Friday, November 14, 2008

When a Pecuniary Externality Isn't

[Warning: About Economics]

The CEO of a corporation releases an optimistic report on its future prospects; the stock goes up. Six months later the future arrives and the optimism turns out to have been misplaced. The stock goes back down. An enterprising lawyer sues the corporation in a class action on behalf of everyone who bought stock between the two events, claiming that their loss when the price fell was due to their being fraudulently induced to buy at too high a price by the CEO's report and that since the CEO was an agent of the corporation the corporation is liable for their losses.

Arguably one problem with the argument, from the economic standpoint, is that the buyers' losses are the sellers' gains, hence the announcement did no net damage. It produced what economists call a pecuniary externality, an action by A that causes a transfer from B to C. That was the argument against fraud on the market suits that I offered in my Law's Order.

A more obvious example would be A becoming a physician, thus driving down the prices other physicians can charge for their services. That is an external cost to the other physicians but a matching benefit to their customers, so A is imposing no net negative externality. That is the economic argument in support of the well established common law rule that competition is not a tort--one firm can't collect damages from another just because the other's competition caused it to lose money.

Yesterday I read a paper, and heard a talk about it by the author, which provided a simple and interesting rebuttal. His argument was that the CEO is supposed to act as an agent for the existing stockholders--that, after all, is the theory of how a joint stock company works, even if imperfectly realized in practice. Everyone who gains from the temporary price rise by selling stock is someone who owned stock when the report was made and the price went up. So we can think of the CEO as acting not for himself nor for the firm, whatever that means, but for the existing stockholders. If we do, the externality is no longer pecuniary. It is merely an ordinary case of A taking an action that benefits him but injures B. The standard economic argument is that he will take such an action even if the gain (to him) is less than the loss (to B), hence the existence of externalities can result in actions that on net make us worse off.

Generalizing the point, whether we classify an externality as normal or pecuniary depends critically on what we assume about the relation between the actor and those affected. If A takes an action that benefits B at the cost of C that is a pecuniary externality--unless A had been talking with B first, and made some suitable arrangement to be reimbursed for helping him at C's expense.

It does not follow that fraud on the market suits are a good thing. Other objections can be made to the legal theory. But the objection I offered in Law's Order implicitly assumed that the CEO should not be viewed as a faithful agent of the current stockholders, an assumption it never occurred to me that I was making.



At 1:30 PM, November 14, 2008, Blogger dWj said...

Perhaps I was mistaken, but I didn't take pecuniary externality to mean that I was neither of the parties among whom redistribution was taking place; in a Marshallian sense, welfare is conserved, even if I increase my portion of it. The point where it becomes a net cost is where resources are expended solely to produce the transfer. The rent-seeking form of pecuniary externality differs from the disinterested version in that incentives are now put in place such that I would be inclined to destroy wealth to move some of it from someone else to me, but that's different from asserting that a specific action actually does so -- the last assertion being independent of any incentives that are being acted on.

At 2:28 PM, November 14, 2008, Blogger Seth said...

How does the CEO over-estimating profits for the benefit of existing shareholders (including himself) differ from someone claiming that the land in Florida he's selling is perfect for building on? In both cases, there's a transfer of wealth from the (gullible) victim.

At 8:39 AM, November 15, 2008, Anonymous Douglas Knight said...

The point where it becomes a net cost is where resources are expended solely to produce the transfer.

What I see as the core of the concept of rent-seeking is that you should expect zero-sum games to turn into negative-sum games. If you see transferable resources, you should expect people to try to transfer them.

At 9:11 AM, November 15, 2008, Anonymous Paul Birch said...

The question whether or not the externality is "pecuniary" seems in this case to miss the important point; which is whether or not the CEO was acting fraudulently. If he was giving an honest evaluation then he was not - how much weight people give his opinion is their own affair. If however he was deliberately or negligently mis-stating the position (perhaps to make himself look good to the shareholders, or to enable them to sell at inflated prices) he was behaving dishonestly and defrauding those who were deceived to their disadvantage, and who ought therefore to be able to find remedy at law.

A good rule of thumb is that if your legal or economic arguments conflict with the plain morality of the situation, there's probably something wrong with those arguments.

At 12:04 AM, November 16, 2008, Blogger Michael F. Martin said...

One quibble with your characterization of the CEO who pushes the stock above its intrinsic value. In practice, it is often the case that such CEOs benefit both existing stockholders and themselves at the expense of later stockholders. This is because many CEOs receive options compensation, which often isn't expensed on the P&L statement, and wan't even taxed as an expense until relatively recently.

I suggest that the temporal scheme to this type of fraud is actually a more general feature of many supposedly "pecuniary" losses. As another example, consider false advertising. One might argue that the seller of goods that do not perform as claimed internalizes the entire loss of the buyers of such goods since over time the market price should come to reflect the intrinsic value of the goods regardless of how they are advertised. But this ignores the reality in which the seller is often not around when the price plummets after goods are returned because of defects, &c.

Efficient market theory doesn't take account of temporal evolution.

At 7:44 AM, November 16, 2008, Blogger John Sullivan said...

If someone sells stock and loses money, the buyer does not gain what the seller has lost. The buyer merely establishes the cost basis of his investment and only later, upon sale, will realize a gain or loss.

In a free economy all goods and services compete against each other; such as lap tops competing against hockey gear. This means that someone might have a monopoly on something but yet still be unable to raise prices or even not be able to sell the monopoly item at all. It also means that an entire market may lose money--like a stock market--by people pulling out of it. Often, when this happens it is said that wealth is lost or disappears without it turning up as a gain elsewhere, but this is false reasoning because the "paper" wealth never truly exists until it is realized or converted into a commodity with stable and lasting value--such as cash or gold, etc.

Goods and services are valued based on what people think they will be worth in the future. If a market were being inflated 1000% a year or even undergoing a leveraging process that we've recently experienced this decade, much of the 'supposed' wealth could quickly be lost if there were a simultaneous movement in the market for people to realize their gains or to halt inflation. In stock equities, it's rare that a company's market valuation is equal to or less than the present value of its future cash flows. This means that the stock market is always overpriced. People are paying to much to begin with.

The CEO should never be viewed as being an agent for stockholders ahead of him first being an agent for himself. Any individual will only represent the wishes of others when they intersect with his own. Fraud should be limited only to the misrepresentation of whether or not an asset or liability exists, but never to its value. This is because all human valuations are subjective. For example, if I pay a boy to mow my lawn and he comes to my house and does the work, I shouldn't be able to legally withold pay because I didn't like the quality of his work, or claim that he defrauded me by promising me a better job. I would only have a claim if I paid him and he never showed up. In this case, he was fraudulent regarding the "existence" of the asset he sold me--which in this case was the performance of an act of labor.

CEO's should never have to suffer law suits against them for what their subjective opinions are or are not regarding value. However, they should be fired.

At 4:51 PM, November 25, 2008, Blogger Carl Edman said...

An interesting argument, but which still doesn't justify the current 10b-5 regime, if for a slightly different reason.

If the CEO is the agent of the shareholders at the time of the fraudulent statement, he is indeed enriching his principals at the expense of the shareholders at the time the fraudulent statement is revealed. If the CEO can somehow coordinate with his principals (or be one of them), then the reason to impose liability is as good as that for any other involuntary transfer of wealth (such as plain old theft).

Under this model, the problem is not with liability, but with the remedy. The current remedy is to compensate shareholders at the time after the fraud is revealed at the expense of the corporation.

However, that just takes money out of the pocket of the corporation (that is, its shareholders) at the time liability is priced into the share price and puts it into the pocket of the shareholders at the time the fraud is revealed.

Assuming efficient markets, those times (and sets of shareholders) are the same, so the remedy is completely without effect except wasted transaction costs (like my lawyer salary).

Not assuming efficient markets, it still punishes shareholders at the time the liability is priced in for the benefit of shareholders when the fraud is revealed. Considering that the former were not the beneficiaries of the fraudulent statement (and in fact were probably more like the victims than the beneficiaries, because closer in time), that also seems indefensible.

No, the correct remedy under that theory would compensate shareholders at the time the fraud is revealed at the expense not of the corporation, but of every individual shareholder who reduced his or her position for any reason between the fraudulent statement and its revelation. That would effectively undo the effect of the fraud, thereby eliminating its incentives.

Good luck getting Congress or even the judiciary to go after Mom and Pop shareholder rather than Evil Corporations who can just pay damages out of the sacks of gold they have buried under the HQ.


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