The efficient markets hypothesis can land you in jail

The use and abuse of the effecient markets hypothesis in the legal system is illustrated in the following example from the economist.

It seems that the legal system in this case is subject to the same limitations as journalists:

• Keep it simple and
  
• ignore any criticque of the assumptions behind the methods.

JAMIE OLIS knows better than most people that the ideas conjured up by economists in their ivory towers can have a big effect on the real world. The tax accountant, found guilty of committing fraud while working for Dynegy, an energy-trading firm, has been doing time since March 2004, in large part thanks to a controversial economic theory, the efficient markets hypothesis. Last October an appeals court threw out Mr Olis's 24-year jail term, because Judge Sim Lake, who sentenced him, got his economics wrong. But Mr Olis stayed in prison pending resentencing, again by Judge Lake. That will follow a hearing, due on September 12th, that is likely to be dominated by a debate over market efficiency.

In essence the efficient markets hypothesis, which was developed in the 1950s and 1960s, says that subject to certain conditions, the market price of a security—a share, say—fully and accurately reflects all the available information relevant to its value. In an efficient market the only reason why a price changes is that new information comes to light.

This hypothesis has been hugely influential in the world of finance, becoming a building block for other theories on subjects from portfolio selection to option pricing. Of more relevance to Mr Olis, it also has the rare distinction, for an economic theory, of the approval of America's Supreme Court. In 1988, in Basic Inc v Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them.

That ruling has proved a goldmine for America's trial lawyers, who have won fortunes by suing firms for damages when news (often, in practice, a restatement of their accounts) is followed by a sharp fall in their share prices. The fall is treated as proof of overvaluation due to the initial, wrong statement.

Increasingly, a similar logic has been used in criminal cases, as Mr Olis discovered. His 24-year sentence stemmed from a calculation of the financial loss caused to investors in Dynegy by Project Alpha, an accounting fraud in which he took part. That financial loss was estimated using the fall in Dynegy's share price on the news that Project Alpha was fraudulent. According to Judge Lake, it was so big that, under sentencing guidelines then in place, Mr Olis had to go to jail for a long time.

In rejecting that sentence, the appeals court ruled that Judge Lake had attributed far too much of the fall in Dynegy's share price to Project Alpha and too little to other news. Next week the prosecution and defence will each use economists as expert witnesses to debate exactly how much of the loss was due to Project Alpha. This will highlight several tricky technical issues that arise when applying the efficient markets hypothesis to fraud.

Exhibit Alpha

According to the prosecution's expert, Frank Graves, of the Brattle Group, a consultancy, Project Alpha was responsible for $4.45 of the $11.13 decline in Dynegy's share price on April 25th and 26th 2002, after the firm announced that it had reduced its reported profits because of the fraud. According to the prosecution, that justifies a sentence of up to 15 years for Mr Olis.

But in a paper filed on behalf of Mr Olis, Joseph Grundfest, a Stanford law professor and a former commissioner at the Securities and Exchange Commission (SEC), claims that Mr Graves has made numerous technical errors. Correct these, writes Mr Grundfest, who is working pro bono, and a quite different conclusion follows: Mr Graves, he says, “fails to establish that Project Alpha inflated Dynegy's stock on any date by any amount” or that “any portion of Dynegy's stock price decline” on the dates in question can be attributed to Project Alpha.

Among other things, Mr Grundfest notes that the markets were also digesting far more serious news: of a pending SEC investigation into aspects of Dynegy's business that were unrelated to Project Alpha; and of threats by California's governor, Gray Davis, to try to reclaim profits made by energy traders, including Dynegy and its rival, Enron, by exploiting flaws in California's energy regulations.

More fundamentally, Project Alpha was designed to bring forward the date at which some profits were recognised in Dynegy's accounts; but its overall effect on the firm's cashflow over time was neutral. Surely in an efficient market investors would look past the accounts to the underlying economic reality, argues Mr Grundfest, so that the effect on the share price would be negligible. Indeed, he notes, Dynegy's share price did not fall on April 3rd, when the press first commented on problems with Project Alpha, a fact dismissed out of hand by Mr Graves.

None of these objections challenges the use of the efficient markets hypothesis. Yet for years the hypothesis has been under increasingly fierce attack in academia, unnoticed by the legal system. In a recent paper, Bradford Cornell, of California Institute of Technology, and James Rutten, of Munger, Tolles and Olson, a Los Angeles law firm, argue that even highly developed financial markets such as the New York Stock Exchange are not efficient enough to allow courts to use declines in share prices to calculate the financial damage caused by a fraud. In particular, markets often react disproportionately to news, especially bad news. They therefore conclude that estimates of damages based on the hypothesis and on share-price movements will be overstated. If Judge Lake has been spending the summer getting up to date on economics, perhaps Mr Olis will be out of prison much sooner than he must once have feared.