Opinion ID: 201963
Heading Depth: 2
Heading Rank: 1

Heading: The Fraud-on-the-Market Theory

Text: The Supreme Court has described the basic elements of a securities fraud action under § 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder as including: (1) a material misrepresentation (or omission); (2) scienter, i.e., a wrongful state of mind; (3) a connection with the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation. In re Stone & Webster, Inc., Sec. Litig., 414 F.3d 187, 193 (1st Cir. 2005) (quoting Dura Pharm., Inc. v. Broudo, 125 S. Ct. 1627, 1631 (2005)); see also Wortley v. Camplin, 333 F.3d 284, 294 (1st Cir. 2003). While reliance is typically demonstrated on an individual basis, the Supreme Court has noted that such a rule would effectively foreclose securities fraud class actions -13- because individual questions of reliance would inevitably overwhelm the common ones under Rule 23(b)(3). Basic, 485 U.S. at 242. To avoid this result, the Supreme Court has recognized the fraud-on-the-market theory, which relieves the plaintiff of the burden of proving individualized reliance on a defendant's misstatement, by permitting a rebuttable presumption that the plaintiff relied on the integrity of the market price which reflected that misstatement.10 As the Supreme Court recognized in Basic, [t]he 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, including any available material misstatements. Id. at 241 (internal quotation marks and citation omitted). Since investors who purchase or sell stock do so in reliance on the integrity of the market price, id. at 247, they indirectly rely on such misstatements because they purchase or sell stock at a price which necessarily reflects that misrepresentation. Under the fraud-on-the-market theory, [m]isleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements. 10 Assuming the plaintiff gets the benefit of the rebuttable presumption at the class-certification stage, the defendant may still rebut this presumption at trial. According to the Court in Basic, [a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance. 485 U.S. at 248. -14- Id. at 242-43 (quoting Peil v. Speiser, 806 F.2d 1154, 1160-61 (3d Cir. 1986)); see also Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1218 (1st Cir. 1996) (noting that in cases involving fraud-on-themarket theory, the statements identified by plaintiffs as actionably misleading are alleged to have caused injury, if at all, not through the plaintiffs' direct reliance upon them, but by dint of the statements' inflating effect on the market price of the security purchased). Before an investor can be presumed to have relied upon the integrity of the market price, however, the market must be efficient. See Basic, 485 U.S. at 248 n.27 (recognizing elements cited by court of appeals for invoking fraud-on-the-market presumption of reliance, including that the shares were traded on an efficient market).11 Efficiency refers to the flow of information in the relevant market and the effect of that 11 In addition, the plaintiff must prove: (1) that the defendant made public misrepresentations; (2) that the misrepresentations were material (i.e., that there is a substantial likelihood that such misrepresentations would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available), and would induce a reasonable, relying investor to misjudge the value of the shares; and (3) that the plaintiff traded the shares between the time the misrepresentations were made and the time the truth was revealed. Basic, 485 U.S. at 231-32, 248 n.27 (citing Levinson v. Basic, Inc., 786 F.2d 741, 750 (6th Cir. 1986), vacated on other grounds, 485 U.S. 224 (1988)); see generally A&J Deutscher Family Fund v. Bullard, No. CV 85-1850 PAR(JRX), 1988 WL 152011, at -12 (C.D. Cal. Nov. 29, 1988) (applying Basic's multi-prong test for determining presumption of reliance). These factors are not in dispute in this interlocutory appeal; therefore, we need not address them. -15- information on the price of the stock. See In re Laser Arms Corp. Sec. Litig., 794 F. Supp. at 490 (stating that [t]he underlying premise of the fraud on the market theory assumes that the market is a transmission belt which efficiently translates all information concerning a security, including misleading information, into a price). In an efficient market, the defendant's misrepresentations are said to have been absorbed into, and are therefore reflected in, the stock price. Conversely, when a market lacks efficiency, there is no assurance that the market price was affected by the defendant's alleged misstatement at all. Instead, the price may reflect information wholly unrelated to the misstatement. See Freeman v. Laventhol & Horwath, 915 F.2d 193, 198 (6th Cir. 1990) (stating that [a]n inefficient market, by definition, does not incorporate into its price all the available information about the value of a security. Investors, therefore, cannot be presumed to rely reasonably on the integrity of the market price of a security that is traded in such a market). The fraud-on-the-market presumption of reliance and its relationship to market efficiency can thus be reduced to the following syllogism: (a) an investor buys or sells stock in reliance on the integrity of the market price; (b) publicly available information, including material misrepresentations, is reflected in the market price; and therefore, (c) the investor buys or sells stock in reliance on material misrepresentations. This -16- syllogism breaks down, of course, when a market lacks efficiency, and the market does not necessarily reflect the alleged material misrepresentation. With this understanding as background, we must now decide the appropriate standard for determining whether a market is efficient.