Fraud on the (Inefficient?) Market

By Matt Skurnik

Yesterday, in Halliburton Co. v. Erica P. John Fund, Inc., the Supreme Court, among other holdings, upheld the more than 25-year-old “fraud on the market” theory for securities fraud class actions. Though at first glance this complex case may seem to involve only a very specific and technical distinction, the end result has wide-reaching (and expensive) implications for every large public company involved in U.S. securities markets.

Under SEC Rule 10b-5, one of the requirements for relief in a securities fraud action is that the plaintiff had to have relied on the fraudulent information in making his decision to buy or sell. As an individual plaintiff, showing this reliance is a simple factual inquiry. For a large class action, however, if each plaintiff had to show that he individually relied on the fraudulent information, no securities fraud class could ever get certified. The claims of the putative class members would become too uncommon with each other, rendering the class action device inappropriate.

In 1988, the Supreme Court responded to this issue. It ruled in Basic, Inc v. Levinson that when the security at issue in a 10b-5 case was part of an open and developed securities market (think large number of shares and lots of buyers, sellers and analysts), the plaintiffs would get a rebuttable presumption of reliance. Putting their faith in a then-popular economic theory called the “efficient capital markets hypothesis,” the court reasoned that in an open and developed market, the price of a security generally reflected publicly available information, and that most investors relied on the security’s price in making their decision to buy or sell. By this reasoning, known as the “fraud on the market” theory, Basic saved the securities fraud class action.

Over the past decade, settlements between companies and investors have totaled $62 billion dollars, with $10.5 billion going to plaintiff’s lawyers. Writing for a 9-0 majority with three justices concurring in the judgment, Justice Roberts today ensured that these settlements will continue. Though there is certainly a question of whether, as a matter of policy, the huge costs that securities class actions impose on corporations (and therefore shareholders) are a good idea, when it comes to economics, Chief Justice Roberts’s majority got the decision right.

By contrast, in a concurrence joined by Justices Scalia and Alito, Justice Thomas challenged what he viewed as “armchair” economics. He argued that since Basic, the belief that markets are efficient in reflecting information in securities prices has been deeply challenged, and thus the presumptions underlying the “fraud on the market” theory simply did not hold true. If prices failed to fully reflect all of the available information in the market, how could the plaintiff’s reliance on that price mean that he relied on the fraudulent information?

The problem with Justice Thomas’s reasoning is in assuming that Basic necessarily depended on markets efficiently reflecting information. The two-step legal fiction of “fraud on the market” works whether the market fully and immediately reflects information or not. All Basic reasoned was that because the plaintiff bought or sold the security at a certain price, he necessarily relied on that price, and that that price in some respects reflected information in the market. That is all the court needed in order to say that the plaintiff himself in some way relied on the mass of information out there in the market, including the fraudulent pieces of it.

Contrary to what Justice Thomas argued, “fraud on the market” is not about the integrity of a price. Chief Justice Roberts correctly pointed out that if a security is over or undervalued because of market inefficiency, the legal fiction is still tenable. Sellers and purchasers still rely on the price—in the sense that that is the price they pay—and that price is still affected by the fraudulent information whether the market fully reflects all of its nuances or not. The result of the fraud is still a different price for the plaintiff and therefore the possibility for harm.

Consequently, to the dismay of corporate America, “fraud on the market” is here to stay and the securities fraud class action lives on.

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