Dismal science, dismal sentence: How an economics theory can land you in the slammer

Yes, Virginia, market theories can put you in the clink. Jamie Olis knows better than most people that the ideas conjured up by economists in their ivory towers can have a big effect on the real world. The tax accountant, found guilty of committing fraud while working for Dynegy, an energy-trading firm, has been doing time since March 2004, in large part thanks to a controversial economic theory, the efficient markets hypothesis. Last October an appeals court threw out Mr Olis's 24-year jail term, because Judge Sim Lake, who sentenced him, got his economics wrong. But Mr Olis stayed in prison pending resentencing, again by Judge Lake. That will follow a hearing, due on September 12th, that is likely to be dominated by a debate over market efficiency.

In essence the efficient markets hypothesis, which was developed in the 1950s and 1960s, says that subject to certain conditions, the market price of a security—a share, say—fully and accurately reflects all the available information relevant to its value. In an efficient market the only reason why a price changes is that new information comes to light.

This hypothesis has been hugely influential in the world of finance, becoming a building block for other theories on subjects from portfolio selection to option pricing. Of more relevance to Mr Olis, it also has the rare distinction, for an economic theory, of the approval of America's Supreme Court. In 1988, in Basic Inc v Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them.

That ruling has proved a goldmine for America's trial lawyers, who have won fortunes by suing firms for damages when news (often, in practice, a restatement of their accounts) is followed by a sharp fall in their share prices. The fall is treated as proof of overvaluation due to the initial, wrong statement.

Increasingly, a similar logic has been used in criminal cases, as Mr Olis discovered. His 24-year sentence stemmed from a calculation of the financial loss caused to investors in Dynegy by Project Alpha, an accounting fraud in which he took part. That financial loss was estimated using the fall in Dynegy's share price on the news that Project Alpha was fraudulent. According to Judge Lake, it was so big that, under sentencing guidelines then in place, Mr Olis had to go to the Big House for a long time.

In rejecting that sentence, the appeals court ruled that Judge Lake had attributed far too much of the fall in Dynegy's share price to Project Alpha and too little to other news. Next week the prosecution and defence will each use economists as expert witnesses to debate exactly how much of the loss was due to Project Alpha. This will highlight several tricky technical issues that arise when applying the efficient markets hypothesis to fraud.

http://www.economist.com/finance/displaystory.cfm?story_id=7880472