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Friday, January 3, 2014

A Deep Dive into Till v. SCS Credit Corp -- Part VIII: Toward a Clearer Understanding of the Phrase "Efficient Market" in Relation to Credit Markets

The term “efficient market” in economics has a much more rarefied meaning than I perceive the bankruptcy judges using it to recognize, and that is another reason why I doubt that the plurality intended the term to function as a legal standard. 

In classic economic theory, efficiency usually means “Pareto efficiency” after the great Italian economist Vilfredo Pareto, and is specifically the state in which no participant can be made better off without some other participant being made worse off.   Here is an excerpt from "The Cartoon Introduction to Economics: Volume I: Microeconomics" by Klein and Bauman (2010) that illustrates this:

Hey, it's a cartoon, sorry.  I edited out the stereotyped cartoon at the bottom but could not get Blogger to take the edited image.
In any introductory micro-economics course, the students will learn that a perfectly competitive market – one in which all products are identical or can be traded off against one another, where no participant has enough market power to affect the market by its actions, where everyone has perfect knowledge, where there are no transaction costs -- is “Pareto-efficient” at equilibrium.  In fact, that statement is the "first fundamental theorem" of "welfare economics."

The equilibrium state is usually illustrated by drawing two lines on an X/Y graph, which represent the hypothetical demand and supply calculations of, respectively, the buyers and sellers in the market, in such a way that they intersect at a point somewhere around the middle of the upper right quadrant, which is called the equilibrium point or the “market clearing” point, at which both buyers and sellers get the most they can out of the market, and then showing how moving on any curve away from that point makes some better off and some worse off; thus the equilibrium point is Pareto-efficient.  Here is a typical visual representation of the theorem, which I copied from this site):
The site I took that from explains the diagram as follows:

In the diagram above, the market is in equilibrium at price P1 and output Q1. At this point, the total area of consumer and producer surplus is maximized. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market equilibrium price is deemed to be allocative-efficient.

Obviously, the theorem and its underlying conditions constitute a highly stylized representation of markets and reality, and I think it is fair to say they represent an ideal or quasi – Platonic conceptualization of the perfectly competitive market – absolutely no one can be better or worse off  -- and do not correspond to very many real world markets, all of which have some departure from the absolutist conditions that define the idealized perfectly competitive market (they have some transaction costs, some market participants have greater knowledge than others, or the full roster of products may not be perfect substitutes for one another, and so on).  At the date of this writing, the wikipedia entry on the "fundamental theorems of welfare economics" says : "The ideal conditions of the theorems, however, are an abstraction."

People who make their living arguing legal issues will, I think, recognize that how rigorously a standard is defined has a lot to do with whether the standard is satisfied in a given case, and further that it is a frequent tactic in legal argument, and debate generally, to try to have your adversary’s position measured against the highest standard possible, while at the same time trying (as subtly as possible) to position your own point of view against as low a standard of review as possible.  For example, many advocates of governmental intervention in the economy cry "market failure" whenever the real world fails to satisfy the idealized conditions of the first fundamental theorem, and call for government to intervene in the economy to fix the purported shortcomings of the market  -- never bothering to hold the proposed government intervention to the same exacting standard, or even to offer proof that the government intervention results in a net welfare improvement compared to the market outcome.  This post from my favorite blog, Marginal Revolution, is a succinct commentary on the logical fallacies and analytic shortcomings of such an argument.

So, too, if courts were to interpret the "efficient market" reference in the Till footnote to be satisfied only upon a showing that chapter 11 debtors have access to an idealized, perfectly competitive market, it is unlikely that debtors would ever lose a cram-up litigation.  And why then would we need to give creditors disclosure or let them vote? 

Is this what the justices in the Till plurality opinion meant by an “efficient market”?  Even though it was signed by the left wing of the Court, I think not.  It would be disingenuous for a lawmaker in a republic, where the citizenry is supposed to be sovereign, to impose a criteria of perfection for exemption from governmental action without saying so, and perhaps also making clear that the lawmaker was aware of the difficulty of human beings achieving perfection.

Secondly, more specifically in the context of chapter 11 of the Bankruptcy Code, it is a law that largely addresses relationships of a private, commercial nature, where all issues are decided by a preponderance of the evidence. In that realm, I would expect the Court to impose nothing more stringent than a commercially reasonable perspective, much as they justified the prime-plus formula  in Till itself on pragmatic, administrative grounds.
A recent article by Professor Henry Hu at the University of Texas Law School sheds more light on the justices’ understanding of the term “efficient market”.  In his 2012 paper “Efficient Markets and the Law: A Predictable Past and an Uncertain Future,” Professor Hu explains how the Supreme Court, in Basic, Inc. v Levinson allowed a 10b-5 lawsuit to proceed without a showing of individual reliance by plaintiffs, but instead afforded them a presumption that, if they could show the stock market was processing information about the company efficiently, their individual reliance on that information would be presumed.  This doctrine has come to be known as the “fraud on the market” theory and is in part responsible for expanding enormously the expert witness opportunities for economists, who are asked to create “event studies” showing how the stock market reacted to information about a company involved in a 10b-5 suit.  A 2007 article by Howard Hammer and Ronald Groeber at this link has a succinct overview of the intellectual dynamic whereby the EMH led to the "fraud on the market" theory.[1]

As Professor Hu most recently observes,

although the Supreme Court did not define efficient market, subsequent lower courts have generally adopted the Fama (1970) definition of it as being one in which the market price of the stock fully reflects all public information [citing In re PolyMedica  Corp., Securities Litigation, 432 F.3d 1 (1st Cir. 2005)].  The Supreme Court also did not distinguish between informational efficiency (a market where prices react quickly to new information) and value efficiency (where market prices reflect intrinsic value).  Lower courts have required only a showing of informational efficiency.

Hu continues: “To determine the presence of informational efficiency, courts have looked at factors such as weekly trading volume and the number of securities analysts covering a given stock”. 
The reference to “Fama (1970)” is to the scholarly paper from which the “efficient market hypothesis” sprung, which is generally credited with launching a new field of study by economists of financial markets and supplied the analytic foundation for index investing.[2]  For his work in that field, Fama was awarded the Nobel in Economics in 2013, along with Robert Shiller, whose work calls into question several of Fama’s theses and the EMH; the Nobel committee's explanation of their work is here and provides a nice background summary of the topic and their contributions to the field.  Fama's paper, which he created after being asked to review various stock market investment strategies and concluding that none of them systematically worked, posited that well-functioning capital markets were sufficiently efficient that no one could systematically earn more than the market's return over an extended time.  Fama did not claim that all, or particular, financial markets were perfectly efficient.  In fact, he posited certain levels of efficiency: the "weak" form, which simply said that it is impossible to predict, based solely on a security's historical price trend, what the security's price is going to be in the future, and therefore it is impossible to outperform the market systematically using that knowledge.  The "semi-strong" form, which is what most people focus on, held that market prices respond to publicly available information so efficiently that, again, no one can systematically earn more than a market return based on that information.  Last, he posited a  "strong" form of capital market efficiency, in which even non-public information is efficiently incorporated into security prices, a state that the insider trading laws make it hard to achieve.  

This short transcript of recent remarks by John Cochrane, President of the American Economics Association and a colleague of Fama’s at the University of Chicago, contains a discussion that is relevant to understanding what “informational efficiency” means in the context of financial markets.  Cochrane decries the widespread

ignorance of the definition of informational ‘efficiency.’ Every field of scholarly research develops a technical terminology, often appropriating common words. But people who don’t know those definitions can say and write nonsense about the academic work.

An informationally-efficient market can suffer economically inefficient runs and crashes -- so long as those crashes are not predictable. An informationally efficient market can have very badly regulated banks. People who say ‘the crash proves markets are inefficient’ or ‘efficient market finance is junk, you did not foresee the crash’ just don’t know what the word ‘efficiency’ means. The main prediction of efficient markets is exactly that price movements should be unpredictable! Steady profits without risk would be a clear rejection.

I once told a reporter that I thought markets were pretty ‘efficient.’  He quoted me as saying that markets are ‘self-regulating.’ Sadly, even famous academics say things like this all the time.

There is a fascinating story here, worth study by historians and philosophers of science and its rhetoric. What would have happened had Gene [Fama] used another word? What if he had called it the ‘reflective’ markets hypothesis, that prices “reflect” information? Would we still be arguing at all?

What Cochrane is saying is that too many people confuse "informational efficiency" with "value efficiency", that whether prices in an efficient market reflect available information is a different proposition from with whether those prices “correctly” predict and discount the future cash flows of the entities in question.  Whereas the former tracks relatively easily identifiable data -- price movements and information dissemination -- there are two additional levels of subjectivity in the latter proposition: the subjective judgment of investors in valuing the disseminated information, and the subjective judgment of the analyst of those valuations in positing an extrinsic standard for “correct” valuation.[3]

Without going too deeply into the academic debate over the EMH, it should be noted that this distinction was noted by Fama in his early exposition of the EMH. In articulating what came to be known as the "joint hypothesis" conundrum, he wrote: "An efficient market will always ‘fully reflect’ available information, but in order to determine how the market should 'fully reflect' this information, we need to determine investors’ risk preferences.  Therefore, any test of the EMH is a test of both market efficiency and investors’ risk preferences.”  This "dual hypothesis" conundrum is well recognized in the academic literature examining the EMH.[4] 

Still -- and again, without wading too deeply into the academic thicket -- it is generally held in financial economics that (1) prices in the financial markets reflect the information relevant to the securities/claims traded therein, and (2) assuming the conditions to an efficient market are satisfied, the allocation of risk and income in such a market will wind up being Pareto-efficient.

One point needs to be emphasized regarding the meaning of "efficient market" because it is of particular importance to understand whether the term “efficient market” is being applied intelligently in chapter 11 cram-ups. “Pareto-efficiency” does not mean that everyone in the market gets the terms they desired.  This needs to be repeated:  Pareto-efficiency does not mean that everyone in the market gets to buy or sell the quantity they want at exactly the price they unilaterally specify.  The supply curve and the demand curve only intersect at one point; every higher price on the supply curve, and every lower price on the demand curve, represent better outcomes for, respectively, sellers and buyers.  Sellers would rather sell less units for more money and buyers would rather buy more units for less money, but the gap between the market – clearing price and each side’s desires does not mean the market is inefficient; it means the opposite: because part of the definition of an "efficient market" is that no one has enough market power to move the market price on his or her own, the term implies that no market participant's preference about pricing is privileged over another's.   If a buyer approaches a seller who quotes too high a price, the buyer can find a lower one somewhere else.  If a buyer offers too low a price, the seller can transact with someone who is willing to pay more. That is the fundamental dynamic of the efficient market.  A seller / lender is not forced to sell/lend below market, and a buyer/borrower is not forced to pay above market. 

So, while I think the term "efficient market" in footnote 14 was not intended to convey a precise technical meaning, to the extent it has taken on a life of its own in the lower courts, I wanted to lay out some basic points about its technical meaning, as it appears to me that the lower courts have been proceeding in considerable ignorance of that meaning in their interpretations of footnote 14.  The crucial takeaways should be that

1) the phrase "efficient market" should be interpreted to require only pragmatic, not idealized, efficiency because chapter 11 is a pragmatic, not idealized, context;

2) to the extent the phrase is to be given a technical meaning, it likely means "informational efficiency", i.e., that the financial market is one in which prices adjust rapidly to changes in information about the risk and reward embedded in the financial transaction, nothing more;

3) it is vital to recognize that risk preferences must be accounted for in assessing a financial market’s efficiency;

4) in an efficient market, everyone is a price taker and therefore no participant is privileged to impose a non-market price on his, her or its counterparty; and

5) in the context of financial markets, if no single investor’s judgments about the price-information relationship can be expected to systematically outperform the rest of the market over the long term, then it is unlikely single bankruptcy judges should be expected to do better than the market in putting a price on credit risk.

[1] The doctrine has been questioned for various reasons outside the scope of this article.  In the current term, the Supreme Court has granted cert in Halliburton Co. v. Erica P. John Fund, Inc., which, as this Harvard Law School blog post explains, may become a vehicle to overrule Basic Inc and throw the "fraud on the market" theory out of securities law.

[2]  In fact, the original insight into this feature of financial markets came from the Ph.D thesis of a French  mathematician Louis Bachelier, "Theory of Speculation" in 1900, that went unnoticed for decades, perhaps due to the impact of two wars on the French economy.

[3] A further concern that courts should keep in mind in evaluating approaches to cram-down issues is whether adjudication in a government forum of the testimony of experts is a superior mechanism to establish an extrinsic standard of what is a correct value for a security.   I think it is safe to say that in the history of the last century of judicial review of economic regulation, courts have evolved a considerable reluctance to become the forum for setting prices for economic actors to pay in the future.

[4]  This recent paper by Robert Jarrow and Martin Larsson claims to solve (i.e., eliminate) the "joint hypothesis" conundrum although I confess its math is beyond me.