Efficient Markets and the Law

I’ve been catching up on some reading and I found this article in The Economist which is a few weeks old. In general I seem to criticise those who rubbish the Efficient Markets Hypothesis too much, but then there is the US Supreme court who it seems may take it too seriously.

JAMIE OLIS knows better than most people that the ideas conjured up by economists in their ivory towers can have a big effect on the real world. The tax accountant, found guilty of committing fraud while working for Dynegy, an energy-trading firm, has been doing time since March 2004, in large part thanks to a controversial economic theory, the efficient markets hypothesis.

Not just a little bit of time mind you, but 24 years, at least until a court threw out the sentence.

…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 [Supreme] 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.

Which is fine except for the fact that we know that prices move around regardless of new information, at least not the sort of information that comes from public announcements. Similarly news may take some time to be absorbed by the market which may over-react, and it is well known that volatility clusters. Don’t announce a fraud when the market is already volatile, the moves are likely to be bigger. Its a very tough call to equate a market move after an announcement entirely to that announcement, or even know when do you consider the information fully incorporated.

Of course that hasn’t stopped the lawyers and Judges from using it.

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 Olis 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.

The question is was the fraud the reason for the market move or was it going to happen anyway based on other news at the time. The defence of course claims the latter.

Mr Grundfest notes that the markets were also digesting far more serious news: of a pending SEC investigation into aspects of Dynegy’s business that were unrelated to Project Alpha; and of threats by California’s governor, Gray Davis, to try to reclaim profits made by energy traders, including Dynegy and its rival, Enron, by exploiting flaws in California’s energy regulations.

While it doesn’t seem unreasonable to give the market impact some weight in the sentencing, to regard this as the literal truth of the size of the offence seems to be very dubious.

I had thought it was just evolutionary theory that the courts in the US decided, but they are now onto finance and economics. Is this in effect the Scopes Monkey Trial for modern finance?

Update: I after being informed by a friend I note, Jamie Olis has had his sentence reduced to 6 years. Also I’ve included a link to the original Supreme Court decision.

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One Response to Efficient Markets and the Law

  1. Oz says:

    Personally I’m no believer in Efficient Markets Hypothesis. particularly the notion that prices reflect available information. No one can figure out the future based on current factors alone. I mean the people who came up with the theory of how to price options lost bilions of dollars in the end when they tested their theory. Furthermore, people don’t all interpret information in the same way despite having the same information.
    I’m more a believer in the Keynesian notion that most of the time its not about the actual prices and information but trying to second-guess what other people will probably do to benefit from their future actions. The tech boom was a perfect example.

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