Controversial Orthodoxy: The Efficient Capital Markets Hypothesis and Loss Causation

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Abstract

Since the Supreme Court's landmark holding in Basic, Inc. v. Levinson, courts have incorporated the efficient capital markets hypothesis as an analytical tool in securities fraud cases. Nevertheless, recent turmoil in the financial markets and a growing chorus of scholarship challenging traditional notions of market efficiency have caused some courts to reconsider the role of the efficient capital markets hypothesis in securities fraud litigation. This Note analyzes a question that has split the circuits and marks the intersection of market efficiency and securities fraud: how quickly must an equity security depreciate in price following the publication of a corrective disclosure for a plaintiff to plead and prove loss causation? Part I introduces the efficient capital markets hypothesis, securities fraud actions, and the ways in which courts have traditionally employed concepts of market efficiency into their analyses. Part II analyzes the circuit split regarding the speed with which the market must incorporate information into price for a plaintiff to properly plead and prove loss causation. Finally, Part III argues that courts should resist the temptation to draw bright-line rules in the context of loss causation and should engage each case on its facts by analyzing the efficiency of the relevant market during each event giving rise to the fraud and economic loss.

INTRODUCTION................. 192

I. ECONOMIC AND LEGAL BACKGROUND .................193

A. THE EFFICIENT CAPITAL MARKETS HYPOTHESIS ...........193

B. SECTION 10(B) SECURITIES FRAUD ......................196

C. ELEMENTS OF RULE 10B-5 IN AN EFFICIENT CAPITAL MARKET.................. 200

1. Materiality ..............200

2. Reliance .....................201

3. Loss Causation ................203

II. THE CIRCUIT SPLIT ....................205

A. IMMEDIATE DEPRECIATION REQUIRED ...............205

B. IMMEDIATE DEPRECIATION NOT REQUIRED ...........211

III. COURTS SHOULD FOLLOW THE FIFTH CIRCUIT'S DECISION IN LORMAND ..................215

A. CONTEMPORARY CRITICISM OF THE EFFICIENT CAPITAL MARKETS HYPOTHESIS .............................216

B. TEMPORALLY ACCURATE AND INDIVIDUAL ANALYSIS OF EACH 10B-5 ELEMENT .........................218

C. CONSISTENCY WITH LANDMARK RULE 10B-5 CASES ............223

D. ARGUMENTS IN FAVOR OF A BRIGHT-LINE RULE ..............225

CONCLUSION ................230

INTRODUCTION

There is an old joke, widely told among economists, about an economist strolling down the street with a companion when they come upon a $100 bill [layingl on the ground. As the companion reaches down to pick it up, the economist says "Don't bother- if it were a real $100 bill, someone would have already picked it up."1

This joke is representative of a widely endorsed economic theory - the efficient capital markets hypothesis ("ECMH") - taken to its logical extreme.2 Developed in its contemporary form by the Chicago School of Economics, the ECMH posits that in "efficient" markets, the prices of securities accurately reflect all publicly available information.3 Over the course of the last four decades, the ECMH has had a monumental influence on securities litigation, particularly in the context of Rule 10b5 securities fraud.4 This Note examines a question that has split the circuits: how quickly must an equity security depreciate in price following the release of a corrective disclosure for a plaintiff to prove the element of loss causation? Part I provides a brief explanation of the ECMH, Rule 10b-5, and the ways in which at least three elements of Rule 10b-5 have been shaped by judicial endorsement of the ECMH. Part II examines the circuit split regarding this issue and discusses recent case law addressing the rapid incorporation of information into securities prices. Part III takes the position that courts should adopt a fact-specific rule with respect to loss causation and resist the temptation to apply any bright-line rule based on the ECMH. …