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University of Richmond UR Scholarship Repository Law Faculty Publications School of Law 2005 Does the Efficient Market Theory Help Us Do Justice in a Time of Madness William O. Fisher University of Richmond, [email protected] Follow this and additional works at: http://scholarship.richmond.edu/law-faculty-publications Part of the Securities Law Commons Recommended Citation William O. Fisher, Does the Efficient Market Theory Help Us Do Justice in a Time of Madness, 54 Emory L.J. 843 (2005). This Article is brought to you for free and open access by the School of Law at UR Scholarship Repository. It has been accepted for inclusion in Law Faculty Publications by an authorized administrator of UR Scholarship Repository. For more information, please contact [email protected]. DOES THE EFFICIENT MARKET THEORY HELP US DO JUSTICE IN A TIME OF MADNESS? William 0. Fisher· INTRODUCTION .............................................................................................. 847 I. IN THE BEGINNING: THE SUPREME COURT ADOPTS THE FRAUD- ON-THE-MARKET THEORY ................................................................. 848 A. The Basic Decision ..................................................................... 848 B. Just What Does "Efficient Market" Mean? Mechanical Versus Value Efficiency .............................................................. 850 C. The Importance of Market Professionals in Efficient Market Theory ......................................................................................... 854 D. Market Professionals as the Link to Value Efficiency Justifying the Use of Efficient Market Theory To Dispense Justice in Cases Decided by the Courts ...................................... 855 II. BASIC APPLIED: THE FACTORS THAT COURTS REVIEW TO DETERMINE WHETHER A MARKET Is "EFFICIENT" So THAT THE FRAUD-ON-THE-MARKET THEORY WILL BE USED ............................ 857 A. The Cammer Factors, and a Few Others as Well ...................... 858 B. Whether the Factors Are Consistently Applied and Whether They Make Sense ........................................................................ 863 C. The Courts' Focus on Mechanical Efficiency, Not Value Efficiency .................................................................................... 867 D. Factors Measuring the Participation of Market Professionals, Who Conceivably Provide the Link Between Mechanical and Value Efficiency .......................................................................... 868 E. The Dominance of Efficiency Analysis ....................................... 869 • William 0. Fisher is a member of the California Bar. He practiced with Pillsbury Winthrop LLP (formerly Pillsbury Madison & Sutro LLP and now Pillsbury Winthrop Shaw Pittman LLP) for approximately twenty-five years. He also served in the Department of Justice in Washington, D.C. Mr. Fisher is a Lecturer at the University of California, Berkeley, Boalt Hall School of Law. I gratefully acknowledge the comments by John Hirshleifer, John Haut, and Robert Enriques-all of CRA International-while noting expressly that none of those individuals necessarily agrees with my analysis and that CRA International does not necessarily agree with my analysis. The views expressed in this Article are mine alone. I thank Alison Britton, Jean Taylor, Vitalee Giarnmalvo, Bea Rickels, and Alice Mitchell for their assistance in word processing, cite checking, copyediting, and research. All errors belong to me. 844 EMORY LAW JOURNAL [Vol.54 III. THE "EVENT STUDY" AS THE CRITICAL TOOL TO BRING EFFICIENT MARKET THEORY TO BEAR ON MULTIPLE lOB-5 ELEMENTS AND THE CONNECTION BETWEEN EVENT STUDIES AND THE NORMATIVE VALUES INHERENT IN 1.0B-5 ELEMENTS ........................ 871 A. A Rough Description of an Event Study ...................................... 872 B. An Event Study Investigates Only the Relationship Between New Information and the Change in Securities Prices, Not Whether Prices Before or After the Change Reflected the Issuer's Fundamental Value, and Not Whether Market Professionals Controlled the Price Change That Occurred ....... 873 C. An Event Study May Be Used To Establish Multiple JOb-5 Elements: Reliance, Materiality, Causation, and Damages ....... 874 D. The Normative Aspects of the Elements That an Event Study Can Address in a Case Assuming an Efficient Market ............... 883 1. Reliance Must Be Reasonable .............................................. 883 2. A "Material" Fact Is One That Is Important to a Reasonable Investor Who, in a FOTM Case, Is Assumed To Be a Market Professional ................................................ 885 3. Loss Causation Places Legal Responsibility for Harm on Those Who Should Justly Bear It .......................................... 887 4. Damages Are Not Designed To Insure Investors Against All Risks but Are Limited to Losses That the Defendant Caused and Do Not Include Loss From Movement of the Market as a Whole or Other Nonfraud Causes .................... 888 5. How Theory Links the Mechanical Efficiency Documented by an Event Study to the Normative Aspects of JOb-5 Elements ............................................................................... 889 IV. THE SHAPE OF THE INTERNET AND TELECOMMUNICATIONS BUBBLE, SEVERANCE OF PRICE FROM VALUE AND SEVERANCE OF MECHANICAL EFFICIENCY FROM THE MORAL CONTENT OF lOB-5 ELEMENTS .......................................................................................... 890 A. The Anatomy of The Bubble ....................................................... 890 B. The Significance of Mechanical Efficiency During The Bubble .................................................................................. 897 V. THEORETICAL AND EMPIRICAL CHALLENGES TO MARKET EFFICIENCY, A BEHAVIORAL FINANCE EXPLANATION OF THE BUBBLE, AND THE QUESTIONS THAT EXPLANATION RAISES FOR USE OF EFFICIENT MARKET THEORY IN SECURITIES LITIGATION ...... 898 2005] EFFICIENT MARKET THEORY 845 A. Significant Academic Thought Now Argues That the Market Does Not Act Rationally ............................................................. 899 1. An Introduction to the Behavioral Challenge: Market Overreaction to Perceived Trends ........................................ 901 2. A Behavioral Explanation of The Bubble ............................. 908 a. A Behavioral Explanation for Why the Market Went Nuts ................................................................................ 908 b. A Behavioral Explanation for Why Market Professionals Did Not Stop the Madness ....................... 913 B. The Significance of the Behavioralist Explanation of The Bubble to the Use of Efficient Market Analysis in Securities Cases Arising Out of Bubble Facts ............................................. 920 VI. AMATEUR TRADING DURING THE BUBBLE AND THE QUESTIONS THAT TRADING RAISES FOR THE USE OF EFFICIENT MARKET THEORY IN SECURITIES LITIGATION ................................................... 921 A. Day Traders and Other Trend Chasers Contributed to Increased Bubble Trading Volume ............................................. 922 B. What the Prominence ofAmateur Traders During The Bubble Means for Court Use of the Efficient Market Theory ................. 930 VII. WHETHER ANALYSTS WERE BIASED DURING THE BUBBLE: A SERIOUS QUESTION THAT, EVEN IF LEFT UNRESOLVED, SHOULD AFFECT THE APPLICATION OF EFFICIENT MARKET ANALYSIS TO BUBBLE CASES ................................................................................... 932 A. Court and Regulator Praise for Analysts ................................... 932 B. Evidence That Analysts May Have Been Biased During The Bubble ......................................................................................... 934 1. The Overwhelming Number of "Buy" Recommendations and the Very Few "Sell" Recommendations During The Bubble ................................................................................... 935 2. "Buy" Ratings Maintained on Stocks as They Dropped ...... 939 3. Regulator Allegations of Instances in Which Analysts Did Not Believe the "Buy" Ratings They Assigned ..................... 943 4. Regulator Allegations That Investment Banking Considerations Influenced Analysts To Publish "Buy" Ratings .................................................................................. 944 5. A Host of Other Factors That May Have Influenced Analysts in Favor of "Buy" Recommendations .................... 950 846 EMORY LAW JOURNAL [Vol. 54 6. Multiple Regulators Conducted a Massive Investigation of Analyst Bias, Which Led to a $1.4 Billion Settlement by Major Brokerage Houses and Institutionalized Changes To Curtail Bias ..................................................................... 955 a. The Settlement Between Industry and Regulators Suggests That Charges of Analyst Bias Were Not Frivolous ........................................................................ 957 b. The Circumstance That Congress Demanded New Rules To Curtail Bias, as well as the Circumstance that the NYSE, NASD, and the SEC Adopted Extensive Rules to Curtail Bias, Suggest That Charges of Analyst Bias Were Not Frivolous ................................... 961 C. The Implications of Possible Analyst Bias for Efficient Market Analysis in lOb-5 Cases .............................................................. 966 1. Courts Should Not Conclude that Analysts Caused The Bubble ................................................................................... 966 2. Courts Should Not, in Bubble Cases,
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