The unprecedented injections of public cash for corporations during COVID-19 may undermine the ability of investors to hold companies financially accountable, writes Alberto Thomas.
A curious phenomenon has emerged in stock markets in the last month. On 30 April 2020, Australia and New Zealand Banking Group published their half-year results for the period ending on 31 March 2020. Even though earnings per share were well below expectations, the company’s stock price nevertheless rose by 1.4 per cent on day the bad news came out.
It appears that investors’ assumptions that the government will underwrite risk may well be flipping the usual relationship between corporate financial announcements and stock prices. Bad news can be good news when a firm announcing poor results becomes a likely candidate for a bailout. This appears to be driving up firms’ stock prices, despite (or more perversely, even because of) the signal that all is not well.
By itself, this moral hazard would be cause for concern – investors are taking riskier, less responsible bets because they expect that the government will rescue them. But a reversal of the natural order in equity prices may also be creating some perverse short-term incentives for executives with skeletons in their closets and sabotaging a crucial check on corporate malfeasance.
Withholding important information, making false claims, and outright book-cooking can cause a firm’s stock prices to float above their true market value, because the information available to the public about the firm is misleadingly positive. When such wrongdoing comes to light, however, investors who paid inflated prices are entitled to compensation through litigation. This is no fringe practice.
Since 1999, more than 50 shareholder class actions have been commenced in Australia. Shareholder claims accounted for more than 20 per cent of all class action filings in the last decade, with settlements up to $500 million. Shareholder litigation serves both as an incentive for transparency and as one of the only means by which shareholders can hold companies accountable.
Under normal circumstances, courts estimate the size of the harm done in a shareholder litigation case by looking at the drop in stock prices immediately following the revelation of wrongdoing. As the new information emerges, markets price this information into their valuation of the company’s stock (often in real time, and sometimes even in a flurry of trading that occurs mid-announcement).
This means that the size of the correction in the market following a disclosure of wrongdoing is a good indication of how much value had been falsely priced into the stock – and hence, a good indication of how much investors have overpaid.
Of course, other information and market effects are built into share price movements as well. Australian courts have come to accept a standard methodology for isolating the “idiosyncratic” movement of a single firm’s stock price immediately following a disclosure from the movement of the wider sector and market, using regression analysis.
In the first-ever shareholder litigation class action suit to reach judgement in Australia in 2019, the court relied on this standard methodology widely accepted by the US courts.
But, in a topsy-turvy environment where poor performance drives stock prices up instead of down, this standard tool for measuring harm no longer works. Managers may be able to reveal their wrongdoing without facing consequences, because the existing econometric framework cannot provide investors with an estimate of their damages when the disclosure of bad news produces increases in stock price.
Given the high pleading standards for shareholder litigation claims and the need to show a plausible estimate of harm at an early stage, class action cases will struggle to survive defendants’ applications for dismissal.
Worryingly for the existing shareholder litigation framework, the phenomenon of negative disclosures and positive reactions in the equity market seems to extend beyond a few struggling companies.
On 21 April 2020 the governor of the Reserve Bank of Australia said that the Australian economy is expected to record a contraction in GDP of around 10 per cent over the first half of 2020; by the end of the day, the S&P/ASX 200 index dropped 2.5 per cent. In the face of a dire economic outlook, stock prices are rising as if lifted by an occult hand.
As other commentators have observed, a major economic downturn has a way of forcing long-term accounting fraud to the surface. But the unprecedented public cash injections for corporations brought on by the crisis may also be undermining one of the only means by which investors can hold companies financially responsible for their wrongdoing.
Alberto Thomas is the co-founder of economic consulting firm Fideres.