This previous post highlighted the egregiously disingenuous approach that the Justice Department has taken on the market loss issue in order to promote an absurdly long prison sentence for former mid-level Dynegy executive, Jamie Olis.
Now, the Third Circuit in In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005) addresses the same market loss issue that is involved in the Olis case and undresses the same superficial reasoning that the DOJ has used to support its dubious sentencing campaign against Olis (hat tip to Lyle Roberts for the link to the Merck decision).
In the Olis case, Project Alpha — the transaction on which Olis worked and was prosecuted — was disclosed to the investing public in a Wall Street Journal article in early April 2002 that criticized Dynegy’s accounting characterization of the transaction.
However, despite the WSJ’s criticism, Dynegy’s stock price did not decline.
Over three weeks later, Dynegy filed an 8-K with the SEC that formally disclosed the recharacterization of Project Alpha along with about a half-dozen other negative matters that were more significant than the disclosure on Project Alpha.
Dynegy’s stock price tumbled, and the Justice Department ultimately relied on the market loss resulting from that decline in promoting the draconian 24-year sentence of Olis under the then-mandatory federal sentencing guidelines.
In Merck, the Third Circuit addressed whether Merck’s failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.
On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed an S-1 with the SEC that disclosed for the first time that the subsidiary had recognized as revenue the co-payments that consumers had paid, but the S-1 did not disclose the total amount of co-payments recognized.
Immediately after the filing of the S-1, Merck’s stock price actually increased. Two months later, a Wall Street Journal article reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck’s stock price dropped two dollars immediately after that WSJ article.
On appeal, the Third Circuit (with a panel that included new Supreme Court Justice Alito) concluded that, in an efficient market, the materiality of disclosed information is measurable by the movement of the company’s stock price immediately following the disclosure.
Inasmuch as Merck’s stock price did not decline when the S-1 was filed on April 17, the Third Circuit concluded that the co-payment recognition information had an immaterial impact on Merck’s stock price.
In response to the plaintiffs’ argument that the true disclosure took place two weeks later when the Wall Street Journal article publicized the estimated amount of the co-payment recognition, the court concluded that the “minimal, arithmetic complexity of the calculation” that the WSJ reporter made “hardly undermines faith in an efficient market.” The court noted that this was especially true given how closely analysts followed a company such as Merck:
“[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier.”
Applying Merck to the Olis case, the efficient market for Dynegy stock understood the bad news about Project Alpha when it was disclosed on April 3rd and no market loss resulted from the news.
Thus, when Dynegy’s stock price dropped weeks later after the company’s disclosure of more bad news, the efficient market attributed that loss to the additional bad news items and not Project Alpha.
In short, the Merck decision is strong support for the position that the Justice Department has failed to establish any causation between Project Alpha and the astronomical market loss figures that the DOJ has used in advocating lengthy prison sentences for Olis.
The new Third Circuit decision in Merck is not the only recent appellate authority that contradicts the Justice Department’s market loss position in the Olis sentencing. Despite that, Jamie Olis remains in prison awaiting a re-sentencing hearing in which the government will almost assuredly seek a prison sentence longer than 15 years.
Here’s hoping that U.S. District Judge Sim Lake takes a page from his colleague Ewing Werlein’s sentencing book and rejects the Justice Department’s disingenuous market loss claims in the Olis case, and — in so doing — reins in a Justice Department that increasingly runs amok in its zeal to criminalize the unpopular business executive of the moment.