In the
United States Court of Appeals
For the Seventh Circuit

No. 02-8001

Dean West and Lyndell Eickholz,
individually and on behalf of a class
of investors in Jefferson Savings
Bancorp, Inc.,

Plaintiffs-Respondents,

v.

Prudential Securities, Incorporated,

Defendant-Petitioner.

On Petition for Leave to Appeal from the United States
District Court for the Southern District of Illinois.
No. 99-567-GPM--G. Patrick Murphy, Chief Judge.

Submitted January 30, 2002--Decided March 7, 2002



  Before Easterbrook, Manion, and Kanne,
Circuit Judges.

  Easterbrook, Circuit Judge. According to
the complaint in this securities-fraud
action, James Hofman, a stockbroker
working for Prudential Securities, told
11 of his customers that Jefferson
Savings Bancorp was "certain" to be
acquired, at a big premium, in the near
future. Hofman continued making this
statement for seven months (repeating it
to some clients); it was a lie, for no
acquisition was impending. And if the
statement had been the truth, then Hofman
was inviting unlawful trading on the
basis of material non-public information.
He is a securities offender coming or
going, see Bateman Eichler, Hill
Richards, Inc. v. Berner, 472 U.S. 299
(1985), as are any customers who traded
on what they thought to be confidential
information--if Hofman said what the
plaintiffs allege, a subject still to be
determined. What we must decide is
whether the action may proceed, not on
behalf of those who received Hofman’s
"news" in person but on behalf of
everyone who bought Jefferson stock
during the months when Hofman was
misbehaving. The district judge certified
such a class, invoking the fraud-on-the-
market doctrine of Basic, Inc. v.
Levinson, 485 U.S. 224, 241-49 (1988).
Prudential asks us to entertain an
interlocutory appeal under Fed. R. Civ.
P. 23(f). For two reasons, this is an
appropriate case for such an appeal,
which we now accept. See Blair v. Equifax
Check Services, Inc., 181 F.3d 832 (7th
Cir. 1999).

  First, the district court’s order marks
a substantial extension of the fraud-on-
the-market approach. Basic held that
"[b]ecause most publicly available
information is reflected in market price,
an investor’s reliance on any public
material misrepresentations, therefore,
may be presumed for purposes of a Rule
10b-5 action." 485 U.S. at 247. The theme
of Basic and other fraud-on-the-market
decisions is that public information
reaches professional investors, whose
evaluations of that information and
trades quickly influence securities
prices. But Hofman did not release
information to the public, and his
clients thought that they were receiving
and acting on non-public information; its
value (if any) lay precisely in the fact
that other traders did not know the news.
No newspaper or other organ of general
circulation reported that Jefferson was
soon to be acquired. As plaintiffs
summarize their position, their "argument
in a nutshell is that it is unimportant
for purposes of the fraud-on-the-market
doctrine whether the information was
’publicly available’ in the . . . sense
that . . . the information was
disseminated through a press release, or
prospectus or other written format". Yet
extending the fraud-on-the-market
doctrine in this way requires not only a
departure from Basic but also a novelty
in fraud cases as a class--as another
court of appeals remarked only recently
in another securities suit, oral frauds
have not been allowed to proceed as class
actions, for the details of the deceit
differ from victim to victim, and the
nature of the loss also may be statement-
specific. See Johnston v. HBO Film
Management, Inc., 265 F.3d 178, 185-92
(3d Cir. 2001). See also, e.g., Szabo v.
Bridgeport Machines, Inc., 249 F.3d 672
(7th Cir. 2001). The appeal thus presents
a novel and potentially important
question of law.

  Second, very few securities class
actions are litigated to conclusion, so
review of this novel and important legal
issue may be possible only through the
Rule 23(f) device. What is more, some
scholars believe that the settlements in
securities cases reflect high risk of
catastrophic loss, which together with
imperfect alignment of managers’ and
investors’ interests leads defendants to
pay substantial sums even when the
plaintiffs have weak positions. See Janet
Cooper Alexander, Do the Merits Matter? A
Study of Settlements in Securities Class
Actions, 43 Stan. L. Rev. 497 (1991);
Reinier Kraakman, Hyun Park & Steven
Shavell, When Are Shareholder Suits in
Shareholder Interests?, 82 Geo. L.J. 1733
(1994); Roberta Romano, The Shareholder
Suit: Litigation Without Foundation?, 7
J.L. Econ. & Org. 55 (1991). The strength
of this effect has been debated, see Joel
Seligman, The Merits Do Matter, 108 Harv.
L. Rev. 438 (1994), but its existence is
established. The effect of a class
certification in inducing settlement to
curtail the risk of large awards provides
a powerful reason to take an
interlocutory appeal.

  Because the parties’ papers have
developed their positions fully, and the
district court has set a trial date less
than two months away, we think it best to
resolve the appeal promptly, and thus we
turn to the merits.

  Causation is the shortcoming in this
class certification. Basic describes a
mechanism by which public information
affects stock prices, and thus may affect
traders who did not know about that
information. Professional investors
monitor news about many firms; good news
implies higher dividends and other
benefits, which induces these investors
to value the stock more highly, and they
continue buying until the gains are
exhausted. With many professional
investors alert to news, markets are
efficient in the sense that they rapidly
adjust to all public information; if some
of this information is false, the price
will reach an incorrect level, staying
there until the truth emerges. This
approach has the support of financial
economics as well as the imprimatur of
the Justices: few propositions in
economics are better established than the
quick adjustment of securities prices to
public information. See Richard A.
Brealey, Stewart C. Myers & Alan J.
Marcus, Fundamentals of Corporate Finance
322-39 (2d ed. 1998).

  No similar mechanism explains how prices
would respond to non-public information,
such as statements made by Hofman to a
handful of his clients. These do not come
to the attention of professional
investors or money managers, so the
price-adjustment mechanism just described
does not operate. Sometimes full-time
market watchers can infer important news
from the identity of a trader (when the
corporation’s ceo goes on a buying spree,
this implies good news) or from the sheer
volume of trades (an unprecedented buying
volume may suggest that a bidder is
accumulating stock in anticipation of a
tender offer), but neither the identity
of Hofman’s customers nor the volume of
their trades would have conveyed
information to the market in this
fashion. No one these days accepts the
strongest version of the efficient
capital market hypothesis, under which
non-public information automatically
affects prices. That version is
empirically false: the public
announcement of news (good and bad) has
big effects on stock prices, which could
not happen if prices already incorporated
the effect of non-public information.
Thus it is hard to see how Hofman’s non-
public statements could have caused
changes in the price of Jefferson Savings
stock. Basic founded the fraud-on-the-
market doctrine on a causal mechanism
with both theoretical and empirical
power; for non-public information there
is nothing comparable.

  The district court did not identify any
causal link between non-public
information and securities prices, let
alone show that the link is as strong as
the one deemed sufficient (by a bare
majority) in Basic (only four of the six
Justices who participated in that case
endorsed the fraud-on-the-market
doctrine). Instead the judge observed
that each side has the support of a
reputable financial economist (Michael J.
Barclay for the plaintiffs, Charles C.
Cox for the defendant) and thought the
clash enough by itself to support class
certification and a trial on the merits.
That amounts to a delegation of judicial
power to the plaintiffs, who can obtain
class certification just by hiring a
competent expert. A district judge may
not duck hard questions by observing that
each side has some support, or that
considerations relevant to class
certification also may affect the
decision on the merits. Tough questions
must be faced and squarely decided, if
necessary by holding evidentiary hearings
and choosing between competing
perspectives. See Szabo and, e.g., Isaacs
v. Sprint Corp., 261 F.3d 679 (7th Cir.
2001).

  Because the record here does not
demonstrate that non-public information
affected the price of Jefferson Savings’
stock, a remand is unnecessary. What the
plaintiffs have going for them is that
Jefferson’s stock did rise in price (by
about $5, or 20% of its trading price)
during the months when Hofman was touting
an impending acquisition, plus a model of
demand-pull price increases offered by
their expert. Barclay started with a
model devised by another economist, in
which trades themselves convey
information to the market and thus affect
price. See Joel Hasbrouck, Measuring the
Information Content of Stock Trades, 46
J. Fin. 179 (1991). Hasbrouck’s model
assumes that some trades are by informed
traders and some by uninformed traders,
and that the market may be able to draw
inferences about which is which. The
model has not been verified empirically.
Barclay approached the issue differently,
assuming that all trades affect prices by
raising demand even if no trader is well
informed--as if there were an economic
market in "Jefferson Savings stock" as
there is in dill pickles or fluffy
towels. Hofman’s tips raised the demand
for Jefferson Savings stock and curtailed
the supply (for the tippees were less
likely to sell their own shares); that
combination of effects raised the stock’s
price. Yet investors do not want
Jefferson Savings stock (as if they
sought to paper their walls with
beautiful certificates); they want
monetary returns (at given risk levels),
returns that are available from many
financial instruments. One fundamental
attribute of efficient markets is that
information, not demand in the abstract,
determines stock prices. See Myron S.
Scholes, The Market for Securities:
Substitution Versus Price Pressure and
the Effects of Information on Share
Prices, 45 J. Bus. 179 (1972); Richard A.
Brealey, An Introduction to Risk and
Return from Common Stocks 15-18, 25-46
(2d ed. 1983). There are so many
substitutes for any one firm’s stock that
the effective demand curve is horizontal.
It may shift up or down with new
information but is not sloped like the
demand curve for physical products. That
is why institutional purchases (which can
be large in relation to normal trading
volume) do not elevate prices, while
relatively small trades by insiders can
have substantial effects; the latter
trades convey information, and the former
do not. Barclay, who took the view that
the market for Jefferson Savings
securities is efficient, did not explain
why he departed from the normal
understanding that information rather
than raw demand determines securities
prices.

  Data may upset theory, and if Barclay
had demonstrated that demand by itself
elevates securities prices, then the
courts would be required to attend
closely. What Barclay did is inquire
whether the price of Jefferson Savings
stock rose during the period of
additional demand by Hofman’s customers.
He gave an affirmative answer and
stopped. Yet it is not possible to prove
a relation between demand and price
without considering other potential
reasons. Was there perhaps some truthful
Jefferson-specific information released
to the market at the time? Did Jefferson
perhaps move with the market? It rose
relative to a basket of all financial
institutions, but (according to Cox’s
report) not relative to a portfolio of
Midwestern financial intermediaries.
Several Missouri banks and thrifts
similar to Jefferson Savings were
acquired during the months in question,
and these transactions conveyed some
information about the probability of a
deal involving Jefferson Savings. If the
price of Jefferson Savings was doing just
what one would have expected in the
presence of this changing probability of
acquisition, and the absence of any
Hofman-induced trades, then the causal
link between Hofman’s statements and
price has not been made out. By failing
to test for and exclude other potential
sources of price movement, Barclay
undercut the power of the inference that
he advanced.
  Indeed, Barclay’s report calls into
question his belief that the market for
Jefferson Savings stock is efficient, the
foundation of the fraud-on-the-market
doctrine. In an efficient market, how
could one ignorant outsider’s lie cause a
long-term rise in price? Professional
investors would notice the inexplicable
rise and either investigate for
themselves (discovering the truth) or
sell short immediately, driving the price
back down. In an efficient market, a lie
told by someone with nothing to back up
the statement (no professional would have
thought Hofman a person "in the know")
will self-destruct long before eight
months have passed. Hofman asserted that
an acquisition was imminent. That
statement might gull people for a month,
but after two or three months have passed
the lack of a merger or tender offer puts
the lie to the assertion; professional
investors then draw more astute
inferences and the price effect
disappears. That this did not occur
implies either that Jefferson Savings was
not closely followed by professional
investors (and that the market therefore
does not satisfy Basic’s efficiency
requirement) or that something other than
Hofman’s statements explains these price
changes.

  The record thus does not support
extension of the fraud-on-the-market
doctrine to the non-public statements
Hofman is alleged to have made about
Jefferson Savings Bancorp. The order
certifying a class is

reversed.
