Fraud-on-the-market doctrine: a proinvestor principle in securities regulation

What is the fraud-on-the-market theory in stock market transactions?

This was the subject of a lengthy discourse in the case of Basic Incorporated vs. Levinson, 485 U.S. 224 (1988).

Briefly, sometime in 1977 and 1978, Combustion Engineering, Inc. engaged in merger negotiations with some directors and officers of Basic Inc., a company listed on the New York Stock Exchange (NYSE).

In the course of the discussions, Basic made three public statements: the first denied that the company was engaged in merger negotiations, and the latter two effectively announced that the company knew of no developments that would explain the abnormally high trading activity and price fluctuations in the company’s stock.

Later in 1978, however, Basic asked the NYSE to suspend trading of its shares and issued a release stating that it had been “approached” by another company concerning a merger. The next day, Basic’s board approved Combustion’s tender offer for all outstanding shares.

Max Levinson, a Basic shareholder who sold his shares between Basic’s first public denial and the trading suspension, filed a class action suit against Basic and its directors. The basic theory of the complaint was that had Basic not made the denials, the plaintiffs would not have been misled into selling their Basic shares at much lower prices than the tender offer price.

The question was whether the suing shareholders were entitled to a presumption of reliance on Basic’s disclosure when they sold their shares in the stock market, even if they did not directly rely on the misstatements.

The US Supreme Court first examined the underlying policy behind the Securities Exchange Act, which is to protect investors.

Adopting a proinvestor stance, the Court relied on the fraud-on-the-market theory in resolving the issue.

This theory is based on the hypothesis that the share price of a company in the stock market is determined by the available material information about the company and its business.

Under this theory, there is a causal link between any misstatement and any stock purchase, because the misstatements defraud the entire market and thus affect the price of the stock.

Observing that face-to-face transactions are rare in the securities market, the Court noted that requiring the investors to prove actual reliance would place an unnecessary evidentiary burden on them and would effectively deprive them from seeking relief from the courts.

The Court further found the rebuttable presumption of reliance (through the fraud-on-the-market theory) to be a reasonable compromise between the requirements of the federal rules of civil procedure and the securities fraud element of reliance. It stated that the presumption could anyway be rebutted by showing that there was no link between the misstatements and price paid or received by the investors.

This is familiar territory in the Philippines.

Oftentimes, we read press reports about merger discussions involving our listed companies. These are normally accompanied by unusual trading activity in the company’s shares. As a standard procedure, the Philippine Stock Exchange (PSE) sends queries to the listed company about these press reports. The standard reply is that it is unaware of any development.

That is risky. The PSE rules expressly presume the reply to have been made after consulting the chair of the board, president or corporate secretary of the listed company. Under the Securities Regulation Code (SRC), any false or misleading statement exposes the guilty party not only to actual damages but also to triple the amount of the transaction and exemplary damages by way of civil penalty.

The morale of the story: corporate information or compliance officers better think hard and long before sending the so-called standard reply to the PSE. They may be exposing—unwittingly—their company and its officers to gargantuan damages under the SRC.

(The author, former president of the Philippine Stock Exchange, is now a senior partner of the Angara Abello Concepcion Regala & Cruz Law Offices [Accralaw] and the president of the Shareholders’ Association of the Philippines [SharePHIL]. The views in this column are exclusively his, and should not be attributed in any way to the institutions with which he is currently affiliated. He may be contacted through [email protected].)