William O. Fisher, Does the Efficient Market Theory Help Us Do Justice in a Time of Madness?

• Publication year: 2005

DOES THE EFFICIENT MARKET THEORY HELP US DO JUSTICE IN A TIME OF MADNESS?

William O. Fisher^*

INTRODUCTION .............................................................................................. 847

I. IN THE BEGINNING: THE SUPREME COURT ADOPTS THE FRAUD-

ON-THE-MARKET THEORY ................................................................. 848

A. The Basic Decision ..................................................................... 848

B. Just What Does "Efficient Market" Mean? Mechanical

Versus Value Efficiency .............................................................. 850

C. The Importance of Market Professionals in Efficient Market

Theory ......................................................................................... 854

D. Market Professionals as the Link to Value Efficiency Justifying the Use of Efficient Market Theory To Dispense Justice in Cases Decided by the Courts ...................................... 855

II. BASIC APPLIED: THE FACTORS THAT COURTS REVIEW TO DETERMINE WHETHER A MARKET IS "EFFICIENT" SO THAT THE FRAUD-ON-THE-MARKET THEORY WILL BE USED ............................ 857

A. The Cammer Factors, and a Few Others as Well ...................... 858

B. Whether the Factors Are Consistently Applied and Whether

They Make Sense ........................................................................ 863

C. The Courts' Focus on Mechanical Efficiency, Not Value

Efficiency .................................................................................... 867

D. Factors Measuring the Participation of Market Professionals, Who Conceivably Provide the Link Between Mechanical and

Value Efficiency .......................................................................... 868

E. The Dominance of Efficiency Analysis ....................................... 869

III. THE "EVENT STUDY" AS THE CRITICAL TOOL TO BRING EFFICIENT MARKET THEORY TO BEAR ON MULTIPLE 10B-5 ELEMENTS AND THE CONNECTION BETWEEN EVENT STUDIES AND THE

NORMATIVE VALUES INHERENT IN 10B-5 ELEMENTS ........................ 871

A. A Rough Description of an Event Study ...................................... 872

B. An Event Study Investigates Only the Relationship Between New Information and the Change in Securities Prices, Not Whether Prices Before or After the Change Reflected the Issuer's Fundamental Value, and Not Whether Market Professionals Controlled the Price Change That Occurred ....... 873

C. An Event Study May Be Used To Establish Multiple 10b-5

Elements: Reliance, Materiality, Causation, and Damages ....... 874

D. The Normative Aspects of the Elements That an Event Study

Can Address in a Case Assuming an Efficient Market ............... 883

1. Reliance Must Be Reasonable .............................................. 883

2. A "Material" Fact Is One That Is Important to a

Reasonable Investor Who, in a FOTM Case, Is Assumed

To Be a Market Professional ................................................ 885

3. Loss Causation Places Legal Responsibility for Harm on

Those Who Should Justly Bear It .......................................... 887

4. Damages Are Not Designed To Insure Investors Against All Risks but Are Limited to Losses That the Defendant Caused and Do Not Include Loss From Movement of the Market as a Whole or Other Nonfraud Causes .................... 888

5. How Theory Links the Mechanical Efficiency Documented by an Event Study to the Normative Aspects of 10b-5

Elements ............................................................................... 889

IV. THE SHAPE OF THE INTERNET AND TELECOMMUNICATIONS BUBBLE, SEVERANCE OF PRICE FROM VALUE AND SEVERANCE OF MECHANICAL EFFICIENCY FROM THE MORAL CONTENT OF 10B-5

ELEMENTS .......................................................................................... 890

A. The Anatomy of The Bubble ....................................................... 890

B. The Significance of Mechanical Efficiency During

The Bubble .................................................................................. 897

V. THEORETICAL AND EMPIRICAL CHALLENGES TO MARKET EFFICIENCY, A BEHAVIORAL FINANCE EXPLANATION OF THE BUBBLE, AND THE QUESTIONS THAT EXPLANATION RAISES FOR

USE OF EFFICIENT MARKET THEORY IN SECURITIES LITIGATION ...... 898

A. Significant Academic Thought Now Argues That the Market

Does Not Act Rationally ............................................................. 899

1. An Introduction to the Behavioral Challenge: Market

Overreaction to Perceived Trends ........................................ 901

2. A Behavioral Explanation of The Bubble ............................. 908

a. A Behavioral Explanation for Why the Market Went

Nuts ................................................................................ 908

b. A Behavioral Explanation for Why Market

Professionals Did Not Stop the Madness ....................... 913

B. The Significance of the Behavioralist Explanation of The

Bubble to the Use of Efficient Market Analysis in Securities

Cases Arising Out of Bubble Facts ............................................. 920

VI. AMATEUR TRADING DURING THE BUBBLE AND THE QUESTIONS THAT TRADING RAISES FOR THE USE OF EFFICIENT MARKET THEORY IN SECURITIES LITIGATION ................................................... 921

A. Day Traders and Other Trend Chasers Contributed to

Increased Bubble Trading Volume ............................................. 922

B. What the Prominence of Amateur Traders During The Bubble

Means for Court Use of the Efficient Market Theory ................. 930

VII. WHETHER ANALYSTS WERE BIASED DURING THE BUBBLE: A SERIOUS QUESTION THAT, EVEN IF LEFT UNRESOLVED, SHOULD AFFECT THE APPLICATION OF EFFICIENT MARKET ANALYSIS TO BUBBLE CASES ................................................................................... 932

A. Court and Regulator Praise for Analysts ................................... 932

B. Evidence That Analysts May Have Been Biased During The

Bubble ......................................................................................... 934

1. The Overwhelming Number of "Buy" Recommendations and the Very Few "Sell" Recommendations During The Bubble ................................................................................... 935

2. "Buy" Ratings Maintained on Stocks as They Dropped ...... 939

3. Regulator Allegations of Instances in Which Analysts Did

Not Believe the "Buy" Ratings They Assigned ..................... 943

4. Regulator Allegations That Investment Banking Considerations Influenced Analysts To Publish "Buy" Ratings .................................................................................. 944

5. A Host of Other Factors That May Have Influenced

Analysts in Favor of "Buy" Recommendations .................... 950

6. Multiple Regulators Conducted a Massive Investigation of Analyst Bias, Which Led to a $1.4 Billion Settlement by Major Brokerage Houses and Institutionalized Changes

To Curtail Bias ..................................................................... 955

a. The Settlement Between Industry and Regulators Suggests That Charges of Analyst Bias Were Not Frivolous ........................................................................ 957

b. The Circumstance That Congress Demanded New Rules To Curtail Bias, as well as the Circumstance that the NYSE, NASD, and the SEC Adopted Extensive Rules to Curtail Bias, Suggest That Charges of

Analyst Bias Were Not Frivolous ................................... 961

C. The Implications of Possible Analyst Bias for Efficient Market

Analysis in 10b-5 Cases .............................................................. 966

1. Courts Should Not Conclude that Analysts Caused The

Bubble ................................................................................... 966

2. Courts Should Not, in Bubble Cases, Attempt To Determine the Efficiency of the Market for a Stock by Counting the Number of Sell-Side Analysts Who Followed the Stock ............................................................................... 972

3. The Real Possibility of Analyst Bias Should Contribute to Courts' General Unease in Applying the Efficient Market Theory To Prove 10b-5 Elements in Bubble Cases .............. 973

CONCLUSION .................................................................................................. 974

INTRODUCTION

The efficient market hypothesis looms large in open market securities fraud cases. That hypothesis underlies the fraud-on-the-market doctrine, which permits stock buyers to proceed in these cases by class actions because the doctrine allows buyers to avoid proving that they individually relied on the defendants' allegedly false statements. The buyers satisfy the reliance element by alleging that the market for the stock was "efficient." The buyers thereby invoke a presumption that the market prices at which all class members bought the stock impounded the falsity that the defendants spoke, which is the essence of the efficient market hypothesis.

The actual effect of each false statement on a stock's price, as it fluctuated to incorporate new information within its efficient market, is often tested by an "event study." Such a study purports to isolate the impact of each false announcement on the stock's price, thereby possibly proving loss causation, materiality, and damages, as well as reliance.

This Article questions how well the efficient market theory, as applied by event studies, works in cases originating during the Internet, high-tech, and telecommunications bubble of 1998 to 2001. In doing so, the Article discusses technical and theoretical challenges to the efficient market theory. Principally, however, this Article argues that the use of the efficient market theory-and relatedly the event study methodology-is inappropriate in bubble cases for normative reasons. The normative connection between the efficient market theory-applied through event studies-and the 10b-5 elements-reliance, materiality, loss causation, and...