David A. Brown (left) is a partner at Sherin and Lodgen in Boston, Massachusetts. Raymond W. Henney (center) and Sheldon S. Toll (right) are partners at Honigman, Miller, Schwartz & Cohn in Detroit, Michigan. "[T]he laws of economics have not yet achieved the status of the law of gravity...."1
This article explores the difficulties modern, speculative trading practices pose to the existing legal framework for adjudicating federal securities fraud claims. The existing framework is based on the fraud-on-the-market theory the Supreme Court adopted 13 years ago in Basic Inc. v. Levinson
Application of the theory relieves plaintiffs of the burden of proving personal reliance on the fraud when making their own decision to buy or sell a security. The theory only applies when a stock's price is produced by an "efficient" market,3 i.e
., a market in which material public information is incorporated promptly into the stock's price. Current judicial standards for determining market efficiency, however, focus chiefly on mechanical factors such as the stock's average trading volume and the number of analysts who routinely follow and report on the stock. That focus often is ill-suited to modern trading technologies and strategies and requires re-examination in light of current investment practices.
In early 1997, those strategies and practices substantially affected the share price of shares of Centennial Technologies, Inc., in a way that illustrates the problem. In 1996, Centennial had been a favorite of investors who saw its share price increase 450 percent to a high of $55 per share. In February of 1997, however, Centennial disclosed that its CEO had engaged in fraud so massive and widespread that the company's financial stability was in serious question and announced that its stock would be delisted from the New York Stock Exchange effective March 3, 1997. In reaction to the news, the price of Centennial's shares plummeted but, thereafter, as delisting day approached, rose and fell in a manner that, with the possible exception of one brief period, appeared to bear no relation to new information about the company's status. Empirical and anecdotal evidence suggest that the market for Centennial's stock during some of this period was dominated by speculative investors, including investors attempting to profit from an anticipated "dead-cat bounce" in the price of the company's shares.4
If so, the market for Centennial's stock during periods of speculative domination was not "efficient" because speculators had caused a material deviation, or bubble, in the price of Centennial's shares that was unrelated to the value of those shares based on available information about the company. But current judicial standards for determining market efficiency are unlikely to expose market inefficiencies borne of market domination by speculators. Thus, courts are likely to apply the fraud-on-the-market theory in situations where, as in the Centennial case, that theory truly should not apply.
This Article outlines the fraud-on-the-market theory, discusses the concept of market efficiency that forms the economic underpinning of that theory, reviews the path taken by Centennial shares after disclosure of the CEO's fraud and the evidence suggesting that the path was blazed by speculation, and discusses bubble pricing and the difficulties the existing legal framework faces in the context of modern trading technology and strategies.
I. The Fraud-on-the-Market Theory
Federal securities fraud claims arise under Section 10(b) of the Exchange Act of 1934 and Rule10b-5 promulgated thereunder.5
To state a cause of action for securities fraud, the plaintiff must prove that the defendant, through its agents (1) made misstatements or omissions of material fact; (2) with scienter, that is, either with reckless indifference to the truth or with the intent to manipulate, defraud or deceive; (3) in connection with the purchase or sale of securities; (4) upon which plaintiffs relied; and (5) plaintiffs' reliance was the proximate cause of their injury.6
As in a tort action for fraud or misrepresentation, detrimental reliance by the investor plaintiff is an essential element of a Rule 10b-5 cause of action. The reliance requirement is intended to ensure that plaintiffs recover damages only for injuries that result from the defendant's misrepresentation or omission.7
The United States Supreme Court adopted the fraud-on-the-market in Basic Inc. v. Levinson
That theory is grounded on a belief that investors rely on the integrity of the market.9
In fraud-on-the-market cases, therefore, "the statements identified by plaintiffs as actionably misleading are alleged to have caused injury, if at all, not through the plaintiffs' direct reliance upon them, but by dint of the statements' inflating effect on the market price of the security purchased."10
Building on that foundation, the theory substitutes a rebuttable presumption of investor reliance on alleged misrepresentations or omissions for the requirement that an investor prove his or her actual reliance. Indeed, when the theory applies, investors need not even know about the allegedly fraudulent acts, much less prove detrimental reliance on such acts, in order to recover damages.
Since the Supreme Court's decision in Basic
, federal courts have held that an "efficient" market is a prerequisite to the theory's application.11
Absent an efficient market for the security at issue, plaintiffs may not obtain the presumption of detrimental reliance.12
II. Market Efficiency Under the Fraud-on-the-Market Theory
"The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company. . . ."13
This statement reflects the Supreme Court's implicit adoption of the Efficient Capital Market Hypothesis as the economic underpinning of the fraud-on-the-market theory.14
An "efficient" market, as defined by the Efficient Capital Market Hypothesis, is one that incorporates material publicly available information into share price so rapidly that investors cannot develop a trading rule that will systematically yield greater returns than the market.15
Thus, according to the Efficient Capital Market Hypothesis, material public information about a company is reflected immediately, or nearly so, in the price of a stock. In practical terms, the Efficient Capital Market Hypothesis presumes either (1) that speculative investors will be balanced between predicting short-term increases and predicting short-term decreases in share price, or (2) that in the event of a speculative price imbalance, arbitrageurs and other investors will promptly counter-act the price imbalance, such that the share price will return immediately, or almost so, to equilibrium at a level where the price reflects available public information.16
Stated otherwise, an "efficient" capital market is one in which the current price of a security is the best estimate of what the price of that security will be in the future.17
Accordingly, under the Efficient Capital Market Hypothesis, it is reasonable for investors in an efficient market to rely on the stock price as accurately reflecting all material information publicly available about the company.18
Early studies of market efficiency supported the Efficient Capital Market Hypothesis.19
Such studies examined trading patterns in stocks of large companies listed on the New York Stock Exchange. The empirical evidence showed that share prices responded immediately, or at least "very quickly," to the release of material information.20
Indeed, the data showed that the largest portion of stock price responses occurred within five to fifteen minutes after the release of material information.21
In recent years, however, economic theorists have increasingly questioned the factual validity of the Efficient Capital Market Hypothesis.22
Indeed, a group of eminent theorists believes that "noise" - pricing influences not associated with rational expectations about asset values - plays a far greater role in stock market behavior than previously thought and contributes to market inefficiencies.23
Courts, too, have questioned the validity of the Efficient Capital Market Hypothesis.24
Despite these criticisms, market efficiency as defined by the Efficient Capital Market Hypothesis remains the theoretical foundation for application of the fraud-on-the-market theory. Thus, courts continue to require a factual showing of market efficiency before allowing plaintiffs a presumption of investor reliance.25
"Efficiency" in this context is market efficiency at the time the plaintiff purchased or sold stock.26
The inquiry into market efficiency requires a detailed factual presentation. The initial burden is on the plaintiff to establish a prima facie case of market efficiency.27
The burden then falls on the defendant to rebut the prima facie case and to demonstrate a lack of market efficiency for the particular stock during the putative class period. If the evidence fails to demonstrate market efficiency, or if market inefficiency is shown, then the fraud-on-the-market theory does not apply and the presumption of detrimental reliance is not available.28
When deciding whether an efficient market existed at a particular time, courts consider a variety of factors.29
Most courts use the five factor test set out by the court in Cammer v. Bloom
. Those factors focus on market processes, as follows: (1) the stock's average trading volume; (2) the number of analysts who follow and report on the stock; (3) the number of market makers; (4) the company's eligibility to file an S-3 Registration Statement; and (5) the reaction of the stock price to unexpected news events.30
Some courts have identified other factors to consider, including (6) capitalization of the company; (7) the bid-ask spread of the stock; and (8) the "float", or percentage of stock not held by insiders.31
The cited cases focused on market efficiency in the context of the mechanics or process of the market rather than on the correlation, or lack thereof, between share price and the information available about the company. However, the efficient market theory presumes that all material information is reflected in the share price, and thus that the share price is an accurate predictor of value. Consistent with this theory, a demonstration that share price is unrelated to available information, and that it therefore would be unreasonable to rely on share price as an accurate predictor of value, should be sufficient to demonstrate a lack of market efficiency and thus to deprive investors of the presumption of reliance available under the fraud-on-the-market theory.
III. The Case Study32
Trading in the shares of Centennial Technologies, Inc. during a relatively brief period in February 1997, provides a concrete example of the problem discussed above. Centennial is a Delaware corporation that manufactures computer cards and related hardware in Massachusetts. Centennial's stock was traded on the New York Stock Exchange. In 1996, Centennial's share price increased 450 percent, reaching a high of $55 per share in December 1996. It was the highest flying stock on the Exchange that year.
Unfortunately, the extraordinary market performance of Centennial's stock was the result of a massive fraud engineered by Centennial's founder and Chief Executive Officer Emmanuel Pinez. The fraud artificially inflated Centennial's sales volume and profit figures, which increased Centennial's share price. Absent the fraud, Centennial's records suggest that it would never have shown a profit and, indeed, that it likely would not have met the requirements for listing on the New York Stock Exchange.
The fraud was discovered and disclosed in early February 1997. Several things happened immediately. Pinez was removed from office (and arrested); the New York Stock Exchange suspended trading on Feb. 10, 1997, and then announced its intention to move to de-list Centennial's stock from the exchange effective March 3, 1997 (the last trading day would be Friday, Feb. 28 1997); Centennial hired accountants to investigate and to determine the precise scope of the fraud; and Centennial hired an Interim CEO to run the company during this difficult time.
Trading in Centennial's stock resumed on Tuesday, Feb. 18 1997. By Thursday, Feb. 20 1997, Centennial's stock price had dropped to $2 per share. On Monday, Feb. 24 1997, the stock opened at $2.75. That day the share price began to rise on heavy volume, despite the fact that trading was expected to close on Friday, Feb. 28 1997. By the end of the day, Centennial's stock had reached $4.50 per share. Centennial's stock opened at $5.75 per share on Tuesday, Feb. 25 1997. Shortly before noon that day, the price reached more than $7.50 per share. In effect, the price of the stock had more than tripled in a day and a half, without any material new information about the company becoming available.
At 11:49 a.m. on Tuesday, Feb. 25 1997, the Reuters News Service published a report containing certain statements purportedly made by the Interim CEO in a telephone interview that morning.33
During the next half hour, trading volume in Centennial's stock was high, but the price reaction to the Reuters publication was small (or non-existent); Centennial's share price rose from $7.50 to $8.125.
Later the same day, some two-and-a-half hours after the Reuters publication, Centennial's share price began to rise sharply in a high volumes of trading. Shortly after 3:00 p.m., Centennial's share price reached $14.75. The New York Stock Exchange then halted trading due to an order imbalance on the buy side. Shortly thereafter, the trading halt was changed from order imbalance to "news pending", i.e
., an expected announcement by the company of material new information.
The halt continued until the morning of Thursday, Feb. 27 1997. In the interim, Centennial clarified the remarks reported by Reuters and released new information about the company. On Thursday, Centennial's stock opened at $3.75 per share and, after a brief halt in trading that morning due to an order imbalance, the stock closed at $3.50. Centennial's stock closed at $3.00 per share on Feb. 28 1997, which was the last day it traded on the New York Stock Exchange (or any other major exchange).
Investors who bought Centennial shares after Reuters published its news article sued, claiming that the reported comments allegedly made by the Interim CEO were misleading. Plaintiffs claimed that the run-up in share price following publication of the Reuters article was attributable to the comments reported to have been made by the Interim CEO. Plaintiffs sought damages for the difference between their purchase price and the "true" value of Centennial's stock. The class period was slightly more than three hours long.
The available evidence indicates that trading activity in Centennial's stock on the afternoon of Feb. 25 1997, was heavily influenced not by the Reuters story but by individual investors pursuing momentum investment and other short-term trading strategies.34
In the absence of any new public information about the company, the share price rose from $2.75 when the market opened on Feb. 24 to almost $8 by noon on Feb. 25. The stock price nearly doubled again to $14.75 by 3 p.m. that afternoon. Although it is difficult to determine the precise cause of the increase, noise traders appear to have had a substantial influence on volume and share price. Postings on Internet chat boards that afternoon, although anecdotal only, support the suggestion that many investors were seeking to take advantage of a "dead cat bounce" in Centennial's share price. For example, "Day Trader's image of the bouncing dead cat has been realized. Congratulations to the gamblers who bought low and are reaping salvation on lost funds and to those who saw an opportunity, gambled and are taking profits. The saga continues to unfold." (Posted Monday, 2/24/97, at 5:22 p.m., ET); "That dead cat must have been made of rubber!! Made 100 percent today, just bought in last week. I'm out and never looking back!!!" (Posted Monday 2/24/97, at 5:46 p.m., ET); "To all, any idea what this dead cat is going to do tomorrow??? Is it going to wake up and jump again????" (Posted 2/24/97 at 8:06 p.m., ET). It is relatively clear that investors had created a speculative bubble in Centennial's share price, and that an "efficient" market - one in which the share price accurately reflected available public information - did not exist in Centennial stock on the afternoon of Feb. 25 1997.35
IV. Bubble Pricing And The Efficient Capital
Bubble pricing, like that seen in trading of Centennial shares, is not unusual, particularly for short periods of time. Although the price of securities eventually reaches a price/value equilibrium through arbitrage,36
market efficiency has a time dimension,
that is, the market requires time to correct error-driven or irrational order flows.
As Professor Langevoort has recognized, "[s]mart money cannot operate as an immediate counterweight" to a stock price driven by "a crowd of trend chasers, overreacting to the most recent or vivid news, their illusions and emotions....."37
In fact, in the short run, arbitrageurs can tend to feed the bubble rather than help dissolve it.38
Indeed, even professional investment managers will, under some circumstances, mimic the investment decisions of other managers.39
Thus, "a bubble may persist for a very long period of time, even if arbitragers recognize the existence of the bubble....."40
The Efficient Capital Market Hypothesis does not account adequately for the time element necessary to correct speculative bubbles or other market imbalances. As Langevoort states:
[T]he efficiency hypothesis states that market prices behave as if investors were rational and invest resources in information only to the limited point of positive expected return. Nothing in that hypothesis denies what most popular accounts assume: that much information searching and trading by investors, from institutions on down, is done in the (perhaps erroneous) belief that undervalued or overvalued stocks exist and can systematically be discovered. Noise theorists only stress that the behavior of this class of speculators can be driven by pseudo-signals and cognitive illusions, as well as by fundamental analysis, thus moving prices away from value more frequently and for longer periods of time
The Centennial case study illustrates that momentum investors engaging in short-term trading strategies can create market inefficiencies when group trading practices over-react to events or expectations.42
Such a group dynamic can lead to random swings in investor sentiment which can have profound effects on share price, particularly for a small stock.43
Thus, periods of market inefficiency are not rare, and the mechanisms for creation of such inefficiency are well-recognized. The speed and nature of modern trading practices have the potential to increase the occurrence of pricing bubbles caused by group over-reaction. Market inefficiency can also persist for significant periods of time, sustained by investment decisions unrelated to underlying information about the company. Those circumstances require careful reexamination of the legal framework for application of the fraud-on-the-market theory.
V. Issues Concerning The Current Legal Framework For Application of The Fraud-On-The-Market Theory.
"The linchpin of the fraud-on-the-market theory is the existence of an efficient market."44
The Centennial case raises the question whether judicial analysis of market efficiency should focus only on market processes, or whether a demonstrated lack of nexus between market price and available material information about the company should be sufficient to demonstrate a lack of efficiency and thus to preclude the presumption of reliance. In the Centennial case, investors seeking to profit from the "dead cat bounce" created a speculative bubble in Centennial's share price. The economic theory underlying the fraud-on-the-market doctrine suggests that a speculative pricing bubble – itself demonstrative of a lack of market efficiency - should preclude investors from obtaining the advantages of the presumption of reliance.45
As discussed earlier, courts have tended to focus on the mechanics or processes of the market in applying the fraud-on-the-market theory. However, if the theory is to be applied consistently, investors who buy stocks at prices clearly unrelated to underlying value or available information, such as investors who purchased Centennial stock on the afternoon of Feb. 25 1997, should not be able to benefit from the presumption of reliance. It is difficult to presume investor reliance on the integrity of the market price where such integrity is obviously suspect or missing. In such cases, as with short sellers, the fraud-on-the-market theory should not be available.46
There are contrary views. For example, Professor Jonathan Macey and his colleagues have suggested that, regardless of market efficiency, investors should be entitled to rely on the integrity of the market and, if the market has been influenced by fraud, should be entitled to recover damages for injuries caused by the fraud. Under this approach, plaintiffs need not prove market efficiency or any issues relating to reliance. Rather, plaintiffs must prove only that at the time of purchase the share price of the stock was influenced by the fraud. Plaintiffs then would be entitled to recover damages for losses the fraud caused.47
Professor Macey's approach has not been adopted by the courts. Moreover, in cases like Centennial, this approach is likely to cause more problems than it solves. Investors are entitled to recover damages only for injuries caused by fraud, i.e.
, for the incremental increase in price the investor paid for the stock that is causally connected to the fraud.48
Typically, experts perform event studies to estimate the incremental increase in share price caused events on which the suit is based.49
However, in markets where prices are unrelated to available information about the company, it is exceedingly difficult if not impossible to differentiate between the increase caused by fraud and the increase caused by other factors.
There is no single solution to the difficulties facing the fraud-on-the-market theory when that theory encounters speculative trading. As the Centennial case demonstrates, however, short-term price disequilibrium caused by speculative group behavior is likely to be a growing phenomenon. So, too, is the phenomenon of longer-term bubble pricing, as recent events in technology stock pricing have shown. Both situations are demonstrative of a lack of market efficiency. The fraud-on-the market theory, as traditionally formulated, should not apply to these situations.
The fraud-on-the market theory applies only where the market for a security is "efficient." Courts have focused their analysis of the efficiency on market processes but that focus does not account properly for inefficiencies demonstrated by price/value disequilibrium in markets dominated by modern, speculative trading practices. The Centennial case provides an example of market inefficiency where share price was unrelated to material information available about the company or to the company's underlying value. In such cases, investors who purchase stock should not be presumed to be acting in reasonable reliance on the integrity of the market and thus should not be entitled to the presumption of reliance.
1. In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 271 (2nd Cir. 1993). [back]
2. 485 U.S. 224 (1988) [back]
3. The fraud-on-the-market theory is based on the Efficient Capital Market Hypothesis. The Efficient Capital Market Hypothesis is an economic theory which holds that efficient capital markets incorporate material available information about a company into the company's share price immediately, or nearly so, such that investors cannot develop a trading rule that will deliver greater returns than the market. Nathaniel Carden, Implications of the Private Securities Litigation Reform Act of 1995 for Judicial Presumptions of Market Efficiency
, 65 U. Chi. L. Rev. 879 (1998). [back]
4. The "dead-cat bounce" is a market pattern whereby a large decline in a stock's price is followed by a brief sharp increase in share price. Thus, where a company's stock suffers a catastrophic price decline followed by a "bounce" or short-term increase in the share price, the increase is termed a "dead-cat bounce." For an example of the use of the term to describe this phenomenon, see Ann Coleman, "Dead CAT Bounce," Foolish Four Portfolio (The Motley Fool), November 22, 1999. [back]
5. 15 U.S.C. § 78j (2001); 17 C.F.R. § 240.10b-5 (2001). [back]
6. Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1217 (1st Cir. 1996). [back]
7. Tolan v. Computervision Corp., 696 F. Supp. 771, 773 (D. Mass. 1988). [back]
8. 485 U.S. 224 (1988). [back]
. at 247 ("An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price"). Investors who do not rely on the integrity of the market, such as short sellers, do not gain the benefit of the presumption of reliance available under the fraud-on-the-market theory. See
Zlotnick v. TIE Communications, 836 F.2d 818, 822 (3rd Cir. 1988) (illogical to presume reliance on integrity of market by short sellers since short sellers by definition believe that the market price overstates the value of the security). See also
Ganesh LLC v. Computer Learning Centers, Inc., 183 F.R.D. 487, 491 (E.D. Va. 1998). [back]
, 82 F.3d at 1218. [back]
In re Resource America Sec. Litig., 202 F.R.D. 177 (E.D. Pa. 2001); In re Ribozyme Pharm., Inc. Sec. Litig., 119 F. Supp.2d 1156 (D. Colo. 2000); In re MDC Holdings Sec. Litig., 754 F. Supp. 785 (S.D. Cal. 1990). See also
Cammer v. Bloom, 711 F. Supp. 1264 (D. N.J. 1989) (holding that the fraud on the market theory presumption is available only when the plaintiff alleges and proves that securities were traded in an efficient market). See also
Victor Bernard, Christine Botosan & Gregory D. Phillips, Challenges to the Efficient Market Hypothesis: Limits to the Applicability of Fraud-on-the-Market Theory
, 73 Neb. L. Rev. 781, 785-86 (1994); Freeman v. Laventhol & Horwath, 915 F.2d 193 (6th Cir. 1990) (stating that fraud on the market theory cannot be applied logically to securities that are not traded in efficient markets). [back]
12. Krogman v. Sterritt, 2001 WL 313963 (N.D. Tex. 2001) (denying class certification in absence of presumption of reliance where no efficient market established); Griffith v. GK Intelligent Systems, Inc., 197 F.R.D.298 (S.D. Tex. 2000) (denying application of the fraud-on-the-market theory where plaintiffs failed to establish market efficiency); Yadlosky v. Grant Thornton LLP, 2000 CCH Sec. L. Rep. *90, 920 (E.D. Mich. 2000) (same). [back]
13. Basic Inc
., 485 U.S. at 241 (quoting
Peil v. Speiser, 806 F.2d 1154, 1160-61 (3rd Cir. 1986)). [back]
Lawrence A. Cunningham, From Random Walks to Chaotic Crashes: The Linear Geneology of the Efficient Capital Market Hypothesis
, 62 Geo. Wash. L. Rev.
546, 548 & fn. 6 (1994); Jonathon R. Macey & Geoffry P. Miller, Good Finance, Bad Economics: An Analysis of the Fraud-on-the-Market Theory
, 42 Stan. L. Rev.
1059 (1990) ("Macey & Miller"). [back]
note 3, at 879.There are strong, semi-strong and weak versions of the Efficient Capital Market Hypothesis. Macey & Miller, supra
note 14 at 1077. All references in this article are to the "semi-strong" version of the Efficient Capital Market Hypothesis. See
In re Resource America Sec. Litig.
, 202 F.R.D. 177 (E.D. Pa. 2001), at n.12 (Supreme Court in Basic
adopted the semi-strong version of the Efficient Capital Market Hypothesis). [back]
Binder v. Gillespie, 184 F.3d 1059, 1064-65 (9th Cir. 1999). See, e.g.
, In re Burlington Coat Factory Sec. Litig.
, 114 F.3d 1410, 1425 (3rd Cir. 1997) (an efficient market i