Loyola University Chicago

Institute For Investor Protection

School of Law

Securities Fraud and Expert Witnesses

Securities fraud schemes and the securities markets themselves have become increasingly complex. This complexity often necessitates expert testimony. Expert testimony is so paramount in securities fraud litigation that the law governing the admissibility of securities fraud experts has become inseparable from the substantive law governing securities fraud litigation.



Federal Rule of Evidence 702 governs the admission of expert testimony. Under this Rule, an expert witness can offer opinion testimony in a securities fraud case if: (1) the witness is qualified by skill, knowledge, experience, training, or education; (2) the witness’s scientific, technical, or other specialized knowledge will assist the trier of fact; and (3) the witness offers testimony that is based upon sufficient facts or data, is the product of reliable principles and methods, and the application of principles and methods is applied reliably to the facts of the case. 
Experts help the trier of fact understand the theory of liability and damages. Experts can be used to opine on each of the essential elements of a securities fraud claim. Some of these issues include: 
• Whether the financial instrument at issue is a “security” under the securities laws.
• Whether the defendant conformed with a standard of care? 
• Whether the misstatement or omission would have been considered by a reasonable investor, or whether a misstatement probably caused a movement in the company’s stock price? 
• Whether the market for the security is efficient?
• Whether the plaintiff suffered damages and what those damages are?



• Do not be intimidated by a perceived, relative lack of specialized knowledge.
• Prepare by exploring qualifications, bias, prior testimony, foundation of the testimony, and the nature and terms of the expert’s engagement.
• Do not confuse the expert for a neutral mediator who will offer nonpartisan testimony. The expert witness is an adverse and sometimes hostile witness.
• Base questions on a thorough understanding of the facts of the case and identify case-specific information that the expert has reviewed in reaching an opinion.
• Never assume that the expert is qualified.
• Crystallize and exhaust the expert’s opinion.



Liability under the securities laws often comes down to whether the defendant’s misrepresentation or omission created a disparity between the transaction price of a security and its true value measured by the precise reaction of the market price to the disclosure of the concealed information. A misrepresentation or omission that creates that disparity is material. Plaintiffs who invest at a market price that communicate that disparity show their reliance by a fraud on that market price. Where the disclosure of the previously concealed information alters the market price so as to create economic loss, investors can establish loss causation. The measure of damages is the quantification of that precise alteration or correction in the market price. 
Federal courts often rely on expert testimony and an event study to determine whether the defendant’s fraud created a disparity between the transaction price of a stock and its true value. A proper event study generally consists of four steps: (1) identify the event; (2) establish an event window; (3) isolate the impact of the event from market forces, industry factors, and nonfraudulent company-specific factors; and (4) estimate the effects of the event.

Step 1. Identify the Event

An event study must first identify the event that causes investors to change their expectations about the value of the company. An event may include an earnings report, dividend changes, stock splits, company press releases on projected revenues, regulatory rulings, acquisition bids, asset sales, tax legislation, lawsuits, product recalls, deaths of corporate executives, adoption of antitakeover provisions, a change in the state of incorporation, or any other information that is relevant to an investors’ assessment of future cash flows.
The selection of an event may prove more difficult in practice. Some events may have several distinct dates with each new event providing new information to investors about the likelihood of a coming event. Once an event is identified, the expert must also determine the announcement date—the day on which the event is made known to the public. Identifying the announcement date is vital because under the securities laws and the efficient market hypothesis, the impact of the event on the value of the firm would normally occur on the announcement date. 
Omission Cases. Securities fraud cases involving omissions present unique challenges for experts. If the case involves an omission, one would not expect to observe a price reaction to an omission because of the nature of the event. It is incorrect and improper to use an event study to analyze or quantify the effect of omitted information; rather an expert should focus on the date the omission is corrected or completed.
Confirming Market Expectations. Experts must also ensure that the event is not merely a confirmatory statement of information that the market already knows. The predicate of an event study is that the information being studied is new to the marketplace; thus, one will not expect stock price reaction in an efficient market when the misstatement merely confirms the market’s prior expectations.

Step 2. Establish an Event Window

Once an event has been identified, the expert must select an “event window,” or period over which the stock price movements are calculated. Typically, this window starts at the end of the trading day, or before news of the event reached the public. The difficulty in establishing an event window lies in determining the cut-off date. The longer an event window, the more likely the study will capture the release of the news (the event) and the market’s reaction to it, but this also makes it more likely that the market may be reacting to other unrelated events. The general rule of thumb for an event window is three days, starting a day before and ending a day after the event. Courts have, however, accepted shorter event windows.

Step 3. Isolate the Impact of the Event from Market Forces, Industry Factors, and Non-Fraudulent Company-Specific Factors

This step is often the key element of a proper event study for purposes of securities litigation. Experts must carefully isolate the effect of the event from the impact of market forces, industry factors, and non-fraudulent company-specific factors that also may be influencing the company’s stock price. To isolate the effect of market forces and industry factors, experts frequently use a comparative index model. The proper formula is: R = a + bMR + cIR = e

R = The return on the stock (i.e., its price movement for each day in question).

a = The constant return on the stock regardless of market or industry forces. Frequently “a” is presumed to be zero.

b = The percentage of linear correlation (or “ratio of co-variance”) between the return of the stock price of a company and the return of the market, measured by an index (e.g., the S&P 500 Index). A “b” close to zero would mean that the stock return to the company and the return of the index have no statistically significant relationship. A “b” of one would be a linear correlation, meaning, for example, that 5% change in the index return would be associated with a 5% change in the stock return of the company in the same direction. 
MR = The market return.

c = The percentage of linear correlation between the return of the stock price of a company and the average return on the stock of a peer group (similar industry and market cap), measured by an index. The company’s registration statement filed with the SEC and other filings of public companies must identify their peer group.

IR = The industry return.

e = The error term of the regression, which is assumed to have a zero mean, but numerous factors can distort the comparative index method analysis including the effect that non-fraudulent company specific information has on the company’s stock.

The comparable index model aims to subtract the expected return from the actual announcement-period return. The comparable index model assembles stock price movement for each day during the class period and compiles the stock price movement for each day during the period for (1) the company whose stock is the subject of the litigation; (2) the market index; and (2) the industry peer group performing a regression analysis for the “clean” period to estimate the parameters. Then based upon the estimated parameters, the model predicts the company’s stock returns during the class period. The difference between the actual returns and the predicted returns is the basis for further damage analysis.

Step 4. Estimate the Effects of the Event

Fourth, the estimated relationships achieved by the regression analysis are applied to control for market and industry movements in the event window. Then, the predicted return is compared to the actual return in the event window. The difference between the two is the abnormal or excess return. This return must be statistically significant so the results are not because of mere chance. This excess return is multiplied by the company stock price to provide an estimate of the per-share dollar effect of the event.



CBIZ Valuation Group, LLC: http://www.cbiz.com/valuationgroup/.
NERA Economic Consulting: http://www.nera.com/index.htm
Stanford Consulting Group, Inc.: http://www.scginc.com/
T.A. Myers & Co.: http://www.tamcoforensic.com/