The US Supreme Court reaffirmed the ‘fraud-on-the-market’ theory into today’s ruling on the Halliburton v. Erica P John Fund, affirming its support for a moderate form of the efficient market hypothesis (EMH). While this ruling kept the standards established in Basic Inc V. Levinson in place, it made an important procedural change that will help corporations defend themselves against class action lawsuits.
Fraud-on-the-market relies on EMH to demonstrate reliance
In order for investors to recover damages for securities fraud, they have to show that they relied on the fraudulent information when buying the stock.
“In Basic Inc. v. Levinson, 485 U. S. 224, this Court held that investors could satisfy this reliance requirement by invoking a presumption that the price of stock traded in an efficient market reflects all public, material information—including material misrepresentations,” Supreme Court Chief Justice John Roberts in the majority opinion. “The Court also held, however, that a defendant could rebut this presumption by showing that the alleged misrepresentation did not actually affect the stock price—that is, that it had no ‘price impact’.”
In other words, fraudulent statements are assumed to be priced into securities unless defendants can specifically prove that they aren’t because markets are thought to be generally efficient.
“Moreover, in making the presumption rebuttable, Basic recognized that market efficiency is a matter of degree and accordingly made it a matter of proof. Halliburton Company (NYSE:HAL) has not identified the kind of fundamental shift in economic theory that could justify overruling a precedent on the ground that it misunderstood, or has since been overtaken by, economic realities,” Roberts concludes.
This isn’t an extreme position in favor of the EMH, but even Eugene Fama who was awarded the Nobel Prize last year for coming up with the EMH didn’t expect absolute efficiency.
“The idea that markets are perfectly efficient was always an extreme and unlikely hypothesis. (Fama told us this in class in the 1980s),” write Clifford Asness and John Liew, who studied under Fama together at the University of Chicago and later formed AQR Capital Management. They explain that while they think EMH is a good default position to take on the market, they recognize that inefficiencies are real and that they create opportunities for traders.
Defendants can challenge fraud-on-the-market before class certification
Leaving the fraud-on-the-market theory intact isn’t what Halliburton Company (NYSE:HAL) was hoping for, but the company did win a significant victory. Before this ruling companies weren’t allowed the challenge the fraud-to-market argument before class certification, but after class certification companies are under a lot of pressure to settle because of the risks of losing at trial are high. Now defendants can try to prove that the statements had no price impact during class action certification, potentially preventing a class action lawsuit from getting off the ground in the first place.
“Forbidding defendants to rely on the same evidence prior to class certification for the particular purpose of rebutting the presumption altogether makes no sense, and can readily lead to results that are inconsistent with Basic’s own logic,” writes Roberts.