The Truth-On-The-Market Defense and its Relevance in SEC Enforcement Actions

I INTRODUCTION The efficient capital market hypothesis (1)--a financial theory that posits that security prices reflect all relevant information available to the market--first found its way into Supreme Court jurisprudence in Basic Inc. v. Levinson. (2) In that case, the Court adopted a new framework within which to evaluate securities-fraud claims. Subsequent cases recognized logical extensions of the efficient market hypothesis in the context of securities fraud, including fraud-on-the-market reliance and the truth-on-the-market defense against materiality. Two recent district-court cases, however, indicate that the hypothesis itself and, consequently, the legal theories based upon that hypothesis, are not well understood: These courts rejected the use of the truth-on-the-market defense based on logic inconsistent with the efficient market hypothesis. (3) The securities antifraud provisions of the Securities Exchange Act have long been recognized to authorize both official SEC enforcement as well as private litigation. Although key elements of a successful cause of action under the securities antifraud provisions--such as material misrepresentation, a connection between the misrepresentation and the purchase or sale of a security, and scienter--remain the same, the full requirements for SEC enforcement actions and private suits differ in certain aspects. Notably, although private litigants are required to demonstrate reliance, causation, and injury, the SEC is not. This difference lies in the original basis and purposes of private litigation versus SEC enforcement: Broad SEC authority is statutorily granted by Congress to preserve the integrity of the capital markets, while private litigation emerged in a form similar to the common-law tort of misrepresentation and deceit. Therefore, the SEC enjoys the ability to seek remedies under its broad statutory authority that are unavailable to private litigants. (4) In private suits, one way for defendants to rebut allegations of material misrepresentations in securities offerings is the truth-on-the-market defense. Grounded in the efficient capital market hypothesis, (5) the truth-on-the-market defense essentially claims that, in light of corrective information credibly entering the market and being reflected in the price of a security, an alleged misstatement or omission is rendered immaterial and cannot mislead investors. Thus, a successful truth-on-the-market defense rebuts assertions of the materiality of the misstatement or omission in question--an element required of both SEC enforcement actions and private suits. However, the frequent use of this defense in fraud-on-the-market cases has perhaps clouded the grounding of the truth-on-the-market defense in the materiality inquiry. Such confusion is demonstrated by two recent district-court cases in the Ninth Circuit--SEC v. Reys (6) and SEC v. Mozild (7)--in which defendants were denied access to the truth-on-the-market defense based on imperfect understandings of its underlying basis. Although the truth-on-the-market defense has clearly been recognized by federal courts in private suits, it has rarely been asserted in SEC enforcement actions. Hence, it remains of questionable application in SEC enforcement actions. In this note I consider the efficient market hypothesis as adopted by the Court and its application in the securities-fraud context, particularly through the development and application of the truth-on-the-market defense. Part II discusses the basic principles of the efficient market hypothesis. Part III then looks to section 10(b) of the Exchange Act and Rule 10b-5 and the basic elements required under these causes of action for securities fraud. Part IV continues with a discussion of the truth-on-the-market defense, while Part V considers the rationales of two recent Ninth Circuit cases foreclosing that defense in SEC actions. Part VI then considers whether any intrinsic difference between the SEC and private litigants warrants limitation of the truth-on-the-market defense to only private suits, ultimately finding no reasonable basis for such a limitation. …