The 'Less Than' Efficient Capital Markets Hypothesis: Requiring More Proof From Plaintiffs In Fraud-On-The-Market Cases

Fri Jan 30 15:24:38 EST 2004
By Dr. David Tabak with Paul Ferrillo of Weil, Gotshal and Manges and former NERA Senior Vice President Dr. Fred Dunbar

The Supreme Court's 1988 ruling in Basic, Inc. v. Levinson allowed plaintiffs in shareholder class actions to rely on the efficient market hypothesis as a means to presume reliance for a proposed class. The ruling was based on the hypothesis that the price of a company's stock in an "efficient" securities market is determined by the available information regarding the company. In such a market, misleading statements will defraud investors, even if those investors do not directly depend on the information when purchasing the stock. For the past 15 years courts have struggled with determining the appropriate tests, or proxies for such tests, to determine when a stock can be found to have traded in an "efficient" market. To further complicate the matter, recent research into the efficient capital markets hypothesis has been critical, finding holes in the theory and bringing its very underpinnings into question.

The authors of this article argue that the efficient capital markets hypothesis sometimes does not hold for a given security. To grasp the impact Basic has had on securities litigation, the authors analyze the plurality and dissenting opinions in Basic, discuss how the courts since Basic have interpreted and viewed the question of whether a particular stock traded in an efficient market, and discuss alternative views to the efficient market hypothesis. The authors apply the lessons of behavioral finance to the Internet bubble. Finally, the authors propose that legal considerations may require plaintiffs to provide evidence that the stock at issue traded in an "efficient market," and that such an analysis may assist a court in addressing the issue of class certification.

This article was first published in 78 St. John's Law Review 81 (2004).