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The Paradox of “Fraud-on-the-Market Theory”: Who Relies on the Efficiency of Market Prices?


  • We thank participants at the 2008 Rand/Claremont McKenna College conference on “The Future of Securities Fraud Litigation” for their comments and suggestions. We also benefited from comments of an anonymous referee and seminar participants at Chapman University, University of Hawaii, University of California Riverside, the Searle Research Symposium on the Economics and Law of the Entrepreneur at Northwestern University Law School, University of Tampa, Université Laval, and King's University College at University of Western Ontario.

Richard Smith, Anderson Graduate School of Management, University of California Riverside, 900 University Ave., Riverside, CA 92521; email: Erenburg is Assistant Professor, King's University College at University of Western Ontario; J. Smith is the Von Tobel Professor of Economics and Dean, Robert Day School of Economics and Finance, Claremont McKenna College; R. Smith is the Philip L. Boyd Chair and Professor of Finance, A. Gary Anderson Graduate School of Management, University of California, Riverside.


Our evidence points to 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. Based on a sample of securities class action cases, we find that (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; and (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.