Law and the Performativity of Economics: “Fraud-on-the-Market” Claims and the EMH

The performativity of economics has taken on a lot of meanings in the past 15 years, but all of them revolve around the ways that economic theories alter the objects about which they are theorizing. Some versions – MacKenzie’s story of Black-Scholes-Merton – focus on the self-fulfilling character of economic theories, where the theory is mobilized by interested actors to legitimate the market and then used to price the options bought and sold on the market and thus the prices converge to the theory’s expectations. Other versions focus on how economic theories call new objects into being – my own work, for example, looks at how macroeconomic statistics and theories change how we think about “the economy” as a whole. Often, these arguments are a bit messy, as it can be difficult to show the consequences of a particular theory (in the absence of the neat tests performed by economists themselves on specific predictions, as in MacKenzie’s work). Court cases and regulations present interesting opportunities for studying the performativity of economics that I think are so far underexploited. Let me offer one interesting example suggested by a friend working as a research attorney.*

The Securities and Exchange Commission regulates securities transactions and, in particular, investigates and punishes fraud and deceit related to securities. SEC Rule 10b-5 prohibits fraud, specifically stating:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.

Rule 10b-5 and its interpretation and implementation establish the elements needed to prosecute someone for committing fraud. One of those elements is that the defrauded party needs to have relied on the false information provided by the offender. In other words, if I lie to you and swear that Apple shares are going to tank tomorrow (because of some information that I know will be released, say), and you sell a block of shares, you still have to show that the false information about Apple that I provided led you to sell the shares (and that, for example, you were not already planning on selling them as part of a longer-term strategy laid out weeks in advance). This is known as “reliance.”

Ok, that’s all well and good, but what does this have to do with the performativity of economics? Well, in the 1960s, economist began writing about something called the efficient markets hypothesis (or EMH, see Quiggin 2010 for an excellent critical summary). The EMH argues, in one formulation, that well-functioning financial markets capture all public information about a traded security. In other words, the price of a stock on a prominent stock exchange already reflects all of the publicly available information released about the company. This theory came to prominence in the 1960s, and has been debated ever since, but still holds a lot of sway among financial economist (especially the “weak”“semi-strong” form, more or less what I described).**

In 1988, the efficient markets theory produced a new kind of claim: “fraud-on-the-market.” In Basic Inc. v. Levinson, the Supreme Court ruled that because the NYSE was an efficient market, fraudulent statements made by a company to the public would be reflected in the company’s stock price. Any investor who made decisions based on the company’s stock price – that is to say, all of them! – would then be able to satisfy the “reliance” component of a fraud case. By releasing false information publicly into an efficient market, the company committed a “fraud-on-the-market.” I haven’t read the case itself, but here’s the wikipedia summary of the holding related to this new claim:

Observing that the reality of modern securities markets is such that face-to-face transactions are rare, Justice Blackmun noted that requiring a showing of actual reliance would effectively prevent plaintiffs from ever proceeding as a class action. Also finding that investors often rely on market price, he found the rebuttable presumption of reliance (through the fraud-on-the-market theory) to be a reasonable compromise between the requirements of Federal Rules of Civil Procedure 23 and the securities fraud element of reliance. Blackmun further noted that both Congress’ intent and recent empirical studies reflect the idea that open markets incorporate all material information into share price.

I’m not sure this case merits a full paper, but I think it would fit nicely into a larger argument about law and the performativity of economics, or the history of the efficient markets hypothesis and its real world effects. Here we can see how a new kind of claim – “fraud-on-the-market” – was made possible by a new theory of what financial markets do – capture all publicly available information and summarize it into the price of a security. And the whole story is political down to its very core, involving regulators, legislation, courts, and business interests vying on each side for money and power. This is not a story of a theory having some autonomous power to determine the fate of the economy, but rather a story about the subtle interactions between politics and technopolitics, or between theories of the world and disputes over how the world should be run.

*I thank Max Milstein for pointing out this example. Note that I am not a lawyer, nothing in this post should be taken as the opinion of a lawyer, yadda yadda.
**Corrected to reflect John Quiggin’s comment below.



  1. So here, EMH expanded the standing of private parties to assert claims under Rule 10b-5, which is a boon to the SEC. But throughout the 70s, the Commissioners would rail against EMH (e.g. “Economists know about numbers and models, we know about real investors”), because they assumed that the EMH was undercutting the SEC’s reason for existence. Finance scholars argued that the market has already priced in all material information well before Form 10-K’s could reach investors. So under that reading of EMH, the SEC’s disclosure function is a redundant waste of corporate time and resources.

    The justification for the SEC in the 30s-70s relied on Fundamentals Analysis, so this decision (especially if the SEC filed an amicus curiae) would be an interesting case of the Commission transitioning from legitimation by one paradigm to another, by incorporating a theory that had largely been promulgated by people hostile to the Commission’s mission in the first place. There’s got to be a paper there . . .

    • Carl,

      You are by far the best positioned person I know to look into this! I didn’t know about the EMH’s backstory at the SEC, that’s fascinating. If you poke around and find anything interesting, let me know.

      Are you going to be at ASA this year?

      • Yep, I’ll be at ASA. I’ll also be down the Red Line from SASE, though not attending this year.

        • Excellent. I think ASA is my only conference this year (the rest of my travel will be archival), so I hope to see you there!

  2. That’s actually the “semi-strong” version. The weak version just rules out successful trading strategies based on past price movements (charting).

    The strong version says that the price incorporates all info, public and private, which would, I think, make fraud on the market impossible.

    • Dear John,

      Thanks for the correction. That’s what I get for blogging from memory! Edit made.

    • Also, another quick thought: since the strong form implies that fraud is impossible, the existence of fraud would be (another) disproof. Right? Not that we are lacking for disconfirmations of the strong EMH, but I hadn’t thought of that one before.

      Thanks again!

  3. Dan,

    To the point about performativity, is this really an instance of this? You mention that cases of performativity “revolve around the ways that economic theories alter the objects about which they are theorizing.” This seems more like a case where an economic theory had a political impact outside of its normal field of activity; rather than a case where it altered the object about which it theorizes. In a direct sense, EMH is about prices (and what they tell us), so I would see the closest connection to performativity in a case where the calculation of prices was accomplished, with the idea that the calculation must accord with the EMH.

    The reasoning of the court is a wonderful piece of logic, BTW. As far as I can tell, fraud can only be perpetrated directly on a certain set of investors. Even if you make a fraudulent claim on a daily news program, you are only directly lying to those people who watched that program (of course you’ve indirectly spread false information to many others). But, using the EMH logic, the people who act on a fraudulent claim will alter the market price of a stock, and because every investor should be watching the price of their stocks, ipso facto all investors are automatically now relying on fraudulent data. Following this logic, the main criterion for “reliance” is how much you inflected the price of the stock, and if this amount is great enough, you automatically have a class action in front of you, even if you lied to just one main investor who told no one else about your fraudulent claim.

    • Jeff,

      You are right that the claim of performativity here is a bit different from, say, MacKenzie (and Millo)’s BSM story. I think we can definitely make the “generic” and even “effective” performativity claims (from MacKenzie’s typology): the theory had a real impact. But that impact did not seem to make the theory “more true.” But I do think the EMH altered how regulators and judges saw the world – it changed what financial markets were (as Carl points to in his quick historical recap of the SEC’s take on the EMH). Once accepted, the EMH tells us what securities markets are and thus changes how we can act on them – it becomes legally possible to commit “fraud on the market.” So, the EMH changes the nature of the object it theorizes about, albeit in a subtle way. Does that make sense?

      And agreed, the logic is beautiful.

  4. Michael Bishop

     /  January 19, 2012

    Here’s a quick way to get some insight into what economists believe regarding the efficient market hypothesis:

    Numerous other links on the EMH available from here:

  5. No story about fraud on the market would be complete without mentioning the case of Jamie Olis, a tax accountant at Dynegy given a 24-year sentence in 2004 based on damages to investors estimated via an event study of the revelation of his fraud. Joe Grundfest, a former SEC commissioner, re-ran the numbers in 2006 and determined that the original study was flawed, the revelation of fraud had no discernible effect on share price, and therefore Olis’s sentence was far too long. As Rick Perry might say, “Oops.”

  6. cemferreira

     /  January 24, 2012

    Reblogged this on Markets At The Intersection and commented:
    The discussion around performativity of economics in the courtrooms, not just on the trading floor is well worth the time to read. Make sure you find the time to go over the comments as well.

  7. cemferreira

     /  January 24, 2012

    Excellent insights, there is definitely a paper in there somewhere. I can’t remember reading any serious exploration of the idea of “the market” being performed outside the trading floor.

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