Estimating Economic Damages in Class Action Securities Fraud Litigation
Dyl, Edward A., Journal of Forensic Economics
Estimating economic damages in class action litigation involving common stock is necessary because it is generally impossible to actually measure the damages sustained by each and every investor who purchased and/or sold the firm's common stock during the Class Period. Plaintiffs in such suits number in the thousands. In addition, the individual plaintiffs in a class action lawsuit are frequently not fully identified until the suit is well underway or has even been litigated or settled. Only then are potential plaintiffs necessarily notified, asked if they choose to remain a party in the class action, and required to document their claim to a share of the proceeds.
Most class action lawsuits alleging securities fraud are brought under Rule 10b-5 of the Securities Exchange Act of 1934 and generally accuse the defendant of either disseminating misleading information or failing to disclose adverse information, which action(s) caused the firm's common stock to trade at an incorrect price. Although liability under Rule 10b-5 requires that individual plaintiffs prove that the false information influenced their decision to buy or sell the stock, class action lawsuits generally rely on a "fraud on the market" argument. Under the "fraud on the market" theory if the misrepresentation materially affected the price of the security and if the plaintiff relied on the integrity of the market price when trading the security, then the reliance requirement is satisfied.(1) The concept of "fraud on the market" derives from the notion that the stock market is efficient, in the sense that stock prices properly incorporate all publicly available information. False information causes stocks to be priced incorrectly, and thus defrauds investors who purchase stock under the assumption that market prices correctly reflect the firm's true situation.
Although estimates of economic damages in securities fraud cases are generally prepared as if they will be presented in court, in fact the vast majority of these class action cases settle without coming to trial. This phenomenon has caused speculation that most such suits are simply nuisance suits designed to elicit a settlement and to earn fees for the attorneys filing the suit.(2) Whether or not this is the case, estimates of economic damages form the basis for the negotiation of settlements in class action suits alleging securities fraud, and these estimates are prepared by financial economists who must ultimately be qualified to testify in court as expert witnesses.
This paper examines the issues that an expert witness must consider in estimating economic damages in class action securities litigation. These issues include estimating the amount by which the misleading or withheld information distorted the price of the firm's stock during the Class Period, determining the actual volume of purchases or sales by public investors, and adjusting the resulting damage estimate to account for in-and-out trading during the Class Period. We use an actual class action suit, Delano et. al. v. Reddi Brake Supply Corporation et. al., which was filed in late 1995 and settled in 1996. Section II provides background information about the case, Section III illustrates the estimation of economic damages, and Section IV summarizes the paper.
II. Background Information
Figure 1 shows the daily closing price of the common stock of Reddi Brake Supply Corporation ("Reddi Brake") from January 3, 1995, through April 28, 1995. The Class Period for the Delano v. Reddi Brake litigation is from January 3, 1995, through February 27, 1995. The plaintiffs allege that during this time Reddi Brake's stock traded at an artificially high price because material information about the company was withheld from investors and analysts and/or was misrepresented to investors and analysts. The specifics of the allegations are generally irrelevant to the computation of damages, aside from disclosure dates and other facts that affect the value of the plaintiffs' investment. …