Bowe v. Polymedica Corp.

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."

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 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).

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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)).

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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.

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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).

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 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

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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.

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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

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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

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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.

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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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