The Limits of the Fraud on the Market Doctrine
William J. Carney, 44(4): 1259–92 (Aug. 1989)
This Article explores the economic reasoning that underlines the fraud-on-the-market doctrine for open and developed markets. It first reviews the rules governing rule 10b-5 decisions and the economic theory used in formulating evidentiary presumptions. Next, it examines the behavior of participants in impersonal markets, and then it examines the market process in open and developed secondary trading markets. It concludes with an analysis of the economic forces operating with respect to new issues and the integrity of an offering.
Mirkin v. Wasserman: The Supreme Court of California Rejects the Fraud-on-the-Market Theory in State Law Deceit Actions
Christopher Boffey, 49(2): 715–39 (Feb. 1994)
In Mirkin v. Wasserman, 858 P.2d 568 (Cal. 1993), the California Supreme Court rejected a call to incorporate the fraud-on-the-market theory into the law of deceit in that state. The theory allows plaintiffs in actions under rule 10b-5 to establish the required element of reliance by showing that they relied on the integrity of the market price for securities they purchased. The author reviews the case and argues that the fraud-on-the-market theory is equivalent to the indirect reliance theory, which is already available to California tort plaintiffs.
Merritt B. Fox, 60(4): 1547—1576 (August 2005)
This article evaluates the issues remaining open after the recent Supreme Court decision in Dura Pharmaceuticals, Inc. v. Broudo, concerning causation in Rule 10b—5 fraud—on—the—market actions. Analytically, for a positive misstatement to cause an investor to suffer a loss, (1) the misstatement must inflate the market price of a security, (2) the investor must purchase the security at the inflated price, and (3) the investor must not resell the security sufficiently quickly that the price at the time of sale is still inflated. The lower courts have been left the task of designing a comprehensive set of rules concerning what the plaintiff must plead and prove, and the acceptable forms of evidence, concerning each of these critical elements. Dura simply narrowly holds that a plaintiff cannot establish causation merely by pleading and proving that the misstatement inflated price.
One important matter on which the Court expresses no opinion is whether loss causation can ever be established where the price at the time suit is brought (or, if earlier, the time of sale) is higher than the purchase price. The article concludes that a blanket rule against actions where the price has increased would be inappropriate because there are situations where the price has increased but each of the three critical elements can still be reasonably easily and definitively established. Where one or more of these elements cannot be reasonably easily and definitively established, however, a price increase is a negative piece of evidence and under some specified circumstances a bright line rule barring actions might be appropriate.
The other important matter on which the Court expresses no opinion is whether the plaintiff must plead and prove a price drop immediately following the unambiguous public announcement of the truth. Again, the Article concludes that a blanket rule requiring such a showing is inappropriate. Other ways of demonstrating that the misstatement inflated price are sufficiently reliable that they should be allowed under at least some circumstances. The absence of a price drop after the announcement, however, makes it less clear when the inflation dissipated, which is relevant to whether the plaintiff bought at an inflated price and did not sell at one. Some plaintiffs can show these other elements reasonably easily and definitively in other ways, for example plaintiffs who purchase the security immediately after the misstatement is made and still hold it at the time of the public announcement of its falsity. For ones who cannot, it may be appropriate to ban actions where there is no post announcement price drop. This problem is less critical for class actions because at least minimum losses to the class as a whole can be established without concern as to when the inflation dissipated.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Independent Directors as Securities Monitors
Hillary A. Sale, 61(4):1375-1412 (August 2006)
This paper considers the role of independent directors of public companies as securities monitors. Rather than engaging in the debate about whether independent directors are good or bad, important or unimportant, the paper takes their existence and basic governance role as a given, focusing instead on what recent statements from Securities and Exchange Commission officials indicating an increased focus on independent directors and their role in preventing securities fraud. The paper notes that the SEC believes that independent directors are on the board to act, at least in part, as securities monitors. This securities monitor role is another aspect of the information-forcing-substance disclosure model that the SEC has used to achieve improved corporate governance. Although directors face heightened risk when they draft or sign disclosure documents, they also have an ongoing responsibility to be informed of developments within the company, ensure good processes for accurate disclosures, and make reasonable efforts to assure that disclosures are adequate. Independent directors with expertise should be involved in reviewing and, sometimes, drafting statements. All directors, however, should be fully aware of the company's press releases, public statements, and communications with security holders and sufficiently engaged and active to question and correct inadequate disclosures. In addition to defining the role of independent directors as securities monitors, the article reviews the liability independent directors might face under private causes of action and contrasts it with the SEC's enforcement powers and remedies. The article describes some of the SEC's prior statements that emphasize the role of independent directors as securities monitors and the importance of their providing both guidance and check and balance.
When Should Investor Reliance Be Presumed in Securities Class Actions?
Roberta S. Karmel, 63(1): 25–54 (November 2007)
Reasonable or justifiable reliance is one of the elements of a claim by a private party under section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"). Section 18 of the Exchange Act has an even stricter reliance requirement, but proof of reliance is not required for a claim under section 11 of the Securities Act of 1933. This Article will discuss the basis for these discrepancies and inquire into whether traditional interpretations of the reliance requirement need to be re–examined. There are at least two possible reasons for such a re–examination at this time. First, the reliance requirement is frequently presumed in securities class actions based on the efficient capital market hypothesis ("ECMH"), but the ECMH has come to be seriously questioned in the academic literature. Second, high–powered decision makers in several recent reports have asserted that U.S. capital markets are becoming less competitive than overseas markets due, in part, to the high level of civil liability under the federal securities laws. These decision makers recommend that the uncertainties as to the elements of liability under Rule 10b–5 be resolved. Once such element is reliance because the issue of reliance in the certification of class actions has become an actively litigated area and the decisions in these cases are often crucial to the outcome of the litigation.
This Article argues that in developing the law of civil liability under Rule 10b–5, the courts should be guided by the doctrine that public companies impliedly represent that the statements they make in U.S. Securities and Exchange Commission ("SEC") filings and other required public utterances are truthful, and accordingly, they should be liable when materially false or misleading statements are made that cause damage to investors, whether or not investors can prove they read and relied upon such statements in purchasing or selling securities. Nevertheless, a plaintiff should be required to prove that such presumed reliance was reasonable. Such a theory of constructive reliance could be achieved through a reinterpretation of section 18 of the Exchange Act, through presumptions concerning reliance in Rule 10b–5 cases, or through legislation or possibly rule making by the SEC.
This Article will discuss the common law action for deceit, its inapplicability to issuer fraud in modern securities markets, and the defects of section 18 of the Exchange Act as a substitute for the common law. The development of Rule 10b–5 actions as an alternative cause of action and the requirements for reliance in Rule 10b–5 cases will also be covered. This Article then will discuss the ECMH, the theories of its supporters and detractors, as well as its use by the SEC in formulating securities disclosure policy. Finally, a revisionist view will be presented of how the fraud–on–the–market doctrine should be used in connection with proof of reliance in securities litigation.
Campbell, Iridium, and the Future of Valuation Litigation
Michael W. Schwartz and David C. Bryan, 67(4): 939 - 956 (August 2012)
Five years ago, two landmark federal court valuation decisions, Campbell and Iridium, held that market evidence—rather than the testimony of paid litigation experts—should be relied on to value corporations for purposes of litigation. While a number of decisions have followed Campbell and Iridium, their full potential to make business valuation litigation less costly and less susceptible to hindsight bias has yet to be realized.
Damages and Reliance Under Section 10(b) of the Exchange Act
Joseph A. Grundfest; 69(2): 307-392 (February 2014)
A textualist interpretation of the implied private right of action under section 10(b) of the Exchange Act concludes that the right to recover money damages in an aftermarket fraud can be no broader than the express right of recovery under section 18(a) of the Exchange Act. The Act’s original legislative history and recent Supreme Court doctrine are consistent with this conclusion, as is the Act’s subsequent legislative history. Section 18(a), however, requires that plaintiffs affirmatively demonstrate actual “eyeball or eardrum” reliance as a precondition to recovery and does not permit a rebuttable presumption of reliance. Accordingly, if the Exchange Act is to be interpreted as a “harmonious whole,” with the scope of recovery under the implied section 10(b) private right being no greater than the recovery available under the most analogous express remedy, section 18(a), then section 10(b) plaintiffs must either demonstrate actual reliance as a precondition to recovery of damages, or the U.S. Supreme Court should revisit Basic, as suggested by four Justices in Amgen, and overturn Basic’s rebuttable presumption of reliance. A textualist approach thus provides a rationale for either distinguishing or reversing Basic that avoids the complex debate over the validity of the efficient market hypothesis, an academic dispute that the Court is not optimally situated to referee.
Lucian A. Bebchuk and Allen Ferrell; 69(3): 671-698 (May 2014)
In the Halliburton case, the United States Supreme Court is expected to reconsider the ruling in the decision of Basic Inc. v. Levinson that, twenty-five years ago, adopted the fraud-on-the-market theory, which has since facilitated securities class action litigation. We seek to contribute to this reconsideration by providing 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.
Halliburton II: It All Depends on What Defendants Need to Show to Establish No Impact on Price
Merritt B. Fox; 70(2): 437-464 (Spring 2015)
Rule 10b-5 private damages actions cannot proceed on a class basis unless the plaintiffs are entitled to the fraud-on-the-market presumption of reliance. In Halliburton II, the Supreme Court provides defendants with an opportunity, before class certification, to rebut the fraud-on-the market presumption through evidence that the misstatement had no effect on the issuer’s share price. It left unspecified, however, the standard by which the sufficiency of this evidence should be judged.
This Article explores the two most plausible approaches to setting this standard. One approach would be to impose the same statistical burden on defendants seeking to show there was no price effect as is currently imposed on plaintiffs to show that there was a price effect when the plaintiffs later need to demonstrate loss causation. The other approach would be to decide that defendants can rebut the presumption of reliance simply by persuading the court that the plaintiffs will not be able meet their statistical burden. If the courts choose the first approach, Halliburton II is unlikely to have much effect on the cases that are brought or on their resolution by settlement or adjudication. If they choose the second approach, the decision’s effect will be more substantial. The Article concludes with a brief discussion of some of the considerations that should be relevant to courts in their choice between the two approaches.
The Myth of Morrison: Securities Fraud Litigation Against Foreign Issuers
Robert Bartlett, Matthew D. Cain, Jill E. Fisch, and Steven Davidoff Solomon; 74(4) 967-1014 (Fall 2019)
Using a sample of 388 securities fraud lawsuits filed between 2002 and 2017 against foreign issuers, we examine the effect of the Supreme Court’s decision in Morrison v. National Australia Bank Ltd. We find that the description of Morrison as a steamroller, substantially ending litigation against foreign issuers, is a myth. Instead, we find that Morrison did not significantly change the type of litigation brought against foreign issuers, which, both before and after this case, focused on foreign issuers with a U.S. listing and substantial U.S. trading volume. Although dismissal rates rose post- Morrison, we find no evidence that this was related to the decision. Settlement amounts and attorneys’ fees remained unchanged post-Morrison. We use these findings to theorize that Morrison was primarily a preemptive decision about standing that firmly delineated the exposure of foreign issuers to U.S. liability in response to the Vivendi case, which sought to expand the scope of liability for foreign issuers whose shares traded primarily in non-U.S. venues. When Morrison is placed in its true context, it is justified as a decision in line with administrative and court actions that have historically aligned firms’ U.S. liability to be proportional to their U.S. presence. Although Morrison had this defining effect, it did not change the litigation environment for foreign issuers, which was the oft-cited import of the decision. More generally, our analysis of Morrison also underscores how the decision has been mistakenly characterized as a case primarily about extraterritoriality rather than standing.
State Section 11 Litigation in the Post-Cyan Environment (Despite Sciabacucchi)
Michael Klausner, Jason Hegland, Carin LeVine, and Jessica Shin; 75(2): 1769-1790 (Spring 2020)
In Cyan, Inc. v. Beaver County Employees Retirement Fund, the U.S. Supreme Court held that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) preserved state courts’ jurisdiction to adjudicate cases brought under the Securities Act of 1933, with defendants having no right to remove a case to federal court. The result of this decision has been a dramatic increase in section 11 cases litigated in state court, often with a parallel case brought in federal court against the same defendants based on the same alleged misstatements.