Accounting for Bad News: Securities Fraud Litigation and the Equal Application of Market Efficiency

Abstract

The Fraud-on-the-Market theory holds that high volume markets, such as the New York Stock Exchange, effectively incorporate all available information of present and expected value into a security’s price. As endorsed by the United States Supreme Court, fraud on the market serves an important procedural role within the context of securities litigation by providing a general reliance presumption for all investors. An investor, or class of investors, is able to sue upon a claim of management misrepresentation without having to show actual reliance on the fraudulent information. When a market is assumed to be efficient, misinformation is deemed to defraud investors who have relied upon the integrity of the market itself. The presumption of market efficiency may thus be seen as an aspirational device, for placing the costs of rebuttal upon a corporation is said to encourage market transparency and the very same integrity of information that is assumed theoretically. For the soundness of market information to be encouraged through such a litigation presumption, the effect should not become counter-distorting through the double compensation of litigation loss. If fraud on the market is to be applied with consistent logic, then one must assume that the instant a misrepresentation is made public that rational investors will automatically discount the stock price to account for the inevitable class action suit that will arise. A post misrepresentation fall in share price generally serves as the basis for securities fraud claims of loss. Yet, this entails that plaintiffs are able to recover on a market valuation that includes both the diminishment in the asset due to fraud and the anticipated cost of its future litigation. Unlike traditional fraud recovery, the operation of an anticipatory market incorporates litigation outcomes into asset valuation at the time of awareness. Accordingly, damage recovery may unwittingly grant relief on a loss assessment that is composed of two factors: 1) the market assessment of asset devaluation due to fraud; and 2) the market prediction of the very same plaintiff recovery. One can then see that plaintiffs have their litigation recovery count twice: as they receive it from the court, and as it formed the basis of the very amount of claimed loss. In response to this problem, the following paper draws upon methods of alternative company valuation to arrive at a simple formula for filtering out anticipated litigation loss from securities damages.