In its June 2014 opinion in the Halliburton case, the U.S. Supreme Court held that securities lawsuit defendants may introduce evidence at the class certification stage to try to show that the alleged misrepresentation on which the plaintiffs rely did not impact the defendant company’s share price. To show the absence of price impact, defendants typically will rely on “event study” methodology to analyze factors affecting a company’s share price. The event study methodology has a well-established academic pedigree. But in a recent paper, two authors ask the question “Are event studies in securities litigation reliable?”
In their March 19, 2015 paper, “Event Studies in Securities Litigation: Low Power, Confounding Effects, and Bias” (here), Duke Business School Professor Alon Brav and J.B. Heaton of the Bartlit, Beck, Herman, Palanchar, & Scott law firm identify several problems in the way event studies are used in securities litigation. Their longer academic paper is summarized in a shorter April 14, 2015 post on the CLS Blue Sky Blog (here).
Event studies are used in securities litigation to try to answer two questions: First, was an alleged misrepresentation or corrective disclosure associated with a price impact? Second, if there was a price impact, how much of it was caused by the alleged misrepresentation or corrective disclosure as opposed to other, unrelated factors?
The problem with the use of event studies in securities litigation, as the authors see it, is that the methodology used in court differs from the methodology used in academic research. In general, the studies used in court are single-firm event studies, while almost all academic research event studies are multi-firm event studies. As the authors note, “importing a methodology that financial economists developed for use with multiple firms into a single-firm context creates substantial difficulties, and review of the case law suggests that courts and litigants often have failed to recognize these problems.”
The problem with using single-firm event studies is that they lack “statistical power” to detect price impacts unless the price impacts are “quite large.” This has the effect of giving a “free pass” to some economically meaningful price impacts and may encourage more small- to mid-scale fraud. The use of statistical significance concepts that are appropriate to multi-firm event studies “implements a legal regime where the probability of incorrectly exonerating securities defendants is much higher than the probability of incorrectly finding securities defendants liable.”
A second problem with the use of event studies in securities litigation is that when a single-firm event study does detect a price impact, “it reflects confounding effects that are unrelated to the fraud.” It is well known that stock prices move for a variety of reasons, many of them unrelated to news about the company. So the stock price moves reflect a component related to the event and a component unrelated to the event. There is, however, no mathematically precise way to separate the two components. Single-firm event studies “do not average away confounding effects.”
The low statistical power of single-firm event studies and the presence of confounding effects means that there is a “sizeable upward bias in detected price impacts and therefore in damages.” That is, if the event study measures a price impact large enough to be detected, the detected price impact “may be substantially higher than the true price impact.”
The authors suggest three steps for improving the use of event studies in securities litigation. First, the authors suggest courts should require litigants and their expert witnesses to report the results of a statistical power analysis for the event study. A power analysis will “tell the court whether the litigant’s event study was reliable for detecting price impacts of various sizes.” The authors add that a “securities litigant should not be heard to say that a misrepresentation or corrective disclosure caused no price impact based on a text that had little or no power to detect a price impact that the court determines to be material.”
Second, to address the confounding effects problem, the authors suggest that courts should allow litigants flexibility to present other evidence to prove that a price impact from misrepresentation or corrective disclosure did or did not occur. This evidence might include, for example, intraday analyses and quantitative analysis of other news about the firm that day, as well other factors, to value posited confounding effects.
Third, courts and litigants should recognize that statistically significant price impacts determined through a single-firm event study are “biased estimates of true impacts” and that because of this bias, detected price impacts are more likely to overestimate price impact than underestimate it.
It is important to note that events studies have long been used for other purposes in securities lawsuits. Indeed, one of the reasons that the Halliburton court agreed to allow price impact evidence at the class certification stage is that it would make no sense to allow price impact evidence for, say, the purpose of establishing that the company’s shares trade on an efficient market, but to preclude the evidence that the alleged misrepresentation did not actually affect the share price and therefore that the fraud-on-the-market presumption should not apply. Price impact evidence is also used for purposes of materiality and reliance, and to determine the existence or absence of loss causation and the amount of damages.
Because price impact evidence can be relevant to multiple issues in a securities case beyond just the question of class certification, the defects with the way that event studies are used in securities litigation can affect a number of issues and determinations. For that reason, it is, as the authors suggest, important for courts and litigants to have a “firmer basis for considering evidence based on single-firm event studies.”
Note to Readers: On Tuesday, I changed the email service provider that I use for email distributions. The new service provider has a very rigorous filter to try to eliminate bad email addresses. If you are a subscriber and you did not receive an email on Wednesday, your email address may have been filtered out by the new email service provider. If you would like to continue to receive emails, please re-subscribe by entering your email address in the Subscribe by Email box in the right-hand column – be sure to click the confirmation link in the confirmation email you will receive. I apologize for any inconvenience. Please let me know if you continue to have problems receiving emails.