Like clockwork, The Economist touches this week (subscription required) on the issue of the day here at Going Private. One might be tempted to think that yours truly has an inside track with one of The Economist editors, so regular and aligned are the weekly topics between that publication and your humble author's print here. (Your author actually prefers the egotistical, and rather unlikely, intrepretation that Economist writers regularly read Going Private to get the pulse of the financial world).
"The efficient market hypothesis can land you in jail," is The Economist's latest stroll across the Going Private commons. Quoth The Economist:
[The efficient market hypothesis] also has the rare distinction, for an economic theory, of the approval of America's Supreme Court. In 1988, in Basic Inc. v. Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them.
That ruling has proved a goldmine for America's trial lawyers, who have won fortunes by suing firms for damages when news (often, in practice, a restatement of their accounts) is followed by a sharp fall in their share prices. The fall is treated as proof of overvaluation due to the initial, wrong statement.
Increasingly, a similar logic has been used in criminal cases, as Mr James Olis, [the tax accountant, found guilty of committing fraud while working for Dynegy] discovered. His 24-year sentence stemmed from a calculation of the financial loss caused to investors in Dynegy by Project Alpha, an accounting fraud in which he took part. That financial loss was estimated using the fall in Dynegy's share price on the news that Project Alpha was fraudulent. According to Judge Lake, it was so big that, under sentencing guidelines then in place, Mr Olis had to go to jail for a long time.
This would be all fine and good, perhaps, if the efficient market hypothesis were understood to be fact. It is, of course, not.
None of [the defense's objections] challenges the use of the efficient markets hypothesis. Yet for years the hypothesis has been under increasingly fierce attack in academia, unnoticed by the legal system. In a recent paper, Bradford Cornell, of California Institute of Technology, and James Rutten, of Munger, Tolles and Olson, a Los Angeles law firm, argue that even highly developed financial markets such as the New York Stock Exchange are not efficient enough to allow courts to use declines in share prices to calculate the financial damage caused by a fraud. In particular, markets often react disproportionately to news, especially bad news. They therefore conclude that estimates of damages based on the hypothesis and on share-price movements will be overstated. If Judge Lake has been spending the summer getting up to date on economics, perhaps Mr Olis will be out of prison much sooner than he must once have feared.