US court rules that IPO market is inherently inefficient

The ruling of the US Court of Appeal in Miles et al v Merrill Lynch et al (In Re: Initial Public Offering Securities Litigation is a sweeping judgement on the inherent inefficiency of the IPO market that effectively makes it impossible to use private litigation to deal with IPO fraud. The court not only tightened the legal standard for class action but then went on to decide the matter itself rather than remand it to the District Court. In the process it presented a dim view of the IPO market that effectively puts many kinds of wrong doing in this market beyond the purview of a class action law suit. This effectively rules out private litigation and makes the market dependent entirely on timely action by the regulator. This is extremely unfortunate.

The court’s views on the IPO market are as follows:

In the first place, the market for IPO shares is not efficient. As the late Judge Timbers of our Court has said, sitting with the Sixth Circuit, “[A] primary market for newly issued [securities] is not efficient or developed under any definition of these terms.” Freeman v. Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) (internal quotation marks omitted); accord Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65, 68 n.5 (S.D.N.Y. 2000) (The fraud-on-the-market “presumption can not logically apply when plaintiffs allege fraud in connection with an IPO, because in an IPO there is no well-developed market in offered securities.”). As just one example of why an efficient market, necessary for the Basic presumption to apply, cannot be established with an IPO, we note that during the 25-day “quiet period,” analysts cannot report concerning securities in an IPO, see 17 C.F.R. 230.174(d), 242.101(b)(1), thereby precluding the contemporaneous “significant number of reports by securities analysts” that are a characteristic of an efficient market. See Freeman, 915 F.2d at 199.

Some good might still come out of it if these strong words induce the SEC to drop the unwarranted quiet period during IPOs.

Posted at 10:41 am IST on Sat, 9 Dec 2006         permanent link

Categories: equity markets, law

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