Fraud-on-the-market theory is the idea that, since stock prices incorporate material information, material fraudulent statements will affect stock prices. The theory is most often invoked in class action cases alleging Rule 10b-5 securities fraud actions. In Basic v. Levinson, 485 U.S. 224 (1988), the Supreme Court adopted the theory to allow a class of plaintiffs to proceed in a Rule 10b-5 action. The Court recognized that requiring each individual plaintiff to prove direct reliance on the defendant’s alleged misrepresentation would create an unrealistic evidentiary burden. So, the Court allowed the plaintiffs to plead a Rule 10b-5 cause of action if they could show that the defendant’s alleged misrepresentations were material and publicly known, that the stock traded in an efficient market, and that the plaintiff traded in the defendant’s stock during that time. The Court justified that their adoption of the fraud-on-the-market theory by reasoning that investor who trades in public markets relies on the integrity of that price, and “because most publicly available information is reflected in market price, an investor's reliance on any public material misrepresentations may be presumed for purposes of a Rule 10b-5 action.”
[Last updated in February of 2022 by the Wex Definitions Team]