Article

Distortion Other Than Price Distortion

Urska Velikonja

The fraud-on-the-market doctrine adopted in Basic Inc. v. Levinson (“Basic”) allows the plaintiff suing under Rule 10b-5 to satisfy the reliance requirement by showing that the market in which the security was traded was efficient and that she purchased the security at the market price during the period of the misrepresentation. If she succeeds, the plaintiff is entitled to two presumptions: first, that the misrepresentation distorted the price of that security, and second, that she purchased the security in reliance on that misrepresentation.

In Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), the Supreme Court considered a direct attack on Basic’s presumptions, and declined to do away with them. Judging by the volume of academic commentary to date, the most significant contribution of Halliburton II is a more pragmatic definition of market efficiency, which is the underlying mechanism that converts information about securities into their prices. To invoke the presumption of reliance in a fraud-on-the-market suit, plaintiffs no longer need to show that the market for a public company security is hyper-efficient, in that it fully and quickly impounds into stock prices all publicly available information, as some courts have required. Rather, the Court embraced the notion that market efficiency is a “matter of degree.”

In this Article, I propose that much of Halliburton II’s second holding—that a defendant can prevent class certification by showing no statistically significant movement in the price of the security at the time of corrective disclosure—does nothing to improve the quality of securities class-action litigation, and could make it worse. Financial misreporting by public companies distorts more than just the price of the firms’ securities, and that distortion other than that affecting the prices of public securities can in some circumstances be more significant and economically wasteful than stock price distortion. This Article develops an analytical matrix that identifies possible combinations of distortions in the stock price and economic dislocation to suggest when fraud-on-the-market litigation is likely to insufficiently deter disclosure fraud. Based on empirical studies, this Article identifies the circumstances in which large economic distortions caused by false disclosures are likely to be particularly large. In light of these observations, the Article suggests that fraud-on-the-market litigation should not be understood primarily as a remedy for victimized shareholders, who can often eliminate the cost of fraud ex ante, but as a quasi qui tam cause of action available to purchasers and sellers of (usually equity) securities to police economically-harmful false disclosures by public companies. Even in cases where buyers and sellers of stock are not the class most significantly harmed by disclosure fraud, they nearly always suffer some identifiable losses, thus avoiding difficult evidentiary questions about standing. When viewed through this lens, many of the objections to securities litigation become moot and its virtues are revealed.