University of Pennsylvania Law Review
This Article contends that, contrary to its present use in the securities fraud realm as sanctioned by the Supreme Court and as assumed to be correct by most commentators, the CAPM is irrelevant for measuring damages in Rule 10b-5 cases because the CAPM is not designed to measure what stock prices would have been if the requisite fraud had not occurred. Instead, the CAPM is designed to help investors and portfolio managers determine optimal asset portfolios. That is, the CAPM is designed to help people make decisions about assets with uncertain future returns, rather than to analyze the actual past returns of assets in a manner that would allow for the measurement of damages pursuant to Rule 10b-5.This Article further asserts that the legal community should, in the context of the measurement of damages in Rule 10b-5 cases, reject the use of empirical derivations of the CAPM, and, in its place, use more accurate models designed to analyze past asset performance. In attacking the very foundations of the present methodology for calculating securities fraud damages, Part I of this Article reviews Rule 10b-5 and the basic methodology of calculating damages in Rule 10b-5 cases. Part II examines the intersection of judicial theory and capital market theory by considering the fraud-on-the-market doctrine and the capital market theories under which the doctrine and the measurement of damages may be justified: the Efficient Capital Markets Hypothesis, systematic risk compensation and the Capital Asset-Pricing Model. Part III contrasts the forward-looking basis of the CAPM with the historical basis for Rule 10b-5 damages. As Part III illustrates, whereas the CAPM approach calculates the historical relationship between stock price and the Standard & Poor's 500 Index (“S&P 500 Index” or “S&P 500”) and then projects the relationship forward to the period of the fraud, the technique we employ recognizes that it is erroneous to discount or ignore other factors besides movements in the S&P 500 Index that might actually have an even more powerful causal impact on a relevant security's price. Part IV introduces an alternative to the CAPM for damage measurement, utilizing the principles of arbitrage pricing theory. Finally, Part V surveys an empirical study that compares the ability of the CAPM with other derivative methods to explain the returns of common stocks and also introduces our own empirical study -- one that is clearly superior to the CAPM's derivatives for measuring Rule 10b-5 damages. Capital Asset-Pricing Model, Rule 10b-5
Edward Adams and David E. Runkle, Solving a Profound Flaw in Fraud-on-the-Market Theory: Utilizing a Derivative of Arbitrage Pricing Theory to Measure Rule 10b-5 Damages, 145 U. Pa. L. Rev. 1097 (1997), available at https://scholarship.law.umn.edu/faculty_articles/554.