The use of efficient market hypothesis: beyond SOX.

• Author: Muir, Dana M.
• Position: Sarbanes-Oxley Act of 2002

This Article focuses on the regulatory use of finance theory, particularly the efficient market hypothesis ("EMH"), in two areas where securities pricing is at issue: shareholder appraisal cases and the use of employer stock in benefit plans. Regarding shareholder appraisal cases, the Article finds that the Delaware courts seem to implicitly respect the principles of EMH when ascertaining the fair value of stock, but recognize that markets cannot operate efficiently if information is withheld. Regarding employer stock in benefit plans, it concentrates on the explicit adoption of EMH by the Department of Labor to exempt directed trustees from traditional duties of inquiry regarding the prudence of investment directions.

TABLE OF CONTENTS INTRODUCTION I. CORPORATE GOVERNANCE IMPLICATIONS A. Statutory Appraisal Actions B. Fiduciary Duties C. The Link to SOX II. RETIREMENT PLAN POLICY AND THE EMH A. History of the EMH in Pension Policy B. The Directed Trustee and the EMH 1. Directed Trustees with Public Information and the EMH 2. Directed Trustees with Nonpublic Information and the EMH 3. The EMH as a Ruse for Directed Trustee Protection? CONCLUSION INTRODUCTION

As scholars in employee benefits and corporate governance, our interest in the Sarbanes-Oxley Act ("SOX") (1) is in asking what insights its enactment, motivating principles, and substantive provisions provide for these fields. In some ways the intersections are obvious. In past work we have considered how securities law, state corporate law, and federal employee-benefits law differ in setting standards for directors' conduct (2) and have examined directors' loyalty obligations in the context of company stock transactions. (3) Other commentators have expressed a variety of views on the intersection between federal regulation under SOX and the traditional realm of state corporate governance law. (4)

Professor Roberta Romano has argued that SOX's substantive corporate governance mandates conflict with the empirical finance literature's findings on what constitutes effective regulation. (5) In this Article we focus on the regulatory use of finance theory, particularly the efficient market hypothesis CEMH"), (6) in two related areas where securities pricing is at issue: shareholder appraisal cases and the use of employer stock in company-sponsored employee investment plans] For a substantial time it seemed that the general trend in legal and finance literature was to accept some form of EMH. (8) EMH's acceptance in jurisprudence accelerated after the Supreme Court effectively adopted it for purposes of securities-fraud claims in Basic, Inc. v. Levinson (9) in 1988. More recently, though, EMH has met increasing skepticism in financial theory due to research in areas such as noise trading, (10) market bubbles, (11) and behavioral finance. (12) Although the legal scholarship has remained current with this debate, (13) arguably much jurisprudence and policy-making in state corporate law and in federal employee-benefits law has remained loyal to basic EMH principles. (14)

In this Article we begin, in Part I, by examining the use of EMH in shareholder appraisal cases. In that Part, we find that the Delaware courts seem to respect the principles of EMH implicitly when ascertaining the fair value of stock, but they also recognize that markets cannot operate efficiently if information is withheld. In addition, the courts' analyses of the concurrent fiduciary duty claims brought in some of these cases seem to reflect a tacit judicial belief that shareholders are entitled to full information. The courts more closely scrutinize transactions involving conflicts of interest due, at least in part, to concerns that the shareholders might not have received full information. In Part II we analyze EMH as it relates to the use of employer stock in company-sponsored employee investment plans. The focus is on the explicit adoption of EMH by the Department of Labor ("DOL") to exempt directed trustees from historic duties of inquiry regarding the prudence of investment directions. This offers the opportunity to consider the opposite side of Professor Romano's critique of substantive provisions of SOX--how well or poorly policy-makers do when they purport to rely on principles developed in finance research.

Although securities law scholars take a variety of positions on the robustness of market-efficiency theory and the extent to which federal legislation should intervene in favor of capital market efficiency, all seem to agree that markets benefit from sufficient and accurate information. (15) Similarly, it appears that increased reliability of information transmission to the market was Congress's intent in enacting SOX, regardless of whether scholars view it as a positive step in that direction. (16) Our inquiry finds that the Delaware courts and legislature believe that informational problems can necessitate fact-specific analyses of whether market price reflects fair value. In contrast, the DOL purports to believe, almost without exception, in the efficiency of markets for all publicly traded securities and that efficient pricing is sufficient to establish investment prudence.

1. CORPORATE GOVERNANCE IMPLICATIONS

   In deciding cases involving stock price valuations, the Delaware courts seem more concerned than the DOL (17) with the possibility that the markets may be unable to price shares fairly. The courts thus seem somewhat more skeptical of reliance on the market price, and the EMH, for the fair valuation of stock. At least one visible concern of the courts is the availability of material information in the market. The courts recognize that without full information, the market, in a particular instance, may be unable to price shares fairly.

   1. Statutory Appraisal Actions

      One area where the EMH is implicated in this way, at least implicitly, is in the Delaware jurisprudence on shareholder statutory appraisal actions. In these actions, minority shareholders claim that they have not received fair value for their shares given up in a merger or consolidation. Under these circumstances, the minority shareholders may seek judicial determination of the fair price of their shares. (18)

      The EMH appears to underlie the defense in these actions. The defendants often argue that the buyout price is fair to the extent it reflects the market price of the stock. Not surprisingly, plaintiffs dispute this contention and question the market price as the appropriate benchmark for assessing the fair value of the shares. We recognize that valuation is a rather complex topic (19) and we do not attempt to provide an exhaustive review of the valuation approaches used by the Delaware courts in appraisal actions or the surrounding controversies. Rather, in this Section, we review selected Delaware cases that demonstrate the subtle role the EMH plays in the valuation analysis. (20)

      According to Delaware General Corporate Law, stockholders of Delaware corporations are entitled to statutory appraisal of their shares when the shares of stock are held through the effective date of a merger or consolidation, provided that certain procedures have been followed. (21) The statute denies appraisal rights to shares traded on a national exchange, thus implicitly, it seems, respecting the EMH. This exclusion, however, does not apply if the shareholders are required to accept cash rather than stock or depository receipts for their shares in the merger or consolidation. (22) Thus, shareholders who are frozen out of the corporation and forced to accept cash for their shares are entitled to appraisal rights, even if the shares of the company were traded on a national exchange. (23)

      In the appraisal action, the court must determine the "fair value" of the corporation that issued the stock. (24) The dissenting shareholder is then entitled to his or her "proportionate interest in [the corporation as] a going concern" (25) without application of a minority discount. (26) Thus, the court's "task in an appraisal proceeding is to value what has been taken from the shareholder." (27) A crucial question in this analysis is how much weight, if any, should be given to the market value of the corporation's stock in the valuation. (28)

      When the market for a publicly traded security is active and efficient, the market price of the corporation's common stock is important corroborative evidence of value. (29) According to the EMH (in semi-strong form), (30) financial markets are efficient, and thus all public information is calculated into a stock's current share price such that securities prices reflect all known information. (31) If courts were confident that the markets are operating efficiently, it would be reasonable to expect courts to give stronger preference to the market price of a corporation's stock in a stock appraisal action. However, although they respect the capital markets and consider market price a factor to be weighed in the analysis, the Delaware courts acknowledge that market prices do not necessarily reflect the fair value of the stock, (32) even when the stock is traded on a national market.

      One of the earlier cases in Delaware evidencing skepticism with respect to market price as a proxy for valuation in appraisal proceedings is Chicago Corp. v. Munds. (33) The Munds court decided the issues pursuant to an earlier version of the appraisal statute. In Munds, the court observed that "[t]he experience of recent years is enough to convince the most casual observer that the market in its appraisal of values must have been woefully wrong in its estimates at one time or another.... Markets are known to gyrate in a single day." (34) The Munds court further noted that market value "undoubtedly is a pertinent consideration," but not exclusive. (35) Munds was decided in 1934, on the heels of the Great Depression, and at the onset of federal regulation of securities. (36) Thus, given the time frame of the...