A number of securities class actions have been filed since the outbreak of the COVID-19 pandemic, and more are expected. These class actions will include as a part of the class period the current COVID-19 crisis, which has seen some of the most extreme swings in U.S. stock market prices in the past twenty years. Thus far, most of these swings have been concentrated in March 2020. Indeed, the CBOE Market Volatility Index (VIX), commonly referred to as the “fear index,” which measures the thirty-day forward-looking volatility of the S&P 500, experienced a spike in March 2020 as severe as the one during the height of the financial crisis.

Historically, extreme stock price movements have led to regulatory measures such as automatic trading halts and/or restrictions on short-selling activity on exchanges. The SEC first implemented a rule for triggering an automatic market-wide “circuit breaker” to curb excessive selling in periods of market stress, following the 1987 “Black Monday” stock market crash. Before the COVID-19 pandemic, this market-wide circuit breaker was triggered only once, on October 27, 1997. By contrast, in March 2020 alone, this circuit breaker was triggered on four separate days. Within the past decade, the SEC has also implemented a number of additional mechanisms to automatically restrict certain trading and short-selling activity in specific stocks, and some of these restrictions are still enforced today.

Automatic trading halts and other trading restrictions were adopted in an attempt to mitigate excessive market volatility and to prevent potentially destabilizing short-selling activity. A number of academic studies have found that these restrictions can be effective in addressing some of the stated objectives but may have the unintended consequence of potentially hampering price discovery and thus, affecting market efficiency. This article explains how certain current trading restrictions work, documents their prevalence in the period of extreme market volatility in March 2020, and discusses the potential implications of these restrictions for analyzing market efficiency in securities litigation.

Types of automatic trading restrictions

Trading halts and other trading restrictions were put in place by regulators to curb certain trading and/or short-selling activity during periods of extreme stock price volatility.[1] In the current regulatory regime, some trading restrictions can halt trading automatically on entire exchanges while others affect trading in individual securities. Trading restrictions also vary in duration and the type of affected activity (i.e., whether short selling is involved). Described below are the market-wide and security-specific trading restrictions in place today.

Market-wide circuit breakers were adopted by the SEC following the crash of 1987.^[2] There are currently three levels of market-wide circuit breakers: Level 1 is triggered by a 7 percent decline in the S&P 500 from the prior day’s close, Level 2 is triggered by a 13 percent decline, and Level 3 is triggered by a 20 percent decline. Level 1 and 2 triggers result in fifteen-minute halts in trading if they occur before 3:25 PM. If the circuit breaker is triggered after 3:25 PM, trading continues for the rest of the day unless a Level 3 halt is reached. Level 3 halts will stop trading for the remainder of the day, no matter the time.^[3]

The Limit Up-Limit Down (LULD) rule was implemented to address extraordinary volatility in individual securities by preventing trades outside certain bounds.^[4] The SEC approved the rules guiding the LULD rule in 2012 for all national market system securities (“NMS securities”), except options.^[5]

The LULD mechanism replaced the single-stock circuit breaker mechanism[6] that was put in place in response to the “Flash Crash” of May 6, 2010.[7] Under the LULD mechanism, the market for a security enters a “limit state” if the national best bid hits the lower price band or the national best offer hits the upper price band. Price bands are set at a certain percentage level above and below the reference price, which is based on the average transaction price over the last five minutes.

The LULD trading pause is triggered if a security does not exit the limit state within fifteen seconds. The LULD trading pause is also triggered if a security enters a “straddle state,” which occurs when the national best bid is below the lower price band or the national best offer exceeds the upper price band. Once triggered, the trading pause remains in place for five minutes, after which the market reopens with an auction on the primary listing market.[8] If the reopening auction cannot be priced within the applicable auction price collars due to continuing market imbalances, a trading pause may continue beyond the initial five minutes.[9] The percentages applied to create the price bands differ depending on whether the security is Tier 1 or Tier 2.^[10] Tier 1 NMS securities are those included in the S&P 500, Russell 1000, and select exchange-traded products. Tier 2 NMS securities are all other NMS securities, except options.^[11]

Automatic short-sale restrictions were implemented by the SEC in early 2010 under Rule 201, also known as the “alternative uptick rule” (hereinafter “SEC Rule 201 short-sale restrictions”).[12] The SEC implemented this rule in an attempt to “promote market stability and preserve investor confidence”[13] as well as to “address erosion of investor confidence in [its] markets generally.”^[14] The SEC Rule 201 restricts the price at which a security may be sold short when its price decreases by 10 percent or more from the previous day’s closing price.^[15] Specifically, once triggered, the rule prevents the execution or display of short-sale orders at a price that is below or equal to the current national best bid.^[16] If triggered, the SEC Rule 201 short-sale restriction on the stock remains effective for the remainder of the day and the following day.^[17] The SEC Rule 201 applies to all NMS securities, except options.[18]

Triggers of automatic trading restrictions during the COVID-19 crisis

Due to the extraordinary level of market volatility during the COVID-19 crisis, specifically in March 2020, Level 1 market-wide circuit breakers have been triggered four times since March 2020, on March 9, March 12, March 16, and March 18.[19] To put this into context, as noted above, the last instance of a market-wide circuit breaker being triggered was on October 27, 1997.[20]

In addition, since March 2020, there has been a large increase in the number of LULD trading pauses and SEC Rule 201 short-sale restrictions triggered. During March alone, over 28 percent of stocks listed on the NYSE or Nasdaq were subject to security-specific LULD trading pauses as compared to 1.4 percent of listed stocks subject to such restrictions in January 2020.[21] During the same time, in March 2020, almost 90 percent of stocks listed on NYSE or Nasdaq were subject to SEC Rule 201 short-sale restrictions as compared to 16 percent of listed stocks subject to such restrictions in January 2020.

Similarly, the number of stocks subject to LULD trading pauses or SEC Rule 201 short-sale restrictions on a typical trading day increased substantially from January to March 2020. On a typical trading day in March 2020, 5.1 percent of stocks listed on the NYSE or Nasdaq were subject to LULD trading pauses, as compared to 0.1 percent in January 2020. On a typical trading day in March 2020, more than 38 percent of stocks listed on the NYSE or Nasdaq, on average, were subject to SEC Rule 201 short-sale restrictions as compared to 2.9 percent, on average, in January 2020.

Stocks subject to LULD trading pauses or SEC Rule 201 short-sale restrictions tended to be subject to such restrictions over longer periods of time in March 2020 as compared to January 2020. Conditional on being subject to at least one LULD trading pause in a given month, a stock was subject to such restriction on four days, on average, in March 2020, as compared to two days, on average, in January 2020. Conditional on being subject to at least one SEC Rule 201 short-sale restriction in a given month, a stock was subject to such restriction on eleven days, on average, in March 2020, as compared to four days, on average, in January 2020.

Trading restrictions and assessment of market efficiency

Under the U.S. Supreme Court ruling in Basic v. Levinson,[22] plaintiffs can invoke the fraud-on-the-market presumption of class-wide reliance if they demonstrate that the stock traded in an efficient market.

In an efficient market, security prices fully and rapidly reflect public information.[23] The underlying rationale for why prices in an efficient market fully reflect all publicly available information is that competition among investors and the ability to trade on public information would quickly eliminate opportunities to profit on such information.

In the past, courts have ruled that the fraud-on-the-market presumption of reliance requires that the stock traded in an efficient market throughout the entire class period.[24] Defendants have challenged plaintiffs’ presumption of market efficiency on the grounds of trading impediments that can affect market efficiency. One notable example is IBEW Local 90 Pension Fund et al. v. Deutsche Bank AG et al., where defendants successfully argued that plaintiffs failed to establish market efficiency for Deutsche Bank’s Global Registered Shares (GRS) partly by ignoring short-sale restrictions and other trading disruptions that affected the markets at the height of the financial crisis.^[25] The court denied class certification on the basis that plaintiffs failed to demonstrate that the market for the at-issue securities was efficient, noting that “an analysis of market efficiency that ignores…the fact that the Class Period encompasses an extraordinary financial crisis directly impacting trading conditions and the firm at issue, is fatally flawed.”^[26] Similarly, in PolyMedica (on remand) the district court denied class certification on the basis of plaintiffs’ failure to demonstrate market efficiency and noted that “[defendant’s] evidence suggests significant barriers to short selling, a mechanism which is…relevant to information efficiency.”[27]

Given the extreme level of market distress observed in March 2020, and the frequency of automatic trading restrictions being triggered, it is worth assessing whether similar issues could arise when experts try to establish market efficiency for stocks affected by these trading restrictions. Specifically, for stocks subject to trading interruptions and constraints on short-sale activity, economic evidence may be needed to demonstrate that such restrictions did not prevent the stock price from quickly and fully impounding new value-relevant information. In particular, if trading interruptions or short-sale restrictions occurred during the class period, additional analysis may be needed to assess whether these restrictions affected price discovery for the purposes of establishing reliance.[28]

Academic research shows that trading restrictions can hamper price discovery and thus, potentially prevent the stock prices from quickly and fully impounding new value-relevant information.[29] For instance, studies show that trading halts may have an undesirable effect on market volatility and liquidity.[30] While the occurrence of trading halts may create a chance for the market to change course from its extreme movement,[31] it may inadvertently cause traders to concentrate their trading prior to the expected triggering of the trading halt, causing additional price volatility and increasing bid-ask spreads, both in anticipation of and after the halt.[32] This empirical observation is consistent with the notion of the “magnet effect.”[33] The academic literature has used this term to describe the mechanism where traders of the stock whose price is close to the circuit breaker limit may concentrate their trades prior to the expected triggering of the circuit breaker. This may in turn increase price variability and the probability of the price crossing the circuit breaker bound.[34]

Similarly, academic research has also examined constraints on short selling and whether these can potentially impact price discovery and market efficiency.[35] The 2008 financial crisis provided a particularly effective setting for examining short-sale constraints, because the SEC instituted a broad ban on short selling in stocks of financial companies that lasted from September 18, 2008, to October 8, 2008,[36] and European countries took more far-reaching actions. A number of articles have empirically studied the effect of short-sale bans on publicly traded stocks, and have shown evidence of short-sale constraints leading to distortions in stock prices and preventing information from being fully and quickly reflected in stock prices, thus impacting market efficiency.[37] At the same time, academic research has also found evidence of short-selling behavior exacerbating downward price movements in periods of extreme market stress, showing a potential need for these measures.[38]

Finally, as discussed above, automatic restrictions on short-selling activity under the SEC Rule 201 have become much more prevalent since the COVID-19 crisis began in March 2020. A recent academic study examining the impact of short-sale restrictions under the SEC Rule 201 suggests that “short-sale restrictions harm the price discovery process and lead to a reduction in market efficiency.”[39] Parties may need to consider this evidence in the context of market efficiency for the affected stocks.

Conclusion

The views expressed in this article are solely those of the authors, who are responsible for the content, and do not necessarily represent the views of Cornerstone Research. This article was first published in Law360.