The "Less Than" Efficient Capital Markets Hypothesis: Requiring More Proof from Plaintiffs in Fraud-on-the-Market Cases
Ferrillo, Paul A., Dunbar, Frederick C., Tabak, David, St. John's Law Review
In 1988, the United States Supreme Court in Basic Inc. v. Levinson1 created a "rebuttable" presumption of reliance2 for all members of a class alleging misstatements or omissions of material fact in their purchase or sale of securities of an issuer.3 This presumption allows a plaintiff, without any showing that he or she actually read or heard a misrepresentation, to assert, on a motion for class certification under Rule 23(b)(3) of the Federal Rules of Civil Procedure, that common issues with respect to reliance predominate over any individual issues of reliance present among the proposed class members.4 The presumption switches the burden to the defendant to "disprove actual reliance."5 If the defendant is unable to make such a showing, the proposed class may be certified.6
The Basic Court founded its decision in reliance upon the fraud on the market theory, which is premised upon the efficient capital markets hypothesis. Specifically, the plurality opinion noted that:
"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business. . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements."7
The Basic Court was clear to note that the fraud on the market's "rebuttable presumption of reliance" was indeed rebuttable, and was conditioned upon, among other things, a finding that the market for a particular stock was "impersonal [and] well-developed."8 For example, it has been held that the fraud on the market presumption could fail "where a defendant shows that an 'individual plaintiff traded or would have traded despite his knowing the statement was false,' or makes '[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price.' "9
In the years since the Supreme Court decided Basic, courts have struggled with the fraud on the market theory, fashioning their own theories, concepts, and tests to determine when a stock can be found to have traded in an "efficient" market.10 As the case law has gotten arguably less cohesive, scholarship on the efficient capital markets hypothesis has revealed empirical anomalies and debatable assumptions calling for a more complicated view of securities markets.
Consequently, rather than being supportive, recent research into the efficient capital markets hypothesis has been critical at best. Scholars have pointed to many holes in both the theory and its predictions, including a lack of correlation in the price movements of individual stocks to public announcements,11 "noise trading,"12 irrational investors, and the limits of arbitrage, and have concluded, like the thesis of this article, that the efficient capital markets hypothesis is sometimes less than efficient for a given security.13 So, in sum, if courts have struggled previously with "indicia" of an efficient market in the past, their task in the future could be even more complex as the intellectual underpinnings of the fraud on the market theory have come under attack.
But as we set forth herein, a court's journey through over 30 years of "efficient capital markets" and "fraud on the market" dogma can be simplified by requiring plaintiffs who seek to rely on the presumption of reliance on a motion for class certification under Rule 23 to make some affirmative showing that the stock at issue traded in an "efficient market."14 Clearly one determinative inquiry here is analysis of the reaction of the issuer's stock price to corporate news and events to ascertain whether the stock price accurately and timely incorporates all such publicly available information.15 If it can be shown, at the very least, that the company's stock price responded rapidly to news and unexpected information and was not overly volatile in the absence of such news these would be important, and perhaps even compelling, indicators of an efficient market. …