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US Manufacturers Ask Supreme Court to Apply Efficient Market Theory to Loss Causation Element of Rule 10b-5

By Jim Hamilton

The federal courts should apply the efficient market theory underlying the fraud-on-the-market presumption equally to both the reliance and loss causation elements of Rule 10b-5, said the National Association of Manufacturers in an amicus brief filed with the US Supreme Court. The association asked the Court to review a Ninth Circuit panel ruling that embraced the efficient market theory in order to certify a class, but effectively rejected it on the issue of loss causation. Assessing loss causation with reference to events that occur long after corrective public disclosure of the relevant facts in a theoretically efficient market improperly expands the potential exposure of defendants in securities class action cases, argued the association, and decreases the certainty with which companies can assess this exposure. Apollo Group, Inc. v. Policemen?s Annuity and Benefit Fund of Chicago, Dkt. No. 10-649.

The question before the Court, which awaits a grant or denial of certiorari, is whether a plaintiff, invoking the efficient market theory to avoid having to prove reliance on a misrepresented stock price that caused him loss, is barred from trying to prove loss causation based on a decline in price that happened weeks or months after a corrective disclosure, rather than immediately after the disclosure.

Amicus points out that the ability to bring a securities fraud class action is grounded in the presumption of reliance under the fraud on the market theory, without which each investor would have to prove actual reliance on the allegedly false statement. The presumption of reliance is based on the efficient market theory, which holds that in an efficient securities market all information available to the market is always rapidly reflected in the price at which securities trade in the market. Thus, the fact that an investor was not aware of a particular statement is irrelevant under the theory because the stock price, of which the investor was aware, already incorporates the statement. In turn, the efficient market theory is based on the premise that competition among investors and traders forces stock prices to rapidly reflect all publicly available information.

By beginning class certification periods immediately after the allegedly false statement is made, said the brief, federal courts embrace the concept that efficient markets act quickly in assimilating new facts into the price of securities for purposes of applying the presumption of reliance.

If the securities markets are presumed for purposes of class certification and reliance to be efficient in their ability to rapidly assimilate any false statements made by a company into the price of securities, reasoned the association, they should likewise be presumed for purposes of assessing loss causation to be efficient in their ability to rapidly assimilate any corrective statements made by that company into the price of securities.

There is no rational basis for applying different standards of market efficiency for false statements and true statements, contended amicus, thus if an investor gets the benefit of a reliance presumption based on the efficient market theory, a compamy should get the benefit of the same market efficiency reacting to all available corrective disclosures.

Due to the split in the circuit courts on the issue, continued the brief, U.S. manufacturers whose shares trade on efficient markets run the risk of being whipsawed. On the front end, courts assume that their stock price immediately reflects all available information, while in some jurisdictions courts do not permit manufacturers to rely on the same presumption to establish that the immediate market reaction to an appropriate corrective disclosure effectively caps their damages.

Full post as published by Jim Hamilton's World of Securities Regulation on December 28, 2010 (boomark / email).