Universität Augsburg

Diplomarbeit

Ad-hoc disclosure ­ a law and economics

approach

Lehrstuhl für Bürgerliches Recht, Wirtschaftsrecht, Europarecht,

Internationales Privatrecht und Rechtsvergleichung

an der Universität Augsburg

von

Veronika Fischer

Studienrichtung: Rechts- und Wirtschaftswissenschaften

7. Fachsemester

---

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2

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3

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4

---

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5

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quoted as Yadlin, Fraud on the Market

6

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Outline:

A. Introduction

10

a.

Importance and motivation 10

b.

Outline 11

B. Role of information in capital markets and price influence

11

a.

Efficient capital market hypothesis 12

b.

Behavioral finance 13

i.

Information traders and noise traders 13

ii. Publications effects 14

iii. Ease-of-processing effects 14

iv. Bounded willpower and emotional influences 15

v. Halo effect 16

vi. Conformity effect 16

c.

Random walk hypothesis and technical analysis 17

d.

Empirical pricing process 17

e.

Summary 18

C. Necessity of rules for ad-hoc disclosure

19

a.

Protection of information as public and collective good 19

b.

Motivation of investor participation 20

c.

Guarantee of information processing 21

d.

Avoidance of future market ignorance 21

e.

Protection of informed investor choices 22

f.

Prevention of agency conflicts 22

g.

Prevention of the destruction of company value 23

h.

Rather insufficient results in efficiency measures 23

i.

Summary 24

D. Ad-hoc-disclosure

25

a.

German law 25

i.

Object of legal protection of regulations concerning ad-hoc disclosure 25

1.

Efficiency of capital market and price integrity 25

2.

Investors as a group 26

3.

Individual investor 26

4.

Summary 27

ii. Duty of ad-hoc disclosure 27

iii. Defective ad-hoc disclosure 29

iv. Legal protection in criminal liability 31

v. Legal protection in civil liability 31

1.

Licit plaintiff 32

2.

Defendant 33

a.

Issuer 33

b.

Board 34

c.

Both issuer and board 35

3.

Bases for claims 35

a.

Pre-2002 bases 35

b.

§§ 37b, c German Securities Trading Act (WpHG) 36

c.

§ 826 German Civil Code (BGB) 37

d.

Summary 38

4.

Culpability 38

a.

§ 37b, c German Securities Trading Act (WpHG) 38

b.

§ 826 German Civil Code (BGB) 39

7

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5.

Damage 39

a.

§§ 37b, 37c German Securities Trading Act (WpHG) 39

b.

§ 826 German Civil Code (BGB) 41

6.

Loss causation and burden of proof 42

a.

§§ 37b, 37c German Securities Trading Act (WpHG) 42

b.

§ 826 German Civil Code (BGB) 43

c.

Facilitation of proof 43

7.

Assertion of rights 45

8.

Statute of limitation and exclusion 45

9.

Summary 46

b. US law 46

i.

Duty of ad-hoc disclosure 46

ii.

Legal protection in civil liability 47

1.

Licit plaintiff 48

2.

Defendant 49

3.

Basis for claims: Rule 10b-5 Securities Exchange Act 50

4.

Culpability 51

5.

Damage 52

6.

Causation and burden of proof 53

7.

Statute of limitation 54

8.

Assertion of rights 54

iii.

Summary 55

E. Mathematical determination of damages awarded

55

a.

Rescission 55

b.

Out-of-pocket measure 56

i.

Damage according to German Law 56

ii. Damage according US Law 56

iii. Flaws of those methods 57

iv. Finance-mathematical models of damage computation 57

1.

Damage as price minus true value 57

a.

Fundamental analysis 58

b.

Comparable index approach 58

c.

Event study approach 58

d.

Summary 59

2.

Damage according to the Capital Asset Pricing Model 59

F.

Economic analysis of the duty of disclosure

61

a.

Issuer as cheapest cost avoider 61

b.

Issuers self-interest 62

c.

Prevention of detrimental behavior inside the issuers company 62

d.

Risk of over-information 63

e.

Risk of liability for advice 63

f.

Negative 3rd-party effects such as free-riders gains 64

g.

Summary 64

G.

Economic analysis of liability of board members

64

a.

No duty of disclosure 65

b.

Infringement on the liability system 65

c.

Economic efficiency of enterprise liability 66

d.

Risk of misuse 66

e.

Deterring effect on business decisions 67

f.

Additional cost to the company/all shareholders 67

g.

Preferential treatment of shareholders 68

8

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h.

No additional security for plaintiffs 68

i.

No additional incentive for correct behavior 69

j.

Summary 70

H.

Economic analysis of damage

71

a.

No damage at all 71

b.

Out-of-pocket expense 72

c.

Trivialized damage and shift of the burden of proof 73

d.

Out-of-court settlements 74

e.

Rescission 75

i.

Shift of the risk of investment 76

ii. Bounded rationality and negative externalities 77

iii. Over-compensation and over-deterrence 77

iv. Inequality between shareholders 78

v. Summary 78

f.

Duty to mitigate damage 78

I.

Economic analysis of the assertion of rights

80

a.

US-law: Class action 80

b.

German Law: Representative Proceedings 82

c.

Summary 83

J.

Conclusion

84

9

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A. Introduction

a. Importance and motivation

In the late 1990s, a multitude of people grasped the chance to make a

quick fortune in speculating at the stock market: enterprises with a new-

technology background, i.e. internet services, information and computing

technology, boomed, reached positive corporate figures as well as sharp

growth rates and went public. Positive publicity about the companies, the

expected profit and the business development led to enormously rising

share prices. The investors eagerness to take part in this rapid wealth

accelerated the cycle ­ more capital, growth, higher profits, rising stock

prices. Nevertheless, the greed cycle came to a quick and devastating end

when investors discovered that the figures published did not have suffi-

cient or any materialization at all. Share prices collapsed, in some cases to

10% of their original value1. Even worse, investors learned that the posi-

tive view on some companies had been provoked by material misstate-

ments and/or omissions of and ad-hoc disclosure. EM.TV, Comroad, In-

fomatec, Met@box and Biodata were in the news again, but this time it

was negative publicity.

Thus, several courts were concerned with claims of deceived investors,

and developed rules for the civil liability of both the issuing company and

the responsible board members. Furthermore, the legislator enacted in

2002 regulations intended to ameliorate the protection of investors and to

ensure the integrity of the capital market by establishing bases for claims

for special liability concerning defective or omitted ad-hoc disclosure.

As the phenomenon of intentionally defective ad-hoc disclosure or inten-

tional admission is well-know in the US since the Wall Street crash of

1929, and the principles of legal protection and sanctions have evolved

steadily in the course of several cases, US law often served as an example

for the newly enacted German law. In the US, the majority of households

possess shares, whereas in Germany, a growing, but still meager 16.7%

takes part in the stock market2. From this, we must conclude that investor

protection does influence investor behavior. If investors are aware of risks

and fairly evaluated expected returns, they will be able to make informed

1 Möllers et al., Haftung von Vorständen, p.1648.

2 DAI-Factbook, chapter 06.3

10

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decisions, thus ensuring due functionality of the capital mark et, whereas

the falsification or omission of information leads to loss of confidence,

ineffective allocation of capital and finally market failure.

Thus, the legislator must thrive to enforce the flow of correct information

by on the one hand prescribing regular disclosure for relevant financial

data and entrepreneurial information, and by on the other hand sanction-

ing behavior aimed at blurring information, i.e. withholding or intention-

ally falsifying it3, as only sanctions will provide sufficient incentives to

act accordingly. Whereas the principles of regular publicity will not be

treated in the following, existing and intended rules and regulation for ad-

hoc disclosure will be discussed and analyzed as to whether they provide

the intended results.

b. Outline

In its beginning, the paper will sum up the role of information in capital

markets and its influence on pricing, whereas the most known concepts,

such as Famas efficient capital market hypothesis and the principles of

behavioral finance will be discussed. After detailing the necessity of rules

for ad-hoc disclosure, the paper will lay down the rules for legal protec-

tion of investors and the sanctions concerning intentionally defective ad-

hoc disclosure, be it misstatements or omissions, according to German

and US law. This background being clarified, an economic analysis of the

distribution of the duty of disclosure, and the liability of board members

follows. Furthermore, the damages and their measures will be analyzed in

both the finance-mathematical principles of how to compute the actual

amount of damage and the economic efficiency of the damage awarded

will be determined. The paper will furthermore evaluate the possibilities

for the assertion of rights. At last, the economic analysis will provide ar-

guments for the conclusive judgment of the current legislation and for

further legislative proposals.

B. Role of information in capital markets and price influence

Information being the price-governing factor on capital markets, the prin-

ciples of its distribution and absorption are the key to its efficient func-

tioning. Therefore, any rules and regulations concerned with capital mar-

3 Hopt et al., Prospekt- und Kapitalmarktinformationshaftung, Vorwort p.1.

11

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ket efficiency should thrive to incorporate the key concepts of capital

markets, as "the findings of capital market research have severe implica-

tions for a sensible definition of the liability for information"4. Thus, in

the following, the most common scholarly concepts are detailed.

a. Efficient capital market hypothesis

The efficient capital market hypothesis, developed by E. Fama in the

1970s, claims that share prices at any time reflect available information5,

whereas three forms exist: According to the strong form, security prices

reflect all information, public or not, whereas the semi-strong form would

agree only as to already public news6. The weak form at last claims that

share prices only contain past, but not actual and future information7.

The information analysis and thus its incorporation in the prices are effec-

tuated by professional traders, who constantly gather information and

react on it8. This advantage in information provides them with above-

average gains, and those gains, vice versa, provide an incentive for further

gathering of information9. Nevertheless, it must be underlined that those

above-average gains are not made "at the expense of the general investing

public, [but] are incentive and adequate compensation for the effort un-

dertaken in the interest of all market participants"10, i.e. correct market

prices which reflect the true value of a share with all information incorpo-

rated. Due to the work of professional traders, individual investors in

small shares can rely on the correctness of prices. They do not need to

costly gather information and can be simple "price takers"11.

Empirical studies have proven both the content of the efficient capital

market hypothesis and the enormously short amount of time (only several

minutes) after which a piece of information becomes incorporated12. Nev-

ertheless, the concept has as well been criticized:

At first, we must keep mind the so-called efficient capital market hypo-

thesis paradox: if too many investors believe the share price to incorpo-

4 Sauer, Kausalität und Schaden, p.27.

5 Sauer, Kausalität und Schaden, p.26.

6 Swan, Insider Trading, p.74; Escher-Weingart et al., Schadensberechnung, p. 1850.

7 Feldhaus, Kursbeeinflussung, p.107, Perridon et al., p.272.

8 Gutzy, Ad-hoc Dienstleister, p.9.

9 Sauer, Kausalität und Schaden, p.26.

10 Sauer, Kausalität und Schaden, p.26.

11 Sauer, Kausalität und Schaden, p.26.

12 Sauer, Kausalität und Schaden, p.26.

12

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rate all information available and rely on it, market prices cease to incor-

porate all information as too few investors gather it, and vice versa. If

only few investors rely on price integrity, the efficient capital market hy-

pothesis works, as investors gather avidly information to reach an insider

status which allows them to make gains.

Furthermore, the efficient capital market hypothesis is contested by the

fact that insider knowledge actually does exist and can be used by some

individual to reap extraordinary benefits, whereas according to the effi-

cient capital market hypothesis in its strong version, it must be expected

that all information is incorporated in the price. This is even more perti-

nent as insiders might play with the market mechanism to enhance gains.

Thus, we might negate at least the strong form of the efficient capital

market hypothesis.

Thus, related to ad-hoc disclosure, the Efficient capital market hypothesis

teaches us that sooner (strong form) or later (semi-strong or weak form)

the disclosed piece of information will be contained in the stock prices.

b. Behavioral finance

Behavioral finance takes on opposite view on capital markets and claims

that "individual psychology affects prices"13, whereas the concept is

based on the observation that individuals do not "maximize the expected

value of a utility function"14, but modify such rational considerations with

psychological behaviors.

i. Information traders and noise traders

According to the behavioral finance models, share traders are two-fold:

information traders "use a [...] learning rule to form estimates of re-

turns"15, whereas noise traders act without such rules and thus generate

errors. Behavioral finance argues that in a market fully composed by in-

formation traders, the Efficient capital market hypothesis would be true,

while it fails in all other (and thus all real) markets16. Whereas the effi-

cient market possesses a key single driver who would change prices, i.e.

new information, an inefficient market where noise traders participate

13 Hirshleifer, Investor Psychology, p.1533.

14 Rabin, Psychology and Economics, p.11.

15 Shefrin et al., Behavioral CAP Theory, p.323.

16 Shefrin et al., Behavioral CAP Theory, p.323.

13

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displays a second driver, i.e. behavior, which drives prices away from

efficiency17.

Thus, "noise traders do not process information rationally"18 ­ a most

valuable conclusion. As we must assume that most individual investors

are such noise traders due to their lacking experience and lacking means

of efficient information processing, we can expect that they will over- or

underestimate information given, or mismap probabilities of its occur-

rence19 due to their "particular cognitive errors"20. Those are sustained by

so-called "bounded rationality", i.e. the fact that the human being is only

able to absorb a certain amount of information21. Thus, everyone would,

if they were given the same piece of information, derive the conclusion

which fits with their general assumptions and beliefs derived by recent

history22 regardless of the content of the information.

ii. Publications effects

Experiments suggest that the form in which information is presented in-

fluences investors behavior, and thus eventually share prices: perfor-

mance information "is valued more when it is explicitly recognized, [...]

and perceptions also depend on how items are grouped"23 or whether they

are included in the disclosures main part or as footmarks only. Thus, we

must conclude that the way ad-hoc disclosure is published influences

strongly its impact. Empirical evidence suggests that even "irrelevant,

redundant or old news affect security prices"24 if published in a way

which provokes investor reactions. Thus, it must be a clear goal of regu-

lation to define the form in which ad-hoc disclosure must be made in or-

der to avoid overreactions by the investing public.

iii. Ease-of-processing effects

We must acknowledge that every individual only possesses "limited at-

tention, memory and processing capacities"25 for the evaluation of infor-

mation given. Thus, an overflow of information would "trigger associa-

17 Shefrin et al., Behavioral CAP Theory, p.327.

18 Shefrin et al., Behavioral CAP Theory, p.330.

19 Shefrin et al., Behavioral CAP Theory, p.331.

20 Shefrin et al., Behavioral CAP Theory, p.330.

21 Jolls et al., Behavioral approach, p.1477.

22 Shefrin et al., Behavioral CAP Theory, p.337.

23 Daniel, Investor Psychology, p.169; Schuster, Nachrichtenereignisse, p.16.

24 Daniel, Investor Psychology, p.169.

25 Hirshleifer, Investor Psychology, p.1541.

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tions that influence judgments"26 ­ exactly what happened in ad-hoc dis-

closure. Several pieces of positive news, be it of the same or related issu-

ers, caused investors to judge the market segment or the issuer as a whole

(although this was not inferred by the individual ad-hoc disclosures) ­ and

this judgment was, necessarily, wrong, as it was based on faulty assump-

tions. Such a process is heavily supported by "salience and availability

effects"27, i.e. the fact that ad-hoc information differs heavily from for-

merly know information and contains events of the normal course of

business, which are recalled more easily.

The most severe influence, nevertheless, is the so-called "illusion of the

truth"28: people will infer the truth of a statement if it is easy to process.

As the ease of processing is a prescription for ad-hoc disclosure29, inves-

tors will infer truth for each and every disclosure and not spend the neces-

sary critical attention to determine whether it indeed is. This is reinforced

by the phenomena of "cue competition"30, which describes the fact that

salient cues weaken the effect of less salient ones, and of confirmatory

bias, which means that "people are often too inattentive to new informa-

tion contradicting their hypotheses"31, or even misread adverse evidence

as support for their initial hypothesis. Thus, although defective ad-hoc

disclosure has been corrected, its effect might remain, as investors con-

tinue to trust in it.

iv. Bounded willpower and emotional influences

Both concepts offer an explanation for the mass reactions to news: people

tend to conclude "that the probability of an event [...] is greater if they

have recently witnessed an occurrence of the event"32 ­ if, then, a suffi-

cient amount of investors would have reaped benefits while investing in

share x, they themselves would believe in its profitability regardless of

contradicting signs. Such a structure will be nourished by "bounded will-

power"33, i.e. the fact that people do for short-term well-being even things

26 Hirshleifer, Investor Psychology, p.1541.

27 Hirshleifer, Investor Psychology, p.1542.

28 Hirshleifer, Investor Psychology, p.1542.

29 see below

30 Hirshleifer, Investor Psychology, p.1543; Rabin, Psychology and Economics, p.30.

31 Rabin, Psychology and Economics, p.26.

32 Jolls et al., Behavioral approach, p.1477.

33 Jolls et al., Behavioral approach, p.1479; Rabin, Psychology and Economics, p.34.

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