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The Paradox of “Fraud‐on‐the‐Market Theory”: Who Relies on the Efficiency of Market Prices?

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  • Grigori Erenburg
  • Janet Kiholm Smith
  • Richard L. Smith

Abstract

Our evidence points to an inconsistency between the efficient markets hypothesis and the way U.S. courts have applied the hypothesis in cases involving allegations of fraud on the market. Based on a sample of securities class action cases, we find that (1) some cases certified for class action status do not satisfy the conditions for even weak‐form efficiency; (2) numerous opportunities exist for cost‐effective investors (those who can trade quickly and at low cost) to profit by using simple momentum‐based strategies; (3) including such investors as class members effectively subsidizes their strategies and overstates damages from reliance on market efficiency; (4) when such investors can profit by rejecting market efficiency, standard measures of damage overstate the fraud‐related damage of other investors; and (5) because of endogeneity, the factors that commonly are relied on by the courts for determining market efficiency bear little or no relation to weak‐form efficiency.

Suggested Citation

  • Grigori Erenburg & Janet Kiholm Smith & Richard L. Smith, 2011. "The Paradox of “Fraud‐on‐the‐Market Theory”: Who Relies on the Efficiency of Market Prices?," Journal of Empirical Legal Studies, John Wiley & Sons, vol. 8(2), pages 260-303, June.
    • Handle: RePEc:wly:empleg:v:8:y:2011:i:2:p:260-303
    DOI: 10.1111/j.1740-1461.2011.01209.x
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