Accounting for Bad News: Securities Fraud Litigation and the Equal Application of Market Efficiency

• Publication year: 2022

43 Creighton L. Rev. 471. ACCOUNTING FOR BAD NEWS: SECURITIES FRAUD LITIGATION AND THE EQUAL APPLICATION OF MARKET EFFICIENCY

ACCOUNTING FOR BAD NEWS: SECURITIES FRAUD LITIGATION AND THE EQUAL APPLICATION OF MARKET EFFICIENCY

MICHAEL ILG(fn*)

ABSTRACT:

The Fraud-on-the-Market theory holds that high volume markets, such as the New York Stock Exchange, effectively incorporate all available information of present and expected value into a security's price. As endorsed by the Supreme Court of the United States, fraud on the market serves an important procedural role within the context of securities litigation by providing a general reliance presumption for all investors. An investor, or class of investors, is able to sue upon a claim of management misrepresentation without having to show actual reliance on the fraudulent information. When a market is assumed to be efficient, misinformation is deemed to defraud investors who have relied upon the integrity of the market itself. The presumption of market efficiency may thus be seen as an aspirational device, for placing the costs of rebuttal upon a corporation is said to encourage market transparency and the very same integrity of information that is assumed theoretically.

For the soundness of market information to be encouraged through such a litigation presumption, the effect should not become counter-distorting through the double compensation of litigation loss. If fraud on the market is to be applied with consistent logic, then one must assume that the instant a misrepresentation is made public that rational investors will automatically discount the stock price to account for the inevitable class action suit that will arise. A post misrepresentation fall in share price generally serves as the basis for securities fraud claims of loss. Yet, this entails that plaintiffs are able to recover on a market valuation that includes both the diminishment in the asset due to fraud and the anticipated cost of its future litigation. Unlike traditional fraud recovery, the operation of an anticipatory market incorporates litigation outcomes into asset valuation at the time of awareness. Accordingly, damage recovery may unwittingly grant relief on a loss assessment that is composed of two factors: (1) the market assessmentof asset devaluation due to fraud; and (2) the market prediction of the very same plaintiff recovery. One can then see that plaintiffs have their litigation recovery count twice: as they receive it from the court, and as it formed the basis of the very amount of claimed loss. In response to this problem, the following Article draws upon methods of alternative company valuation to arrive at a simple formula for filtering out anticipated litigation loss from securities damages.

Table Of Contents

I. Introduction...................................472

II. Uniqueness and Procedural Problems ...477

III. Reliance.........................................480

IV. Market Efficiency and Public Policy.....482

V. Recognizing Reliance and Loss ............484

VI. Filtering Loss..................................487

A. The Intuitive Rise..............................488

B. The Intrinsic Rise..............................489

C. The Extrinsic Fall.............................491

D. The Intrinsic Fall.............................492

E. The Intuitive Fall.............................493

VII. Quantifying Loss..............................494

A. Traditional Treatment of Loss................494

B. A Further Fall Past Equilibrium..............496

C. Discounting Against Double Recovery........498

VIII. Identifying Litigation Loss.................499

IX. Conclusion ..................................... 503

I. INTRODUCTION

The judicial adoption of economic assumptions arguably achieved an apex in the area of securities litigation.(fn1) The availability of class action relief for securities fraud rests almost entirely upon the judicial endorsement of an abstract ideal of market efficiency adopted from theories of economics and finance.(fn2) The adopted theory is that of the Efficient Capital Markets Hypothesis ("ECMH"), which holds that in modern developed markets all information of value is automatically incorporated into a security's price.(fn3) The unique circumstance of the Supreme Court of the United States endorsing an abstract theory of economic finance, under the given legal label of "fraud on the market,"(fn4) has likely more to do with procedural necessity than the descriptive force of the theory.(fn5) For fraud on the market circumvents, conveniently, the reliance obstacle to establishing a common cause of class action pleadings, and allows a class of investors to claim misrepresentation without each having to show actual reliance.(fn6) A near impossibility of showing common reliance within the infinitely varied entry into the stock market is averted with an ideal vision of efficiency-as each is held to have relied upon the market itself, not upon disparate pieces and conveyances of information that make up the market.(fn7)

When a market is assumed to be perfectly efficient, misinformation is deemed to defraud investors who have relied upon the integrity of the market as information is at once in instantly incorporated into price. Such a presumption of market efficiency appears an aspirational device; for placing the costs of rebuttal upon a company's management, to show that reliance did not occur, is said to encourage market transparency and the very same integrity of information that is assumed theoretically.(fn8) What is presumed procedurally and theoretically is to be encouraged systemically.

While procedural gains perhaps have been achieved through the judicial adoption of market efficiency assumptions, supposedly furthering incentives for management transparency, it also appears that procedure has limited the logical treatment, extension of the efficiency assumption to the entire range of a fraudulent claim. Obscured is the extent to which the economic assumptions of fraud on the market should also and necessarily extend to the amount of damages claimed. While a wealth of judicial and academic attention has been paid to the initial procedural stages of securities fraud,(fn9) such as reliance, materiality, and loss causation, less attention has been paid to the question of assessing the quantum of damages sought; of loss outright and in conclusion.(fn10)

For the soundness of market information to be encouraged through the litigation presumption of information efficiency, the effect should not become counter-distorting through an over-compensation in damage award. Although a subsequent, post misrepresentation fall in share price traditionally has been the basis of loss claims,(fn11) the result is that a class of investors is able to recover on an amount that also includes the market's anticipated cost of its future litigation. The following Article proposes a method for discounting anticipated litigation claims to make for a more accurate reflection of defrauded investor loss. The supplied method is comprised of two simple steps. First, an intrinsic measure of a company's value is selected, such as discounted future cash flow, to provide a mirror valuation with which to contrast against share price. The anticipated loss from a misrepresentation's disclosure, or the lessened future expectations of the company, is then compared along both the share and intrinsic values.

The second step involves running the intrinsic value to also account for the total class action damage claim. This retroactive inclusion is supported by the same rational assumption of the efficient market hypothesis that is used to justify the class action certification itself. If the efficient markets assumption is to be applied with consistent logic, then one must assume that the instant a misrepresentation is made public that rational investors will automatically discount the stock price to account for the inevitable class action suit that will arise. This perfect market assumption would be mirrored in the intrinsic value measure through an additional, secondary diminishment of expected company earnings.

If the purchaser anticipates a future litigation claim by a share's seller against the company asset, as the ideal of efficiency and rationality require, the result is that such anticipated litigation is discounted from the purchase price in an estimated value. A straightforward damage assessment of inflated purchase price minus sale price would allow for the wronged seller to gain a monetary award that is based upon both his or her depreciated asset and the anticipation of his or her judicial claim. The wronged seller's recovery, in this scenario, would include a double accounting of fall in price due to both diminished company expectations and the cost to company of compensating for the same wrong through future litigation.

The secondary loss including damage claim thus becomes an additional portion, or ratio, to be compared with the initial misrepresentation loss. The ratio of litigation to misrepresentation loss may then be incorporated into the mirror measure of share price to arrive at the estimation of a rational investor's price discount for litigation loss. Any damage award must logically account for this rational discounting on the part of the post disclosure, entering share purchaser, who notably sets the figure of misrepresentation loss. In short, the assumption of market efficiency means that any subsequent loss claim would have been...