Chapter 16 - § 16.15 • THE FRAUD-ON-THE-MARKET THEORY

• Jurisdiction: Colorado

§ 16.15 • THE FRAUD-ON-THE-MARKET THEORY

The fraud-on-the-market theory is a concept that is unique to securities litigation. Under the fraud-on-the-market theory, an open-market purchaser of a security for which there is a developed market may maintain a cause of action by alleging that the price at which he or she purchased the security was inflated due to the defendant's fraud. The Supreme Court has based the fraud-on-the-market theory "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."³⁵⁴

§ 16.15.1—Need For An Efficient Market

The basis for the fraud-on-the-market theory and, therefore, giving plaintiffs the benefit of avoiding the requirement of proving individual reliance (which would be prohibitive in most class actions), is the efficiency of the markets in which the securities are traded.³⁵⁵ Without an efficient market there can be no fraud-on-the-market.³⁵⁶ Because of the importance of the efficient market, courts have looked at the issue in determining whether to certify a class under Rule 23 of the federal Rules of Civil Procedure.

Basic did not attempt to define an efficient market, saying only that the fraud-on-the-market theory was "based on the hypothesis that, in an open and developed securities market, the price of a company's stock is determined by available material information regarding the company."³⁵⁷ In determining whether a security is traded on an efficient market, many courts look to Cammer v. Bloom,³⁵⁸ which required courts to examine:

1) The stock's average weekly trading volume;
2) The number of security analysts who follow the stock;
3) The existence of market makers and arbitrageurs active in the stock;
4) The eligibility to file a Form S-3 registration statement; and
5) The "empirical facts showing a cause and effect relationship between unexpected corporate events or financial releases and an immediate response in the stock price."

The elements to determine the existence of an efficient market were restated in Freeman v. Laventhol & Horwath,³⁵⁹ which held the fraud-on-the-market theory is not applicable to claims involving a new issue of tax-exempt municipal bonds since such a market is not an efficient market.

The Freeman court found that a primary market for newly issued, tax-exempt municipal bonds is not efficient and, when the market is not efficient, there is less probability that investors reasonably relied on the price of the bonds as reflecting their true market value.³⁶⁰

The Fourth Circuit conducted an analysis regarding the existence of an efficient market in connection with a motion for class certification in Gariety v. Grant Thornton, LLP.³⁶¹ There, citing Cammer, the court vacated and remanded the district court's class certification because the district court had failed to conduct a rigorous analysis of the market's efficiency. Similarly, in at least two cases, the Fifth Circuit has reversed class certification orders because of the failure of the district courts to apply an appropriately rigorous analysis of the Cammer factors.³⁶² In one of those cases, linger v. Amedisys Inc.,³⁶³ the court vacated class certification in a securities fraud litigation saying that the lower court "applied too lax a standard of proof to the plaintiffs' fraud-on-the-market allegations." The court went on to say that in many cases involving heavily traded securities or well-known stocks, "market efficiency will not even be an issue."³⁶⁴ When the lawsuit "involves small-cap stocks traded in less-organized markets, a demonstration of an efficient market is a prerequisite for certification. . . . Absent an efficient market, individual reliance by each plaintiff must be proven, and the proposed class will fail the predominance requirement."³⁶⁵ The Fifth Circuit indicated that the list it set forth was not exhaustive, but illustrative. The factors "must be weighed analytically, not merely counted, as each of them represents a distinct facet of market efficiency."³⁶⁶

The First Circuit developed a more plaintiff-friendly approach when it said: "To apply the fraud-on-the-market theory, it is sufficient that the market be 'efficient' only in the sense that the market prices reflect the available information about the security."³⁶⁷

The Third Circuit directs courts to "Took[ ] to the movement, in the period immediately following disclosure, of the price of the firm's stock.'"³⁶⁸ Where disclosure correcting the alleged misstatement does not result in negative market movement, the Third Circuit held that the misstatement should not be considered material.

In determining whether the market is "efficient," the Third Circuit has held that, when the investor alleged that the average weekly trading volume on NASDAQ was 38,000 shares, and the stock was actively followed by at least five market analysts whose reports were publicly disseminated, the market was sufficiently efficient.³⁶⁹

§ 16.15.2—Elements Of The Fraud-On-The-Market Theory

The Supreme Court validated the fraud-on-the-market theory in Basic Inc. v. Levinson.³⁷⁰ The Court repeated the court of appeal's finding "that petitioners 'made public material misrepresentations and [respondents] sold Basic stock in an impersonal, efficient market. Thus the class, as defined by the district court, has established the threshold facts for proving their loss.'"³⁷¹ The Supreme Court went on to say that "[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance."³⁷² When a plaintiff alleges that "materially misleading statements have been disseminated into an impersonal, well-developed market for securities, the reliance of individual plaintiffs on the integrity of the market price may be presumed."³⁷³ Loss causation (that is, the decline in the stock price was a result of the correction of a prior misleading statement) is not an element required for the Basic rebuttable presumption of reliance to be applied.³⁷⁴

The Supreme Court reaffirmed Basic's efficient market theory in Halliburton Co. v. Erica P. John Fund, Inc.³⁷⁵ with Basic's rebuttable presumption of reliance that enables securities class actions to proceed without proof of actual reliance on the alleged misrepresentations or omissions.³⁷⁶ However, the Court also held that defendants, such as Halliburton in this case, could oppose class certification by showing that the alleged misrepresentations did not in fact affect the price of the securities at issue. The Court reasoned that evidence of lack of price impact would be admissible to show lack of market efficiency so there was no reason not to allow a defendant also to use it to defeat the presumption of reliance at the class certification stage.³⁷⁷

In the first appellate case applying the Halliburton rationale, IBEW Local 98 Pension Fund v. Best Buy Co., Inc., 818 F.3d 775 (8th Cir. 2016), the Eighth Circuit determined that the plaintiffs' expert showed that conference call statements (following a press release) had no additional price impact on Best Buy's stock beyond the impact from the earlier, non-fraudulent, press release. The Eighth Circuit concluded that the plaintiffs and the defendant's expert reports "severed any link between the alleged conference call misrepresentations and the stock price at which plaintiffs purchased" Best Buy stock, and therefore the district court had "abused its discretion by certifying the class." Id. at 783.

The conference call at 10:00 a.m. on September 14, 2010, followed the issuance of a press release at 8:00 a.m. that day to inform investors that Best Buy was increasing its full-year earnings guidance. The press release was deemed by the district court not to be fraudulent "because it was forward-looking and accompanied by meaningful cautionary statements." Id. at 778. On December 14, 2010, Best Buy held a conference call to indicate that third-quarter sales were less than expected, and it reduced its earnings guidance. The plaintiffs own expert had opined that the economic substance of the non-fraudulent press release and the later conference call statement were "virtually the same." Id. at 782. Plaintiffs expert also concluded that while the press release had immediate price impact, the later conference call "had no additional price impact." Id. Thus plaintiffs own expert was determined sufficient to rebut the Basic Inc. fraud-on-the-market presumption to prove reliance.

The fraud-on-the-market theory was addressed in Dura Pharmaceuticals, Inc. v. Broudo,³⁷⁸ where the Court said, "Normally, in cases such as this one (i.e., fraud-on-the-market cases), an inflated purchase price will not itself constitute or proximately cause the relevant economic loss,"³⁷⁹ but the plaintiff must prove six elements:

1) A material misrepresentation or omission;
2) Scienter (wrongful state of mind);
3) A connection with the purchase or sale of a security;
4) Reliance (sometimes referred to in fraud-on-the-market cases involving public securities markets as "transaction causation");
5) Economic loss; and
6) Loss causation, or a clear "causal connection between the material misrepresentation and the loss."³⁸⁰

The Supreme Court reasoned that a reduced stock price might be caused by market factors or events other than alleged fraud. The Court found that the Ninth Circuit's approach "would allow recovery where a misrepresentation leads to an inflated purchase price but does not proximately cause any economic loss."³⁸¹

In one of the first cases applying Dura, the Central District of California considered a number of material omissions in private offering materials. The plaintiffs in In re Robert T. Harvey Securities Litigation³⁸² asserted that, but for the omissions in the offering materials, they would not have purchased...