The Use And Abuse of "Event Study" Analysis

In vacating a summary judgment grant to the defendant, circuit remands after considering the appropriate use of "event study" expert evidence for assessing a plaintiff's fraud-on-the-market claim in a securities fraud class action dispute, in Findwhat Investor Group v. Findwhat.com, __ F.3d __ (11th Cir. Sept. 30, 2011) (No. 10-10107)

As particularly used in securities fraud litigation, an "event study" presents a statistical regression analysis of the effect of an event (e.g., allegedly fraudulent statement or omission) on a company's stock price. Use of this data is based on application of the efficient market hypothesis in which a security's price reflects all publicly available information. An event study assesses the relation between changes in stock price in light of public announcement by the defendant company that is owing to the arrival of new information in the market provided by that announcement or omission. Recently, the Eleventh Circuit described the use of an "event study" in deciding, contrary to some other circuits, that confirmatory statements that wrongfully lengthen a period in which stock is traded at inflated prices, can be subject to suit under the securities law.

In the case, plaintiff investors sought recovery from a company they had invested in, the defendant. The plaintiff's theory of recovery was that the defendants violated section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The plaintiffs alleged that the defendant Internet company had manipulated the price of securities in its “pay-per-click” advertising venture. In this business, the defendant company placed ads for clients on websites in exchange for the advertisers paying the defendant each time an Internet user clicks on the placed ad.

The plaintiffs alleged that the defendant committed “click fraud” - a practice in which their confederates searched for and clicked on Internet advertisements placed by the defendant for various clients. The sole purpose of "click fraud" was to force the advertising client to pay the defendant for the clicks. These actions helped the defendant company maintain its profit margins and its stock prices -- attracting stock investors because of the exaggerated advertising "click throughs" that the defendant orchestrated.

The trial court disposed of the case in motions at the pretrial stage. The defendants made a motion for summary judgment, alleging that the plaintiff had failed to show any substantial disagreements of fact as to the defendant's role in causing the infraction of the law, or as to the size of whether any damages resulted.

The circuit disagreed and noted that these contentions depended upon the defendant's expert's “event study” to demonstrate loss causation and to estimate damages. “An event study," noted the circuit, "is a statistical regression analysis that examines the effect of an event[, such as the release of information,] on a dependent variable, such as a corporation's stock price.” As acknowledged by the Defendants' expert, event studies are a “common method” of establishing loss causation, “used routinely in the academic literature to determine whether the release of particular information has a significant effect on a company's stock price.” Findwhat, __ F.3d at __.

The trial court granted summary judgment for the defendants, reasoning that the plaintiffs showed no factual dispute existed as to whether they suffered any actionable fraud or damages as a result of the defendant's actions. In this particular, the circuit noted the defense expert expert witness's testimony. That testimony included the opinion and calculation that the defendants' stock "was inflated by 26.44 percent before and throughout" the period of the alleged fraud on the class due to providing false information in the marketplace to the effect that the defendant company did not rely on "click fraud" to boost revenues and that it could thrive in the absence of such practices. The expert witness concluded, by conducting an "event study[,] that immediately after the Company finally revealed the truth about its heavy reliance on click fraud on May 5, 2005—admitting in an investor conference call that “a couple” of [it]'s distribution partners had been employing 'capabilities ... to get additional traffic.” Findwhat, __ F.3d at __ (citations to record omitted).

In conducting this "event study," the expert followed how the "the inflation" in defendant's stock price caused substantial losses to the investors. "Dr. Hakala excluded other possible explanations for the price drop following the May 5, 2005 disclosure, concluding that 'the primary if not exclusive reason for the [price] drop [on May 5–9, 2005] was related to ... the subject matter of the fraud.... [T]he confounding information in my analysis could not account for the drop—did not account for the drop....” Reasoning that the plaintiff class would not have suffered those losses if the Company had disclosed the truth at the beginning, instead of at the end, "Dr. Hakala estimated total Class Period damages to be $22.24 million." Findwhat, __ F.3d at __ (citations to record omitted).

To make a long story short, the circuit briefly summarized the use of the event study in assessing the case:
In other words, the basic logic underlying the district court's grant of summary judgment is that, because the inflation in [defendant]'s stock price predated the Class Period, the statements made by the Defendants during the Class Period—even if knowingly and materially false or misleading—could not have “caused” the [price] inflation, and therefore could not have “caused” the Plaintiffs' losses [in holding out on the stock when they should have sold]."
Findwhat, __ F.3d at __


The circuit rejected this reasoning as "misapprehend[ing] the nature of market fraud. In doing so, it described some of the difficulty of utilizing the plaintiff expert's study of loss and causation. According to the circuit:

Event studies can be used to determine retrospectively the cause of a stock price movement. The analyst first estimates a “predicted return,” based on the firm's average return during a control period as well as on market and industry factors. If the actual stock price moves differently than the predicted return, the analyst then determines whether such “abnormal returns” are the result of chance or are instead statistically attributable to the information release."
Findwhat, __ F.3d at __ (citing In re Williams Sec. Litig., 496 F.Supp.2d 1195, 1272 (N.D.Okla. 2007); Allen Ferrell & Atanu Saha, The Loss Causation Requirement for Rule 10b–5 Causes of Action: The Implications of Dura Pharmaceuticals, Inc. v. Broudo, 63 Bus. Law. 163, 167 (2007).


The Eleventh Circuit explained there was a problem with application of the "Event Study" in the case. The circuit opined that

"The analysis also appears to conflate the concepts of reliance and loss causation—two distinct elements of a Rule 10b–5 claim. As noted above, reliance polices the front-end causation question of whether the defendant's fraud in fact inflated the plaintiff's purchase price, while loss causation polices the back-end causation question of whether the fraud-induced inflation in the plaintiff's purchase price ultimately caused financial losses. To the extent the district court concluded that the Defendants' fraud did not affect the purchase price the Plaintiffs paid—because the inflation in the price predated the fraudulent statements—this appears to be a conclusion drawn about reliance, not loss causation. Indeed, the Court in Basic presaged the Defendants' argument here and expressly placed it under the rubric of reliance, saying that fraud-on-the-market defendants may rebut the presumption of reliance by showing that “the misrepresentation in fact did not lead to a distortion of price.” 485 U.S. at 248, 108 S.Ct. 978. This appears to be essentially what the Defendants argued and the district court accepted, albeit using the language of loss causation. On remand, the parties should clarify their causation arguments, and specify whether their dispute actually goes to reliance or loss causation."
Findwhat, __ F.3d at __ .


As noted by the Eleventh Circuit, use of event studies is common in securities litigation and that its use as a methodology of event studies has been sustained by many circuits. Findwhat, __ F.3d at __ ; See, e.g., Archdiocese of Milwaukee, 597 F.3d at 341 (noting that event studies “demonstrate[ ] a linkage between the culpable disclosure and the stock-price movement”); Schiff, 602 F.3d at 173–74 & nn. 29–31 (accepting as reliable under Daubert, 509 U.S. 579, 113 S.Ct. 2786, an event study that linked a stock price drop with the revelation of fraud, for purposes of establishing materiality); Schleicher, 618 F.3d at 684 (affirming class certification based on expert's event study).

Federal Rules of Evidence
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