[Our decisions] to do something positive... can only be taken as a result of animal spirits... and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.
-John Maynard Keynes, A General Theory of Employment, Interest and Money (1936).1
The recent Enron bankruptcy is one of those rare events that brings corporate and securities law close to sustained public attention.2 It has shaken confidence that the prevailing legal norms work as well as we want, or that the marketplace imposes the kind of discipline we have assumed. Among its many puzzles is one about the stock markets. How was the market for such a widely followed stock so easily fooled, especially when (in hindsight, at least) warning signs about obscure accounting, risk-shifting, and self-dealing practices were visible?
To a skeptic about the stock markets, the Enron debacle comes as no surprise. It was an issuer-specific stock bubble, different from countless IMAGE FORMULA7
predecessors only in terms of its size and the political attention it gained. The market fell in love with the company and, like many lovers, was far too slow to realize that the object of devotion was cheating. Keynes's animal spirits were at work. The ones with the explaining to do are the believers in market efficiency, especially those whose faith is so strong in its miraculous healing powers that they think legally mandated disclosure has little role to play in investor protection.3
It is much too early to judge whether any plausible rational explanation is available as to Enron in particular, though no doubt some will be offered. Instead, this article seeks more general answers in the increasingly sophisticated debate over the validity of the efficient market hypothesis (EMH), the most venerable tenet of financial economics and a staple of contemporary legal analysis. In the form most often invoked by legal academics, the EMH teaches that the prices of the stocks of actively traded companies, like Enron, rapidly adjust to reflect the rational expectations generated by all available information as it becomes available. Stocks are consistently "rationally" priced, in other words. But faith in the EMH among economists has been weakening for some time.4 That is not new news; by the mid-- 1980s, the notion of market efficiency was already under attack by finance scholars of considerable prominence.5 Since then, however, the battle has turned into something akin to a siege. Critics are still increasing in visibility and numbers and seldom does an edition of one of the best finance journals appear without at least one or two major papers offering theoretical or empirical claims inconsistent with strong views of efficiency. Yet, the orthodox EMH adherents are far from dead and still claim sizable numbers on their side.6 As often happens with long sieges, if we look closely we see a IMAGE FORMULA9
good bit of intermarrying occurring as scholars quietly redefine efficiency or inefficiency in a way that mediates between the two camps.7
In this Article, I will explore this debate, which-as Enron shows-is profoundly important to legal academics.8 What I especially want to draw from is the most interesting development in the past decade from the EMH critics' camp. It is one thing to attack market efficiency simply by showing that empirical reality does not conform to its predictions or by offering explanations for the inconsistency. It is a more ambitious task, both empirically and theoretically, to build an alternative model of market pricing. If so-called irrational activity is simply random and unpredictable, then markets are nothing more than noisy.
However, if the nonrational properties of the securities markets reflect predictable behavioral tendencies-in other words, that the animal spirits that seemingly drive the markets are well grounded in cognitive and social psychology-then there is something more to say that might be useful to the task of securities regulation. …