Remarks on the Halliburton Oral Argument (2): Implementing a Fraudulent Distortion Approach

Lucian Bebchuk is William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, Harvard Law School. Allen Ferrell is Greenfield Professor of Securities Law, Harvard Law School. They are co-authors of Rethinking Basic, a Harvard Law School Discussion Paper forthcoming in the May 2014 issue of The Business Lawyer, that is available here. This post is the second in a three-part series in which they remark on the oral argument at the Halliburton case; the first post is available here.

In our first post on the Halliburton oral argument (transcript available here), we discussed the encouraging signs that a number of the Justices might choose to avoid making a judgment on the state of efficient market theory and to focus on the presence of fraudulent distortion (sometimes also referred to as price impact). In this post, we remark on how a fraudulent distortion approach could be implemented should the Court indeed adopt such an approach. In particular, we discuss the financial econometric tools for assessing the presence or absence of fraudulent distortion and we explain that these tools are not limited to event studies at the time of the misrepresentation.

In Rethinking Basic, we present a detailed case for using a fraudulent approach and explain why it would provide a conceptually superior framework than a focus on market efficiency. We go on, however, to show that an approach focusing on fraudulent distortion would have significant administrability and implementation advantages over the federal courts’ practice in this area.

Because the courts have thus far had to provide a yes/no answer to whether the market for a given security is efficient, significant problems of over- and under-inclusion have arisen (as has been noted by the Supreme Court in its Amgen decision). Focusing on the presence of fraudulent distortion in the case at hand would avoid these significant problems. Furthermore, as we describe in Rethinking Basic, there are standard and sound methods drawn from the academic finance and accounting literature for ascertaining the presence of a distortionary price impact (a toolkit that should displace the current exclusive focus on the Cammer factors, which test for market efficiency). Without attempting to be comprehensive, we discuss below three tools that are potentially available for implementing a fraudulent distortion approach.

Event Study at Time of Misrepresentation

An event study is a potentially powerful method for establishing fraudulent distortion. If the misstatement was a surprise to the market, a statistical analysis of whether the market price reacted upon learning of the information could be probative of whether fraudulent distortion exists. It is worth noting that a finding of a price reaction is consistent with some specific forms of inefficiency commonly discussed in the academic literature, notably long-run return predictability, and that failure to find a price reaction is consistent with generally efficient markets.

At the oral argument, a number of the Justices’ questions focused on using event studies at the time of misrepresentation to assess the presence of fraudulent distortion. For instance, Justice Kennedy asked about requiring event studies at the class certification stage. Justice Alito asked about the accuracy of event studies in identifying the impact of a disclosure. Chief Justice Roberts asked whether an event study would be more difficult than establishing efficiency in a typical case. On a similar note, Justice Kennedy asked whether requiring event studies would be costly. In short, the Justices expressed a great deal of interest in the use of event studies in connection with a fraudulent distortion approach.

While event studies at the time of misrepresentation are an important tool, it is crucial to emphasize that the tools available for implementing a fraudulent distortion approach are not limited to event studies at the time of misrepresentation. A fraudulent distortion approach should not be generally implemented by conducting an event study at the time of misrepresentation.

Indeed, as we explained in Rethinking Basic, there are reasons to expect that event studies at the time of misrepresentation would fail to identify a fraudulent distortion in some cases in which it exists. This would be the case when the misstatement was a so-called confirmatory lie—that is, a misstatement made so as to meet market expectations. In such a case, failure to document a price reaction to it would not be expected even assuming the misstatement had a fraudulent impact. In such a fact situation, the confirmatory lie might prevent a stock price drop that would have occurred had the truth been told.

To address the problem of fraudulent distortions produced by confirmatory lies, other analytical tools are needed, and below we discuss two such tools.

Event Study at Time of Corrective Disclosure

Another potential tool would be to measure whether there was a price reaction when the market learned the truth about the misstatement—that is, at the time of a corrective disclosure. This could potentially be relevant as to whether the misstatement at the time it was made resulted in fraudulent distortion (even if it was a confirmatory lie).

In using an event study in this manner, there might be a number of issues that would need to be addressed for such an approach to be convincing. For example, it might be necessary to examine whether the market relevance of the information changed between the misrepresentation and the corrective disclosure. We expect, however, that this tool would be useful in a meaningful number of cases.


Another potential analytical tool, with a long tradition in the finance and accounting literature, is forward-casting. (See Allen Ferrell and Atanu Saha, “Forward-casting 10b-5 Damages: A Comparison to other Methods,” 37 Journal of Corporation Law 365 (2011); Esther Bruegger & Frederick C. Dunbar, “Estimating Financial Fraud Damages with Response Coefficients,” 35 Journal of Corporation Law 11 (2009)). The basic idea is to estimate (i) the difference between how much the market would have been surprised if the truth had been told, relative to how surprised the market actually was given what was allegedly misreported; and (ii) what would have been the expected market price reaction (if any) to this level of surprise, given price reactions to similar types of disclosures (by the same firm or comparable firms).

To fix ideas, assume the misrepresentation is a confirmatory lie concerning earnings. In such a situation, an event study at the time of misrepresentation would likely not be informative as to fraudulent distortion. However, by measuring price reactions when the market had actually been surprised in the past when firm earnings were released, one can still estimate what the market reaction would have been had the market been told the truth. Alternatively, one could estimate price reactions for comparable firms when they reported earnings surprises. Using these estimates, one might be able to estimate the expected price impact (if any) of the misrepresentation in question.

To conclude, event studies are ubiquitous in corporate finance and it was natural for the Justices to explore this topic at oral argument. However, it is worth recognizing that the determination of fraudulent distortion would not always be best done by conducting an event study at the time of the misrepresentation.

Both comments and trackbacks are currently closed.