Taking "Efficient Markets" out of the Fraud-on-the-Market Doctrine after the Private Securities Litigation Reform Act
Oldham, Jeffrey L., Northwestern University Law Review
In Basic, Inc. v. Levinson,1 the Supreme Court opened the federal court doors far wider than ever before to securities fraud class action plaintiffs. Before Basic, plaintiffs bringing a Rule 10b-5(2) securities fraud claim against a company were required to prove that they had actually relied upon the company's alleged misrepresentation when deciding to trade the company's security. In Basic, however, the Court did away with the need for plaintiffs to show such actual reliance in class action cases involving open market securities transactions.3 Recognizing the "fraud-on-the-market" theory, the Court reasoned that when a company whose securities trade in an open and developed market allegedly makes a misrepresentation about its securities, the market price of its securities will reflect that misrepresentation. Since investors purchase or sell the securities in reliance upon the integrity of the market price, they indirectly rely upon the alleged misrepresentation because they buy or sell the security at a price that reflects the misrepresentation. For this reason, the Court held that the company's alleged misstatement acts as a fraud on the entire market and that the plaintiffs' reliance on the market price indirectly suffices to establish the reliance requirement.4 This approach drastically modified existing doctrine and revolutionized Rule 1 Ob-5 securities fraud class action suits.5
Prior to the Court's endorsement of the fraud-on-the-market presumption in Basic, there were two forms of the fraud-on-the-market theory developed by lower courts and scholars. Initially, some scholars6 argued that where a plaintiff class could prove that an alleged misrepresentation caused a change in the market price of a company's securities, i.e., where the plaintiffs could show loss causation,7 then showing individualized reliance on the misstatement would be unnecessary because the plaintiffs' reliance on the market price, which reflected the misrepresentation, constituted indirect reliance.8 Other scholars more radically applied the "efficient market theory" from financial economics to the fraud-on-the-market theory and proposed a form of the fraud-on-the-market doctrine that would essentially presume both the earlier loss-causation inquiry and the reliance element.9 These scholars posited that where a plaintiff class could show that the security at issue traded on an efficient market,10 it would be likely that the stock price reflected the alleged misrepresentation and that the stock price changed as a result. Thus, this second form of the theory amounted to a double presumption that would presume both loss causation11 and reliance:
whereas the earlier fraud-on-the-market concept was triggered by a showing that the purported misrepresentation caused the stock price to change, this new version was triggered by a mere showing of an efficient market. Since the new presumption would be rebuttable, the practical effect of the double presumption was to relieve plaintiffs from having to prove either loss causation or reliance affirmatively, and to shift the burden to the defendant to disprove both.
While the Basic Court did not expressly state which of these two forms of the fraud-on-the-market theory it was endorsing, the Court's analysis reveals its acceptance of the second form of the presumption. For example, it explicitly set up the presumption so that defendants could rebut it by disproving either loss causation or reliance. Furthermore, commentators agree that Basic's analysis can be logically justified only with the efficient market theory as its underlying basis, giving support to the notion that the Court adopted the double presumption. Moreover, lower courts have uniformly interpreted Basic's fraud-on-the-market presumption to be closely wedded to the efficient market theory, and therefore have implicitly applied it as a double presumption of both the loss-causation trigger and reliance upon a showing of an efficient market. …