Fraud on the Market: Pay on Say

The legal theory behind huge pay-outs to aggrieved shareholders goes on trial.
Economist StaffFebruary 28, 2014

Of the numerous controversial theories about the workings of stock markets, few have had a bigger pecuniary impact than a marriage between the notion of efficient markets and a legal principle known as “fraud-on-the-market.” This pairing has provided grounds for sweeping claims for damages whenever a company’s share price moves abruptly. After decades of wrangling, the tactic will come before America’s Supreme Court on March 5 in the case of Halliburton v. Erica P John Fund.

Reflecting the stakes, 11 briefs have been filed with the court on behalf of Halliburton. A dozen have also been filed on behalf of the plaintiff. Former and current congressmen may be found on each side of the issue, as are former members of the Securities and Exchange Commission, America’s foremost financial regulator. Both sides feel an adverse decision will undermine the appeal of participating in America’s stock markets.

The factual underpinnings of the case are mundane. A charity, known at the time the case was filed as the Archdiocese of Milwaukee Supporting Fund, maintains that Halliburton, which provides services to oil companies, was insufficiently forthcoming in its public statements in 2002 about the impact on its earnings of a merger, asbestos litigation and various troubled contracts. As a result of Halliburton’s reticence, the charity claims, it suffered a loss on its holding.

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That is the essence of the principle of “fraud-on-the-market”: that by its communication (or lack of it), a firm’s management can, in effect, defraud all its shareholders.The idea was enshrined after a 1988 ruling in which the Supreme Court sided with an investor who lost money when he sold shares in a company called Basic Inc. because a pending merger was being publicly denied by the firm.

In its decision, the Supreme Court endorsed three ideas: that share prices are a reflection of all relevant public information (the so-called “efficient-market hypothesis”); that all investors can reasonably be presumed to have relied on information of this sort, so lawsuits can be brought on their collective behalf;  and that if a company’s share price moves, it may be the result of previous misinformation, making shareholders the victims of fraud.

After 1988 if the price of a company’s shares moved abruptly by various measures, lawsuits would be filed on behalf of all shareholders who may have either seen their holdings decline in value, or sold too soon and thus suffered an opportunity cost. If a court granted preliminary approval for a case to proceed, lawyers representing this “class” would be able to demand vast amounts of internal information to see whether managers had ever spoken misleadingly about the factors affecting the share price. That demand alone would often be enough to prompt a settlement. Studies cited in the amicus briefs suggest the big winners are the attorneys bringing the cases.

A report presented at the U.S. Chamber of Commerce reckons that the suits have cost shareholders a total of $700 billion in lost wealth since 1996. And one of the briefs in support of Halliburton calculates that 40 percent of all corporations listed on big American stock exchanges were the target of class action over the same period. The cost, in terms of settlements, legal fees and management time, is not the only problem, the brief argues. It also punishes the shareholders at the time of the settlement and discourages stock market listings.

Lawyers for the plaintiffs, supported by the Department of Justice, assert that the threat of fraud-on-the-market lawsuits keeps managers honest. Far from dimming the appeal of America’s securities markets, it provides a strong deterrent that bolsters their integrity and consequently enhances their appeal, the principle’s supporters say.

There has been no shortage of debate about whether financial markets are efficient, or at least efficient enough to form the foundation of such lawsuits. For companies that have long complained that the practice is unreasonable, there is hope. In a dissent to a ruling in a similar case last year, three justices explicitly invited a re-examination of the precedent set in 1988; a fourth suggested much the same in the oral argument that preceded the ruling. If this skeptical foursome wins over another justice, that will give them a majority on the nine-member court.

Under John Roberts, the chief justice since 2005, the court has become more sympathetic to corporate concerns, broadly speaking. A curtailment of fraud-on-the-market is therefore quite possible. Sadly, however, no market exists to predict court decisions, whether efficiently or otherwise.