Traditional Method Looks at an Isolated Event -- But That Won't Work When Economic Downturn Creates a Flood of Negative Information or When Management Loads on Bad News to Hide the Truth; Courts Should Instead Use Investment Analysis Techniques -- Says Authority on Accounting Litigation at Marks Paneth & Shron
NEW YORK, NY--(Marketwire - November 15, 2010) - How much money do investors lose when management cooks the books? Courts try to answer this question every day. But the methods they use have stopped working, says Donald May, Ph.D., a director at New York accounting firm Marks Paneth & Shron LLP and an authority on securities litigation involving accounting fraud.
"The traditional way of determining damages looks at bad news in isolation," says Dr. May.
But that's hard to do when there's a flood of bad news -- either the bad news produced by the economic downturn, or the bad news loaded into earnings restatements by managers eager to hide the impact of accounting fraud in a welter of terrible announcements.
"There's a lot of bad news out there, the economy produces bad news every day," Dr. May says. "So under-handed managers have gotten skillful at gaming the system by loading lots of other bad news into their earnings restatements to make it harder to detect the impact of their fraud. So the traditional methods don't work very well anymore."
Instead of looking at bad news in isolation, courts should instead look at long-term earnings and cash flows, using the analytic tools that investors typically use to determine a company's valuation. And it should use several of them at once, Dr. May says.
"Event Study" Method Fails -- Because Bad News Doesn't Happen in Isolation
According to Dr. May, the traditional way of assessing damages -- an "event study" -- looks at a company's share price just before and just after a "bad news" announcement, such as earnings restatement or a report of a fraud investigation. The bad news announcement makes the fraud public knowledge.
"After the announcement, the share price typically goes down," Dr. May explains. "Courts assume that the price before the announcement -- the higher price -- was inflated because the company lied about its performance. The lower price is assumed to be the real price without the fraud. The difference is then assumed to show the amount that investors overpaid because of the fraud, and the courts use it to set damages."
"The event study method is simple and it's worked well for decades," Dr. May says.
But today, the method is often too simple to match current realities. "Because today there's so much information in the marketplace -- and thanks to the economy, much of it is bad -- it's hard to say that any one announcement had an impact on the share price in the absence of any other factors," he says.
"In addition, managers recognize this problem, and they tend to load up their announcements with all sorts of bad news. Sometimes this is done because of marketing or public relations considerations -- you try to get all the bad news out of the way at once. But sometimes it's a deliberate move by management to conceal the impact of their fraud," Dr. May says. "They know how the event study method works, and they've learned to add 'noise' to the announcement to make it harder for the courts to determine how much damage their fraud caused. Then they can argue that the damages should be less because other factors harmed the company's share price."
Courts Should Abandon or Supplement the "Event Study" and Use Other Means to Measure Impact of Fraud
In response, courts should abandon or supplement the event study method and apply the techniques that investors use to determine company valuations, Dr. May says.
"These methods are normally used to set a valuation over a long period of time, not at a particular point in time," he explains. "That means they're not subject to contamination by other news, the way the Event Study method is."
"None is perfect -- they all have strengths and weaknesses. But especially when several are used in combination, they give a much more accurate picture of the harm done to investors and therefore they can be used to set damages more accurately," he says.
Courts Should Consider Three Approaches -- and Use Them in Combination
Among the methods Dr. May suggests that courts use in place of the event study test are:
"There are challenges with all of these methods," Dr. May says. "But they may be superior to the traditional Event Study approach because they look at the impact of the fraud when the fraud actually occurred and are not subject to noise inherent in today's event study approaches."
Since there are difficulties with each individual method of fraud measurement, the best approach is to use several of them, then apply a weighted average to identify which results best match the situation," Dr. May continues.
"Difficult times call for new approaches, and we need to rely on these new approaches to measure the impact of fraud," Dr. May says.
For more information, or to schedule an interview or arrange for a bylined article, contact Itay Engelman of Sommerfield Communications at (212) 255-8386 or itay@sommerfield.com.
About Dr. Donald M. May
Donald M. May, Ph.D., is a director in the Litigation and Corporate Financial Advisory Services Group at Marks Paneth & Shron LLP. He is a valuation specialist with nearly twenty years of experience in industry, academia and public accounting and deep expertise in litigation and strategic consulting.
Previous to his role at MP&S, Dr. May was with leading global consulting and accounting firms including a Big Four firm and most recently Experts-on-Experts LLC, a New York-based litigation support firm where he served as Managing Partner and economic advisor to law firm clients across various industries on valuation, lost profits, opposing expert reports and deposition and trial preparation.
Earlier in his career, Dr. May was an Assistant Professor in the Sloan School of Management at the Massachusetts Institute of Technology where he published research and taught MBA and Ph.D. level classes in economics, accounting, financial statement analysis and statistics.
About Marks Paneth & Shron
Marks Paneth & Shron LLP is an accounting firm with nearly 475 people, of whom 64 are partners and principals. The firm provides businesses with a full range of auditing, accounting, tax, bankruptcy and restructuring services as well as litigation and corporate financial advisory services to domestic and international clients. The firm also specializes in providing tax advisory and consulting for high-net-worth individuals and their families, as well as a wide range of services for international, real estate, media, entertainment, nonprofit, professional and financial services and energy clients. Visit www.markspaneth.com for more information.
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