A federal judge in the Northern District of Illinois recently precluded the use of the Proportional Trading Model (PTM) to estimate aggregate damages in the securities fraud class action context Kaufman v. Motorola Inc., Case No. 95 C 1069. After a two-day evidentiary hearing at which Kirkland & Ellis represented the defendants, the court found that the PTM did not pass the admissibility standards of Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579 (1993). The rationale for this ruling should apply to all trading models.
The PTM, developed and commonly used by plaintiffs' experts, generates an estimate of the number of shares bought and held during a class period, or what plaintiffs often refer to as "damaged shares." The central assumption of the PTM is that every share outstanding and available for trading has an equal probability of trading. From this assumption, the model estimates, by examining daily trading volume relative to an estimate of shares available for trading, the number of damaged shares. Plaintiffs' experts then multiply this estimate of damaged shares by an estimated per share inflation factor to produce an aggregate damage claim -- frequently, a very large one.
While defendants challenged the admissibility of the PTM on several grounds, the primary challenge was to the reliability of the PTM's equal probability trading assumption. In particular, defendants argued that plaintiffs had failed to produce empirical evidence; economic literature; peer review; or other testing to support this trading assumption. Defendants further offered evidence that -- given the heterogeneous trading propensities of shareholders -- the equal probability trading assumption is almost certainly false.
After receiving extensive testimony and exhibits, including the testimony of plaintiffs' and defendants' (Lexecon Inc.) economists, the court held that the PTM "does not meet any of the Daubert standards." As support, the court pointed to the testimony of plaintiffs' own economic experts, who agreed with the test of reliability for an economic model articulated by economist Milton Friedman: "the reliability of an economic theory is tested by comparing it to reality." The court found that the PTM failed that test.
The court recognized that its ruling would preclude plaintiffs from submitting an aggregate damage claim to the jury. However, this did not mean that a securities law violation would go unremedied, observed the court, because an adequate remedy may be fashioned on a per share basis. The jury may determine a per share damage loss and, thereafter, through a claims submission process, an aggregate damage figure will be reached.
We believe that the practical impact of the Kaufman decision will be to limit substantially the potential damage exposure in securities class actions. Defendants will no longer be threatened by aggregate damage theories inflated through use of the PTM, but truly injured plaintiff class members will be able to recover in full.
Garrett B. Johnson and Jeffrey L. Willian are partners in Kirkland & Ellis' Chicago office.
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