I share Alden’s disappointment that the Supreme Court did not overrule Basic v. Levinson in Monday’s Halliburton decision. I’m also surprised by the Court’s ruling. As I explained in this lengthy post, I expected the Court to alter Basic to require Rule 10b-5 plaintiffs to prove that the complained of misrepresentation occasioned a price effect. Instead, the Court maintained Basic’s rule that price impact is presumed if the plaintiff proves that the misinformation was public and material and that “the stock traded in an efficient market.”
An upshot of Monday’s decision is that courts adjudicating Rule 10b-5 class actions will continue to face at the outset not the fairly simple question of whether the misstatement at issue moved the relevant stock’s price but instead whether that stock was traded in an “efficient market.” Focusing on market efficiency—rather than on price impact, ultimately the key question—raises practical difficulties and creates a bit of a paradox.
First, the practical difficulties. How is a court to know whether the market in which a security is traded is “efficient” (or, given that market efficiency is not a binary matter, “efficient enough”)? Chief Justice Roberts’ majority opinion suggested this is a simple inquiry, but it’s not. Courts typically consider a number of factors to assess market efficiency. According to one famous district court decision (Cammer), the relevant factors are: “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.” In re Xcelera.com Securities Litig., 430 F.3d 503 (2005). Other courts have supplemented these Cammer factors with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation. No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible? How large may the bid-ask spread be?). Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t. It’s a crapshoot.
In addition, focusing at the outset on whether the market at issue is efficient creates a market definition paradox in Rule 10b-5 actions. When courts assess whether the market for a company’s stock is efficient, they assume that “the market” consists of trades in that company’s stock. This is apparent from the Cammer (and supplementary) factors, all of which are company-specific. It’s also implicit in portions of the Halliburton majority opinion, such as the observation that the plaintiff “submitted an event study of various episodes that might have been expected to affect the price of Halliburton’s stock, in order to demonstrate that the market for that stock takes account of material, public information about the company.” (Emphasis added.)
But the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), the economic theorem upon which Basic rests, rejects the notion that there is a “market” for a single company’s stock. Both the semi-strong ECMH and Basic reason that public misinformation is quickly incorporated into the price of securities traded on public exchanges. Private misinformation, by contrast, usually is not – even when such misinformation results in large trades that significantly alter the quantity demanded or quantity supplied of the relevant stock. The reason private misinformation is not taken to affect a security’s price, even when it results in substantial changes in quantities demanded or supplied, is because the relevant market is not the stock of that particular company but is instead the universe of stocks offering a similar package of risk and reward. Because a private misinformation-induced increase in demand for a single company’s stock – even if large relative to the number of shares outstanding – is likely to be tiny compared to the number of available shares of close substitutes for that company’s stock, private misinformation about a company is unlikely to be reflected in the price of the company’s stock. Public misinformation, by contrast, affects a stock’s price because it not only changes quantities demanded and supplied but also causes investors to adjust their willingness-to-pay or willingness-to-accept. Accordingly, both the semi-strong ECMH and Basic assume that only public misinformation can be assured to affect stock prices. That’s why, as the Halliburton majority observes, there is a presumption of price effect only if the plaintiff proves public misinformation, materiality, and an efficient market. (For a nice explanation of this idea in the context of a real case, see Judge Easterbrook’s opinion in West v. Prudential Securities.)
The paradox, then, is that Basic and the semi-strong ECMH, in requiring public misinformation, assume that the relevant market is not company specific. But for purposes of determining whether the “market” is efficient, the market is assumed to consist of trades of a single company’s stock.
The Supreme Court could have avoided both the practical difficulties in assessing market efficiency and the theoretical paradox identified herein had it altered Basic to require plaintiffs to establish not an efficient market but an actual price impact. Alas.