Fraud-on-the-market Theory Is a Market Efficient
The principle that the reliance requirement can be satisfied in an efficient capital market shifts the plaintiff's burden of demonstrating reliance on the misrepresentation per se to a presumption that reliance has been satisfied because the security traded in an efficient market. This concept is known as the fraud-on-the-market principle.
Generally, the plaintiff goes on to demonstrate the effect of the misrepresentation on the security's price and the investor's reliance on the market. In an efficient securities market, the market itself performs a substantial part of the valuation process through its reaction to new information. The Basic court said that the "market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price." Basic shifts the burden to the defendant to rebut the presumption that reliance has been satisfied because the security traded in an efficient market.
The key to satisfying the reliance requirement in a fraud-on-the-market case is the demonstration that the securities market on which the security in question trades is efficient. However, the Basic court did not elaborate on how to demonstrate market efficiency. Since then, courts have grappled with the appropriate measure of market efficiency. Similarly, economists have debated market efficiency in the literature. While generally concluding that most markets are efficient, they have debated issues related to the extent of inefficiencies and market abnormalities.
Theory Overlooks Anomalies
A market is generally considered efficient if a security's price rapidly reflects available information such that investors are unable to earn abnormal expected returns by trading the security at the current price in the market. While many securities are broadly followed and widely traded, the certainty of market efficiency becomes less evident for the many securities not traded on the NYSE or those not frequently traded on Nasdaq or another exchange. Also troubling to some researchers are the findings that there are a number of anomalies in the marketplace indicating that abnormal returns can be earned in certain situations. Examples of such anomalies include:
- The January Effect. Small-sized stock portfolios outperform large-sized stock portfolios in January.
- The Book-to-market Effect. Portfolios of firms with the highest book-to-market values have the highest market returns over the long run.
- The Price-earnings Ratio Effect. Portfolios consisting of stocks with low price-earnings ratios outperform stocks with high price-earnings ratios over the long run.
- The Reversal Effect. The worst-performing stocks over a five-year period rebound and outperform previously strong performing stocks over the following three-year period.
According to Random Walk Down Wall Street author Burton Malkiel, the S&P 500 beat 90 percent of large-cap equity funds over a 20-year period.4 A book co-authored by Nobel Prize-winning William Sharpe also concludes that in the United States, financial markets are highly efficient.5 Yet many of the fraud-on-the-market cases addressed by the courts since Basic have focused on small companies, less active than those trading on the NYSE. Some have addressed Nasdaq-traded stocks, others have addressed issues trading on the over-the-counter bulletin board, and still others have addressed bonds or other securities.
It is useful to recall that the Basic court indicated that to accept reliance, "we need only believe that market professionals generally consider most publicly announced material misstatements about companies, thereby affecting stock market prices." To the extent that the expert relies on highly sophisticated technical tools to measure minute degrees of market inefficiency, it may well be economically unjustifiable to conclude that a market being analyzed is inefficient. Furthermore, the court stated that "[w]e 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 Cammer Factors
The criteria for efficiency described by the Cammer court in 1989 are still addressed by courts today.6 These criteria include weekly trading volume, number of security analysts, the existence of numerous market makers, whether the company was entitled to file an S-3 Registration Statement and whether empirical facts show a "cause and effect relationship between unexpected corporate events or financial releases and an immediate response in the stock price."
While courts typically look to Cammer for guidance, the Krogman court in 2001 considered several additional criteria, namely market capitalization, bid-asked spread and float.7 Subsequent decisions have discussed other technical measures, such as serial correlation. Although courts have on occasion considered such small, yet possibly statistically significant, inefficiencies, these inefficiencies are often difficult, if not impossible, to exploit economically.
While defendants frequently make the case that the market for a security in question is inefficient based on the elements listed in the Cammer decision, plaintiffs on the basis of the same elements argue that the market is efficient. Courts have come to carefully question the applicability of the above factors to each particular case. Some factors are potentially more relevant than others. Some, in fact, may contradict others and some may be highly correlated with others. As a result, each factor must be carefully considered and judged in the context of each of the other relevant factors. While defendants' attorneys sometimes argue that there never is sufficient "scientific basis" to support a market-efficiency argument, such a blanket assessment is inappropriate.8 Such language has the effect of making the case that even for companies such as General Motors, Microsoft and Exxon Mobil, the market for their securities cannot be determined to be efficient. These statements have little merit and merely add to the confusion surrounding the appropriate determination of market efficiency. Similarly, it is equally inappropriate for plaintiff's lawyers to conclude efficiency exists by merely listing the Cammer factors in a particular case. To the extent possible, both science and judgment should be used where appropriate in the determination of market efficiency. Since each situation is different, there is no simple formula to determine efficiency. Each situation must be treated with judgment and care. The objective in each case is to determine if the characteristics of the market in which the security trades are such that new information quickly reaches the marketplace.
Consider, for example, some possible issues that may be relevant in considering the Cammer factors:
- Weekly Trading Volume. Large volume ensures that new information is quickly and accurately incorporated into a security's price. Cammer suggests that turnover be measured as a percentage of outstanding shares. Yet if there exists a sizeable holding of shares by insiders, the fraction of total outstanding shares trading weekly may be less relevant than the fraction of the float that trades weekly. The former may inappropriately suggest less-active trading with a slower time to market for new information. In a recent paper describing the indicators of common-stock efficiency, volume was determined to be one of two reliable determinants of market efficiency.9
- Number of Security Analysts. As more analysts follow a stock
or bond, it is generally assumed that information will more quickly be
incorporated into the security's price. Yet some analysts have more
influence than others. Certain analysts work for bulge bracket firms;
others have been cited by Institutional Investor and others have
a particular following. On the other hand, some analysts work for
prestigious firms producing expensive and small circulation newsletters
where new information may reach the market, but not as quickly as the
reports produced by other analysts. Thus, in certain situations a single
analyst can assure rapid information dispersal, while in other matters
several analysts following a security may result in slower capture of
new information by the marketplace. In the paper mentioned in the
previous paragraph, the authors conclude that the number of analysts is
a reliable indicator for determining market efficiency.10
The relevant question for the courts to ask is: Was the market efficient enough so that the security price reflected the misinformation or fraud, thereby causing damage to the investor?
- Number of Market-makers. The existence of numerous market-makers contributes to the speed with which a market reacts to new information. In O'Neil v. Appel the court determined that the number of market-makers is not sufficient and that it is also relevant to determine the volume of shares that they commit to trade and the volume actually traded.11 The impact of market-makers on the speed of information dissemination in any situation must be carefully assessed. Interestingly, the research by Barber, Griffin and Lev indicates that the number of market-makers failed to discriminate between efficiently and inefficiently priced securities.
- Eligibility to File an S-3 Registration Statement. A corporation is entitled to file an S-3 Registration Statement if it has been current in its SEC filings for the last 12 months and if the stock held by non-affiliates has an aggregate market value of more than $75 million. While S-3 eligibility has been found in several cases to weigh in favor of market efficiency, it is not a necessary condition. Smaller firms, for example, may well have other characteristics enabling news to rapidly and fully become imbedded in the security's price.
- Reaction to Unexpected News Events. While the Cammer court listed the factors described in the prior paragraphs, it made clear that the core element in determining whether markets are efficient is whether the stock price reflected the "misinformation" alleged to have been disseminated. In the absence of news, security prices are typically relatively stable, moving up and down randomly with the market. For a market to be efficient, news should rapidly affect a security's price. However, there is no general consensus on the specifics of how quickly the security's price should be affected. Researchers typically analyze the speed with which information reaches the market with an event study. The period over which the researcher measures the time it takes for information to be incorporated into the security's price is called the event window. Experts analyzing market efficiency have presented a wide array of event windows in both the financial literature and in court. In particular, each situation must be carefully evaluated.
The factors described above, along with other germane factors, must be evaluated to determine both relevancy to the matter at hand and their influence on market efficiency. In particular, other factors such as market capitalization, bid-asked spread and float may be relevant in considering whether a market for a security is efficient. Nevertheless, market reality dictates the possibility of market inefficiency for certain securities in certain markets under certain conditions. However, it is important to recall that most researchers agree that markets in the United States are predominantly efficient. The efficient-market debate must not be confused by those using unusually high-powered tests to detect minute inefficiencies that are generally not exploitable. The relevant question for the courts to ask is: Was the market efficient enough so that the security price reflected the misinformation or fraud, thereby causing damage to the investor? It is not to assess whether there was a minute, albeit statistically significant, inefficiency that is difficult to exploit and economically immaterial.
1 Drs. Michel and Shaked are professors at Boston University's School of Management and managing directors of The Michel-Shaked Group, a Boston-based firm providing financial consulting and expert witness services nationwide. Return to article