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E-MailLucian 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. They are co-authors of Rethinking Basic, a Harvard Law School Discussion Paper forthcoming in the May 2014 issue of The Business Lawyer, that is available here. This post is the first in a three-part series in which they remark on the oral argument at the Halliburton case.
Last week the Supreme Court heard oral arguments in the Halliburton case (transcript available here), which is expected to have a major impact on the future of securities litigation. Encouragingly, there were signs that a number of the Justices might choose to avoid making a judgment on the state of efficient market theory and to focus on the presence of fraudulent distortion (sometimes also referred to as price impact). As we explain in our recent paper, Rethinking Basic, adopting such an approach would be the desirable outcome of this major case both conceptually and practically.
In this first post of a three-part series on the Halliburton oral argument, we comment on prospects of the fraudulent distortion approach in light of what was said at the oral argument. The two subsequent posts will discuss (1) the implementation of such an approach and, in particular, the availability of tools other than events studies for this implementation, and (2) the consistency of the fraudulent distortion approach with not resolving merit issues at the class certification stage. In their briefs, one side of the case argued that the Justices should overrule the Basic ruling in part because of the evidence of market inefficiency that has accumulated over the past twenty five years. The other side, however, urged the Justices to recognize the substantial support that the efficient market hypothesis still has among financial economists.
In contrast to the primary claims made by the parties, our analysis has shown that the choice the Justices face does not require assessing the validity or scientific standing of the efficient market hypothesis; the Justices need not, as it were, decide whether they find the view of Eugene Fama or Robert Shiller more persuasive. 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.
The alternative approach that we support would make class-wide reliance depend not on the “efficiency” of the market for the company’s security but on the existence of fraudulent distortion of the market price. As we analyze in detail in Rethinking Basic, focusing on fraudulent distortion avoids the problems with current judicial practice identified by petitioners (as well as those stressed by Justice White in his Basic opinion). Furthermore, it provides a coherent and implementable framework for identifying class-wide reliance in appropriate circumstances. It also has the considerable 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. The fraudulent distortion approach thereby avoids the significant over- and under-inclusion problem that plagues the current “fraud on the market” approach.
We were thus pleased to see a number of questions from the Justices signaling recognition that the Court should avoid choosing between Professors Fama and Shiller. Chief Justice Roberts asked, “How am I supposed to review the economic literature and decide which of you is correct on that?” Furthermore, at one point during the oral argument, Justice Kagan asked defense counsel, “so you are not relying anymore on the notion that the efficient markets hypothesis has been undermined. That is not one of the three points that you’re making . . . You just say Halliburton has never said that market prices, has never contested that market prices generally respond to new material information. So you are agreeing with that, that market prices generally respond to new material information?” Defense counsel answered, “Cited at that general—general level, we don’t disagree with it.”
We were also pleased to hear questions from the Justices raising the possibility of a test that focuses on what in our view should be the touchstone—the existence or absence of fraudulent distortion. For instance, at one point during the oral argument, Justice Kennedy noted that an approach based on fraudulent distortion “does seem to me to be a substantial answer to your economic analysis to the—to the—challenge you make to the economic premises of the Basic decision.” Justice Sotomayor on a similar note stated “If you’re going to require proof of price impact, why not do away with market efficiency? The whole premise of the other economic theory that you rely on is that market efficiency is irrelevant.” Justices Alito, Breyer and Ginsburg also asked questions related to the issue of fraudulent distortion.
Of course, predicting the outcome of the case from what was said at the oral argument is difficult. But we have found what was said to be promising. Basing class certification on the existence of fraudulent distortion, rather than on the general efficiency of the market in which the company’s securities are trading, would provide a conceptually sound and workable framework for securities litigation. We will discuss in subsequent posts how such an approach should be implemented and its consistency with recent Supreme Court cases on the stage in which merit issues should be resolved.
