it up against what preceded it and then see if acts, omissions or statements of defendants can plausibly be said to be responsible for the ‘truth’ not emerging earlier when plaintiffs traded their securities.” Ruling
Ruling on statistical significance
The 5’th Circuit decision in Crossroads Systems (see above) also determined that the statistical significance of a percentage change in stock price over two days is properly determined by comparing it to volatility rather than to the (very large) overall decline in price over the class period. “A drop of 10% for a volatile stock may not be statistically significant whereas the same drop for a stock with little average movement may be significant.”
Liability without damages
In April, the Court of Appeals for the 4’th Circuit upheld a jury verdict in a case where negative reports publicized by the defendant (a short seller) were found to be defective in some respects, and a proximate cause of the plaintiffs’ losses, even though the jury awarded the plaintiffs no damages. The jury apparently found that plaintiffs’ losses were caused in substantial part by the reports, consistent with liability, but when it came to deciding damages was unable to disentangle the separate contributions to losses of various causal factors, including some for which the defendant was not liable. The appeals court found this scenario plausible, noting that whatever calculations the plaintiffs’ damages expert performed were “apparently done in his head” because the economist “never committed any portion of his event analysis, other than his ultimate conclusion, to written form.” Ruling
FASB issues option-expensing exposure draft FASB Document
Analyst opinion and market efficiency
In March, Judge Rakoff of the Southern District of New York declined to dismiss a lawsuit by RealNetworks shareholders who purportedly relied on Lehman Brothers analyst opinion. The Court said: “...the Complaint adequately alleges that in or around October, 2000 the market was finally apprised of the negative information concerning RealNetworks that had earlier led Stanek to take a secretly negative view of the stock....” (Demarco v. Lehman Brothers, Inc., 2004 WL 602668, S.D.N.Y.) Stanek, the Lehman Brothers analyst, allegedly possessed secret negative information, but the SEC apparently found no violation of Regulation FD. Absent this allegation, the facts of this case resemble those underlying Judge Pollack’s decision of last June, which dismissed a class action regarding Merrill Lynch analyst opinion, saying: “...plaintiffs brought their own losses upon themselves when they knowingly spun an extremely high-risk, high-stakes wheel of fortune.” Ruling
It is at least plausible that Stanek’s secret negative opinion was based on information that was public while the buy rating was in place. If, in addition, RealNetworks common stock traded in an efficient market, the stock price paid by shareholders would have reflected the negative information underlying the secret opinion. If the market for RealNetworks stock was not efficient, but instead dominated by irrational exuberance, a hypothetical withdrawal of the Lehman Brothers buy recommendation would have needed to improve investors’ rationality to matter.
Materiality of merger talks
In March, the Court of Appeals for the 11’th Circuit reinstated a jury verdict in the SEC’s action against Scott Ginsburg, the CEO of a prospective acquirer of a company publicly soliciting merger proposals. Ginsburg was a party to the talks who knew of “concrete steps.” The Appeals Court said the jury could recognize as material the difference between public information regarding merger talks and potential sale prices and “nonpublic information about a private meeting between executives and the specific share price they discussed confidentially.” The jury effectively found that a hypothetical disclosure of the concrete steps would have further boosted (to a degree commensurate with materiality) a stock price that already reflected some expectation of a premium bid. Ruling
Stock-Price evidence and confounding news
In February, Judge Pollack of the Southern District of New York dismissed a lawsuit by Tyco shareholders who purportedly relied on Merrill Lynch analyst opinion. Loss causation could not be established because the stock-price drop in question coincided with confounding, fundamental news. That most analyst reports have a news hook generally complicates expert opinion regarding materiality and loss causation in analyst-opinion cases. Ruling
Market timing at Mutual Funds
A number of mutual-fund management companies have allowed favored fund shareholders to practice market timing (i.e., excessive exchanges among funds in the family) despite prospectus language to the contrary. The amount of restitution required in settlements with regulators has ranged from $500,000 to $175,000,000. For many of the impacted funds, the costs to long-term fund shareholders of improper market timing likely fall at the lower end of this range. Curiously, the impacted funds have been mostly growth funds and not the international funds where time-zone arbitrage is likely to be profitable. More (PDF file)
Materiality of Martha Stewart’s Denials
In February, Judge Cedarbaum ruled that the jury in the Martha Stewart trial would not hear from the government’s experts on materiality, who were prominent stock analysts. An event-study analysis (using stock-price evidence rather than analyst opinion) reveals that the materiality of Martha Stewart’s public assertions of her innocence is, at most, inconclusive. More (PDF file)
Black-Scholes formula and expected life
It has been argued (example) that the Black-Scholes options-pricing formula is inappropriate for determining the cost of employee stock options because employees can’t sell their options, and therefore value them below Black-Scholes values. This argument confuses value and cost, of course, but illiquidity can have a feedback effect on cost by causing early exercise (as the next-best alternative to a sale). Companies already routinely adjust for early exercise by inputting to the Black-Scholes formula an “expected life” shorter than the nominal, 10-year life of the option. This lowers cost estimates by 20%-40%, where option life is modeled as a constant derived from the issuer’s average historical experience with employee stock options. Ron Rudkin of Analysis Group finds that estimates are reduced further when option-holder behavior is made endogenous and reflected in the internal logic of the (Binomial) model. Models that yield lower cost estimates can be quite complex. See, for example, The Effect of Exercise Date Uncertainty on Employee Stock Option Value, where option life is modeled as a random variable with a Gamma distribution.
Abuse of the efficient market hypothesis
Some complaints filed by plaintiffs in private, class-action securities litigation cannot pass a statistical test commensurate with internal logical consistency. More (PDF file)
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