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?