Damages in 10b-5 Claims


Key Findings

§ Class definition in securities fraud claims is often restricted to shares, neglecting the holders of options who are also damaged

§ Traded volume and therefore damages can be particularly large for publicly listed companies that attract highly leveraged speculative trading

§ In this Research Alert, we explore available methodologies for the estimation of damages for option holders, both on a class-wide and individual basis


The Options Market

Options give the holder the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a specified strike price, prior to or on a specified expiration date (maturity). The price for buying an option is called the premium. The market for options, both in terms of premia and the traded value of contracts, has a volume of billions of dollars and continues to grow:

 

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What Affects the Price of an Option?

Option values are particularly sensitive to changes in market conditions. Sophisticated pricing models have to be used to quantifying these effects. The following inputs, ordered by importance for the vast majority of option contracts, are most relevant: underlying stock’s price, market’s expectation of future volatility (so-called implied volatility), underlying’s historical volatility, time to maturity, interest rates and dividends.

New market information can materially affect these factors, especially the stock’s price and the implied volatility. The table below provides an example of how small changes in share prices and implied volatilities have large impacts on the price of put and call options. These figures refer to an option with a maturity of six months and strike price of $100.

Share Price

Implied Volatility

Call Option Price

Put Option Price

$ 100

20%

$ 6.63

$ 5.08

$ 110

20%

$ 13.70 (+107%)

$ 1.72 (-66%)

$ 90

20%

$ 2.22 (-66%)

$ 10.24 (+102%)

$100

30%

$ 9.39 (+42%)

$ 7.84 (+54%)

 

 

 

Options and Ongoing 10b-5 Cases

Both sellers and buyers of options can suffer damages in securities fraud cases. Total option premia of large companies amount to hundreds of millions of dollars. This table summarizes option premia and trading volumes for selected companies that are currently defendants in 10b-5 class actions:

 

Company

Case

End of class period (month)

Transactions in month at end of class period (thousands)[1]

Total premiums in month at end of class period

($ billions)[2]

Facebook

Violation of own data privacy policies

July

2018

1,361

4.88

Goldman Sachs

Misleading publication of financial condition

April

2010

1,316

4.72

Tesla

Misleading "Funding Secured" Tweet

August

2018

1,204

4.32

Twitter

Misleading statements about business prospects

July

2015

648

2.32

Alibaba

Dubious or illegal business practices

January

2015

603

2.16

Exxon Mobil

False reports on climate change recognition

January

2017

212

0.76

Johnson & Johnson

Asbestos in baby powder

December 2018

191

0.69

 

 
Note that these figures are based on an average premium of $432 per contract and an average of 8.3 contracts per transaction, drawn from the December 2018 Options Clearing Corporation report. 

Illustrative Example: Johnson and Johnson

This example shows the effect on option positions particularly clearly. In December 2018, Reuters reported that “Johnson & Johnson knew about asbestos in its baby powder for decades”. JNJ share price dropped precipitously as soon as the news broke:

 

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Option positions were heavily affected by this decline in share price:
 

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Bloomberg lists 7760 different available/traded option contracts for Johnson & Johnson in December 2018. The following chart shows the price changes for two exemplary options that are both liquidly traded and significantly affected by the observed price drop in the stock:

§  Call, strike $130, maturity 18 January 2019, and

§  Put, strike $130, maturity 18 January 2019

 

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As illustrated, the call option lost approximately 75% (or $12) of its value per contract on December 14 2018. The put option gained 1300% ($3.25) per contract that day. Premiums of put options and call options react inversely to changes in the share price, but from a perspective of trading strategies, a clients’ option portfolio is often either “long” or “short” on the underlying. Furthermore, as elaborated on in section 3, other market factors influence options values.

In addition to the 7760 different option contracts in December, further option premiums are affected by the event on December 14, since the class-period is longer than only a few weeks and the underlying equity’s price behavior was artificially distorted for a longer period.

Due to the non-linear, rather complicated scaling behavior of value changes in option positions, damages have to be calculated for specific option portfolios (or the portfolio of all open option contracts).

Inclusion of Option Damages into Established Methodology

Damages on stock positions are calculated using event studies and by determining the share prices in a “but-for” world, where the relevant information was reflected in a timely manner.  Option pricing models can be adapted to the event study framework and used to estimate damages on option positions in 10b5 claims. The following chart shows the calculation of “but-for” prices for the mentioned JNJ options (section 5) and the underlying stock:

 

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The estimated “but-for” prices for options can be used to calculate damages incurred on portfolios that comprise of options and/or equity positions. Given the large volume of option positions, this approach significantly increases and better reflects the overall damages in 10b-5 cases.