Supreme Court Isn't Impressed by Market Efficiency
Last fall, when the Nobel Prize in economics went to two scholars with opposing views on the efficiency of markets, my physicist friends raised their eyebrows: What kind of science is that? Now the U.S. Supreme Court has entered the economics-bashing game, and on a related subject.
In Halliburton v. Erica P. John Fund, argued yesterday, the court considered whether economists' revision of the efficient capital markets hypothesis means the court should reverse the long-standing doctrine known as "fraud on the market" that underlies most securities class-action lawsuits. If the oral argument is any guide, it looks as if the fraud-on-the-market doctrine is due for revision.
Why should changes in economic theory affect the law at all? It's an important question, but not a simple one. The answer goes back to 1988, when the court decided to expand securities class actions -- lawsuits brought by a common "class" of shareholders, all of whom are supposed to have been similarly injured by the same material misrepresentation by a company whose shares were traded on a national exchange. In the case of Basic v. Levinson, the court relied in part on an economic theory called the efficient capital markets hypothesis to explain why all shareholders who bought at the market price were affected by a public lie.
According to the theory as it then stood, markets rapidly and efficiently incorporate new information into price. From this premise, the court concluded that judges could presume that a material misrepresentation affected all purchasers, even those who never heard the lie -- because it influenced the market price. The practical consequence was to make it much easier to "certify" a class and file the class action. In practice, after a class is certified, cases don't go to trial. They are settled by companies terrified by the risks of litigation.
Since then, securities class actions have been a growth industry, lauded by plaintiffs' attorneys as an important watchdog and derided by corporations as a cash cow that benefits no one but the lawyers. For years, opponents have hoped to get the Supreme Court to reverse Basic. Since 1988, the justices have turned over almost totally. Only Anthony Kennedy and Antonin Scalia remain from the court that decided Basic v. Levinson -- and they were both recused in the case.
The opponents' big chance came with faltering academic confidence in the efficient capital markets hypothesis. When the court overturns its own precedent, it likes to have the excuse that something's changed. It's awkward to admit that the new element is changed politics, and so one of the court's favorite ploys is to blame it on new science.
The most prominent example of this is Brown v. Board of Education, where in a famous footnote the court cited findings from social science that segregation harmed black children psychologically. This was supposed to be new evidence that segregation wasn't actually neutral between blacks and whites, as the court had bizarrely claimed in the horrific 1896 decision Plessy v. Ferguson.
Today economists acknowledge broadly that not all capital markets incorporate new information immediately and efficiently into price. Sure, some intensely followed markets, such as the New York Stock Exchange, seem to incorporate new information fast and well. But other, less-scrutinized capital markets, including even Nasdaq, demonstrate anomalies that can be observed by careful analysis of what happens when new information enters the market. Some investor strategies depend on exploiting these anomalies while they last. Market efficiency, it turns out, is more a process than a state of being.
To hear the justices debate the issue was to see the conservatives looking to make economists the fall guys for their plan to rein in securities class actions. At one point, the attorney for Halliburton said that he wanted the court to get out of the business of reviewing the economic literature altogether. Chief Justice John Roberts put him sternly back on message: "No, your submission is that we should jettison the Basic test because economists now believe that the efficient market theory is not ... sufficiently accurate or true to support it."
For their part, the court's liberals found themselves scrambling to make excuses for the embarrassing fact that social science ain't exactly a science. Justice Ruth Bader Ginsburg suggested that the Basic decision "wasn't relying strictly on an economic theory," but also on common sense and the law. Justice Elena Kagan argued that it didn't matter if not all markets were efficient -- plaintiffs could simply prove that in the relevant market, new information was incorporated into price. This was a straightforward effort to preserve the Basic presumption without relying on the efficient markets theory.
The crowning irony of the oral argument was the justices' intense interest in an amicus brief filed by a group of law professors, many with economic training. It offered a third path between greatly limiting securities class actions and preserving the status quo. The professors recommended that courts rely on "event studies," observational economic analysis of market behavior before, during and after the incorporation of new information.
The justices clutched at the event studies -- the state of the art now -- as if they were drowning people grabbing for a life raft. But event studies, too, will eventually become obsolete. Already, experimental economists are questioning the post-hoc nature of event observation, which must identify and exclude confounding factors rather than test hypotheses specified in advance. Some even say observational studies aren't really science. The court may adopt the event studies as the new standard. If it does, count on the issue being reargued in 25 years -- maybe sooner -- on the basis that the science was wrong.
(Noah Feldman, a law professor at Harvard University and the author of "Cool War: The Future of Global Competition," is a Bloomberg View columnist. Follow him on Twitter at @NoahRFeldman.)
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