Assessing Market Efficiency For Reliance On The

Fraud-On-The Market Doctrine After Wal-Mart and Amgen

Mukesh Bajaj, Sumon C. Mazumdar and Daniel A. McLaughlin 

December 12, 2013

JEL Classification: G14 (Information and Market Efficiency; Event Studies); K22
(Corporation and Securities Law)

Key words: securities fraud class actions, class certification, reliance, fraud-on-the
market, informational efficiency, market efficiency tests, Cammer factors, event studies,
limits to arbitrage, financial crisis.

 Bajaj is the Global Head of the Finance and Securities Practice of Navigant Consulting. Mazumdar is the
Lead Director of the Finance and Securities Practice of Navigant Consulting. Both are members of the
Finance faculty at Haas School of Business, University of California-Berkeley. Daniel A. McLaughlin is
Counsel with Sidley Austin LLP. The opinions expressed herein are opinions of the authors alone and not of
their respective organizations of their clients The authors thank Carl Vogel and Debo Sarkar of Navigant
Economics, and Howard Privette and D. Scott Carlton at Paul Hastings for their comments on earlier drafts,
Christina Hang for her valuable research assistance and the editor Jim Langenfeld and an anonymous referee
of this journal for their helpful comments.

Electronic copy available at: http://ssrn.com/abstract=2302734

 Table of Contents

ABSTRACT ........................................................................................................................ 3
1. Overview ..................................................................................................................... 4
2. The Link between the Fraud on the Market Theory (a judicial doctrine) and Market
Efficiency Hypothesis (an economic theory) ...................................................................... 5
a. Basic and Class Action Law ....................................................................................... 5
b. Efficient Capital Markets .......................................................................................... 13
c. From Basic to Cammer ............................................................................................. 16
3. Tests of efficiency used in the economics literature ................................................. 20
Weak-form efficiency tests ........................................................................................... 22
Semi-strong form efficiency tests ................................................................................. 26
Law of One Price tests .................................................................................................. 33
4. The Cammer factors are not conclusive proof of market efficiency ........................ 34
5. The global liquidity crisis of 2007-2008, limits to arbitrage and market inefficiency . 43
6. Conclusion ................................................................................................................ 47

Electronic copy available at: http://ssrn.com/abstract=2302734

 ABSTRACT

Following the Supreme Court’s 1988 decision in Basic, securities class plaintiffs can
invoke the “rebuttable presumption of reliance on public, material misrepresentations
regarding securities traded in an efficient market” [the “fraud-on-the market” doctrine] to
prove class-wide reliance. Although this requires plaintiffs to prove that the security traded
in an informationally efficient market throughout the class period, Basic did not identify
what constituted adequate proof of efficiency for reliance purposes.

Market efficiency cannot be presumed without proof because even large publicly-traded
stocks do not always trade in efficient markets, as documented in the economic literature
that has grown significantly since Basic. For instance, during the recent global financial
crisis, lack of liquidity limited arbitrage (the mechanism that renders markets efficient) and
led to significant price distortions in many asset markets. Yet, lower courts following
Basic have frequently granted class certification based on a mechanical review of some
factors that are considered intuitive “proxies” of market efficiency (albeit incorrectly,
according to recent studies and our own analysis). Such factors have little probative value
and their review does not constitute the rigorous analysis demanded by the Supreme Court.

Instead, to invoke fraud-on-the market, plaintiffs must first establish that the security
traded in a weak-form efficient market (absent which a security cannot, as a logical matter,
trade in a “semi-strong form” efficient market, the standard required for reliance purposes)
using well-accepted tests. Only then do event study results, which are commonly used to
demonstrate “cause and effect” (i.e., prove that the security’s price reacted quickly to news
--- a hallmark of a semi-strong form efficient market) have any merit. Even then, to claim
class wide reliance, plaintiffs must prove such cause and effect relationship throughout the
class period, not simply on selected disclosure dates identified in the complaint as plaintiffs
often do.

These issues have policy implications because, once a class is certified, defendants frequently
settle to avoid the magnified costs and risks associated with a trial, and the merits of the case
(including the proper application of legal presumptions) are rarely examined at a trial.

3
 1. Overview

In its seminal decision in Basic1 in 1988, the Supreme Court permitted plaintiffs to prove
class-wide reliance by endorsing the “fraud-on-the market” doctrine, which allows plaintiffs
to “invoke a rebuttable presumption of reliance on public, material misrepresentations
regarding securities traded in an efficient market.”2 Basic did not clarify what constituted
adequate proof of efficiency for reliance purposes.3 Instead, left to develop their own
standards of proof in this regard, lower courts typically rely on a “jumbled”4 list of factors
(the best-known coming from Cammer v. Bloom,5 a district court decision shortly after
Basic) that are considered intuitive indicators or “proxies” 6 of market efficiency.
However, according to a large body of economic evidence documented since Basic, even
large and actively followed publicly-traded securities do not always trade efficiently.
Indeed, this year’s Nobel Prize in economics was shared by Eugene Fama, the father of
market efficiency theory, and Robert Shiller, one of that theory’s leading critics. We
believe that continued reliance on ad hoc Cammer factors is inadequate to meet the
Supreme Court’s requirement that, to obtain class certification, plaintiffs must prove that
the security at issue traded in an efficient market throughout the class period based on
rigorous analysis.

To see why, we begin in section 2 by discussing the link between fraud-on-the-market (a

judicial doctrine) and market efficiency theory (an economic theory). In section 3 we
review the economic underpinnings of market efficiency theory and the
commonly-accepted empirical tests of the theory. In that section we also discuss how
many economic reports related to class certification ignore the economic literature and
approach the plaintiffs’ burden to establish market efficiency as if it was at best a
perfunctory step with a foregone conclusion. In this connection, we discuss how most of
the Cammer factors (and other similar indirect “indicators” of market efficiency) have

1
Basic, Inc. v. Levinson, 485 U. S. 224 (1988)
2
Amgen v. Connecticut Ret. Plan & Trust Funds, 133 S. Ct. 1184, 1188 (2013) (citing Basic, 485 U.S. at
241-49).
3
See for example, Langevoort (2009).
4
Langevoort (2009), page 167.
5
Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J. 1989)
6
Erenburg et al (2011), page 263.

4
almost no power to detect a violation of market efficiency. Even the last Cammer factor
(the cause-and-effect factor), which is the only Cammer factor that is a direct test of market
efficiency, is typically analyzed using event studies in a perfunctory manner and in ways
that cannot detect economic inefficiency. In section 4, we demonstrate that such analyses
have little probative value. We do so by focusing on a sample of well-documented cases of
stocks that unquestionably violated the Law of One Price and hence did not trade in
efficient markets over the identified periods. We show that even over these periods the
stocks at issue nevertheless satisfied the Cammer factors. In section 4, we discuss the limits
to arbitrage that arose during the recent financial crisis, rendering the market for numerous
securities inefficient. Such evidence, coupled with the large body of literature in finance
that over the more than two decades following Basic, indicates that a mechanical review of
efficiency factors is clearly inadequate to assess market efficiency for class certification
purposes. In Section 6, we offer our concluding remarks.

2. The Link between the Fraud on the Market Theory (a judicial

doctrine) and Market Efficiency Hypothesis (an economic theory)

a. Basic and Class Action Law

In securities class actions, for a plaintiff class to be certified under Rule 23(b)(3) of the
Federal Rules of Civil Procedure, a court must find “that the questions of law or fact
common to class members predominate over any questions affecting only individual
members,” which as the Supreme Court noted in its 2011 Halliburton decision, “often
turns on the element of reliance.”7 In fact, the Supreme Court has recognized that, in the
absence of some method for resolving questions of reliance on a class-wide basis, the
inherently individual question of what investors relied on in making a purchase or sale
decision would make class action treatment of securities fraud claims impractical and
unmanageable.8

7
Erica P. John Fund, Inc. v. Halliburton Co., 563 U. S. ___, 131 S. Ct. 2179, 2181 (2011) (“Halliburton”).
8
See Wal-Mart Stores, Inc. v. Dukes, 564 U. S. ___, 131 S. Ct. 2541, 2552 n. 6 (2011); Halliburton, 131 S.
Ct. at 2184-85; Basic, Inc. v. Levinson, 485 U. S. 224, 242 (1988).

5
In its seminal decision in Basic9 in 1988, the Supreme Court adopted a judicially created
presumption to permit plaintiffs to dispense with proving individualized reliance on
alleged misrepresentations where they purchased in the open market, but stressed that
reliance was nonetheless a crucial element of a securities fraud case, providing the causal link
between a misrepresentation and harm to the investor:
Reliance provides the requisite causal connection between a defendant's
misrepresentation and a plaintiff's injury…There is, however, more than
one way to demonstrate the causal connection. Indeed, we previously have
dispensed with a requirement of positive proof of reliance, where a duty to
disclose material information had been breached, concluding that the
necessary nexus between the plaintiffs' injury and the defendant's wrongful
conduct had been established.

***

Requiring a plaintiff to show a speculative state of facts, i.e., how he would

have acted if omitted material information had been disclosed…or if the
misrepresentation had not been made…, would place an unnecessarily
unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on
an impersonal market.10

Driven by this practical concern, the Court permitted plaintiffs to prove class-wide reliance by
endorsing the “fraud-on-the market” doctrine, which allows plaintiffs to “invoke a rebuttable
presumption of reliance on public, material misrepresentations regarding securities traded in
an efficient market.”11 As Justice Thomas noted in his dissenting opinion in the Court’s 2013
Amgen decision, fraud-on-the market is “a judicially invented doctrine based on an
economic theory adopted to ease the burden on plaintiffs bringing claims under an implied
cause of action.”12 The Court adopted this economic theory as a legal presumption on the

9
Basic, Inc. v. Levinson, 485 U. S. 224 (1988)
10
Basic, 485 U.S. at 243, 245 (citations omitted). See also Halliburton, 131 S. Ct. at 2185; Stoneridge
Invest. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 159 (2008) (“[U]nder the fraud-on-the-market
doctrine, reliance is presumed when the statements at issue become public. The public information is
reflected in the market price of the security. Then it can be assumed that an investor who buys or sells stock at
the market price relies upon the statement.”).
11
Amgen v. Connecticut Ret. Plan & Trust Funds, 133 S. Ct. 1184, 1188 (2013) (citing Basic, 485 U.S. at
241-49).
12
Amgen, 133 S. Ct. at 1213 (Thomas, J., dissenting). “The fraud-on-the-market rule says that purchase or
sale of a security in a well-functioning market establishes reliance on a material misrepresentation known to
the market. This rule is to be found nowhere in the United States Code or in the common law of fraud or
deception; it was invented by the Court in Basic Inc. v. Levinson, 485 U. S. 224 (1988).” Id. at 1205 (Scalia,

6
basis of (1) the legislative history of the Securities Exchange Act of 1934 showing a
Congressional “premise” that “competing judgments of buyers and sellers as to the fair
price of a security brings [sic] about a situation where the market price reflects as nearly as
possible a just price,” and (2) its assessment of “common sense and probability” derived
from “[r]ecent empirical studies [through the use of sophisticated statistical analysis and
the application of economic theory that] have tended to confirm Congress’ premise that the
market price of shares traded on well-developed markets reflects all publicly available
information, and, hence, any material misrepresentations.”13 Thus, the Court concluded
that, “[b]ecause most publicly available information is reflected in market price, an
investor’s reliance on any public material misrepresentations, therefore, may be presumed
for purposes of a Rule 10b-5 action.”14

After Basic, the courts view the link between the market efficiency hypothesis and
fraud-on-the market theory as a “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 syllogism breaks down, of
course, when a market lacks efficiency, and the market does not necessarily reflect the
alleged material misrepresentation.”15 The Court more recently, in Halliburton, distilled
as “Basic’s fundamental premise-that an investor presumptively relies on a
misrepresentation so long as it was reflected in the market price at the time of his
transaction.”16 The Court in Amgen further anchored the presumption in the view of
market reality that market efficiency theory portrays:

J., dissenting).
13
Basic, 485 U.S. at 246-47 & n. 24 (quotations omitted; citing literature on the “efficient-capital-market
theory”).
14
Id. at 247.
15
PolyMedica I, 432 F.3d at 8.
16
Halliburton, 131 S. Ct. at 2186 (emphasis added). See also Amgen, 133 S. Ct. at 1195 (Basic presumption
“is premised on the understanding that in an efficient market, all publicly available information is rapidly
incorporated into, and thus transmitted to investors through, the market price.”)

7
 This presumption springs from the very concept of market efficiency. If a
market is generally efficient in incorporating publicly available information
into a security's market price, it is reasonable to presume that a particular
public, material misrepresentation will be reflected in the security's price.
Furthermore, it is reasonable to presume that most investors—knowing that
they have little hope of outperforming the market in the long run based
solely on their analysis of publicly available information—will rely on the
security's market price as an unbiased assessment of the security's value in
light of all public information.17

The validity of this premise therefore depends on the court using economically sound
evidence to show that the market in question was actually acting the way the theory posits.
Because the presumption is not dictated by statute but is adopted as a method of proving
actual causation through economics, that places an obligation on courts to consider the
advances in economic understanding of markets in the quarter century since Basic.

The efficient market hypothesis, which was widely accepted by financial economists at the
time of Basic 18 hypothesizes that a security’s price quickly and correctly 19 impounds

17
Amgen, 133 S. Ct. at 1192.
18
As Grundfest (2013) notes, “Basic was decided at a time when confidence in the efficient market
hypothesis was at its historic peak. Since then, a large literature challenging the efficient market hypothesis
has emerged, but that literature has spawned an equally vigorous defense. The debate over market efficiency
is nuanced and complex, and it implicates fine points of econometrics and finance theory. It splits leading
scholars.” Grundfest (2013) cites Gilson and Kraakman (2013 forthcoming) as describing “the evolution of
the efficient market hypothesis as “itself the subject of a bubble, where its refraction from theory to policy
through the prism of politics inflated its claims far beyond what the original academic theory could support.”
Grundfest (2013) notes, “The Supreme Court’s reliance on the theory as a foundation for its ruling in Basic
can be viewed as one example of this inflation.” [Grundfest (2013), page 59-60]
19
“Correctly” in this context merely means that the market has placed its best aggregate estimate on the value
of information; the efficient capital markets hypothesis does not assume that the valuation of a security at a
particular point in time will be accurate as a predictive matter, only that it incorporates the collective
judgment of the market as to the best estimate of that valuation based on all available public information as of
that point in time.
As a legal matter, the First Circuit has ruled that reliance requires only “informational efficiency” and not
“fundamental value efficiency” i.e., the market price must rapidly reflect all public information but not
necessarily be the best possible estimate of the stock’s actual worth. In re PolyMedica Corp. Sec. Litig., 432
F.3d 1, 14-19 (1st Cir. 2005) (“PolyMedica I”) (holding that “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
distinction may be meaningful in clarifying what the courts mean by efficiency, in the sense that they
ordinarily do not need to receive evidence on the generally speculative question of whether the market price
was “right” about the value of the company. But as an economic matter, it is not very important. A security’s

8
material new public information.20 If a security is temporarily mispriced (given available
information) then such mispricing is quickly corrected in an efficient market through
“arbitrage.” Lo (2007) describes this process as trading by “an army of investors [who]
pounce on even the smallest informational advantages at their disposal [to earn a profit],
and in doing so they incorporate their information into market prices and quickly eliminate
the profit opportunities that first motivated their trades. If this occurs instantaneously,
which it must in an idealized world of ‘frictionless’ markets and costless trading, then
prices must always fully reflect all available information.”21 At its most basic level, for
instance, two securities with identical cash flows must trade at the same price in an
efficient market (referred to as “Law of One Price”). In short, it is the looming presence of
arbitrage trading that keeps a market efficient. Given such arbitrage activity, no obvious
arbitrage opportunity should persist in an efficient market. If it does (i.e., if the
“no-arbitrage condition” is violated) then the market is considered inefficient. The
Supreme Court, in Amgen, explained:

The fraud-on-the-market theory rests on the premise that certain well

developed markets are efficient processors of public information...Few
investors in such markets, if any, can consistently achieve above-market
returns by trading based on publicly available information alone, for if such
above-market returns were readily attainable, it would mean that market
prices were not efficiently incorporating the full supply of public
information. See R. Brealey, S. Myers, & F. Allen, Principles of Corporate
Finance 330 (10th ed. 2011) ("[I]n an efficient market, there is no way for
most investors to achieve consistently superior rates of return.").22

Importantly, to invoke Basic’s rebuttable presumption of reliance in the context of a class

action, plaintiffs must prove at the class certification stage that the security at issue traded in
an “efficient market” during the alleged class period, as the Supreme Court has re-iterated in
two recent decisions (Halliburton and Amgen). For instance, in Halliburton, the Court

price on any current date is simply the sum of its historical price at some earlier date and the cumulative price
changes thereafter through the current date. If a security trades in an informationally efficient market in
which it correctly impounds all new information, then, as a cumulative effect of such price reactions, the
security’s price converges over time to its fundamentally efficient value.
20
If information-gathering and trading costs exist, “[a] A weaker and economically more sensible version of
the efficiency hypothesis says that prices reflect information to the point where the marginal benefits of
acting on information (the profits to be made) do not exceed the marginal costs .” [Fama (1991), page 1575].
21
Lo (2007), page 2-3.
22
Amgen, 133 S. Ct. at 1192.

9
noted that “it is undisputed that securities fraud plaintiffs must prove certain things in order
to invoke Basic’s rebuttable presumption of reliance . . . . [F]or example, that plaintiffs
must demonstrate that the alleged misrepresentations were publicly known (else how
would the market take them into account?), that the stock traded in an efficient market.”23
In Amgen, the Court, citing Wal-Mart, re-iterated: “‘[P]laintiffs seeking 23(b)(3)
certification must prove that their shares were traded on an efficient market,’ an element of
the fraud-on-the-market theory (emphasis added)).” 24 The Amgen opinion noted that
“without that proof, there is no justification for certifying a class.”25

Moreover, the courts have increasingly emphasized that such proof cannot be perfunctory.
As the Supreme Court held in Wal-Mart, class certification is proper only if the “trial court
is satisfied, after a rigorous analysis, that the prerequisites of Rule 23(a) have been
satisfied” and that “Rule 23 does not set forth a mere pleading standard. A party seeking
class certification must affirmatively demonstrate his compliance with the Rule – that is, he
must be prepared to prove that there are in fact sufficiently numerous parties, common
questions of law or fact, etc.”26 The reason for this is that the defendant’s potential liability
to a class “must be of such a nature that it is capable of classwide resolution—which means
that determination of its truth or falsity will resolve an issue that is central to the validity of
each one of the claims in one stroke.”27 In addition to liability, the Supreme Court in its
2013 Comcast decision held that damages must be capable of determination on a common
basis according to a common damages model that flows from the determination of liability;
otherwise, “[q]uestions of individual damage calculations will inevitably overwhelm
questions common to the class.”28

Consistent with Basic’s focus on practical market realities, Wal-Mart and Comcast
emphasized that a class action is designed for the situation where a jury can make a final,
up-or-down decision as to the class that is actually true as to all class members, rather than
use a sampling of cases to conduct what the Court in Wal-Mart described as “Trial by

23
Halliburton, 131 S. Ct at 2182, 2185.
24
133 S.Ct. at 1198 (citing Wal-Mart, 131 S. Ct. at 2542 n.6).
25
Id. at 1210.
26
Wal-Mart, 131 S. Ct. at 2551 (emphasis in original).
27
Id.
28
Comcast Corp. v. Behrend, 133 S. Ct. 1426, 1433 (2013).

10
Formula” while ignoring defenses that the defendant would have been entitled to raise in
particular cases.29 In Comcast, the Court noted that a damages model in an antitrust case
against a cable television company would not show that the case was a proper class action
unless it “plausibly showed that the extent of [the antitrust violation] would have been the
same in all counties” where the company did business.30 The Court in Amgen stressed that
the question of materiality, by contrast, could properly be determined on a class-wide basis
because “[t]he alleged misrepresentations and omissions, whether material or immaterial,
would be so equally for all investors composing the class…a failure of proof on the issue of
materiality would end the case, given that materiality is an essential element of the class
members’ securities-fraud claims. As to materiality, therefore, the class is entirely
cohesive: It will prevail or fail in unison.”31 Amgen contrasted this to the situation where
issues individual to particular investors were raised by the investor buying at a time when
the price was not affected by the misrepresentation:

A security's market price cannot be affected by a misrepresentation not yet

made, and in an efficient market, a misrepresentation's impact on market
price is quickly nullified once the truth comes to light. Thus, a plaintiff
whose relevant transactions were not executed between the time the
misrepresentation was made and the time the truth was revealed cannot be
said to have indirectly relied on the misrepresentation through its reliance
on the integrity of the market price. Such a plaintiff's claims, therefore,
would not be “typical” of the claims of investors who did trade during the
window between misrepresentation and truth revelation.32

The theory must assume that if the market is efficient, each purchaser during the class
period will be affected in the same way and in the same amount, just as the Court required
for antitrust damages in Comcast – that “price inflation” enters the price of the stock as
soon as the misrepresentation enters the market (and exits the price as soon as it is
corrected).33 If that common price impact is not present, then the presumption is a false
guide: not every purchaser of stock was affected in the same way, and the class will include

29
Wal-Mart, 131 S. Ct. at 2561.
30
Comcast, 133 S. Ct. at 1435 n. 6.
31
Amgen, 133 S. Ct. at 1191.
32
Amgen, 133 S. Ct. at 1198.
33
As the Court held in Halliburton, proof of how and when inflation exits the price is not required to invoke
the presumption at the class certification stage, although the Court in that case did not address any situation in
which there were individual variations in how inflation was dissipated from the price.

11
some members who did not actually buy stock at a time when misrepresentations were
“reflected in the security's price.” 34 Thus, the Basic presumption provides the cohesion
and “unison” required by Wal-Mart, Comcast and Amgen only if the underlying economic
theory can reliably show that a common price impact on all purchasers over every day of
the class period, such that price inflation can reasonably be presumed simply from a
purchase during the period (and damages can later be computed mathematically from a
showing of when the price inflation was dissipated by a corrective disclosure). The longer
the class period and the larger the number of misrepresentations alleged, the greater the
importance of assuring that the market remained consistently efficient at all times to avoid
inclusion in the class of investors who purchased at prices unaffected by
misrepresentations.35

Finally, the test for market efficiency, to be useful to courts, must be capable of testing by
evidence in the adversary process, and not merely the subject of speculation or the ipse
dixit of the expert. This requirement is all the more important given that the Supreme Court
has held that neither materiality nor loss causation is a required element of proof at the
class certification stage. The Supreme Court has long warned, especially in the context of
the judicially created Rule 10b-5 cause of action, against creating liabilities that depend on
proof of speculative facts that cannot be tested by objective, extrinsic evidence. 36 Indeed,
34
Amgen, 133 S. Ct. at 1192.
35
This is true not only with regard to misrepresentations but with regard to other statements considered in the
mix of public information. For example, under Basic, courts will commonly presume that markets
incorporate disclosures that rendered the alleged misrepresentation stale or immaterial. See, e.g., Teachers’
Ret. Sys. of Louisiana v. Hunter, 477 F.3d 162, 187-88 (4th Cir. 2007); In re Merck & Co., Inc. Secs. Litig.,
432 F.3d 261, 270 (3d Cir. 2005) (“[a]n efficient market for good news is an efficient market for bad news”);
Greenberg v. Crossroads Sys., Inc., 364 F.3d 657, 665-66 (5th Cir. 2004) (“confirmatory information has
already been digested by the market and will not cause a change in stock price.”); Oran v. Stafford, 226 F.3d
275, 282 (3d Cir. 2000) (Alito, J.). The entire project of determining the effect of information in the market
over the course of the class period on a common basis assumes that each piece of information entering the
market was so reflected.
36
See, e.g., Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1092-96 (1991) (declining to permit
litigation confined solely to questions of motivation, unless testable by objective evidence); Blue Chip
Stamps v. Manor Drug Stores, 421 U.S. 723, 743 (1975) (warning against litigation of “hazy issues of
historical fact the proof of which depended almost entirely on oral testimony” regarding whether investors
would have bought or sold stock). See also Anza v. Ideal Steel Supply Corp., 547 U.S. 451, (2006) (rejecting
“speculative” theory of RICO damages in light of “the difficulty that can arise when a court attempts to
ascertain the damages caused by some remote action” and the “intricate, uncertain inquiries” needed to
ascertain damages); The Wharf (Holdings) Ltd. v. United Int’l Holdings, Inc., 532 U.S. 588, 594-95 (2001)
(permitting litigation over oral sales where, unlike Blue Chip Stamps, “both parties would be able to testify as
to whether the relevant events had occurred”); Banca Cremi, S.A. v. Alex. Brown & Sons, Inc., 132 F.3d 1017,
1035 (4th Cir. 1997) (court “acutely uncomfortable” with theory of liability where “every element of fraud –
materiality, reliance, scienter, and proximate cause of damages – is inferred or can be presumed.”).

12
that was one of the justifications for the Basic presumption itself. It is imperative that
courts, in basing class certification on a theory of market efficiency, actually put that
theory’s applicability to a test that can be evaluated on some objective, scientific basis and
not just presumed from the existence of a loss on the plaintiff’s investment.

There is substantial basis in the economic literature for finding markets to be

informationally efficient, but not for simply presuming them efficient without
examination. As discussed below, market efficiency theory cannot simply be assumed to
be always true given the large body of finance literature has emerged since Basic
demonstrating that the theory does not always hold. Instead, objective and rigorous
analysis of evidence supporting the plaintiffs’ claims that the security at issue traded in an
efficient market throughout the alleged class period is imperative at the class certification
stage, as we discuss in detail in this paper.

b. Efficient Capital Markets

In a market without frictions, an arbitrageur can earn an immediate risk-free profit with no
up-front capital by simultaneously buying and selling identical securities at different
prices. Such arbitrage trading in mispriced securities leads prices to correct quickly and
restores market efficiency. In theory, such arbitrage “requires no capital and entails no
risk” and thus, can be readily implemented. But in practice, market frictions may limit
arbitrage, the mechanism by which markets are rendered efficient and the Law of One
Price is enforced). Indeed, since Basic was decided, a very large body of economic
literature has established that while actively-traded and widely-followed securities that trade
on well-developed public markets are generally informationally efficient, violations of
market efficiency are far more numerous and systematic than was previously thought, given
limits to arbitrage. As a result, security prices can deviate from what would be observed in
efficient markets, sometimes over extended periods of time. What is more, such instances
of market inefficiencies (or “anomalies”) are observed even for stocks issued by some of
the largest publicly traded companies that are extensively followed by analysts and widely
traded by investors. Tellingly, this year’s Nobel Prize in Economics was shared by Eugene

13
Fama, the father of market efficiency theory and Robert Shiller, one of that theory’s principal
critics.37

The large body of research that has developed since Basic to examine this economic issue has
identified several real-world phenomena that may limit arbitrage even when investors are
assumed to act rationally.38 We discuss a few well-accepted limits to arbitrage here. First,
if gathering information is costly, then an arbitrageur would be willing to invest in gathering
information only if he could profit from it. But if the security’s price is always efficient then
such arbitrage profits are impossible. Knowing this, no arbitrageur would then be willing to
invest in gathering information, and then, paradoxically, the security’s price could not be
informationally efficient.39 This paradox, first articulated by Nobel laureate Joseph Stiglitz
and Sanford Grossman, implies that given information gathering costs, security prices cannot
fully reflect all available information at all times. Instead, a certain degree of inefficiency is
necessary to incentivize arbitrageurs to invest in gather more information about a security.40
Thus, as Fama (1991, page 1575) noted, when information-gathering and trading costs exist,
“[a] weaker and economically more sensible version of the efficiency hypothesis says that
prices reflect information to the point where the marginal benefits of acting on information
(the profits to be made) do not exceed the marginal costs.”

37
“The two men, leading proponents of opposing views about the rationality of financial markets — a dispute
with important implications for investment strategy, financial regulation and economic policy — were joined
in unlikely union Monday as winners of the Nobel Memorial Prize in Economic Science. Mr. Fama’s
seminal theory of rational, efficient markets inspired the rise of index funds and contributed to the decline of
financial regulation. Mr. Shiller, perhaps his most influential critic, carefully assembled evidence of
irrational, inefficient behavior and gained a measure of fame by predicting the fall of stock prices in 2000 as
well as the housing crash that began in 2006.” [Appelbaum, Binyamin, “Economists Clash on Theory, but
Will Still Share the Nobel,” The New York Times, October 14, 2013].
38
According to the “behavioral finance” literature (which is now widely accepted and for which the Nobel
Prize was recently awarded), investors do not necessarily act rationally, rationally, and their “irrational”
behavior affects their attitudes towards risk and their assessment of probabilities. [See Barberis and Thaler
(2003). The effect of such irrational behavior, especially if it is systemic, may make a market inefficient.
Standard graduate texts also now cover behavioral finance. See for example, Brealey et al, pages 326-327.]
39
This result, known as the “Grossman-Stiglitz Paradox,” was first articulated by Nobel laureate Joseph
Stiglitz and Sanford Grossman [See Grossman and Stiglitz (1980)].
40
As Fisher Black, a pre-eminent financial economist (of Black-Scholes option pricing theory fame) noted in
his presidential address to the American Finance Association,“All estimates of value are noisy, so we can
never know how far away price is from value. However, we might define an efficient market as one in which
price is within a factor of 2 of value, i.e., the price is more than half of value and less than twice value.1 The
factor of 2 is arbitrary, of course. Intuitively, though, it seems reasonable to me, in the light of sources of
uncertainty about value and the strength of the forces tending to cause price to return to value.” [See Black
(1986), page 533].

14
Second, the risk that mispriced securities’ prices may diverge further from their
informationally correct values before correcting may limit the supply of capital necessary
for arbitrage. As Shleifer and Vishny (1997) note, arbitrage is a specialized activity that is
generally conducted by profession fund managers who use other people’s capital. Such
investors may become nervous and demand their money back if the securities purchased by
the fund manager on behalf of these outside investors decline further in value (which can
occur if mispriced securities’ prices temporarily diverge further from their correct values).
To honor such redemption requests by investors the fund manager may be forced to sell the
mispriced securities prematurely (before the mispricing is corrected) and incur a loss.
Anticipating this problem, arbitrageurs (fund managers) may not undertake certain
arbitrage trades, and security mispricing may persist. Studies have documented that even
under “normal” market conditions, stocks of certain large publicly-traded companies have
violated the Law of One Price (the most basic condition for a market to be deemed
efficient). Notably, these violations persisted for extended periods even though they were
discussed extensively in the popular press at the time.41 These cases are considered glaring
instances of inefficiency in the academic literature.

The lack of capital to conduct arbitrage was especially evident during the unprecedented
global financial crisis of 2007-2009. The “depletion of dealer capital was so severe that,
among other effects, large distortions in arbitrage-based pricing relationships appeared,”42
as Stanford economist, Darrell Duffie noted in his presidential address to the American
Finance Association in 2010 [See Duffie (2010)]. As we discuss later, such a liquidity
crunch severely limited arbitrage and resulted in Law of One Price violations in several
markets.

In short, given this large body of academic evidence, economists today do not consider
market efficiency a foregone conclusion in every situation, as might be the case decades
ago.43 Instead, the academic debate about the validity of the efficient markets hypothesis in
various contexts based on decades of rigorous, peer-reviewed research continues to this
day.44 An economist approaching a particular market would examine the efficiency of the

41
See for example, Lamont and Thaler (2003a and b) and Mitchell et al (2002).
42
Duffie (2010), page 1245.
43
See Brealey et al, page 321.
44
See for example, Fama and French (2012) and Erenburg et al (2011).

15
market for the particular security at issue at the time in question, rather than assuming it. In
contrast, such rigorous analysis is often absent in the “proof” that courts have routinely
been provided at class certification stage.

c. From Basic to Cammer

Basic did not clarify what constituted adequate proof of efficiency for reliance purposes.45
Instead, left to develop their own standards of proof in this regard, lower courts typically
rely on a “jumbled”46 list of factors (the best-known coming from Cammer v. Bloom,47
from a district court decision shortly after Basic) as such factors are considered intuitive
indicators or “proxies”48 of market efficiency. The original five factors listed in Cammer
have been augmented to include the following eight factors that are generally considered:

(1) the average weekly trading volume expressed as a percentage of total

outstanding shares; (2) the number of securities analysts following and
reporting on the stock; (3) the extent to which market makers and
arbitrageurs trade in the stock; (4) the company’s eligibility to file SEC
registration Form S-3 (as opposed to Form S-1 or S-2); (5) the existence of
empirical facts “showing a cause and effect relationship between
unexpected corporate events or financial releases and an immediate
response in the stock price;” (6) the company’s market capitalization; (7)
the bid-ask spread for stock sales; and (8) float, the stock’s trading volume
without counting insider-owned stock.49

Courts have varied in their application of these factors, and some courts have tended to
gloss over them when a stock trades on a well-known market such as the New York Stock
Exchange or NASDAQ. 50 Others, such as the Second Circuit, have emphasized that

45
See for example, Langevoort (2009).
46
Langevoort (2009), page 167.
47
Cammer v. Bloom, 711 F. Supp. 1264 (D.N.J. 1989)
48
Erenburg et al (2011), page 263.
49
Unger v. Amedisys, Inc., 401 F.3d 316, 323 (5th Cir. 2005) (collecting cases). Cammer identified the first
five factors, see Cammer v. Bloom, 711 F. Supp. 1264, 1286-87 (D.N.J. 1989); later courts added the other
three. See Krogman v. Sterritt, 202 F.R.D. 467 (N.D. Tex. 2001). For ease of discussion, unless otherwise
noted, we shall henceforth refer to all factors identified in Krogman, Unger and Cammer (except, the
cause-and-effect factor), collectively as the “Cammer factors.”
50
See, e.g., In re Merck & Co., Inc. Secs., Deriv. & “ERISA” Litig., MDL No. 1658 (SRC), 2013 WL
396117, at *11 (D.N.J. Jan. 30, 2013). But see In re Fed. Home Loan Mort. Corp. (Freddie Mac) Sec. Litig.,

16
“factor five,” the rapid share price reaction to unexpected corporate news, is the primary
focus of the market efficiency inquiry:

Evidence that unexpected corporate events or financial releases cause an

immediate response in the price of a security has been considered the most
important Cammer factor . . . and the essence of an efficient market and the
foundation for the fraud on the market theory. Without the demonstration
of such a causal relationship, it is difficult to presume that the market will
integrate the release of material information about a security into its price.
An event study that correlates the disclosures of unanticipated, material
information about a security with corresponding fluctuations in price has
been considered prima facie evidence of the existence of such a causal
relationship.51

However, as several economic studies have recognized, many of the Cammer factors do
not prove that a security traded in an efficient, as they fail to distinguish between securities
that trade in efficient markets from those that do not.52 According to some studies, stocks
which did not trade in informational efficient markets according to more rigorous and
direct tests of efficiency nevertheless satisfied the Cammer factors. 53 Below, we also
demonstrate that the Cammer factors were “satisfied” by several stocks that violated the
Law of One Price – the most basic market efficiency condition – for extended periods
according to studies published in leading academic journals.

281 F.R.D 174, 178 (S.D.N.Y 2012) (“[I]t would be illogical to apply a presumption of reliance merely
because a security traded within a certain ‘whole market’ without considering the trading characteristics of
the individual stock itself.”).
51
Teamsters Local 445 Freight Div. Pension Fund v. Bombardier Inc., 546 F.3d 196, 207-08 (2d Cir. 2008)
(emphasis added; quotations and citations omitted).
52
For example, Barber et al (1994) examine if Cammer factors can differentiate stocks that are
(semi-strong-form) efficiently priced (display a price response to an announcement of an extreme earnings
surprise) from those that are not (i.e., lack such a price response to an announcement of an extreme earnings
surprise). They find that except for trading volume and number of analysts following the stocks, other factors
commonly used (firm size, percentage of bid-ask spread, return volatility, price and institutional holdings)
“either fail to significance test or yield results counter to our expectations” [Barber et al (1994), page 310]
i.e., have no probative value in this context. Note however, that even the two factors that Barber et al (1994)
identified as potentially useful in distinguishing stocks as semi-strong form efficient were not useful in
detecting weak-form efficiency (an essential first step in any efficiency analysis) according to Erenburg et al
(2011)’s study which we discuss in greater detail later.
53
See Erenburg et al (2011), and Barber et al (1994). The only Cammer factor that is recognized in the
economics profession is the “cause-and-effect” factor, which plaintiffs typically seek to demonstrate by
providing “event study evidence. However, as we discuss later, such evidence constitutes proof of
“semi-strong form efficiency,” which is moot if the stock does not even trade in a “weak-form efficient”
market.

17
Even though several of the Cammer factors are only secondarily related to market
efficiency, and others may fail consistently to detect market inefficiency, a plaintiff’s claim
of reliance based on such factors “is not disputed in the vast majority of shareholder class
actions,” and, until recently, “has not been rebutted in any case involving actively traded
securities.”54 As a result, classes have been frequently certified 55 which generally forces
defendants to settle, given the magnified costs and risks associated with a trial. 56 Not
surprisingly, billions of dollars have been paid out in settlements in 10b-5 lawsuits “as a
result of Basic”57 and only “8 percent of all federal class action securities fraud claims ever
result in a ruling on a motion for summary judgment.”58 The merits of the plaintiffs’
claims, which are assessed only at the trial stage, are thus made largely irrelevant in many
cases.59 Given the rigor required by Wal-Mart, this is not an acceptable result in cases
where a closer examination would have revealed that the market was not actually efficient.

Several justices’ opinions in the Supreme Court’s February 2013 Amgen decision echo the
view that the policy consequences demand a closer look at the theory under which such
classes are certified. The Court was not asked to revisit Basic’s fraud on-the-market
presumption or market efficiency in Amgen, as the defendant had conceded that the market
for its stock was efficient. 60 Nevertheless, Justice Scalia opined that, by eliminating one
predicate for applying the theory (materiality), the Amgen majority opinion “does not
merely accept what some consider the regrettable consequences of the four-Justice opinion
in Basic; it expands those consequences from the arguably regrettable to the
unquestionably disastrous.” 61 Justice Thomas called the continued reliance on the

54
Dunbar and Heller (2006), Abstract, page 455. Notable exceptions in this regard being the case of Freddie
Mac’s NYSE-traded Series Z preferred stocks in Freddie Mac, and more recently, George v. China Auto. Sys.,
Inc., 11 CIV. 7533 KBF, 2013 WL 3357170 (S.D.N.Y. July 3, 2013), in which the plaintiffs’ proof of market
efficiency related to the securities at issue were considered inadequate by the court.
55
Dunbar and Heller (2006).
56
See China Auto. Sys., 2013 WL 3357170, at *1.
57
Langevoort (2009), page 152.
58
Brief for Former SEC Commissioners and Officials and Law and Finance Professors as Amici Curiae
Supporting Petitioners, Amgen v. Connecticut Ret. Plans and Trust Funds, 133 S. Ct. 1184 (2013) (No.
11-1085), 2012 WL 3555291. “Of the 92% of cases resolved prior to issuance of a ruling on summary
judgment, 41% are dismissed, and 51% are settled.” Id.
59
Cooper (1991), Grundfest (1995).
60
Amgen, 133 S. Ct. at 1193 & 1197 n. 6.
61
Id. at 1206 (Scalia, J., dissenting).

18
fraud-on-the market doctrine “questionable.” 62 He noted that the concerns about the
fraud-on-the market doctrine which Justice White had expressed in his dissenting opinion
in Basic – that “[c]onfusion and contradiction in court rulings are inevitable when
traditional legal analysis is replaced with economic theorization by the federal courts” and
that the Court is “not well-equipped to embrace novel constructions of a statute based on
contemporary microeconomic theory” – “remain valid today.” 63 Even the majority
opinion in Amgen took note of arguments presented in the briefs that “modern economic
research [tends] to show that market efficiency is not ‘a binary, yes or no question,”64 and
in his concurring opinion, Justice Alito noted that “more recent evidence suggests that the
presumption may rest on a faulty economic premise. …. In light of this development,
reconsideration of the Basic presumption may be appropriate.”65

62
Id. at 1208 n.4 (Thomas, J., dissenting).
63
Id.
64
Id. at 1197 n.6 (quoting Langevoort, Basic at Twenty: Rethinking Fraud on the Market, 2009 Wis. L. Rev.
151, 167).
65
Amgen, 133 S. Ct. at 1204 (Alito, J., concurring).

19
 3. Tests of efficiency used in the economics literature

Fraud-on-the market theory was based on some influential academic studies of market
efficiency published in the 1960s and 1970s. 66 Since then, many implications of the
Efficient Market Hypothesis (“EMH”) have been empirically examined for a wide range of
financial securities, 67 and even other assets, such as real estate. 68 In this vast body of
literature in financial economics, certain types of empirical tests have become well
accepted and standard. We begin by reviewing how degrees of market efficiency are
defined in the financial economics literature and review the standard empirical tests of
efficiency commonly used in the academic literature.

In an efficient market, a security’s price fully reflects all available information. Hence, in
his seminal paper on the subject Fama (1970) classified empirical tests of market efficiency
into three “forms” (weak-, semi-strong and strong) based on particular sub-set of available
information considered:

Weak-form efficiency tests examine if a security’s current price fully reflects its historical
prices (as well as the prices of other assets). As one court has observed, “the weak
form…asserts simply that the current share price in an efficient market reflects all
information about past share prices. If the weak form of the hypothesis accurately
describes a market, it is impossible to predict future prices using only past prices.” 69

66
Erenburg et al (2011).
67
In their survey of the efficient market literature, economists at the Reserve Bank of Australia noted that
“Within a decade, the efficient market hypothesis was so well established that Jensen (1978) was prompted to
write that he believed there to be ‘no other proposition in economics which has more solid empirical evidence
supporting it’. Such confidence portends a reversal, and the subsequent twenty years of research and
asset-market experience have rendered the efficient market hypothesis a much more controversial
proposition.”[Beechey, Gruen and Vickery (2000), page 21.]
68
Maier and Herath (2009) provide a recent survey of tests of market efficiency in real estate markets. They
conclude based on their comprehensive survey of the empirical literature on the topic that “the result found in
the literature is inconclusive. Majority of studies provide evidence supporting inefficiency of the real estate
market while several studies maintain the notion of real estate market efficiency.” [Maier and Herath (2009),
page 1]
69
In re IPO Securities Litigation, 260 F.R.D. 81, 98 n. 148 (S.D.N.Y. 2009).

20
“[T]he weak form . . . posits that all previous stock prices, which are necessarily a subset of
all public information, are already incorporated into current stock prices.”70 Such tests
include examining whether prices are “serially correlated” – e.g., whether they follow a
predictable trend based on one or more prior day’s movement – or instead follow. a
“random walk”; A momentum-based strategy such as “buy-high/sell-low” which is based
on stale information about historical prices should not outperform a simple “buy and hold”
strategy in an efficiently functioning market after accounting for transaction costs.71

Semi-strong form efficiency tests if a security’s current price fully reflects a larger set of
information, namely all public information (not only historical prices). It is generally
accepted by the courts that the fraud-on-the-market theory is based on the semi-strong form
of market efficiency.72 It follows that, if a stock’s price does not fully impound information
related to historical prices (i.e., does not trade in a market that is even weak-form efficient),
then it cannot be said to trade in a semi-strong form efficient market.73Therefore, tests of
semi-strong form efficiency (such as event studies used to establish cause-and-effect – the
most important Cammer factor – are relevant only if it is first confirmed that the security at
issue trades in a weak-form efficient market.

In theory, in a strong form efficient market, a security’s price fully reflects not just
historical price data or all publicly available information, but all possible information,
public and private, including information available to insiders. Financial economists
believe that markets are not strong form efficient; the concept of strong form of market
efficiency thus is simply a theoretical benchmark.74

70
Ferillo,Dunbar and Tabak (2004), page 103, citing Fama (1970).
71
Fama (1970) discusses a momentum strategy known as the y% filter strategy, He notes, “But when one
takes account of even the minimum trading costs that would be generated by small filters, their advantage
over buy-and-hold disappears.” [Fama (1970), page 396]. Ferillo, Dunbar and Tabak (2004), page 103.(“The
main implication of the EMH [Efficient Market Hypothesis], when it holds, is that an investor cannot earn an
above-average return by using stale or previously known information.”)
72
See, e.g., PolyMedica I, 432 F.3d at 10.
73
See Erenburg et al (2011).
74
As Bodie et al’s text notes, “This version of the hypothesis is quite extreme. Few would argue that the
proposition that corporate officers have access to pertinent information long enough before public release to

21
Weak-form efficiency tests

The central feature of an informationally efficient market is succinctly summarized in the

title of Nobel Laureate Paul Samuelson’s seminal paper published in 1965: “Proof that
Properly Anticipated Prices Fluctuate Randomly.” In other words, for a stock to trade in an
informationally efficient market (i.e., the stock’s price fully incorporates available
information) it must be impossible to forecast future price changes from observing prior
price changes. Therefore, tests of the predictability of stock returns are commonly used to
preliminarily assess market efficiency.

A common measure of such returns predictability is “serial correlation,” which measures

mathematically the “correlation between the current return on a security and the return on
the same security over a later period.”75 As Ross et al, a well-known basic finance text
notes:76
A positive coefficient of serial correlation for a particular stock indicates a tendency
toward continuation. That is, a higher-than-average return today is likely to be followed by
higher-than-average returns in the future. Similarly, a lower-than average return today is
likely to be followed by lower-than-average returns in the future. A negative coefficient of
serial correlation for a particular stock indicates a tendency toward reversal. A
higher-than-average return today is likely to be followed by lower-than average returns in
the future. Similarly, a lower-than-average return today is likely to be followed by
higher-than-average returns in the future. Both significantly positive and significantly
negative serial-correlation coefficients are indications of market inefficiencies; in either
case, returns today can be used to predict future returns.

Thus, contrary to some recent commentary,77 statistically significant serial correlation in

publicly-traded stocks is rare, and according to research by Nobel Laureate Clive Granger,

enable them to profit from trading on that information. Indeed, much of the activity of the Securities and
Exchange Commission is directed toward preventing insiders from profiting by exploiting their privileged
situation.” [Bodie, Kane and Marcus (2008), page 361].
75
Ross et al., pages 358-359.
76
Ross et al., page 359.
77
Gang and Marcus (2012) incorrectly claim that “it is a generally accepted and articulated principle in the
finance literature that serial correlation in daily stock returns and deviations from the random walk model are
not necessarily proof of market inefficiency,” citing certain theoretical studies by LeRoy (1973) and Lucas
(1978) to buttress their claim. These theoretical studies, which consider abstract theoretical paradigms that
bear little relevance to the real world, do not demonstrate that that periods of serial correlation are “not
incompatible with efficiency of the market,” as Gang and Marcus assert. For instance, Lucas (1978) analyzes
the “stochastic behavior of equilibrium asset prices in a one-good, pure exchange economy,” i.e., an economy
in which there is only a single good produced, all consumers are identical (in terms of their preferences and

22
if serial correlation in a stock’s returns is found to be “large enough to cover the size of
transaction costs,” the finding “invalidate[s]” the conclusion that the stock trades in an
efficient market.78 Thus, serial correlation tests, which date back to studies in the 1960s by
Cootner (1962) and Fama (1965 and 1970), continue to be used in current research.

For instance, a recent study by Erenburg et al (2011) used serial correlation and other
common tests of weak-form efficiency developed in the finance literature (runs tests and
tests of profitable momentum strategies) to identify stocks at issue in federal class actions
field in 1996 and 1997 that did not trade in weak-form efficient markets according to such
empirical tests. It next examined if five indicators of efficiency commonly considered by
the courts could also detect such weak-form inefficiency and concluded that the factors
courts commonly considered exhibited “little relation to weak‐form market efficiency.”79

wealth) and the good is “perishable”, i.e., there is no means of storing the good for future consumption. In
other words, financial securities, that allow one to save for future do not exist in this hypothetical world.
Given such perishability, consumers are willing to pay relatively more for the good in a drought year
compared to a normal year (i.e., declining marginal utility of consumption which manifests itself in risk
aversion) which creates predictability in prices. Such a theoretical model and its conclusions bear little
resemblance to the real world. Similarly, Leroy (1973) assumes, among other things that, “all earnings on
stock are paid out in dividends,” (i.e., companies cannot retain any earnings for future investment needs),
each investor holds “an equal share of the equity and an equal allocation of cash,” and “can always make an
unbiased forecast of the price of stock.” Leroy himself notes that some of his model’s assumptions are
“particularly unrealistic,” and consequently, his conclusion that, in theory, the “return on stock will not
satisfy the martingale property [i.e., display serial correlation] was proved only in a very restricted context.”
He concludes that his paper “demonstrated, then, not that any particular systematic departure from the
martingale property is to be expected, but. … if capital markets are efficient, rates of return will follow a
martingale distribution as a fair approximation [i.e., data will not empirically show serial correlation].”
Contrary to Gang and Marcus’ assertion that “If one were to accept the premise that deviations from the
random walk model make a security market inefficient, then one would have to conclude that almost all
publicly traded stocks … are inefficient as well,” the Lo and MacKinlay (1988) study that Gang and Marcus
themselves cite noted that there was no evidence of significant serial correlation on average across their
sample of 625 stocks. While minor “spurious” negative serial correlation due to market frictions, such as
lack of trading as Gang and Marcus note, in practice the odds of detected serial correlation being spurious is
extremely low as Lo and MacKinlay (1990) confirm. These authors demonstrate that for even minimal
spurious serial correlation (of -0.37%) to be detected in daily returns data, the stock’s lack of trading would
have to be extreme, i.e., the stock could trade no more than once every “35.4 days.” In short, as, a study by
Professor Timmermann and Nobel Laureate Clive Granger (which Gang and Marcus also cite) notes, if serial
correlation in a stock’s returns is found to be “large enough to cover the size of transaction costs,” the finding
“invalidate[s]” the conclusion that the stock trades in an efficient market.
78
Timmermann and Granger (2004), a study that Gang and Hu (2012) cite.
79
Erenburg et al (2011), Abstract page 260.

23
Specifically, it found the “blanket presumption of market efficiency for NYSE‐listed firms
or the Cammer court’s presumption of greater market efficiency for NYSE‐listed firms
relative to NASDAQ” unsupportable because both groups displayed “evidence of weak‐
form inefficiency” such as serial correlation to a degree that could not be reasonably
attributed to chance alone.80 The study also found the “legal presumption” that stocks with
coverage by more analysts will be more efficiently priced was “backward” because analyst
following was related to one-day serial correlation and stocks followed by more analysts
were candidates for profitable one‐day momentum strategies.81 The study also concluded
that trading volume (turnover) was no indicative of efficiency, contrary to the courts’
intuition. Instead, “inefficient pricing (or “slow price adjustment”) induces more trading.”
82
In a similar vein, Erenburg et al (2011) also found that high‐market‐cap firms [with
market cap of at least $1 billion] have more‐positive serial correlation relative to other
firms in their sample, which again contradicts the court’s intuition. 83 Finally, Erenburg et
al (2011) found that wide bid-ask spreads, which is considered an indicator of inefficiency
according to the Krogman court, also impeded profitable momentum strategies (which
exist if the market is weak-form inefficient). Hence, again counter to the court’s opinion,
Erenburg et al (2011) found that the evidence “indicates that profitable momentum trading
is more likely for firms with narrower spreads. 84

Significant serial correlation is indicative of weak-form inefficiency, but it is not the only
test. Another way of measuring weak-form inefficiency is through the use of “trading
rules” – tests to see if a profit could have been earned simply by buying and selling the
stock based on its observed price movement in order to capitalize on momentum.85 Fama
(1970) notes that is it “difficult to judge what degree of serial correlation would imply the

80
Erenburg et al (2011), page 289
81
Erenburg et al (2011), page 290.
82
Erenburg et al (2011), page 291.
83
Erenburg et al (2011), page 291.
84
Erenburg et al (2011), page 291.
85
As noted above, Erenburg et al (2011) consider serial correlation as well as momentum trading rules to
detect weak-form inefficiency.

24
existence of trading rules with substantial expected profits,” so he suggests that “for many
reasons it is desirable to directly test the profitability of various trading rules.” While a
variety of filter rules can be considered, a simple one is the “y-filter” based trading rule,
which examines if a momentum strategy, devised without the benefit of hindsight, earns
greater profits than a buy-and-hold strategy. 86 In a weak-form efficient market, such
excess profits should be impossible, net of transaction costs.87 If net of reasonable cost
assumptions, y-filter rules indicate profits in excess of the buy-and-hold benchmark then
security at issue did not trade in even a weak-form inefficient market over the relevant
period.

The scope of weak-form efficiency tests may be expanded to include “tests for return
predictability” e.g., “forecasting returns with variables like dividend yields and interest
rates.”88 Hence, in the spirit of Fama (1991) one may examine (using regression analysis
and daily or intra-day data if available) if the security at issue’s returns are statistically
significantly related to lagged returns of other securities (in addition to serial correlation
tests) to assess weak-form efficiency. If a stock’s future price change can be forecast in a
statistically significant manner based on past changes in the price of a related security
(such as preferred stocks or bonds issued by the same issuer, or the stocks of other
companies in the same industry) then such predictable price trends based on information
that was already known to investors would indicate that the stock at issue did not trade in a
weak-form efficient market. Recent academic research has shown that not all publicly
traded stocks always trade in a market that is even weak-form efficient. In fact,

86
Fama (1970) describes the y-filter rule as: “If the price of a security moves up at least y%, buy and hold the
security until its price moves down at least y% from a subsequent high, at which time simultaneously sell and
go short. The short position is maintained until the price rises at least y% above a subsequent low, at which
time one covers the short position and buys. Moves less than y% in either direction are ignored.” [Fama
(1970), page 394-395]. A buy-and-hold strategy is a passive strategy in which the stock is bought and held
until the end of the analysis period. The weak-form market efficiency model that Fama (1970) considers in
this connection is referred to as a sub-martingale in prices, according to which in an efficient market investors
expect next-period returns on a stock to be greater than or equal to zero. [See Fama (1970), page 386]
87
Fama (1970) cautions that y-filter trading rule profits may arise because transaction costs such as
commissions are ignored. Thus, to have probative value from an economic perspective, y-filter tests of
weak-form efficiency should incorporate the transaction costs (commissions and bid-ask spreads) that
implementing such a strategy would actually entail.
88
Fama (1991), page 1576.

25
“momentum” (the tendency for rising asset prices to rise further, and falling prices to keep
falling),89 is a pervasive anomaly that has been repeatedly documented and is considered
by many to be an indicator of market (weak-form) inefficiency.

Semi-strong form efficiency tests

Courts have generally concluded that, to invoke the fraud on the market doctrine, plaintiffs
must prove that the security at issue traded in a semi-strong form efficient market90 in
which the stock price quickly impounds all publicly available information (i.e., is
informationally efficient). Semi-strong form efficiency is commonly assessed by
examining if a security’s price quickly and correctly impounds new information (the
“cause and effect” Cammer factor) using a statistical technique known as “event study.”91

The mechanics of an event study are straightforward. The study has the following steps: (1)
the event window (day or days) on which the market received unexpected news is
identified; (2) the stock’s return or price change over the event window is calculated; and
(3) the stock’s “residual” return (also referred to at times as the “market-adjusted” or
“abnormal” return) over the event window is calculated. The residual return is typically
estimated by calculating the “predicted” return “using a [regression] model that takes into
account market and industry effects on stock price returns … [and subtracting] the
predicted return from the actual return to compute the so-called abnormal return”.92 As the
residual return fluctuates daily even in the absence of any news, a statistical measure
referred to as the “t-statistic” is then commonly used (4) to determine if the residual return
on a particular day was abnormally large (or significantly different from zero), given its

89
For instance, Jegadeesh and Titman (1993) documented that stocks with strong past performance continue
to outperform stocks with poor past performance in the next period with an average excess return of about 1%
per month over the 3-12 month horizon. In a more recent study, Fama and French (2012) examined
momentum in four regions (North America, Europe, Japan, and Asia Pacific) and found “momentum
everywhere” except Japan. [See Fama and French (2012)].
90
“An efficient market is one in which the market price of the stock fully reflects all publicly available
information.” PolyMedica I, 432 F. 3d at 10.
91
Fama (1991) recognized that event studies test for semi-strong form efficiency. He noted, “Instead of
semi-strong-form tests of the adjustment of prices to public announcements, I use the now common title,
event studies.” [Fama (1991), page 1577]
92
Tabak and Dunbar (2001), section 19.2.

26
past fluctuations. 93 If a stock’s abnormal return is statistically insignificant (or not
distinguishable from zero with a high degree of certitude), then the event study result does
not support the conclusion that the stock price reacted to the identified news. The
converse, however, is not necessarily true. A statistically significant price reaction on any
day (even following some contemporaneous news release) does not necessarily prove that
such news caused the observe price reaction, because correlation alone is not proof of
causation. To draw an economic conclusion regarding “cause and effect,” further analysis
is critical for several reasons.

First, the mechanical steps of an event study can be conducted for any day and the results of
such a mechanical calculation alone do not explain what caused the observed price
reaction. Although an event study can be conducted for any security, the study’s results
(which are used to assess semi-strong for efficiency) have little probative value unless it is
first established that the security at issue traded in a weak-form efficient market. If a
security does not trade in even a weak-form efficient market, then its price change could in
part be attributable to a delayed reaction to stale information (including information about
its past prices) or momentum rather than any new information released that day. The
presence of such an alternative explanation for the price movement makes it unreasonable
to reject the “null hypothesis” of no cause and effect solely on the basis of correlation
between the event and the price movement; a study simply cannot conclude what caused
the movement with confidence. Thus, the empirical finding that the security’s residual
return following a news release is statistically significant does not prove that observed
price reaction was a quick and correct reaction to such news. Without such proof, a
statistically significant price movement does not demonstrate cause-and-effect, the “most
important” Cammer factor related to efficiency. 94

93
The t-statistic is a ratio of the residual return and its standard error (or the “standard deviation” of the
residual return over the estimation period, where the term “standard deviation” refers to the average squared
difference of a variable’s observed values compared to the variable’s mean value). A t-statistic with an
absolute value of 1.96 or greater means that the residual return is statistically significant at the 95%
confidence level, i.e., there is only a 5% chance that the residual return can be attributed to chance. In such
instances, the residual returns are typically considered “statistically significant.”
94
Teamsters v. Bombardier, 546 F.3d at 207-08.

27
Second, it is important to recognize that the first step of an event study (identifying the
event date when unexpected news first became public) is critical. Instead of arbitrarily
focusing on some selected dates, or certain dates identified in the complaint, a careful
review of prior mix of information available in the market is necessary. Otherwise, it is
impossible to ascertain if the identified event was unexpected new information (“news”) or
simply stale information. If a security trades in an efficient market, then its price should not
react to stale information because such information would have been impounded into the
stock price soon after it was first released.95 Therefore, a statistically significant abnormal
price reaction attributed to such information would not prove cause-and-effect. To the
contrary, such a finding would support the opposite conclusion, i.e., that the security did
not trade in an efficient market.

Third, a proper event study for purposes of determining market efficiency over a class
period looks for consistent demonstration of market efficiency, not just occasional price
movements on days with news. The results of an event study based on a small sample of
dates when the security price was already known to have declined sharply are not
probative. For instance, to prove the cause-and-effect relationship, some economic reports
focus on only a handful of dates out of the alleged class period which are typically those
identified in the complaint when the stock price was known to decrease significantly.
Some have argued that such a limited enquiry (rather than proving that the security at
issues traded in an efficient market throughout the class period) is sufficient to prove
reliance for class certification purposes.96 We believe such a claim does not constitute the
“rigorous analysis” demanded by Wal-Mart for certification purposes.

95
The courts have recognized that this is a corollary of the efficient markets hypothesis. See, e.g., In re
Omnicom Group, Inc. Secs. Litig., 597 F.3d 501, 512 (2d Cir. 2010). See also supra note 32.
96
For instance, Macey et al (1991) argue, “We suggest that the focus of the Supreme Court’s holding in Basic
is misplaced: what determines whether investors were justified in relying on the integrity of the market price
is not the efficiency of the relevant market but rather whether a misstatement distorted the price of the
affected security …[which can be determined using a] simple empirical technique, called an event study…
Whenever event study methodology shows that a fraudulent event has had a statistically significant effect on
the price of a firm's securities, courts are justified in presuming reliance under the fraud-on-the-market
theory.” [Macey et al (1991), page 1018.]

28
One reason why is hindsight bias. Some of the news releases may be identified as material
misrepresentation or curative disclosure dates in the complaint. 97 When a security’s
observed daily return is large, its residual return is typically also large and statistically
significant.98 Thus, confirming that the stock’s price declined “significantly” on a large
price-drop date amounts to merely repeating the complaint’s allegations, as such a date was
likely identified as a curative disclosure in the complaint (at least in part) because the stock
price was known to have dropped sharply that day. Statistical significance on a particular
date, a technical finding, does not by itself prove that a consistent cause-and-effect
relationship existed throughout the relevant period. 99

A second reason is that episodic events are not proof of a consistent cause-and-effect
relationship. A limited showing of a relationship between news and price movements on a
handful of dates does not demonstrate that the stock traded in an informationally efficient
market throughout the alleged class period. From an economic perspective, a rigorous
analysis of the security’s price reaction over time is necessary to prove reliance. In
PolyMedica II, for example, the plaintiff’s expert had found that the stock price reacted
significantly to news on five (or 3.13%) of 160 trading days in the contested period in that
case.100 However, the Court opined that a “mere listing of five days on which news was
released and which exhibited large price fluctuations proves nothing.”101

97
Analysis of the security’s price change following on such dates may well be relevant to the plaintiffs’ loss
causation and damage claims, which the Supreme Court has noted need not be proven for class certification.
See Halliburton, 131 S. Ct. at 2186-87.
98
This follows from the fact that the adjustment made for contemporaneous changes in market and industry
benchmarks in standard event studies is typically small over daily horizons.
99
By the same logic, an event study of selected dates during the alleged class period (which may or may not
be mentioned in the complaint) when the price change was known to be large and significant, and the expert
found some positive (or negative) news ex post that were consistent with the direction of the observed price
change does not prove cause-and-effect. Instead, such a claim is an instance of the well-known “post hoc”
fallacy. (The Latin term for the fallacy is post hoc, ergo propter hoc [“After this, therefore because of this”]
and refers to the incorrect conclusion that if an event of kind A is followed in time by an event of kind B, then
A must have caused B.)
100
In re PolyMedica Corp. Sec. Litig., 453 F. Supp. 2d 260, 270 (D. Mass 2006) (“PolyMedica II”).
101
Id.

29
Dunbar, Ferrillo and Tabak (2004) also reason that, to establish that the security at issue
traded in an informationally efficient market, it is not adequate to demonstrate that its price
reacted statistically significantly on a handful of news dates. Instead they argue that, to
prove efficiency for reliance purposes, plaintiffs must demonstrate that the security’s price
reacted statistically significantly more often on days with news (“news dates”) compared
to days without news.102 However, the power of Dunbar, Ferrillo and Tabak’s test depends
critically on how such news dates are identified. If “news dates” are indeed those dates
when the market learnt material new information then the security’s price should reacted
significantly to “most new, material news” as the court noted in Freddie Mac.103 If, instead,
news dates are picked mechanically by simply identifying all dates when the company was
“mentioned” in the press as Ferrillo, Dunbar and Tabak (2004) suggest,104 such purported
“news” may in fact be stale information or immaterial. Even in an efficient market one
would not expect to see a significant price reaction on such days. Notably, large companies
are mentioned in the press almost daily. Hence almost all days in any sample period could
be identified as news dates in such cases, which would limit the applicability of the
Dunbar, Ferrillo and Tabak’s test. Given these limitations, in Freddie Mac, the Court found
the plaintiff expert’s use of Dunbar, Ferrillo and Tabak’s test unreliable.105 Moreover,
simply showing that the market reacted more often to news than to non-news does not,
logically, support presuming that it always reacted to news of the type contained in the
alleged misrepresentations – the very presumption that is the entire purpose of using fraud
on the market as a basis for class certification.

For purposes of litigation, a focus on price reactions on the date of a few major negative
news events affecting the company fails the test of showing that the market was
consistently efficient throughout the class period for purposes of proving reliance on

102
That is Ferrillo, Dunbar and Tabak’s test compares the “percentage of days with news that have a
statistically significant price movement to the percentage of days without news that have a statistically
significant price movement. [Ferrillo, Dunbar and Tabak (2004, page 120)].
103
Freddie Mac, 281 F.R.D. at 180 (emphasis added).
104
Ferrillo, Dunbar and Tabak (2004), page 120.
105
“The Fisher’s Exact and Chi-Square tests [proposed by Ferrillo, Dunbar and Tabak] do not show that the
price of Series Z consistently responded to unexpected, material news.” [Freddie Mac, 281 F.R.D. at 180]

30
statements that may not have been as dramatically newsworthy. The corrective event at the
end of a class period in litigation is often a drastic event such as a bankruptcy, receivership
or major restatement of earnings, and even an inefficient market will typically show some
reaction to such an event; this does not mean that the market was sufficiently efficient to
swiftly incorporate all prior statements uniformly throughout the relevant period.

This can also prevent problems of speculative evidence. It is not infrequent in securities
class actions that there is no statistically significant price reaction on the dates of the
alleged misrepresentations. The plaintiffs in such cases often argue the speculative
proposition that the misstatement merely confirmed expectations and should not have been
expected to move the market price – and that the amount of price inflation should be
inferred from the subsequent stock drop.106 For instance, Langevoort (2009) argues, “This
is particularly apt when what plaintiffs allege is an omission rather than affirmative lie: the
omission will not necessarily lead to an identifiable market move – rather, plaintiffs’ claim
is that the market would have adjusted had the truth been told.”

The problem with such a theory is that it is not testable. It is doubly problematic in such
cases, where price impact is inferred from a later price decline, to also use that decline as
proof of market efficiency. The better course is to require a rigorous showing by other
evidence that the price actually did react consistently to unexpected events before the stock
drop.

In other cases, plaintiffs have sought to show efficiency based on proof that the market
reacted on some percentage of dates, but not others – a conclusion that, applied to a class,
would suggest that misstatements could be presumed to have caused harm to all class
members when the actual empirical evidence suggests that only a much lower percentage
were affected. This is an unacceptable basis for certifying a class and awarding damages,

106
This is one reason why the Fifth Circuit does not permit claims to be asserted on such a theory of
confirmatory misrepresentation. See Greenberg v. Crossroads Sys., Inc., 364 F.3d 657, 665-66 (5th Cir.
2004).

31
as the Supreme Court held in Comcast.107 After Comcast, a court would not certify an
antitrust case where 40% of the class suffered no injury; neither should it certify a
securities class where an event study shows that the market failed to react to new, material
information 30% or 40% of the time, or where an event study simply failed to examine
most of the days in the class period.

For example, in Freddie Mac, the plaintiffs’ expert had set aside 136 of the 193 trading
days in the alleged class period for the security at issue (Freddie Mac’s Series Z preferred
stock) and reported that, over the remaining segment of the class period, the security’s
abnormal return was statistically significant on 28% of the news days he had considered.
The Court found this proof inadequate to establish efficiency for reliance purposes, noting
that “[a] plaintiff must show that the market price responds to most new, material news.” 108
Citing Bajaj (one of this paper’s authors who had testified as an expert for the
defendants109), the Court noted that “an economist may conclude that a market is efficient
if it reacts to news 80 to 90% of the time, depending on the number of news dates at
issue.”110 In China Automotive Systems, the plaintiff’s expert found that the stock price
reacted significantly to news on seven out of sixteen identified dates, and significantly but
in the wrong direction on another day. The Court opined that “[e]ven assuming that the
methodology was proper, showing that only seven out of sixteen days resulted in a market
reaction is an insufficient foundation upon which to pronounce market efficiency.”111

To confirm from an economic perspective that investors could have relied on the integrity
of the security’s price throughout the alleged class period – and to provide an economic
basis for a legal presumption that all investors were equally affected at all times – it is
necessary to conduct a comprehensive analysis of all news released during that entire

107
Comcast, 133 S. Ct. at 1433
108
Freddie Mac, 281 F.R.D. at 180 (emphasis added).
109
Another one of this papers authors, Mr. McLaughlin, was one of the counsel representing one of the
defendants in Freddie Mac.
110
Id.
111
China Auto. Sys., Inc., 2013 WL 3357170 at *10.

32
period and confirm using well-accepted scientific tests that the security’s price consistently
reacted quickly and correctly to all such news releases.

Law of One Price tests

The Law of One Price is a central tenet in financial economics and a fundamental criterion
for an efficient market. Hence, tests for Law of One Price violations constitute a basic and
direct test of efficiency.112 For example, put-call parity tests are commonly used to tests
for violations of the Law of One Price. In this test, a portfolio of a call and a put option on
the stock and a risk free bond is constructed to have the same cash flow as the stock by
design. The portfolio and the stock are therefore, in effect, identical securities that should
always trade at identical prices in an efficient market. This fundamental relationship
between the value of the portfolio and the stock is known as put-call parity and is described
in most standard finance texts.113 As contemporaneous (and past) prices of the options,
bond and stock are publicly known, violations of this parity relationship parity violations
that are sufficiently large to yield arbitrage profits net of transaction costs such as “bid-ask
spreads” and commissions) suggest that the security at issue does not trade in an
informationally efficient market.

Such direct tests of efficiency are more probative in distinguishing between efficient and
inefficient securities markets 114 whereas indirect tests using ad hoc proxies for efficiency
such as Cammer factors cannot, as we explain in the next section.

112
See Lamont and Thaler (2003 a and b), Ofek et al, and Battalio and Schultz (2006). As Lamont and Thaler
(2003 b) note, “Do arbitrage trades actually enforce the law of one price? This empirical question is easier to
answer than the more general question of whether prices reflect fundamental value. Tests of this more general
implication of market efficiency force the investigator to take a stance on defining fundamental value. Fama
(1991, p. 1575) describes this difficulty as the “joint-hypothesis” problem: “market efficiency per se is not
testable. It must be tested jointly with some model of equilibrium, an asset-pricing model.” “In contrast, one
does not need an asset-pricing model to know that identical assets should have identical prices.” [Lamont and
Thaler (2003b), page 228]
113
See Battalio and Schultz (2006) for a discussion of Law of One Price tests using put-call parity including
the use of such tests for dividend paying stocks.
114
Barber et al (1994).

33
 4. The Cammer factors are not conclusive proof of market efficiency

Some scholars have identified defects in the use of Cammer factors for assessing market
efficiency. Langevoort refers to the list as a “jumble,” some redundant, and “[a]s with
most multi-factor lists, Cammer is unclear what is to be done except examine the factors in
order. It invited an ad hoc approach informed by expert testimony, but in fact largely
unconstrained.” Barber et al (1994) also refer to the Cammer factors as “ad hoc,” and note
that, “We know of no systematic body of evidence showing that these or any other criteria
distinguish between efficient and inefficient stocks. Nor are we aware of evidence
supporting specific cutoff values of these criteria.” 115

Yet, limited by economic reports presented to them, courts have continued to rely on
Cammer factors to evaluate efficiency as these factors are commonly viewed as intuitive
proxies for efficiency. Such a view, however, does not constitute rigorous analysis. For
instance, Erenburg et al (2011) construct different measures of weak-form efficiency
(including serial correlation) for securities at issue in 236 federal securities class actions
cases filed during 1996 and 1997, and find that the “actual relation of the [Cammer] factors
to weak-form efficiency is sometimes the converse of the courts’ intuition.” The study
concludes that:116

(1) some cases certified for class action status do not satisfy the conditions for even
weak‐form efficiency; (2) numerous opportunities exist for cost‐effective investors
(those who can trade quickly and at low cost) to profit by using simple momentum‐
based strategies; (3) including such investors as class members effectively
subsidizes their strategies and overstates damages from reliance on market
efficiency; (4) when such investors can profit by rejecting market efficiency,
standard measures of damage overstate the fraud-related damage of other investors;
(5) because of endogeneity, the factors that commonly are relied on by the
courts for determining market efficiency bear little or no relation to weak‐
form efficiency. [emphasis added]

115
Barber et al (1994), page 290.
116
Erenburg et al (2011), Abstract, page 260.

34
Thus, Erenburg et al (2011) note, there is an “inconsistency between the efficient markets
hypothesis and the way U.S. courts have applied the hypothesis in cases involving
allegations of fraud on the market.” 117 Their “findings raise serious questions about the
standards used by the courts in granting motions for class action status and about the
economic appropriateness of routinely presuming universal reliance on market efficiency
when certifying broad classes consisting of all investors who traded during the class
period.” 118

We also assess the probative value of Cammer factors next by examining seven
well-known instances in which stock prices violated the Law of One Price, and thus did not
trade in informationally efficient markets according to prior studies. As we demonstrate,
even though these stocks did not trade in efficient markets, they satisfied the Cammer
factors demonstrating once again these factors have little probative value in assessing
efficiency.

The case of the “twin stocks”, Royal Dutch/Shell, identified by Lamont and Thaler (2003a)
is one of the stocks in our sample. In this case, a single firm, the Royal Dutch/Shell Group,
has two sets of traded shares (Royal Dutch shares traded in Amsterdam and Shell shares
traded in London). Contractually, Royal Dutch shares receive 60 percent and Shell shares
receive 40 percent of the firm’s cash flows. Therefore, the market value of the Royal Dutch
shares should be 1.5 times the market value of Shell shares. However, as Lamont and
Thaler (2003a) found, this ratio has varied considerably from its theoretical value, “from
30 percent too low in 1981 to more than 15 percent too high in 1996.” The authors noted
that such a large and persistent violation of the Law of One was “surprising since both
Royal Dutch and Shell trade in highly liquid and open markets in Europe and, additionally,
have ADRs trading in the United States. Thus, to profit from the mispricing, a U.S.

117
Erenburg et al (2011), Abstract, page 260.
118
Erenburg et al (2011), page 264.

35
investor doesn’t even need to trade in international markets. All that is necessary is to short
the overpriced shares, buy the underpriced shares and hold forever.” 119

In another study, Lamont and Thaler (2003b) identified a sample of 18 cases from April
1996 to August 2000 of companies that conducted initial public offerings in a subsidiary
(known as a “carve-out”)120 with the announced intention of spinning off the rest of the
subsidiary to the parent company’s shareholders at a later date. In six cases, the
aftermarket price of the subsidiary was so high that if the same value were attached to the
remaining shares owned by the parent, the implied value of the rest of the parent’s assets
would be negative, which is of course impossible in an efficient market because a stock
investment represents limited liability (i.e., a shareholder’s loss is limited to the amount he
paid for the shares). For example, in 1999 the Silicon Valley technology company, 3Com
spun off a small portion of its handheld computer division, Palm, through an initial public
offering (IPO), while retaining 95% of Palm which would be distributed in about six
months to 3Com shareholders, when each 3Com shareholder would receive 1.5 shares of
Palm. Hence, following Palm’s IPO, each 3Com share was expected to be valued at 1.5
times the price of a Palm share, plus the per share value of the remainder of the 3Com
business (excluding Palm). However, after its IPO, Palm’s stock price rose significantly
while that of 3Com actually fell,121 to the point that the market value of the 95% stake in
Palm that 3Com still held was higher than the remaining business of 3Com, i.e., the rest of
3Com’s business had a negative value (-$22 billion). This irrational mispricing was widely
discussed in the press the day after Palm’s IPO, “including in two articles in the Wall Street
Journal, one in the New York Times, and …USA Today.”122 In another instance, Fedenia
and Hirschey (2009) found Chipotle’s Class A shares traded at a premium to Class B shares
even though the former had inferior voting rights.123

119
All quotes in the above paragraph are from Lamont and Thaler (2003a), page 195.
120
Lamont and Thaler (2003b), page 233.
121
Following its IPO, Palm closed at $95.06 on its first day of trading while 3Com closed at $81.81. [See
Lamont and Thaler (2003b), page 230].
122
Lamont and Thaler (2003a), page 198.
123
See Fedenia and Hirschey (2009).

36
Table 1 below lists the cases we have analyzed and their relevant analysis periods.124 Each
of these represents a well-known case of securities that have not traded in informationally
efficient markets for specific periods.

124
For the “negative stub” cases identified by Lamont and Thaler (2003b) that we have analyzed, the analysis
periods are as defined by Lamont and Thaler (2003b). The analysis period for the Chipotle case is as defined
in Fedenia and Hirschey (2009), which documented Chipotle’s violation of the Law of One Price. Lamont
and Thaler (2003a) documented the Royal-Dutch and Shell pricing anomaly from 1990 to August, 2002. For
illustrative purposes, we have focused on the January 1, 1997 - June 30, 2002 sub-period, which spans more
than five years, in our analysis of the Royal Dutch-Shell example.

37
Table 1: Analyzed Securities that violated the Law of One Price Unger Factors Were
Satisfied

A: Instances in Which the Parent Company’s Assets Had “Negative Stub” Value *
Analysis Period
# Parent Subsidiary Start Date End Date
1 Creative Computers stock UBID stock December 3, 1998 June 7, 1999

2 HNC Software stock Retek stock November 17, 1999 September 29, 2000

3 Daisytek stock PFSWeb stock December 1, 1999 July 6, 2000

4 3Com stock Palm stock March 1, 2000 July 27, 2000

5 Methode Electronics Class-A stock Stratos Lightwave stock June 26, 2000 April 28, 2001

B: Other Pairs of Securities for Which the Law of One Price Was Violated **
6 Royal Dutch ADR Shell Trading & Transport Co. ADR January 1, 1997 June 30, 2002

7 Chipotle Class-A Stock Chipotle Class-B Stock October 16, 2006 August 31, 2008

* In the five “negative stub” cases, the implied market value of the parent company’s residual assets (excluding the value of its
shares in a spun-off subsidiary) was negative following the spin-off (or IPO of shares) of a subsidiary. [See Lamont and
Thaler (2003b)]. For the negative stub cases identified by Lamont and Thaler (2003b) that I have analyzed, the analysis periods
are as defined by Lamont and Thaler (2003b). The analysis period for the Chipotle case is as defined in Fedenia and Hirschey
(2009), which documented Chipotle’s violation of the Law of One Price. See Lamont and Thaler (2003a), which documented
the Royal-Dutch and Shell pricing anomaly from 1990 to August 2002. For illustrative purposes, I have focused on the
1/1/1997 – 6/30/2002 sub-period, which spans more than five years, in my analysis of the Royal Dutch-Shell example.
** In the Royal Dutch-Shell example, the Royal Dutch ADR’s claim to the cash flows of the Royal-Dutch-Shell Plc. was 1.5
times that of the Shell ADR’s claim. Yet, the market value of the Royal Dutch ADR violated parity (i.e. , 1.5 times the value
of the Shell ADR) consistently for almost a decade. [See Lamont and Thaler (2003a)]. In the Chipotle case, Chipotle had two
classes of traded shares. Even though they had inferior voting rights, however, the Class A shares were found to have traded
“at a persistent price premium of as much as 20% more than superior Class B shares.” See Fedenia, Mark and Mark Hirschey
(2009), “The Chipotle Paradox,” Journal of Applied Finance Issues 1 & 2, pages 1-16.

As Table 2 shows, despite violating the Law of One Price and trading in an inefficient
market over particular analysis periods, these securities satisfied the Cammer factors (such
as sufficient average weekly trading volume, analyst coverage, market capitalization, and a
low bid-ask spread)125 over their respective analysis periods, and were publicly traded on

125
Historical data over the relevant analysis period regarding the number of market makers for the securities
analyzed are unavailable on widely-recognized databases for such data e.g., Bloomberg and the Center for
Research on Security Prices (CRSP). Public float data were only available for Chipotle Class A and Class B
shares over the relevant analysis period. However, the average bid-ask spread during the Analysis Period for
most of the securities listed in Table 2 was lower than the 2% to 2.15% which represent the average traded
stock’s percentage quoted spread on the NYSE and Nasdaq, respectively for a sample spanning the two
weeks immediately after the beginning of decimal trading in the Nasdaq market: April 9-20, 2001
[“Comparing Bid-Ask Spreads on the New York Stock Exchange and Nasdaq Immediately Following
Decimalization,” prepared by NYSE Research, July 26, 2001]. Such low bid-ask spreads are indicative of

38
NYSE/ Nasdaq. 126 Among the criterion for eligibility to file form S-3, the Court in
Cammer noted that it is “the number of shares traded and value of shares outstanding that
involve the facts which imply efficiency.” As Table 2 shows, all the firms had significantly
higher market capitalization compared to the required public float to be eligible to file form
S-3.127

sufficient activity by market makers who provide liquidity in a security by posting bid and ask quotes at
which they are willing to buy or sell the security immediately, respectively.
Over the Analysis Period, the public float for Chipotle Class A and Class B shares was 98% and
93% respectively as a percentage of total shares outstanding. [Source: Bloomberg L.P.]
126
Source: CRSP US stock database.
127
A company was required to have an outstanding float over $150 million held by non-affiliates, or $100
million of such float coupled with annual trading volume exceeding 3 million shares at the time of Cammer
Opinion, and the threshold for float has since been reduced to US $75 million. As we noted earlier, public
float data is available only for Chipotle Class A and B shares over the Analysis Period. For both Chipotle
class A and class B shares, average public float during Analysis Period was $1,268,113,512 and
$1,381,714,099, respectively, more than 8-9 times the threshold of US $150 million.

39
Table 2: Cammer - Unger Factor Related Evidence for Selected Securities
Daily
Date of Average Average
Start End Average Weekly Number of Earliest S-3/ Market Bid-Ask
# Security Period Period Turnover Analysts F-3 Filing* Capitalization Spread

1 Creative 3-Dec-98 7-Jun-99 38.43% 3 Analysts, 8 17-Oct-07 $335,177,990 0.81%

Computers Reports
2 HNC Software 17-Nov-99 29-Sep-00 8.92% 9 Analysts, 49 4-Mar-97 $1,786,106,220 0.37%
Reports
3 Daisytek 1-Dec-99 6-Jul-00 8.10% 6 Analysts, 17 26-Feb-98 $298,065,642 0.82%
Reports
4 3Com 1-Mar-00 27-Jul-00 15.42% 4 Analysts, 10 22-Jun-95 $19,037,647,538 0.13%
Reports
5 Methode 26-Jun-00 28-Apr-01 8.76% 5 Analysts, 36 8-Aug-95 $1,090,986,919 0.49%
Electronics Reports
(Class - A
shares)
6 Royal Dutch 1-Jan-97 30-Jun-02 1.45% 101 Analysts, 20-Jul-05 $45,399,477,394 0.11%
Shell 1455 Reports
(Amsterdam)
7 Shell Transport 1-Jan-97 30-Jun-02 3.39% 101 Analysts, 20-Jul-05 $1,990,918,927 0.33%
& Trading 1455 Reports
8 Chipotle - Class 16-Oct-06 31-Aug-08 23.28% 27 Analysts, N/A $1,297,857,287 0.17%
A shares 172 Reports
9 Chipotle - Class 16-Oct-06 31-Aug-08 5.78% 27 Analysts, N/A $1,484,489,924 0.28%
B shares 172 Reports
Sources: Stock price, volume and shares outstanding data is from CRSP. Number of analysts covering a company was determined using
Thomson-Reuters database.
* Date of earliest filing of form S-3 is from EDGAR database maintained by SEC. Foreign companies file form F-3. Per SEC, the general
eligibility conditions to file Form F-3 are the "same as Form S-3, except the company must be a foreign private issuer (that is, not a domestic
(U.S.) company)." ["Eligibility of Smaller Companies to Use Form S-3 or F-3 for Primary Securities Offerings," available at SEC website on
http://www.sec.gov/info/smallbus/secg/s3f3-secg.htm].

To assess the fifth Cammer factor, we analyzed the stock price reaction to earnings
announcements in the cases of (i) the five parent companies which had negative stub values
following their subsidiaries’ spin-offs listed in Table 1, panel A; and (ii) the Royal-Dutch
ADR, the Shell ADR, the Chipotle Class A and the Chipotle Class B shares, listed in panel
B of Table 1.128 We identified 38 instances in which these companies announced quarterly
earnings that constituted a “surprise” 129 relative to the consensus (mean) analyst forecast,

128
We determined the earnings announcement date and time through Factiva, a Dow Jones product, which is
a widely used database containing news from worldwide sources.
129
We compute earnings surprise for the firm as the excess of actual earnings over the mean estimate of
analysts. We obtained data on mean earnings estimate and actual earnings from Thomson Reuters I/B/E/S
data base, which is a well-known database that “provides detailed and consensus estimates featuring up to 26
forecast measures including GAAP and pro-forma EPS, revenue/sales, net income, pre-tax profit and
operating profit, and price targets and recommendations for more than 60,000 companies in 67 countries
worldwide.” [http://thomsonreuters.com/products_services/financial/financial_products/a-z/ibes/,

40
and were not coupled with any confounding news [See Table 3 below]. In 35 of these 38
cases, these companies’ stock prices moved immediately in the right direction, i.e.,
increased following a positive earnings surprise, and declined following a negative
surprise. We also confirmed that in these 35 cases the price reactions were in the right
direction even on a market-adjusted basis, using the typical market model we see in many
economic reports for class certification purposes. 130 Further, the market-adjusted price
reaction was statistically significant and in the right direction in 25 of the 38 cases
analyzed.131

In short, the securities analyzed above satisfied the Cammer factors, including appearing to
satisfy the test for cause and effect. However, these securities traded in markets that were
clearly inefficient over the relevant analysis periods. This finding confirms that even if a
stock satisfies such an ad hoc list of factors, it does not constitute adequate proof that the
stock traded in an efficient market.

downloaded August 1, 2011]. We verified the earnings surprise with information contained in news articles
through Factiva, if such information was available. In case the earnings surprise based on news articles was
different from the earnings surprise based on IBES data, I used the earnings surprise based on news articles
because IBES updates its database once a month.
130
The event study first uses a regression model to estimate the historical relationship between the subject
stock’s daily return to that of a market index (in this case the S&P 500 index), or the index “beta”, over an
estimation period. We defined the estimation period to be the 252 days preceding each earnings surprise date
analyzed, except in three instances, when price data were unavailable for 252 days prior to the earnings
surprise. In these three cases, the estimation period comprised of the maximum number of days for which
such price data were available. Then, given the observed change in the market index on the event date at issue
(when the earnings surprise was announced), and the estimated beta, the stock’s expected return is calculated.
131
Even though the price reaction was not in the right direction on three occasions, the market-adjusted
returns on these occasions were insignificant, confirming that the earnings news considered in these cases
was immaterial, after adjusting for contemporaneous changes in the market index.

41
Table 3: Earnings Surprises and Price Reactions

Release Event Raw Residual Earnings

Security Date Date [1] Return Return t-Stat Surprise [2]
1. Chipotle Mexican Grill Inc 2/15/2007 2/16/2007 5.9% * 6.0% 2.5 ** +
2. (Class A) 5/1/2007 5/2/2007 17.9% * 16.9% 8.1 ** +
3. 7/31/2007 8/1/2007 12.3% * 11.2% 5.2 ** +
4. 2/14/2008 2/15/2008 -3.1% * -3.6% -1.4 -
5. 7/23/2008 7/24/2008 -19.7% * -16.6% -6.1 ** -
6. Chipotle Mexican Grill Inc 2/15/2007 2/16/2007 6.9% * 7.2% 4.5 ** +
7. (Class B) 5/1/2007 5/2/2007 17.3% * 16.5% 10.5 ** +
8. 7/31/2007 8/1/2007 11.5% * 10.3% 4.9 ** +
9. 2/14/2008 2/15/2008 -1.5% * -1.9% -0.7 -
10. 7/23/2008 7/24/2008 -21.2% * -17.8% -6.5 ** -
11. Creative Computers (PC Mall Inc) 2/8/1999 2/8/1999 -3.3% * -5.0% -0.5 -
12. HNC Software 1/26/2000 1/27/2000 9.3% * 9.1% 1.5 +
13. HNC Software 4/19/2000 4/20/2000 -3.5% -4.6% -0.8 +
14. HNC Software 7/19/2000 7/20/2000 -3.6% -5.0% -0.9 +
15. Royal Dutch Petroleum 5/6/1999 5/6/1999 2.8% * 3.7% 1.8 +
16. 8/5/1999 8/5/1999 3.6% * 3.1% 1.4 +
17. 2/10/2000 2/10/2000 5.0% * 4.8% 2.6 ** +
18. 2/8/2001 2/8/2001 0.2% * 0.2% 0.1 +
19. 5/2/2002 5/2/2002 2.0% * 2.1% 1.5 +
20. 8/7/1997 8/7/1997 -4.0% * -3.4% -3.5 ** -
21. 2/12/1998 2/12/1998 -1.6% * -2.1% -1.6 -
22. 8/6/1998 8/6/1998 -7.0% * -8.0% -5.5 ** -
23. 11/5/1998 11/5/1998 -3.3% * -4.6% -2.6 ** -
24. 2/11/1999 2/11/1999 -2.1% * -4.1% -2.0 ** -
25. 11/4/1999 11/4/1999 -5.0% * -5.4% -2.9 ** -
26. 11/2/2000 11/2/2000 -6.8% * -7.0% -3.6 ** -
27. Shell 5/6/1999 5/6/1999 3.9% * 4.6% 2.3 ** +
28. 8/5/1999 8/5/1999 4.9% * 4.4% 2.1 ** +
29. 2/10/2000 2/10/2000 8.2% * 7.9% 4.1 ** +
30. 2/8/2001 2/8/2001 -0.2% -0.1% -0.1 +
31. 5/2/2002 5/2/2002 3.4% * 3.6% 2.3 ** +
32. 8/7/1997 8/7/1997 -4.7% * -4.2% -4.3 ** -
33. 2/12/1998 2/12/1998 -1.1% * -1.5% -1.2 -
34. 8/6/1998 8/6/1998 -4.4% * -5.1% -4.0 ** -
35. 11/5/1998 11/5/1998 -4.1% * -5.2% -3.2 ** -
36. 2/11/1999 2/11/1999 -2.6% * -4.2% -2.3 ** -
37. 11/4/1999 11/4/1999 -5.1% * -5.4% -2.9 ** -
38. 11/2/2000 11/2/2000 -6.4% * -6.7% -3.2 ** -

[1] Event date is the trading day on which impact of earnings announcement is analyzed. For earnings
announced after trading hours, event day equals the first trading day following announcement of earnings.
[2] Positive, and negative earnings surprise are denoted by '+', and '-'.
*Raw return is consistent with earnings surprise.
** Market adjusted return is statistically significant and in the right direction

42
 5. The global liquidity crisis of 2007-2008, limits to arbitrage and market
inefficiency

A global liquidity and credit crisis of unprecedented magnitude erupted on August 9, 2007,
when France’s largest bank, BNP Paribas, announced that it had frozen redemptions for
three investment funds, because of the “complete evaporation of liquidity in certain market
segments of the US securitization market [which had]... made it impossible to value certain
assets fairly regardless of their quality or credit rating.”132 When liquidity, a key ingredient
for arbitrage evaporates, it triggers several knock-on effects that amplify economic shocks
to a “full-blown financial crisis.”133 As Brunnermeier (2009) noted, “When asset prices
drop, financial institutions’ capital erodes and, at the same time, lending standards and
margins tighten. Both effects [which Brunnermeier referred to as “liquidity spirals”] cause
fire-sales, pushing down prices and tightening funding even further.” The mortgage crisis
also amplified because (i) runs on financial institutions, like those that on Bear Stearns,
Lehman Brothers, and Washington Mutual, suddenly eroded bank capital and (ii) financial
counterparties began to hold additional funds to protect themselves from counterparty risk
that are not netted out, (which can occur when multiple trading parties fail to cancel out
offsetting positions because of concerns about counterparty credit risk).

The liquidity crunch resulted in the LIBOR-OIS spread,134 which former Fed Chairman
Greenspan described as a “barometer of fears of bank insolvency”135 tripling overnight

132
BNP Paribas Press Release, “BNP Paribas Investment Partners temporaly [sic] suspends the calculation of
the Net Asset Value of the following funds: Parvest Dynamic ABS, BNP Paribas ABS EURIBOR and BNP
Paribas ABS EONIA,” August 9, 2007.
133
Brunnermeier (2009), page 78.
134
“The 3-month London Interbank Offered Rate (LIBOR) is the interest rate at which banks borrow
unsecured funds from other banks in the London wholesale money market for a period of 3 months.
Alternatively, if a bank enters into an overnight indexed swap (OIS), it is entitled to receive a fixed rate of
interest on a notional amount called the OIS rate. In exchange, the bank agrees to pay a (compound) interest
payment on the notional amount to be determined by a reference floating rate (in the United States, this is the
effective federal funds rate) to the counterparty at maturity. … Entering into the OIS exposes the bank to
future fluctuations in the reference rate. However, the bank can guarantee itself longer-term funding while
still paying close to the overnight rate. Because the alternative would be rolling over the funds on a daily
basis at changing overnight rates, banks are willing to pay a premium. This is reflected in the LIBOR-OIS
spread (defined as the difference between the LIBOR rate and the OIS rate).” [Sengupta and Tam (2008)].

43
from 13.4 basis points (bps) on August 8 to nearly 40 bps on August 9, 2007. Central banks
around the world injected liquidity into their national banking systems to prevent asset
sales at depressed “fire-sale” prices and further deleveraging by broker dealers.136 Noting
that loss of confidence in markets due to false rumors could result in panic selling, and lead
stock prices to “artificially and unnecessarily decline well below the price level that would
have resulted from the normal price discovery process,”137 the SEC banned naked short
selling of the stocks of 19 significant financial institutions on July 15, 2008 and nine days
later announced that it would expand the list of companies covered by the ban to the entire
market.138

Despite these measures, by September 2008, the financial markets were on the brink of
collapse and illiquidity had reached unprecedented proportions and by the end of the
month, the financial landscape was forever changed as several large financial institutions
were either taken over by the U.S. government, failed or merged with other firms. On
Sunday, September 7, 2008, Freddie Mac and Fannie Mae, government-sponsored entities
established to provide liquidity in the secondary mortgage market were put into
receivership by the US government, in one of the largest bailouts in US history. On
Monday, September 15, 2008, Lehman Brothers Holdings Inc. filed for bankruptcy
protection - “one of the biggest credit events in history”139 and Merrill Lynch announced it
would be acquired by Bank of America. On September 16, 2008, AIG, a major insurer of
credit risk, was taken over by the U.S government.140 By the end of the month, the global

135
Former US Fed Chairman Alan Greenspan quoted in Thornton (2009).
136
Ben S. Bernanke, Chairman, Fed. Reserve, Remarks on Liquidity Provision by the Federal Reserve at the
Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Georgia ( May 13, 2008),
available at http://www.federalreserve.gov/newsevents/speech/bernanke20080513.htm.Chairman Bernanke
presented identical remarks to the Risk Transfer Mechanisms and Financial Stability Workshop, Basel,
Switzerland, on May 29, 2008.
137
Taking Temporary Action to Respond to Market Developments Emergency Order, Exchange Act Release
No. 58166, 73 Fed. Reg. 42379-01 (July 21, 2008).
138
Wutkowski, Karey and Rachelle Younglai, “UPDATE 2-US SEC looks to expand short rule to entire
market ,” Reuters News, July 24, 2008. The SEC’s ban on naked short selling meant that in order to short sell
a company’s stock investors would have to first borrow the stock.
139
BIS (2008), page 4.
140
For example, on September 16, 2008, the government extended a two-year emergency loan of $85 billion

44
financial landscape was forever changed. A wave of deposit withdrawals triggered the
failure of the Seattle thrift, Washington Mutual, the largest bank failure in U.S. history141
and Goldman Sachs and Morgan Stanley, the only two large remaining U.S. investment
banks announced plans to become bank holding companies to obtain liquidity from the
U.S. Federal Reserve.142

As noted earlier, markets are rendered efficient through the costly efforts of arbitrageurs to
gather relevant information and trade to profit from such information. Such arbitrage is
essential for a market to be informationally efficient. Arbitrage is conducted mainly by
institutional investors such as hedge funds that rely on external funding.143 Thus, when
investors withdrew their capital from hedge funds during the crisis, the funds’ ability to
arbitrage by purchasing additional undervalued assets became severely limited and funds
were forced to sell assets at a huge loss. In 2008, the typical fund lost about one-fifth of its
value and “convertible arbitrage” funds (that try to exploit price anomalies among
corporate bonds) lost 46%, their worst losses since 1990, according to The Economist.
Over the next few quarters the number of funds, which had risen to over 7,000, was
estimated to fall by half. 144 The article noted that hedge funds’ lack of liquidity was
“simply another part of a vast, debt-dependent ecosystem that is now being starved of
oxygen.” 145

Numerous recent academic studies too have documented that the liquidity crisis limited
arbitrage and rendered markets inefficient. For instance, Pedersen (2009) focuses on

to AIG, a major insurer of credit risk, and in exchange was entitled to 79.9 percent equity ownership of the
company through preferred stock [AIG Annual Report for 2008, page 1].
141
“WSJ Update: JPMorgan To Buy Most Ops of Washington Mutual,” Dow Jones News Service, September
25, 2008.
142
Schroeder, Robert, 2008, “Goldman, Morgan to become holding companies, Companies get access to Fed
lending in exchange for oversight,” MarketWatch September 21, 2008.
143
See Shleifer and Vishny (1997).
144
See “Hedge funds in trouble: The incredible shrinking funds,” The Economist, October 23, 2008 (citing
statistics from Hedge Fund Research), page 1 of 6.
145
See “Hedge funds in trouble: The incredible shrinking funds,” The Economist, October 23, 2008 (citing
statistics from Hedge Fund Research), page 2 of 6.

45
“quants” (quantitative traders who use algorithmic trading strategies) and finds that in
early August 2007 such traders “ran for the exits” as liquidity froze. As a result, the
cumulative return to a long-short market-neutral value and momentum strategy for U.S.
large-cap stocks displayed “amazing short-term predictability and volatility”,146 which was
clear evidence that even large-cap stocks’ prices during this period were not
informationally efficient.

Hu et al (2011) demonstrate that even the U.S. Treasury market, the largest, safest and most
liquid asset market in the world,147 was rendered inefficient during the fall of 2008.148
Griffoli and Ranaldo (2010) from the Swiss National Bank found that the covered interest
parity (a no-arbitrage condition) was persisted violated during the crisis.149 Gârleanu and
Pedersen (2011) study the CDS–bond basis, which is a measure of the price discrepancy
between corporate bonds and credit default swaps (CDS), which are securities with nearly
identical economic exposures. Thus in a well-functioning market, the basis should be zero,
which these authors document was not (i.e., the Law of One Price was violated) the case
during the crisis.

In sum, security markets are not always efficient. For markets to be efficient, it is essential
that arbitrageurs have the incentive and the ability to take advantage of temporary
mispricing in securities (given available information). Indeed, it is through such arbitrage
that markets become efficient. Thus, arbitrage is the lifeblood of an efficient market and

146
Pedersen (2009), page 179.
147
Hu et al (2011) focus on the US Treasury market for three reasons: (i) the market’s global importance and
use of Treasury yields as pricing benchmarks for other securities; (ii) its safety (or absence of credit risk)
which implies that price deviations in the US Treasury market are likely to provide information about
liquidity shortages per se, and not be contaminated by other risk factors that typically affect other security
prices; and (iii) its significant liquidity relative to other asset markets, which implies that a shortage of
liquidity in this market would constitute a strong signal about liquidity in the overall market. [See Hu et al
(2011), pages 1-2]
148
Hu et al (2011), page 1.
149
Covered interest parity (CIP) arbitrage entails borrowing in one currency and lending in another to take
advantage of interest rate differentials while avoiding exchange rate risk. “Arbitrage normally ensures that
covered interest parity (CIP) holds. Until recently, excess profits, if any, were documented to last merely
seconds and reach a few pips. Instead, …following the Lehman bankruptcy, these were large, persisted for
months and involved strategies short in dollars.” [Griffoli and Ranaldo (2010)].

46
limits to arbitrage can result in a security trading at prices that are obviously
informationally inefficient for extended periods. The most recent and dramatic instance of
such inefficiency occurred during the global financial crisis of 2007-2009 when several
assets markets became acutely dislocated.

6. Conclusion

To seek class certification under Rule 23, securities fraud plaintiffs must prove with
rigorous analysis that the security at issue traded in an efficient market in which its price
fully reflects all available information throughout the alleged class period. Instead of using
well-accepted empirical tests of market efficiency that are grounded in the economic
principles of market efficiency theory, courts are often presented with expert testimony
that is limited to a mechanical review of ad hoc Cammer factors. Courts usually grant class
certification without having the benefit of rigorous economic analysis. Our analysis
confirms that the factors have little probative value in assessing efficiency. We show that
even stocks that have violated the Law of One Price, a fundamental condition for efficiency
according to several well-known prior studies, satisfy the Cammer factors. Thus, a review
of Cammer factors does not constitute rigorous analysis that the Supreme Court in
Wal-Mart ruled was necessary for class certification.

Further, the market efficiency hypothesis on which the Supreme Court adopted its judicial
doctrine of fraud-on-the market in Basic in 1988 has been challenged on several fronts in
the last twenty-five years. Today, market efficiency is not considered a foregone
conclusion in every instance. In particular, during severe financial crises such as the one
witnessed during 2007-2008 arbitrage (the mechanism through which markets become
efficient) can be severely restricted. Thus, as numerous studies have confirmed, various
asset markets became dislocated and security prices became informationally inefficient
during the crisis.

In light of such modern economic research, the continued reliance on the fraud-on-the
market doctrine (and market efficiency) is questionable, as dissenting opinions in the

47
recent Supreme Court decision in Amgen have noted. At the very least, courts should
require plaintiffs invoking the fraud-on-the market doctrine to prove the market for the
security at issue was efficient using rigorous analysis based on scientific methods that have
been well-developed in the economics profession over the past twenty-five years. If
security prices are obviously severely dislocated due to limits to arbitrage it is
unreasonable to assume that investors would have relied on the “integrity” of such prices.
Hence, a mechanical review of Cammer factors which are ad hoc and fail to distinguish
between securities that trade in an efficient market from those that did not does not
constitute sufficiently rigorous economic analysis for proving reliance based on the
fraud-on-the- market doctrine

48
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