On Monday October 19, 1987, the Dow Jones Industrial Average of New York Stock Exchange Listings dropped 508 points, a decline of more than twenty-two percent of its value in a single day. Two weeks later, on Monday, November 2, the United States Supreme Court heard argument in Basic Inc. v. Levinson.
Arguing that stock markets efficiently reflect all public information concerning price, former shareholders of Basic claimed that they had sold their shares at an artificially depressed price because management had denied falsely that the corporation was engaged in merger negotiations. Although the shareholders did not know of the corporation's statements at the time they sold their shares, and therefore could not prove reliance in the traditional sense, they argued they could rely on the integrity of the market to reflect such information. In the chaos and continued fall in the stock market following Black Monday, it is not surprising that at oral argument the defendant directors described stock market efficiency as "a hypothesis that many people have questioned in light of the events of the last few weeks."
Notwithstanding the market crash, a plurality of the Supreme Court ultimately accepted the "fraud-on-the-market" basis for plaintiff standing under Rule 10b-5.
By allowing plaintiffs in class actions to claim a fraud-on-the-market as a substitute for individualized proof of reliance on management's false statements, the Basic decision has dramatically reinvigorated the use of 10b-5 actions to attack corporate misrepresentations. This Article addresses two issues at the core of the Basic decision: (1) whether corporations should be allowed to lie to the market; and (2) how different notions of stock market efficiency underlie regulation of corporate speech and other aspects of corporate law.
Part I argues that corporations should be given the option of lying, but that corporations that contemplate lying should be forced to disclose that they do not warrant the truth of their statements. Efficient corporate law should not only give corporations the opportunity to precommit to honesty, it should give them the opportunity to precommit to silence, as well. When given these choices, market forces will drive virtually all firms to commit to honesty, and at least some will commit to (or establish reputations for) remaining silent.
Part II distinguishes between two independent dimensions of stock market efficiency: A market is "informationally efficient" if certain classes of information are immediately incorporated into a stock's price; a market is "fundamentally efficient" if a stock's price reflects only information relating to the net present value of the corporation's future profits.
Part II first examines how informational and fundamental efficiency relate to the Supreme Court's analysis of fraud-on-the-market theory. Second, it considers different beliefs about how these two independent dimensions of market efficiency affect the fiduciary relationship desired by shareholders and, consequently, a broad spectrum of corporate regulation. If markets are not both informationally and fundamentally efficient, shareholders will want managers to act in ways that would partially replicate their trading opportunities in a more efficient stock market.