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The fraud-on-the-market theory is critical to securities fraud cases because it allows classes of plaintiffs who have not actually seen or relied upon a misleading statement to bring lawsuits. While the theory is rarely challenged in securities fraud cases, recent economic developments suggest that it is vulnerable to attack. If so, courts need to hear these economic arguments. If they succeed, these arguments could have a profound effect on securities litigation, particularly class actions. FRAUD ON THE MARKET The foundation of the fraud-on-the-market theory is the presumption that an efficient market for securities exists. The efficient-market hypothesis is based on the idea that competition will force stock prices to quickly reflect all publicly available information. An efficient securities market has many participants (traders, investors, etc.) who are all trying to be the first to get information, which they then use to buy and sell stock. The fraud-on-the-market theory says that where a stock trades in an efficient market, investors are implicitly trading in reliance on the stock price to incorporate all public information. Therefore, when alleging that the corporation had fraudulently provided information that altered its stock price, individual plaintiffs do not have to prove that they personally saw or read the inaccurate information. Clearly, this presumption simplifies plaintiffs’ burden in proving reliance for the members of a proposed class. Neither the fraud-on-the-market theory nor the efficient-market hypothesis has any grounding in the Securities Exchange Act of 1934 (which authorized the Securities and Exchange Commission’s Rule 10b-5, under which many fraud suits are brought). Both concepts were developed by academics in the 1960s and 1970s. Fraud-on-the-market was not adopted by a federal court until 1975, when the U.S. Court of Appeals for the 9th Circuit first recognized it in Blackie v. Barrack. A plurality of the U.S. Supreme Court gave the fraud-on-the-market theory its blessing in Basic v. Levinson (1988). Although the Basic Court never explicitly endorsed the efficient-market hypothesis, the dissenting opinion in Basic (as well as subsequent commentators) observed that the majority had effectively adopted the efficient-market hypothesis by endorsing the fraud-on-the-market theory. Many commentators have criticized the fraud-on-the-market theory as being at odds with the system of corporate “full disclosure” under the 1934 act because the theory obviated the need for any individual investor to read any company statements. Nevertheless, fraud-on-the-market is so entrenched today that even the existence of an efficient market is not seriously challenged, much less the fraud-on-the-market theory itself. For example, the U.S. District Court for the Southern District of New York, in Fellman v. Electro Optical Systems Corp. (2000), found an efficient market based upon a mere assertion that “millions of shares of [the company's] stock were actively traded on the Over the Counter Bulletin Board.” THE RISE OF BEHAVIORAL FINANCE Recent developments, however, give some hope of rebutting the reliance presumption established by the fraud-on-the-market doctrine and the efficient-market hypothesis. The primary challenge to the efficient-market hypothesis comes from the study of behavioral finance. Behavioral finance examines the psychology underlying investors’ decisions and attempts to use it to explain such phenomena as stock price overreaction to past price changes and stock price underreaction to new information. Behavioral economists argue that stock markets are imperfect because people stray away from rational decisions. This behavior creates “market breakdowns” and buying opportunities for savvy investors. Speculative bubbles that expand out of nowhere and crash without apparent reason occur, according to behavioral economists, because investors sometimes run like a herd, all thoughtlessly galloping in the same direction. For many investors, their brokerage statements after the bursting of the Internet bubble have provided painful evidence that stock prices have not always reflected the fundamentals of the underlying companies. Developments in behavioral finance have shown that there are many stock market anomalies, i.e., reliable, widely known, and inexplicable patterns in stock returns. Commonly discussed anomalies include size effects, where small companies are more likely to provide higher stock returns than large ones. There are apparent calendar effects, such as the January effect � which seems to indicate that higher returns can be earned in the first month of the year � and the weekend or “blue Monday on Wall Street” effect � which suggests that stocks tend to sell at slightly higher prices on Friday afternoon and at slightly lower prices on Monday. There are also the indicators of undervalued stocks used by value investors, such as low price-earnings ratios and high dividend yields. UNDERSTANDING INVESTORS Strengthening the challenge to the efficient-market hypothesis, more sophisticated trading technology has reminded us that traders do not always think or act alike. Some investors are quick-trigger day traders. Others are corporate treasurers. Others are central bankers. Others are long-term investors who rarely trade. The advent of high-frequency or intra-day data � essentially, a minute-by-minute record of trading activity � offers a better picture of trading behavior and a more accurate measure of the speed it takes a price to react to certain information. By examining how traders react to information during the day, analysts, lawyers, and researchers can better determine whether a stock’s price reflects its true value. These intra-day movements in stock price provide more detail on whether a stock’s price reacts rapidly and appropriately to news that has implications for the future cash flows of the company. In fact, high-frequency data have brought to light some behaviors that could not be observed when only lower-frequency data, such as daily closing prices, were available. This increased availability of detail on prices, orders, and other market information has the potential to help prove, or disprove, whether a particular market is efficient. In challenging whether the security was traded on an efficient market, defendants can now point to additional factors that should be analyzed beyond the traditional ones. Courts must ask questions about how information is incorporated into the security’s price. While few would question that an efficient market exists for an actively traded large-company stock on the New York Stock Exchange, not all securities trade in this type of market. LEGAL CONSEQUENCES In light of these ongoing developments, the fraud-on-the-market presumption is increasingly vulnerable to attack. If a particular market is inefficient, plaintiffs proffering a fraud-on-the-market case would have to establish reliance upon the alleged corporate misstatement. If they cannot do so, their suits must be dismissed. Rebutting the fraud-on-the-market presumption is particularly important in the class action context because in the absence of the presumption of reliance afforded by the fraud-on-the-market theory, individual issues of fact arise (that is, each investor’s individual reliance on the misrepresentations) that usually would preclude class certification. Without class certification, many securities cases are not economically viable and become “negative value” cases where the costs of litigation are higher than any expected recovery. The Supreme Court has the opportunity this term to comment on the efficient-market hypothesis when it considers Dura Pharmaceuticals Inc. v. Broudo next year. That case addresses the issue of whether a plaintiff invoking the fraud-on-the-market theory must demonstrate loss causation by pleading and proving a causal connection between the alleged fraud and the stock’s decline in price. In Dura Pharmaceuticals, the Court is expected to reverse the 9th Circuit’s adoption of a purchase-time inflation theory for showing loss causation. The 9th Circuit requires only allegations that a security was inflated at the time of purchase, as opposed to the other circuits’ requirement that the element of loss causation be satisfied by showing the price of a security declined when a corrective disclosure was made. In essence, the 9th Circuit stretches the efficient-market hypothesis beyond its breaking point. Although securities plaintiffs like to argue that the efficient-market hypothesis supports the purchase-time inflation theory, the opposite is actually true. If there is no price drop in reaction to a corrective disclosure, the alleged inflation in the security, if it existed, must be due to other causes (if the market is efficient). The Supreme Court’s expected rejection of the purchase-time inflation theory may pave the way for renewed challenges to other abuses of the efficient-market hypothesis. In sum, recent developments in behavioral finance and trading data collection show that a more rigorous inquiry into a market’s efficiency may provide a stronger defense in a fraud-on-the-market securities case. Absent an efficient market, an alleged fraudulent statement would not necessarily distort prices, and the fraud-on-the-market presumption would not be applicable. For plaintiffs, these new arguments mean that the fraud-on-the-market presumption should not be taken for granted. Mark D. Wegener and Martin F. Cunniff are partners in the D.C. office of Howrey Simon Arnold & White. They wish to give special thanks to Paul Lowengrub, an economist at CapAnalysis, a subsidiary of their law firm. Wegener can be reached at [email protected]; Cunniff can be reached at [email protected].

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