Rethinking Basic

Lucian Bebchuk is William J. Friedman and Alicia Townsend Friedman Professor of Law, Economics, and Finance and Director of the Program on Corporate Governance, Harvard Law School. Allen Ferrell is Greenfield Professor of Securities Law, Harvard Law School. This post is based on their recent Harvard Law School Discussion Paper, Rethinking Basic, available here.

Next spring, 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 and has since facilitated securities class action litigation. In a Harvard Law and Economics Discussion Paper that we recently issued, Rethinking Basic, we seek to contribute to the expected reconsideration.

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—focused on the existence of fraudulent distortion—to those advanced by petitioners and those opposing certiorari in Halliburton. 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. 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.

Here is a more detailed overview of our paper and analysis:

On November 15, 2013, the Supreme Court granted certiorari in a case that promises to be of fundamental importance to securities class action litigants. The questions presented in the Halliburton case are twofold: first, whether the Court should overrule or substantially modify the holding of Basic Inc. v. Levinson 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 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.

Rethinking Basic provides 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. 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.

We reach these conclusions on the basis of three fundamental points that should set the conceptual and economic framework within which the questions should be explored:

First, and most crucially, whether a court certifies a securities class action should not depend on a judicial assessment of the “efficient market hypothesis.” Nor should it depend on whether a court deems the market in a particular security (or at a particular moment in time) to be “efficient.” It is unnecessary for the Supreme Court, or for the federal courts more generally, to assess whether conditions of market efficiency obtain in general or in the case of a given company in particular. In short, the Supreme Court does not have to determine whether it finds the view associated with Eugene Fama or the view associated with Robert Shiller (both recipients of the 2013 Nobel Prize in economics for their work on this subject) more persuasive.

To show that an assessment of market efficiency should not be decisive for determining whether potential members of a securities class action are similarly situated in terms of reliance, we explain what the standard tests for efficiency in financial economics are and why they should not be used for assessing class-wide reliance. We review the key types of evidence that have been put forward to question market efficiency and show that, even fully accepting the views and evidence of efficiency critics such as Professor Shiller, it is possible for market prices to be distorted by fraudulent disclosures. Conversely, we demonstrate that, 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 a given fraudulent disclosure. In short, even assuming that the Court is in a position to adjudicate its relative merits, the debate on market efficiency in financial economics should not be the focus in determining class-wide reliance.

Second, the economic issue that should be the focal point of judicial inquiry into whether potential class members are similarly situated in terms of reliance is whether fraudulent distortion of a security’s market price exists. If it does exist, there will be a certain class of investors who are similarly situated in terms of the reliance inquiry.

Consider a scenario in which a materially misleading statement inflated the market price of a security so that the price was higher than it would have been but for the fraudulent statement, and suppose that a class of investors purchased the stock at a price that, unknown to them, was fraudulently distorted. It is appropriate for these investors to rely on the market price not being fraudulently distorted, and in such a scenario, they are similarly situated to the extent that the market price was in fact fraudulently compromised. The existence of such fraudulent distortion—the price being different than it would have been in the absence of the fraud—should be key for assessing class-wide reliance. Whether fraudulent distortion exists can be assessed directly and should not be decided by assessing whether the efficient market hypothesis generally holds true or whether the market for the particular security was efficient.

While the proposed rule, with its focus on fraudulent distortion, represents a meaningful modification of Basic, it retains the Basic Court’s recognition that misstatements and omissions can affect (and thereby get reflected in) market prices and that this can produce class-wide consequences. At the same time, as we explain, our modification addresses the concerns expressed by Justice White in his Basic opinion: among other things, it does not place general reliance on contestable economic theories, and it makes no assumptions about the “true value” of a security.

Third, the rule we propose would avoid some of the significant administrability and implementation problems that have afflicted the federal courts’ practice in this area. Because the courts have thus far had to provide a yes/no answer to whether the market for a given security is efficient, significant problems of over- and underinclusion have arisen. As we explain, a focus on fraudulent distortion would avoid much of the administrability problems lower courts have struggled with when applying Basic. Furthermore, as we document, there are standard and sound methods drawn from the academic finance and accounting literature for ascertaining whether a disclosure resulted in a distortionary price impact (a toolkit that should displace the current Cammer factors, which focus on market efficiency).

In addition, we discuss the allocation of the burden of proof. The proposed modified rule could place that burden on plaintiffs, requiring them to prove the existence of fraudulent distortion, or it could require defendants seeking to prevent class certification to demonstrate the lack of such a distortion. Either allocation of the burden of proof would be consistent with our approach and analytical framework.

The paper is available here and comments would be most welcome.

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