One interesting subject at the intersection of law, finance, and human behavior is the impact of looming litigation and enforcement actions on the affected company’s stock price. This post is going to be a bit of a think piece, as truly fleshing out some of the concepts here would require not just more research but industry expertise and empirical modeling.
With that caveat, a core assumption of Wall Street traders, financial economists, and the investing public holds that new information, including new information on legal risk, will generally move the market if it’s material. Materiality in this sense is basically circular; it’s something that moves the market. That’s a pretty high bar. However, securities law and accounting rules (GAAP, which applies to public and nonpublic companies alike) treat materiality in the disclosure context much more liberally. Where the chance of a litigation loss is “probable” or even “reasonably possible”—terms that mean somewhere between 10-70% chance of a loss—it usually must be disclosed.
The gap between the market sense of “materiality” and the legal and accounting sense is critical. As this Perkins Coie note discusses, the SEC “has increasingly taken the position that it is not enough that a possible loss or range of loss cannot be determined ‘with precision and confidence,’ and has indicated that it may ask companies to provide support for an assertion that an estimate cannot be made, particularly as litigation progresses.” So the possibility of a litigation loss must be disclosed even if its probability and magnitude can’t really be estimated yet and many of the underlying facts aren’t yet known.
The drafters of the legal and accounting rules may not have intended a significant gap between their definition of materiality and the economic definition, but I suspect the gap was known. One policy goal behind a rule that promotes early disclosure of relatively improbable risks is to make it hard for companies to conceal the risk of losses, and thus to promote better cost internalization and risk management. That’s a crucial objective, but it is pregnant with tradeoffs. Accuracy is probably one downside, since the disclosure obligation kicks in before much is known about the probability or magnitude of the risk. It could be that early disclosure tends to exaggerate the market response, because the risks are simply impossible to price at the early stage they are disclosed.
Share price movements of public companies following high-profile scandals provide some opportunity to measure the ability of the market to price disclosed-yet-unresolved legal risks. General Motors, for example, is currently in the throes of an unfolding legal and regulatory scandal. The company announced a major recall February 7, 2014 and has announced nearly 50 more since, involving a total of 17 million cars in the US and a few million more abroad so far (here’s a timeline of events).
GM’s problems have a lot of legally and politically salient features beyond those of most corporate legal scandals. Grim deaths of totally blameless consumers, grieving families, a simple fix that would have cost pennies per car to implement. And GM’s new CEO, Mary Barra, has admitted that the company knew about these problems for a decade. Criminal and civil investigations are ongoing, and Congress is investigating.
Of course, at at time like this, the impact on the company’s share price is not the main concern, but looking at it might provide an interesting, rough-and-ready measure of the market’s perception of this newly-disclosed legal risk. The cost of the mechanical fix is currently expected to come in around $700 million, but the legal and reputational damage is harder to gauge. Is the market doing a decent job of pricing them, or are traders overreacting to dramatic events? And what if any role are the securities laws and accounting rules playing here?
Let’s try to assess the reaction first. As depicted below, between February 7 (the announcement of the recall) and yesterday’s close, GM shares (blue) significantly underperformed those of its chief US rival, Ford (in red), as well as the broader S&P 500 index (green). GM is essentially flat (+0.5%), whereas Ford is up 12.5% and the S&P is up 8.9%. This could be a recall effect.
But did the market go too far in punishing GM? In March, some financial journalists suggested that GM’s recalls might be unjustifiably depressing share prices and this week TheStreet rated GM stock a buy. Does this lend support to that view?
It’s not entirely clear (and the reasons why underscore how hard it is to get market predictions right). However, if current trends continue, the market may have seriously overestimated GM’s legal risk in April relative to the facts known at that time.
The case of GM involves a watershed event in the form of a series of damaging disclosures made in a short, discrete window of time, followed by a rapid and massive drop in share prices, followed in turn by a strong rally.
Adding more competitors makes for a richer comparison. In this second chart, GM (blue) is underperforming rival Daimler, but outperforming both Honda and Toyota, with Honda down over 4% in the same window: All these stocks are performing poorly in this period, except Daimler. It could be that GM’s weak share price is attributable to the weakness of the auto sector in general relative to the S&P. Even so, I think this window may be somewhat obscuring the share-price impact of the unfolding recall. At the risk of stumbling into empirical territory, I think it’s clear here that selecting the right time window is important.
I have three observations in that connection: