Exhibit 69: Efficient Capital Markets, the Crash, and the Fraud on the Market Theory (Dkt. 567-69, S.D. Fla.)
Summary
Exhibit 69 (Document 567-69) in Case 1:21-md-02989-CMA, entered on the FLSD docket June 7, 2023, an 18-page copy of a law review essay, Efficient Capital Markets, the Crash, and the Fraud on the Market Theory by Daniel R. Fischel, from 74 Cornell L. Rev. (1988-1989). The essay states that the fraud on the market theory, developed in class actions under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, shifted the focus from the individual plaintiff to whether a challenged disclosure affected the market as a whole. It describes the theory's use in securities fraud litigation, analyzes the effect of the October 1987 stock market crash and the Supreme Court decision in Basic Inc. v. Levinson, and concludes that the crash provides no basis for rejecting the theory.
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- 2023-06-07
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“Exhibit 69: Efficient Capital Markets, the Crash, and the Fraud on the Market Theory (Dkt. 567-69).”
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Case 1:21-md-02989-CMA Document 567-69 Entered on FLSD Docket 06/07/2023 Page 1 of
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Exhibit 69
Case 1:21-md-02989-CMA Document 559-36
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EXHIBIT 34
21-md-02989-CMA Document 559-36
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EFFICIENT CAPITAL MARKETS, THE CRASH,
AND THE FRAUD ON THE MARKET
THEORY
Daniel R. Fischelt
An individual asserting a common law fraud claim must prove
reliance on the challenged misstatement. Proof focuses on the ef-
fect of the challenged statement on the individual bringing the
claim. The fraud on the market theory, developed in class action
litigation under section 10(b) of the Securities Exchange Act of
1934,1 and its accompanying Rule lOb-5, 2 has shifted the focus from
the individual plaintiff to whether a challenged disclosure affected
the market as a whole.
The fraud on the market theory has revolutionized securities
fraud litigation. It has also been of particular interest to scholars
because courts have expressly based their acceptance of the theory
not on the legislative history of the securities laws but rather on the
3
academic support for the efficient markets hypothesis. Many be-
lieve, however, that the stock market crash of October 1987 has cast
doubt on the concept of efficient capital markets. Thus it is useful to
examine the relationship between the efficient markets hypothesis
and the crash and the continuing validity of the fraud on the market
theory after the crash. That is the purpose of this essay.
I begin in Part I with a brief description of the use of the fraud
on the market theory in securities fraud litigation and the develop-
ment of the theory in the courts. In Part II, I analyze the effect of
the October 1987 stock market crash on the concept of efficient cap-
ital markets and the fraud on the market theory. Finally, in Part III,
I analyze certain aspects of the recent Supreme Court decision in
Basic Inc. v. Levinson 4 where the Court endorsed the theory by a vote
of four to two with three Justices not participating.
t Lee and Brena Freeman Professor of Law, The University of Chicago; Professor
of Law and Business, The University of Chicago Graduate School of Law and Business.
1 15 U.S.C. § 78j(b) (1982).
2 17 C.F.R. § 240.10b-5 (1987).
3 See, e.g., In re LTV Sec. Litig., 88 F.R.D. 134, 144 (N.D. Tex. 1980) (citing stud-
ies). For academic commentary on the fraud on the market theory, see Black, Fraudon
the Market: A Criticismof Dispensingwith Reliance Requirements in Certain Open Market Transac-
tions, 62 N.C.L. REv. 435 (1984); Fischel, Use of Modern Finance Theory in Securities Fraud
Cases Involving Actively Traded Securities, 38 Bus. LAw. 1 (1982); Note, The Fraud-on-the-
Market Theory, 95 HARV. L. REV. 1143 (1982).
4 108 S. Ct. 978 (1988).
907
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I
THE FRAUD ON THE MARKET THEORY
A. The Use of the Theory in Securities Fraud Litigation
Plaintiffs in securities fraud litigation initially advanced the
fraud on the market theory in seeking to satisfy the reliance require-
ment for purposes of class certification. The relationship between
the theory and the reliance requirement is straightforward. Most
investors do not read the documents or hear the speech alleged to
contain disclosure defects. Interpreting the reliance requirement to
mean that investors actually be familiar with the challenged state-
ment makes it difficult for most investors to satisfy the requirement.
Additionally, the need for detailed individual inquiry into which in-
vestors relied on the challenged statement decreases the probability
that any proposed class will satisfy the commonality requirement
necessary for class certification.
The fraud on the market theory avoids these problems by inter-
preting the reliance requirement to mean reliance on the integrity of
the market price rather than reliance on the challenged disclosure.
By interpreting the requirement in this manner, lack of familiarity
with the challenged disclosure becomes irrelevant. Instead the rele-
vant issue becomes the effect of the challenged disclosure on the
market price or, in the jargon of securities litigation, whether the
challenged disclosure artificially inflated (deflated) the market price
of the particular security. Inquiry into whether the market price was
inflated (deflated) replaces individualized inquiry into the extent to
which particular investors were aware of a challenged disclosure.
Moreover, this new inquiry goes to the merits of the case and is not
decided at the class certification stage. Thus, the development of
the fraud on the market theory has effectively eliminated the reli-
ance requirement as a barrier to class certification.
The extent to which the fraud on the market theory represents
a departure from the common law fraud model, however, should
not be exaggerated. Even at common law, a plaintiff must show
more than mere reliance on a misstatement; he must show objec-
tively reasonable reliance. The fraud on the market theory can be
interpreted as defining whether an individual's reliance was reason-
able under the ultimate objective standard-whether investors as a
whole were fooled.
Apart from the proper interpretation of the reliance require-
ment, the fraud on the market theory has other important implica-
tions in securities fraud litigation. Market professionals obtain
information about particular securities from multiple sources.
These sources include disclosures by the firm, analyst reports, and
stories in the trade and financial press. For this reason, the extent
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EFFICIENT CAPITAL MARKETS 909
to which a challenged disclosure results in an artificial inflation of
price-a fraud on the market-cannot be determined solely by ref-
erence to the accuracy of the disclosure itself. Market participants
may have learned the truth from other sources. Analogously, if fi-
nancial results are questioned, it is not sufficient to determine
whether the results were reported according to conventionally ac-
cepted accounting principles. Investors may see through incorrect
accounting or again figure out the truth from other sources of infor-
mation. In this event, no injury occurs because market participants
have not been fooled-there has been no fraud on the market.
Thus, the fraud on the market theory has profound implications
for securities fraud litigation far beyond reformulation of the reli-
ance requirement. The fundamental question in securities fraud liti-
gation is whether a challenged disclosure has caused investors to
suffer an injury and if so, by how much. This question can be recast
as whether a fraud on the market has occurred and if so, to what
extent. Indeed, inquiry into materiality, causation, and damages, as
well as reliance, is subsumed into the question of whether, and to
5
what extent, a fraud on the market has occurred.
The importance of the fraud on the market theory is best illus-
trated by an example. Suppose that on February 1, 1983, an Ameri-
can company, Waste, Inc., announces that it has entered into a
contract with the government of Saudi Arabia for the provision of
waste management services. The press release states that Saudi
Arabia will pay Waste, Inc. $1 billion over a three year period. The
contract also contains a provision allowing the Saudis to terminate
for convenience; this provision is not disclosed in the press release.
On December 1, 1983, the Saudis terminate the contract. On De-
cember 2, Waste, Inc.'s stock price is $20 as compared with $30
before the announcement of the contract on February 1. Plaintiffs
file a class action lawsuit under the securities laws alleging that the
failure to disclose the termination provision was materially mislead-
ing and resulted in Waste, Inc.'s stock price being artificially inflated
by $10, the difference between $30 and $20.
The fraud on the market theory enables the plaintiffs to satisfy
the reliance requirement without proving that investors read the
press release. Instead, plaintiffs need only allege that they relied on
the integrity of the market price which was artificially inflated by the
materially misleading press release. But, as discussed above, be-
cause the theory shifts emphasis to the effect of the challenged dis-
closure on the market as a whole, rather than on particular plaintiffs,
5 This point is discussed at length in Fischel, supra note 3.
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the impact of the theory extends far beyond the reliance
requirement.
Plaintiffs in this hypothetical lawsuit contend that investors
were fooled by the absence of explicit disclosure of the termination
provision in the press release. Whether investors were in fact fooled
by the alleged omission-whether the omission was material-can
be tested directly, however, by analyzing relevant stock price move-
ments and other information available to investors. If on March 1 a
second press release disclosed the termination provision and Waste,
Inc.'s stock price fell (did not fall) by a statistically significant
6
amount, then the omission was probably (probably not) material.
Analysis of other sources of information also sheds light on the ma-
teriality issue. The more (less) widespread the understanding in
analysts reports and the financial press that the Saudis had the right
to terminate, the less (more) likely the alleged omission was
material.
Analysis of stock price movements also makes it possible to test
whether the decline in Waste, Inc.'s stock price was caused by the
disclosure of the termination provision allegedly withheld in the
original process release, or whether other factors were responsible
for the decline. Any stock price movement attributable to disclosure
of the termination provision can be calculated as damages 7 provided
the information could have been disclosed in the original press re-
lease and the other requirements of the securities laws are satisfied.8
Conversely, stock price movements attributable to other factors
should be excluded from damages.
B. The Relationship Between the Fraud on the Market Theory
and Efficient Capital Markets
The efficient capital markets hypothesis posits that stock prices
quickly reflect information without bias. The three forms of the hy-
6 Note that the price reaction to disclosure of termination of the contract, even if
statistically significant, does not establish the materiality of the failure to disclose the
termination provision. The reason is that the certainty of cancellation is a different piece
of information than the possibility of termination. Even if the market as a whole was
fully aware of the possibility of termination, disclosure of actual termination could cause
Waste, Inc.'s stock price to decline.
7 Although it is customary to calculate damages in securities fraud cases in this
manner, an argument could be made that damages should focus on disgorgement of the
gains obtained by those perpetrating the fraud rather than on losses suffered by certain
investors. For a discussion of the choice between disgorgement versus loss-based meas-
ures of damages, see Easterbrook & Fischel, Optimal Penaltiesfor Securities Offenses, 52 U.
CHi. L. REV. 611 (1985).
8 For example, plaintiffs will have to satisfy the scienter requirement-the require-
ment that the alleged omission be made with an intent to defraud or with extreme reck-
lessness tantamount to an intent to defraud. See Ernst & Ernst v. Hochfelder, 425 U.S.
185 (1976).
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CAPITAL MARKETS
pothesis differ on what type of information is reflected in prices: the
weak form of the hypothesis holds that past price movements are
incorporated in prices; the semi-strong form suggests that publicly-
available information is reflected in prices; and the strong form
posits that all information from whatever source is fully incorpo-
rated in prices. The empirical evidence to date (with some excep-
tions) appears to establish the validity of the weak and semi-strong
versions but not the strong form of the efficient capital markets
hypothesis. 9
The link between the concept of efficient capital markets and
the fraud on the market theory is clear. The central premise of the
fraud on the market theory is that prices of actively-traded securities
reflect publicly-available information. This premise is roughly
equivalent to the semi-strong version of the efficient capital markets
hypothesis. Not surprisingly, courts adopting the fraud on the mar-
ket theory have alluded to the empirical studies establishing the va-
lidity of the semi-strong version of the efficient capital markets
hypothesis for support. 10
To illustrate why the fraud on the market theory depends on
prices reflecting publicly-available information, consider a face-to-
face transaction where Smith offers to sell a piece of land in another
state to Jones for $1000. The potential purchaser, Jones, has no
reason to rely on the integrity of the $1000 price offered by Smith.
That price may or may not reflect information concerning the value
of the land. It is perfectly possible, for example, that market profes-
sionals believe the land is worth only $500 but the judgment of
these professionals will not be reflected in Smith's offer to Jones.
Now, consider the difference between the above example and a
transaction involving actively-traded securities. Market prices of ac-
tively-traded securities are much more likely to reflect relevant in-
formation about those securities because of the continuous buying
and selling decisions of investors. Thus if a consensus among mar-
ket professionals exists that a particular type of land owned by a
publicly-traded real estate company is worth a certain amount, this
consensus will be reflected in the company's stock price. Because
market prices of actively-traded securities do reflect publicly-avail-
able information, it is rational for many investors to accept the mar-
ket price as given. For the same reason, investors are harmed if they
purchase securities at prices which reflect false information as a re-
sult of disclosure defects.
9 For a useful summary of the theory and evidence, see Gilson & Kraakman, The
Mechanisms of Market Efficiency, 70 VA. L. REV. 549 (1984) (citing studies).
10 See, e.g., In re LTV Sec. Litig., 88 F.R.D. 134, 144 (N.D. Tex. 1980) (citing
studies).
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The critical difference between face-to-face transactions and
transactions involving actively-traded securities, in sum, is the pres-
ence or absence of reliable market prices reflecting information pos-
sessed by diverse sets of traders. Where such market prices exist, as
in the case of actively-traded securities, investors are protected by
purchasing (or selling) at the market price. Where such prices do
not exist, as in the case of face-to-face transactions, it is not reason-
able to rely on the offer price as incorporating relevant information
about the value of the underlying asset. While the difference be-
tween these two polar cases is fairly clear, there will be many situa-
tions that fall somewhere in the middle. No clear answer exists to
the question of how much and how quickly information has to be
incorporated into prices for the fraud on the market theory to apply.
The most that can be said is that the more rapidly prices reflect
publicly-available information, the more sensible it is to apply the
theory. Factors which will be relevant in analyzing how rapidly
prices reflect information include whether the security is listed on a
national exchange, whether it is actively traded, and whether it is
followed by analysts and other market professionals. In addition,
the speed of price adjustment to new information can be tested di-
rectly by use of widely-accepted statistical techniques.'" Neverthe-
less, there will inevitably be some marginal cases where the
applicability of the fraud on the market theory is unclear.
II
THE FRAUD ON THE MARKET THEORY AFTER THE CRASH
A dramatic unanticipated event always causes some reexamina-
tion of generally accepted wisdom; the crash is no exception. Thus,
it is worthwhile to examine the effect of the crash on the fraud on
the market theory. Before doing so, however, it is necessary to ana-
lyze the concept of efficient capital markets more carefully.
A. The Meaning of an Efficient Capital Market
Much of the discussion of efficient capital markets suffers from
ambiguity concerning what characteristics capital markets must sat-
isfy to be considered "efficient." At least two definitions of "effi-
cient" capital markets exist. The first, as discussed in Part I, focuses
on the speed with which market prices reflect publicly-available in-
11 For illustrative studies using statistical techniques to measure the speed of price
adjustment, see Dann, Mayers & Raab, Jr., Trading Rules, Large Blocks and the Speed of Price
Adjustment, 4J. FIN. ECON. 3 (1977);Jennings & Stark, Information Content and the Speed of
Stock Price Adjustment, 23 J. AccT. RES. 336 (1985); Patell & Wolfson, The Intraday Speed of
Adjustment of Stock Prices to Earnings and Dividend Announcements, 13 J. FIN. ECON. 223
(1984).
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17 913
formation and whether the price reaction to new information is
without bias. Under this definition, a market is efficient if it is im-
possible to devise a trading rule that systematically outperforms the
market (net of transaction costs) absent possession of inside infor-
mation. In this essay, I refer to this definition as "trading-rule effi-
ciency." There is general consensus that capital markets that list
12
actively-traded securities are trading-rule efficient.
The second definition of efficient capital markets focuses on the
extent to which security prices reflect the present value of the net
cash flows generated by a firm's assets. I refer to this definition of
efficiency as "value efficiency."
John Maynard Keynes originated the view that stock markets
are not value efficient because factors other than judgments con-
13
cerning the value of underlying assets influence security prices.
Keynes analogized the stock market to a beauty contest where trad-
ers, like those trying to predict the winner of a beauty contest, base
their decisions not only on what they think, but also on what they
believe others are thinking. Just as someone trying to predict the
winner of a beauty contest will consider his judgment of relative
beauty as well as his belief concerning how others will assess relative
beauty, Keynes argued, so too will traders consider their judgment
about the value of the asset and their beliefs about how others will
value the asset. This model of security prices as driven by the ex-
14
pectations of other traders has gained adherents in recent years.
Adherents of the expectations model face several logical diffi-
culties. First, why should the expectations of other traders be based
on anything other than their judgments concerning the present
value of future net cash flows? Second, why shouldn't it be assumed
that beliefs of traders who base their judgments on other factors are
random, thus cancelling each other out? As a response to these co-
nundrums, some economists have posited the existence of a class of
uninformed and unsophisticated traders who are influenced by fads,
mob psychology, and similar factors. 15 These uninformed or noise
traders who are motivated by factors other than the present value of
12 Some studies suggest that certain anomalous situations exist where it may be
possible to devise a trading rule and outperform the market. Examples of these anoma-
lies include the small firm effect, the low price earnings ratio effect, and the January
effect. Many of these anomalies seem to disappear, however, when risk and transactions
costs are taken into account. For a summary of the evidence, see T. COPELAND & J.
WESTON, FINANCIAL THEORY AND CORPORATE POLICY 221-48 (1983).
13 See J. KEYNES, THE GENERAL THEORY OF EMPLOYMENT, INTEREST AND MONEY
(1936).
14 For a summary of the literature in this area see C. CAMERER, BUBBLES AND FADS
IN ASSET PRICES: A REVIEW OF THEORY AND EVIDENCE (University of Pennsylvania Work-
ing Paper No. 87-09-03 1987).
15 Id.
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future net cash flows create the possibility of speculative bubbles
and other departures from pricing based on the underlying value of
assets. Additionally, because of these noise traders, prices can
change dramatically with a change in expectations-even with no
change in the value of the underlying assets. For these reasons, the
argument runs, noise traders prevent financial markets from being
value efficient.
Unfortunately, no direct method exists for testing how closely
prices reflect value because the "value" of an asset cannot be mea-
sured apart from its price. As a result, researchers have relied on
indirect tests such as attempting to determine whether the variabil-
ity of prices is greater than the variability of dividends over time. If
prices are more variable than dividends, it might be argued that
changes in prices cannot be explained by changes in underlying val-
ues and thus must be caused by noise traders. Thus far the results
and the interpretation of these studies have been extremely
controversial. 16
For the sake of argument, assume that noise traders affect
prices. The implications of this assumption for the concept of effi-
cient capital markets, however, and value efficiency in particular, are
still unclear. Value efficiency means that prices are typically the best
indicators of underlying values (at least absent inside information).
No evidence demonstrates that a better model exists for ascertain-
ing the value of a publicly-traded firm's assets than looking at the
prices of its securities.
The existence of noise traders who affect price does not imply
that such a model exists. Noise traders cause prices to reflect factors
such as mob psychology as well as underlying values. But so long as
market participants cannot determine how much noise is contained
in prices, knowing that prices reflect the expectations of noise trad-
ers will not lead to any superior method for ascertaining the under-
lying value of assets. In other words, the existence of noise traders
increases volatility but does not create any detectable upward or
downward bias in pricing. Prices are still the best indicators of value
even assuming that they are noisier signals because of psychologi-
cally motivated traders.
The existence of noise traders implies nothing about the valid-
ity of trading-rule efficiency. Unless market participants can deter-
mine how much noise is contained in price, and can predict how the
16 Compare Shiller, Do Stock Prices Move Too Much to beJustified by Subsequent Changes in
Dividends?, 71 AM. ECON. REV. 421 (1981) with Kleidon, Bias in Small Sample Tests of Stock
Price Rationality, 59J. Bus. 237 (1986); Kleidon, Variance Bounds Tests and Stock Price Valua-
tion Models, 94 J. POL. EcON. 953 (1986) and Marsh & Merton, Dividend Variability and
Variance Bounds Tests for Rationality of Stock Market Prices, 76 AM. ECON. REV. 483 (1986).
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EFFICIENT CAPITAL MARKETS 915
expectations of noise traders will change in the future, the existence
of noise traders does not create a profitable trading rule. It is one
thing to believe in speculative bubbles after prices have fallen; it is
quite another to recognize one at the time.
In sum, the current debate over the relationship between noise
traders and the concept of efficient capital markets is really a variant
of the familiar Nirvana fallacy of comparing the imperfect to the
ideal and concluding that the ideal dominates. The relevant ques-
tion in determining whether capital markets are value efficient is not
whether noise traders exist but rather whether there is a better
proxy than market prices for the underlying value of a publicly-
traded firm's assets. Or, to put the point differently, it takes a theory
to beat a theory and thus far none exists.
One final caveat. I do not mean to suggest that prices are always
the best predictor of underlying values or that there is never any
role for other methods of valuation such as discounted cash flow
analysis. Analysts and other market professionals constantly search
for mispriced securities where prices do not reflect information con-
cerning value. It is even possible that the premium paid in some
takeovers or going private transactions occurs because prices do not
reflect underlying values and this is discovered by resort to other
valuation techniques.' 7 That these valuation techniques are profita-
bly used, however, is in no way inconsistent with the critical role of
market prices as a proxy for underlying values. Indeed, the constant
search by market professionals for mispriced securities is the mecha-
nism whereby prices reflect information about underlying values.
And, to emphasize again, the critical question is not whether market
prices are always a perfect proxy for the underlying value of assets
but whether a better proxy exists on a consistent basis. Thus far the
answer to this critical question is no.
B. The Crash and Efficient Capital Markets
On October 19, 1987, the DowJones Industrial Average fell by
508 points or 22 percent. For the slightly longer period between
the close of trading on October 13, 1987, and the close on October
19, 1987, the Dow fell 769 points or 31 percent. To date, no con-
vincing explanations of this dramatic decline exist. The dramatic
nature of the decline, coupled with the absence of any convincing
explanation for it, has led many to suggest that the crash calls into
question the continuing validity of the efficient capital markets
hypothesis.
17 The evidence demonstrates, however, that undervaluation is not a convincing
explanation for most corporate control transactions. See Bradley, Desai & Kim, The Ra-
tionale Behind Interfirm Tender Offers: Information or Synergy, 11 J. FIN. ECON. 185 (1983).
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It is not obvious, however, why this should be true. Consider
the first type of efficiency, trading rule efficiency. Nobody has ar-
gued that the crash created a profitable trading rule that did not
exist before. Both before and after the crash, prices appeared to
incorporate publicly-available information, making it highly unlikely
that a profitable trading rule would exist.
Now consider value efficiency. Admittedly, the absence of any
new information concerning the value of assets in the economy that
can plausibly explain the stock market crash is frustrating.1 8 On the
other hand, economists are still arguing about why the stock market
crashed in 1929, so it is hardly surprising that no obvious explana-
tion exists for the crash of 1987. Moreover, the mystery of what
caused the 1987 crash poses the same problem for those who hold
the expectation-driven Keynesian view of the stock market. Just as
there does not appear to be any new information concerning the
value of assets that can plausibly explain the stock price decline, nor
does there appear to be any new information concerning the psy-
chology or expectations of other traders. Finally, and most impor-
tantly, the crash does not imply that any better model exists for
determining security prices than the present value of future cash
flows generated by a firm's assets. For this reason, the crash, prop-
erly interpreted, has no implications for value efficiency, or, more
generally, for the concept of efficient capital markets.
Several other points about the crash should also be made.
First, as documented by Richard Roll,1 9 the worldwide nature of the
crash is inconsistent with various popular explanations which attri-
bute the crash to program trading, futures markets, portfolio insur-
ance, and similar institutional arrangements that exist only in a few
markets. Second, the fact that prices fluctuated around the post-
crash level for an extended period of time suggests that the crash
was not an overreaction but a movement to a new equilibrium level.
This is desirable whether the crash was caused by a change in funda-
mentals or a bursting of a speculative bubble. Thus, regulatory pol-
icies designed to prevent prices from falling in a similar manner in
the future appear to be misguided. Indeed, under the speculative
bubble theory, the problem is the gradual price rise during 198720
18 For an argument that the crash is consistent with the traditional understanding
of efficient capital markets even if the cause of the crash cannot be identified, see Fama,
Perspectives on October 1987, or, What Did We Learn From the Crash, in BLACK MONDAY AND
THE FUTURE OF FINANCIAL MARKETS 71 (R. Kamphuis, R. Kormendie and J.W. Watson
eds. 1989).
19 See Roll, The InternationalCrash of October 1987, in BLACK MONDAY AND THE FUTURE
OF FINANCIAL MARKETS 35 (R. Kamphuis, R. Kormendie and J.W. Watson eds. 1989).
20 On August 25, 1987, the Dow Jones Industrial Average reached a record high
close of 2,722, having risen by more than 40% during the year.
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before the crash, not the crash itself. I am unaware of any regula-
tory proposals, however, that have as their goal the elimination of
gradual price rises in the future.
C. The Crash and the Fraud on the Market Theory
The above discussion of market efficiency and the crash shows
that the crash does not provide a basis for rejecting the fraud on the
market theory. That American capital markets where publicly-
traded securities are listed are trading-rule efficient is a proposition
that was generally accepted before the crash and has not been ques-
tioned since. This means that before and after the crash, publicly-
available information, including false information, is incorporated in
stock prices with the corollary that investors who purchase (sell) at
artificially inflated (deflated) prices are injured. This is true whether
or not prices reflect noise created by the expectations of other
traders.
The implications of the theory for materiality, causation, and
damages are also unaffected by the crash. The reason is that the
effect of an alleged disclosure defect on price can be analyzed with-
out having to resolve the extent to which noise traders affect price.
For example, one could confidently conclude that the stock price
decline on October 18, 1987 of any particular security was in all
probability not caused by the revelation of a fraud, but rather by the
collapse of the market as a whole, without having to resolve whether
the crash was caused by new information concerning fundamentals
or the bursting of a speculative bubble. The same would be true in
cases involving other alleged speculative bubbles. Thus it would be
relevant in a hypothetical securities suit against a hula-hoop com-
pany, which first sold at significant multiples of earnings and then
went bankrupt, that other hula-hoop companies also cratered when
the public lost its taste for the companies' product. In short, by ana-
lyzing the timing of stock price movements both in response to par-
ticular pieces of information and in comparison with those of other
firms, it is possible to identify factors influencing stock price move-
ments other than alleged disclosure defects even if the factors them-
selves are not understood completely.
III
BASIC INC. v. LEVINSON
In Basic Inc. v. Levinson,2 1 a plurality of the United States
Supreme Court in an opinion written by Justice Blackmun held that
courts should apply a rebuttable presumption that investors in pub-
21 108 S. Ct. 978 (1988).
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lic securities markets rely on the integrity of the market price. 2 2 Jus-
tice White, joined by Justice O'Connor, dissented; 23 three Justices
did not participate. 24 Thus, a majority of the Court has not yet
passed on the validity of the fraud on the market theory creating the
possibility that the Court might consider the issue again in the near
future. For this reason, it is particularly appropriate to examine the
arguments of the two dissenting Justices who criticized application
of the theory in securities cases. The dissent's three principal argu-
ments are discussed below.
A. The Claim that the Fraud on the Market Theory is an
Investor Insurance Scheme
The plurality opinion emphasized that courts should apply a re-
buttable, not conclusive, presumption that investors relied on the
integrity of the market price: "Any showing that severs the link be-
tween 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." 2 5 The
plurality discussed situations where the market price was not artifi-
cially inflated because the truth was available from other sources,
and situations where investors would have traded anyway regardless
of price as examples where the link would be severed and the pre-
26
sumption of reliance rebutted.
The two dissenting Justices agreed with the plurality that the
presumption of reliance should be rebuttable, but argued that "such
rebuttal is virtually impossible in all but the most extraordinary
case." 2 7 Since the presumption will for all practical purposes be
non-rebuttable, the dissent concluded that the plurality's endorse-
ment of the fraud on the market theory would operate as "an inves-
28
tor insurance scheme."
The dissent correctly doubted the probability of rebutting the
presumption of reliance. Consider the two situations where the plu-
rality stated the presumption would be rebutted. In the first situa-
tion where the market price is not artificially inflated because the
truth becomes known from other sources, it is inaccurate to suggest
that the presumption of reliance is rebutted. In fact, the example
has nothing to do with reliance. Investors do not rely any less on
the market price because that price has not been artificially inflated.
22 Id. at 991.
23 Id. at 993 (White, J., concurring in part and dissenting in part).
24 Id.
25 Id. at 992.
26 Id.
27 Id. at 996 n.7 (White, J., concurring in part and dissenting in part).
28 Id. at 996.
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It would be more accurate to characterize this situation as one
where no fraud on the market occurred.
The second example used by the plurality-investors believe
the market price is artificially inflated but transact anyway-is con-
ceivable but extremely unlikely. Purchasing (selling) securities at ar-
tificially inflated (deflated) prices means that the investment has a
negative expected return. The number of situations where investors
expect to lose money but transact anyway notwithstanding the
29
plethora of alternative investments is surely going to be trivial.
Thus the presumption of reliance, as the dissent claimed, is for all
practical purposes non-rebuttable.
Nevertheless, it does not follow that an effectively non-rebutta-
ble presumption of reliance creates investor insurance. Investors'
ability to claim that they relied on the integrity of the market price
helps to obtain class certification but in no way establishes the mer-
its of the underlying claim. Plaintiffs must still establish that the al-
leged disclosure defect artificially inflated the market price and, if
so, by how much. Given the multiple alternative sources of informa-
tion and the sophistication of market professionals, this task will fre-
quently be difficult even if plaintiffs can establish that less than a
model disclosure was made. Thus, the fraud on the market theory
in no way creates an investor insurance scheme when all of the the-
ory's implications are considered.
B. The Claim that the Fraud on the Market Theory is
Logically Inconsistent
The dissent further argued that the fraud on the market the-
ory's reliance on the integrity of the market price as a reflection of
value is logically flawed. The difficulty with this concept, according
to the dissent, is that "it implicitly suggests that stocks have some
'true value' that is measurable by a standard other than their market
price." 30 Moreover, the dissent argued that even if securities have
some "value" apart from market price, investors do not always as-
sume that a stock's price is a reflection of this value. Rather, the
dissent stressed, investors frequently base their investment decision
on a belief that stock prices do not reflect value perfectly. 3 ' Other-
29 For purposes of this point, it is useful to distinguish between purchases at in-
flated prices and sales at depressed prices. It is for all practical purposes inconceivable
that an investor would knowingly pay too much for a security given the infinite number
of alternative investments. In the sale situation, by contrast, it is conceivable that an
investor with limited access to capital markets might be forced to sell at too low a price
for liquidity reasons.
30 108 S. Ct. at 996 (White, J., concurring in part and dissenting in part).
31 Id.
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920 CORNELL LA W REVIEW
wise, in many cases particular stocks would not have been purchased
or sold.
These points are correct but have nothing to do with the fraud
on the market theory. The theory does not posit that there is some
"true value" of an asset other than its price. On the contrary, the,
theory assumes that market price is the best indicia of value which
makes it all the more important that this price not be distorted by
fraudulent information. For this reason, the theory is far superior to
other valuation methods sometimes used by courts in corporate and
32
securities litigation that ignore the critical role of market prices.
Similarly, the theory does not depend on the assumption that
all investors accept the market price as a perfect predictor of value
or, more accurately, future prices. Some investors search for mis-
priced securities. But any such search necessarily involves a com-
parison between current prices and expected future prices. For this
reason, these investors, like passive investors, rely on the integrity
of the market price as not distorted by fraud. Indeed, one of the
main economic justifications for antifraud rules is that such rules
minimize wasteful search.3 3 Thus there is no tension between the
existence of investors who do not accept the market price as a per-
fect predictor of future prices and the fraud on the market theory.
C. The Claim that the Fraud on the Market Theory is Judicial
Legislation Inconsistent with Congressional Intent
Finally, the dissent argued that the fraud on the market theory
represents an attempt "to reconfigure the securities laws, based on
recent economic theories," 34 particularly the efficient capital mar-
kets hypothesis. Moreover, the dissent stressed that the plurality's
willingness "to embrace novel constructions of a statute based on
contemporary microeconomic theory" 3 5 was particularly unfortu-
nate because the fraud on the market theory "is at odds with the
federal policy favoring disclosure" 3 6 embodied in the mandatory
disclosure system. Thus, the dissent concluded, the fraud on the
market theory should be adopted, if at all, by Congress and not the
federal courts.
This claim is misguided as well. Congress did not provide any
express private right of action under either section 10(b) or Rule
32 For a fuller discussion of this point, see, e.g., Fischel, The BusinessJudgment Rule
and the Trans-Union Case, 40 Bus. LAw. 1437 (1985); Fischel, The Appraisal Remedy in Corpo-
rate Law, 1983 AM. BAR. FOUND. REs. J. 875 (1983).
33 See Easterbrook & Fischel, Mandatory Disclosure and the Protectionof Investors, 70 VA.
L. REV. 669 (1984).
34 108 S. Ct. 995 (White, J., concurring in part and dissenting in part).
35 Id. at 994.
36 Id. at 997.
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lOb-5; courts have implied one. Thus, courts must decide what the
contours of this private right of action will be. Because Rule lOb-5
is an antifraud provision, courts have looked to the common law of
fraud for guidance. As discussed above, the fraud on the market
theory can be understood as an embodiment of the common law
requirement of reasonable reliance where reasonableness is defined
by the ultimate objective standard-whether the market as a whole
was fooled. All courts of appeals that have faced the question have
adopted some version of the fraud on the market theory. 3 7 Thus, it
is inaccurate to characterize the theory as a radical change in the
securities laws. The theory is judicial legislation only in the sense
that all interpretation of Rule 1Ob-5 is judicial legislation.
Nor is it accurate to suggest that federal courts should refuse to
embrace the theory because it is based on untested economic princi-
ples and assumptions. First, there is nothing unusual about eco-
nomic theories influencing legal doctrines. For example, the legal
understanding of the range of anticompetitive practices under the
antitrust laws is very much influenced by economic principles. In-
deed, it is hard to understand how antitrust law could be given any
content without reliance on economic theories. Moreover, the eco-
nomic premises underlying the fraud on the market theory are not
novel or untested. The opposite is true. As discussed above, there
is widespread consensus that the prices of actively-traded securities
quickly reflect publicly-available information. Whatever debate ex-
ists concerning the concept of efficient markets does not undermine
the logic of the theory.
Finally, the theory is not inconsistent with the federal policy
favoring disclosure embodied in the mandatory disclosure system.
The justification for the mandatory disclosure system is that firms
are the lowest cost producers of information about themselves and
may have inadequate incentives to disclose relevant information vol-
untarily.3 8 The fraud on the market theory does not weaken firms'
incentive to disclose accurate information to investors. Rather, the
theory penalizes fraudulent disclosures to the marketplace regard-
less of investors' familiarity with the particular challenged disclo-
sure. Moreover, the theory does not weaken investors' incentives to
search for mispriced securities for reasons other than detecting
fraud. Finally, to the extent that the theory eliminates the need to
become informed to be eligible for recovery if fraud is demon-
strated, this is desirable. No reason exists why investors should be
given incentives to invest resources to become informed solely for
37 Id. at 991 n.25 (collecting cases).
38 For a discussion of the costs and benefits of the mandatory disclosure system see
Easterbrook & Fischel, supra note 33.
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the purpose of being able to sue for securities fraud. On the con-
trary, the elimination of such incentives with the resulting avoidance
of expenditures is one of the benefits of the fraud on the market
theory.
CONCLUSION
The fraud on the market theory, explicitly premised on the con-
cept of efficient capital markets, has revolutionized securities fraud
litigation. The crash, properly understood, provides no basis for re-
jeciing the fraud on the market theory.
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