Opinion ID: 201963
Heading Depth: 3
Heading Rank: 4

Heading: Market Efficiency Defined

Text: On the basis of the authorities and considerations cited, we conclude that the definition of market efficiency adopted by the district court is inconsistent with the presumption of investor -29- reliance at the heart of the fraud-on-the-market theory. By rejecting the prevailing definition of market efficiency advocated by PolyMedica, and focusing instead on the general consideration by market professionals of most publicly announced material statements about companies, the district court applied the wrong standard of efficiency. For application of the fraud-on-the-market theory, we conclude that an efficient market is one in which the market price of the stock fully reflects all publicly available information. Anticipating the possibility of this definition, Plaintiff complains that it forces him to prove that market price correctly reflects a stock's fundamental value18 before a market will be considered efficient. This argument misconstrues the conclusion that market price must fully reflect all publicly available information. The words fully reflect have two distinct meanings, each of which points to a different concept of market efficiency. 5. Informational v. Fundamental Value Efficiency The first meaning of fully reflect focuses on the ability of the market to digest information, thereby preventing 18 As we discuss in further detail below, fundamental value is a technical concept which depends on the present value of expected future cash flows (e.g., dividends, interest or principal payments, liquidations values), as estimated by well informed and capable analysts. Jonathan R. Macey et al., Lessons from Financial Economics: Materiality, Reliance, and Extending the Reach of Basic v. Levinson, 77 Va. L. Rev. 1017, 1022 (1991). -30- trading profits: market price fully reflects all publicly available information when prices respond so quickly to new information that it is impossible for traders to make trading profits on the basis of that information. Stout, supra, at 651. This is known as informational efficiency, and is best understood as a prediction or implication about the speed with which prices respond to information. Id. at 640; see also Daniel R. Fischel, Efficient Capital Markets, the Crash, and the Fraud on the Market Theory, 74 Cornell L. Rev. 907, 913 (1989) (stating that [u]nder this definition, a market is efficient if it is impossible to devise a trading rule that systematically outperforms the market . . . absent possession of inside information). With many professional investors alert to news, markets are efficient in the sense that they rapidly adjust to all public information . . . . West, 282 F.3d at 938. Where the market reacts slowly to new information, it is less likely that misinformation was reflected in market price and therefore relied upon. See City of Monroe Employees Ret. Sys. v. Bridgestone Corp., 399 F.3d 651, 676 (6th Cir. 2005) (stating that in an open and efficient securities market[,] information important to reasonable investors (in effect, the market) is immediately incorporated into stock prices) (internal quotation marks and citation omitted); Freeman, 915 F.2d at 199 (stating that [a]n efficient market is one which rapidly reflects new information in price) (quoting -31- Cammer, 711 F. Supp. at 1276 n.17); Fischel, supra, at 912 (stating that the more rapidly prices reflect publicly-available information, the more sensible it is to apply the [fraud-on-themarket theory]). Determining whether a market is informationally efficient, therefore, involves analysis of the structure of the market and the speed with which all publicly available information is impounded in price. See Fischel, supra, at 912 (enumerating factors relevant to determination of trading-rule [i.e., informational] efficiency, including whether a stock is actively traded, and whether it is followed by analysts and other market professionals. . . . , [and] the speed of price adjustment to new information [which] can be tested directly by use of widelyaccepted statistical techniques). The second, and much broader meaning of fully reflect, focuses on the price of the stock as a function of its fundamental value: market price fully reflects all publicly available information when it responds to information not only quickly but accurately, such that market prices mirror the best possible estimates, in light of all available information, of the actual economic values of securities in terms of their expected risks and returns. Stout, supra, at 640. This is known as fundamental value efficiency. See Fischel, supra, at 913 (stating that fundamental value efficiency focuses on the extent to which -32- security prices reflect the present value of the net cash flows generated by a firm's assets). Determining whether a market is fundamental value efficient is a much more technical inquiry than determining informational efficiency. Depending on the method of valuation used, a stock's fundamental value turns on an assessment of various factors, including present operations, future growth rates, relative risk levels, and the future levels of interest rates. Newkirk, supra, at 1399; see, e.g., Stout, supra, at 641, 643-44 (discussing valuation of stocks based on Capital Asset Pricing Model, which focuses on expected risks and returns); cf. Fischel, supra, at 914 (stating that the results of certain kinds of tests which measure how closely prices reflect value, such as those which measure whether the variability of prices is greater than the variability of dividends over time . . . . have been extremely controversial). Courts and commentators often use these two concepts of market efficiency interchangeably. See Newkirk, supra, at 1407 (stating that [t]he manner in which the courts apply the [efficient market hypothesis] is problematic because courts often fail to distinguish between value efficiency and information efficiency).19 In fact, informational and fundamental value 19 The parties, themselves, appear to confuse these two concepts. In its briefs to this Court, PolyMedica does not mention accuracy -33- efficiency often are [] made to go hand-in-hand, with fundamental value efficiency flowing naturally from informational efficiency. See Stout, supra, at 641. Despite this blurring of concepts, one thing is clear: a market can be information efficient without also being fundamental value efficient. Stout, supra, at 651 (stating that informational efficiency and fundamental value efficiency are distinct concepts); see also Fischel, supra, at 913-14. While fundamental value efficiency may be the more comprehensive of the two concepts, encompassing both speed and accuracy, '[e]fficiency' is not an all-or-nothing phenomenon. Eckstein, 8 F.3d at 1130. of stock price as a condition of market efficiency, and explicitly states that an efficient market need not always set a statistically 'correct price' at each instant. However, the report of PolyMedica's expert, Dr. Neumann Martin, together with PolyMedica's surreply to the district court, contend that market efficiency requires proof that the resulting stock price fully and correctly reflected the news. PolyMedica's surreply goes on to state that the case law makes clear that the market for a particular stock must absorb all publicly available information to bring about the 'correct price' in order for a market to be efficient, and furthermore, that in an efficient market, the price must accurately reflect the stock's value based on that information. Thus, while PolyMedica purports to argue that the PolyMedica market was not efficient in the informational sense, PolyMedica occasionally uses language that reflects the broader concept of fundamental value. By the same token, in his reply brief to this Court, Plaintiff objects to PolyMedica's application of a correct price approach to market efficiency. However, in his response to PolyMedica's surreply to the district court, Plaintiff appears to embrace this approach by quoting Hurley v. FDIC, 719 F. Supp. 27 (D. Mass. 1989), for the proposition that an efficient market is one that obtains material information about a company and accurately reflects that information in the price of the stock. Id. at 33 (emphasis added). -34- Therefore, by requiring that stock price in an efficient market fully reflect all publicly available information in order to establish the fraud-on-the-market presumption, we do not suggest that stock price must accurately reflect the fundamental value of the stock. This distinction is well-supported by the legal and economic commentary. See Jill E. Fisch, Picking a Winner, 20 J. Corp. L. 451, 464 (1995) (book review) (stating that [s]tock prices regularly and persistently depart substantially from present value models as well as from financial variables that would appear to supply most of the information relevant to a calculation of fundamental value); Baruch Lev & Meiring de Villiers, Stock Prices and 10B-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7, 20 (1994) (stating that overwhelming empirical evidence suggests that capital markets are not fundamentally efficient); Newkirk, supra, at 1399 (noting that a major drawback to fundamental value theory is that it requires a great deal of specific, sometimes unobtainable, information). Our focus on whether a particular market has absorbed all available information (and misinformation) – such that an ordinary investor cannot beat the market by taking advantage of unexploited profit opportunities – is not a fundamental value inquiry. See Stout, supra, at 651 (stating that when finance economists define market efficiency in terms of the difficulty of making arbitrage profits, they have implicitly abandoned the more-powerful claim -35- that efficient markets price securities accurately). On the contrary, for purposes of establishing the fraud-on-the-market presumption of reliance, investors need only show that the market was informationally efficient. See In re Verifone Sec. Litig., 784 F. Supp. at 1479 n.7 (stating that the fraud-on-the-market theory does not require proof that the market correctly reflects some 'fundamental value' of the security. To apply the fraud-on-themarket theory, it is sufficient that the market for a security be 'efficient' only in the sense that market prices reflect the available information about the security.). The fraud-on-themarket theory is concerned with whether a market processes information in such a way as to justify investor reliance, not whether the stock price paid or received by investors was correct in the fundamental value sense. Still, as a matter of logic, we cannot say that fundamental value efficiency has no place in applying the fraud-onthe-market presumption of reliance at the class-certification stage. Evidence bearing on a stock's fundamental value may be relevant to the efficiency determination as, for example, circumstantial evidence that arbitrageurs are not trading in the market, with the result that securities prices do not fully reflect all publicly available information. In other words, evidence of fundamental value may be relevant to the extent that it raises questions about informational efficiency. But there are practical -36- limits on the evidence a court can or should consider during the class-certification proceedings. Courts which choose to consider such fundamental value evidence at the class-certification stage run the risk of turning the class-certification proceeding into a mini-trial on the merits, which must not happen. See Eisen, 417 U.S. at 178 (stating that [i]n determining the propriety of a class action, the question is not whether the plaintiff or plaintiffs . . . will prevail on the merits, but rather whether the requirements of Rule 23 are met) (internal quotation marks and citation omitted). 6. Evidence Necessary to Prove Presumption of Reliance It is important to remember that the application of the fraud-on-the-market presumption only establishes just that – a presumption of reliance. That reliance can be rebutted at trial. See Cammer, 711 F. Supp. at 1290 (stating that if it were concluded after a hearing [that] the market appeared efficient, and [that] plaintiffs could proceed under the rebuttable presumption, [the defendant] would be entitled to prove to a jury that the market was inefficient, thereby rebutting the presumption); see also Lehocky v. Tidel Techs., Inc., 220 F.R.D. 491, 505 n.16 (S.D. Tex. 2004) (stating that [a]t [the class-certification] stage of the proceedings, the Court need only inquire whether the stock traded in an efficient market and not examine the merits of the -37- case. . . . Thus, the Court will not address whether Defendants' [sic] can rebut the presumption of reliance). As the notes of the Advisory Committee on Rule 301 of the Federal Rules of Evidence, cited in Basic, make clear, a party need only establish basic facts in order to invoke the presumption of reliance. See Basic, 485 U.S. at 245 (citing Rule 301 and Advisory Committee Notes in support of statement that presumptions are . . . useful devices for allocating the burden of proof between parties); see also Cammer, 711 F. Supp. at 1291 n.48 (stating that under the notes of the Advisory Committee on Rule 301, the nonmoving party has the burden of establishing the nonexistence of the presumed fact once the party invoking the presumption establishes the basic facts giving rise to it) (emphasis in original) (internal quotation marks omitted). The question of how much evidence of efficiency is necessary for a court to accept the fraud-on-the-market presumption of reliance at the class-certification stage is therefore one of degree. District courts must draw these lines sensibly, mindful that evidence of fundamental value may be relevant to the determination of informational efficiency, but other more accessible and manageable evidence may be sufficient at the certification stage to establish the basic facts that permit a court to apply the fraud-on-the-market presumption. -38- We have no illusions that this line-drawing is easy. Knowing the high stakes in the class-certification decision,20 the parties will try to move the court in different directions, with plaintiffs arguing for less evidence of efficiency and defendants for more, some of it highly technical. Exercising its broad discretion, and understanding the correct definition of efficiency and the factors relevant to that determination, the district court must evaluate the plaintiff's evidence of efficiency critically without allowing the defendant to turn the class-certification proceeding into an unwieldy trial on the merits. In this highly variable setting, these generalities are the best we can do.