• August 3, 2016

ContortionistLet’s say XYZ Company sells stock on a publicly traded exchange. And let’s say that XYZ Company’s publicly available financial information inaccurately overstates the company’s value.  XYZ’s share price does not reflect the company’s actual, lower, value; it is inflated based on the false information.

Every trading day while the truth is unknown, XYZ shares change hands on the open market. Sellers are paid more than the shares are worth. Buyers are overpaying. For the shareholders, as a whole, it is a wash, right? For every penny buyers overpaid, sellers got a premium. No harm, no foul? Maybe securities fraud class actions and millions of dollars in attorneys’ fees to “undo” this “revenue neutral” swap are massive wastes of time and resources?

Some make this argument although it seems particularly weak if we add the fact that some of the sellers knew the non-public truth and acted on this information to dump their stock. Still, let’s assume that some company insiders knew and sold inflated stock but millions of other trades were made between clueless outside investors. The percentage of “tainted trades” would be minuscule compared with the overall trading volume and the damages would be the insider’s ill-gotten gain, not every buyer’s over-payment (offset by most sellers’ innocent windfall profits). So, again, maybe securities fraud class actions are inefficient overkill?

And what about shareholders who bought AND sold the same number of shares during the inflated price period (or even sold more than he bought)? You could have someone suing for securities fraud when they actually profited from the fraud themselves. And what about a shareholder who bought inflated shares but, when the truth came out and the share price collapsed, increased her holdings substantially after the disclosure? It is imaginable that this shareholder actually made a net profit from the alleged fraud…Scarecrow Wizard of Oz Pointing

These are the kinds of economic puzzles that interest and befuddle legislators, regulators, lawyers, and courts. But maybe they should not.

The bottom line is that the market for publicly traded stock is premised on equal access to accurate information. If companies knowingly conceal important information or knowingly disclose false information, our legal system might not be able to get a handle on the exact amount of damages but most of us will agree that it must still take steps to shore up the market’s foundation in truth and fairness. Otherwise, the entire system collapses.

In my view, this is the upshot of U.S. District Court Judge Ann D. Montgomery’s (D. Minn.) ruling last week in Beaver County Employee’s Retirement Fund v. Tile Shop Holdings, Inc. The regulation of securities fraud is imprecise but necessary.

The allegations in this particular securities fraud class action are that the CEO’s brother-in-law had interests in companies that sold materials to the Tile Shop. The Tile Shop failed to disclose this relationship. There is a regulation that specifically requires disclosure of “related party transactions,” which The Tile Shop clearly failed to do.

But, to me, these allegations make the puzzle even more complex. The brother-in-law is alleged to have sold materials to Tile Shop at “artificially low prices.” Let’s assume he did. Plaintiffs’ counsel argues that this resulted in Tile Shop’s artificially inflated share price. What is “artificial” about that? If the Tile Shop were getting cheaper materials than its competitors, whether through a family connection or smarter negotiations, why does this, by itself, mean the Tile Shop’s valuation was inflated?

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