The Mercurial Efficiency of Markets

This morning the Supreme Court decided Halliburton v. Erica P. John Fund, Inc. (The SCOTUSblog page for the case is here.) In short, the Court reaffirmed the so-called fraud-on-the-market presumption in securities fraud cases. I’ll give a brief summary of the law, but I’d like to make a small point about conservative hypocrisy on the usefulness of markets. Halliburton presents an interesting about-face for many conservatives. To protect business interests, the usually pro-market voices on the right argued that we should not trust markets to accurately and efficiently allocate resources. That’s not the tune those voices normally sing.

Fraud on the Market: An Introduction

Here’s (generally) how the fraud-on-the-market presumption works: In a run-of-the-mill fraud case, the plaintiff needs to prove reliance on the defendant’s fraudulent statement. So, if I’m buying a house and the seller knowingly makes a false statement about the house in our negotiations, I can’t win just by proving that the seller made a false statement; I also need to prove that I relied on that statement in making my decision to purchase the house.

But in securities fraud cases, the Supreme Court has said that the plaintiff does not need to prove that he relied on a specific fraudulent statement when buying a stock. Indeed, the individual stock purchaser likely didn’t even know about the specific statement when he bought the stock—whether it was a statement on an earnings call, or in an SEC filing, or whatever. Rather, the plaintiff can prove reliance by showing that the fraudulent statement was made to the public and that the stock trades in a so-called “efficient” market (like the New York Stock Exchange). Based on those facts, the court will presume that the efficient market incorporated the fraudulent statement into the stock’s price. Since the plaintiff bought the security based in reliance on the integrity of the market, the fraudulent statement’s effect on the price is sufficient to create a presumption of reliance. At some point in the future, when the fraudster is outed (the so-called “corrective disclosure”), the stock price takes a hit because the market then incorporates the true information. Then the plaintiff loses a bunch of money and eventually sues.

This is obviously a big deal for securities class actions. The fraud-on-the-market presumption makes it easy to create a plaintiff class: everyone who bought the stock following the fraudulent statement and who held the stock through the loss-causing corrective disclosure. All of those plaintiffs can show reliance—the same reliance—using the fraud-on-the-market presumption. If the plaintiffs were required to prove individual knowledge of and reliance on a given fraudulent statement, that individualized inquiry would likely defeat class certification.

And securities class actions are where the money is. Individual small investors are never going to bring securities fraud claims against companies for their individual losses; it just doesn’t make financial sense. These cases are hard to prove, with lots of discovery and the need for expert testimony. Few individual plaintiffs (outside of large institutional investors) would have the resources or potential recoveries to make those claims. That’s why certain folks have been trying to kill the fraud-on-the-market presumption: Killing the presumption would kill securities class actions, which would be great for many businesses’ bottom lines.

Conservatives’ “Love Them, Love Them Not” Relationship with Markets

It’s no surprise, then, that Halliburton presented an opportunity to kill the fraud-on-the-market presumption. But the nature of the attack was quite interesting. Halliburton argued that the presumption should be rejected because markets—even huge public markets like the NYSE—cannot be trusted to assimilate material public information. In other words, the foundation of the presumption was wrong: We cannot rely on the integrity of market prices and courts therefore should not create a presumption based on that presumed integrity.

This reasoning didn’t sway the Court, but it carried Justice Thomas’s concurrence (joined by Justice Scalia and Justice Alito). Justice Thomas would have killed the presumption because even “when markets do incorporate public information, they often fail to do so accurately.” In his view, even large markets like the NYSE are subject to “‘[s]cores’ of ‘efficiency-defying anomalies.'” These unreliable inefficiencies are why many sophisticated investors enter the market: “because they think the market has under- or overvalued the stock.”

In other words, the stock market is a crooked game that’s stacked against individual investors and that large/informed investors play for big profits. That’s all well and good, and perhaps even true. But this on-again, off-again love affair with markets seems highly hypocritical among political conservatives. For example, on the issue of healthcare: How should we allocate life-saving and sometimes bankrupting medical care to American citizens? A government program based on a public policy of care and insurance? No. Markets! The healthcare insurance markets will properly allocate all the medical services the country needs, and they will do so efficiently.

What about retirement savings? How should America protect against an impoverished class of retirees? How can we avoid forcing people in their 70s to choose between working until they die or living out their years in poverty? A public social security system, perhaps? No. Markets! We should rely on the stock market to efficiently and properly allocate retirement savings to our grandparents.

The same arguments are made against public schools (“Vouchers to let the market decide which schools are best!”) and various other public functions. Time and time again, markets are held up as the proper, trustworthy, and efficient way to allocate resources. And not just financial resources, but moral resources: education, healthcare, etc.

Not so when it comes to the most financial and market-appropriate resource at all: ownership of large publicly traded corporations. For some reason, that market is one in which we cannot trust market efficiency, we cannot trust the market to reliably allocate resources and information, we cannot rely on the market’s integrity.

But it’s just fine for the allocation of health insurance.

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