Assessing market efficiency for reliance on the fraud-on-the-market doctrine afterWal-MartandAmgen☆Bajaj is the Global Head of the Finance and Securities Practice of Navigant Economics. Mazumdar is the Lead Director of the Finance and Securities Practice of Navigant Economics. Both are members of the Finance faculty at the Walter A. Haas School of Business, University of California-Berkeley. Daniel A. McLaughlin is Counsel with Sidley Austin LLP. The opinions expressed herein are opinions of the authors alone and not of their respective organizations or their clients

Following the Supreme Court’s 1988 decision inBasic, securities class plaintiffs can invoke the “rebuttable presumption of reliance on public, material misrepresentations regarding securities traded in an efficient market” [the “fraud-on-the-market” doctrine] to proveclasswidereliance. Although this requires plaintiffs to prove that the security traded in an informationally efficient market throughout the class period,Basicdid not identify what constituted adequate proof of efficiency for reliance purposes. Market efficiency cannot be presumed without proof because even large publicly traded stocks do not always trade in efficient markets, as documented in the economic literature that has grown significantly sinceBasic. For instance, during the recent global financial crisis, lack of liquidity limited arbitrage (the mechanism that renders markets efficient) and led to significant price distortions in many asset markets. Yet, lower courts followingBasichave frequently granted class certification based on a mechanical review of some factors that are considered intuitive “proxies” of market efficiency (albeit incorrectly, according to recent studies and our own analysis). Such factors have little probative value and their review does not constitute the rigorous analysis demanded by the Supreme Court. Instead, to invoke fraud-on-the-market, plaintiffs must first establish that the security traded in a weak-form efficient market (absent which a security cannot, as a logical matter, trade in a “semi-strong form” efficient market, the standard required for reliance purposes) using well-accepted tests. Only then do event study results, which are commonly used to demonstrate “cause and effect” (i.e., prove that the security’s price reacted quickly to news – a hallmark of a semi-strong form efficient market), have any merit. Even then, to claimclasswidereliance, plaintiffs must prove such cause-and-effect relationship throughout the class period, not simply on selected disclosure dates identified in the complaint as plaintiffs often do. These issues have policy implications because, once a class is certified, defendants frequently settle to avoid the magnified costs and risks associated with a trial, and the merits of the case (including the proper application of legal presumptions) are rarely examined at a trial.