Event Study Methodology and the Computation of Damages for Secondary Market Misrepresentations: Striving for a Technicolor Palette
62 Pages Posted: 30 Mar 2020 Last revised: 7 May 2020
Date Written: May 5, 2020
The use of event study methodology (“ESM”) for computing damages for secondary market misrepresentations is poorly understood by lawyers, judges, and policy makers in Canada. This paper reviews the economic foundations of ESM and discusses the various pitfalls that may arise, particularly in a market that is not informationally efficient, so that share prices respond slowly to new information. In such a market, the calculation of beta may be rendered problematic due to asynchronicity or the occurrence of confounding corporate events in the estimation period. While in an efficient market, a one- or two-day event window is often quite adequate, this is not the case in an informationally inefficient market. In that case, the event window will often be much longer; in addition, it must be tailored to the particular issuer and the facts at hand. The longer event window creates a far greater probability that confounding events will contaminate the data. Moreover, because long event windows typically exhibit a lower signal to noise ratio (particularly if trading is dominated by retail noise traders), the power of the test may be materially reduced, increasing the likelihood of a type II error and making it more difficult to establish statistical significance. In the context of civil litigation where the standard of proof is a balance of probabilities, and keeping in mind that there is a trade-off between type I and type II errors, it may be appropriate to set the level of statistical significance at 0.10, rather than the usual 0.05. Whether the market is efficient or inefficient, however, care must be taken to determine if either insider trading or rational market anticipation has moved the stock price prior to a corrective announcement, and the event window adjusted appropriately. While there is a dearth of empirical studies, I present evidence that many Canadian public companies do not trade in an informationally efficient market, such that many of the above-noted complications will often arise in the use of ESM. Finally, I examine the scheme for computing secondary market damages under the Ontario Securities Act (“OSA”). The OSA mandates the use of mechanical rules that are almost certain to materially mis-estimate damages in both efficient and inefficient markets.
Keywords: Securities law, Damages, Secondary Market Misrepresentation, Fraud on the Market, Event Studies
JEL Classification: G14, G18, K22
Suggested Citation: Suggested Citation