The Intersection of Law and Financial Theory

When lawyers and judges venture into the realm of financial theory, interesting things happen, often accompanied by unintended consequences. Take, for example the efficient market hypothesis. As anyone with a grounding in financial theory knows, the efficient market hypothesis (in the semi-strong version) holds that the market quickly incorporates all readily available information into stock prices. In 1988 the United States Supreme Court used this theory to create the legal doctrine of “fraud on the market”, which holds that shareholders do not have to directly prove that there is a connection between a shareholder’s losses and the fraud being alleged. Rather, the courts assume that the shareholders have been harmed by an alleged fraud because the market has incorporated the fraudulent information into the stock price, regardless of whether the aggrieved shareholder can show direct reliance on the fraudulent information.

The upshot (and unintended consequence) of this legal doctrine was a surge in the number of securities class actions filed beginning in 1988. In fact, it became so bad that Congress stepped into the fray and enacted the Private Securities Litigation Reform Act of 1995. This act made things tougher on plaintiffs, requiring them to plead the alleged securities fraud with a great deal more specificity than before and creating a “safe harbor” for forward looking statements made by a company. But the act did not specifically do away with the “fraud on the market” doctrine, and plaintiff’s lawyers, being a resilient and resourceful bunch, continued to file securities class action lawsuits. In fact, according to a paper written by Donald C. Langevoort at the Georgetown University Law Center, such lawsuits in the last 15 years have resulted in more than $70 billion in settlements (Judgment Day for Fraud on the Market? Reflections on Amgen and the Second Coming of Halliburton http://scholarship.law.georgetown.edu/facpub/1226 http://ssrn.com/abstract=2281910). This is because, even with the heightened filing requirements, with the fraud on the market doctrine, all shareholders are part of the class of damaged investors, not just those investors that can show they relied upon the alleged fraud. As a result, the class is so large and the potential damages can be so great that almost all securities fraud class actions that survive the pleadings stage wind up getting settled. Which, coincidentally, generates large fees for plaintiffs’ lawyers.

Now, however, the Supreme Court is taking a second look at the “fraud on the markets doctrine. Arguments in the case of Erica P. John Fund v. Halliburton Co. will be heard shortly and four of the Supreme Court justices are on record as opposing the fraud on the market doctrine. If the court reverses the doctrine, or even if they significantly curtail it, the upshot will be a lessening of class action securities lawsuits. For the first time since 1988, plaintiffs will have to actually prove that they were aware of, relied upon, and were damaged by the corporate statements they allege are fraudulent. Wouldn’t that be something?