A broker at a major Canadian bank was implicated in a fraudulent trading scheme involving the shares of a micro-cap company that were listed for trading on a junior stock exchange (the TSX-V). Investors who held shares at the time the scheme collapsed claimed damages for their trading losses. One investor, who held a significant number of the outstanding shares, claimed damages on the basis that, but for the alleged conduct of the bank and its employee, he would have been able to sell his shares at an earlier date when the stock price was still high.

NERA Director Bradley A. Heys provided expert analysis to assess the likelihood that the investor could have sold his shares at a higher price prior to the collapse of the scheme.

The fraudulent trading scheme was carried out by a consortium of company executives and other parties who conspired to restrict sales, and otherwise take steps to support the market price, of the company’s shares. The purpose of the scheme was to use the elevated stock price to facilitate non-cash acquisitions. Following the collapse of the scheme, several criminal and civil matters ensued, including civil claims brought by investors against the bank through which the fraudulent trades flowed. 

Counsel for the bank retained NERA to assess the investor’s claim and analyze whether or not the large block of shares could have been sold at the higher price or whether and to what extent offering such a large block of shares might have had an effect on the market price.

Mr. Heys provided analysis, which explained that the impact on the market price of any attempt to sell these shares depended on how steep the demand curve for the shares was during the relevant period and for any interval of time over which those shares would have been traded.

If the shares had been efficiently traded (in the sense that the market price reflected all publicly available information about the Company and would rapidly adjust to incorporate any new, value-relevant information—such as one often finds for the securities of larger, well-followed companies), the demand curve over even a relatively short period of time would be very flat—i.e., for even a small decrease in the market price, investors would be prepared to purchase a large number of shares. In such a case, an increase in the supply of shares would tend not to have a large impact on the market price of the shares. Had the shares of the Company been traded in such an efficient market, the investor would likely have been able to sell his shares relatively quickly and without a significant negative impact on the price (i.e., the price might have moved from P₀ to P₁ in the diagram below).

However, the shares of this company appeared not to be efficiently traded (likely a feature of the market that made the fraudulent trading scheme possible). Rather, among other things, the shares were very thinly traded during the relevant period. In such a case, even a small increase in the supply of shares could potentially have a very significant negative impact on the market price. (i.e., move the price from P₀ to P₂ in the diagram above).

However, without information regarding the depth of the market (from brokerage order books), it would be difficult to determine how negative the impact might have been if the investor had attempted to sell his shares on the open market.

Mr. Heys further explained that even if there had been a deep market for these shares and had the market been efficient, the best the investor could have hoped to recover from the sale of his shares was their fundamental value—i.e., in an efficient market, other investors presumably would have been prepared to purchase these undervalued shares if the price had gone lower than their value.

In this case, the stock price seemed to have been extremely high in relation to the earnings of the Company, which had a history of losses, and apparently limited future prospects, with the result that the value multiples implied by the stock price at the time (such as its EV/EBITDA and price-earnings multiples) were unrealistically high.

These facts, in turn, suggested that if even a modest number of additional shares had been put into the market for sale (and certainly any number of shares beyond the capacity of the manipulation scheme), the stock price would have collapsed dramatically—likely to less than 10% of the price at which the investor’s damage claim was based. 

The case settled following a successful mediation with the investor recovering a fraction of the amount claimed.