Does the Efficient Market Theory Help Us Do Justice in a Time of Madness?

Abstract

The efficient market hypothesis looms large in 10b-5 open market securities fraud cases. That hypothesis underlies the fraud-on-the-market doctrine, which permits stock buyers to proceed in these cases by class actions because the doctrine allows the buyers to avoid proving that they individually relied on the defendants’ allegedly false statements. Instead, buyers satisfy the reliance element by alleging that the market for the stock was “efficient.” The buyers thereby invoke a presumption that the market prices at which all class members bought the stock impounded the falsity that the defendants spoke.

The actual effect of each false statement on the price of a particular stock, as that price fluctuated to incorporate new information within its efficient market, is often tested by an “event study.” Such a study purports to isolate the impact of each false announcement on the stock’s price, thereby proving loss causation, materiality and damages, as well as reliance. Each of these 10b-5 elements has a normative component.

The efficient market theory, as applied through the event study methodology, yields legal results that comport with the normative elements of a private, open market securities case when the market displays both (i) mechanical efficiency, with stock prices reacting to new information, and (ii) at least approximate value efficiency, with stock prices rationally related to the values of issuing companies according to some fundamental financial calculation such as that produced by discounting future cash flows to the stockholder for both risk and time of receipt. But when stock prices divorce themselves from company values – as stock prices did during the Internet and telecommunications bubble of 1998-2001 – then the market may continue to display mechanical efficiency but no longer display even approximate value efficiency. Under these circumstances, using the event study methodology to establish the elements of the 10b-5 claim produces results that conflict with the norms behind those elements. When that happens, efficient market theory yields injustice, not justice.

JEL Classification: G18, K22