Very Efficient

An interesting appellate decision from late last year illustrates the double-edged nature of the efficient market hypothesis for securities fraud litigants. In In re Merck & Co. Sec. Litig., 432 F.3d 261 (3rd Cir. 2005), the Third Circuit addressed whether Merck’s failure to disclose certain accounting practices of a wholly-owned subsidiary was a material omission.

On April 17, 2002, in connection with the initial public offering of the subsidiary, Merck filed a Form S-1 that disclosed for the first time that the subsidiary had recognized as revenue the co-payments paid by consumers. The Form S-1 did not disclose, however, the total amount of co-payments recognized. On the day the Form S-1 was filed, Merck’s stock price went up. Two months later, the Wall Street Journal reported that the subsidiary had been recognizing the co-payments as revenue and estimated the total amount of this revenue in 2001 at over $4 billion. Merck’s stock price dropped two dollars.

On appeal, the Third Circuit held that in an efficient market the materiality of disclosed information may be measured by looking at the movement of the company’s stock price immediately following the disclosure. Since Merck’s stock price did not decline when the Form S-1 was filed, the court found that the revenue recognition information was immaterial as a matter of law. In response to the plaintiffs’ argument that the real disclosure took place when the Wall Street Journal made public the estimated magnitude of the co-payment recognition, the court found that the “minimal, arithmetic complexity of the calculation” made by the reporter “hardly undermines faith in an efficient market.” The court noted that this was especially true given how closely Merck was followed by analysts.

Holding: Dismissal affirmed.

Quote of note: “[Plaintiff] is trying to have it both ways: the market understood all the good news that Merck said about its revenue but was not smart enough to understand the co-payment disclosure. An efficient market for good news is an efficient market for bad news. The Journal reporter simply did the math on June 21; the efficient market hypothesis suggests that the market made these basic calculations months earlier.”

Addition: One of the panel judges was Samuel Alito, who has since become Justice Alito.