Saturday, October 19, 2013

A Possible Introduction to Fraud-on-the-Market Reliance

Stephen Davidoff recently posted a piece on DealBook entitled “A Push to End Securities Fraud Lawsuits Gains Momentum,” in which he notes that “Halliburton is asking the Supreme Court to confront one of the fundamental tenets of securities fraud litigation: a doctrine known as “’fraud on the market.’”  He goes on to provide a lot of interesting additional details, so you should definitely go read the whole thing, but I focused on the following:

In its argument, Halliburton is asking the Supreme Court to confront one of the fundamental tenets of securities fraud litigation: a doctrine known as “fraud on the market.” The doctrine has its origins in the 1986 Supreme Court case Basic v. Levinson. To state a claim for securities fraud, a shareholder must show “reliance,” meaning that the shareholder acted in some way based on the fraudulent conduct of the company. In the Basic case, the Supreme Court held that “eyeball” reliance — a requirement that a shareholder read the actual documents and relied on those statements before buying or selling shares — wasn’t necessary. Instead, the court adopted a presumption, based on the efficient market hypothesis, that all publicly available information about a company is incorporated into its stock price…. A group of former commissioners at the Securities and Exchange Commission and law professors represented by the New York law firm Wachtell, Lipton, Rosen & Katz have also taken up the cause. In an amicus brief, the group argues that, in practice, the Basic case has effectively ended the reliance requirement intended by the statute, something that is not justified. They rely on a forthcoming law review article by an influential professor, Joseph A. Grundfest of Stanford Law School. Professor Grundfest argues that the statute on which most securities fraud is based — Section 10(b) of the Exchange Act — was intended by Congress to mean actual reliance because the statute is similar to another one in the Exchange Act that does specifically state such reliance is required.

This got me to thinking about how I might introduce the fraud-on-the-market reliance presumption to students the next time I teach it.  This is what I came up with as a possibility:

Assume you know that a particular weather app is 100% accurate.  Assume also that you know all your neighbors check the app regularly.  If in deciding whether you need an umbrella you simply look out your window to see whether any of your neighbors are carrying one, rather than checking the weather app, are you not still actually relying on the weather app?  The fraud-on-the-market presumption of reliance effectively answers that question in the affirmative.  In the securities context it provides that instead of reviewing all publicly available disclosures when deciding to buy or sell securities, it is enough for you to simply “look out your window” at the market price because we assume the market price reflects the consensus equilibrium of all publicly available information.

One might protest that the plaintiff should still have to prove that all the neighbors are in fact checking the weather app, and this is in fact the case when we require plaintiffs seeking the benefits of the FOM presumption to prove the relevant market is efficient.  Alternatively, one might protest that the idea that the actions of your neighbors reflect well-enough the information provided by the weather app is questionable, but since Eugene Fama just won the Nobel prize in economics it might be an uphill battle to overturn the presumption on that basis.  Another objection might be that we don’t need the presumption because there are enough alternative mechanisms to hold corporate actors accountable for fraud, and it is certainly the case that when the Supreme Court adopted the FOM presumption, a large part of the rationale was the perception that there was a need for the presumption in order to facilitate actions that would otherwise never be brought in any form.  What I see as a possible obstacle to this approach is that, while one may debate whether the Roberts Court is in fact pro-business, I do believe it is concerned about appearing overly so – and authoring a decision that states we no longer need the FOM presumption because alternative corporate accountability mechanisms are working so efficiently strikes me as just throwing fuel on that fire when the Court could arguably reach the same result by continuing to tighten up class-action law generally.  Finally, one might object that the FOM presumption actually allows folks who just run out of the house without either checking the app or looking out their window to claim the presumption, but at least a partial answer to this objection is that the Basic decision itself provides that: “Any 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, will be sufficient to rebut the presumption of reliance,” Basic Inc. v. Levinson, 485 U.S. 224, 248 (1988), and this is typically understood to at least include plaintiffs who are, to continue the analogy, rushing out of the house because they don’t have time to grab an umbrella.

Obviously, the issues are ultimately more complicated than the foregoing suggests, but it is just intended to serve as an introduction, which can be expanded to account for more complicated matters as the discussion proceeds. I’d be curious to hear what readers think needs to be added/amended to make this introduction work.

Current Affairs, Financial Markets, Securities Regulation, Stefan J. Padfield, Teaching | Permalink


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