The 'Fraud-on-the-Market' Theory

I acknowledge the assistance of Raymond W. Henney, Esq., Ruth E. Zimmerman, Esq., and David A. Brown, Esq.

"I can calculate the motions of the heavenly bodies, but not the madness of people." Sir Isaac Newton1

"[T]he laws of economics have not yet achieved the status of the law of gravity ."2

The fraud-on-the-market theory is a flawed presumption that does away with individual issues of reliance, and thereby permits securities fraud cases to proceed as class actions.3 The fraud-on-the-market theory, which assumes that material information about a company is immediately reflected in the price of its stock,4 is based upon the Efficient Capital Markets Hypothesis, or "ECMH." The ECMH assumes that securities markets incorporate5 publicly available knowledge about publicly traded companies so rapidly that investors cannot develop a trading rule (including one based on research into company or industry fundamentals) that will systematically yield greater returns than the market.6

Basic Incorporated v. Levinson, 485 U.S. 224 (1988) adopted the fraud-on-the-market theory as establishing, in proper cases, a rebuttable presumption of reliance.7 However, Basic and its progeny have explicitly limited the application of the theory to securities which trade on an efficient market. Freeman v. Laventhol & Horwath, 915 F.2d 193 (6th Cir. 1990)(holding, as a matter of law, that the primary market for newly issued municipal bonds is not an efficient market; the faud-on-the-market presumption of reliance does not apply when securities are not traded on an efficient market).8 Plaintiffs have the burden of proving that the market was efficient. Zlotnick v. T.I.E. Communications, 836 F.2d 818, 821-22 (3rd Cir. 1988)(securities fraud complaint dismissed for failure to state a claim).

The early studies about the efficiency of stock markets examined securities of large corporations (like IBM or General Motors) traded on the New York Stock Exchange.9 However, the market for a small cap stock may not be equally efficient. Further, there is no per se rule that any security traded on the New York Stock Exchange ("NYSE") is traded on an efficient market. Where a stock is traded is not the crucial issue. The important question is whether trading in a particular stock displays the identifying characteristics of an efficient market. Stat-Tech Liquidating Trust v. Fenster, 981 F. Supp. 1325, 1346 (D. Col. 1997); O'Neil v. Appel, 165 F.R.D. 479, 504 (W.D. Mich. 1996)(the issue is not whether the NASDAQ is an efficient market); Greenberg v. Boettcher & Co., 755 F. Supp. 776, 783 (N.D. Ill. 1991)(allegation that secondary market for municipal bonds is efficient did not show an efficiency for particular bonds purchased); Hurley v. Fed. Dep. Ins. Corp., 719 F. Supp. 33 (D. Mass. 1989) ("Where the stock is traded is not crucial. The important question is whether the stock is traded in a market that is efficient - one that obtains material information about a company and accurately reflects that information in the price of the stock."); Harman v. LyphoMed, 122 F.R.D. 522, 525 (N.D. Ill. 1988) ("the question is always whether the stock trades in an efficient market, i.e., one in which material information on the company is widely available and accurately reflected in the value of the stock.").

Where trading appears to have been irrational, or at least predominated by extreme short-term speculation, the fraud-on-the-market presumption should be overcome in such situations because the presumption should not apply to such market activity. The underpinnings for this argument can be found in Basic, which held that the fraud-on-the-market presumption applies to shares traded on "an open and developed securities market." Id., at 241. When such a market exists, then investors are relieved from showing reliance because they are said to have relied upon the "integrity of the price set by the market." Id., at 245. This concept of a "developed" market that sets a price of "integrity" - the value of a company based upon the publicly available information - is not defined in Basic.

It is well recognized that despite temporary irrational price swings, the price of a security will eventually be driven to its fundamental value by informed investors based on an evaluation of available information. See, e.g., DeLong, Schleifer, Summers & Waldman, Noise Trader Risk in Financial Markets, 98 J. of Pol. Econ. 703 (1990). However, there is an important time element in that equation that cannot be overlooked. As Professor Langevoort recognizes in Theories, Assumptions, and Securities Regulation: Market Efficiency Revisited, 140 Pa. L. Rev. 851, 872 (1992), "smart money cannot operate as an immediate counterweight" to a stock price driven by "a crowd of trend chasers, overreacting to the most recent or vivid news, their illusions and emotions..".

Langevoort's article discusses "noise theory," which holds that the response to news about a security can be unrelated to a rational determination of the security's value in light of the news, but rather, can be an expression of the "cognitive imperfections" of human decisionmakers. His critique raises questions regarding the presumed mechanisms of market efficiency:

For example, suboptimal behavior that is common and predictable10 will not be of the random sort that classical theory holds will cancel out. For this effect to operate with substantial cleansing power, . . . investors must operate in a largely independent fashion with unsystematic biases. * * * [I]f their errors take on a systematic or contagious character, this analysis weakens. [However,] assuming there is plenty of smart money in the market, any irrational tendencies will immediately be exploited and eliminated through arbitrage.

Id, at 862-863.

[T]he efficiency hypothesis states that market prices behave as if investors were rational and invest resources in information only to the limited point of positive expected return. Nothing in that hypothesis denies what most popular accounts assume: that much information searching and trading by investors, from institutions on down, is done in the (perhaps erroneous) belief that undervalued and overvalued stocks exist and can systematically be discovered. Noise theorists only stress that the behavior of this class of speculators can be driven by pseudo-signals and cognitive illusions, as well as by fundamental analysis, thus moving the price away from value more frequently and for longer periods of time.

Id., at 895.

Thus, it is clear that the price of securities will eventually reach a price/value equilibrium by the exploitation and elimination of irrational investment...