Efficient Markets and the Law: A Predictable Past and an Uncertain Future

Abstract

This article analyzes the manifold situations in which the efficient-market hypothesis (EMH) has influenced—or has failed to influence—federal securities regulation and state corporate law, and the prospective roles for the EMH in these contexts. In federal securities regulation, the EMH has offered a theoretical construct to accompany the general belief in the value of accurate and complete information that has animated the US Securities and Exchange Commission (SEC) since its creation. Specific applications of the EMH have been straightforward and predictable: For instance, its tenets as to market processing of public information helped motivate the streamlining of procedural requirements as to corporate disclosures and, more controversially, as to private securities class action lawsuits. In state corporate law, the EMH has influenced developments as to takeovers and the corporate objective. In contrast, the EMH and related learning have failed to sufficiently inform governmental actions to address financial illiteracy. Belief in the EMH and the value of efficient markets has weakened in the face of recent market anomalies and stress. The May 2010 flash crash is not easily reconciled with the EMH, and related phenomena such as high frequency trading involve an equity market microstructure far different from the microstructure at the time the EMH emerged. Actions motivated by the global financial crisis (GFC), such as the SEC short-selling ban in September 2008, arguably suggest a greater willingness to subordinate market efficiency in favor of other governmental goals. A range of important EMH-related issues loom beyond those associated with financial illiteracy, the equity market microstructure, and governmental goals. Foremost are those relating to the informational predicate on which market efficiency rests. One key aspect of the informational predicate relates to the disclosure challenges associated with financial innovations (such as asset-backed securities) and business entities heavily involved in financial innovation activities (such as certain money center banks). The “intermediary depiction model” that the SEC has always used is inadequate in financial innovation–related contexts. Another key aspect relates to the massive amounts of information that the Dodd-Frank Act requires to be provided to governmental bodies.