Bias of Damage Awards and Free Options in Securities Litigation

31 Pages Posted: 7 Sep 2000

See all articles by Philip H. Dybvig

Philip H. Dybvig

Washington University in St. Louis - John M. Olin Business School

Ning Gong

Deakin University; Financial Research Network (FIRN)

Rachel Schwartz

affiliation not provided to SSRN


Damage measures in securities fraud cases are very imprecise because they are based on security price changes that reflect both the correction of previous misrepresentation and other independent information. Consequently, potential plaintiffs have a valuable "free option" to decide whether or not to file suit, and average damage awards are greater than actual damages, much greater when markets are volatile. The "Private Securities Litigation Reform Act of 1995" was intended to curb abusive litigation and to address the problem of excessive damage awards. Motivated by a misdiagnosis that excess awards are due to temporary price drops, the Act limits damages to the difference between the purchase price and the time-average trading price from the release of the corrective information until 90 days later or until the sale of the security, whichever is first. Unfortunately, the Act's modified measure of damages suffers from a more severe free-option problem than did the traditional measure. Also, the Act introduced an additional new option to time the sale of the security; the effects of these options may be mitigated by the impact of the positive drift in stock prices over time, if the time-average price is not adjusted for market movements. As a result, the bias can be larger or smaller under the new Act, depending on how severe the free-option problem is.

We propose an alternative approach to addressing the issue of excessive damages: courts should adopt a threshold of measured damages below which no damage would be awarded. The threshold would depend on several factors, most notably the volatility of the stock in the period under question. That is, damages will be awarded only if measured damages exceed the threshold, and awards would be capped by the formula presented in the Reform Act.

Keywords: Damages awards, securities litigation, free option

JEL Classification: K22, G38, M49

Suggested Citation

Dybvig, Philip H. and Gong, Ning and Schwartz, Rachel, Bias of Damage Awards and Free Options in Securities Litigation. Available at SSRN: or

Philip H. Dybvig

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Ning Gong (Contact Author)

Deakin University ( email )

Department of Finance
Faculty of Business and Law
Burwood, Victoria 3125
+61 3 9246 8492 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane


Rachel Schwartz

affiliation not provided to SSRN

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