Halliburton and the Integrity of the Public Corporation
James J. Park*
When the fraud-on-the-market presumption applies, courts assume
that investors uniformly rely on the integrity of a security’s market price.1
The validity of this presumption rests on two related propositions. The first
is descriptive. A company’s stock price in an efficient market will
accurately reflect publicly released information about the company and its
economic prospects. The second is normative. Investors can reasonably rely
on the integrity of market prices when they purchase stock.
This essay assesses the second of these ideas. It concludes that the
reasonableness of investor reliance on market prices is grounded in the
regulatory structure governing which corporations can be publicly traded.
Put another way, the fraud-on-the-market presumption is best justified not
because of an expectation that markets have integrity, but the increasing
expectation that a public corporation must meet a certain level of integrity.
An investor may rely on the belief that a stock trading in an efficient market
meets private and public norms governing whether a company is fit for
public trading. Such reliance is clearly disrupted when fraud hides
information indicating that a company should be delisted or is heading
towards bankruptcy.
I.
Two Views of Market Integrity
In the Halliburton v. Erica P. John Fund2 briefs arguing that the
presumption should be overruled, the essence of the argument was that
investors simply cannot trust market prices. Stocks are constantly
fluctuating in value and their prices reflect not just useful information
relevant to the company’s performance but also noise that is distracting at
best and misleading at worst. Therefore, no investor could believe that the
stock price scientifically reflects the true value of the company. The
*
Professor of Law, UCLA School of Law.
This uniform reliance establishes commonality among these investors, allowing for
certification of a federal class action alleging claims under Rule 10b-5.
2
134 S. Ct. 2398 (2014).
1
1
Supreme Court in Basic v. Levinson had rejected this argument, concluding
that an investor can rely on the integrity of markets.3
The Supreme Court in Halliburton affirmed its conclusion in Basic,
while adding some additional responses to arguments that markets lack
integrity.4 The opinions in Basic and Halliburton both extensively discuss
market integrity as a reason for the validity of the fraud-on-the-market
presumption. Lengthy portions of each of the dissenting opinions attempt to
refute the majority conclusion that markets can be trusted.
This Part unpacks the concept of market integrity discussed by the
Court. There are two different conceptions of market integrity. The first
makes a strong claim that investors can rely on the belief that market prices
reflect the fundamental value of the trading corporation. The second makes
a weaker claim that investors should be able to rely on the assumption that
market prices do not reflect fraud by the public corporation.
A. Market Prices Reflect Fundamental Value
The stronger version of market integrity is based on the assumption
that markets are fundamentally efficient. The strongest version of the
efficient markets hypothesis contends that markets not only incorporate
public information about the company’s stock price, but that they do so
correctly to the extent that the market price is an accurate approximation of
the company’s true value.5
This bold descriptive claim about the functioning of an efficient
market has normative implications for what investors can expect when
investing in that market. If markets are fundamentally efficient, an investor
can believe that when buying a security, the price of that asset largely
reflects its value. If there is fundamental efficiency, buying stock can easily
be distinguished from gambling at a casino. Rather than simply making a
bet, a stock owner has purchased something of value and it is likely that
value will persist. Securities fraud disrupts this process. When a company
3
485 U.S. 224 (1988).
573 U.S. __ (2014).
5
For a recent discussion of the hypothesis, see Ronald J. Gilson & Reinier Kraakman,
Market Efficiency After the Financial Crisis: It’s Still a Matter of Information, 100 Va. L.
Rev. 313 (2013).
4
2
commits fraud, investors will pay too much for the security and suffer
losses when the truth is revealed and the stock returns to its fundamental
value.
The Basic and Halliburton decisions do not directly refer to
fundamental value when discussing market integrity. It is the dissent in
Basic that brings up the point, arguing that the majority’s view reflects the
assumption that markets are fundamentally efficient. Pointing to the
majority’s citation of a district court opinion asserting that investors can
“rely on the price of a stock as reflection of its value,” the dissent argues
that the majority “implicitly suggests that stocks have some ‘true value’ that
is measurable by a standard other than their market price.”6 Put another
way, the dissent in referring to “true value” argued that the Basic Court
relies on a fundamental value view of market integrity.
Both the Basic and Halliburton dissents criticize the idea that
markets are fundamentally efficient. They do so primarily by invoking the
value investor, an investor who buys stock believing it is underpriced in that
the market price is below the stock’s fundamental value. The value investor
does not believe the market price has integrity in the fundamental sense, but
instead tries to exploit, for profit, inefficiencies in the market.
The existence and success of value investors is a problem for the
fraud-on-the-market presumption in two ways. First, the ability of such
investors to earn abnormal returns undermines the descriptive point that
markets are so efficient that such profits cannot be made. Second, the
presence of value investors undermines the normative point that investors
can reasonably believe that market prices reflect the correct value of their
investment.
The Halliburton decision responds to these arguments on two
grounds. The first is that “most” investors do not fit into the category of
value investors.7 The majority of investors know “they have little hope of
outperforming the market in the long run,” thus they “will rely on the
security’s market price as an unbiased assessment of the security’s value in
6
7
Basic, 485 U.S. at 255.
Halliburton, 11-12
3
light of all public information.” The second is that even value investors rely
on the belief that market prices will eventually reflect fundamental value.8
The first argument in response to the criticism of Halliburton is
problematic for a number of reasons. Even taking at face value the assertion
that “most” investors are not value investors, it is difficult to deny that
many investors take on a value approach. It may be the case that value
investors are outnumbered by passive investors, but investors who assess
whether or not market prices reflect fundamental value do more to set
market prices than passive investors.9 If most investors simply buy and hold
securities, it is less likely that such investors will be affected by fraud than
value investors who purchase stock more frequently. Finally, the question is
not solely whether or not there are more value investors than passive
investors, the mere existence of value investors should signal to passive
investors that they cannot naively believe that market prices reflect the
value of a stock.
The second argument essentially contends that even if there are
inefficiencies in the market price, investors rely on the belief that markets
eventually reflect fundamental value. The Court notes that for a value
investing strategy to succeed, the stock must return to its fundamental value.
Such an investor will calculate the extent to which the stock has diverged
from such value, “and such estimates can be skewed by a market price
tainted by fraud.”10
This is a stronger argument than the first, but it is somewhat unclear
what the Court means by the example. Typically, value investors look for
stocks that are underpriced by the market. Yet fraud tends to inflate the
price of a stock. Perhaps there will be cases where a value investor believes
a stock trading at $10 a share is worth $15 a share, but it turns out that the
company is committing a fraud and the stock is only worth $5 a share. The
value investor suffers damages, so there is an argument that he should be
Halliburton, 12 (“an investor implicitly relies on the fact that a stock market’s price will
eventually reflect material information. . . .”).
9
For an argument that this price discovery is the “essential” role of the securities laws, see
Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55
Duke L.J. 711 (2006).
10
Halliburton at 12.
8
4
able to recover the difference. On the other hand, it is still difficult to argue
that the value investor was relying on the integrity of market prices.
B. Market Prices are not Distorted by Fraud
The weaker view of market integrity would not require fundamental
efficiency, but only that the market price reflects public information. Even
if stock prices do not accurately measure the true value of a stock, if a
market is informationally efficient, its prices will incorporate fraudulent
statements. Put another way, if a fraud inflates earnings by 10%, that
misstatement will also inflate the stock price trading in an efficient market
by some amount. Even if the stock price does not accurately reflect the
fundamental value of the company, an investor has still paid more for the
stock with the misrepresentation than without, and arguably should be able
to recover some amount of damages. To say that markets have integrity
does not mean that stock prices always reflect fundamental value, but
simply that investors should be able to rely on the assumption that the
market price is not inflated by fraud.
The Court in Basic relied in part on this absence of fraud form of
market integrity.11 The majority opinion notes that “the market price of
shares traded on well-developed markets reflects all publicly available
information, and, hence, any material misrepresentations.”12 According to
the Court, all investors rely on the absence of fraud because they would not
invest in what was “a crooked crap game.”13
Market integrity as absence of fraud is easier to defend than market
integrity as fundamental value. Even if there is no knowable intrinsic value
of a stock, because fraud causes a relative increase in what investors are
paying, it is possible to conclude that in the absence of fraud, investors
would be paying less for a stock. Even a value investor, who relies on the
11
See, e.g., Jill E. Fisch, The Trouble With Basic: Price Distortion After Halliburton, 90
Wash. U. L. Rev. 895, 897 (2013) (noting that Basic “Court constructed a complex theory
of market integrity relying on the fact that, in an efficient market, fraudulent public
statements distort stock prices.”).
12
Basic, 485 U.S. at 246.
13
Basic, 485, U.S. at 246.
5
belief that a stock is undervalued, would pay even less for that undervalued
stock in the absence of fraud.
On the other hand, conceding that markets are not fundamentally
efficient has its costs for a theory of market integrity. If markets cannot
distinguish between fraudulent and unfraudulent statements, how can they
distinguish between useful information and noise? If the market price is
constantly distorted by noise, shouldn’t investors move forward with
caution? If a fraud distorts the stock price by 5%, but irrational expectations
inflate the price by 100%, the risk of fraud is relatively trivial in the overall
volatility of a stock. If investors are willing to invest knowing the historical
ups and downs of market cycles, they should be willing to invest even
knowing that there is a modest risk of fraud.
Perhaps the deficiency of the absence of fraud approach to market
integrity is that it does not differentiate between types of frauds. A case
could be made that investors should expect minor distortions from earnings
manipulations by management.14 On the other hand, the complete collapse
of a company’s stock price in a matter of weeks in the wake of a fraud is not
something that an investor should typically expect. The Court in discussing
market integrity does not delve deeply into such distinctions. To fully
appreciate market integrity, one must look beyond markets to the regulatory
framework that allows efficient markets to develop.
II.
An Alternative Approach: Integrity of the Public Corporation
Because the efficient markets hypothesis originated in the academic
finance literature, it is limited by the particular approach of that discipline.
In studying markets, financial economists tend to focus on accurately
describing those markets and how they operate. Normative questions of
interest to courts and policymakers are not directly addressed by the
hypothesis. Thus, focusing solely on whether the efficient markets
hypothesis is valid or not does not adequately address the validity of the
assumption of market integrity and what that means.
14
Donald C. Langevoort, Basic at Twenty: Rethinking Fraud on the Market, 2009 Wis. L.
Rev. 151, 160 (“Fraud and manipulation are predictable enough that it would be foolish for
anyone simply to assume that a stock price has integrity.”).
6
Rather than resting its case for integrity on the operation of markets,
this article takes the different approach of examining the legal framework
governing public companies. For the most part, a company must be public
in order to trade in a market, and such public markets are the most likely to
be efficient. In order to understand why a market has integrity, it makes
sense to look at the regulatory framework that permits companies to be
traded publicly. Put another way, the integrity of a market rests necessarily
on the integrity of the public corporation trading in that market. Companies
trading in public markets make an implicit representation that they are
indeed worthy of being a public corporation. Investors do not put their trust
solely in markets, but also in the fact that a company that is public should
be public.
A. Securities Laws, the Public Corporation, and Efficient Markets
The argument that stock markets cannot be trusted unfairly
dismisses the significant effort over the years by private and public actors to
construct norms and law to improve the integrity of public companies.
Though these mechanisms are not perfect, they attempt to distinguish
between those companies in which public investment is appropriate and
those that are not. Without these initial determinations as to whether a
company should be public, an efficient market would be less likely to arise
for the securities of that company.
Efficient markets do not exist without actors who facilitate the
valuation of the assets trading in that market. Professors Gilson and
Kraakman make this point in a famous article, The Mechanisms of Market
Efficiency.15 They note that while financial economists have spent much
time in assessing whether a particular market is efficient, they have not
focused as much on the question of the factors that act to make a market
efficient.16 Professors Gilson and Kraakman identify some of the
institutions that facilitate market efficiency such as brokers and analysts
who process new information about a company.17 Moreover, they conclude
15
Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Va.
L. Rev. 549 (1984).
16
Id. at 553 (“despite the substantial progress that has been made, we still lack a single,
comprehensive explanation for the existence of market efficiency.”).
17
Id. at 571-72.
7
that law is likely to play a role in that the securities laws operate to reduce
the costs of processing and verifying information.18
More recently, financial economists have been more interested in
the role law plays in the development of trading markets. An extensive body
of research on law and finance has posited that common law protections are
associated with stronger securities markets, and presented evidence to
support the hypothesis.19 There is no consensus as to the validity of these
results, and the studies in measuring the effect of law do not delve much
into the details of how securities law operates in facilitating the rise of
markets. However, these findings suggest that law matters in facilitating the
development of well-functioning markets.
There is good reason to believe that legal and private norms play a
significant role in enabling the efficiency of markets. There are two major
mechanisms of interest.
The first is the private regulation set forth by stock exchanges. In
particular, the exchanges have listing requirements that assess whether a
company will trade on a market widely available to public investors. For
example, at the time of listing, the company must show an aggregate market
value of $40 million for its publicly-held shares to list on the New York
Stock Exchange.20 If the average market value of a company over thirty
days is less than $15 million, the Exchange will proceed to delist the
company.21 In setting forth listing requirements, exchanges make
determinations as to which companies should trade in efficient markets.22
The second are the federal securities laws. The Securities Act of
1933 and Securities Act of 1934 set forth extensive requirements for
companies that become public so that they are traded on markets. To sell
securities to the public, a company must have audited financial statements.
18
Id. at 601.
See, e.g., Rafael La Porta, et al., Investor Protection and Corporate Governance, 58 J.
FIN. ECON. 3, 4 (2000); Rafael La Porta, et al., Law and Finance, 106 J. Pol. Econ. 1113
(1998).
20
NYSE Rule 102.01B.
21
NYSE Rule 802.01B.
22
The exchanges have significant incentives to monitor its listed companies. See generally
A.C. Pritchard, Markets as Monitors: A Proposal To Replace Class Actions with
Exchanges as Securities Fraud Enforcers, 85 Va. L. Rev. 925, 963-81 (1999).
19
8
A public company must file periodic reports with the SEC in order for it to
remain a public company. In setting forth such requirements, these statutes
set forth standards that draw the line between public and private companies.
B. Valuation and the Public Corporation
For some time, the distinction between public and private companies
has been growing. There is a much greater expectation that public
companies invest in corporate governance and provide accurate disclosures.
Whether or not the cost of these measures is justified, few would deny the
characterization that these efforts are meant to improve the integrity of the
public corporation.
The first set of requirements relates to the accuracy of public
company disclosures. The primary mechanism for this effort has been to
require public companies maintain a certain level of internal controls. These
requirements were initially imposed through the Foreign Corrupt Practices
Act after the discovery that company assets were secretly being used to pay
bribes in foreign countries.23 Such conduct was seen as affecting the
integrity of the use of company assets. After the collapse of two major
public companies, Enron and WorldCom, the Sarbanes-Oxley Act requires
an assessment of the adequacy of these internal controls by both auditors
and management.24 Commentators have noted that these provisions
“produced the sharpest cleavage in terms of differentiating public
companies.”25
The second set of requirements relates to the governance of public
corporations. Exchanges now require listed companies to have boards with
a majority of independent directors. After Sarbanes-Oxley and Dodd-Frank,
important board committees such as the audit and executive compensation
committees must consist entirely of independent directors.26 This move to
23
Foreign Corrupt Practices Act, Pub. L. No. 95-213, 91 Stat. 1494 (1977).
Sarbanes-Oxley also makes efforts to ensure that auditors of public companies do not
have conflicts of interests that would affect their integrity in auditing financial statements.
25
Donald C. Langevoort & Robert B. Thompson, “Publicness” in Contemporary Securities
Regulation After the JOBS Act, 101 Geo. L.J. 337, 380 (2013).
26
See Sarbanes-Oxley § 301, Pub. L. No. 107-204, 116 Stat. 745 (2002); 17 C.F.R. §
240.10A-3; Dodd-Frank § 952; 17 C.F.R. § 240.10C-1(b)(1).
24
9
independence seeks to ensure that corporate governance of public
companies have integrity by removing conflicts of interest, some of which
may facilitate fraud.
Public companies have not only been distinguished through greater
regulation, but also through efforts that seek to reduce regulatory costs for
companies that are so established that the integrity of their valuations
should not be in doubt. Under certain circumstances, companies that have
offered securities to the public may file registration statements that are not
as extensive as unseasoned companies.27 If a company meets certain size
thresholds, it will be considered a Well-Known-Seasoned Issuer that can
offer securities to the public with even fewer restrictions than seasoned
issuers. The timing of some of these cost-reduction efforts suggests that
given the costs of statutes such as Sarbanes-Oxley, a regulatory effort is
being made to offset those costs to public companies in other areas.28
In policing the boundary between public and private companies, the
securities laws make judgments about which companies have integrity to
trade on public markets. These efforts have raised many questions about
whether the line is being drawn in the correct place. Professors Langevoort
and Thompson have documented these trends and argue that “[f[ull
publicness treatment should be reserved for companies with a larger societal
footprint.”29 The JOBS Act of 2012 is an effort to allow such companies
access to the capital markets without taking on all of the burdens of statutes
such as Sarbanes-Oxley for the first few years. In doing so, the statute
continues the trend of differentiating between public and private companies.
The expectations of public companies go beyond technical
requirements of greater accuracy and corporate governance. Professor
Hillary Sale notes that the public now expects more with respect to integrity
27
Such an issuer may rely upon SEC Form S-3, which incorporates by reference the
information in periodic filings. The most commonly used test for determining whether a
market is efficiency considers whether the issuer is a Form S-3 filer. See Cammer v.
Bloom, 711 F. Supp. 1264, 1286-87 (D.N.J. 1989).
28
I make this argument in another article. See James J. Park, Two Trends in the Regulation
of the Public Corporation, 8 Ohio State Entrepreneurial Bus. L.J. 429 (2012).
29
Langevoort & Thompson, “Publicness”, supra note XX, at 342.
10
of public corporations. 30 Companies that fail to meet social norms with
respect to their conduct will face public censor that can affect their business
as well as their stock price. These demands for integrity require investment
in compliance efforts by public companies, and the demand for such efforts
is likely to grow.
III.
Investor Reliance and the Public Corporation
Shifting attention from markets to the law defining the public
corporation has a number of implications for the fraud-on-the-market
presumption. Rather than resting the case for the presumption on the
accuracy of the market price, the question is whether the company should
be trading on a public market.
Redirecting the focus of integrity from markets to the public
corporation provides a more solid foundation for the fraud-on-the-market
presumption. When a market for a particular stock is efficient, it is the
culmination of a long process where a company goes from a private
company that is difficult to value, to a public company that outsiders are
comfortable valuing. Such a company will be tested by gatekeepers such as
private investors, underwriters, auditors, exchanges, and research analysts
before emerging on the public markets. When an investor purchases a stock
on the New York Stock Exchange, he justifiably has more confidence in the
value of that security than if it were trading on the penny stock market. The
investor trusts markets not because market prices are always accurate, but
law and norms help screen out companies that should not be publicly
traded.
Any company trading on a public market represents that it is
meeting the requirements for being a public company in good faith. To the
extent that there is a fundamental change in the company’s condition, the
company should disclose such developments to investors. Even if the
company’s stock price does not precisely reflect its fundamental value, the
fact that the company continues to trade implies that there is a more solid
foundation for valuing the company than if it were private.
Hillary A. Sale, The New “Public” Corporation, 74 Law and Contemporary Problems
137 (2011).
30
11
Investors purchasing stock on an efficient market should be able to
rely on the representation that the company is sufficiently stable so that it
should be trading on a public market. This reliance expectation can be
violated by companies that hide the fact that they are heading towards
bankruptcy or delisting. In doing so, a company continues to trade when in
fact it should be in bankruptcy court or trading on the pink sheets. Investors
who continue to purchase stock without knowledge of such fundamental
developments have paid too much for the stock.
Not all securities frauds would disrupt this reliance interest, but the
most severe frauds would. Recent securities frauds do not rest on the
argument that prices were somewhat inaccurate. Securities frauds have
become severe enough so they involve companies that arguably should not
be public. As one of my earlier papers shows, about 15% of the securities
class actions filed from 1996-2004 involved companies that filed for
bankruptcy.31 Securities frauds became more severe in the early part of the
2000s, as evidenced by the increasing percentage of cases where
bondholders, who are typically shielded from securities fraud, recover some
part of a securities class action settlement.32 19 of the 30 largest securities
class action settlements from 1996-2005 involved a bondholder recovery.33
Focusing on the integrity of the public corporation rather than the
integrity of markets would provide a firmer foundation for the fraud-on-themarket presumption for the most severe frauds. The idea that securities
class actions are all strike suits that target temporary stock price fluctuations
has been disproven by the wave of significant frauds in the early 2000s. The
investors suffered losses not because they relied on the questionable
assumption that a particular stock price was inaccurate. They suffered losses
because they relied on the belief that public corporations meet basic levels
of integrity.
Shifting to a focus on the public corporation would support the
argument that the focus of the securities class action should be on a smaller
subset of securities fraud. Indeed, the reliance interest identified by an
31
James J. Park, Securities Class Actions and Bankrupt Companies, 111 Mich. L. Rev. 547
(2013).
32
James J. Park, Bondholders and Securities Class Actions, 99 Minn. L. Rev. 585 (2014).
33
Id.
12
integrity of the public corporation approach would be narrower than the
reliance interest associated with an integrity of the markets approach. If
investors do not rely on the belief that a particular stock price is accurate,
they should not be able to recover for what turn out to be minor stock price
fluctuations.
This narrower reliance interest could be translated into doctrine in a
couple of ways. The first would only allow for the fraud-on-the-market
presumption for cases involving allegations of significant frauds that hide
the fact that a company should not be public. However, this determination
would be difficult to make on a class certification motion. Thus, a second
option, which would use substantive materiality determinations at the merit
stages of the case would probably be preferable. If the reasonable investor
relies on the integrity of the public corporation rather than the accuracy of a
particular market price, there will be a stronger case that a narrower range
of misstatements will be material to that investor. To be material, a fraud
must do more than affect stock prices, it must hide a fundamental change
that questions whether a company should be public.34
Defendants may object that a stronger materiality standard is not of
much help to them because it is difficult to win a materiality motion on a
motion to dismiss. But it is unclear why public corporations could not make
an effort to select cases that are weak on materiality to go to trial. In doing
so, they would create more law on the issue, making it easier to dismiss
cases in the future, as well as deter plaintiffs from bringing strike suits in
the future.
An objection to a focus on larger cases would be that smaller frauds
can be significant as well. Larger frauds may often be the culmination of
multiple decisions to manipulate disclosures in what seem to be minor
ways. Even if private class actions are not as viable for such cases, the SEC
could fill in the gap. To the extent that smaller frauds may be simpler cases,
they may be well-suited for a bureaucracy that can find it difficult to digest
34
As I have argued elsewhere, materiality should be narrowed to focus on fraud that
significantly distorts the fundamentals of the company. James J. Park, Assessing the
Materiality of Financial Misstatements, 34 J. Corp. L. 513 (2009).
13
complex cases. Moreover, the SEC has the resources to pursue cases even
when they may not be economically viable for private firms.
Conclusion
In affirming Basic’s assumption that investors rely on the integrity
of efficient markets, the Halliburton Court’s decision rests on an uneasy
foundation. Professor Langevoort has described the fraud-on-the-market
presumption as one of juristic grace,35 and Halliburton does not provide a
reason to change his conclusion. This article seeks to provide a firmer
foundation for the presumption of reliance that makes securities class
actions under Rule 10b-5 possible. The reliance is not on markets, but in the
extensive law and norms that have defined the public corporation for many
years. These principles are moving in a direction of greater integrity, not
less.
35
Langevoort, supra note XX, Basic at Twenty, at 195; see also Barbara Black, Behavioral
Economics and Investor Protection: Reasonable Investors, Efficient Markets, 44 Loyola U.
Chi. L. J. 1493, 1502 (2013) (“At its core, however, Basic is a pragmatic, not a theoretical
opinion based on the purposes of the federal securities laws, including the protection of
investors and the enhancement of investor confidence.”).
14