Fraud-on-the-market Theory Is a Market Efficient

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May 2005

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Serious misstatements or omissions of
material fact by a company in a press release or other public
announcement are sometimes a precursor to the firm's financial distress
or even bankruptcy. For investors who have lost money purchasing or
selling a company's debt or equity securities or options as a result of
these misrepresentations, class action litigation has often become the
only economically feasible approach to seek redress. In the 1988 case
Basic Inc. v. Levinson, the Supreme Court dramatically changed
the nature of 10b-5 securities litigation by upholding the principle
that in an efficient market the stock price reflects all publicly
available information, and thus the investor relies on the integrity of
that price.<a href="#3" name="3a">3</a> In
other words, it is not necessary in an efficient market that an investor
directly rely on the specific misstatement made by the firm. A
misleading statement can defraud an investor even if the investor never
directly heard the misstatement, because the price of the security
reflects that misleading information. Basic states that "the
causal connection between the defendants' fraud and the plaintiffs'
purchase of stock in such a case is no less significant than in the case
of direct reliance on misrepresentations."

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.

<h4>Theory Overlooks Anomalies</h4>

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:

<ul>
<li>The January Effect. Small-sized stock portfolios outperform
large-sized stock portfolios in January.

</li><li>The Book-to-market Effect. Portfolios of firms with the
highest book-to-market values have the highest market returns over the
long run.

</li><li>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.

</li><li>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.
</li></ul>

While these and other market anomalies exist, many leading economists
still argue that markets in the United States are generally efficient
and that it is difficult, if not impossible, to consistently exploit
profit opportunities based on new information arriving in the
marketplace. None of these anomalies are predicated on new information
coming to the market, but on longstanding security and market
characteristics (e.g., P/E ratios, Book/Market ratios).

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.<a href="#4" name="4a">4</a>
A book co-authored by Nobel Prize-winning William Sharpe also concludes
that in the United States, financial markets are highly
efficient.<a href="#5" name="5a">5</a> 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."

<h4>The Cammer Factors</h4>

The criteria for efficiency described by the Cammer court in
1989 are still addressed by courts today.<a href="#6" name="6a">6</a> 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.<a href="#7" name="7a">7</a> 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.<a href="#8" name="8a">8</a> 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:

<ul>
<li>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.<a href="#9" name="9a">9</a>

</li><li>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.<a href="#10" name="10a">10</a>

<blockquote><blockquote>
<hr>
<big><center>
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?
</center></big>
<hr>
</blockquote></blockquote>

</li><li>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.<a href="#11" name="11a">11</a> 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.

</li><li>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.

</li><li>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.
</li></ul>

<h4>Conclusion</h4>

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.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> 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. <a href="#1a">Return to article</a>

<a name="2">2</a> Dr. Steven Feinstein is a
professor at Babson College and a senior expert at The Michel-Shaked
Group. <a href="#2a">Return to article</a>

<a name="3">3</a> Basic v. Levinson,
485 U.S. 224, 108 S.Ct. 978, 989-91, 99 L.Ed. 2nd 194 (1988). <a href="#3a">Return to article</a>

<a name="4">4</a> Malkiel, Burton,
"Reflections on the Efficient Market Hypothesis: 30 Years Later," The
Financial Review, Issue 40. 2005. <a href="#4a">Return to
article</a>

<a name="5">5</a> Sharpe, Alexander and
Bailey, Investments, Prentice Hall, Upper Saddle River (1999). <a href="#5a">Return to article</a>

<a name="6">6</a> Cammer v. Bloom,
711 F. Supp. 1264, 1277 (D. N.J. 1989). <a href="#6a">Return to
article</a>

<a name="7">7</a> Krogman v.
Sterritt, 202 F.R.D. 467 (N.D. Tex. 2001). This matter involved an
OTC bulletin board stock. <a href="#7a">Return to article</a>

<a name="8">8</a> Brav, Alon and Heaton,
J.B., "Market Indeterminacy," The Journal of Corporation Law,
(Summer 2003). <a href="#8a">Return to article</a>

<a name="9">9</a> Barber, Brad, Griffin,
Paul and Lev, Baruch, "The Fraud-on-the-market Theory and the Indicators
of Common Stocks' Efficiency," The Journal of Corporation Law
(Winter 1994). <a href="#9a">Return to article</a>

<a name="10">10</a> Ibid. <a href="#10a">Return to article</a>

<a name="11">11</a> O'Neil v. Appel,

165 F.R.D. 479 (W.D. Mich. 1996). <a href="#11a">Return to article</a>

Journal Authors

Allen Michel

Israel Shaked

Steven P. Feinstein

Journal Date

Sunday, May 1, 2005 - 12:00