I’ve always thought Sherwood vs. Walker was wrongly decided

NSDAQ cancelled all trades based on a faulty algorithm a couple of weeks ago. Buyers in good faith were screwed, and idiots rewarded. Typical for Wall Street, but hardly just, or fair.

The best laid schemes of mice and men gang aft agley.  I thought I’d celebrate turning in my Contracts grades by musing about the contractual doctrine of mistake and the “Flash Crash” of May 6.

Here’s where the cows come in.  Lawyers, remember that old chestnut, Sherwood v. Walker? Buyer buys cow for “beef on the hoof” price, but before the cow is delivered, it’s discovered that she is pregnant, and therefore a “breeding cow” and considerably more valuable.  Seller claims the right to rescind because of mutual mistake: both buyer and seller were mistaken as to the fundamental nature of the transaction (barren vs. fertile cow), so the deal should be void.  Mutual mistake still applies today, with the Restatement requiring both parties to be mistaken about a basic assumption and that the claimant not bear the risk of the mistake.

On May 6th the DJIA plunged almost 1,000 points. Congressional hearings followed, and while there was widespread speculation that a “fat finger” entered some extra zeroes into a P&G order, that’s not the mistake that interests me.  It’s the fact that the stock exchanges canceled trades occurring between 2:40 and 3pm at prices 60% above or below the 2:40 price.  According to the WSJ, “Nasdaq alone canceled more than 10,000 trades involving at least 1.4 million shares.”

On what grounds?  Mutual mistake sprang to my mind.  Both parties think they’re getting the “true market price,” they’re mistaken as to that basic assumption.  As James Stewart put it, “presumably no rational person would sell Accenture for a penny.”

But what about the risk-bearing question?  Stewart asks interesting questions:

If the trades resulted from sophisticated algorithms that failed to take into account the possibility of such volatile trading conditions, do those investors deserve to be bailed out by having the trades unwound? Should MIT-trained engineers turned professional traders be protected from their lack of foresight? Conversely, should those traders who devised programs to take advantage of such a free fall be denied their profits?

In other words, where do we allocate the risk of mistake?  I like teaching Sherwood because it illustrates that most market transactions are premised on a mistake.  Sellers think the buyer is paying too much (caveat emptor), and buyers think the seller is charging too little (caveat vendor).  Where do we draw the line between “great deal” and mistake?

10 Comments

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10 responses to “I’ve always thought Sherwood vs. Walker was wrongly decided

  1. Gideon Fountain

    “Sellers think the buyer is paying too much (caveat emptor), and buyers think the seller is charging too little (caveat vendor).”

    I disagree with the above premise. In fact, in many sales transactions, the seller is unhappy and so is the buyer. Both are left feeling that they could have made a better deal. Such is the nature of man.

  2. Anonymous

    I agree with you CF: the exchanges should not be allowed to nullify these trades after the fact. To me, it sounds like they’ve committed an illegal act by doing so.

    “Buyers in good faith were screwed, and idiots rewarded.”

    Exactly.

    “If the trades resulted from sophisticated algorithms that failed to take into account the possibility of such volatile trading conditions, do those investors deserve to be bailed out by having the trades unwound? Should MIT-trained engineers turned professional traders be protected from their lack of foresight?”

    That question is laughable.

    Absolutely, positively not!

    Let them take their losses like anyone else.

  3. out looking in

    Just one comment for all you market experts- the algo guys were not necessarily the victims- it was guys like Chris Fountain and Anon and even brother Gideon- put a stop in an exchange traded fund to mimmic the returns of a 1000 company small cap ETF to sell at 43…it becomes a MARKET order when $43 trades…you get filled at $0.01…now who’s fu^&ed?

    Chris- please post editorial in today’s WSJ by Spitznagel “The Fed and the May 6 ‘Flash Crash'”..full disclosure- Spitznagel is the partner of the famous Nassim Taleb (Mr Black Swan)

  4. Anonymous

    Don’t know that markets were less corrupt 20 yrs ago when the clueless, overpaid stockbroker was charging the clueless, overpaid doctor or car dealer or lawyer in suburban America hundreds of bucks for simple stock trades, trades which cost near-nothing today and are a tap away on an iPhone

    Software is inherently almost never dumb/corrupt; rather, it’s the dumb/corrupt engineers, trading executives and HF kings who sign off on poorly engineered, dumb/corrupt algorithms: natural selection and common sense judgment prevails even in a virtual, low-friction, algorithmic era

  5. just_looking

    out – in: Avoid the problem with a “Stop -Limit” order not a “Stop”. Everyone learns that the first time they get blown out well below the mkt (like bad news over night, or an earnings miss, or a wells notice). Call it tution and write it off against your gains. No gains? Then stop trading.

  6. out looking in

    just_looking

    only morons and amateurs use either…but thanks for the free advice, although next time i’ll ask…but if u do your homework, you’ll find that the trade busts were on balance not for the benefit of algo traders…if u would like a spot on cnbc or bloomberg tv to expound ur wisdom, let me know and i’ll see if i can arrange it

  7. just_looking

    out/in: amateurs are who I thought you were referring to (6:42am) “…guys like …”. I agree that it seems unfair to get stopped out on an event like May6th, but it seems more unfair to bust the buy trades that stepped in during that mess. You are correct, in that I have not done my homework. Where are you seeing data on the busted trades?

  8. out looking in

    just_looking

    its anecdotal, but my points are that for the most part 1) retail, not professional investors use “paper” stops (put on the “book”). We like to use mental stops because often the market will go on “raids”, where sellers will lean on a market to actually trigger stops, where we cover and reverse. Pros can do this because we are in front of the screen ALL day, and sometimes night.
    2) if fills were allowed on an ETF like VIG (its on the NYSE- look it up to see underlying sahres) at $0.01, because there were no paper bids below say $32 on that day, and the next bid was placed by machines as “placeholders” at $0.01, it would cause widespread panic and multiple suits against “pricipals and agents” (aka brokerage firms).
    Why the picked an arbitrary level like 60% is beyond me…
    I once had a moment of dyslexia and enetered a simple like ABC as ACB and was filled at a price over 25% from what I expected (it was pre-9:30am), I called my prime broker Morgan Stanley who called the exchange and busted the trade. The other side agreed- no problem. It would have cost my fund investors tens of thousands in losses (really not meaningful to NAV), but it was the point.

  9. just_looking

    I agree with your points, especially the $0.01 trades. I thought that mkt makers had a responsibility to maintain an orderly market, so that nothing gapped down from $32 to $0.01.

    Anyway, my issue is mostly the arbitrary gov’t rules coming in after the fact. Someone who BOT at -59% keeps their trade but the next guy who BOT -61% doesn’t because the gov’t chose an imaginary line in the sand.