Solving a profound flaw in fraud-on-the-market theory: utilizing a derivative of arbitrage pricing theory to measure Rule 10b-5 damages.

• Author: Adams, Edward S.

Introduction

The idea of a free, open and well-developed securities market is premised on the hypothesis that the competing judgments of buyers and sellers regarding a security's fair price will drive market prices to reflect, as much as possible, that security's just price.(1) Investors who buy and sell stock at market prices do so in reliance on the integrity of that price.(2) In fact, "'it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?'"(3) Because of this reliance on the integrity of market prices, when materially misleading statements are disseminated into the market, such misleading information affects the price of certain securities and, thereby, affects all those who trade in those securities.(4) In a Rule 10b-5 action, once a plaintiff establishes there is liability for materially misleading statements that affected the securities market, the issue of damages arises. Without knowing the exact extent of an investor's reliance on a security's price, or the exact extent misleading information affected a security's price, it is difficult to ascertain with any degree of certainty the amount of damages caused. In general, damages in Rule 10b-5 cases are measured as the "difference between the price [of the security] under correct information and the actual market price."(5)

The practice of measuring damages in Rule 10b-5 suits came to rely on the capital market theory known as the Efficient Capital Markets Hypothesis ("ECMH") long before the United States Supreme Court's implied acceptance of it in Basic Inc. v. Levinson.(6) The ECMH holds that securities' prices adjust quickly and without bias to publicly available information. Assuming that the ECMH is valid, it is but a short step from the application of other capital market theories to the calculation of damages in Rule 10b-5 suits.

The celebrated capital market theory that has been applied to the measurement of damages in Rule 10b-5 suits is the market model, which is an empirical derivation of the Capital Asset-Pricing Model ("CAPM").(7) The market model holds that a security's return is a linear function of a general market factor, where the general market factor serves as a proxy of economic conditions that influence returns to securities in the capital market. The CAPM is an equilibrium asset-pricing theory which posits that the sole variable that explains the differences in expected returns for securities is a risk coefficient known as beta ([Beta]). Beta is the ratio of the covariance of a security's return and the market's return to the variance of the market's return, ([s.sub.sm]/ [s.sup.2] m).(8) The CAPM asserts that the relationship between a security's expected returns and beta is positive and linear.

This Article contends that, contrary to its present use in the securities fraud realm as sanctioned by the Supreme Court and as assumed to be correct by most commentators, the CAPM is irrelevant for measuring damages in Rule 10b-5 cases because the CAPM is not designed to measure what stock prices would have been if the requisite fraud had not occurred. Instead, the CAPM is designed to help investors and portfolio managers determine optimal asset portfolios. That is, the CAPM is designed to help people make decisions about assets with uncertain future returns, rather than to analyze the actual past returns of assets in a manner that would allow for the measurement of damages pursuant to Rule 10b-5.

This Article further asserts that the legal community should, in the context of the measurement of damages in Rule 10b-5 cases, reject the use of empirical derivations of the CAPM, and, in its place, use more accurate models designed to analyze past asset performance. In attacking the very foundations of the present methodology for calculating securities fraud damages, Part I of this Article reviews Rule 10b-5 and the basic methodology of calculating damages in Rule 10b-5 cases. Part II examines the intersection of judicial theory and capital market theory by considering the fraud-on-the-market doctrine and the capital market theories under which the doctrine and the measurement of damages may be justified: the Efficient Capital Markets Hypothesis, systematic risk compensation and the Capital Asset-Pricing Model. Part III contrasts the forward-looking basis of the CAPM with the historical basis for Rule 10b-5 damages. As Part III illustrates, whereas the CAPM approach calculates the historical relationship between stock price and the Standard & Poor's 500 Index ("S&P 500 Index" or "S&P 500") and then projects the relationship forward to the period of the fraud, the technique we employ recognizes that it is erroneous to discount or ignore other factors besides movements in the S&P 500 Index that might actually have an even more powerful causal impact on a relevant security's price. Part IV introduces an alternative to the CAPM for damage measurement, utilizing the principles of arbitrage pricing theory. Finally, Part V surveys an empirical study that compares the ability of the CAPM with other derivative methods to explain the returns of common stocks and also introduces our own empirical study--one that is clearly superior to the CAPM's derivatives for measuring Rule 10b-5 damages.

1. Rule 10b-5 and the Calculation of Damages

   1. Rule 10b-5 Overview

      Rule 10b-5 is one of the most significant remedies for fraud provided under the Securities Exchange Act of 1934.(9) It is the primary antifraud weapon against material misrepresentations or nondisclosures by issuers, insider trading and corporate mismanagement involving securities transactions. The Securities Exchange Commission ("SEC") promulgated Rule 10b-5 under the rulemaking authority vested in it by Congress under [sections] 10 of the Securities Exchange Act of 1934. Unchanged since its promulgation in 1942, Rule 10b-5 provides:

      It shall be unlawful for any person, directly or indirectly, by the

      use of any means or instrumentality of interstate commerce, or of the mails

      or of any facility of any national securities exchange,

      (a) To employ any device, scheme, or artifice to defraud,

      (b) To make any untrue statement of a material fact or to omit to state

      a material fact necessary in order to make statements made, in the light

      of the circumstances under which they were made, not misleading, or

      (c) To engage in any act, practice, or course of business which operates

      or would operate as a fraud or deceit upon any person,

      in connection with the purchase or sale of any security.

      The text of Rule 10b-5 does not expressly provide a private right of action. This absence of positive language detailing a private right of action remains the root of pervasive uncertainty and ambiguity in Rule 10b-5 jurisprudence. Nevertheless, courts have long held that Rule 10b-5 implies a private right of action under which investors may seek a remedy for injury independent of any enforcement action undertaken by the SEC.(11)

      Despite recent decisions limiting the expansive reach of Rule 10b-5,(12) it remains the chief private remedy against fraud in the purchase and sale of securities. As a threshold matter, establishing federal jurisdiction is usually not a problem. A plaintiff need only demonstrate that the defendant conducted some aspect of the contested securities transaction using an instrumentality of interstate commerce. Interstate telephone calls and interstate use of the mails certainly qualify; notably, intrastate telephone calls or use of the mails qualify as well.(13) Moreover, a defendant cannot assert a lack of jurisdictional means merely by arguing that the violative misrepresentation or omission was itself never transmitted using an instrumentality of interstate commerce; any memorandum or telephone call transmitted using an instrumentality of interstate commerce, preceding or following the alleged violation, provides sufficient jurisdictional means for the entire transaction. Importantly, however, face-to-face conversations do not independently establish jurisdictional means.

      The transactional scope of Rule 10b-5 is equally broad. Rule 10b-5 provides three sweeping and widely overlapping causes of action. Each cause of action requires a plaintiff to sustain the burden of proof for five substantive elements. First, clauses (a) and (c) of Rule 10b-5 require a showing of a fraud or deceit, while clause (b) requires a showing of a misrepresentation or omission of a material fact. Next, a plaintiff must demonstrate that the fraud, deceit, misrepresentation or omission was perpetrated (2) by any person (3) in connection with (4) the purchase or sale (5) of any security. Finally, the elements of common law fraud overlay the five substantive elements of Rule 10b-5. Thus, a plaintiff must also establish materiality, reliance, causation and damages.

      A plaintiff relying on clause (b), for example, must prove the existence of a misrepresentation or omission of fact by the defendant and her reliance upon the defendant's misrepresentation or omission of fact when making her investment decision. "Reliance" requires that the misrepresentation constitute a substantial factor in the plaintiffs investment decision.(14) The "purchase or sale" requirement likewise demands that the plaintiff actually purchased or sold the securities involving the alleged misrepresentation, omission, fraud or deceit.(15) In addition, the plaintiff must prove that the misrepresentation or omission of fact was material, that the defendant intentionally or recklessly made the misrepresentation or omission of fact, and that the plaintiff suffered damages as a result of the defendant's conduct.(16) "Materiality" requires that there be a substantial likelihood that a reasonable investor would consider the disclosure of the omitted fact as significant in making an investment decision.(17) Causation is established by proving a sufficient...