Abstract

http://ssrn.com/abstract=2314058
 


 



Idiosyncratic Risk during Economic Downturns: Implications for the Use of Event Studies in Securities Litigation


Edward G. Fox


University of Michigan at Ann Arbor - Department of Economics

Merritt B. Fox


Columbia University - Law School

Ronald J. Gilson


Stanford Law School; Columbia Law School; European Corporate Governance Institute (ECGI)

August 27, 2013

Columbia Law and Economics Working Paper No. 453
Stanford Law and Economics Olin Working Paper No. 452

Abstract:     
We reported in a recent paper that during the 2008-09 financial crisis, for the average firm, idiosyncratic risk, as measured by variance, increased by five-fold. This finding is important for securities litigation because idiosyncratic risk plays a central role in event study methodology. Event studies are commonly used in securities litigation to determine materiality and loss causation.

Many bits of news affect an issuer’s share price at the time of a corporate disclosure that is the subject of litigation. Because of this, even if an issuer’s market–adjusted price changes at the time of the disclosure, one cannot determine with certainty whether the disclosure itself had any effect on price. An event study is used to make a probabilistic assessment of whether in fact it did. Use of event studies generates a certain rate of Type I errors (disclosures that had no actual effect on price being identified as having had an effect) and a certain rate of Type II errors (disclosures that had an actual effect not being identified as such).

This paper sets out a simple model of the tradeoff between these Type I and Type II errors. The model is used to establish three fundamental points. First, an economic crisis can radically worsen this tradeoff by making it much more difficult to catch a disclosure of a certain size without introducing more Type I errors. Second, during crisis periods a relaxation of this standard (and hence an increase in the acceptable rate of Type I errors) may actually decrease Type II errors by less than it would in normal times. We prove that whether the decrease is greater or smaller in crisis times depends on whether the disclosure’s actual impact on price is more or less negative than a definable crossover point. Third, whether relaxation of the standard in troubled times would increase or decrease social welfare is ambiguous. It depends on distribution of potentially actionable disclosures in terms of their actual impact on price and the social costs and social benefits of imposing liability for disclosures of each given level of actual negative impact on price.

Number of Pages in PDF File: 29

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Date posted: August 27, 2013 ; Last revised: October 8, 2013

Suggested Citation

Fox, Edward G. and Fox, Merritt B. and Gilson, Ronald J., Idiosyncratic Risk during Economic Downturns: Implications for the Use of Event Studies in Securities Litigation (August 27, 2013). Columbia Law and Economics Working Paper No. 453; Stanford Law and Economics Olin Working Paper No. 452. Available at SSRN: http://ssrn.com/abstract=2314058

Contact Information

Edward G. Fox
University of Michigan at Ann Arbor - Department of Economics ( email )
611 Tappan Street
Ann Arbor, MI 48109-1220
United States
Merritt B. Fox (Contact Author)
Columbia University - Law School ( email )
435 West 116th Street
New York, NY 10025
United States
Ronald J. Gilson
Stanford Law School ( email )
559 Nathan Abbott Way
Stanford, CA 94305-8610
United States
650-723-0614 (Phone)
650-725-0253 (Fax)
Columbia Law School ( email )
435 West 116th Street
New York, NY 10025
United States
212-854-1655 (Phone)
212-854-7946 (Fax)
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
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