Establishing whether or not the market for a security is efficient is critical in securities class action lawsuits. If a security trades in an efficient market, then its market price factors in all material information, the price will rise with good news and fall with bad news. In this way, news is transferred through price.
When investors evaluate a security, the current price is central to their analysis. (If they believe the security is undervalued at the current price, they will purchase it, or if they own it and believe it is overvalued, they will sell it.) If the market for the security is efficient, its price reflects all the existing information about the company, and thus investors who are evaluating the security are implicitly incorporating all the existing information about the company into their decisions.
Therefore, if there is an omission or misstatement of material information, there is a clear link between it and any consequent damages because the omission or misstatement would have been incorporated into the security price through the efficient market.
Consequently, if a security trades in an efficient market, then plaintiffs can use a fraud-on-the-market theory to file a class action that includes the pool of all investors who traded in the security. In short, an efficiently traded security allows each stockholder to show reliance on a material misstatement or omission without having to show that he or she actually read or heard the material misstatement or omission first hand.
Obviously, this standard greatly increases class pool eligibility.
Defendants, at both the class certification and merits stages, often attempt to show that an investment trades in an inefficient market. If a security price doesn’t react to new material information in the first place, then how can an omission or misstatement of material information be a cause of damages to investors who relied on the price?
Photo: Eugene Fama, grandfather of efficient markets
Defining Market Efficiency
The efficient market hypothesis (“EMH”) was developed by Professor Eugene Fama during his Ph.D. thesis in the early 1960s at the University of Chicago Booth School of Business. This work, which Fama continued to develop over his career, led to his sharing the Nobel Prize in Economics in 2013. The Nobel Committee cited Fama’s seminal work in their award, noting:
Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient.
As with all great theories, the idea that markets adjust to new information now seems self-evident. Indeed, it is a cliché that the markets are a “discounting mechanism”.
Fama argued that markets can be efficient at three levels:
- Weak-form efficiency – Implies that current prices reflect all market information inherent in past prices and assumes that past rates of return have no effect on future rates;
- Semi-strong form efficiency – Implies current prices reflect all information in past prices and all “publicly” available information (including financial statements and news reports);
- Strong form efficiency – The current price reflects all information, public and private.
Although economists make distinctions of different forms of market efficiency, the courts have not seemed to focus on them. Instead, they have appeared to generally accept the idea of market efficiency and have been interested in whether or not a particular security can be said to have an efficient market. Establishing the extent of information efficiency, as we will explore below, is critical in making fraud-on-the-market class action claims.
Legal Precedence – Basic v. Levinson (1988)
In 1988 the Supreme Court ruled on Basic v. Levinson which give life to the fraud-on-the-market theory.
The fact pattern of Basic was simple: the President of Basic, Inc. denied publicly that his company was involved in any merger discussions, and then the next day approved a tender offer from another company. Plaintiff Max L. Levinson, a Basic shareholder, brought a class action suit against Basic alleging that he and other shareholders were damaged by selling Basic shares at artificially depressed prices.
The case went to the Supreme Court, where the Court ruled in favor of the plaintiff, and also adopted a rebuttable presumption of reliance based on the fraud-on-the-market theory. Specifically, the plurality noted that:
The fraud on the market theory is based 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 and its business... Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.
From Basic to Present Day
The interpretation of Basic has been tested many times since 1988, with the economic underpinnings of efficient market theory driving most of the debate. Almost a year after Basic a lower court developed a list of factors that could be checked to determine whether the market for a security demonstrated some elements of being efficient. This case was known as Cammer v. Bloom and in their decision the Court identified five elements of market efficiency:
- Eligibility to file an SEC Form S-3;
- Average weekly trading volume;
- Analyst coverage;
- Existence of market makers and arbitrageurs;
- Price reaction to company-specific information;
The Court in Unger v. Amedisys expanded upon Cammer and listed eight factors that determine market efficiency. The first five were identical, but the Court added the following three: 
- Market capitalization;
- Bid-ask spread for stock sales, and;
The fifth factor in Cammer, whether or not the price of a security responds to company-specific news, has emerged by consensus to be the most important. The extent to which a security price moves when material news is released can be statistically measured. This exercise is known as an “event study”. Typically, event studies are prepared by experts on both sides of a class action.
Halliburton v. Erica P. John Fund
Basic recently faced one of its strongest attacks in the Supreme Court’s Halliburton v. Erica P. John Fund decision. Originally brought to lower courts back in 2002, Halliburton shareholders led by Erica P. John Fund sued the company over understating its asbestos liabilities while overstating revenues in its engineering and construction business and the benefits of its merger with Dresser Industries. Halliburton sought Supreme Court review after losing in lower courts.
While declining to overturn Basic, the Court’s 9-0 decision issued on June 23, 2014 did give defendants another tool to work with in their efforts to push back during the class certification stage of a trial. Defendants can now rebut plaintiff presumption of reliance by showing direct evidence “that the alleged misrepresentation did not actually affect the stock’s price and, consequently, that the Basic presumption does not apply.”
This new ruling should serve to increase the importance of event studies and price impact studies during the earlier stages of litigation.
 Eugene F. Fama – Facts. Nobelprize.org. Nobel Media AB 2014. Available at http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2013/fama-facts.html; Accessed September 26, 2014.
 Wikipedia, s.v. “Efficient-market hypothesis”; Available at http://en.wikipedia.org/wiki/Efficient-market_hypothesis; Accessed September 24, 2104.
 Basic Inc. v. Levinson, 485 U.S. 224 (1988)
 Basic Inc. v. Lensions, 485 U.S. 224 (1988). http://caselaw.lp.findlaw.com/scripts/getcase.pl?navby=CASE&court=US&vol=485&page=224.
 Rose Cammer, et al., Plaintiffs v. Bruce M. BLOOM, et al., Defendants (1989). http://www.leagle.com/decision/19891975711FSupp1264_11775.xml/CAMMER%20v.%20BLOOM.
 S-3 Filing is an indicator of efficiency because the original intention of this filing by the SEC was to be an abbreviated filing for companies that met certain criteria. SEC Securities Act Release No. 6331, 46 Fed. Reg. 41,902 (Aug. 13, 1981) establishes the criteria for a Form S-3 filing in conjunction with an equity offering. They include the following: a company must have been filing reports under the Exchange Act for the last 3 years; and, either have outstanding $150 million of voting stock held by non-affiliates or $100 million of stock outstanding with an annual trading volume of three million shares per year.
Companies eligible for filing an S-3 were eligible because they were deemed to trade in an efficient market by the SEC, so Courts still use this as a factor.
 On Petition for a Writ of Certiorari to the United States Court of Appeals for the Fifth Circuit, Halliburton v. Erica P. John Fund.
 HALLIBURTON CO. ET AL. v. ERICA P. JOHN FUND, INC., Supreme Court of the United States. CERTIORARI TO THE UNITED STATES COURT OF APPEALS FOR THE FIFTH CIRCUIT. http://www.supremecourt.gov/opinions/13pdf/13-317_mlho.pdf
The Accelerant market efficiency and event study expert is Steve Pomerantz.
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