The 5th Circuit and the Fraud on the Market Theory

Under the fraud on the market theory, reliance by investors on an alleged misrepresentation is presumed if the company’s shares were traded on an efficient market. The investors are not entitled to the presumption, however, if they are unable to show that the misrepresentation actually affected the market price of the stock.

The U.S. Court of Appeals for the Fifth Circuit issued an opinion this week, Greenberg v. Crossroads Systems, Inc., No. 03-50311 (5th Cir. April 14, 2004), discussing the fraud on the market theory in a case where the plaintiffs failed to establish that the defendants’ falsely positive statements had increased the company’s stock price. Under these circumstances, the determinations of reliance and loss causation essentially merged, with the court holding that the plaintiffs were only entitled to a presumption of reliance for the falsely positive statements that they could connect to the subsequent decline in the company’s stock price when the “truth” was revealed.

Holding: Affirming in part and vacating in part the district court’s grant of summary judgment.

Quote of note: “We are satisfied that plaintiffs cannot trigger the presumption of reliance by simply offering evidence of any decrease in price following the release of negative information. Such evidence does not raise an inference that the stock’s price was actually affected by an earlier release of positive information. To raise an inference through a decline in stock price that an earlier false, positive statement actually affected a stock’s price, the plaintiffs must show that the false statement causing the increase was related to the statement causing the decrease. Without such a showing there is no basis for presuming reliance by the plaintiffs.”

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