Mismatch: the misuse of market efficiency in market manipulation class actions.

• Author: Korsmo, Charles R.

ABSTRACT

Plaintiffs commonly bring two distinct types of claims under section 10(b) of the Securities Exchange Act of 1934: (1) claims of material misrepresentations or omissions, and (2) claims of trade-based market manipulation. Despite the distinctive features of the two types of claims, courts have tended to treat them identically when applying the "fraud on the market" doctrine. In particular, courts have required both types of plaintiffs to make identical showings that the relevant security was traded in an "efficient market" in order to gain a presumption of reliance. The reasons for requiring such a showing by plaintiffs in a misrepresentation case are, however, inapplicable in market manipulation cases. Plaintiffs alleging market manipulation should not be required to demonstrate an efficient market in order to benefit from the fraud on the market doctrine's presumption of reliance. If plaintiffs are made to make any showing at all, it should be a showing of loss causation.

TABLE OF CONTENTS INTRODUCTION I. 10B-5 ACTIONS AND THE FRAUD ON THE MARKET DOCTRINE A. Origins of the 10b-5 Action B. The Fraud on the Market Doctrine 1. Theoretical Underpinnings of the Fraud on the Market Doctrine 2. Basic Inc. v. Levinson 3. Implementation by the Lower Courts--The Requirement of an "Efficient Market" II. MARKET MANIPULATION A. Defining Market Manipulation B. Real-Life Examples of Alleged Market Manipulation 1. United States v. GAF Corporation 2. United States v. Milken 3. United States v. Mulheren 4. In re IPO Securities Litigation 5. Desai v. Deutsche Bank Securities C. Conditions for Successful Market Manipulation 1. Liquidity and Demand Effects 2. Information Effects III. THE "EFFICIENT MARKET" REQUIREMENT IN MANIPULATION CLAIMS IV. IPO AND DESAI--THE "EFFICIENT MARKET" REQUIREMENT IN ACTION A. In re IPO Securities Litigation 1. Initial District Court Proceedings 2. Appeal to the Second Circuit--IPO III 3. Back to the District Court B. Desai v. Deutsche Bank Securities 1. Minnesota District Court 2. California District Court 3. The Ninth Circuit Opinion V. OUT OF THE MUDDLE: A "Loss CAUSATION" REQUIREMENT CONCLUSION INTRODUCTION

On May 20, 2009, the SEC filed a civil complaint against eight participants in an alleged scheme to manipulate the prices of at least four "penny stocks" (1)--a scheme which allegedly netted the participants illicit profits of at least $6.2 million. (2) The allegations regarding one of the four companies, Asia Global Holdings Corporation, are representative. Asia Global shares trade over-the-counter, (3) and traded for around $0.11 per share in August of 2006, just prior to the manipulation. (4) Average trading volume was extremely light, with only a few hundred thousand shares--less than $100,000 worth changing hands in a typical trading week. (5) On August 9, 2009, the manipulators sprang into action and began to engage in massive "wash sales, matched orders, and other manipulative trading, to give the market the false impression that there was real demand for these securities." (6) Trading volume jumped to more than ten million shares per week, and the share price jumped to an intraday high of $0.41 on August 25. (7) Between August 30 and September 5, a week during which trading volume peaked at more than forty million shares, (8) the manipulators dumped nearly eight million shares into the wave of demand, netting approximately $1.3 million. (9) By December of 2006, Asia Global stock was selling below $0.05 per share, and it now trades at around $0.003 per share, with an average weekly volume of only a few hundred thousand shares. (10) That these manipulations took place in small, thinly traded stocks--far from the glare of Wall Street analysts and the financial press--is wholly predictable. To see why, one need only ask what conditions must be met for such a "trade-based" market manipulation to succeed. First and foremost, a would-be manipulator seeks to create a fraudulent price/volume "signal," giving other traders a misleading impression of increased demand for the stock and falsely suggesting that someone has uncovered important new information about the company.

To do so, a manipulator seeks to create a noticeable "spike" in a stock's price--a spike that other traders, perhaps naive day traders searching for stocks with "momentum," will notice and then amplify through their own trading, allowing the manipulator to sell into the resulting wave at a profit. How can such a price spike be created? One potential way would be to buy enough shares all at once to overwhelm the readily available supply of sellers, forcing the price up through liquidity effects. (11) Even if this fails to create a price spike, it may still create a noticeable surge in the stock's trading volume a surge that could convince other traders that someone has uncovered valuable new information, and lead them to adjust their estimate of the stock's value upward.

Such a strategy is highly unlikely to be successful with a bluechip stock like Microsoft. Would a manipulator be able to create a price spike by overwhelming the readily available supply of Microsoft shares? More than fifty million shares of Microsoft stock change hands on an average day--well over $1 billion worth. (12) How many hundreds of millions, or billions, of dollars would need to be put at risk for manipulative buying to stand out in this torrent of trading? Even if the manipulator is able to stand out, how likely is it that the sophisticated arbitrageurs following Microsoft will be fooled into thinking the "signal" is the result of new material information bout a company covered relentlessly by the press and hundreds of professional security analysts?

The natural targets for trade-based manipulations are not bluechip stocks like Microsoft the chances of success are too remote, the financial risk too ruinous. The natural targets are cow-chip stocks like Asia Global. (13) A relatively modest buying spree could easily cause a noticeable spike in price and trading volume, which in turn could attract momentum traders and stimulate a wave of buying. Furthermore, it will seem far more plausible to the penny stock traders that the manipulative trading activity signals the presence of new material information about a less closely followed company.

Thus, that the manipulations alleged by the SEC in its May 20, 2009, complaint took place in penny stocks is entirely unsurprising. What may seem surprising, however, is that no follow-up class actions have been filed by injured shareholders. It may be that the amounts at stake are too small to attract litigation. But it may also be for another reason one having little to do with economics and everything to do with the legal rules governing class actions alleging market manipulations. Due to a doctrinal flaw, shareholders of Asia Global would almost certainly be unable to achieve class certification, no matter how compelling their allegations of manipulation. Conversely--and perversely--shareholders of Microsoft would face few difficulties in certifying a similar class, and thus obtaining leverage for a settlement, no matter how implausible their allegations of manipulation. The sources of this curious result--and a suggestion for remedying it--are the subject of this Article.

The problem finds its root in Basic Inc. v. Levinson, the landmark case in which the Supreme Court adopted the "fraud on the market" (FOTM) doctrine, (14) allowing plaintiffs in Rule 10b-5 (15) securities fraud claims a presumption of reliance in class action cases involving transactions in open and developed securities markets. (16) Prior to the acceptance of the FOTM doctrine, the need to show individual reliance served as a virtually insurmountable barrier to class certification in 10b-5 cases. (17) In order to gain this presumption of reliance, however, the Court required plaintiffs to demonstrate that the relevant security traded in an "efficient market." (18) Though sometimes criticized and often inconsistently applied by lower courts, requiring plaintiffs to show market efficiency has, since Basic, served as one of the primary gatekeeping requirements for class certification--a role that takes on added significance in a world where securities lawsuits are virtually always settled once a class has been certified. (19) In arguing the logic and necessity of the requirement that plaintiffs demonstrate an "efficient market," however, courts and commentators have focused on the kind of claims at issue in Basic--allegations of material misrepresentations or omissions affecting the market price of a security ("misrepresentation claims"). At the same time, they have largely ignored the other common type of claim under section 10(b) of the Securities Exchange Act of 1934--allegations of the kind of trade-based manipulative schemes discussed above ("manipulation claims" or "market manipulation claims"). (20) Allegations of market manipulation have been lumped together with more straightforward allegations of misrepresentations and treated, without analysis, as if they were interchangeable for the purposes of FOTM analysis.

In particular, plaintiffs alleging market manipulation have been required to make the same showing of market efficiency as plaintiffs alleging misrepresentations in order to invoke the FOTM doctrine and gain the benefit of a presumption of reliance. In misrepresentation cases, market efficiency serves a clear purpose: forging a causal chain between the defendant's misrepresentation and the plaintiffs loss. In an efficient market, it is reasonable for the plaintiff to rely on the market price, and any material misrepresentation will be quickly and accurately reflected in that price. (21) Thus, the plaintiff can be said to have indirectly relied on the misrepresentation. (22) This analysis, however, is turned on its head in cases involved trade-based manipulative schemes. Such schemes are more likely to...