Market Efficiency, Crashes and Securities Litigation

Abstract

In Basic, Inc. v. Levinson the United States Supreme Court effectively affirmed the efficient market hypothesis by ruling that a plaintiff who purchased securities on an open and developed market can be presumed to have relied on the integrity of the market price. Although the Court confined its analysis to the question of reliance, and explicitly avoided any question of damages, Justice White worried in his dissent that one could not be separated from the other. In this paper, we argue that Justice White's concerns were well founded. In light of theoretical and empirical research in finance, we show that the failure to understand the differing implications of the efficient market hypothesis for proving reliance and assessing damages introduces a significant plaintiff bias in securities class action litigation. Furthermore, although Congress attempted to address this bias by passing Private Securities Litigation Reform Act of 1995, the steps it took are unlikely to be effective.