Securities laws and their fictions

During the early days of the Roosevelt New Deal era, Congress enacted two landmark statutes aimed at the regulation of securities, the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act was intended to ‘provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes’.Footnote ⁵ The 1934 Act similarly sought ‘to provide for the regulation of securities exchanges and of over-the-counter markets operating in interstate and foreign commerce and through the mails, to prevent inequitable and unfair practices on such exchanges and markets, and for other purposes’ (p. 728). To this day, Section 10 of the 1934 Act makes it

In 1942, acting under the authority granted to it by §10(b) of the 1934 Act, the Securities and Exchange Commission promulgated Rule 10b-5, which provides that:

As the Supreme Court noted in Blue Chip Stamps v. Manor Drug Stores, Section 10(b) does not expressly provide a civil remedy for its violation, nor does its legislative history indicate that Congress considered the issue of private suits under it (p. 729). Similarly, that Court also registered ‘the contrast between the provisions of Rule 10b-5 and the numerous carefully drawn express civil remedies provided in the Acts of both 1933 and 1934’.Footnote ⁶ So, looking solely at the text of the statute and the rule, one would conclude that there is no private right of action under either. Nonetheless, the Court acknowledged its previous confirmation ‘with virtually no discussion … that such a cause of action did exist’ (p. 730). Thus, I would submit that the whole area of private securities litigation has – right down to its roots – more than a whiff of fiction about it. By this I mean only that a court offering essentially no reason for ascribing an unstated intent to the legislature is indulging in a fiction.Footnote ⁷ But this particular indulgence is not our primary object of study here, although it of course looms in the background.

The Supreme Court has repeatedly held that ‘the elements of a private securities fraud claim based on violations of §10(b) and Rule 10b-5 are: (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.’Footnote ⁸ One of these elements – the fourth, reliance – causes a particular problem in private litigation because it stands as a potential obstacle to proceeding on behalf of all defrauded purchasers or sellers of the subject security in a single case (rather than on a plaintiff-by-plaintiff basis). Class actions gain their legitimacy from principles of judicial economy and efficiency, so a class action that doesn't promote economy and efficiency is by definition anathema. These principles animate Rule 23 of the Federal Rules of Civil Procedure,Footnote ⁹ which is loaded with standards that provide at least some guidance as to the desired characteristics for all class actions. Specifically, a court may not certify a class unless it finds that the prerequisites set out in Federal Rule of Civil Procedure 23(a) and at least one subsection of Rule 23(b) have been met.Footnote ¹⁰ The requirements of Rule 23(a) are commonly referred to as numerosity, commonality, typicality and adequacy. The requirements of 23(b) are not so easily captured in shorthand, but our discussion will be confined to (b)(3), which permits a class action if ‘the court finds that the questions of law or fact common to the members of the class predominate over any questions affecting only individual members, and that a class action is superior to other available methods for the fair and efficient adjudication of the controversy’.Footnote ¹¹

This requirement that common issues ‘predominate’ over individual issues is the sticking point because ‘[r]equiring proof of individualized reliance from each member of the proposed plaintiff class effectively would [prevent named plaintiffs] from proceeding with a class action, since individual issues then would … overwhelm[] the common ones’.Footnote ¹² How then to bridge this gap between the substantive requirement of proof of reliance and the procedural requirement of predominance? Cast in Fuller's terms, how is a court in this situation ‘to escape the consequences of an existing, specific rule of law’ without simply ignoring it?

Basic, Inc. and its economic fiction

In Basic, Inc. v. Levinson, the US Supreme Court faced this very problem – and solved it with a fiction. The case was based on allegations that Basic had lied three times in denying that it was conducting merger negotiations with a potential suitor, a suitor with which it ultimately struck a deal. The Court found that this situation ‘required resolution of several common questions of law and fact concerning the falsity or misleading nature of the three public statements made by Basic, the presence or absence of scienter, and the materiality of the misrepresentations, if any. In their amended complaint, the named plaintiffs alleged that, in reliance on Basic's statements, they sold their shares of Basic stock in the depressed market created by [defendants].’ As noted above, requiring proof of individualised reliance from each member of the proposed plaintiff class effectively would have prevented respondents from proceeding with a class action, since individual issues then would have swamped the common ones. To slip this knot, the Supreme Court invoked the fraud-on-the-market theory, which it described thusly:

In adopting the theory, the Supreme Court tacitly agreed with the District Court, which had ‘found that the presumption of reliance created by the fraud-on-the-market theory provided “a practical resolution to the problem of balancing the substantive requirement of proof of reliance in securities cases against the procedural requisites of [Federal Rule of Civil Procedure] 23”’. Interestingly, though, the Court seemed to hint that the theory might have no solid foundation: ‘Our task, of course, is not to assess the general validity of the theory …’ (Basic, p. 242).

Ultimately, the Court grounded its holding on the argument that modern fraud is different from historical fraud and that, consequently, the concepts of reliance and causation must change as well: ‘The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5's reliance requirement must encompass these differences’ (Basic, pp. 243–44). And how best to do this? By deeming the ‘market’ the ‘agent’ of the investor:

With the stage thus dressed, the Court set out to justify its resort to this construct. First, it catalogued the salutary uses of presumptions in law: ‘Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one reason or another, is rendered difficult’ (Basic, p. 245). Fuller would probably concede this point, but in his estimation, a ‘conclusive presumption attributes to the facts “an arbitrary effect beyond their natural tendency to produce belief.” It “attaches to any given possibility a degree of certainty to which it normally has no right. It knowingly gives an insufficient proof the value of a sufficient one”’ (Fuller, Reference Fuller1930–31, p. 394). A conclusive presumption is thus fictional, even though its application in any given case may square with truth. With respect to rebuttable presumptions, Fuller observes that ‘[s]ome rebuttable presumptions have, in the course of time, gathered about them rules declaring what is sufficient to overcome them. So soon as you have begun to limit and classify those things which will rebut a presumption you are importing into the facts “an arbitrary effect” beyond their natural tendency to produce belief.’ Accordingly, then, ‘[n]o presumption can be wholly non-fictitious which is not “freely” rebuttable’.

In Basic, the Court identified ‘a presumption, created by the fraud-on-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of petitioners’ material misrepresentations that price had been fraudulently depressed’ (p. 245). As justification, the Court stated that ‘requiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, or if the misrepresentation had not been made, would place an unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an impersonal market’ (p. 245). But is this really so? Could not an individual plaintiff testify as to what he would or would not have done and let the jury determine the credibility of that testimony? The answer is ‘of course’, but it would be unwieldy (probably impossible) to march every purchaser or seller into the witness box to tell his or her story.

The Court attempted to buttress this justification with appeals to Congressional policy and intent, as well as ‘common sense and probability’, including ‘recent empirical studies [that] have tended to confirm Congress’ premise that the market price of shares traded on well developed markets reflects all publicly available information, and, hence, any material misrepresentations. It has been noted that “it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?”' (p. 247).

With respect to rebuttal, the Court held that ‘[a]ny showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff or his decision to trade at a fair market price will be sufficient to rebut the presumption of reliance’ (Basic, p. 248). It listed three ‘examples’, which included ‘market makers’ who knew the truth, news leaking into the market, and plaintiffs who disbelieved Basic's false statements but traded for other reasons. As anticipated in Fuller's argument, Basic's rebuttable presumption of reliance soon hardened into something close to a conclusive presumption: fifteen years on, no defendant had successfully rebutted the presumption, and no court had allowed a defendant to invoke anything other than the three defences enumerated in Basic (Weiss and Beckerman, Reference Weiss and Beckerman1995, p. 2077 n. 128). But what of this notion of ‘market efficiency’ upon which the presumption of reliance depends?

When the Court, as quoted above, stated that ‘in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business’, it was wading into an economic swamp many decades in the making. Beginning in the late nineteenth century (seeds can be found even farther back in thinkers as diverse as Thomas Aquinas and Adam Smith), stock market gurus postulated that the value assigned to corporate shares in an open market reflects all information available about them (Fox, Reference Fox2009, p. xiii). This mindset soon crystallised into a theory, the rational market theory, which built from the observation that stock prices move randomly (referred to in finance literature as the ‘random walk’), to the claim that one cannot predict stock prices based on public information, and on to the conclusion that stock prices are fundamentally correct (p. xiv). As subsequent research has shown, though, these premises are not exactly right and the conclusion is in any event overstated.

A random walk through economic history

The drive to rationalise markets is probably just an instantiation of the larger drive prevalent in the nineteenth and twentieth centuries to make all the humanities and social sciences more ‘scientific’. There is good evidence that the early proponents of the rational market theory (and its more legally significant adjunct, the ‘efficient-market hypothesis’) saw it as a construct – a model – not a complete description of the economic universe. In a landmark 1953 essay, Milton Friedman made a nod in this direction:

What Friedman is getting at here is the dissatisfaction that comes with purely mathematical descriptions of observed phenomena. This is why scientists build physical models to conceptualise the abstract and thereby offer a surface against which to sharpen their insights. Of course a model is only a representation of reality, but, for scientists, ‘a good model is a successful compromise between simplicity and accuracy’ (Brescia, Arents, Meisclich and Turk, Reference Brescia, Arents, Meisclich and Turk1975 p. 17). Accordingly, both pure and applied scientists build models that ignore troublesome, yet marginal, physical realities. Take, for example, the concept of an ‘ideal gas’, which consists of molecules having mass and velocity, but no volume, and showing no attractive or repulsive forces among themselves or with other matter.Footnote ¹⁵ The ideal gas disperses when unconfined and bounces off the walls of a container with no loss of energy. Despite these departures from reality, the ideal gas model pretty well describes the behaviour of many common gases at ordinary temperatures. Then too, Newtonian models – though at odds with relativity theory at high speeds and quantum mechanics at very small sizes – are generally good enough to keep planes in the air and buildings standing tall. In short, they're good enough for the workaday world.

In the same way, the rational-market hypothesis has had many salutary uses, including as the inspiration for index funds and the development of risk-management tools. So where did it go wrong? The answer is neither simple nor without qualification, but I would lay down three intersecting threads worth following. First, some economists became so enamoured with mathematics and game theory (facilitated by massive advances in computing power) that they gave short shrift to the realities of human behaviour (Morgan, Reference Morgan, Creager, Lumbeck and Norton Wise2007, p. 165). For example, Friedman (along with statistician Jimmie Savage) proposed that John von Neuman and Oskar Morgenstern's mathematics-based utility theory could be used as a way to describe how people in reality make economic decisions: ‘individuals behave as if they calculated and compared expected utility and as if they knew the odds’ (quoted in Fox, Reference Fox2009, p. 75). Friedman famously justified this position with an analogy: billiards players act as if they know the underlying laws of physics. But, as with all tropes (we should regard ‘as-if’ as signalling the presence of a fiction), the analogy's usefulness must be limited by reality: e.g. the analogy cannot be literally true (or an expert billiard player would never miss a carom and would therefore always run out on points) (Vromen, Reference Vromen and Maki2009, p. 262). The point here is that mathematics-inspired models can be useful as predictors, but they cannot be counted on to perform flawlessly.

Second, there was no agreement as to what was meant by the idea of market ‘efficiency’. Three candidates emerged in a taxonomy proposed by Eugene Fama. ‘Weak’ efficiency implies only that one cannot beat the market using data on how the market has moved in the past. ‘Semi-strong’ efficiency means that one cannot beat the market using public information. (This is the version underpinning the Basic Court's holding.) ‘Strong’ efficiency describes an ideal market in which one cannot beat it even with access to private information (Fox, Reference Fox2009, p. 101). But by the late 1960s, some evidence began to appear that even weak-form market efficiency was not a given and that strong-form efficiency could not be true because there would be no incentive to develop proprietary information, a condition plainly contrary to fact.

Finally, ‘behavioural’ economists began to ask questions concerning how people actually make decisions in the face of uncertainty. What scholars like Daniel Kahneman and Amos Tversky found is that people are more heavily invested in the present than in the future (so that they are more frightened by the prospect of a loss today than they are elated by the prospect of a gain tomorrow) and that they evaluate probabilities at the margins different from those in between (Fox, Reference Fox2009, p. 183). And investigators following in this wake learned that people who chose to play the market traded too much, chased stocks that were performing well, and made less money than if they had invested in index funds (Fox, Reference Fox2009, p. 292; Erdlen, Reference Erdlen2008, p. 891; Ribstein, Reference Ribstein2006, p. 139–41). In other words, they behaved irrationally and inefficiently.

None of this is to suggest that the efficient-market hypothesis is useless or flat-out wrong.Footnote ¹⁶ But it is not the only valuable description of how markets work, and experts in the field have not accepted it as a fundamental in the way that would make it anything like a scientific fact. Indeed, after the financial collapse of 2008, the shortcomings of modern economics and finance were starkly revealed. As Princeton economist Paul Krugman opined in the depths of the recession, ‘The economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth’ (quoted in Fox, Reference Fox2009, p. 325). Put in our terms, they resorted to a fiction.

Fiction at the crossroads of law and economics

Against this background, as many commentators have noted, the Basic Court's detour into an economic morass was not inevitable (Langevoort, Reference Langevoort2009, pp. 157–58). It could have, for instance, held that reliance is not an element of a 10b-5 claim – i.e. causation is key and reliance is but one way to demonstrate causation.Footnote ¹⁷ That is the tack that the Court has taken with respect to at least some other statutory-fraud claims (like civil RICO).Footnote ¹⁸ Or it could have adopted an outright fiction and held that a purchaser or seller of a registered security is ‘deemed’ to have relied on an issuer's statements. But the Court did not, choosing instead to cloak a fictional kernel within a presumptive shell. The fiction here is that its version of the fraud-on-the-market theory pivots on the Court's belief that the efficient-market hypothesis not only reflects reality but that there was general agreement at the time that this was so. But as we just noted, and as Justice White noted in dissent, the majority's insistence that purchasers and sellers rely on the ‘integrity’ of market prices as a reflection of ‘value’ was at odds with both some prior case-law and some then-current economic studies (Basic, pp. 255–56).Footnote ¹⁹

At the end of the day, the Court created what many have considered a ‘muddle’, and its ‘obfuscation about the role of efficiency sent the [lower] courts off on a long journey without a particularly good compass’ (Langevoort, Reference Langevoort2009, p. 167). So why did the Court base its holding on a theory that was undeveloped, untested and at least partially fictive? I would offer two answers, one pragmatic, the other rhetorical. The pragmatic answer, as I already suggested, is that the efficient-market hypothesis solved a procedural problem: ‘Without the … hypothesis, there appeared to be a loophole in using the class action remedy for securities fraud’ because defendants could credibly argue that individual issues of reliance would require separate trials on a class member by class member basis (Dunbar and Heller, Reference Dunbar and Heller2006, p. 457). And this would defeat one of the animating forces behind the class-action device – namely, that the most compelling reason for a class action is the ‘negative value’ suit (i.e. a suit in which the damages for each plaintiff are so small that no reasonable person would bother to sue).Footnote ²⁰ As a consequence, in the case of a widely held security, a fraud that causes a relatively small injury on an individual basis – yet massive in the aggregate – could go unremedied and thereby thwart Section 10b. So the Court made a policy decision to shore up the class device with an economic theory that came with an associated cost to the legal rules involved. Thus, ‘Basic cannot be understood except by appreciating that the Court's response is far more a lesson in civil procedure than financial economics’ (Langevoort, Reference Langevoort2009, p. 158).

As a matter of rhetoric, Justice White was probably on to something when he posited that what the majority found alluring was that it could hide behind a shield of ‘scientific’ authenticity: ‘For while the economists’ theories which underpin the fraud-on-the-market presumption may have the appeal of mathematical exactitude and scientific certainty, they are – in the end – nothing more than theories which may or may not prove accurate upon further consideration' (Basic, p. 253). His central point here is that the majority was wrapping itself in a scientific cloak for a rhetorical reason – namely, to borrow the authority of science and thereby give strength to its own. (After all, the methods of science are offered as objective and neutral, cardinal virtues of any system of justice.)

Fuller might have branded this move a ‘creative’ fiction either (1) born of ‘the motive of policy’, which may uncharitably be described as a deceit contrived to disguise a usurpation of legislative authority or, more generously, as an obscurity ‘serv[ing] to create the impression that the change is no greater than that involved in the ordinary case’; or (2) born of the ‘motive of convenience’, ‘which brings the reform within the linguistic cover of existing law’ (Fuller, Reference Fuller1930–31, pp. 519–20). In Basic, as we've already noted, the majority stressed that the complexities of the modern world compelled it to act (Basic, p. 244). In taking this turn, the Court confirmed Robert Ferguson's (Reference Ferguson1990, p. 213) observation that the various writing strategies that an appellate court employs tend to cohere in what he calls a ‘rhetoric of inevitability’. In any event, Justice White saw another ‘inevitability’: ‘Confusion and contradiction in court rulings are inevitable when traditional legal analysis is replaced with economic theorisation by the federal courts.’ His point was essentially twofold, both prudential and jurisdictional. First, ‘with no staff economists, no experts schooled in the “efficient market hypothesis,” no ability to test the validity of empirical market studies, [federal courts] are not well equipped to embrace novel constructions of a statute based on contemporary microeconomic theory’ (Basic, p. 253). Second, even if securities markets have undergone radical transformations because of technology and other advancements, Justice White

Law and the allure of science

Why the turn to science in Basic? The key may be found, I think, in law's claims to legitimacy, which hinge, at least in significant part, on what Gerald Postema has identified as ‘the objectivity of characteristic modes of reasoning and the normative judgments they produce’ (1991, p. 101) – namely, the popular belief that ‘scientific’ evidence is evidence of truth.Footnote ²¹ ‘The idea that scientific inquiry is objective is unquestionably among the ruling ideas of our epoch, and it represents science as not serving the interests of a particular class, but a purely general interest in the understanding of nature. Indeed, the idea of scientific objectivity has often been invoked on behalf of the claim that the attitude of modern science is “the only rational, universally valid” one’ (Railton, Reference Railton, Boyd and Trout1991, p. 763).Footnote ²² And, even in law, science has brought certainty to many questions that heretofore could only be answered with unreliable means and with an uncomfortable degree of inaccuracy.Footnote ²³ Think, for example, of the famous and comical paternity trial of Charlie Chaplin, who was found to be the father of Carol Ann Berry based on ‘what the butler said’ and what the child looked like, even though undisputed and impartial blood-typing evidence showed that Chaplin could not have been the father.Footnote ²⁴ Or, more recently, consider the dozens of individuals cleared by DNA evidence, even though they had been convicted years before with seemingly objective things like eye-witness testimony. In sum, objectivity-believers lodge their faith in the Enlightenment position that, as Peter Railton puts it, ‘objectivity follows automatically once we proceed rationally’” (p. 764). Not surprisingly, then, lawyers and judges often invoke concepts of objectivity in support of their arguments and judgments (Postema, Reference Postema and Leiter2001, p. 115).Footnote ²⁵

Now we may ask a narrower question: Why economics? Although few today would argue that law itself is a ‘science’ in the way that David Dudley Field and Christopher Columbus Langdell argued in the nineteenth century, standards of scientific objectivity as the gold standard still hold sway. Oliver Wendell Holmes was perhaps never more prescient than when he said in Reference Holmes1897 that ‘[f]or the rational study of the law the blackletter man may be the man of the present, but the man of the future is the man of statistics and the master of economics’. This fits hand-in-glove with Holmes's ‘predictive’ theory of law, which valorised above all tools that would allow legal observers to predict how judges would rule in particular cases. Science, of course, offers an attractive model for the very reason that it has shown itself adept at explaining (at least in controlled conditions and across a limited range of inquiry) what happened in the past and what is likely to happen in the future. But it remains true that economics has far fewer ‘laws’ at its disposal than do the hard sciences and that scientists do not use hypotheses to generate ‘facts’, even though a hypothesis is often a useful way of positing what may prove to be the case once experimental techniques catch up (e.g. as I am writing this, maybe the existence of the Higgs boson has just been confirmed). But it seems to me that that when the law is using a hypothesis to settle a fact, that may be one indication that we are in the presence of a fiction.

At any rate, Holmes's anticipation of the ultimate rise of economics in law has proven more or less true in many ways – e.g. the Law and Economics movement has proven influential inside both the academy and courthouses. I'm thinking here foremost of Judge Richard Posner's reflections on the subject; his thoughts are of special importance because he was an early and certainly the most visible proponent of economic legal analysis.Footnote ²⁶ Plainly, Posner once hoped that economics held the interdisciplinary key that would unlock the secret to a perfectly functioning legal system (and explain the breakdowns in less than perfectly functioning legal systems). Thus, in 1975, he was able to opine that an

More recently, however, Posner has retreated from the notion of an all-embracing theory of law formed by yoking the precepts of a unified normative system (like utilitarianism) to the teachings of economics: ‘It has been many years since I flirted with such an approach’ (Reference Posner2003, p. 78).Footnote ²⁷

But that does not mean that economics does not inform legal analysis in deep and significant ways. For good or ill, economic concepts have swamped all others in my primary practice area (anti-trust). In most federal courts, an anti-trust plaintiff cannot state a claim in most types of case brought under the Sherman Act unless he can plead – in his initial complaint – that competition has been injured in a market defined in precise economic terms.Footnote ²⁸ And this is so no matter how ruthlessly anti-competitive the conduct at issue is alleged to be. As a consequence, it is impossible to practise, teach or write about anti-trust law without having a solid working knowledge of economic concepts, and the influence of economics does not end there. As Posner aptly observes, ‘[o]ne by-product of [law and economics] research that has considerable pedagogical importance has been the assignment of precise economic explanations to a number of fundamental legal concepts that had previously puzzled students and their professors, such as “assumption of risk,’ “pain and suffering” as a category of tort damages, contract damages for loss of expectation, plea bargaining, and the choice between damages and injunctive relief' (1975, p. 764).

None of this general ‘helpfulness’ means that economics avoids the pitfalls that are spread throughout all the social sciences. Indeed, over a century ago, John Ruskin decried the scientific pretensions of economics that – in his view – ignored the social realities of human experience:

Ruskin's point is that – even though it looks like science from a lay perspective because it brims with formulas and numbers – a maths-oriented mode of economic analysis will always be incomplete because it is aimed at social phenomena (as opposed to or in addition to natural phenomena). Ultimately, I can only register that whether economics is or is not a science is a debate that continues to this day and is one that I cannot hope to resolve here. But suffice it to say that even Posner early on conceded that ‘economics is an incomplete and imperfect science’ (1975, p. 772). Nonetheless, economics is alluring as a haven from contingency and powerful as a rhetorical mode. This is so, I think, because it can be made to appear as if it were not a human artefact, which it to say that it can be dressed up to appear objective, neutral and independent of human whim and bias. Here's how.

Legal and moral rules depend on human agency and social context (polygamy is illegal and wrong, except where it is not), whereas physical laws do not (the Second Law of Thermodynamics holds no matter what we think about it). Economics facially seems closer to the second category than the first (again, because it uses equations and such), and its predictive failures can be ascribed to its relative immaturity as a discipline or the fact that its inputs are currently too complex and numerous for us to process (which may not always be the case, of course). By some lights, then, this puts economics in the objective-and-neutral camp, which means that its results are superior to those generated by legal rules as interpreted and applied by human agents – because they are dictated by ‘real’ laws. In other words, economics can produce a fact of the matter in cases that would otherwise generate sharp divisions of opinion amongst legal observers (for example cases that present difficult or novel problems of classification or categorisation).