Halliburton: Fraud-On-The-Market Theory – Rethinking Basic

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Halliburton: Fraud-On-The-Market Theory – Rethinking Basic

Lucian A. Bebchuk

Harvard Law School; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR) and European Corporate Governance Institute (ECGI)

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Harvard Law School; European Corporate Governance Institute (ECGI)

April 2014

The Business Lawyer, Vol. 69, No. 3, pp. 671-697, May 2014

Harvard Law School John M. Olin Center Discussion Paper No. 764


In the Halliburton case, the United States Supreme Court is expected to reconsider the Basic ruling that, twenty-five years ago, adopted the fraud-on-the-market theory, which has since facilitated securities class action litigation. In this paper we seek to contribute to this reconsideration. We provide a conceptual and economic framework for a reexamination of the Basic rule, taking into account and relating our analysis to the Justices’ questions at the Halliburton oral argument.

We show that, in contrast to claims made by the parties, the Justices need not assess the validity or scientific standing of the efficient market hypothesis; they need not, as it were, decide whether they find the view of Eugene Fama or Robert Shiller more persuasive. Class-wide reliance, we explain, should depend not on the “efficiency” of the market for the company’s security but on the existence of fraudulent distortion of the market price. Indeed, based on our review of the large body of research on market efficiency in financial economics, we show that, even fully accepting the views and evidence of market efficiency critics such as Professor Shiller, it is possible for market prices to be distorted by fraudulent disclosures. Conversely, even fully accepting the views and evidence of market efficiency supporters such as Professor Fama, it is possible for market prices not to be distorted by fraudulent disclosures. In short, even assuming the Court was somehow in a position to adjudicate the academic debate on market efficiency, market efficiency should not be the focus for determining class-wide reliance.

We put forward an alternative approach that is focused on the existence of fraudulent distortion. We further discuss the analytical tools that would enable the federal courts to implement our alternative approach, as well as the allocation of the burden of proof, and we explain that a determination of fraudulent distortion would not usurp the merits issues of materiality and loss causation. Questions asked by some of the Justices at the oral argument suggest that such an alternative approach might appeal to the Court.

The proposed approach avoids reliance on the efficient market hypothesis and thereby avoids the problems with current judicial practice identified by petitioners (as well as those stressed by Justice White in his Basic opinion). It provides a coherent and implementable framework for identifying class-wide reliance in appropriate circumstances. It also has the virtue of focusing on the economic impact (if any) of the actual misstatements and omissions at issue, rather than general features of the securities markets.

Halliburton: Fraud-On-The-Market Theory – Rethinking Basic- Introduction

The Halliburton case, now before the Supreme Court, promises to be of fundamental importance to securities class action litigants. The questions presented in this case are twofold: first, whether the Court should overrule or substantially modify the holding of Basic Inc. v. Levinson2 to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the-market theory; and, second, whether the defendant may prevent class certification by introducing evidence that the alleged misrepresentation did not distort the market price of its security. The fraud-on-the-market theory is premised on the idea that the price of a security traded in an “efficient” market will reflect all publicly available information about a company; accordingly, a buyer of the security may be presumed to have relied on that information in purchasing the security. The Basic decision has shaped securities litigation over the past twenty-five years, and its expected reexamination could thus be consequential for this area of the law for years to come.

In this paper we provide a conceptual and economic framework for a reexamination of the Basic rule. To this end, we assess the large body of work on market efficiency in financial economics and bring it to bear on the current debate over the fraud-on-the-market presumption. In this literature, a market can be considered efficient with respect to an information set if it is impossible to make abnormal returns by trading on the basis of that information set. Our analysis leads to the following conclusions regarding the questions presented in Halliburton:

(i) Basic should be substantially modified so as to ensure that class certification in terms of the reliance inquiry does not turn on the “efficiency” of the market in which the security trades – or, more generally, on the validity of the “efficient market hypothesis.” Rather, it should turn on the existence of “fraudulent distortion” – that is, on whether a misstatement affected (and was thus reflected in) the security’s market price.

(ii) Given that the existence of fraudulent distortion should determine class-wide reliance, defendants would always have, as would plaintiffs, the ability to introduce evidence concerning the existence of such distortion.

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