The Mist of Halliburton II

The one point that is clear in Halliburton II is that fraud on the market is limited to securities traded in an “efficient market.” Unfortunately, it is not clear what significance to give this principle as the opinion sheds no light on what constitutes such a market or why an efficient market is a sine qua non for fraud on the market. For these reasons, Halliburton II perpetuates the debate that has been on-going since Basic Inc. v. Levinson was decided decades ago.

The issue that propels fraud on the market into securities litigation is the necessity in private litigation to link the defendants’ misconduct with the plaintiffs’ losses.  In the ordinary securities fraud suit reliance serves this purpose as it had at common law misrepresentation suits. Proving reliance, of course, becomes impracticable when there are a large number of claimants who seek to aggregate their claims; individual inquiry into each investor’s reliance defeats the efficiency of aggregation. It is not clear how market efficiency, or the fact that a security was traded in an efficient market, is at all connected with overcoming the overwhelming burden of individual inquiries into investor reliance. For example, the concurrence by Justice Thomas (concurred in by Justices Alito and Scalia) makes much of the fact that studies since Basic Inc. have substantially qualified the efficient market hypothesis; there is much in the concurrence to suggest that nothing less than “fundamental” efficiency would prompt justices Alito, Scalia and Thomas to support any version of fraud on the market. Fundamental efficiency meaning that stock prices reflect the intrinsic value of the shares so that Justice Thomas is able to conclude that value investing assumes there is no efficiency because those seeking gain through this strategy believe shares are mispriced.

In contrast, the majority opinion appears to envision that an efficient market is one that is “informationally efficient” meaning the security’s price most often moves in response to material information. Thus, the majority find no inconsistency between investors frequenting a market that has such mispricing and that market being an efficient market.

What is overlooked in these contesting positions is the irrelevance of the efficient market hypothesis and just why the justices’ different interpretations of efficiency should matter. The efficient market hypothesis offers a view regarding how securities prices are formed under a set of conditions. This seems strangely at odds with how courts should address whether causation is established in open market fraud cases where the plaintiffs seek to aggregate their claims. That is, when the issue at hand is how investors behave it is not clear why we should have so much obeisance to a hypothesis that describes how market’s behave?

Halliburton II is, however, refreshing because both the majority and concurring opinions give attention to multiple ways that investors make their decisions. Chief Justice Roberts, writing for the majority, explains how value investors are not behaving in a way that rejects the belief they are trading in an efficient market; whereas Justice Thomas questions how momentum traders and day traders can be thought to hold a view that markets are efficient. Noticeably absent from their references are the 800 pound gorilla in the room: a variety to passive investment strategies that increasingly dominate investment (setting aside the activity of high frequency traders who can be ignored given their rapid trading removes them from participation in class actions). Among such passive investors are the index funds, the closet indexing that is rampant among large mutual funds, and style investors. None of these traders rely on price; hence, they fit poorly into the standard formulation of reliance, i.e., Investor would not have purchased at that price if the true facts were known.  Had any of the opinions considered these important components of our investment community they would have had to expand the focus of reliance, expand it where it properly can be located, and expand it in a way that is entirely within the principal focus of not just the securities laws but the antifraud provision in particular.

Reflecting on why indexers, passive investors or even style investors should be within the protection of fraud on the market would necessarily lead the Court to consider why should there be a fraud on the market, or for that matter the private action for open market frauds. Indexing, whether overt or passive, and other forms of passive investment strategies, are, as a practical matter, inherently efficient means of managing investments; none of these methods, however, would be justifiable but for the assurance that their managers’ non reliance on financial information, i.e., accepting the truthfulness of information reaching the market place, would not prevent them from recovering against wrongdoers who released false information that caused the fund to purchase or sale at a price influenced by a fraudulent representation.

While Halliburton II does not grapple with any of these questions, by the Supreme Court not burying fraud on the market it permits the lower courts to grapple with what was not answered. The court accords great dignity to price distortion so that minimally the demand for econometric studies will not subside. Indeed, the use of these very expensive and complex studies will likely expand as the general, albeit repeated, references to “efficient market” in the context of price distortions invite courts to test efficiency against the evidence that the affected security’s price moves in response to material information. While Amgen held this need not be established for class certification; Halliburton II makes clear this question can be raised defensively to rebut an alleged claim of causality based on fraud on the market.

The majority’s treatment of price distortion was broadly stated so that it remains possible for the plaintiff to point toward price reaction on revelation of the “truth” to establish both market efficiency and loss causation. This is essential to the very common form of fraud on the market case: the cases of non-disclosure or half-truth statements. In either instance, the misrepresentation is the failure to disclose material information necessary to prevent what was relied on by investors from being misleading. Because price movement cannot be observed for that which has not happened, price distortion is problematic in such non-disclosure cases. For example, a company that first announced it will not engage in an acquisition that will raise its debt-equity ratio. Shortly thereafter, it announced it is engaged in an acquisition negotiation but did not then disclose the merger terms being discussed will dramatically increase its debt-equity ratio. While the stock rise upon announcement of the merger negotiations does not support a claim of material omission regarding the possible rise in debt, the later disclosure of the acquisition terms and ensuing decline in the company’s shares should be relevant on loss causation, market efficiency, and materiality of the alleged omission.

Observing price distortion in this scenario will be essential for the suit to proceed. After Halliburton II, price distortion assumes heightened significance across all open market fraud cases. Thus, Halliburton II clearly invites the econometricians to the bar. But economists and their models are riddled with assumptions even when focused on a portfolio of firms. The assumptions are more problematic when the model is focused on an individual security basis. Thus, what perhaps is most in doubt is whether the Court has placed its faith in false idols.  Mankind was once warned about worshiping false idols!

James D. Cox is the Brainerd Currie Professor of Law at Duke University.