Supreme Court Gives Two Thumbs Up to Modern Portfolio Theory

In our estimation, the last week of the United States Supreme Court’s 2013/2014 term was a watershed for Modern Portfolio Theory and the Efficient Market Hypothesis; two essential components in the notion that publicly available information is rapidly incorporated into the prices of securities traded in a robust public market. For a generation now, intelligent investors have given up trying to “beat the market” with their portfolios. Instead, we rely on these academic theories to construct evidenced-based portfolios designed to cost effectively capture the returns of asset classes – consistent with our goals and risk tolerance.

But it’s not often that we adherents of evidenced-based investing (investors and advisors, alike) get words of encouragement for our strategies from the Supreme Court. From my perspective as a lawyer and financial advisor, I believe that’s exactly what happened in a pair of related cases recently ruled on by the Supreme Court.

In the first case, the Court utilized the theory of efficient markets to provide a legal sword for investors alleged to have been defrauded by company misrepresentations, re-affirming a 25-year-old precedent that had made it easier for plaintiffs to maintain class actions in securities fraud cases.  In the second decision, by contrast, efficient capital markets theory serves as a shield (against suits by plan participants) for company officials acting as trustees of a retirement plan holding company stock in an Employee Stock Ownership Plan (ESOP).

While these decisions do not directly implicate investment strategy, when the highest court in the land adopts these principles to inform legal doctrine involving high stakes financial matters, it is wise to sit up and take notice.

A Pretty Basic Presumption

Securities fraud occurs when a company (or company official) makes a material misrepresentation about the company, an investor relies on the misrepresentation to buy or sell the stock, and the investor is damaged as a result. An aggrieved individual has a right to sue for damages under Section 10(b) of the federal Securities Exchange Act of 1934.

But hundreds of investors buy and sell shares all the time following statements by companies. Large numbers of such claims, brought individually, would clog the federal courts. When there are common questions of law or fact, class action lawsuits are designed to consolidate such claims, so they do not have to be proved individually.

In the landmark case Basic, Inc. v. Levinson (Supreme Court, 1988), company representatives had publicly denied the existence of merger negotiations. Plaintiffs in the class action thereafter sold their stock and were deprived of the resulting profits when a merger was announced. The issue was: Did each shareholder who sold before the merger but after the misrepresentation have to individually prove reliance on the misrepresentation, or could such proof be aggregated and streamlined so that a class action could be maintained on behalf of a large group of injured investors?

Relying on the Efficient Market Hypothesis, the Supreme Court approved the class action by creating a rebuttable “presumption of reliance” for such investors based on the proposition that the public misrepresentations would be rapidly incorporated into stock prices, resulting in a “fraud on the market.”

A presumption is a legal device allowing for the finding of a fact based upon the existence another fact, which normally precedes it logically. Typical examples are the “presumption of paternity” whereby a husband is presumed to be the father of a child born during wedlock and the “presumption of death” when a person has disappeared and is not heard from in seven years.  These presumptions can be rebutted by evidence to the contrary. In Basic, the Supreme Court held that courts may presume a public misrepresentation has indeed impacted stock prices. This obligates securities fraud defendants to rebut the presumption by showing that the market for a particular stock was not efficient, and that their alleged misrepresentations had no price impact.

Not Your Grandfather’s Presumption – A Bold Intellectual Leap

In short, the Supreme Court majority in Basic (Justice Blackmun) accepted the academic notion that most investors rely on the integrity of the market in making their trading decisions.  (Lower federal courts had been applying the fraud-on-the-market doctrine during the previous decade or so.) The Supreme Court held, “An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because 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.”

The dissent, however, (Justice White) believed the Court was opening a Pandora’s Box. “Even when compared to the relatively youthful private cause-of-action under § 10(b)…, the fraud-on-the-market theory is a mere babe. Yet today, the Court embraces this theory with the sweeping confidence usually reserved for more mature legal doctrines. In so doing, I fear that the Court’s decision may have many adverse, unintended effects as it is applied and interpreted in the years to come.” (An interesting footnote is the recusal of Justices Rehnquist, Scalia and Kennedy, for reasons we will probably never know.)

The presumption of reliance, based on efficient markets, was surely a far cry from being as solidly road-tested as other, long-established legal presumptions. Keep in mind, this was only 12 years after Vanguard started the first index fund (First Index Investment Trust) with $11 million — dubbed “Bogle’s Folly” by many at the time and two years before Harry Markowitz and William Sharpe were awarded the Nobel Prize in Economics for their pioneering work in this field during the 1960s and 1970s. At the time of the Basic decision, Vanguard’s fund had grown to only around $500 million in assets and had just become modeled on the S&P 500 Index. There were just a handful of index funds on the market – and the stock market crash of 1987 was barely in the rearview mirror.

Fast Forward to 2014

Understandably, companies and their lawyers have been attacking Basic ever since. The presumption affords an increased likelihood that a securities fraud class action will be certified (allowing it to proceed) with the accompanying settlement leverage. The ensuing decades have brought multiple opportunities for the Supreme Court to reconsider the Basic presumption and this year, in Halliburton, Co v Erica P. John Fund, the Court squarely considered overruling Basic.

The putative class action plaintiffs in Halliburton allege a series of misrepresentations (astoundingly, back between 1999 and 2001) regarding potential asbestos litigation liability, expected revenue from construction contracts and anticipated benefits of a merger – all in an alleged attempt to inflate the stock price. Corrective disclosures, the plaintiffs contend, caused the price to drop and investors to lose money.

In more than a decade of litigation in the federal courts (including a previous trip to the Supreme Court) Halliburton lawyers have been fighting tooth and nail, on numerous grounds, to keep the class action from being certified. The hard fight continued at the Supreme Court on Halliburton’s quest to have Basic overruled, with nearly a dozen amicus briefs filed on each side. One of these briefs in support of retaining the Basic presumption came from a group of financial economists including Dr. Eugene Fama, who won the Nobel Prize in 2013 for his work related to the Efficient Market Hypothesis.

Halliburton’s Supreme Court brief contains a barrage of largely specious arguments, enlisting the services of a series of supposedly “scholarly” law review articles, seeking to undermine the theory of efficient markets. Some examples:

1) Time has only magnified Basic’s flaws. Scholarship has fatally discredited Basic’s key premises. “Economists now largely agree that Basic’s efficientmarkets hypothesis does not reflect reality.

2) Academic consensus now rejects Basic’s view of market efficiency. The brief, quoting a 2002 University of Miami law review article, claims: “Basic came at the end of a long line of legal scholarship that, nearly universally, supported the efficient market hypothesis a ‘scholarly consensus’ that ‘has now evaporated.’”

3) A new “consensus” exists that many investors are betting that the market is in fact inefficient, attempting to locate undervalued stocks in an effort to beat the market. (Of course, Halliburton didn’t see fit to inform the Court that there have always been and there will always be such investors, but that the majority of them will fail on account of market efficiency.)

4) Black Monday, which occurred two weeks before Basic was argued, provides strong evidence that the stock market is not efficient because it is impossible to locate any information that could be responsible for a 22% devaluation in a single day.

5) Experts “have yet to observe a workable test for determining whether the market for a particular security is efficient.” Quoting Dr. Fama himself: “Market efficiency per se is not testable.”

In addition, Halliburton made the standard “chamber of commerce” arguments excoriating the cost and corrosive effect of class actions on American business. The Roberts Court has been generally inhospitable to both class actions and securities fraud claims. But Chief Justice Roberts, in this instance, would have none of such arguments.

Held: Basic Presumption Affirmed

First, the Chief Justice (in his 6 -3 majority opinion) rejected the argument that Basic’s presumption is undermined by the continued debate among economists regarding the degree to which markets are informationally efficient (and the possibility of some investors being able to exploit the inefficiency to make abnormal, above-market returns.) Rather, the Court indicated those debates do not undermine the “modest premise” that “market professionals generally consider most publicly announced material statements about companies, thereby affecting stock market prices.”

The ruling reflects a similar thought process in our evidence-based community. From its inception, the Efficient Market Hypothesis was conceived by Dr. Fama to have three forms, ranging from weak to semi-strong to strong, depending on the kind of information in question and the depth of one’s belief in the rapidity of informational absorption. Here the Court accepted the nearly unanimous belief among the debating economists that a relatively weaker form of EMH is amply sufficient to support its application in this particular context. Investors, of course, may need to make a more calculated judgment about degrees of market efficiency (and other theories developed by financial economists) in developing their own coherent investment strategies.

And, the Chief Justice reminds us, defendants are free to try to prove (at the preliminary class certification stage – this was a second holding in the case) that the market for the defendant’s stock is, in fact, inefficient; thereby rebutting the presumption of reliance.

Further, the Chief Justice declined to fall for Halliburton’s straw man arguments concerning “price indifferent” investors, including the so-called “value investor” – who believes  that certain stocks are undervalued or overvalued and attempts to “beat the market” by buying the undervalued stocks and selling the overvalued ones. As Justice Roberts incisively observes, “there is no reason to suppose that even Halliburton’s main counterexample – the value investor – is as indifferent to market prices as Halliburton suggests. Such an investor implicitly relies on the fact that a stock’s market price will eventually reflect material information – how else could the market correction on which his profit depends occur?” The Basic presumption, adds the Chief Justice, protects even (especially?) the value investor, who “also presumably tries to estimate how undervalued or overvalued a particular stock is, and such estimates can be skewed by a market price tainted by fraud.”

As protective of business as the Roberts Court has been, Halliburton strongly reaffirms the conservative notion that a well-functioning stock market, free from fraud, is essential to our economy. And that securities class actions (warts and all) along with the presumption that markets are efficient enough is essential to keeping the system honest. This is a powerful bootstrap in which efficient markets theory is employed to maintain the integrity of the securities markets; which integrity is required, in turn, to maintain market efficiency.

ESOP’s Foibles

The ink was barely dry on Halliburton when, two days later, the Court decided Fifth Third Bancorp v Dudenhoeffer; strongly relying, once again, on the efficient pricing mechanism of the public securities markets to frame the most important aspect of its holding.

The Dudenhoeffer plaintiffs are former employee/investors in Fifth Third Bank’s Employee Stock Ownership Plan (ESOP). An ESOP allows employees to accumulate ownership of company stock for the dual purposes of having a financial and an emotional ownership stake in the company for which they work. By definition, this is an undiversified portfolio; subjecting the employee/owners to the unsystematic risk that diversification otherwise resolves.

Fifth Third’s ESOP is a part of its defined contribution plan, which contains an assortment of mutual funds for employee contributions. But all of Fifth Third’s matching contributions go into company stock, which participants can choose to move into another fund. However the plan requires the ESOP to be invested primarily in company stock. The plaintiffs allege that by 2007 plan fiduciaries should have known — via both publicly available and non-public information — that Fifth Third’s stock (thereafter decimated by the collapse of the subprime mortgage market which was a large part of the bank’s business) was overvalued and excessively risky and should have been eliminated.

Lower federal courts had been dealing with these so-called “stock drop” cases for years by employing a “presumption of prudence” (there’s that word again) – virtually immunizing ESOP fiduciaries from liability unless the company is on the brink of collapse. In Dudenhoeffer, the Supreme Court rejected this presumption, saying that other than not being statutorily subject to the normal duty to diversify, ESOP fiduciaries are subject to the same general standard of prudence as all other ERISA fiduciaries. However the Court erected a significant defense to the public information component of the claim — available on a motion to dismiss, prior to trial. (The Court dealt separately with the “inside information” part of the claim.)

To the claim that plan fiduciaries should not have “stood idly by while the Plan’s assets were decimated,” Justice Breyer (for a unanimous Court) and citing Halliburton, writes: “Where a stock is publicly traded, allegations that a fiduciary should have recognized from publicly available information alone that the market was overvaluing or undervaluing the stock are implausible as a general rule, at least in the absence of special circumstances. Many investors take the view that ‘they have little hope of outperforming the market in the long run based solely on their analysis of publicly available information’ and accordingly they ‘rely on the security’s market price as an unbiased assessment of the security’s value in light of all public information…’ ERISA fiduciaries, who likewise could see little hope of outperforming the market based solely on their analysis of publicly available information … may, as a general matter, likewise prudently rely on the market price.”

In less-legal English, Breyer seems to be describing what we have long proposed: Markets are efficient enough that investors are better off capturing returns based on long-term growth set by the market as a whole, rather than trying to outguess efficient market pricing in the short run. I fully expect to see Justice Breyer’s language quoted by future courts in other ERISA contexts; for example, in support of the proposition that 401(k) plan fiduciaries may (should) utilize index funds and other evidenced-based strategies in the implementation of such plans.

Market Integrity, Your Anchor to Windward

As you invest for yourself, your family and your own organizations, you will undoubtedly be faced with similar investing challenges. Some will be in the form of markets gone haywire and the cloying “advice” of friends, neighbors and relatives.  Other challenges to staying on course will come in the form of peddlers of the latest products, gimmicks and snake oil.

Whether the “advice” comes from well-meaning but misinformed friends, or those who are placing their own best interests ahead of yours, you can always come back to the science and evidence of investing, which with each passing decade appear to remain standing against the test of time.

The Supreme Court’s collateral reaffirmation of efficient market concepts in these cases appears to be a strong endorsement of the science and research behind the theories. And while the burgeoning academic data on the efficacy of evidenced-based investing is the strongest reason to adopt and maintain such strategies, the Court’s reasoning supplies strong moral support.

Sometimes we need all the support we can get.


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