United States Court of Appeals
For the First Circuit
No. 05-1220
In re POLYMEDICA CORP. SECURITIES LITIGATION
RICHARD BOWE, SEP-IRA, on behalf of himself and all others
similarly situated; JOHN T. MUHA; THOMAS THUMA; LAWRENCE STOREY;
JIANWEI XU; HOWARD HOFFMAN,
Plaintiffs-Appellees,
v.
POLYMEDICA CORP.; LIBERTY MEDICAL SUPPLY, INC.;
ERIC G. WALTERS; WARREN K. TROWBRIDGE; STEVEN J. LEE,
Defendants-Appellants.
APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS
[Hon. Robert E. Keeton, Senior U.S. District Judge]
Before
Torruella, Cyr, and Lipez, Circuit Judges.
Jeffrey B. Rudman, with whom James W. Prendergast,
Michael G. Bongiorno, J. Andrew Kent, and Wilmer Cutler Pickering
Hale and Dorr LLP were on brief, for appellants PolyMedica Corp.
and Liberty Medical Supply, Inc.
Michael DeMarco, with whom Daniel E. Rosenfeld and
Kirkpatrick & Lockhart LLP were on brief, for appellant Eric G.
Walters.
Allan J. Sullivan, with whom Baker & McKenzie LLP was on
brief, for appellant Warren K. Trowbridge.
Anthony M. Feeherry, with whom Gus P. Coldebella, Stuart
M. Glass, and Goodwin Procter LLP were on brief, for appellant
Steven J. Lee.
Thomas G. Shapiro, with whom Theodore M. Hess-Mahan,
Shapiro Haber & Urmy LLP, Andrew M. Schatz, Jeffrey S. Nobel,
Justin S. Kudler, and Schatz & Nobel, P.C. were on brief, for
appellee Thomas Thuma.
December 13, 2005
LIPEZ, Circuit Judge. In this appeal pursuant to Rule
23(f) of the Federal Rules of Civil Procedure from an order
certifying a class in a securities fraud case, we must decide an
issue of first impression in this Circuit: the standard for
determining whether a market was "efficient" when applying the
fraud-on-the-market presumption of investor reliance. We also
address the level of inquiry that a district court may pursue at
the class-certification stage when making that efficiency
determination. Defendants-Appellants PolyMedica Corporation,
Liberty Medical Supply, Inc. ("Liberty"), and various officers of
both companies (collectively, "PolyMedica"1) argue that the
district court erred in finding that common questions predominated
under Rule 23(b)(3) of the Federal Rules of Civil Procedure, by
determining that the market was efficient for eight months of the
class period, from January 2001 through August 2001 (the "Contested
Time Period"), and deeming PolyMedica's expert evidence irrelevant
to that determination. For the reasons set forth below, we vacate
the district court's order certifying the class for the Contested
Time Period, and remand for further proceedings.
1
For the sake of simplicity, we refer to both Defendants-
Appellants who bring this appeal, together with the company whose
stock is at issue in this case, PolyMedica Corporation, as
"PolyMedica."
-3-
I.
Thomas Thuma ("Plaintiff") is a purchaser of PolyMedica
stock, who seeks to represent a class of all purchasers of
PolyMedica stock from October 1998 through August 2001.2
PolyMedica is the parent company of Liberty, a seller of diabetic
testing supplies. According to Plaintiff, PolyMedica reported
record revenues and earnings during the class period based
primarily on the growth of Liberty's diabetic supplies business,
which accounted for up to 80% of PolyMedica's revenues. As a
result of these increases in revenue and earnings, the price of
PolyMedica's stock, which traded on the NASDAQ3 and the American
Stock Exchange during the class period, increased substantially.
2
This is a consolidated action. On November 27, 2000, Richard
Bowe, SEP-IRA, filed a federal securities class action against
PolyMedica Corporation and its Chief Executive Officer, Steven J.
Lee. A like action was subsequently filed by Trust Advisors Equity
Plus LLC on December 19, 2000. The district court consolidated the
two cases on July 30, 2001, and allowed a motion appointing Bowe,
John T. Muha, and Thomas Thuma as lead plaintiffs and approving
their selection of lead counsel. On October 9, 2001, the three
lead plaintiffs, together with three other plaintiffs, Lawrence
Storey, Jianwei Xu, and Howard Hoffman, filed a consolidated
complaint. The district court subsequently allowed Bowe and Muha
to withdraw, leaving Thomas Thuma as lead plaintiff. For the sake
of simplicity, we treat all the plaintiffs' filings as being made
by Thuma.
3
"NASDAQ" stands for the National Association of Securities
Dealers Automated Quotation, "the largest electronic, screen-based
market in the world. . . . [whose] services enable securities firms
to execute transactions in The Nasdaq Stock Market from their own
locations, relying on real-time trade reporting and automated
market surveillance." Nasdaq Stock Market, Inc. v. Archipelago
Holdings, LLC, 336 F. Supp. 2d 294, 297 (S.D.N.Y. 2004).
-4-
In the consolidated complaint, filed on October 9, 2001, Plaintiff
alleges that PolyMedica artificially inflated the market price of
its stock by misrepresenting sales, revenues, and accounts
receivable, and by issuing false press releases, causing Plaintiff
and other members of the class to purchase stock at artificially
inflated prices. Plaintiff further alleges that when the truth of
this fraud became known, PolyMedica's stock lost more than 80% of
its value. Plaintiff seeks damages under Section 10(b) of the
Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (the "Exchange
Act") and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5,
and Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a).
On January 28, 2004, following several years of
litigation, Plaintiff moved for class certification pursuant to
Fed. R. Civ. P. 23(a)4 and (b)(3)5, asserting that common questions
of law and fact predominated, based on the "fraud-on-the-market"
theory. As we explain in greater detail below, under the Supreme
4
PolyMedica does not dispute that the requirements of Rule 23(a)
– numerosity, typicality, commonality, and adequacy – have been
met. Therefore, we do not address them here.
5
Rule 23(b)(3) provides, in relevant part, that "[a]n action may
be maintained as a class action if . . . the court finds that the
questions of law or fact common to the members of the class
predominate over any questions affecting only individual members."
This requirement, "although reminiscent of the commonality
requirement of Rule 23(a), is 'far more demanding' because it
'tests whether proposed classes are sufficiently cohesive to
warrant adjudication by representation.'" Unger v. Amedisys Inc.,
401 F.3d 316, 320 (5th Cir. 2005) (quoting Amchem Prods., Inc. v.
Windsor, 521 U.S. 591, 623-24 (1997)).
-5-
Court's plurality decision in Basic, Inc. v. Levinson, 485 U.S. 224
(1988),6 this theory obviates the need for a plaintiff to
demonstrate individualized reliance on a defendant's misstatement
by permitting a class-wide rebuttable presumption of reliance,
thereby enabling a securities fraud class action to meet Rule
23(b)(3)'s commonality requirement. PolyMedica opposed the motion,
arguing that the fraud-on-the-market presumption of reliance was
inapplicable for the Contested Time Period7 because the market for
PolyMedica stock was not "efficient" (a prerequisite for
application of the presumption). Both sides submitted expert
testimony in support of their respective positions.
Plaintiff's expert, Alan R. Miller, relying upon each of
the five widely-accepted market-efficiency factors set forth in
Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J. 1989), concluded that
the market for PolyMedica stock was efficient. PolyMedica's
expert, Dr. Denise Neumann Martin, in turn, concluded that the
Polymedica market was not efficient, based on three factors not
enumerated in Cammer. A hearing on Plaintiff's motion for class
6
Justice Blackmun delivered the opinion of the Court in Basic,
joined by Justices Brennan, Marshall, and Stevens. Justice White,
joined by Justice O'Connor, dissented from the portion of the
Court's holding applying the fraud-on-the-market presumption of
reliance. Justices Rehnquist, Scalia, and Kennedy took no part in
the consideration or decision of the case.
7
PolyMedica does not dispute that the fraud-on-the-market
presumption of reliance applies to the first two years of the class
period, October 1998 through December 2000.
-6-
certification was held on July 16, 2004. On September 7, 2004, the
district court granted Plaintiff's motion to certify the class for
the entire proposed class period, rejecting Dr. Martin's evidence
as not relevant to the definition of "market efficiency," which the
court derived from Basic. The court also excluded from the class
those investors who participated in short-sale transactions (i.e.,
transactions involving the sale of a borrowed security, as further
discussed below), leaving it to "able counsel [to] develop an
efficient solution" for identifying short-sellers.
PolyMedica filed an interlocutory appeal from the
district court's order certifying the class pursuant to Rule 23(f),
which we permitted on February 15, 2005.8 On appeal, PolyMedica
argues that the district court erred in determining that the market
for PolyMedica stock was "efficient" during the Contested Time
Period, and in concluding that the fraud-on-the-market presumption
of reliance was therefore applicable for these months. PolyMedica
further argues that the district court erred in certifying the
class without a plan for identifying and excluding short-sellers
from the class.
8
Rule 23(f) provides, in relevant part, that "a court of appeals
may in its discretion permit an appeal from an order of a district
court granting or denying class action certification under this
rule if application is made to it within ten days after entry of
the order." Fed. R. Civ. P. 23(f).
-7-
II.
A. Standard of Review
We generally review decisions granting or denying class
certification under the highly deferential "abuse of discretion"
standard. Smilow v. Southwestern Bell Mobile Sys., Inc., 323 F.3d
32, 37 (1st Cir. 2003). Since Rule 23 contains express legal
standards for class certification, "an appeal of a class
certification can pose pure issues of law which are reviewed de
novo," that is, without deference to the district court. Tardiff
v. Knox County, 365 F.3d 1, 4 (1st Cir. 2004). "An error of law
is, of course, always an abuse of discretion." Charlesbank Equity
Fund II v. Blinds To Go, Inc., 370 F.3d 151, 158 (1st Cir. 2004).
Mixed questions of law and fact fall along a degree-of-deference
continuum, ranging from non-deferential plenary review for
law-dominated questions, to deferential clear-error review for
fact-dominated questions. Johnson v. Watts Regulator Co., 63 F.3d
1129, 1132 (1st Cir. 1995).
The formulation of the proper standard for efficiency is
a purely legal question reviewed de novo. Reviewing the
application of that standard to the facts of a case involves the
review of a mixed question of law and fact. See Cammer, 711 F.
Supp. at 1277 (stating that "[t]he question of whether the fraud-
on-the-market theory can substitute for direct reliance in any
given case is both a legal and a factual one: is the market in
-8-
which a particular company's stock trades efficient").9 Given the
various factors relevant to an efficiency determination, and the
abundant evidence that can be developed with respect to each
factor, the determination of whether a market is efficient is a
fact-dominated inquiry. Therefore, deferential clear-error review
applies to that determination. The ultimate decision to certify a
class is, of course, a discretionary one.
B. Level of Inquiry by the District Court
In determining whether to certify the class, the district
court went well beyond the four corners of the pleadings,
considering both parties' expert reports and literally hundreds of
pages of exhibits focused on market efficiency. Before we can
decide whether the district court correctly certified Plaintiff's
class based on a finding of market efficiency, we must determine
whether this detailed level of inquiry was appropriate at the
class-certification stage. Plaintiff, relying on the Second
Circuit's decision in In re Visa Check/MasterMoney Antitrust
9
We recognize that several courts, including the district court in
this case, have characterized the determination of whether a
particular market is efficient as a question of fact. See, e.g.,
In re PolyMedica Corp. Sec. Litig., 224 F.R.D. 27, 42 (D. Mass.
2004) (citing In re Laser Arms Corp. Sec. Litig., 794 F. Supp. 475,
490 (S.D.N.Y. 1989) (stating that "[w]hether in fact [defendant
company] traded in an efficient market is a question of fact")).
Because this determination involves the application of the
definition of efficiency to a particular market, however, we think
it is more accurate to characterize this determination as a mixed
question of law and fact.
-9-
Litigation, 280 F.3d 124 (2d Cir. 2001), argues that a district
court should not engage in a weighing of competing evidence at the
class-certification stage, and should instead confine its review to
the allegations raised in the plaintiff's complaint. At that
stage, according to the Second Circuit, "a district court may not
weigh conflicting expert evidence or engage in 'statistical
dueling' of experts." Id. at 135 (quoting Caridad v. Metro-North
Commuter R.R., 191 F.3d 283, 292-93 (2d Cir. 1999)). In support of
its position, the Second Circuit looked to Eisen v. Carlisle &
Jacquelin, 417 U.S. 156 (1974), in which the Supreme Court held
that Rule 23 did not authorize courts "to conduct a preliminary
inquiry into the merits of a suit in order to determine whether it
may be maintained as a class action." Id. at 177; see also J.B. ex
rel. Hart v. Valdez, 186 F.3d 1280, 1290 n.7 (10th Cir. 1999)
(recognizing that "when deciding a motion for class certification,
the district court should accept the allegations contained in the
complaint as true").
PolyMedica, on the other hand, argues that we should
follow the majority of courts of appeals that have addressed this
issue. According to these courts, a district court is not limited
to the allegations raised in the complaint, and should instead make
whatever legal and factual inquiries are necessary to an informed
determination of the certification issues. See Unger, 401 F.3d at
321 (stating that while "[c]lass certification hearings should not
-10-
be mini-trials on the merits of the class or individual claims. .
. . '[g]oing beyond the pleadings is necessary, as a court must
understand the claims, defenses, relevant facts, and applicable
substantive law in order to make a meaningful determination of the
certification issues'") (quoting Castano v. Am. Tobacco Co., 84
F.3d 734, 744 (5th Cir. 1996)); accord Cooper v. Southern Co., 390
F.3d 695, 712 (11th Cir. 2004); Gariety v. Grant Thornton, LLP, 368
F.3d 356, 365 (4th Cir. 2004); West v. Prudential Sec., Inc., 282
F.3d 935, 938 (7th Cir. 2002) ("Tough questions [at class-
certification stage] must be faced and squarely decided, if
necessary by holding evidentiary hearings and choosing between
competing perspectives."); Johnston v. HBO Film Mgmt., Inc., 265
F.3d 178, 189 (3rd Cir. 2001); see also Wagner v. Taylor, 836 F.2d
578, 587 (D.C. Cir. 1987) (noting that "a decision on class
certification cannot be made in a vacuum," and that "some
inspection of the circumstances of the case is essential to
determine whether the prerequisites of Federal Civil Rule 23 have
been met").
In support of this more demanding inquiry at the class-
certification stage, many of these courts rely on General Telephone
Co. of Southwest v. Falcon, 457 U.S. 147 (1982), in which the
Supreme Court noted that since "the class determination generally
involves considerations that are enmeshed in the factual and legal
issues comprising the plaintiff's cause of action. . . . sometimes
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it may be necessary for the court to probe behind the pleadings
before coming to rest on the certification question." Id. at 160
(internal quotation marks and citations omitted); see also Amchem,
521 U.S. at 616 (noting that Rule 23(b)(3) involves a "close look"
at predominance and superiority criteria).
We have already expressed our preference for the majority
view. In Waste Management Holdings, Inc. v. Mowbray, 208 F.3d 288
(1st Cir. 2000), we upheld a district court's decision to certify
a class, where the court "engaged in a case-specific analysis that
went well beyond the pleadings." Id. at 297. In that case, we
also squared the Supreme Court's holdings in Eisen and Falcon,
noting that while Eisen prohibits a district court from inquiring
into whether a plaintiff will prevail on the merits at class
certification, it "does not foreclose consideration of the probable
course of litigation," as contemplated by Falcon. Id. at 298.
"After all," we explained, "a district court must formulate some
prediction as to how specific issues will play out in order to
determine whether common or individual issues predominate in a
given case." Id.
Three years later, in Smilow v. Southwestern Bell Mobile
Systems, 323 F.3d 32 (1st Cir. 2003), we noted that "[a] district
court must conduct a rigorous analysis of the prerequisites
established by Rule 23 before certifying a class." Id. at 38
(citing Falcon, 457 U.S. at 161). And last year, in Tardiff, we
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noted the split between circuits, reasoning that while "[i]t is
sometimes taken for granted that the complaint's allegations are
necessarily controlling . . . in our view a court has the power to
test disputed premises early on if and when the class action would
be proper on one premise but not another." 365 F.3d at 4-5.
Therefore, in light of our prior precedent, we conclude that the
district court was entitled to look beyond the pleadings in its
evaluation of the applicability of the fraud-on-the-market
presumption of reliance, and its resolution of the class-
certification question.
III.
A. The Fraud-on-the-Market Theory
The Supreme Court has described the "basic elements" of
a securities fraud action under § 10(b) of the Exchange Act and
Rule 10b-5 promulgated thereunder as including: (1) "a material
misrepresentation (or omission)"; (2) "scienter, i.e., a wrongful
state of mind"; (3) "a connection with the purchase or sale of a
security"; (4) "reliance"; (5) "economic loss"; and (6) "loss
causation." In re Stone & Webster, Inc., Sec. Litig., 414 F.3d
187, 193 (1st Cir. 2005) (quoting Dura Pharm., Inc. v. Broudo, 125
S. Ct. 1627, 1631 (2005)); see also Wortley v. Camplin, 333 F.3d
284, 294 (1st Cir. 2003). While reliance is typically demonstrated
on an individual basis, the Supreme Court has noted that such a
rule would effectively foreclose securities fraud class actions
-13-
because individual questions of reliance would inevitably overwhelm
the common ones under Rule 23(b)(3). Basic, 485 U.S. at 242.
To avoid this result, the Supreme Court has recognized
the fraud-on-the-market theory, which relieves the plaintiff of the
burden of proving individualized reliance on a defendant's
misstatement, by permitting a rebuttable presumption that the
plaintiff relied on the "integrity of the market price" which
reflected that misstatement.10 As the Supreme Court recognized in
Basic, "[t]he fraud on the market theory is based on the hypothesis
that, in an open and developed securities market, the price of a
company's stock is determined by the available material information
regarding the company and its business," including any available
material misstatements. Id. at 241 (internal quotation marks and
citation omitted). Since investors who purchase or sell stock do
so in reliance on "the integrity of the market price," id. at 247,
they indirectly rely on such misstatements because they purchase or
sell stock at a price which necessarily reflects that
misrepresentation. Under the fraud-on-the-market theory,
"[m]isleading statements will therefore defraud purchasers of stock
even if the purchasers do not directly rely on the misstatements."
10
Assuming the plaintiff gets the benefit of the rebuttable
presumption at the class-certification stage, the defendant may
still rebut this presumption at trial. According to the Court in
Basic, "[a]ny showing that severs the link between the alleged
misrepresentation and either the price received (or paid) by the
plaintiff, or his decision to trade at a fair market price, will be
sufficient to rebut the presumption of reliance." 485 U.S. at 248.
-14-
Id. at 242-43 (quoting Peil v. Speiser, 806 F.2d 1154, 1160-61 (3d
Cir. 1986)); see also Shaw v. Digital Equip. Corp., 82 F.3d 1194,
1218 (1st Cir. 1996) (noting that in cases involving fraud-on-the-
market theory, "the statements identified by plaintiffs as
actionably misleading are alleged to have caused injury, if at all,
not through the plaintiffs' direct reliance upon them, but by dint
of the statements' inflating effect on the market price of the
security purchased").
Before an investor can be presumed to have relied upon
the integrity of the market price, however, the market must be
"efficient". See Basic, 485 U.S. at 248 n.27 (recognizing elements
cited by court of appeals for invoking fraud-on-the-market
presumption of reliance, including "that the shares were traded on
an efficient market").11 Efficiency refers to the flow of
information in the relevant market and the effect of that
11
In addition, the plaintiff must prove: "(1) that the defendant
made public misrepresentations; (2) that the misrepresentations
were material" (i.e., that there is a substantial likelihood that
such misrepresentations "would have been viewed by the reasonable
investor as having significantly altered the 'total mix' of
information made available"), and "would induce a reasonable,
relying investor to misjudge the value of the shares"; and (3)
"that the plaintiff traded the shares between the time the
misrepresentations were made and the time the truth was revealed."
Basic, 485 U.S. at 231-32, 248 n.27 (citing Levinson v. Basic,
Inc., 786 F.2d 741, 750 (6th Cir. 1986), vacated on other grounds,
485 U.S. 224 (1988)); see generally A&J Deutscher Family Fund v.
Bullard, No. CV 85-1850 PAR(JRX), 1988 WL 152011, at *8-12 (C.D.
Cal. Nov. 29, 1988) (applying Basic's multi-prong test for
determining presumption of reliance). These factors are not in
dispute in this interlocutory appeal; therefore, we need not
address them.
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information on the price of the stock. See In re Laser Arms Corp.
Sec. Litig., 794 F. Supp. at 490 (stating that "[t]he underlying
premise of the fraud on the market theory assumes that the market
is a transmission belt which efficiently translates all information
concerning a security," including misleading information, "into a
price"). In an efficient market, the defendant's
misrepresentations are said to have been absorbed into, and are
therefore reflected in, the stock price. Conversely, when a market
lacks efficiency, there is no assurance that the market price was
affected by the defendant's alleged misstatement at all. Instead,
the price may reflect information wholly unrelated to the
misstatement. See Freeman v. Laventhol & Horwath, 915 F.2d 193,
198 (6th Cir. 1990) (stating that "[a]n inefficient market, by
definition, does not incorporate into its price all the available
information about the value of a security. Investors, therefore,
cannot be presumed to rely reasonably on the integrity of the
market price of a security that is traded in such a market").
The fraud-on-the-market presumption of reliance and its
relationship to market efficiency can thus be reduced to the
following syllogism: (a) an investor buys or sells stock in
reliance on the integrity of the market price; (b) publicly
available information, including material misrepresentations, is
reflected in the market price; and therefore, (c) the investor buys
or sells stock in reliance on material misrepresentations. This
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syllogism breaks down, of course, when a market lacks efficiency,
and the market does not necessarily reflect the alleged material
misrepresentation. With this understanding as background, we must
now decide the appropriate standard for determining whether a
market is efficient.
B. The Meaning of "Market Efficiency"
The efficient market hypothesis began as an academic
attempt to answer the following question: Can an ordinary investor
beat the stock market, that is, can such an investor make trading
profits on the basis of new information? In an efficient market,
the answer is "no," because the information that would have given
the investor a competitive edge and allowed the investor to "beat"
the market is already reflected in the market price. See Lynn A.
Stout, The Mechanisms of Market Inefficiency: An Introduction to
the New Finance, 28 J. Corp. L. 635, 639 (2003) (stating that
"[t]he common definition of market efficiency . . . is really a
shorthand for the empirical claim that 'available information' does
not support profitable trading strategies or arbitrage
opportunities") (internal quotation marks and citation omitted).12
12
Commentators note that "[c]onventional finance recognizes this
cannot be absolutely true, or no one would have incentive to trade
on information in a way that leads to the incorporation of that
information into prices." Stout, supra, at 640 n.24. As further
discussed below, efficient markets are understood to possess enough
profit opportunities to allow a small subset of professional
investors, so-called arbitrageurs, to engage in competition with
each other, thereby moving the price of stock to reflect such
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There is, therefore, no "bargain" from which an investor can
benefit. Since the stock price fully reflects the information, an
investor cannot take advantage of it by either purchasing the stock
(if the information indicates the stock is underpriced) or selling
the stock (if the information indicates the stock is overpriced).
See Philip H. Dyvig & Stephen A. Ross, Arbitrage, in 1 The New
Palgrave Dictionary of Money and Finance 48 (Peter Newman et al.
eds., 1992) (stating that "[t]he intuition behind [the efficient
market hypothesis] is that if the price does not fully reflect all
available information, then there is a profit opportunity available
from buying the asset if the asset is underpriced or from selling
the asset if the asset is overpriced").
One way information gets absorbed into the market and
reflected in stock price is through arbitrageurs, who obtain and
analyze information about stocks from a variety of sources,
including from the issuer, market analysts, and the financial and
trade press. In re Verifone Sec. Litig., 784 F. Supp. 1471, 1479
(N.D. Cal. 1992); see generally Ronald J. Gilson & Reinier H.
Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549,
566 (1983) (discussing variety of mechanisms by which new
information is incorporated into stock price). These arbitrageurs
immediately attempt to profit from such information (for instance,
information.
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through short sales13), thereby causing the stock to move to a price
which reflects the latest public information concerning the stock,
where it is no longer possible to generate profits. See Eckstein
v. Balcor Film Investors, 8 F.3d 1121, 1129 (7th Cir. 1993)
(stating that "[c]ompetition among savvy investors leads to a price
that impounds all available information"); see also Stout, supra,
at 638 n.15 (noting that if arbitrageurs observe a difference
between price and value, "they immediately eliminate it by their
trading") (internal quotation marks and citation omitted).14
The capacity of arbitrageurs to "seek out new information
and evaluate its effects on the price of securities" distinguishes
13
In a short-sale transaction, the seller borrows shares that the
seller believes to be overvalued from a broker, and pays the broker
a so-called "loan fee" for the right to borrow the shares plus
collateral (in cash) for the value of the shares (which is held in
an interest-bearing margin account). The seller agrees to return
shares of a similar type and amount to the broker at an unspecified
date in the future. The seller then sells the borrowed stock.
Assuming the price of the stock later decreases, the seller's
profit will be the positive difference between the price the seller
pays to replace the borrowed shares (a process known as
"covering"), and the price at which the seller sold the stock. If
the price increases before the seller covers its position, the
seller suffers a loss.
14
Plaintiff offers the following example of an arbitrage
opportunity. Assume that the price of gold trading on the New York
commodities market was $100.50 per ounce, while on the London
market, which opened five hours earlier, the price was only $100
per ounce. The arbitrageur could first sell an ounce of gold
"short" in New York, receiving $100.50 in return, and then purchase
an ounce of gold in London for $100, retaining a profit of $0.50.
In an efficient market, the New York market would have swiftly
moved to match the London market price as arbitrageurs moved to
exploit the imbalance in the two markets.
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them from ordinary investors, who "lack the time, resources, or
expertise to evaluate all the information concerning a security,"
and are thus "unable to act in time to take advantage of
opportunities for arbitrage profits." Robert G. Newkirk, Comment,
Sufficient Efficiency: Fraud on the Market in the Initial Public
Offering Context, 58 U. Chi. L. Rev. 1393, 1409 (1991). In an
efficient market, then, an ordinary investor "who becomes aware of
publicly available information cannot make money by trading on it"
because the information will have already been incorporated into
the market by arbitrageurs. Stout, supra, at 640. "An example
would be an investor who decides to sell a stock upon the public
announcement of a decline in corporate earnings, who finds that by
the time she calls her broker, the price has already dropped."
Id.15
According to the prevailing definition of market
efficiency, an efficient market is one in which market price fully
15
The efficient market hypothesis is not without its critics, some
of whom argue that since not all investors have the means to seek
out information on stocks or the expertise to decipher it, "the
price of any given stock is not the same as it would be if all
participants were informed; instead it merely reflects 'the actions
of a mix of informed and uninformed participants.'" Brian E.
Pastuszenski & Inez H. Friedman-Boyce, Back to Basic: Challenging
the Application of the Efficient Market Hypothesis in Federal
Securities Lawsuits, SK080 A.L.I.-A.B.A. 907, 919 (2005). Others
challenge what they interpret to be the efficient market
hypothesis' faulty assumptions about human behavior, that is, that
"human beings are rational actors with stable preferences" who are
"never mislead by emotion and who never make foolish mistakes."
Stout, supra, at 660 (internal quotation marks omitted).
-20-
reflects all publicly available information. Stout, supra, at 639
(citing Eugene F. Fama, Efficient Capital Markets: A Review of
Theory and Empirical Work, 25 J. Fin. 383 (1970)).16 This
definition has been adopted by many lower courts as a prerequisite
for applying the fraud-on-the-market presumption of reliance.
PolyMedica urges us to do likewise, arguing that an "efficient"
market is an open and developed one, in which a stock price will
move quickly to reflect all publicly available information.
16
Courts and commentators have noted that this prevailing
definition of market efficiency is consistent with the "semi-
strong" form of the efficient market hypothesis. See, e.g., In re
Res. Am. Sec. Litig., 202 F.R.D. 177, 189 (E.D. Penn. 2001)
(stating that "[t]he Basic court adopted the semi-strong form of
market efficiency as a prerequisite for a fraud on the market
presumption"); Jonathan R. Macey & Geoffrey P. Miller, Good
Finance, Bad Economics: An Analysis of the Fraud-on-the-Market
Theory, 42 Stan. L. Rev. 1059, 1077-78 (1990). There are three
competing forms of this hypothesis – weak, semi-strong, and strong
– each of which makes a progressively stronger claim about the kind
of information that is reflected in stock price. Under the weak
form, an efficient market is one in which historical price data is
reflected in the current price of the stock, such that an ordinary
investor cannot profit by trading stock based on the historical
movements in stock price. Under the semi-strong form, an efficient
market is one in which all publicly available information is
reflected in the market price of the stock, such that an investor's
efforts to acquire and analyze public information (about the
company, the industry, or the economy, for instance) will not
produce superior investment results. Finally, under the strong
form, an efficient market is one in which stock price reflects not
just historical price data or all publicly available information,
but all possible information – both public and private. Based on
this form of an efficient market, not even an inside trader can
outperform other investors because all such information is
reflected in market price. Macey & Miller, supra, at 1077-78.
Commentators have noted that both strong-form and weak-form market
efficiency are incompatible with the fraud-on-the-market theory.
Id. at 1078-79.
-21-
The district court, on the other hand, expressly declined
to adopt this prevailing definition of market efficiency. Relying
upon language gleaned from the Supreme Court's decision in Basic,
the district court held that "the 'efficient' market required for
[the] 'fraud on the market' presumption of reliance is simply one
in which 'market professionals generally consider most publicly
announced material statements about companies, thereby affecting
stock market prices'"; it "is not one in which a stock price
rapidly reflects all publicly available material information." In
re PolyMedica Corp. Sec. Litig., 224 F.R.D. at 41 (emphasis in
original) (quoting Basic, 485 U.S. at 246 n.24). Plaintiff agrees
with the district court's definition, which, he contends, is drawn
directly from language used by the Supreme Court in Basic.
PolyMedica argues that the district court's definition of
market efficiency, while rooted in a footnote in Basic, defies the
controlling language of Basic, the cases upon which Basic relied,
and the subsequent cases interpreting Basic, all of which support
the prevailing definition of market efficiency. Specifically,
PolyMedica argues that the definition adopted by the district court
wrongly focuses on the thought processes of unidentified market
professionals and whether stock prices are in some way affected by
their consideration of most (but not necessarily all) material
public information. The prevailing definition, on the other hand,
requires a more searching inquiry into whether stock prices fully
-22-
reflect all publicly available information. We must assess these
conflicting positions of the parties.
C. The Standard for Determining an Efficient Market
1. Basic v. Levinson
While endorsing the fraud-on-the-market presumption of
reliance in Basic, the Supreme Court did not explicitly address the
meaning of an "efficient" market. See Gariety, 368 F.3d at 368
(stating that Basic "offers little guidance for determining whether
a market is efficient"). PolyMedica points to various passages in
Basic purportedly showing a preference for the prevailing
definition of an efficient market, noting the Supreme Court's
statements that "[t]he market is acting as the unpaid agent of the
investor, informing him that given all the information available to
it, the value of the stock is worth the market price," and that
"the market price of shares traded on well-developed markets
reflects all publicly available information, and hence, any
material misrepresentations." Basic, 485 U.S. at 244, 246
(emphasis added) (internal quotation marks and citation omitted).
Elsewhere, however, the Basic decision suggests that
something less than "all publicly available information" may be
required, noting that an investor's reliance may be presumed
"[b]ecause most publicly available information is reflected in
market price," id. at 247 (emphasis added). In separate footnotes
-23-
of the decision, the Court further appeared to resist PolyMedica's
suggested definition of an efficient market. As pointed out by the
district court, the Supreme Court, after listing several academic
articles, noted that:
[w]e need not determine by adjudication what economists
and social scientists have debated through the use of
sophisticated statistical analysis and the application of
economic theory. For purposes of accepting the
presumption of reliance in this case, we need only
believe that market professionals generally consider most
publicly announced material statements about companies,
thereby affecting stock market prices.
Id. at 246 n.24. In addition, the Court noted that by accepting a
rebuttable presumption of reliance, it "d[id] not intend
conclusively to adopt any particular theory of how quickly and
completely publicly available information is reflected in market
price." Id. at 249 n.28.
While the Supreme Court's language in Basic provides
support for both the district court's definition of an efficient
market as well as the prevailing definition urged by PolyMedica,
the cases relied upon by the Supreme Court in Basic favor the
latter definition. In Peil, cited extensively in Basic, the Third
Circuit noted that "[t]he 'fraud on the market' theory rests on the
assumption that there is a nearly perfect market in information,
and that the market price of stock reacts to and reflects the
available information." Peil, 806 F.2d at 1161 n.10. Likewise, in
In re LTV Sec. Litig., 88 F.R.D. 134 (N.D. Tex. 1980), which the
-24-
Supreme Court also cited, the district court stated that "[t]he
central assumption of the fraud on the market theory [is] that the
market price reflects all representations concerning the stock. .
. . [E]fficient capital markets exist when security [sic] prices
reflect all available public information about the economy, about
financial markets, and about the specific company involved." Id.
at 144.
Other cases cited in Basic, including the decision of the
Sixth Circuit under review in Basic, similarly support the
prevailing definition. See Levinson, 786 F.2d at 750 (stating that
"[t]he fraud on the market theory is based on two assumptions:
first, that in an efficient market the price of stock will reflect
all information available to the public . . . and, second, that an
individual relies on the integrity of the market price when dealing
in that stock"); T.J. Raney, Inc. & Sons v. Fort Cobb Irrigation
Fuel Auth., 717 F.2d 1330, 1332 (10th Cir. 1983) (stating that
"[t]he [fraud-on-the-market] theory is grounded on the assumption
that the market price reflects all known material information").
Given the Supreme Court's disclaimer that it was not
adopting any particular economic theory in applying the fraud-on-
the-market presumption of reliance, on the one hand, and its
embrace of the holdings of cases adopting the prevailing definition
of market efficiency on the other hand, the most that can be said
of Basic is that it did not directly address the meaning of an
-25-
efficient market, choosing instead to leave the development of that
concept to the lower courts. See Abell v. Potomac Ins. Co. of
Ill., 858 F.2d 1104, 1120 (5th Cir. 1988) (stating that "Basic
essentially allows each of the circuits room to develop its own
fraud-on-the-market rules"), vacated on other grounds sub. nom.
Fryar v. Abell, 492 U.S. 914 (1989). Basic is therefore not the
benchmark for deriving a definition of market efficiency. We must
turn to the decisions of the lower courts, post-Basic, for further
guidance.
2. Lower Courts' Interpretation of "Market
Efficiency"
PolyMedica correctly notes that in the wake of Basic,
many lower courts have accepted a definition of market efficiency
which requires that stock price fully reflect all publicly
available information. The district court conceded as much: "I
also note that the definition I have derived from Basic differs
from much of the existing case law. Most cases define an
'efficient' market as a market in which prices incorporate rapidly
or promptly all publicly available information." In re PolyMedica
Corp. Sec. Litig., 224 F.R.D. at 42.
The district court's observation was apt. The precedents
from other circuits overwhelmingly favor the definition advanced by
PolyMedica. See Gariety, 368 F.3d at 368 (stating that "in an
efficient market, 'the market price has integrity[;] . . . it
-26-
adjusts rapidly to reflect all new information'") (quoting Macey &
Miller, supra, at 1060); Greenberg v. Crossroads Sys., Inc., 364
F.3d 657, 662 n.6 (5th Cir. 2004) (stating that "where securities
are traded in an efficient market, it is assumed that all public
information concerning a company is known to the market and
reflected in the market price of the company's stock"); No. 84
Employer-Teamster Joint Council Pension Trust Fund v. Am. West
Holding Corp., 320 F.3d 920, 947 (9th Cir. 2003) (stating that "in
a modern and efficient securities market, the market price of a
stock incorporates all available public information"); GFL
Advantage Fund, Ltd. v. Colkitt, 272 F.3d 189, 208 (3d. Cir. 2001)
(defining "efficient marketplace" as one "in which stock prices
reflect all available relevant information about the stock's
economic value"); Joseph v. Wiles, 223 F.3d 1155, 1164 n.2 (10th
Cir. 2000) (stating that in an efficient market "the investor must
rely on the market to perform a valuation process which
incorporates all publicly available information, including
misinformation"); Kowal v. MCI Communications Corp., 16 F.3d 1271,
1276 n.1 (D.C. Cir. 1994) (stating that "in an efficient securities
market all publicly available information regarding a company's
prospects has been reflected in its shares' price"); Raab v. Gen.
Physics Corp., 4 F.3d 286, 289 (4th Cir. 1993) (reasoning that
fraud-on-the-market presumption of reliance assumes "the market
price has internalized all publicly available information");
-27-
Freeman, 915 F.2d at 198 (stating that "[t]he fraud on the market
theory rests on the assumption that the price of an actively traded
security in an open, well-developed, and efficient market reflects
all the available information about the value of a company").
The prevailing definition of an efficient market is also
consistent with language in our pre-Basic decision in Roeder v.
Alpha Industries, Inc., 814 F.2d 22 (1st Cir. 1987). There, we
stated that under the fraud-on-the-market theory, "[t]he market
price of stock is taken to be the basis for investment decisions;
because the price reflected all available information, investors
are presumed to have been misled by the nondisclosure." Id. at
27.17
3. Other Arguments Supporting the Prevailing
Definition of "Market Efficiency"
PolyMedica points to statements made by the United States
Securities and Exchange Commission ("SEC") supporting the
prevailing definition of market efficiency. See Brief for the
Securities and Exchange Commission as Amicus Curiae, Basic v.
17
We did not, however, determine the standard for market efficiency
in Roeder. That case required us to decide whether the fraud-on-
the-market theory creates an affirmative duty to disclose material
information to the public. We concluded that it does not, and
stated that once plaintiffs have demonstrated breach of a duty to
disclose material information, the fraud-on-the-market theory
merely obviates the need for a plaintiff to prove reliance on the
nondisclosure. We noted in dicta that this presumption of reliance
stems from a plaintiff's reliance on market price which necessarily
reflects that nondisclosure.
-28-
Levinson, 485 U.S. 224 (1988) (No. 86-279), available at 1987 WL
881068, at *22 (stating that fraud-on-the-market theory rests on
proposition that "in an active secondary market, the price of
company's stock is determined by all material information regarding
the company and its business"); see also Arthur Levitt, Chairman,
U.S. Securities and Exchange Commission, Testimony before House
Subcomm. on Telecomm. & Fin., 104th Cong. 13 (Feb. 10, 1995),
available at http://www.sec.gov./news/testimony/testarchive/1995/
spch025.txt.
PolyMedica also argues with some force that the district
court's definition is logically inconsistent. By requiring that an
efficient market need only be affected by most but not all material
information in order to be efficient, the district court's
definition allows some information to be considered "material" and
yet not affect market price. Cf. In re Burlington Coat Factory
Sec. Litig., 114 F.3d 1410, 1425 (3d Cir. 1997) (stating that "[i]n
the context of an 'efficient' market, the concept of materiality
translates into information that alters the price of the firm's
stock").
4. "Market Efficiency" Defined
On the basis of the authorities and considerations cited,
we conclude that the definition of market efficiency adopted by the
district court is inconsistent with the presumption of investor
-29-
reliance at the heart of the fraud-on-the-market theory. By
rejecting the prevailing definition of market efficiency advocated
by PolyMedica, and focusing instead on the general consideration by
market professionals of most publicly announced material statements
about companies, the district court applied the wrong standard of
efficiency. For application of the fraud-on-the-market theory, we
conclude that an efficient market is one in which the market price
of the stock fully reflects all publicly available information.
Anticipating the possibility of this definition,
Plaintiff complains that it forces him to prove that market price
"correctly" reflects a stock's fundamental value18 before a market
will be considered efficient. This argument misconstrues the
conclusion that market price must "fully reflect" all publicly
available information. The words "fully reflect" have two distinct
meanings, each of which points to a different concept of market
efficiency.
5. "Informational" v. "Fundamental Value" Efficiency
The first meaning of "fully reflect" focuses on the
ability of the market to digest information, thereby preventing
18
As we discuss in further detail below, fundamental value is a
technical concept which depends on the present value of expected
future cash flows (e.g., dividends, interest or principal payments,
liquidations values), "as estimated by well informed and capable
analysts." Jonathan R. Macey et al., Lessons from Financial
Economics: Materiality, Reliance, and Extending the Reach of Basic
v. Levinson, 77 Va. L. Rev. 1017, 1022 (1991).
-30-
trading profits: market price "fully reflects" all publicly
available information when "prices respond so quickly to new
information that it is impossible for traders to make trading
profits on the basis of that information." Stout, supra, at 651.
This is known as "informational efficiency," and is best understood
"as a prediction or implication about the speed with which prices
respond to information." Id. at 640; see also Daniel R. Fischel,
Efficient Capital Markets, the Crash, and the Fraud on the Market
Theory, 74 Cornell L. Rev. 907, 913 (1989) (stating that "[u]nder
this definition, a market is efficient if it is impossible to
devise a trading rule that systematically outperforms the market .
. . absent possession of inside information").
"With many professional investors alert to news, markets
are efficient in the sense that they rapidly adjust to all public
information . . . ." West, 282 F.3d at 938. Where the market
reacts slowly to new information, it is less likely that
misinformation was reflected in market price and therefore relied
upon. See City of Monroe Employees Ret. Sys. v. Bridgestone Corp.,
399 F.3d 651, 676 (6th Cir. 2005) (stating that "in an open and
efficient securities market[,] information important to reasonable
investors (in effect, the market) is immediately incorporated into
stock prices") (internal quotation marks and citation omitted);
Freeman, 915 F.2d at 199 (stating that "[a]n efficient market is
one which rapidly reflects new information in price") (quoting
-31-
Cammer, 711 F. Supp. at 1276 n.17); Fischel, supra, at 912 (stating
that "the more rapidly prices reflect publicly-available
information, the more sensible it is to apply the [fraud-on-the-
market theory]").
Determining whether a market is informationally
efficient, therefore, involves analysis of the structure of the
market and the speed with which all publicly available information
is impounded in price. See Fischel, supra, at 912 (enumerating
factors relevant to determination of "trading-rule" [i.e.,
"informational"] efficiency, including whether a stock "is actively
traded, and whether it is followed by analysts and other market
professionals. . . . , [and] the speed of price adjustment to new
information [which] can be tested directly by use of widely-
accepted statistical techniques").
The second, and much broader meaning of "fully reflect,"
focuses on the price of the stock as a function of its fundamental
value: market price "fully reflects" all publicly available
information when it responds to information not only quickly but
accurately, such that "market prices mirror the best possible
estimates, in light of all available information, of the actual
economic values of securities in terms of their expected risks and
returns." Stout, supra, at 640. This is known as "fundamental
value efficiency." See Fischel, supra, at 913 (stating that
fundamental value efficiency "focuses on the extent to which
-32-
security prices reflect the present value of the net cash flows
generated by a firm's assets").
Determining whether a market is fundamental value
efficient is a much more technical inquiry than determining
informational efficiency. Depending on the method of valuation
used, a stock's fundamental value turns on an assessment of various
factors, including "present operations, future growth rates,
relative risk levels, and the future levels of interest rates."
Newkirk, supra, at 1399; see, e.g., Stout, supra, at 641, 643-44
(discussing valuation of stocks based on Capital Asset Pricing
Model, which focuses on expected risks and returns); cf. Fischel,
supra, at 914 (stating that the results of certain kinds of tests
which measure "how closely prices reflect value," such as those
which measure "whether the variability of prices is greater than
the variability of dividends over time . . . . have been extremely
controversial").
Courts and commentators often use these two concepts of
market efficiency interchangeably. See Newkirk, supra, at 1407
(stating that "[t]he manner in which the courts apply the
[efficient market hypothesis] is problematic because courts often
fail to distinguish between value efficiency and information
efficiency").19 In fact, informational and fundamental value
19
The parties, themselves, appear to confuse these two concepts.
In its briefs to this Court, PolyMedica does not mention accuracy
-33-
efficiency "often are [] made to go hand-in-hand, with fundamental
value efficiency flowing naturally from informational efficiency."
See Stout, supra, at 641. Despite this blurring of concepts, one
thing is clear: a market can be information efficient without also
being fundamental value efficient. Stout, supra, at 651 (stating
that "informational efficiency and fundamental value efficiency are
distinct concepts"); see also Fischel, supra, at 913-14. While
fundamental value efficiency may be the more comprehensive of the
two concepts, encompassing both speed and accuracy, "'[e]fficiency'
is not an all-or-nothing phenomenon." Eckstein, 8 F.3d at 1130.
of stock price as a condition of market efficiency, and explicitly
states that an efficient market need not always set a
"statistically 'correct price' at each instant." However, the
report of PolyMedica's expert, Dr. Neumann Martin, together with
PolyMedica's surreply to the district court, contend that market
efficiency requires proof that "the resulting stock price fully and
correctly reflected the news." PolyMedica's surreply goes on to
state that "the case law makes clear that the market for a
particular stock must absorb all publicly available information to
bring about the 'correct price' in order for a market to be
efficient," and furthermore, that "in an efficient market, the
price must accurately reflect the stock's value based on that
information." Thus, while PolyMedica purports to argue that the
PolyMedica market was not efficient in the informational sense,
PolyMedica occasionally uses language that reflects the broader
concept of fundamental value. By the same token, in his reply
brief to this Court, Plaintiff objects to PolyMedica's application
of a "correct price" approach to market efficiency. However, in
his response to PolyMedica's surreply to the district court,
Plaintiff appears to embrace this approach by quoting Hurley v.
FDIC, 719 F. Supp. 27 (D. Mass. 1989), for the proposition that an
efficient market is "one that obtains material information about a
company and accurately reflects that information in the price of
the stock." Id. at 33 (emphasis added).
-34-
Therefore, by requiring that stock price in an efficient
market fully reflect all publicly available information in order to
establish the fraud-on-the-market presumption, we do not suggest
that stock price must accurately reflect the fundamental value of
the stock. This distinction is well-supported by the legal and
economic commentary. See Jill E. Fisch, Picking a Winner, 20 J.
Corp. L. 451, 464 (1995) (book review) (stating that "[s]tock
prices regularly and persistently depart substantially from present
value models as well as from financial variables that would appear
to supply most of the information relevant to a calculation of
fundamental value"); Baruch Lev & Meiring de Villiers, Stock Prices
and 10B-5 Damages: A Legal, Economic, and Policy Analysis, 47
Stan. L. Rev. 7, 20 (1994) (stating that "overwhelming empirical
evidence suggests that capital markets are not fundamentally
efficient"); Newkirk, supra, at 1399 (noting that a "major drawback
to fundamental value theory is that it requires a great deal of
specific, sometimes unobtainable, information").
Our focus on whether a particular market has absorbed all
available information (and misinformation) – such that an ordinary
investor cannot beat the market by taking advantage of unexploited
profit opportunities – is not a fundamental value inquiry. See
Stout, supra, at 651 (stating that "when finance economists define
market efficiency in terms of the difficulty of making arbitrage
profits, they have implicitly abandoned the more-powerful claim
-35-
that efficient markets price securities accurately"). On the
contrary, for purposes of establishing the fraud-on-the-market
presumption of reliance, investors need only show that the market
was informationally efficient. See In re Verifone Sec. Litig., 784
F. Supp. at 1479 n.7 (stating that the fraud-on-the-market theory
does not require "proof that the market correctly reflects some
'fundamental value' of the security. To apply the fraud-on-the-
market theory, it is sufficient that the market for a security be
'efficient' only in the sense that market prices reflect the
available information about the security."). The fraud-on-the-
market theory is concerned with whether a market processes
information in such a way as to justify investor reliance, not
whether the stock price paid or received by investors was "correct"
in the fundamental value sense.
Still, as a matter of logic, we cannot say that
fundamental value efficiency has no place in applying the fraud-on-
the-market presumption of reliance at the class-certification
stage. Evidence bearing on a stock's fundamental value may be
relevant to the efficiency determination as, for example,
circumstantial evidence that arbitrageurs are not trading in the
market, with the result that securities prices do not fully reflect
all publicly available information. In other words, evidence of
fundamental value may be relevant to the extent that it raises
questions about informational efficiency. But there are practical
-36-
limits on the evidence a court can or should consider during the
class-certification proceedings. Courts which choose to consider
such fundamental value evidence at the class-certification stage
run the risk of turning the class-certification proceeding into a
mini-trial on the merits, which must not happen. See Eisen, 417
U.S. at 178 (stating that "[i]n determining the propriety of a
class action, the question is not whether the plaintiff or
plaintiffs . . . will prevail on the merits, but rather whether the
requirements of Rule 23 are met") (internal quotation marks and
citation omitted).
6. Evidence Necessary to Prove Presumption of
Reliance
It is important to remember that the application of the
fraud-on-the-market presumption only establishes just that – a
presumption of reliance. That reliance can be rebutted at trial.
See Cammer, 711 F. Supp. at 1290 (stating that "if it were
concluded after a hearing [that] the market appeared efficient, and
[that] plaintiffs could proceed under the rebuttable presumption,
[the defendant] would be entitled to prove to a jury that the
market was inefficient, thereby rebutting the presumption"); see
also Lehocky v. Tidel Techs., Inc., 220 F.R.D. 491, 505 n.16 (S.D.
Tex. 2004) (stating that "[a]t [the class-certification] stage of
the proceedings, the Court need only inquire whether the stock
traded in an efficient market and not examine the merits of the
-37-
case. . . . Thus, the Court will not address whether Defendants'
[sic] can rebut the presumption of reliance").
As the notes of the Advisory Committee on Rule 301 of the
Federal Rules of Evidence, cited in Basic, make clear, a party need
only establish "basic facts" in order to invoke the presumption of
reliance. See Basic, 485 U.S. at 245 (citing Rule 301 and Advisory
Committee Notes in support of statement that "presumptions are . .
. useful devices for allocating the burden of proof between
parties"); see also Cammer, 711 F. Supp. at 1291 n.48 (stating that
under the notes of the Advisory Committee on Rule 301, the
nonmoving party has the burden of establishing the nonexistence of
the presumed fact "once the party invoking the presumption
establishes the basic facts giving rise to it") (emphasis in
original) (internal quotation marks omitted).
The question of how much evidence of efficiency is
necessary for a court to accept the fraud-on-the-market presumption
of reliance at the class-certification stage is therefore one of
degree. District courts must draw these lines sensibly, mindful
that evidence of fundamental value may be relevant to the
determination of informational efficiency, but other more
accessible and manageable evidence may be sufficient at the
certification stage to establish the basic facts that permit a
court to apply the fraud-on-the-market presumption.
-38-
We have no illusions that this line-drawing is easy.
Knowing the high stakes in the class-certification decision,20 the
parties will try to move the court in different directions, with
plaintiffs arguing for less evidence of efficiency and defendants
for more, some of it highly technical. Exercising its broad
discretion, and understanding the correct definition of efficiency
and the factors relevant to that determination, the district court
must evaluate the plaintiff's evidence of efficiency critically
without allowing the defendant to turn the class-certification
proceeding into an unwieldy trial on the merits. In this highly
variable setting, these generalities are the best we can do.
IV.
Having concluded that the district court adopted the
wrong definition of market efficiency, we must now decide whether
the court's determination that the market for PolyMedica stock was
efficient is nevertheless supportable. As previously discussed,
the question of whether a particular market is efficient is a mixed
question of law and fact. While the proper definition of market
efficiency is a purely legal issue reviewed de novo, application of
this definition to the facts of a case requires district courts to
20
Very few class actions go to trial. See Barbara J. Rothstein &
Thomas E. Willging, Federal Judicial Center, Managing Class Action
Litigation: A Pocket Guide for Judges 6 (2005) (stating that
according to 2005 study, certified class actions settled ninety
percent of the time).
-39-
make judgments about the structure of the market for a particular
stock. These judgments are reviewed for clear error. Many factors
bearing on the structure of the market may be relevant to the
efficiency analysis, and courts have wide latitude in deciding what
factors to apply in a given case, and what weight should be given
to those factors.
The district court in this case based its analysis of
market efficiency on three factors: "(1) the involvement of market
professionals, (2) the degree to and fluidity with which
information is disseminated, and (3) whether information affected
stock market prices." In re PolyMedica Corp. Sec. Litig., 224
F.R.D. at 42-43. Applying these factors, the district court
determined that the market for PolyMedica stock met the court's
definition of market efficiency, that is, "one in which market
professionals generally considered most publicly announced material
statements about PolyMedica, thereby affecting the stock market
price." Id. at 43. The court explicitly rejected PolyMedica's
proffered evidence,21 which focused on whether market price "fully
21
PolyMedica submitted the expert report of Dr. Denise Neumann
Martin, who asserted that constraints on short sales, as evidenced
by a high degree of shorting, a high cost of borrowing shares, and
the inability to find shares to short, prevented would-be short
sellers from trading on information, thereby preventing the market
from incorporating such information. Dr. Neumann Martin posited
that this breakdown in the ability of the market to incorporate
such information resulted in unexploited profit opportunities, as
evidenced by the results of two tests: the serial correlation test
(assessing whether an investor can predict price changes based on
historical price data) and the put-call parity test (assessing
-40-
and rapidly reflect[ed] all the publicly available material
information," ruling that it was "not relevant to the definition of
market 'efficiency'" announced by the court. Id.
PolyMedica argues that by adopting the wrong definition
of market efficiency, the district court erroneously refused to
consider PolyMedica's evidence and, therefore, erroneously
concluded that the market for PolyMedica stock was efficient.
Plaintiff argues that regardless of whether the court adopted the
wrong definition of efficiency, the factors analyzed by the court
were nevertheless sufficient to support a finding of market
efficiency under the correct definition of market efficiency that
we adopt today. While we agree with Plaintiff that the factors
considered by the district court were relevant to the issue of
market efficiency, these factors are not exhaustive. See Unger,
401 F.3d at 323. If the district court had used the definition of
market efficiency that we adopt today, other factors cited by
PolyMedica may have also been relevant to the efficiency analysis
and may have supported a contrary finding. The district court’s
error, therefore, was not in analyzing the factors that it did, but
whether an investor can guarantee a profit by engaging in a series
of transactions involving a company's stock and its options). We
make no judgment on the relevance of this evidence to the efficient
market determination, or the appropriateness of the court's
consideration of this evidence during class-certification
proceedings. As we have just indicated, those questions are for
the district court to decide in the first instance, applying the
proper definition of efficiency.
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in applying an erroneous definition of market efficiency that
prevented it from analyzing other arguably relevant evidence. We
must therefore vacate its decision and remand for application of
the proper standard.22
V.
We summarize the essential points of our analysis. The
district court was entitled to look beyond the pleadings and
consider evidence in its evaluation of the applicability of the
fraud-on-the-market presumption of reliance, and in its resolution
of the class-certification question. However, the district court
adopted a standard of market efficiency at odds with the prevailing
standard, holding that market efficiency means that market
professionals generally consider most publicly announced material
statements about companies, thereby affecting stock market prices.
This was error.
For purposes of establishing the fraud-on-the-market
presumption of reliance, we adopt the prevailing definition of
market efficiency, which provides that an efficient market is one
22
In its order granting class certification, the district court
specifically excluded all short-sellers from the class, noting that
short-sellers do not rely on the integrity of the market price
(rather, they believe the market price is too high), and therefore
are not entitled to a fraud-on-the-market presumption of reliance.
PolyMedica argues that, even if the market for PolyMedica was
efficient during the Contested Time Period, class certification
still should not have been granted because the class is not
"ascertainable." Because we vacate the district court's order
certifying the class, we need not decide this issue.
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in which the market price of the stock fully reflects all publicly
available information. By "fully reflect," we mean that market
price responds so quickly to new information that ordinary
investors cannot make trading profits on the basis of such
information. This is known as "informational efficiency." We
reject a second and much broader meaning of "fully reflect," known
as "fundamental value efficiency," which requires that a market
respond to information not only quickly but accurately, such that
the market price of a stock reflects its fundamental value.
While evidence of a stock's fundamental value may be
relevant to the extent that it raises questions about informational
efficiency, courts which choose to consider such fundamental value
evidence at the class-certification stage run the risk of turning
the class-certification proceeding into a mini-trial on the merits,
which must not happen. The fraud-on-the-market presumption, after
all, only establishes a presumption of reliance which can be
rebutted at trial. At the class-certification stage, a party need
only establish "basic facts" in order to invoke the presumption of
reliance. The question of how much evidence of efficiency is
necessary to establish the fraud-on-the-market presumption of
reliance is one of degree. While district courts have broad
discretion to draw these lines, they must do so sensibly,
understanding the correct definition of efficiency and the factors
relevant to that determination.
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Having concluded this analysis, we must vacate the
district court's order certifying the class for the period
beginning January 2001 and ending August 2001, and remand for
further proceedings consistent with this opinion. Each party shall
bear its own costs of appeal.
So ordered.
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