Securities Law - Fraud-on-the-Market - First Circuit Defines an Efficient Market for Fraud-on-the-Market Purposes

Harvard Law Review, May 2006 | Go to article overview

Securities Law - Fraud-on-the-Market - First Circuit Defines an Efficient Market for Fraud-on-the-Market Purposes


In Basic Inc. v. Levinson, (1) the Supreme Court adopted the fraud-on-the-market (FOM) theory. (2) Under the theory, plaintiffs in securities fraud class action lawsuits are afforded a rebuttable presumption of reliance (3) on a misrepresentation, so long as they can establish that the market for the security was "efficient." (4) The Basic Court, however, gave little guidance as to what constitutes a sufficiently efficient market. (5) In the wake of Basic, lower courts have formulated multifactor tests for determining whether the market for a stock is sufficiently efficient to invoke the FOM presumption of reliance. (6) Recently, in In re PolyMedica Corp. Securities Litigation, (7) the First Circuit held that a market is efficient for FOM purposes only when the stock price "fully reflects all publicly available information" (8)--striking down the district court's holding that the stock price need only reflect "most" publicly available information. While purporting to adopt a widely accepted definition of market efficiency, the PolyMedica court has imposed a more stringent test for market efficiency than has heretofore been employed by courts--one that forces lower courts to determine whether a real-world market conforms at the margins to a definition of efficiency adopted from efficient capital markets scholarship (9) and that loses sight of the goals of Basic.

From October 1998 through August 2001, PolyMedica reported record revenues and earnings, and the price of its stock increased substantially. (10) When its share price dropped, however, PolyMedica found itself the target of a claim for damages under Rule 10b-5 (11) and section 20(a) of the Securities Exchange Act of 1934. (12) The plaintiff alleged that PolyMedica fraudulently inflated the price of its stock by misrepresenting sales, revenues, and accounts receivable, and by issuing false press releases. (13) On January 28, 2004, the plaintiff moved for class certification, asserting the FOM theory to establish reliance on the misstatements. (14) PolyMedica opposed the motion, arguing first that the plaintiff's definition of efficiency was incorrect, and second that the market for PolyMedica stock was not efficient for portions of the class period. (15)

The district court granted class certification. (16) The court rejected PolyMedica's definition of an efficient market as one in which the stock price reflects all publicly available material information, stating that Basic did not adopt this "academic" or "economic" definition. (17) The court held that "[t]he relevant question is whether the market for PolyMedica common stock is one in which 'market professionals generally consider most publicly announced material statements about [PolyMedica], thereby affecting [the] stock market price[].'"(18) Because PolyMedica's proffered evidence (19) spoke only to whether the stock price reflected all publicly available information about the company, and did not dispute that market professionals generally considered most publicly available information and thereby affected the company's stock price, the court rejected PolyMedica's evidence as "not relevant to the definition of market 'efficiency' ... derived from Basic." (20)

A unanimous panel of the First Circuit vacated and remanded, disputing the district court's interpretation of Basic. (21) While acknowledging that some language in Basic did support defining an efficient market as one that reflects "most," and not "all," publicly available information, the court noted that other passages from Basic supported a definition of efficiency that requires the stock price to reflect "all" publicly available information. (22) The court also noted that the Basic Court approvingly cited cases that seemed to favor an "all" available information definition. (23) Given the Basic Court's "disclaimer that it was not adopting any particular economic theory ... on the one hand, and its embrace of the holdings of cases adopting the ['all' available information] definition of market efficiency on the other hand," the First Circuit concluded that "the most that can be said of Basic is that it did not directly address the meaning of an efficient market. …

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