Exhibit 56: The "Less Than" Efficient Capital Markets Hypothesis: Requiring More Proof from Plaintiffs in Fraud-on-the-Market Cases (Dkt. 567-56, S.D. Fla.)
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Exhibit 56 (Document 567-56) in Case 1:21-md-02989-CMA, entered on the FLSD docket June 7, 2023, a 50-page copy of a law review article, The "Less Than" Efficient Capital Markets Hypothesis: Requiring More Proof from Plaintiffs in Fraud-on-the-Market Cases, by Paul A. Ferrillo, Frederick C. Dunbar and David Tabak, from 78 St. John's Law Review 81 (2004). The article states that Basic Inc. v. Levinson (1988) created a rebuttable presumption of reliance that class members may assert on a Rule 23(b)(3) class certification motion. It argues that courts should require plaintiffs seeking that presumption to make an affirmative showing that the stock traded in an efficient market, chiefly by analyzing how the stock price reacted to corporate news and events.
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Case 1:21-md-02989-CMA Document 567-56 Entered on FLSD Docket 06/07/2023 Page 1 of
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Exhibit 56
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THE "LESS THAN" EFFICIENT CAPITAL
MARKETS HYPOTHESIS: REQUIRING
MORE PROOF FROM PLAINTIFFS IN
FRAUD-ON-THE-MARKET CASES
PAUL A. FERRILLot, FREDERICK C. DUNBAR, PH.D.tt &
DAVID TABAK, PH.D.ttt
In 1988, the United States Supreme Court in Basic Inc. v.
Levinson' 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 an issuer. 3
This presumption allows aplaintiff, without any showing that he
or she actually read or heard amisrepresentation, to assert, on a
motion for class certification under Rule 23(b)(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 members. 4 The presumption
switches the burden to the defendant to "disprove actual
reliance." 5 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 Ferriflo is Of Counsel in the Business and Securities Litigation
Department of Well Gotahal & Manges, J.1.P in New York City.
fl Senior Vice President, NERA Economic Consulting.
fit Vice President, NERA Economic Consulting.
485 U.S. 224 (1988).
2 Reliance is one of the required elements of aclaim under section 10(b) of the
Securities and Exchange Act o. 1934. 15 U.S.C. §78j(b) (2003).
See Bask, 485 U.S. at 245.
Sec id, at 242.
Lipton v Documatian 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)).
6 See Bask, 485 U.S. at 250.
IMMO NNOW
a EXHIBIT
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82 ST. JOHN'S LAW REVIEW [Vol.78:81
capital markets hypothesis. Specifically, the plurality opinion
noted that:
"The fraud on the market theory is based on the hypothesis
that, in an open and developed securities market, the price of a
company's stock is determined by the available material
information regarding the company and its business....
Misleading statements will therefore defraud purchasers of
stock even if the purchas ers d o no t di rec tly rely on the
misstatements?' 7
The Basic Court was clear to note that the fraud on the
market's "rebuttable presumption of reliance" was indeed
rebuttable, and was conditioned upon, among other things, a
finding that the market for a particular stock was "impersonal
[and] well-developed?' 8 For example, it has been held that the
fraud on the market presumption could fail "where a defendant
shows that an 'individual plaintiff traded or would have traded
despite his knowing the statement was false,' or makes 'a]ny
showing that severs the link between the alleged
Id. at 241-42 (quoting Pail v. Speiser, 806 F.2d 1154, 1160 (3d Cir. 1986))
(alteration in original) It is interesting to note that in Pezl V. Speiser , the court
"affirmatively declined to specifically define the term 'open and developed market.'"
Cam mer v Bloom 711 F Supp 1264, 1276 (D NJ 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
securities is reflected nearly instantaneously, in the price of the stock
such that no individual can expect to gain a greater return from that
security than from any other security, and no individual can hope to
perform better than any other individual over the long term. The weak
form of the ECMH, by contrast, proposes that the price of the stock
eventually reflects publicly available information....
Semi-strong efficiency, which,.. [holds] that most information about a
company is reflected in its price fairly quickly, appears to be the form
assumed to exist by the United States Supreme Court in Baste
Kaufman V. i-Stat Corp., 754 A.2d 1188, 1198 (N.J. 2000) (internal citations
omitted); see infra Part III -
A. The definitions of the Kaufman court for the weak and
semi-strong form are actually not those universally accepted in financial economics,
See infra Part M. Other commentators have specifically defined some of the terms
underlying the fraud on the market theory. See, e.g., ALAN B. BROMBERG & LEWIs
B LOWENFELS, 3 BROMBERO AND LOWFNFELS ON SECURITIES FRAuD &
COMMODITIES FRAuD §8.6(641) (2d ed. 2003) [hereinafter BROMBEEG] (defining a
"developed market" as one "which has ahigh level of activity and frequency, and for
which trading information (e.g., price and volume) is widely available," and an
"efficient market" as "one which rapidly reflects new information in price").
8 See Basic, 485 U.S. at 247, 249 n.28.
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misrepresentation and either the price received (or paid) by the
plaintiff, or his decision to trade at afair market price.' "
In the years since the Supreme Court decided Basic, courts
have struggled with the fraud on the market theory, fashioning
their own theories, concepts, and tests to determine when astock
can be found to have traded in an "efficient" market.'° As the
case law has gotten arguably less cohesive, scholarship on the
efficient capital markets hypothesis has revealed empirical
anomalies and debatable assumptions calling for a more
complicated view of securities markets.
Consequently, rather than being supportive, recent research
into the efficient capital markets hypothesis has been critical at
best. Scholars have pointed to many holes in both the theory
and its predictions, including a lack of correlation in the price
movements of individual stocks to public announcements,"
"noise trading,"' 2 irrational investors, and the limits of arbitrage,
and have concluded, like the thesis of this article, that the
efficient capital markets hypothesis is sometimes less than
efficient for a given security.' 3 So, in sum, if courts have
struggled previously with "iridicia" of an efficient market in the
past, their task in the future could be even more complex as the
intellectual underpinnings of the fraud on the market theory
have come under attack.
9 Cramer Finance Ltd. v. Berger, 205 F.R.D. 113, 129 (S.DN.Y. 200 1) (internal
citations omitted); see Krogman v. Sterritt, 202 F.R.D. 467, 473 (N.D. Te. 2001) ("A
defendant may rebut [the fraud on the market] presumption by showing that the
stock price was unaffected by the fraud, or that the plaintiff would have made the
purchase regardless of the undisclosed information?') (citing Ziotnick v. TIE Comm.,
836 F.2d 818, 822 (3d Cir. 1988)).
0 See, e.g., Krogman, 202 F.R.D. at 474 (discussing additional factors
pertaining to market efficiency, such as "(1) the capitalization of the company; (2)
the bid-ask spread of the stock; and (3) the percentage of stock not held by insiders
(the 'float')" (internal citations omitted)); Camrner, 711 F. Supp. at 1286-87
(fashioning afive-part analysis for determining whether or not astock traded in an
efficient market).
11See Richard Roll, 11 2,43 J. FIN, 541, 557-61 (1988) (finding that aside from
issuers which are involved in takeovers or "major disasters," there is generally little
connection between volatility and company specific news releases).
12 Sec generally Fischer Black, Noise, 41 J. FIN. 529 (1986) (explaining that
"noise" in the market comes from "uncertainty about future demand and supply
conditions within and across sectors" and creates inefficiency),
13 See generally ANDREI SHLEIFER, INEFFICIENT MARKETS: AN INTRODUCTION
TO BEHAVIORAL, F1'-NCF 9-11 (2000) (discussing an alternative ,approach to the
efficient markets hypothesis).
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84 ST. JOHN'S LAWEEVIEW [Vol.78:81
But as we set forth herein, acourt's journey through over 30
years of "efficient capital markets" and "fraud on the market"
dogma can be simplified by requiring plaintiffs who seek to rely
on the presumption of reliance on amotion for class certification
under Rule 23 to make some affirmative showing that the stock
at issue traded in an "efficient market." 4 Clearly one
determinative inquiry here is analysis of the reaction of the
issuer's stock price to corporate news and events to ascertain
whether the stock price accurately and timely incorporates all
such publicly available inforrnation. 16 If it can be shown, at the
very least, that the company's stock price responded rapidly to
news and unexpected information and was not overly volatile in
the absence of such news these would be important, and perhaps
even compelling, indicators of an efficient market.' 6 If, on the
other hand, a showing is made that the company's stock price is
"random" in response to fundamental information and
inexplicably "volatile" when there is no change in fundamentals,
then afinding might resultantly be made that such stock did not
trade in an efficient manner during the class period. In fact, this
type of showing is neither unfamiliar to the plaintiffs' bar nor
the defense bar for that matter. Because current securities law
principles under Rule 23 place the burden to show the
presumption of reliance exists in any set of facts warranting
class certification on the plaintiff, 17 this analysis should be
14 See lit re Accelr8 Tech. Corp. Sec. Litig.. 147 F. Supp. 2d 1049, 1056 (D. Cob.
2001) ('Piainti.ffs who invoke the 'fraud on the market theory' have the burden of
establishing the securities were traded on an efficient market") (citations omitted).
I s In one of the leading cases on point in this area Cam iner u Bloom the court
stated that the timely price reaction of acompany's stock to public information is
the "essence of an efficient market and the foundation for the fraud on the market
theory." Cammer, 711 F. Supp. at 1287.
16 See, e.g., Krogman v. Sterritt, 202 F.R.D. 467, 477 (N,D. Tax. 2001)
(concluding that the plaintiffs' failure to demonstrate a relationship between
changes in the stock price and news disclosures "woigh(ed] heavily against afinding
of market efficiency").
17 See generally Stirman v. Exxon Corp., 280 F3d 554, 562 (5th Cir. 2002) ("The
party seeking [class) certification bears the burden of demonstrating that the rule
23 requirements have been met") In re Am. Med Sys Inc 75 F3d 1069, 1079 (6th
Cir, 1996) ("The party seeking the class certification bears the burden of proof.
Subsection (a) of [r]ule 23 contains four prerequisites which must all be Inst before a
class can be certified.. mhe party seeking certification must also demonstrate
. .
that it falls within at least one of the subcategories of [r]ule 23(b).") (internal
citations omitted).
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required of plaintiffs, as it might dramatically and forcefully
assist acourt in certifying, or not, aproposed class.
Part Iof this article discusses the plurality and dissenting
opinions in Basic u. Levinson. Part II describes how courts since
Basic have interpreted and viewed questions addressing whether
aparticular stock at issue traded in an efficient market. Part III
turns its attention to the efficient capital markets hypothesis
and review research that draws into question the underpinnings
of the efficient capital markets hypothesis. Part N discusses
other tests of the efficient markets hypothesis. Part V applies
many of the lessons of behavior finance to the Internet bubble.
Finally, Part VI argues that given the "less than" efficient
capital markets hypothesis for certain categories or classes of
stock, plaintiffs should be required to earn their rebuttable
presumption of reliance by at least making some concrete
showing, through a price reaction analysis, that the stock upon
which they are suing behaved in an "efficient" manner, by
responding rapidly to corporate news and events and performing
as finance theory would predict in the absence of such.
I. DISSECTING BASIC V. LEVINSON
A. The Plurality Opinion
In 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 aclass
of Basic Incorporated ("Basic") stockholders. 18
The stockholders brought their claims against Basic, its
directors and its officers under section 10(b) and Rule lOb-5 of
the Securities Exchange Act of 1934 ("1934 Act"). The
stockholders claimed they were injured by selling their shares in
Basic at artificially depressed prices after the company denied
that it was in merger negotiations with another company. 19 The
district court granted plaintiffs' motion for class certification. In
doing so, it "adopted a presumption of reliance by members of
the plaintiff class upon [Basic's] public statements that enabled
18 Basic Inc. v. Levinson, 485 U.S. 224, 229 (1988),
19Id. at 228. We limit ourselves here to the Bask Court's discussion of the class
certification issues in the case. It is important to note that the Court was also
presented with the issue of whether the company's merger discussions were
"material" under the securities laws. Id. at 240-41.
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86 ST. JOHN'SLAWREVIEW [Vol.78:81
the court to conclude that common questions of fact or law
predominated over particular questions pertaining to individual
plaintiffs."20 The Sixth Circuit followed several other circuits in
recognizing the "fraud-on-the-market-theory" as creating a
rebuttable presumption that the stockholders relied on Basic's
alleged material misrepresentations, and accordingly affirmed
the decision of the district Court. 21
Upon review, the Supreme Court first made it clear that it
was not terribly interested in formally reviewing the
underpinnings of the efficient capital markets hypothesis, the
backbone of the fraud on the market theory. Without a great
deal of deliberation, the Court acknowledged the rationale of
other courts that the fraud on the market theory was valid in
light of the nature of the U.S. securities markets. 2 It stated that
it "need not determine by adjudication what economists and
social scientists have debated through the use of sophisticated
statistical analysis and the application of economic theory.""- '
The Court noted that "[t]he modern securities markets, literally
involving millions of shares changing hands daily, differ from the
face-to-face transactions contemplated by early fraud cases, and
our understanding of Rule 10b-5's reliance requirement must
encompass these differences." 2" Looking to several decisions of
the lower courts, and "[r]ecent empirical studies," the Court also
accepted the efficient markets hypothesis and its proposition
that "the market price of shares traded on well-developed
markets reflects all publicly available information, and, hence,
any material misrepresentations." 25
The Basic Court then turned its attention to whether a
"presumption of reliance" created by the fraud on the market
theory was proper in circumstances where direct proof is
lacking. 26 The Court noted, and apparently acknowledged, the
district court's finding that the "presumption of reliance created
Id. at 228.
26
Id, at 229.
2&
22 See id. at. 243-44.
23 Id. at 246-47 n.24.
24 Id. at 243-44.
24 Id. at 246, The Court further commented, "It has been noted that 'it is hard
to imagine that there ever is abuyer or seller who does not rely on market integrity,
Who would knowingly roll the dice in acrooked crap game?'" id. at 246-47 (quoting
Schianger v, Four-Phase Sys., Inc., 555 F. Supp. 535, 538 (S.D.N.Y. 1982)).
26 Id, at 245.
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by the fraud-on-the-market theory provided a practical
resolution to the problem of balancing the substantive
requirement of proof of reliance in securities cases against the
procedural requisites of [Federal Rule of Civil Procedure] 23."27
Here, the Court commented that
[r]equiring aplaintiff to show aspeculative state of facts, i.e.,
how he would have acted if omitted material information had
been disclosed, or if the misrepresentation had not been made,
would place an unnecessarily unrealistic evidentiary burden on
the [r]ule lOb-5 plaintiff who has traded on an impersonal
market,
Arising out of considerations of fairness, public policy, and
probability, as well as judicial economy, presumptions are also
useful devices for allocating the burdens of proof between
parties. The presumption of reliance employed in this case is
consistent with, and, by facilitating [r]ule lob-5 litigation,
supports, the congressional policy embodied in the 1934 Act. 28
Finally, the Basic Court commented upon the rebuttable
nature of the presumption. In general, the Court commented
that "[a]ny 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." 29 According to
the Court, the presumption could be rebutted by showing, for
example, that (1) the market makers were privy to the truth, and
thus the market price would not have been affected by any
alleged misrepresentation, or by showing (2) that the plaintiffs
divested themselves of shares in the company without relying on
the integrity of the market.-'10
B. The Dissenting Opinion
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
economic theories. Those problems, he stated, are many. Justice
White first expressed apprehension that the majority's decision
went too far beyond the Court's previous holdings in fraud cases
" Id. at 242 (alteration in original) (internal citations and quotes omitted).
28 Id. at 245 (internal citations omitted).
29 leL at 248.
30 Id. at 248-49.
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88 ST. JOHN'S LAWREVJEW [Vol.78:81
and then proposed that a change to the understanding of Rule
10b-5's reliance requirement—if proper at all—come from
Congress, and not the Court. 3'
Second, Justice White noted the potential for confusion
when trying to interpret the standard for market efficiency
announced by the majority. 32 As Justice White said, the phrase
"integrity of the market price" implies that a stock has a "true
value" that is measurable by some definable standard and upon
which investors always rely in making their investment
decision. 33 Justice White then observed that investment
decisions are often made due to perceptions by investors that a
stock price "inaccurately reflects" the underlying value of the
corporation, and furthermore predicted (rather clairvoyantly,
given later research discussed below) that
[i]f investors really believed that stock prices reflected astock's
"value," many sellers would never sell, and many buyers never
buy (given the time and cost associated with executing astock
transaction). As we recognized just afew years ago: [I]nvestors
act on inevitably incomplete or inaccurate information,
[consequently] there are always winners and losers; but those
who have 'lost' have not necessarily been defrauded, 34
Justice White concluded that while the Court should not
"retreat" from the "many protections" afforded investors by prior
interpretations of section 10(b) and Rule lOb-5, movement
beyond such decisions towards "something closer to an investor
insurance scheme" should be the result of federal legislative
action. 3-5
' See id. at 253.-54 (remarking that "[ejven if. Iagreed with the Court that
modern securities markets.,. require that the understanding of [r]ul.e lab-5's
reliance requirement be changed," Justice White would still "prefer that such
changes come from Congress") (internal citations and quotes omitted).
' See id. at 252-53 (noting that without "staff economists [or] experts schooled
in the 'efficient-capital-market-hypothesis' nor any "ability to test the validity of
"
empirical market studies," courts are in poor position "to embrace novel
constructions of astatute based on contemporary microeconomic theory').
33 See id. at 255-56.
' Sec id. at 256 (alteration in original).
35 See id. at 256-57, 262-63 (further noting that the Court had "previously
recognized that 'inexorably broadening.., the class of plaintiff[s] who may sue in
this area of the law will ultimately result in more harm than good" and fearing that
"such a bitter harvest [was] likely to be... reaped from the seeds sewn by" the
majority's decision) Cmternai citations omitted).
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H. THE LOWER COURTS' INTERPRETATION OF BAsic
A. Cammer v. Bloom
A little over one year after Basic, Cammer u. Bloom 36 was
decided by the United States District Court for the District of
New Jersey. Cammer was asecurities fraud class action brought
under sections 10(b) and 20(a) of the 1934 Act against acompany
called Coated Sales, Inc. ("Coated Sales") and its officers and
directors. The action was brought shortly after Coated Sales
filed for bankruptcy after it announced to the public that it
overstated its financial condition for the previous two years.37 As
noted by the court in Cammer, Coated Sales's publicly held
securities were "not listed on a national exchange, but instead
[were] traded in the 'over-the-counter' market... and listed on"
NASDAQ. 38
The auditor's motion to dismiss, among other things,
specifically focused upon whether the plaintiffs coul d show
reliance in connection with their purchases of Coated Sales
securities. In fact, the court's decision noted that in earlier
proceedings, plaintiffs' counsel apparently conceded plaintiffs
could not show direct reliance. 39 Thus, it was incumbent upon
the parties to show, or rebut, reliance upon the fraud-on-the-
market theory. 4°
The court in Cammer quickly determined its challenge:
36 711 F. Supp. 1264 (D.N.J. 1989).
37 Sec Id, at 1270-71.
' Id. at 1271. As elaborated by the Cammer court later in its opinion, the
defendant auditor, among other things, pressed the argument that the fraud-on-the-
market theory was not available to the plaintiffs since the Coated Sales stock traded
as an over-the-counter security, rather than on a"national exchange." id. at 1280.
Thus the auditor's focus was on challenging the efficiency of the entire over-the-
counter market itself, rather than on the individual "market" for the Coated Sales
stock. The Caramer court went on to discuss the various arguments that certain
securities markets are inherently "inefficient" based upon the way the securities
trade and how stock prices are determined in such markets. See Id. at 1281-82. We
will not discuss herein the validity of this "market driven" argument other than to
say that the argument does exist, see, e.g., Krogman v Sterritt, 202 F.R.D. 467, 474
(N.D. Tex. 2001); Harman v. Lyphomed, Inc., 122 F.R.D. 522, 525 (N.D. Iii. 1988),
but was not given credence by the Cammer court. See also Krog,nan, 202 F.R.D. at
474 (noting "the majority of courts hold that the 'inquiry in an individual case
remains the development of the market for that stock, and not the location where
the stock trades.'") (quoting Harmon, 122 F.R. D. at 525).
° See Cammer, 711 F. Supp. at 1273 nJ2.
40 See id. at 1273-74.
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Although Peil [u. Speiser] makes it clear 'the fraud on the
market theory rests on the assumption that there is anearly
perfect market of information,' the Third Circuit affirmatively
declined to specifically define the term 'open and developed
market.' It stated that '[a]s the case at bar involves a widely
traded and established stock, we need not consider whether we
would apply the fraud on the market theory in other instances.'
This unanswered question in Peil goes to the heart of [the
auditor's] motion. 41
After reviewing the characteristics of the national trading
exchanges versus the over-the-counter market, the court
narrowed the issue further, remarking that the appropriate
inquiry focused on "whether market makers in the over-the-
counter market... provided a sufficiently fluid and informed
trading environment," thus allowing investors to make trading
decisions "at informed... bid and asked prices."42 The court
next discussed some of the factors that it considered relevant in
this analysis. Since they were important to the court in
Cammer, and continue to be important to other courts, we
discuss each of these factors in turn:
1. Eligibility to File an SEC Form S-3
In Camnier, the auditor claimed that because Coated Sales
was not eligible to file a Form S-3 during the class period, the
fraud-on-the-market theory should be inapplicable as amatter of
law, 43 Though not a dispositive factor, 44 the court considered
' Id. at 1276 (citations omitted).
42 Id. at 1282-83. In this regard, the plaintiffs proffered certain facts "relevant
to the market for Coated Sales stock,. "Among them
.
[1] Coated Sales stock was traded in an impersonal market involving
brokers, rather than in face to face transa ctions;
[2] During the Class Period, 19 million shares of Coated Sales stock were
outstanding, of which some 12 to 13 million shares were owned by non-
insiders of the Company...;
[3] Coated Sales stock was held by 1200 shareholders of record; . . .some 44
million shares of Coated Sales were traded, representing an average
weekly trading volume of 750,000 shares...;
[4]Coated. Sales had 11 marketmakers who issued competing price
quotations on the NASDAQ system..
[5) Coated Sales was the subject of substantial interest by analysts. At
least 15 research reports on the Company were issued, from July 1987
through June 1988.
Id, at 1283n.30.
43 The court noted earlier in its opinion that
[t]o be eligible to use Form S.3 in connection with an equity offering, an
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Form S-.3 eligibility important, and weighing in favor of market
efficiency, as the concept behind using the document to fulfill
disclosure obligations through "integration" or "incorporation by
reference" expressly assumed an underlying "efficient market"
for the security as issue. The court here quoted the SEC's
pronouncement that:
Under the proposed registration statement framework,
registrants would be classified into three categories: (1)
companies which are widely followed by professional analysts;
(2) companies which have been subject to the periodic reporting
system of the Exchange Act for three or more years, but which
are not widely followed; and (3) companies which have been in
the Exchange Act reporting system for less than three years.
The first category would be eligible to use proposed Form S-3,
which relies on incorporation by reference of Exchange Act
reports and contains minimal disclosure in the prospectus. The
form is predicated on the Commission's belief that the market
operates efficiently for these companies, i.e., that the disclosure
in Exchange, Act reports and other communications by the
registrant, such as press releases, has already been
disseminated and accounted for by the marketplace.
Proposed Form S.3 recognizes the applicability of the efficient
market theory to the registration statement framework with
respect to those registrants which usually provide high quality
corporate reports, including Exchange Act reports, and whose
corporate information is broadly disseminated, because such
companies are widely followed by professional analysts and
investors in the market place. 45
So, as the court noted in Cammer, the Form S-3 filing
requirements inherently presumed some measure of market
efficiency, through disclosure obligations and information
dissemination, which breed both analyst coverage and an
investor following.
issuer must, among other things, have been filing reports under the
Exchange Act for at least thirty-six months and either have outstanding
$150 million of voting stock held by non-affiliates or $100 million of such
stock outstanding coupled with an annual trading volume of three million
shares per year.
Id. at 1271 n.5.
44 Coated Sales was not apublic filer for at least 36 months and thus was not
eligible to use Form S.3. See id. at 1285.
45 !d. at i2S4-85 (quoting Exchange Act Release No. 6331, 46 Fed. Beg. 41,902
(Aug. 13, 198 1) (emphasis omitted.
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92 ST. JOHN'S LAWRE VIEW [Vol.78:81
2. Average Weekly Trading Volume
Relying in large part on previous academic analysis of what
constitutes an "open" or "developed" market, 46 the court next
looked to other factors that it found relevant to showing that a
stock traded in an open and developed market. One factor that
the court felt that the plaintiffs could have alleged was the
existence of "an average weekly trading volume during the class
period in excess of a certain number of shares." 47 According to
the court, the existence of an actively traded market, as
evidenced by alarge weekly volume of stock trades, indicates an
"efficient market" fostered by "significant investor interest," thus
implicitly indicating the likelihood that trades are in fact being
executed due to "newly available or disseminated corporate
information." 8
3. Analyst Coverage
According to the Cammer court, the existence of asignificant
number of securities analysts would imply the financial
information and other disclosures concerning Coated Sales were
reviewed by investment professionals, who would make buy and
sell recommendations to client investors. In this way, the court
stated that the price of Coated Sales stock "would be bid up or
down to reflect the financial information" and other information
regarding Coated Sales. 49
4. Existence of Market Makers and Arbitrageurs
Existence of market makers and arbitrageurs would,
according to the court, "ensure completion of the market
mechanism" by trading stock soon after disclosure of "company
news and reported financial results" and thus "[drive' it to a
changed price level." 50
46See id. at 1286 n.3ö.
' id. at1286. Lawyers had previously surmised about the importance of this
element. See BROMBERG, supra note 7, at §8.6(641)("Turnover measured by
average weekly trading of 2% or more of the outstanding shares would justify a
strong presumption that the market for the security is an efficient one; 1% would
justify asubstantial presumption.").
48 See Cammer, 711 F. Supp. at 1286.
49 Id.
50 Id, at1286-87.
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5. Price Reaction to Company-Specific Information
Finally, the Court indicated that in asserting an efficient
market, a plaintiff should offer empirical proof linking
"unexpected corporate events or financial releases" to immediate
change in the stock price. 5'
B. Recapping Cammer
Though placing great weight on the filing of aForm S-3, the
Cammer Court set forth a series of other factors that lack
objective guidelines for other courts to follow. Perhaps this was
due to the lack of information it was presented by the plaintiffs
in Cam mer. 52 Perhaps it was also due, as Judge White
suggested in his dissent in Basic, to the court being ill-equipped
to determine and analyze the fundamentals of market efficiency;
i.e., in the court's view, "how many" analysts were needed to
ensure that information concerning a company finds its way,
through buy and sell recommendations, 53 into the price of a
company's stock, and "how many" market makers were needed to
ensure the market's "swift" incorporation of company news into
the price of a company's stock. 54 We also note that though the
court considered the reaction of a company's stock price to
company specific news, the "essence" of market efficiency, 55 it
provided no guidance to practitioners as to how to show—or to
show the absence of—this fact when attempting to prove, or
disprove, market efficiency. We see below that the lack of
objective "market efficiency" criteria has caused courts to vary
greatly in their approach to arguments for and against market
efficiency.
61 Id. at 1287 (remarking further that such is both central to "an efficient
market and the foundation for the fraud on the market theory").
62 See id. In fact, given its guidelines and "some" evidence produced by the
plaintiffs, it denied the auditor's motion to dismiss, finding a "genuine issue of
material fact concerning the character of the market for Coated Sales, stock." See id.
at 1287.
33 See, e.g., Cheney v. Cyberguard Corp., 211 F.R.D. 478, 493-94 (S.D. Fig.
2002) (discussing court decisions addressing "how many" analysts covering a
particular stock constituted a"substantial number" of analysts as elaborated upon
by the Cammer court).
' See id. at 494 (discussing the relevance of the existence of market makers to
the market efficiency analysis).
55 See Cammer, 711 F. Supp. at 1287.
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94 ST. JOHN'S LAWREVIEW [Vol.78:81
C. Cases Since Cammer
Courts that have engaged in a market efficiency analysis
since Cam mer can be characterized as generally falling into two
schools of thought, neither of which is totally appropriate given
the effect that the presumption of reliance has on whether or not
a securities class action gets certified as a class. This article
refers to these categories as follows: (1) The "Let's Deal with It
Later" Approach; and (2) The "Subjective Guidelines Sort of Like
Cammer" Approach. Without tongue in cheek, this article
discusses each of these in turn.
1. The "Let's Deal with It Later Approach"
The "Let's Deal with It Later Approach" looks at the issue of
market efficiency as a "pleading" one, rather than as a "burden
of proof' one. Demonstrative of this approach is the decision of
the Court of Appeals for the Third Circuit in Hayes v. Gross. 56
More often than not, this approach is seen at the "motion to
dismiss" phase of a securities case. On occasion, however, it
sometimes arises on the plaintiffs' motion for class certification.
In Hayes, shareholders of Bell Saving Bank ("Bell") brought suit
against its former directors and officers under section 1.0(b) of
the 1934 Act alleging that they knowingly or recklessly
misrepresented the financial and operating condition of Bell,
which later fell under supervision of the Resolution Trust
Corporation. 57 In their motion to dismiss, the defendants
claimed, among other things, that the plaintiffs had not alleged
either direct reliance on the alleged misrepresentations or "facts
sufficient to support a 'fraud-on4he-market theory.' " Given
the procedural stage of the case, the court noted that the
"question on a motion to dismiss is not whether plaintiff has
proved an efficient market, but whether he has pleaded one." 59
In this regard, the plaintiffs' complaint pled the following:
[T]here was an open, efficient, impersonal and well developed
market for the trading of shares of Bell wherein the market
price reflected publicly disseminated thlormation[;]..,. the
average weekly trading volume for Bell stock was
approximately 38,000 shares;,. Bell stock was listed on the.
982 F.2d 104 (3d Cir. 1992).
67 See id. at 105-06.
Id. at 107.
59 Id.
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NASDAQ/National Market System, which gave investors access
to up-to-the-minute information, including real time prices;.
and Bell was actively followed during the class period by at
least five market analysts whose reports were widely
disseminated to the public. 60
On this set of the facts, the court found, without any further
discussions, that the plaintiffs' complaint alleged an efficient
market. 6'
In Feliman v. Electro Optical Systems Corp., 62 the court
appeared to focus on the C'amrner factors even more sparingly.
In that case, the court discussed the plaintiffs' allegations of
reliance in the course of deciding the defendants' motion to
dismiss. In support of the argument that they were entitled to
rely on the fraud-on-the-market theory, the plaintiffs apparently
alleged only that "during the Class Period, millions of shares of
EOSC stock were actively traded on the Over-The-Counter
Bulletin Board? Based on this sole allegation 1the court held
"63
that plaintiffs had sufficiently pleaded that EOSC traded in an
"open and developed market." 64
Finally, in In re Nortel Networks Corp. Securities
Litigation, 65 the Court granted plaintiffs' motion for class
certification over the opposition of the defendants, who argued,
among other things, that the market for the defendant issuer's
stock "was not efficiently driven by fundamental value, and that
is the death knell to application of the fraud-on-the-market
theory." 66 Rejecting the defendants' request to separately
60 Id.
61 J; see Walsh v, Chittenden Corp., 798 F. Supp. 1043, 1051 (D. Vt. 1992) (in
denying defendants motion to dismiss, the court found that plaintiffs had pled
reliance on the fraud on the market theory by alleging that 'Chittenden's, shares
U
have traded on the public, efficient and national market known as [the) NASDAQ
National Market System" and that it "filed periodic public reports and [had a]
trading volume during the class period [that] comprised over two million shares)
(citations omitted); Seidman v. Am. Mobile Syst., Inc., 813 F. Supp. 323 (E.D. Pa.
1993) (motion to dismiss denied in part because complaint alleged an efficient
market).
52 98 Civ. 6403, 2000 U.S. Dist. LEXIS 5324 (S.D.N.Y. Apr. 25. 2000).
63 rd. at *37 (citations omitted).
64 Id. Similarly, in In re Rentway Securities Litigation, 218 F.R.D. 101, 118
(W.D.Pa. 2008), the Court granted the plaintiffs' motion for class certification based,
in large part, upon Reatway's status as aNew York Stock Exchange listed company.
No discussion was made of the Cammer factors.
6 01 Civ. 1855, 2003 U.S.Dist. LEXIS 15702, S.D.N.Y. Sept. 8, 2003
66 Id. At*14.
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96 ST. JOHN'S LAW REVIEW [Vol.78:81
determine whether or not the plaintiffs were entitled to rely on
the fraud on the market presumption, the Court (without any
discussion of the Cammer factors) granted class certification,
noting that "[T]he parties have been afforded "substantial"
opportunity to present their respective points of view." 67
2. The "Subjective Guidelines Sort of Like Cammer" Approach
This is perhaps the more interesting subset of how courts
view market efficiency arguments made by the parties to a
securities fraud lawsuit. Either because the record before them
is incomplete, at best because the litigants are uncertain as to
what factual showings need be made to prove, or disprove, that
the stock at issue traded efficiently during the class period, or
because courts themselves are uncertain as to which of the
Cain mer factors are more important than the others, there exists
alarge body of post-Basic, post-Cammer case law that is all over
the map. This article does not place fault, but rather describes
some of these cases to set forth the issue at hand: the need for
some definable, acceptable test of market efficiency that would
help a court find that plaintiffs are truly entitled to a
"presumption of reliance" in their securities fraud case.
Demonstrative of this approach is the court's decision in
Blatt u. Muse Technologies, Inc. 68 In Blatt, the plaintiffs,
shareholders of Muse Technologies, Inc. ("Muse"), brought
section 10(b) claims against Muse, its former chairman, and its
President and CEO, alleging that the defendants misrepresented
the company's financial condition during the class period. 69 In
their motion to dismiss the plaintiffs' amended complaint, the
defendants called into question whether the plaintiffs were
entitled to rely on the fraud-on-the-market theory's presumption
67 Id. at 17,. Though it is not dear from its decision, the court apparently sided
with plaintiffs' argument that it need not delve in the merits of the defendants'
arguments regarding market efficiency at this stage of the proceeding, finding those
arguments were questions of fact "that must await for resolution at trial." Id. at 16;
but ace, Kirkpatri ck v Bradford, 827 F2d 718, 722 (11th Cir . 1987) (coming to the
opposite conclusion that "a court may look beyond the allegations of the complaint
in determining whether amotion for class certification should be granted."). Thus,
the Court apparently felt it appropriate to continue to rely on the allegations of the
plaintiffs' complaint that all members of the class relied upon Defendants' allegedly
"deceptive and materially false and misleading statements to the investing public,"
Sec Id. at *3, *1718
65 No. 01-11010-BPW, 2002 U.S. Dist. LEXIS 18466 (D. Mass. Aug. 27, 2002).
69 Id. at *23
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of reliance. The defendants claimed that the timing of the
plaintiffs' stock purchases demonstrated their indifference to the
"integrity" of the price of Muse stock. The defendants also
questioned the "openness and efficiency of the market on which
Muse stock traded." 7°
After deferring on the former question, the court converted
the later question into a "particularized inquiry" into whether
the Muse stock traded efficiently during the class period, using
the Cammer factors as guidelines!' or at least it made a
reasonable approximation of using those factors.
The court first noted that the weekly trading volume for
Muse stock during the class period of 234,500 shares (1.8% of
Muse's total outstanding shares) supported a finding of market
efficiency. Here, the court noted Caminer's guidance that an
"average weekly trading [volume] of two percent or more...
would justify astrong presumption' of market efficiency 72
"
Though an analysis of the second and fourth Cammer factors
appeared to weigh against a finding of market efficiency, 73 the
court instead jumped to the third Cammer factor, noting that the
plaintiffs alleged "numerous financial institutions as market
makers." 71 The court's view of the price reaction of Muse stock to
news and corporate events seems at odds with the Cammer
court's discussion of the importance of this factor, perhaps
because of the anecdotal nature of the evidence presented. The
opinion stated:
Similarly, I do not consider a finding of market efficiency
rendered necessary by the fact that the amended complaint
° See id. at *44_45
"I Id. at *45_46
72 Id. at *47 (quoting Cammer v. Bloom, 711. F. Supp. 1264, 1286 (D.N.J. 1989).
. See id, at *4745
73 As to the second factor, the number or market analysts
following Muse, the court noted without much comment that "the lead plaintiffs do
face some difficulty in meeting the second Cammer factor ... The amended
complaint alleges that only Josephthal covered Muse's stock, and further admits the
relationship not to have been a fully independent one." Id. (internal citations
omitted). As to the fourth Cammer factor, the eligibility to use Form 5-3, the court
gave no weight to Muse's ineligibility to use the Form S-3 because it "was not timely
with its necessary filings," stating that Cammer "expressly exempts
ineligibility
. . . because of timing factors." Id. at *47 (internal citations and quotes
omitted) Here, the Muse court misread Camrrzer . The Commer court rieutralu'ed the
Form S.3 factor in its decision, not because of any failure of Coated Sales to timely
file its reports (like Muse), but because it had not been filing publicly for the
requisite 36 months.
4 Id. at *47
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98 ST. JOHN'S LAWREVJEW [Vol.78:81
successfully alleges only two instances that might demonstrate
"immediate response" of Muse's stock price to "unexpected
corporate events or financial releases," namely the short-lived
rise in the immediate aftermath of Josephthal's May 1, 2000
"Buy" recommendation, and the steady decline following Muse's
disclosures in its February 2]., 2001 press release and filing
announcing results of the first quarter of [the] fiscal year 2001.
In particular, Ido not consider the balance in favor of finding
market efficiency to be overturned by the relatively undramatic
performance of Muse's stock in the aftermath of the company's
disclosures in its press release and filings announcing results
for fiscal year 2000. 75
Thus, based almost entirely on Muse's weekly trading
volume and the number of market makers in Muse's stock, the
court found that the defendants failed to overcome the
presumption of plaintiffs reliance on market integrity in trading
Muse stock. 76
In In re 2TheMart.corn Securities Litigation, 7 the court
relied almost exclusively on the alleged reaction of the
defendants' stock to corporate news and events to conclude the
plaintiffs could rely on the fraud on the market's presumption of
reliance. 78 The court noted several instances in which the
plaintiffs established a "cause and effect" relationship between
company disclosures and resulting movements in stock price. 79
Interestingly, the price movements of the defendants' stock
were rapid, but also often extreme. For example, when the
defendants announced that they had received $1.7 million in
funding, that their web-site was in "'final development," and
that they expected a second quarter launch date, the stock
climbed during the course of three days from $3.50 per share on
January 18, 1999, to $8.50 on January 19, 1999, to ahigh of $50
per share on January 20, 1999, then closing at $21.50 per
share. 8° Furthermore, in response to public criticism, on
January 27, 1999, the defendants issued a release "touting the
75Id. at *4549 (citations omitted).
76Id. But see Binder v. Gillespie, 184 F.3d 1059. 1065 (9th Cir. 1999) (noting
that evidence of the presence of market makers and arbitrageurs only was
insufficient as amatter of law to deem the market for the stock at issue efficient).
77114 F. Supp. 2d 955 (C.D. Cal. 2000).
' Id. at 964-65. The stock of the defendant, an internet-based company, traded
on the Electronic Bulletin Board. Id. at 958.
" Id. at 964-65.
8 Id. at 964
0
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abilities and experience" of one of the individual defendants and
noting that they had "secured funding for the final development
of [their] website," and the stock price rose from aprice that day
of $10.875, to a high of $17, before closing the following day at
$16J25. 8' Indeed, the court could have viewed the first of these
price movements as "volatile" in nature, which may have
warranted a different, and less positive outcome for the
plaintiffs. 82
In Serfaty v. International Automated Systems, Inc.,P the
plaintiffs brought suit against International Automated
Systems, Inc. (lAS) and its president for securities law .
violations. 4 On plaintiffs' motion to certify aclass of purchasers
of lAS, the defendants challenged the plaintiffs' reliance on the
fraud on the market theory, alleging that common questions of
law with respect to reliance did not predominate over individual
issues of reliance. The court applied each of the Cammer factors
to find that lAS stock did not trade in an efficient manner during
the class period. 115 The court's discussion of two of the factors is
worthy of discussion.
a. Average Weekly Trading Volume
The plaintiffs' expert in Serfaty here presented evidence that
lAS was actively traded on the Over-the-Counter Bulletin Board
during the class period based on the total number of individual
trades and the total trading volume. 86 The defendants' expert
challenged plaintiffs' conclusion, noting the small float for lAS's
stock. This expert also suggested that the fact that lAS trading
volume exceeded the average daily volume for OTC Bulletin
Board securities was not as important as the plaintiffs' expert
indicated. 87 Despite the evidence proffered by plaintiffs, the
court opined that the Cam mer factor of large weekly trading
volume did not tip the balance towards concluding that lAS's
stock traded in an efficient market. 88
' Id.
82 See supra text accompanying note 16,
93 180 F.R.D. 418 (D. Utah 1998).
Id. at 419.
' See id. at 420-23.
86 Id. at421.
87 Id.
&4 Id. at 422.
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100 ST. JOHN'S LAW RE VIEW [VoL78:81
b. History of Immediate Movement of Stock Price
The court noted that the immediate movement of the stock
price was the factor under which the plaintiffs had the strongest
argument that lAS traded in an efficient market during the class
period. Plaintiffs presented evidence that the price of lAS stock
increased on June 10, 1997, as a result of an lAS press release
touting lAS technology, and decreased on June 28, 1996, when
the defendants failed to unveil their technology. 89 Defendants
countered with evidence that the price reactions of lAS stock
were not consistent with an efficient market, 90 In fact, the court
itself noted the following:
Examination of the OTC Daily Trading Summary offered by
Defendants.,. shows that throughout the class period, the
price of MS shares fluctuated. For example, on May 22, the
price closed at $36.25; the following day, it rose to $50.00.
Similarly, on May 30, the price closed at $54.00; yet by June 7,
the price had decreased to $34.00. Plaintiffs offer no specific
evidence that these, and other significant changes in the price,
were in response to information about LAS. The far more likely
conclusion is simply that the price history of lAS [stock] was
volatile. [Defendants' expert] calculated the standard deviation
of lAS's stock return, awidely-used measure of volatility, and
found it to be 13%, which he concluded was 'relatively high.'
Consideration of all the evidence on this factor does not support
afinding of an efficient market,. 9'
Finally, the court in Krogman u. Sterritt, 92 considered both
the rammer factors and several others in denying the plaintiffs'
motion for class certification. 93 The court found several factors
weighed against finding an efficient market for the defendant's
stock, including a low weekly trading market, a li m it ed number
of analysts following such stock, and afailure by the plaintiffs to
sufficiently demonstrate a relationship between the defendants'
stock's price movements and news disclosures. 94
Id.
94
Id, at 422-23.
00
1 Id. at 423 (internal citations omitted),
02 202 F.R.D. 467 (N.D. Tex. 2001).
93 Id. at 474-78, 480.
94 Id. at 475, 477. As to the price reaction of the defendants' stock, the
defendants' expert "calculated the standard deviation of [the defendant's] stock
return, a widely used measure of volatility, and found the median standard
deviation for weekly trading.... to be twelve percent, which he concluded was
highly variable" and based upon this evidence, he found "very little relationship
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In addition, the court noted that economic theory includes
other possibly relevant factors for determining whether a stock
trades in an efficient market, including market capitalization,
bid-ask spread, and float 95
c. Market Capitalization
The Krogm.an court stated that "[m]arket capitalization
may be an indicator of market efficiency because there is a
greater incentive for stock purchasers to invest in more highly
capitalized corporations." 96
The defendant's expert found that the market capitalization
of the defendant was in the top sixty percent of asample group. 97
Thus, the court found that this factor "weigh[ed] slightly in favor
of adetermination of market efficiency." 98
d. Bid-Ask Spread
The court noted that the bid-ask spread is "the difference
between the price at which investors are willing to buy the stock
and the price at which current stockholders are willing to sell
their shares. A large bid-ask spread is indicative of an
inefficient market, because it suggests that the stock is too
expensive to trade."O On this point, the defendant's expert
concluded that the defendant's stock "had a median bid-ask
spread of approximately 5.6% of its closing price, [which was] in
the highest quartile of the sample used in his study."°° The
court found that the bid-ask spread tends to indicate an
inefficient market. 101
a. Float
The Krogman court also found that, because of the
defendant's relatively low float—"the percentage of shares held
between information and [the defendants'] stock price movements." Id. at 477 ri.13
(internal citations and quotes omitted).
93 Id. at 477-478.
6 Id. at 478,
7 Id.
as Id.
'° Id.
Id.
'°' id.
I
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102 ST. JOHN'S LAW REVIEW [Vol.75:81
by the public"—this factor disfavored a finding of market
efficiency. 102
D. Recapping Cammer's Progeny
What can Cammer's progeny tell us in terms of the
consistency of the federal district courts' analysis of market
efficiency and the ultimate factors which are crucial to any
market efficiency determination? Unfortunately, the answer
may be, "not much."
Depending on which approach a court takes, and the
procedural posture of the particular case, most courts will come
to very individual conclusions concerning whether a particular
stock traded in an efficient manner. Some courts place weight
on the existence of market makers, while others do not. Again,
while some courts place great weight on the weekly trading
volume of astock, other courts gloss over thi s f
ac t
or or defer it to
another day. Finally, some courts give great weight to ashowing
that there is a cause and effect relationship between the
announcement of company-specific news and the price of a
particular stock. On the other hand, some courts, despite some
evidence of a cause and effect relationship, find it important to
understand whether or not the stock fluctuated or behaved in a
volatile manner. The lack of readily definable factors that might
show market efficiency has truly created a massive hodgepodge
of cases and outcomes.
Given this disparity in how courts view market efficiency, it
is no wonder that many plaintiffs and defendants are at a loss
when it comes to establishing or rebutting the fraud on the
market theory's presumption of reliance. Perhaps what is
needed is areturn to the basics.
III. EFFiciiT MARKETS PARADIGM FOUND AND LOST
A. Efficient Markets in Theory
The concept of the Efficient Markets Hypothesis (EMH) is
generally traced back to a 1970 academic article by Eugene F.
Farna. 103 An efficient market is defined as one in which all
102 Id.
See Eugene F. Farna, Efficient Capital Markets: A Review of Theory and
102
Empirical Work, 25 J. PIN. 383 (1970).
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information of a certain type is quickly and properly
incorporated into stock prices.'04 The most sweeping version of
the EMH is the strong form, which argues that all information,
public and private, would be incorporated into stock prices. 105
This version is generally held not to be true, 106 and, if it were,
insiders trading on private information would not be expected to
do better than the average market participant since that
information would already be incorporated into the stock price.' 07
The next version is the semi-strong form, which posits that all
public information is incorporated into stock prices.' 08 The final
version is the weak form, which posits that all previous stock
prices, which are necessarily a subset of all public information,
are already incorporated into current stock prices- 109
The main implication of the EMH, when it holds, is that an
investor cannot earn an above-average return by using stale or
previously known information. For example, if some information
entered the market on Monday at 2 p.m., the effects of that
information would be fully incorporated into the stock price
immediately thereafter (or, at the least as quickly as the market
can process the information).' 10 The information would tell the
market nothing about future stock price changes. 111 Consider
the following scenario: suppose that it was well accepted that the
Monday announcement caused a stock to rise from $20 to $25
and that somehow the general market belief for the next day or
°' See id. at 383, 409-413.
105 See id.
106 See id. at 409-410.
' Thus, it is implicit in relevant statutory law and court decisions finding
liability for insider trading that both legislatures and courts reject strong form
efficiency. See Jonathan R. Macey & Geoffrey P. Miller, Good Finance, Bad
Economics: An Analysis of the F'raud-on-the.MOrket Theory, 42 STAN. L. REV. 1059,
1078-79 (1990) (noting that the Supreme Court has "unambiguously rejected the
strong form").
108 See Farna, supra note 103, at 383.
109 See id.
110 Some EMH purists would argue that much of the incorporation occurs
within five or ten minutes after an announcement. See, e.g., James M. Patell &
Mark A. Wolfson, The Intraday Speed of Adjustment of Stock Prices to Earnings and
Dividend Announcements, 13 J. FIN. ECON. 223 (1984) (discussing the behavior of
stock prices throughout the day and how this behavior is affected by earnings and
dividend announcements).
11 Technically, the information would say nothing about the average level of
future stock price changes. Certainly some information, such as that acompany will
hear about whether it is awarded a large government contract in a week, will
provide information about future volatility.
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so was that this information would cause the stock to rise to $30
by Thursday. In that case, it is necessary to ask which holders of
the stock are so desperate for cash that they are selling the stock
at $25 when it will go up 20% in the next three days? Or,
suppose that someone claims that the rise from $20 to $25 would
have to be reversed in the next three days. If that were a
generally accepted belief, one would have to seriously question
what type of investor would actually be buying the stock at $25 if
it was going to go down to $20 in the near future. Put simply,
once information has been provided to the market, the market as
a whole simply cannot expect that information to have an
additional effect on a stock at a later point in time; instead, all
the effects of the information have to be incorporated into the
stock price immediately. If this were not the case, the market
would have to have alot of desperate sellers or completely foolish
purchasers.
Of course, there are some irrational market participants,
though not necessarily as foolish as those described above. It is
in how these irrational investors are treated that is one of the
main distinguishing features between the strongest advocates of
the EMIT and proponents of contrary theories that have become
the grist of behavioral finance.
Advocates of the EMIT recognized that not all investors are
rational, but also pointed to three mechanisms that they felt
would ensure that the non-rational investors' influence on
markets would be minimal. First, while there is one way to be
rational, there are numerous ways to be irrational. Therefore,
the argument goes, there should be roughly as many irrational
investors putting in ill-considered purchase orders for astock as
putting in ill-considered sell orders for that stock. On average,
these random pressures on a stock would tend to cancel out.
Second, in those cases where the irrational traders' behavior did
not cancel out, perhaps due to chance, rational investors would
take advantage of the opportunity to make a profit. To take an
extreme example, suppose that acompany was going to liquidate
itself tomorrow and pay out $20 per share in proceeds per share
outstanding. Putting aside tax considerations, it is clear that the
share price should be $20 today. If irrational investors really
wanted to sell this stock and pushed the price down to $19,
rational investors would be more than happy to come in and buy
up all the outstanding shares at $19 and make a quick $1
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profit.' 12 In fact, the rational investors would not wait for the
price to drop much below $20 and would quickly push it back up
to that level as they overwhelmed the small group of irrational
investors who by chance happened to be selling the stock. Third,
to the extent that the irrational investors do succeed in pushing
this stock price down to $19, they have lost adollar in value that
they otherwise would have had by not trying to sell. Advocates
of the EMH argued that over the long run, irrational investors
could only lose money by picking the wrong prices. Thus, either
the irrational investors would have no effect on stock prices, or
they would wind up losing money in their trades and remain
restricted to being a very minor force in the market as they
either become impoverished or realize that playing the stock
market is not for them.
B. The Correspondence Between the Academic Efficient Markets
Definition and the Courts' Decisions of Whether aMarket Is
Efficient
Evidence of market efficiency usually focuses on the
conditions under which the Efficient Market Hypothesis holds
and whether the defendant's security (subjectively) meets these
conditions. Neither the definition nor the acceptance of market
efficiency have been raised as issues in the bulk of legal
academic literature. 113
The traditional view is that the possibility of arbitrage,
results in market efficiency. Specifically, an efficient market is
assumed to arise when: (1) securities are auctioned in an honest
and competitive manner among investors; (2) transaction costs
112 More generally, the rational investors might go long the individual stock
and short an index, or vice versa, so that they would profit when the stock pi-ice
returned to its k proper level relative to the index. This type of hedging is done to
help protect arbitrageurs against broad industry or market movements, which
would tend to cancel out by being long (short) astock and short (long) an index of
similar stoëks.
113 The initial law review article on the subject was The Measure of Damages in
Rule JOb5 Cases Involving Actively Traded Securities, 26 STAN. L. REV, 371, 371,
394-95 (1974) (attempting "to determine an appropriate measure of damages in
Irlule lOb.5 suits brought by parties claiming injury from market transactions in an
actively traded stock"). At that time, the definition of efficient markets was in its
formative stages. See Fama, supra note 103, at 383-85, 387-88; Eugene F. Fama et
al, The Adjustment of Stock Prices to New Information, 10 IN'TL Eco\ REV. 1, 1
(1969). Later articles cited the more developed formulation in Eugene Fama's
textbook, See EUGENE F. FAMA, FOUNDATIONS OF FINANCE 133-37 (1976).
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106 ST. JOHN'S LAW RE VIEW [Vol.78:81
are small (for both long and short positions); and (3) there are a
large number of sophisticated investors with access to public
information.'" These conditions are presumed to foster
equilibrium securities prices that respond rapidly and rationally
to new public information.
As we noted above in our discussion of Cammer u. Bloom, in
securities litigation, objective evidence with subjective guidelines
is usually presented to support a claim that the market is
effcient. 115 The purpose of presenting such data is to determine
whether there are large numbers of sophisticated, informed
buyers and sellers who are in competition with each other to
extract the best return from their trading. Cammer, however,
focused primarily on the volume of trading and the number of
traders," 6 rather than the cost of trading and the sophistication
of investors. Krogman improved on this reasoning by also
focusing on transaction costs like bid- ask spreads and float.""
Nevertheless, there is room for further improvement. It is not
enough that there are low transactions costs for long positions—
arbitrageurs may have to go short to drive prices to fundamental
value. Furthermore, the presence of many investors is not
evidence that the "right" kind of investors are trading, that is,
investors who can use risky arbitrage if prices get out of line
with value. Since many mutual funds and pensions are
prohibited by law from taking short positions, one should not
assume that many investors is synonymous with means many
sophisticated investors.
The problem with this type of evidence is that, with the
possible exception of how the stock price responds to news, it
does not show directly whether the market is efficient or that the
security itself is priced efficiently. 1113 In other words, courts have
114 See RICHARD A. BREALEY & STUART C. MYERS, PRINCIPLES OF CORPORATE
FINANCE 285, 298 (1988); see also JONATHAN E. INGERSOLL, JR., THEORY OF
FINANCIAL DECISION MAKING 54, 73 (1987); Ray Ball, Mat Do We Know About
Stock Market Efficiency?, in A REAPPRAISAL OF THE EFFICIENCY OF FINANCI AL
MARKETS 51 (Rui M. C. Guimaraes et al. eds., 1989).
115 See Aff, of Norman Poser, Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J.
1989); see also Binder v. Gillespie, 184 F,3d 1059, 1064-65 (9th Cir. 1999); Cammer,
711 F Supp. at 1285-87.
118 See Cammer, 711 F. Supp. at 1285-87.
1'7 See Krogxnan v Sterr,tt 202 FR B 467, 478 (N .D. Tex 2001)(finding that
the relatively high bid-ask spread and relatively low float of the stock both indicated
market inefficiency),
118 When EMIt was ascendant in the courts, the controversies in the economics
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focused mostly on the preconditions for market efficiency, but
have often downplayed the behavior or performance of the
security's price. As will be shown, even as the courts were
establishing these criteria, academic research was showing that
they were possibly necessary, but certainly not sufficient,
conditions to prove that astock traded in an efficient manner.
C. Challenges to the Efficient Market Hypothesis
1. The Empirical Status of the Efficient Market Hypothesis
After Basic
The EMH reached its peak of respectability in the courts in
response to the Basic decision during the mid-1990s when,
ironically, it was facing a difficult challenge in the academic
literature. Stock market efficiency was no longer apresumption
among economists. Since the mid-1980s, empirical literature
had been finding stock market anomalies at an astounding
pace.' 19
a. The Volatility Puzzle
The first results of interest occurred several years after the
fraud on the market theory had been proposed in the legal
literature and had been accepted in some circuits. LeRoy/Porter
and Shiller, two sets of authors working independently,
attempted to show stock return volatility was higher than
predicted by the efficient market model.' 2°
These results cast doubt on whether stock prices accurately
reflect available information. Under the efficient market model,
today's stock price equals the expected present discounted value
literature over whether and how informationafly efficient rriarkets can be defined
had been largely ignored. See Ball, supra note 114, at 26-55.
11 9 See Eric C. Chang & J. Michael Pinegar, Seasonal uctuations in Industrial
Production and Stock Market Seasonals, 24 J. FIN, & QUANTITATIVE ANALYSIS 59,
59 (1989) 'Many researchers document stock market anomalies that challenge the
efficient markets hypothesis.").
120 See Stephen F. LeRoy & Richard D. Porter, The Present-Value Relation.'
Tests Based on Implied Variance Bounds, 49 ECONOMETRIcA 555, 558 (1981) ("We
see that based on both aggregated and disaggregated data, stock prices appear to be
more volatile than is consistent with the efficient capital markets model."). See
generally Robert J. Shiller, Do Stock Prices Move Too Much to Be Justified by
Subsequent Changes in Dividends? 71 AM. ECON. REV. 421, 421-36 (1981)
(suggesting that stock prices are too volatile to accord with the efficient market
model).
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108 ST. JOHN'S LAWRE VIE,W [Vol.78:81
of all future dividends.' 2' Research showed that stock prices are
more volatile than can be explained by this model. Therefore, it
followed that stock prices are based on factors other than or in
addition to information about future dividends, i.e., factors
besides fundamental value.
In response to various critiques, Campbell and Shiller
solidified the econometrics of these findings, but left an
important conceptual issue in doubt: these volatility tests were
actually testing, at the same time, 'a number of hypotheses of
which market efficiency is only one.' 22 That is, securities
markets could be efficient and Campbell and Shiller could have
still found higher-than-expected volatility. Some other
assumptions about the market, such as the behavior of discount
rates, could have been wrong. If this were the only research t o
cast doubt on efficient markets, then there would still not have
been much reason to question the fraud-on-the-market-theory.
b. Prke Overreaction and Underreaction
Another set of empirical results of importance for the fraud-
on-the-market theory was in literature on price overreaction,
which is more directly related to the central issues in a l0b-5
class action,I 2a First, this literature involved the behavior of
121 See Stephen F. LeRoy, Efficient Capital Markets and Martingales, 27 J.
ECON, LTFERATIJRE 1583, 1584 (1989). This was originally shown for futures
markets. See Paul A. Samuelson, Proof That Properly Anticipated Prices Fluctuate
Randomly, 6 INDUS. MGMT. REV. 41, 41-49 (1965). Samuelson then restated the
result for stock prices and, recently, applied the same concept to land prices. For the
stock price version, see Paul A. Samuelson, Proof That Properly Discounted Present
Values of Assets Vibrate Randomly, 4 BELL J. ECON. & MGMT. Sci. 369, 369-74
(1973).
122 There were several econometric critiques, but the most important article
was probably Robert C. Merton, On the Current State of the Stock Market
Rationality Hypothesis, in MACROECONOMICS AND FINANCE: ESSAYS IN HONOR OF
FE.AI4CO MODIOLIANI, (Stanley Fischer et al. eds., 1987). See generally John Y.
Campbell and Robert J. Shiller, The Dividend-Price Ratio and Expectations of
Future Dividends and Discount Factors, in REVIEW OF FINANCIAL SflJtllES 195-228
(Michael Brennan ed., 1988). Several authors have commented on the problem of
joint hypothesis tests when attempts are made to test the efficient markets
hypothesis. See Eugene F. Fame, Efficient Capital Markets: II, 46 J. FIN., 1575,
1575-1617 (1991) [hereinafter Efficient Capital Markets I1J(MAmbiguity about
information, and trading costs is not. ,, the main obstacle to inferences about
market efficiency. The joint-hypothesis problem is more serious?').
123 See, e.
g.,Rom M,ichaely et al, Price Reactions to Dividend Initiations and
Ornmissions: Overreaction or Drift?, 50 J. FIN. 573, 574 (1995) (discussing studies
regarding price performance following overreaction by the market).
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stock prices after a steep decline as might happen, say, when
there is an alleged corrective disclosure. Second, the
overreaction literature used atechnique, called the event study,
that avoided some of the problems encountered by the other tests
of market efficiency. 124 The event study methodology has been
suggested in the legal literature to determine materiality and
estimate damages in securities cases. 125
It is useful to divide the overreaction literature into long-run
and short-run price reaction studies. The long-run studies
created portfolios of "losers"—stocks whose past performance has
been near the bottom—and tested whether these portfolios
outperform the market. These studies typically examined
monthly returns over long, e.g., three-year, time horizons. The
initial studies, associated with DeBondt and Thaler, showed that
such portfolios did outperform the market.' 26 These results were
consistent with the findings of mean reversion described above.
A series of articles by Chan and Zarowin, however, showed that
these results might also be explained by changes in the risk of
the portfolios or by the well-known size 127 and January' 21 effects
on stock returns.' 29
124 See Efficient Capital Markets II, supra note 122, at 1602 CEvent studies are
the cleanest evidence we have on efficiency (the least encumbered by the joint-
hypothesis problem).").
126 See In re Seagate Technology II Sec. Litig., 843 F. Supp. 1341 (N.D.Ca1.
1994) There the court accepted some of defendants' event studies and disnussed
certain claims on that basis, but ruled that defendants' other event studies were
inadequate and denied their request for summary judgment with regard to those
issues. The court also found plaintiffs' event studies lacking and therefore denied a
cross-motion for summary judgment. Id. at 1368; sEe also fn re Executive Telecard,
Ltd. Sec. Litig., 979 F. Supp 1021, 1025-27 (S.D.N.Y. 1997) (ruling that expert
witness's testimony was inadmissible for failure to conduct an event study)
Goldkrantz v. Griffin, No. 97 CIV. 9075, 1999 U.S. Dist. LEXIS 4445, at *13_15
(S D NY Apr. 6 1999) (granting summary judgment based on plaintiffs failure to
contest defendants' event study analysis).
'-a" See Werner F. M. De Bondt & Richard Thaler, Does the Stock Market
Overreact?, 40 J. FIN., 793, 799 (1985); Werner F. M. De 13ondt & Richard H. Thaler,
Further Evidence on Investor Overreaction and Stock Market Seasonality, 42 J. FIN.,
557, 571 (1987).
12? The size effect refers to the then well-known statistical fact that returns to
portfolios of small firm stocks are greater than returns to portfolios of large firm
stocks.
128 The January effect refers to the then well-known statistical fact that returns
during the typical January are higher than returns in other months.
129 See K. C. Chan, On the Contrarian Investment Strategy, 61 J. Bus. 147, 148
(1988) (proposing that "the risks of winner and loser stocks are not constant over
time"); Paul Zarowin, Does the Stock Market Overreact to Corporat e Earnings
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110 ST. JOHN'S LAWRFJVIEW [Vol.78:81
The results based on short-term periods, i.e., usually daily
returns over the period of a month or more, have provided
evidence of both overreaction and uriclerreaction. For example,
Zarowin, in the last of the series of his articles, showed
significant daily price overreaction (return reversals) within one
month.' 3° These results still obtained after controlling for the
size and January effects. Also important was the work of
Bremer and Sweeney who found that if astock price drops, say,
10 percent on any given day, then it can be expected to retrace a
market-adjusted 6 percent of its price (60 percent of the price
drop) over the next 29 trading days,lSt This result occurred even
alter adjusting for reasonable variations in risk. These two
research efforts were consistent with other findings that stocks
with abnormal one day returns reversed direction in subsequent
days. 132 They were also consistent with the results of Lehmann,
who showed that an arbitrage strategy of buying losers and
selling winners each week will net substantial short-run profits
even after accounting for transaction costs. 1 'On the other hand,
some studies of stock price reactions to news such as earnings
announcements provided evidence that stocks had an initial
reaction to an announcement and then kept moving in that same
direction for several weeks.' 34 This underreaction phenomenon
is not limited simply to news events, but was also noted in
Information? 44 J. FIN. 1385, 1386 (1989) (suggesting that "the overreaction to
earnings phenomenon is another manifestation of the size phenomenon"); Paul
Zarowin, Size, Seasonality and Stock Market Overreaction, 25 J. FIN. &
QUANTITATIVE ANALYSIS 113, 115 (1990) (finding that "differential size, and not
investor overreaction, is driving the winner versus loser phenomenon, and that a
widely regarded efficient markets anomaly is , subsumed by the site and seasonal
phenomena").
130 See Paul Zarowin, Short-run Market Overreaction: Size and Seasonality
Effects, 15.1. PORTFOLIO MGMT 26, 26-29 (1989).
131 M. Bremer & Richard Sweeney, The Information Content of Extreme Daily
Rates of Return, Claremont, Sept. 25, 1987.
132 E. A. Dyl & K. Maxfield, Does the Stock Market Overreact? Additional
Evidence, University of Arizona, June, 1987. K. C. Brown et al., Risk Aversion,
Uncertain Information, and Market Efficiency, University of Texas, Austin, Jan.
1988,
' Sec Bruce N. Lehmann, Fads, Martingales, and Market Efficiency, 105 Q. J.
EcoN. 1, 12-25 (1990).
134 See, e.g., Victor L. Bernard, Stock Price Reactions to Earnings
Announcements. A Summary of Recent Anomalous Evidence and Possible
Explanations, in ADVANCES IN BEHAVIORAL FINANCE 303 305 (Richard H Thaler
ed,,1993) (reviewing research "consistent with the initial reaction being (on average)
too small, and being completed over aperiod of at least six months").
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studies of stocks grouped according to how well they did relative
to the market over a short-term horizon. 135 Underreaction has
also been found in response to dividend initiations and
omissions, 136 as well as share repurchases.' 37 The overall
evidence on short-term overreaction or underreaction is
somewhat uncertain, with different studies providing apparently
contradictory results, though most financial economists now
accept that one may diverge from the predictions of the EMH in
different ways, depending on the particular circumstances being
studied.
2. Theoretical Challenges Upset the EMH
In light of the empirical findings even before the stock
market bubble of the 1990s, economists looked to new theories
from the developing field of behavioral finance.' 38 Many of the
theoretical challenges to the EMH dealt with how the irrational
traders actually behaved. While advocates of the EMH assumed
that there would be avariety of irrational behaviors that would
on net roughly cancel each other out, psychologists and
academics from behavioral finance were investigating whether
there were systematic ways in which people, including investors,
deviated from the postulates of rational behavior.
a. Loss Aversion
One of these deviations, which we use here as an example, is
referred to as "loss aversion," meaning literally that people don't
like to suffer or recognize a loss. Suppose that an investor
purchased two stocks for $100 each and one has gone up in value
130 See, e.g., Narasimhan ,Jegadeesh & Sheridan Titman, Returns to Buying
Winners and Selling Losers: Implications for Stock Market Efficiency, 48 J. FIN. 65,
68-89 (1993) (documenting the short-tern, effects of strategies that buy stocks that
performed well in the past and sell stocks that faired poorly in the past).
136 See Roni Michaely et al., Price Reactions to Dividend Initiations and
Omissions; Overreaction or Drift? 50 J. FIN. 573, 582-605 (1995) (discussing short-
term market reactions to both initiations and omissions of cash dividend payments).
131 David rkenberry et al., Market Underreaction to Open Market Share
Repurchases, NBER Working Paper No. W4965, Dec. 1994, at 2-3 (noting that
"market trends repurchase announcements with skepticism, leading prices to adjust
slowly over time" and referring to the phenomenon as the "linderreaction
Hypothesis").
138 See, e.g, ANDREI SHLEIFER, INEFFICIENT MARKETS: AN INTRODUCTION TO
BEHAVIORAL FINANCE 1 -10, 112-14 (2000) (providing more detail on many of the
discussion points here).
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and one has gone down. If the investor wants to sell some of her
portfolio, which should she sell? Under the EMH, past price
movements say nothing about future movements, so the
"winner" stock is no more likely to go up in the future than the
loser. The main reason to sell the winner stock is to diversify the
portfolio, since by going up in value the winner stock is now a
larger share of the portfolio's overall value; the main reason to
sell the loser stock is because selling the winner results in an
immediate tax liability, whereas selling the loser stock first
saves at least on the time value of the tax liability. Investor
behavior was evaluated by examinations of actual trading data
and through experiments in which investors were presented with
hypothetical portfolios. After controlling for the various reasons,
to sell one stock or another, economists determined that
investors were overly reluctant to sell their losing stocks and
recognize the loss. For the EMIT, the important consequence
was that this would not be a random deviation from rational
behavior that would cause some investors to buy a stock and
others to sell; when a stock went down in value, that would
cause the overwhelming majority of irrational investors to refuse
to sell. Similarly, when a stock went up in value, that should
cause an overwhelming majority of irrational investors to
become inclined to sell that stock relative to their other
holdings.' 39
b. Constraints on Arbitrage
A second part of the theoretical challenge to the EMIT was
whether rational investors would indeed intervene sufficiently to
counter the effects of irrational traders' behavior. The response
here may be summed up in the statement by John Maynard
Keynes that "markets can remain irrational longer than you can
remain solvent." 40 In other words, , there is a real risk in
following a strategy that will pay off in the long run, once the
firm's cash flows come true and investors achieve the value they
estimated in setting the market price, if investors face the
chance that they will lose more money and face the possibility
that they will have to liquidate their positions before then. In
'' See Terrance Odean, Are Investors Reluctant to Realize Their Losses?, 53 J,
FIN. 1775, 1781-95 (1998).
Justin Fox, Is the Market Rational?, FORTUNE, Dec. 9, 2002, at 126.
140
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the context of the Internet bubble, if an investor shorted $100
worth of the Nasdaq Composite Index on December 6, 1996, the
day of Alan Greenspan's speech about irrational exuberance,
then on March 10, 2000, the day the Nasdaq peaked, her
portfolio would have declined in value from a positive value of
$100 to anegative position of $292, or aloss of $392.
C. Irrational Investors Have Staying Power
Finally, there is the question of whether irrational investors
would be driven from the market by their poor performance. The
main response from behavioral economists again focuses on risk,
but this time it is a trade-off between risk and reward. If
irrational investors are taking undue risks, then they may on
average be rewarded with above-average returns. While not all
irrational investment strategies do result in an expected above-
average return, this argument at least makes it unclear whether
on net the irrational traders would tend to be driven out of the
market or in fact gain in prominence over time.
3. Other Behavioral Finance Challenges
Loss aversion is not the only theoretical challenge to the
EMW Some of the other areas of systematic deviation from
rational behavior that psychologists and behavioral finance
economists have documented include the following:
• Extrapolative expectations: the concept that people
often predict the future by projecting the recent past
forward. 14 tTherefore, if astock or the market has been
going up recently, market participants are likely to
assume that it will keep going up in the future, even if
the recent run-up is due to chance.
• Representativeness: the tendency for people to try to
understand aphenomenon by comparing it to asimilar
case that they are familiar with, as opposed to
"' See, e.g., Karl E. Case & Robert J. Shiller, The Behavior of Home Buyers in
Boom and Post-Boom Markets, in MARKEr VOLATILITY 403-429 (Robert J. Shiller
ed., 1989); Jeffrey A. Frankel & Kenneth A. Froot, Explaining the Demand for
Dollars: International Rates of Return, and the Expectations of Chartists and
Fundamentalists, in MACROECONOMICS, AGRICULTURE, AND EXCHANGE RATES
(Philip L. Paarlberg & Robert G. Chambers eds., 1988) (addressing studies on such
behavior).
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114 ST. JOHN'S LA WRE ViEW [Vol.78:81
understanding the relative probabilities of the two
cases. 142
• Conservatism: the tendency for people to anchor their
beliefs to old ideas for an inappropriately long period of
time before changing their beliefs when presented with
new evidence.' 43
• Optimism and overconfidence: Most investors think
they are above average. Overconfidence increases
trading volume. 144 It also causes investors to ignore the
information contained in other people's trades, which
can cause overreaction in stock prices.' 5
• Memory biases in estimating frequencies: One rule of
thumb people use to estimate frequency is the ease of
recalling examples. This makes people overestimate
the frequency of vivid events like plane crashes,
murders—or an Internet stocks doubling in aweek.' 46
4, A "Rational" Challenge to the EMH
Even advocates of rational investor behavior have presented
an argument why a stock price may incorporate all publicly
available information, and generally behave in an efficient
manner, but still not represent the true value of the underlying
company. This theory, known as "rational bubbles," can be
presented as follows.' 47 Suppose that on top of the true value of
a stock, one day the price is a dollar too high. Normally,
investors would want to sell the stock because the dollar will
142 See, e.g., SHLEIFER, supra note 138, at 113; Amos Tversky & Daniel
Kabneman, Judgment Under Uncertainty: Heuristics and Biases, in JUDGMENT
UNDER UNCERTAINTY: HEuRiSTiCS AND BLASES 3-20 (Daniel Kahneman et al. eds.,
1982).
See Ward Edwards, Conservatism in Human Information Processing, in
FORMAL REPRESENTATION OF HUMAN JUDGMENT 17-18 (Benjamin Kleinmuntz ed.,
1968).
'
M See. e.g., Terrance Odean, Do Investors Trade Too Much?, 89 AM. ECON.
REv, 1279, 1280-92 (1999) (discussing overconfidence as one factor leading to
increased trading volume).
145 See, e.g., Kent Daniel at al., Investor Psychology and Security Market Under.
and Over-Reactions, 53 J. FIN. 1839,1944-55 (1998).
46 See generally B.A. Mellers at al., Judgment and Decision Making, 49 ANN.
REV. PSYCHOL. 447 (1998) (explaining the various theories regarding judgmental
errors and biases).
14T Oliver J. Blanchard & Mark W. Watson, Bulles, Anticipations Tationnelles
ot Marches Financiers, (Bubbles, Rational Expectations, and Financial Markets), in
ANNALES DE LINSEE (1984).
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quickly be arbitraged away. On the other hand, suppose that the
reason the price is a dollar too high today is because there is a
fifty percent chance that the price will be two dollars too high
next year and a fifty percent chance that the price will revert
back to the true value next year. If an investor is risk neutral, or
if the risk of the bubble bursting is independent of market risk,
then this is a fair investment because the expected gains equal
the expected losses .1411 The next question is how the stock price
could be two dollars too high next year. This is possible if, once
it reaches the price of two dollars above fundamental value next
year, there is a fifty percent chance that the price falls back to
fundamental value the following year and afifty percent chance
that the bubble again doubles to four dollars above fundamental
value. In fact, as long as the security is potentially infinitely-
lived like a stock (as opposed to a bond with a fixed maturity
date), a rational bubble can be theoretically sustained.
Moreover, there is no reason for rational investors to avoid the
stock or to try to arbitrage away the overvalued price.
Eventually the bubble will burst of course, but it is always afair
investment until that point. During the period when the stock is
afair investment, the fundamental value part of the stock price
can move up and down as new information about the company
becomes available.
This brings up the fact that there are really two commonly-
used definitions of an "efficient market." The traditional
definition is that the market incorporates all news. It was
generally assumed that this definition implied that a security's
price reflected the market's perception of the fundamental value
of the cash flows to which the security had aclaim; however, as
the theory of rational bubbles shows, the stock price can
incorporate all information about a company but still not reflect
its fundamental value. A second definition, and the one that
forms the basis for many statistical tests of market efficiency, is
that one cannot make supernormal profits by trading the stock
to exploit an inefficiency in its pricing behavior. If you knew
that a certain stock doubled in price every Tuesday, you could
buy it at the close on Monday and sell it at the Tuesday close and
earn a tremendous return on your investment even after
Us The same example can be used for risk-averse investors by simply having
the growth of the bubble be larger than one hundred percent per year.
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considering the transaction costs. However, with a rational
bubble, an investor is as likely to gain or lose money and
therefore cannot exploit the mispricing of the stock to make a
profit.
Recent theoretical models and empirical evidence on hedge
fund holdings have found that rational arbitrageurs may profit
more from riding: a bubble than trying to pop it. 149 While
coordinated action by arbitrageurs could burst a bubble,
competitive pressures make coordination difficult or even
undesirable. If arbitrageurs learn sequentially that a bubble
exists, they may not know what other arbitrageurs know. Thus,
this coordination challenge and sequence of discovery can make
it profitable for arbitrageurs to contribute to the bubble until
they think it is about to burst. Stanley Druckenmiller, the
manager of George Soros's eight billion dollar Quantum fund,
explained that although he realized the exaggerated value of
technology stocks, yet he held on to them because he still
believed that the bubble was not over. 150 Recent studies of hedge
funds have supported this theory: hedge funds held significant
long positions in technology stocks throughout the Internet
bubble, typically dumping them just one quarter before each
individual stock crashed. 15 '
IV. EcoNoMic PROOF IN FRAUD-ON-THE-MARKET CASES
IN THE ABSENCE OF THE EMH
What are the implications of these findings on lOb-5 class
actions? It is clear that the presumption of efficient markets is
no longer universally held in the economics profession.
Reputable academics are found on both sides of the debate, with
the leading opponents of the EMH promoting atheory that stock
prices can be affected by speculative bubbles, overreactions, and
underreactions in addition to fundamental information.
149 See Julian Marshall, Hedge Funds: The New Investment Bubble? The Happy
Solution to Volatile Equity Markets or an Accident Waiting to Happen?
EUBOMONIy, Jan. 1, 2002, at 102 (discussing the benefits and drawbacks of hedge
fund investments).
150 Dilip Abreu & Markus Brurmermeler, Bubbles and Crashes, 71
ECONOMETRICA 173, 175 (2003). Druckenmiller remarked that "[w]e thought it was
the eighth inning, and it was the ninth." id.
'' See M. Brunnermeier & S. Nagel, Arbitrage at its Limits, Hedge Funds and
the Technology Bubble, Princeton University Working Paper, Nov. 2002.
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A. What Needs to be Shown
The EMH allowed a court to rely on the rebuttable
presumption that if stocks traded in an efficient market, then
investors could rely on the stock price to accurately incorporate
all publicly available information. This greatly simplified
plaintiffs' burden in proving reliance for the members of a
proposed class. In particular, individual plaintiffs would not
have to prove that they saw the particular misstated piece of
information or that they read the document that should have
contained some omitted information. By relying on the EMH,
individual investors could be said to be implicitly trading in
reliance on the stock price to incorporate all public information.
On the other hand, if the EMU is not true, then even
rational investors would have reasons to trade that were not just
unrelated to the underlying fundamental value of a company,
but even in spite of known deviations of the price from that
fundamental value. For example, under one theory, uninformed
("noise") traders establish a trend that is rational for the
informed traders to follow. Such positive feedback trading by
the informed traders is not based on fundamentals or on reliance
on the integrity of the market.' 52 Consequently, the presumption
that investors can or do rely on the integrity of the market, if
integrity implies that the market is semi-strong efficient, is then
misplaced. Reliance may be more on the trends in the stock and
on the beliefs of uninformed investors.
Moreover, the findings reported above imply that stock
prices are not always based on fundamental value. Summers
has shown that even barely detectable failures in the efficient
market model can lead over the long run to prices exceeding
their fundamental values by thirty percent under reasonable
values for the parameters of his modeL 153 This would reinforce
the conclusion that there is not always ajustifiable presumption
that investors can or do rely on the integrity of market where
that concept is taken to mean the property that stock prices
accurately reflect available information. It also means that, in
securities litigation, individual stocks should be analyzed on a
' See J. Bradford DeLong et al., Positive Feedback Investment Strategies and
Destabilizing Rational Expectations, 45 J. FIN. 379, 380(1990).
143 See generally Lawrence H. Summers, Does the Stock Market Rationally
Reflect Fundamental Values?, 41 J. FIN. 691 (1986).
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case-by-case basis as opposed to an indiscriminate invocation of
the efficient market hypothesis.
If, for example, the positive feedback trading strategy is an
explanation of the performance of adefendant's share price, then
the defendant may not be liable for most of the inflation in the
stock price. 154 When the stock price is inflated during the class
period by a speculative bubble that is pierced by a corrective
disclosure, then there has been a contribution by investors,
including plaintiffs, to the investment losses. The positive
feedback trading causing or compounding price inflation is
beyond the control of the defendant, and thus represents a loss
that would have occurred at some point when the bubble
eventually burst. Thus, the elements of both causation and
damages are affected by the behavior of investors during the
class period.
B. Market Efficiency Diagnostics Based on Stock Price Behavior
1. Bubbles and Overreaction
One of the simplest sets of tests for whether astock behaved
in an efficient manner would include inspection of the stock price
patterns over the class period to see whether fad and
overreaction elements are present. More rigorous testing would
include statistical estimates of the autocorrelation structure, an
examination of the variance of returns over time and various
assessments of whether there has been overreaction or
underreaction in either price increases or price decreases.
These tests 'would then provide evidence on whether the
stock in question blatantly violated the premises of the EMH.
However, they still do not provide evidence that the stock is
154There is no statutory formula for the measurement of lob.6 damages,
though lOb.5 damages are limited through the 4bounce.back" provision of the 1995
Private Securities Litigation Reform Act. Nevertheless, the most common measure
of damages is the "out-of-pocket' measure, under which inflation is measured as the
difference between the amount paid for asecurity and its true value; damages equal
the inflation on purchase less any inflation on sale. Implicit in this definition is
that defendants are responsible for the inflation However , if astocks trading price
can differ from its true value based on fundamentals for reasons other than
defendants' actions, then the logical implication of the securities laws is that
defendants are only responsible for the deviation from true value due to their
fraudulent actions and not any deviation that would have occurred even if no fraud
had been cornniitted.
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actually incorporating news. For example, consider the classic
case of a"stock price" that is initially set at one hundred dollars
and then set in motion by flipping a coin; whenever the coin
turns up heads, the stock price is increased by one dollar and
whenever the coin is tails, the price is moved down one dollar.
Such a stock price series would behave perfectly randomly and
not show statistical evidence of overreaction, underreaction,
fads, or any other psychological phenomenon. However, that
does not mean that the price incorporates any news.i If, for
example, it was announced that starting in ten flips, the coin
would be replaced with another that had a bias towards heads,
the "stock price" would not react until the new coin started to be
used.
2. Price Reaction to News
What is needed, therefore, is a test that examines the
response of the stock price to news even if it does not violate the
basic assumptions of the EMH. Such a test distinguishes
between efficiency as measured by an unpredictable stock price
and one that incorporates all publicly available information.
In terms of the application of the EMIl to securities class
actions, an important question is whether any allegedly
fraudulent information would cause a change in the issuer's
stock price. However, because the market does not know (at the
time) whether any information it receives is legitimate or
fraudulent, this question can be answered by testing whether the
market for a particular issuer's stock responds to news more
generally. If it does, then one is more confident that the stock
price would be affected by any material false information or
would have responded to material omitted information. If the
stock price does not generally respond to news, then the
presumption should then become that the stock was not affected
by any false news and may not have responded to allegedly
omitted information.
Because stock prices move all the time, one must compare
the movements in response to news stories with acontrol group
of prices. One way to do this would be to look at a sample of
days in a class period exclusive of those days alleged to be
corrective disclosure(s) and perform a news search.' 55 An
IM The examination would exclude those days in which acorrective disclosure
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alternative would be to look at a sample just before the class
period. Using whatever sample is chosen, one could then
separate out those days on which the company is mentioned in
the news from those on which it is not, Of course there are
various ways to implement this procedure. For example, there is
the choice of news sources to be searched (e.g., major newspapers
and presswires versus all available news sources), and whether
to limit the search to those stories where the company name
and/or ticker is mentioned in the headline, the headline and lead
paragraph, or anywhere in the story. One could also refine the
search to only focus on particular types of news stories (e.g.,
earnings announcements). In any case, one would still have to
be careful to assign stories to the proper dates (i.e., stories after
a market close could only affect the next day's stock price
movements) and to remove any stories that exist because they
report on aprice movement.
The next step is to determine the abnormal or excess returns
for the stock for each day in the sample period. This procedure is
the same one that is now nearly universally used in measuring
alleged damages; an analyst estimates a relationship between
the issuer's stock price and amarket and/or industry index, finds
the excess price movement in the issuer's stock price relative to
what is predicted by the index, and then determines whether
that movement is statistically significant.' 56
The final step involves comparing the percentage of days
with news that have astatistically significant price movement to
the percentage of days without news that have a statistically
significant price movement. For example, if seven percent of the
days with news have statistically significant price movements
and four percent of the days without news have statistically
significant price movements, then the analyst would test
whether the difference between the seven percent and the four
percent is statistically significant. If it is, then the evidence
would show that, on average, the defendant's stock price reacts
to news announcements; if the difference is not statistically
was made because plaintiffs would normally choose aclass period where corrective
disclosures coincide with large negati ve price movements; including those days in
the analysis would bias the results.
156 The most common choice for statistical significance is the 5% level, though
this test of market efficiency can be done using any level of statistical significance.
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significant, then there would be no basis for saying that the
defendant's stock price is affected by news.
An example of the output of this type of test is shown below
for the Metro Global Media securities litigation.
Metro Global Media, Inc.
Comparison of Significant Price Reactions on Days with News to
Days with No News
September 13, 196 through September 13, 1999
Dave with News Dave with No News
Number with Number with P.Value
Total Significant Percent Total Significant Percent on
Number Price Reaction Significant Number Price Reduction Significant Difference
(2)/(1) (5)1(4)
(1) (2) (3) (4) (5) (6) (7)
10%Signi&ance 204 16 7.8% 551 40 7.3% 0.39
I4wel
6% Significance 284 10 4.9% 551 22 4.0% 0.30
Level
The table illustrates the price movements on the 755 trading
days within the class period for Metro Global Media, Inc. For
each day, we examined whether there was a news story about
the company, excluding 'those stories that simply reported on
prior price movements. We also examined whether the stock
price movement on the day of the news story (or the next trading
day if the story came out after trading ended) was statistically
significant at either the 10% or the 5% significance level.
Looking at the 10% level, we see that in 16 of 204 days with
news stories, or 7.8% of the time, the stock price had a
statistically significant movement associated with the news
story. While this would seem to imply that the stock can react to
news, the analysis on that row also shows that the stock had a
similarly statistically significant movement on 7.3% of the days
when there was no news story.' 57 Column 7 of the table tests
whether the difference between the 7.8% and 7.3% figures is
statistically significant or could be due to chance alone. The
reported p-value of 0.39 means that if we took two random
samples of days without considering if there was news, then 39%
of the time we would find a difference as large as that between
the 7.8% and 7.3% values. 158 This result is far from the standard
167 The fact that the latter figure does not equal 10%, as expected by theory, is
an indication about the change in volatility of the stock and says nothing about
whether it traded in an efficient manner.
158 The test examines whether the means of two samples with potentially
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SLAW REVIEW [Vol.78:81
5% level used in most tests of statistical significance. When we
performed this same test using days that had an even larger
statistically significant price movement, i.e., at the 5% level,
then the difference in the number of days with a statistically
significant price movement was larger (4.9% of the days with
news versus 4.0% of the days without news), but still was not
statistically significant at conventional levels.
While this test addresses the question of whether the stock
responds to news, it does not answer the question about whether
the response is of the correct magnitude. Therefore, this test is a
threshold step, not a sufficient condition, to show that a stock
traded in an efficient market. As discussed, passing this or most
other tests of market efficiency only serves to show that the
stock is responding to news and/or trading in away in which one
cannot earn asupernormal profit; the tests do not show that the
stock price itself necessarily reflects the fundamental value of
the underlying company.
3. Damages in the Absence of the EMH
The question of whether a stock trades in an efficient
market goes not just to the issue of reliance, but also to whether
one can have a reasonably certain proof of damages. Suppose
that an expert determines that after controlling for market and
industry effects astock declined by $10 in response to acurative
disclosure. She must then determine by how much the stock
price was inflated earlier in the class period. If the stock traded
in an efficient market, then the news provided in the disclosure
would generally be assumed to have been accurately valued in
the market as worth $10 at the time of the disclosure. If the
content of the news did not change over the class period, then
one could say that there was an inflation of $10 over the entire
class period due to the news in that disclosure. Alternatively, in
some cases one might argue that the $10 should be measured
using another rule, such as a percentage of the pre-disclosure
stock price (that percentage would represent the inflation over
the class period).' 59
different variances are the same and considers both the 0.5% difference in the two
figures and the variances (or spread) in the daily returns within each of the two
samples.
59 The choice of aconstant-percentage methodology, however, could result in
artificially high damages if claims are limited to the $10 loss actually caused by the
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If the stock does not trade in an efficient market, however,
then it is not clear how any of these rules could apply. That is, if
the market for astock is not efficient, then the $10 price decline
caused by the corrective disclosure need not be related to the
amount that the stock price was inflated at any point other than
the exact moment of the disclosure. Without an efficient market,
the same information that caused a $10 decline at the actual
disclosure could have caused a $1 deàline, a $20 decline, or
perhaps even an increase in the stock price, had it been
announced at any other time. Therefore, unless the market for a
stock is efficient, one cannot use an analysis of the effects of a
disclosure to make areasonably certain estimate of the amount
of fraud in acompany's stock price at any other point in time.
Also, if tests show that the efficient market hypothesis fails
to describe defendant's stock returns, then any estimate of
damages would have to be adjusted for the contribution to
investment losses attributable to the plaintiffs or other factors
beyond the control of the defendants.' 6°
V. MARKET INEFFICIENCY AND THE INTERNET BUBBLE
The findings by psychologists and behavioral economists
have particular relevance for stocks during the period of the
Internet bubble. Specifically, even when Internet stocks
possessed many of the features that courts have used as proxies
for market efficiency, they still were more likely to be inefficient
than non-Internet stocks.
One distinguishing feature about many Internet stocks was
that they traded les on the basis of past performance and more
on a promise of future performance that was not based on a
reasonable growth from the past. While all stock prices are
ultimately based on expectations of future cash flows, for
established companies like General Motors or Ford, those cash
flows can be reasonably estimated and rarely are expected to
corrective disclosure, as opposed to losses incurred over aperiod when other factors
were impacting the stock price. The same concern applies to any non-constant-
dollar measure of inflation.
150 One approach to estimating damages is to use historic information on how
this particular stock, or stocks generally, typically react to earnings surprise
announcements. Such estimates would be based on the large and growing literature
on earnings response coefficients. The general idea is to measure the inflation not
by the difference in stock prices, but by estimating what the effect of the
misstatement is directly.
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grow at rates well in excess of their past growth rates. Internet
stocks differed in that projected future growth rates were often
enormous compared to historical growth rates. Analysts
struggled to quantify both the new technology and its effect on
stock prices. Often, future cash flows were not estimated by
using current cash flows as a starting point; instead, "eyeballs"
and revenues were used to estimate the size of a potential
market, which itself was assumed would grow dramatically as
Internet usage expanded, to which some expected profit margin
was applied. Consequently, there was enormous uncertainty in
these cash flow estimates and in the estimates for Internet
companies' stock prices. 161
Along with this uncertainty came the possibility that if one
could price Internet company stocks properly, there was, at least
in theory, atremendous profit to be made by picking the proper
investments. This feeling only grew as the Nasdaq market took
off and many investors were making large gains, apparently by
picking any company with ".com" in its name or any tie to the
"new economy" of the Internet. One of the interesting
consequences of this mania for Internet stocks was that these
stocks often appeared to satisfy many of the proxies for market
efficiency, such as alarge trading volume, a significant number
of securities analysts following the stock, and numerous market
makers, simply because they were actively traded and followed
by those eager to cash in on the fast-growing sector.
In fact, many of the characteristics of Internet stocks
actually made them more likely to be traded in an inefficient
manner, particularly once they started to take off. For example:
' Because people tended to focus on industries they knew,
which obviously were initially successful or they
wouldn't be around, then due to representativeness, they
were likely to overestimate the probability that
companies in the dot-corn industry would be successful.
This effect would cause a large difference from
fundamental value, particularly in cases where the
actual probability of success was small and ignored.
• Once the Internet stocks started doing well, this
misperception became exacerbated as investors'
l' See Adam M. Zaretsky, Bubble, Bubble, Toil and Trouble: Asset Prices and
Market Speculation, REGIONAL ECONOMISTS, Apr. 1999 (discussing the uncertainty
of whether sharp drops in asset prices may indicate bursting market bubbles).
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tendency to use extrapolative expectations biased many
into assuming that the previous growth in Internet
stocks would be highly likely to continue.
• And, as the Internet stocks rose in value, investors' bias
from selling winning stocks held down the number of
sell orders that would otherwise have appeared, and
which would have exerted downward pressure on these
stocks.
• The high betas (or degree of correlation between the
stock and the market) meant that investors in Internet
stocks would be expected to earn an above-average
return in periods when the market was rising. Thus, as
long as the market generally was going up, Internet
investors would be expected to do extraordinarily well
and not be driven out of the market by experiencing
poor returns.
• Internet stocks also had characteristics that made
potential arbitrageurs even less likely than normal .to
want to intervene when they felt that the prices of these
stocks were unjustifiably high.
• Internet stocks tended to have a very high volatility,
which made arbitrage more risky because there could be
large changes in the vluè of an Internet stock or in the
difference between an Internet stock and whatever was
being used to hedge in the arbitrage attempt.
• Because the overpricing seemed to affect the entire
Internet sector, there was not a similar stock with
which arbitrageurs could hedge. Therefore, it would be
difficult to try to arbitrage away the inefficiencies in the
pricing of any particular stock.
• The Internet stock sector was widely perceived as a
bubble, but one that had been going on for anumber of
years. Thus, the probability of the bubble breaking at
any point seemed low, and those shorting the sector
might have to survive large losses before their bet that
the sector was overvalued paid off.
There was never any guarantee that Internet stocks would
grow into abubble, though with hindsight it is easy to see how
this came about. Once the bubble began, it was easy to see how
it continued and why even those investors who recognized the
existence or likelihood of the bubble did not put in sufficient
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selling pressure to cause the bubble to burst. It is also easy to
see that many of the investors in the Internet sector were not
trading on news or economic fundamentals, but on the
psychological belief that since the sector had done so well in the
recent past, it was likely to continue in the future and they
wanted to be along for the ride.
VT. CLASS CERTIFICATION AND THE FRAUD ON THE MARKET
THEORY: BACK TO THE BASICS (AND GAMMER TOO)
The presumption of reliance in Basic is founded upon the
acceptance of the efficient capital market hypothesis, upon which
the fraud on the market theory is based. The presumption
assists plaintiffs in the proving their claims under section 10(b),
and greatly assists them at the time of class certification.
There are multiple problems. First, neither Basic nor
Camrner truly set forth readily definitive, measurable factors or
markers of market efficiency. This has left courts and litigants
to their own devices. The result is ahodgepodge of case law.
Second, though the Basic Court might have been convinced
on the record before it that the efficient market theory was
"solid," and thus very worthy of granting the plaintiffs a
presumption (rebuttable or not) of reliance, subsequent research
has shown various holes in the efficient market theory.These
holes allow us to question whether plaintiffs in section 10(b)
cases should always be entitled to such a powerful presumption
of reliance simply by invoking ageneral theory and alleging that
it applies to the case at hand, most times without any factual
support..
But assuming no change in the status of either. Basic or
Cainmer—indeed, both have demonstrated longevity, creating
create yet another presumption based upon the principle of stare
decisis—we have tried above to suggest asolution. That solution
really requires a return to the Basic[s], to Rule 23 and Cammer
u. Bloom, in no particular order.
The "Basics" start with the fundamental reality of Rule 23.
As recently stated by the Fifth Circuit Court of Appeals, "[t]he
party seeking [class] certification bears the burden of proof." 62
The burden of proof goes not only to showing compliance with
Berger v. Compaq Computer Corp., 257 F.3d 475, 479 n.4 (5th Cit. 2001)
(citing Castano v. Am. Tobacco Co., 84 F.3d 734, 740 (5th Cir. 1996)).
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the requirements of Rule 23(a), but also to showing that the class
action "is maintainable under Rule 23(b)(1), (2), or (3),"163
Because most securities fraud class actions are certified under
Rule 23(b)(3), it is thus plaintiffs burden to show that common
questions "predominate over any questions affecting only
individual members," and that class resolution is "superior to
other available methods for the fair and efficient adjudication of
the controversy." 164 Thus, under this case law, presumptions or
not, it is plaintiffs' ultimate burden to show that common
questions of reliance predominate over any reliance questions
affecting only individual class members", On amotion for class
certification, it is beyond dispute that court may go behind the
pleadings to ascertain whether the plaintiffs have met the
requirements of Rule 23(a) and 23(b). As noted by the Supreme
Court in General Telephone Company of the Southwest v.
Falcon: 166
[T]he class determination generally involves considerations
that are enmeshed in the factual and legal issues comprising
the plaintiff's cause of action. Sometimes the issues are plain
enough from the pleadings to determine whether the interests
of the absent parties are fairly encompassed within the named
plaintifFs claim, and sometimes it may be necessary for the
court to probe behind the pleadings before coming to rest on the
certification question. 167
6
2 3 Amehern Products., Inc. v. Windsor, 521 U.S. 591, 614 (1997).
164 Id. at 615.
165 See Cainmer v, Bloom. 711 F. Supp. at 1264, 1285 n,34 (D.N.J. 1989)
(discussing the five elements necessary to invoke the presumption of reliance)
(citing Levirison v. Basic, 786 F.3d 741, 750 (6th Cir. 1986)).
The Third Circuit held in the Basic case that in order to invoke the
presumption of reliance based upon the fraud on the market theory, a
plaintiff must allege and prove five elements. A plaintiff must
demonstrate (1) that the defendants made public misrepresentations, (2)
that the misrepresentations were material, (3) that the stock was traded
on an efficient market, (4) that the misrepresentations would induce a
reasonable, relying investor to misjudge the value of the stock, and (5) that
the plaintiff traded in the stock between the time the misrepresentations
were made and the time the truth was revealed. The Supreme Court
essentially approved of these elements but noted elements (2) and (4) may
collapse into one.
Id. (internal quotations and citations omitted).
6 457 U.S. 147 (1982).
1 0
167 Id. at 160 (internal quotations and citation omitted). Indeed, given the
holes in the efficient market theory, one might question whether or not acourt, in
considering aplaintiffs' motion for class certification, could make arote finding that
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Considering that it is a securities class action and it is the
plaintiffs' burden to show compliance with Rule 23(b)(3), how
might—or as we argue, should—such a showing be made by the
plaintiffs that they are entitled to rely on the fraud on the
market theory's presumption of reliance? Clearly, some Cam mer
factors can be helpful in establishing indocators that the stock in
question was capable of trading in an efficient manner. As
demonstrated, however, just relying on many of Cammer's
factors does not necessarily prove that the stock in question
behaved in an efficient manner. Many of the factors, like the
existence of market makers and coverage by securities analysts,
do not even go to the market behavior of a stock. Other factors,
like the average weekly trading volume, are imprecise as well,
and certainly do not show or prove market efficiency. Indeed,
during the Internet boom, many stocks exhibited relatively high
average weekly trading volumes, but also behaved in a volatile
manner, often rising many dollars per share without the
disclosure of news or material information concerning the
company.
In support of their motion for class certification, securities
fraud plaintiffs ought to be required to make some detailed
showing that the stock in question traded in an efficient manner.
Merely demonstrating a single or small number of cases where
there is an apparent cause and effect relationship is not enough,
since this measures only one point in time during the class
period, and only the stock's response to one or a handful of
disclosures. If we have learned anything about the advances of
knowledge, it is that proper tests of whether an effect is present
must be done through the scientific method. One such scientific
approach is to examine both a control group and a treatment
group and, applying the identical test to both, see whether there
is a significant difference in the results. In the case of testing
whether there is a cause and effect relationship between news
and movements in astock price, this means not simply finding a
case where there was news and a stock price movement, but
finding two samples of defendant's stock prices—one with news
and one without—and testing whether the price movements for
the two samples are distinguishable. Though one may argue as
aplaintiff is entitled to rely on the fraud on the market theory's presumpti on of
reliance without a detail review of evidence the evidence submitted by a plaintiff
under the guise of satisfying Cam mer.
Case 1:21-md-02989-CMA Document 567-56 Entered on FLSD Docket 06/07/2023 Page 50 of
50
2004] LESS THAN EFFICIENT CAPITAL MARKETS 129
to how such a price reaction study ought to be performed and
what criteria of stock price movement should be deemed
significant, as noted by the Cczmmer court, this would be a
scientific test of what that Court called "the essence of an
efficient market and the foundation of the fraud on the market
theory?" 8
6 Camrner, 711 F. Supp. at 1287.
1 8
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