Securities class-action lawsuits play a crucial role in holding corporations accountable for financial misdeeds. They typically involve allegations of securities fraud, where a company makes misleading statements or omits important information that leads to an inflated stock price. When the truth emerges, and the stock price drops, investors seek damages for the losses they incurred. But how exactly are these damages calculated? In a new article, I offer a more nuanced and precise method for measuring damages in securities class action litigation.

The Traditional Approach

Traditionally, damages in securities class actions are calculated based on the decline in a company’s stock price after a significant event is revealed. In cases of “fraud on the market,” plaintiffs argue that the company’s misstatements or omissions related to that event caused the stock price to be artificially inflated. Once the truth becomes known, the stock price falls, and shareholders seek to recover the difference between the price they paid and the stock’s “true” value.

The standard method for calculating damages typically assumes that the full amount of the stock price drop is attributable to the fraud. This approach focuses almost exclusively on realized losses – those that occur when the stock price falls. However, this method doesn’t always account for the complexity of market dynamics, including how much risk investors actually take on and whether stock price drops can be partially attributed to broader market conditions rather than the fraud itself.

A Refined Method: The Role of Risk and Market Movements

In my article, I introduce an approach that factors in not only the stock price drop but also market movements and the underlying risk of the stock. My study shows that damages should be calculated based on a combination of realized losses and an increase in the stock’s risk related to beta.

In particular, I highlight that stock price declines following the revelation of a market event aren’t just a result of corrected misstatements. They’re also driven by changes in how the market perceives the risk associated with the stock. Past researchers have thought about applying risk to damages but assumed that a firm’s beta goes to zero, or at least significantly drops following the event. I find that is not the case; stock beta tends to increase after a significant price drop, meaning investors require a higher return (due to perceived higher risk) to justify holding the stock. Thus, not adjusting for market changes and a firm’s beta is a serious failing in any shareholder damages calculation.

In essence, the true harm to shareholders isn’t just the drop in the stock’s price, but also the increased risk they face moving forward. By including beta and market movements in the damage calculation, my method offers a more accurate and justifiable measure of harm.

Figure 1: An Illustration of Market and Non-Market Damages:

How This Affects Damage Calculations

Traditionally, damages have been based solely on the price drop resulting from the fraud’s revelation. My approach takes into account how much of the price drop was caused by an increase in the stock’s risk. This refined method helps to ensure that investors are compensated not only for the loss they experienced when the stock price dropped but also for the increased risk they were exposed to due to the misstatement.

For example, imagine a company that misled investors about a serious operational flaw. Once the truth comes out, the stock price falls by 25 percent. Under the traditional method, damages would be calculated based on that 25 percent drop. But what if the market also perceives the company as much riskier now, and investors require a higher return to hold the stock? My method would take into account that investors are now facing greater risk, which should be reflected in a higher discount rate (K) in the damage calculations. This can result in a larger, more accurate damages award for shareholders.

Implications for Attorneys

For securities litigation attorneys, my approach has several important implications:

1. More Accurate Damages Calculations: Attorneys can use this refined method to argue for larger damages that reflect both the stock price drop and the increase in risk.
2. Defending Against Misleading Damage Estimates: In cases where the defense might argue that the price drop was driven by broader market conditions or unrelated events, my model offers a more nuanced way to separate the impact of the fraud from other factors.
3. Better Representation of Clients: This method allows attorneys to present a more complete picture of the harm suffered by investors, particularly those who did not sell their shares immediately after the price drop but still face increased risk.
4. A New Lens for Assessing Risk: Attorneys can also use this method when assessing potential cases, determining not only whether there was a significant stock price drop but also whether the market’s perception of the company’s risk has changed.

Figure 2: An Illustration of Losses Decomposition

Conclusion

My research offers a valuable new perspective on the measurement of shareholder damages in securities class action litigation. By considering both realized losses and increased risk, this approach provides a more accurate and comprehensive method for calculating the harm investors suffer when companies commit fraud. For attorneys, this means a more effective tool for securing fair compensation for their clients, as well as a new way to think about risk and market dynamics in securities litigation.

This post comes to us from Professor Michael McDonald at Fairfield University’s Charles F. Dolan School of Business. It is based on his recent article, “Drivers of Investor Required Rates of Return Following Stock Price Drops: Implications for Securities Class Action Litigation,” available here.