Ferrillo St. Johns Law Review Article

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1. ST.JOHNS LAW REVIEW THE “LESS THAN” EFFICIENT CAPITAL MARKETS HYPOTHESIS: REQUIRING MORE PROOF FROM PLAINTIFFS IN FRAUD-ON-THE-MARKET CASES P A U L A. FERRILLO~,…
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  • 1. ST.JOHNS LAW REVIEW THE “LESS THAN” EFFICIENT CAPITAL MARKETS HYPOTHESIS: REQUIRING MORE PROOF FROM PLAINTIFFS IN FRAUD-ON-THE-MARKET CASES P A U L A. FERRILLO~, FREDERICKC. DUNBAR, H . D . t t & P DAVIDTABAK, ~ . D . t t t P In 1988, the United States Supreme Court in Basic Inc. u. Leuinson’ 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 a n i ~ s u e r . ~ 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@)(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 member^.^ The presumption switches the burden to the defendant to “disprove actual reliance.”s 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 t Paul Ferrillo is Of Counsel in the Business and Securities Litigation Department of Weil Gotshal & Manges, LLP in New York City. Senior Vice President, NERA Economic Consulting. ttt Vice President, NERA Economic Consulting. 1 485 U.S. 224 (1988). 2 Reliance is one of the required elements of a claim under section IO@) of the Securilies and Exchange Act of 1934. 15 U.S.C. 5 78J@) (2003). 3 See Basic, 485 U.S. a t 245. 4 See id. a t 242. 5 Lipton v. Documation, Inc., 734 F.2d 740, 746 (11th Cir. 1984) (stating that once a plaintiff alleges reliance on market prices when buying a securities, the defendant then has the burden of disproving any actual reliance) (citing Blackie v. Barack, 524 F.2d 891 (9th Cir. 1955)). fi See Basic, 485 U.S. at 250. 81
  • 2. 82 ST. JOHNS LAW REVIEW [vel.78:81 20041 LESS THAN EFFICIENT CAPITAL MARKETS 83 capital markets hypothesis. Specifically, the plurality opinion misrepresentation and either the price received (or paid) by the noted that: plaintiff, or his decision to trade at a fair market price.’ ’3 “The fraud on the market theory is based on the hypothesis In the years since the Supreme Court decided Basic, courts that, in an open and developed securities market, the price of a have struggled with the fraud on the market theory, fashioning company’s stock is determined by the available material their own theories, concepts, and tests to determine when a stock information regarding the company and its business. . . . can be found to have traded in a n “efficient” market.1° As the Misleading statements will therefore defraud purchasers of case law has gotten arguably less cohesive, scholarship on the stock even if the purchasers do not directly rely on the efficient capital markets hypothesis has revealed empirical mis~taternents.”~ anomalies and debatable assumptions calling for a more The Basic Court was clear to note that the fraud on the complicated view of securities markets. market’s “rebuttable presumption of reliance” was indeed Consequently, rather than being supportive, recent research rebuttable, and was conditioned upon, among other things, a into the efficient capital markets hypothesis has been critical a t finding t h a t the market for a particular stock was “impersonal best. Scholars have pointed to many holes in both the theory [and] well-developed.”a For example, it has been held that the and its predictions, including a lack of correlation in the price fraud on the market presumption could fail “where a defendant movements of individual stocks to. public announcements,lt shows that a n ‘individual plaintiff traded or would have traded “noise trading,”12irrational investors, and the limits of arbitrage, despite his knowing the statement was false,’ or makes ‘[alny and have concluded, like the thesis of this article, that the showing t h a t severs the link between the alleged 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 a n efficient market in the past, their task in the future could be even more complex a s the 7 Id. at 241-42 (quoting Peil v. Speiser, 806 F.2d 1154, 1160 (3d Cir. 1986)) intellectual underpinnings of the fraud on the market theory (alteration in original). I t is interesting to note t h a t in Peil u. Speiser, the court “affirmatively declined to specifically define the term ‘open and developed market.’ ” have come under attack. Cammer v. Bloom, 711 F. Supp. 1264, 1276 (D.N.J. 1989). There are three generally accepted versions of the efficient capital markets hypothesis: In a strong-form efficient market, all information that exists about a company and would be of interest to a purchaser of the company’s $1 Cromer Finance Ltd. v. Berger, 205 F.R.D. 113, 129 (S.D.N.Y. 2001) (internal securities is reflected, nearly instantaneously, in the price of the stock, citations omitted); see Krogman v. Sterritt, 202 F.R.D. 467, 473 (N.D. Tex. 2001) (“A such that no individual can expect to gain a greater return from t h a t defendant may rebut [the fraud on the market] presumption by showing that the security than from any other security, and no individual can hope to stock price was unaffected by the fraud, or that the plaintiff would have made the perform better t h a n any other individual over the long term. The weak purchase regardless of the undisclosed information.”) (citing Zlotnick v. TIE Comm., form of the ECMH, by contrast, proposes that the price of the stock 836 F.2d 818, 822 (3d Cir. 1988)). eventually reflects publicly available information. . . . 1 0 See, e.g., Krogman, 202 F.R.D. at 474 (discussing additional factors Semi-strong efficiency, which. . . [holds] that most information about a pertaining to market efficiency, such as “(1)the capitalization of the company; (‘2) company is reflected in its price fairly quickly, appears to be the form the bid-ask spread of the stock; and (3) the percentage of stock not held by insiders assumed to exist by the United States Supreme Court in Basic. (the ‘float’)” (internal citations omitted)); Cumrner, 71 1 F. Supp. a t 128G87 Kaufman v. i-Stat Corp., 754 A.2d 1188, 1198 (N.J. 2000) (internal citations (fashioning a five-part analysis for determining whether or not a stock traded in a n omitted); see infra Part 1II.A. The definitions of the Kaufman court for the weak and efficient market). semi-strong form are actually not those universally accepted in financial economics. 11 See Richard Roll, Rz, 43 J. FIN.541, 557-61 (1988) (finding that aside from See infra Part 111. Other commentators have specifically defined some of the terms issuers which are involved in takeovers or “major disasters,” therc is generally little I underlying the fraud on the market theory. See, e.g., ALANR. BROMBERG LEWIS & connection between volatility and company specific news releases). D. LOWENFELS, 3 BROMBERGAND LOWENFELS ON SECURITIES FRAUU & 12 See generally Fischer Black, Noise, 41 J. FIN. 529 (1986) (explaining that COMMODITIES FRAUD 0 8.6(641) (2d ed. 2003) [hereinafter BROMBERG] (defining a “noise” in the market comes from “uncertainty about future demand and supply “developed market” as one “which h a s a high level of activity and frequency, and for conditions within and across sectors” and creates inefficiency). which trading information (e.g., price and volume) is widely available,” and a n 13 See generally ANDKEI SHI,EIFEK, INEFFICIENI’ MAKKII‘I’S: JNI’ROUUCTION AN “efficient market” as “one which rapidly reflects new information in price”). T o BEHAVI~KAL FINANCE l 1 (2000) (discussing a n alternative approach to the % 8 See Basic, 485 U S . at 241,249 n.28. efficient markets hypothesis).
  • 3. 84 ST. JOHNS LAWREVIEW [vo1.78:81 2004 LESS THAN EFFICIENT CAPITAL MARKETS 85 But a s we set forth herein, a court’s journey through over 30 required of plaintiffs, a s it might dramatically and forcefully years of “efficient capital markets” and “fraud on the market” assist a court in certifying, or not, a proposed class. dogma can be simplified by requiring plaintiffs who seek to rely Part I of this article discusses the plurality and dissenting on the presumption of reliance on a motion for class certification opinions in Basic u. Leuinson. Part I1 describes how courts since under Rule 23 to make some affirmative showing that the stock Basic have interpreted and viewed questions addressing whether at issue traded in a n “efficient market.”l4 Clearly one a particular stock a t issue traded in a n efficient market. Part 1 1 1 determinative inquiry here is analysis of the reaction of the turns its attention to the efficient capital markets hypothesis issuer’s stock price to corporate news and events to ascertain and review research that draws into question the underpinnings whether the stock price accurately and timely incorporates all of the efficient capital markets hypothesis. Part IV discusses If such publicly available i n f ~ r m a t i o n . ’ ~ it can be shown, a t the other tests of the efficient markets hypothesis. Part V applies very least, that the company’s stock price responded rapidly to many of the lessons of behavior finance to the Internet bubble. news and unexpected information and was not overly volatile in Finally, Part VI argues that given the “less than” efficient the absence of such news these would be important, and perhaps capital markets hypothesis for certain categories or classes of even compelling, indicators of a n efficient market.16 If, on the stock, plaintiffs should be required to earn their rebuttable other hand, a showing is made that the company’s stock price is presumption of reliance by at least making some concrete “random” in response to fundamental information and showing, through a price reaction analysis, that the stock upon inexplicably “volatile” when there is no change in fundamentals, which they are suing behaved in a n “efficient” manner, by then a finding might resultantly be made that such stock did not responding rapidly to corporate news and events and performing trade in a n efficient manner during the class period. I n fact, this a s finance theory would predict in the absence of such. type of showing is neither unfamiliar to the plaintiffs’ bar nor the defense bar for that matter. Because current securities law I. DISSECTING v. BASIC LEVINSON principles under Rule 23 place the burden to show the presumption of reliance exists in any set of facts warranting A. The Plurality Opinion class certification on the plaintiff,17 this analysis should be I n Basic, the Supreme Court was presented with a decision of the United States Court of Appeals for the Sixth Circuit, which affirmed the grant of class certification in favor of a class ~~ of Basic Incorporated (“Basic”) stockholders.18 l4 See I n re Accelr8 Tech. Gorp. Sec. Litig., 147 F. Supp. 2d 1049, 1056 (D. Colo. 2001) (“Plaintiffs who invoke the ‘fraud on the market theory’ have the burden of The stockholders brought their claims against Basic, its establishing the securities were traded on a n efficient market.”) (citations omitted). directors and its officers under section lo@) and Rule lob-5 of ‘ 5 In one of the leading cases on point in this area, Cammer u. Bloom, the court the Securities Exchange Act of 1934 (“1934 Act”). The stated that the timely price reaction of a company’s stock to public information is the “essence of a n efficient market and the foundation for the fraud on the market stockholders claimed they were injured by selling their shares in theory.” Camrner, 711 P. Supp. at 1287. Basic a t artificially depressed prices after the company denied See, e.g., Krogman v. Sterritt, 202 F.R.D. 467, 477 (N.D. Tex. 2001) that it was in merger negotiations with another company.19 The (concluding that the plaintiffs’ failure to demonstrate a relationship between district court granted plaintiffs’ motion for class certification. I n changes in the stock price and news disclosures “weigh[ed] heavily against a finding of market efficiency”). doing so, it “adopted a presumption of reliance by members of 17 See generally Stirman v. Exxon Gorp., 280 F.3d 554, 562 (5th Cir. 2002) (“The the plaintiff class upon [Basic’s] public statements that enabled party seeking [class] certification hears the burden of demonstrating that the rule 23 requirements have been met.”); I n re Am. Med. Sys., Inc., 75 F.3d 1069, 1079 (6th Cir. 1996) (“The party seeking the class certification hears the burden of proof. 1” Basic Inc. v. Levinson, 485 U.S. 224, 229 (1988). Subsection (a) of [rlule 23 contains four prerequisites which must all he nict before a 19 Id. a t 228. We limit ourselves here to the Basic Court’s discussion of the class class can be certified. . . .[T]he party seeking certification must also demonstrate certification issues in the case. I t is important to note that the Court was also that it falls within a t least one of the subcategories of [r]ule 23(h).”) (internal presented with the issue of whether the company’s merger discussions were citations omitted). “material” under the securities laws. Id. at 240-41.
  • 4. 86 ST. J O H N S LAWREVIEW vo1.78:81 20041 LESS THAN EFFICIENT CAPITAL MARKETS 87 the court to conclude that common questions of fact or law by the fraud-on-the-market theory provided a practical predominated over particular questions pertaining to individual resolution to the problem of balancing the substantive plaintiffs.”20 The Sixth Circuit followed several other circuits in requirement of proof of reliance in securities cases against the recognizing the “fraud-on-the-market-theory’’ a s creating a procedural requisites of [Federal Rule of Civil Procedure] 23.”27 rebuttable presumption that the stockholders relied on Basic’s Here, the Court commented that alleged material misrepresentations, and accordingly affirmed [rjequiring a plaintiff to show a speculative state of facts, i.e., the decision of the district court.21 how he would have acted if omitted material information had Upon review, the Supreme Court first made it clear that it been disclosed, or if the misrepresentation had not been made, was not terribly interested in formally reviewing the would place an unnecessarily unrealistic evidentiary burden on underpinnings of the efficient capital markets hypothesis, the the [rlule lob-5 plaintiff who has traded on an impersonal backbone of the fraud on the market theory. Without a great market. deal of deliberation, the Court acknowledged the rationale of Arising out of considerations of fairness, public policy, and other courts t h a t the fraud on the market theory was valid in probability, as well as judicial economy, presumptions are also light of the nature of the U S . securities markets.22 It stated that useful devices for allocating the burdens of proof between it “need not determine by adjudication what economists and parties. The presumption of reliance employed in this case is social scientists have debated through the use of sophisticated consistent with, and, by facilitating [rlule lob-5 litigation, statistical analysis and the application of economic theory.”2:j supports, the congressional policy embodied in the 1934 Act.28 The Court noted t h a t “[tlhe modern securities markets, literally Finally, the Basic Court commented upon the rebuttable involving millions of shares changing hands daily, differ from the nature of the presumption. I n general, the Court commented face-to-face transactions contemplated by early fraud cases, and that “[alny showing that severs the link between the alleged our understanding of Rule lob-5’s reliance requirement must misrepresentation and either the price received (or paid) by the encompass these differences.”24 Looking to several decisions of plaintiff, or his decision to trade at a fair market price, will be the lower courts, and “[rlecent empirical studies,” the Court also sufficient to rebut the presumption of reliance.” 29 According to accepted the efficient markets hypothesis and its proposition the Court, the presumption could be rebutted by showing, for that “the market price of shares traded on well-developed example, that (1)the market makers were privy to the truth, and markets reflects all publicly available information, and, hence, thus the market price would not have been affected by any any material misrepresentations.”25 alleged misrepresentation, or by showing (2) that the plaintiffs The Basic Court then turned its attention to whether a divested themselves of shares in the company without relying on “presumption of reliance” created by the fraud on the market the integrity of the market.3” theory was proper in circumstances where direct proof is lacking.26 The Court noted, and apparently acknowledged, the B. The Dissenting Opinion district court’s finding that the “presumption of reliance created Justice White wrote the dissenting opinion in Basic. He inherently recognized the potential problems that may result when courts are asked to intermingle legal concepts with 20Id. at 228. economic theories. Those problems, he stated, are many. Justice 2lId. at 229. 22 See id. at 243-44. White first expressed apprehension that the majority’s decision 23 Id. at 246-41 n.24. went too far beyond the Court’s previous holdings in fraud cases 24 Id. at 243-44. 2s Id. at 246. The Court further commented, “It has been noted that ‘it is hard to imagine that there ever is a buyer or seller who does not rely on market inlegrity. 27 Id. at 242 (alteration in original) (internal citations and quotes omitted). Who would knowingly roll the dice in a crooked crap game?’” Id. at 24G47 (quoting 28 Id. at 245 (internal citations omitted). Schlanger v. Four-Phase Sys., Inc., 555 F. Supp. 535, 538 (S.D.N.Y. 1982)). 29 Id. at 248. 26 Id. at 245. 3u Id. at 248-49.
  • 5. 88 ST. JOHNS LAW REVIEW [vo1.78:81 20041 LESS THAN EFFICIENT CAPITAL MARKETS 89 and then proposed that a change to the understanding of Rule 11. THELOWER INTERPRETATION COURTS’ OF BASIC lob-5’s reliance requirement-if proper at all-come from Congress, and not the A. Cammer v. Bloom Second, Justice White noted the potential for confusion A little over one year after Basic, Cammer u. Bloom36 was when trying to interpret the standard for market efficiency decided by the United States District Court for the District of announced by the majority.:j2 As Justice White said, the phrase “integrity of the market price” implies that a stock has a “true New Jersey. Cammer was a securities fraud class action brought value” that is measurable by some definable standard and upon under sections 1O(b) and 20(a) of the 1934 Act against a company called Coated Sales, Inc. (“Coated Sales”) and its officers and which investors always rely in making their investment decision.33 Justice White then observed that investment directors. The action was brought shortly after Coated Sales decisions are often made due to perceptions by investors that a filed for bankruptcy after it announced to the public that it stock price “inaccurately reflects” the underlying value of the overstated its financial condition for the previous two years.“7 As corporation, and furthermore predicted (rather clairvoyantly, noted by the court in Cammer, Coated Sales’s publicly held given later research discussed below) that securities were “not listed on a national exchange, but instead [were] traded in the ‘over-the-counter’market. . . and listed on” [i]f investors really believed that stock prices reflected a stock’s NASDAQ.“* “value,”many sellers would never sell, and many buyers never buy (given the time and cost associated with executing a stock The auditor’s motion to dismiss, among other things, transaction). As we recognized just a few years ago:
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