Abstract
In the popular imagination, legal proceedings and their rules of law are thought of as paths to unalloyed truth. Both practitioners and scholars know this is often not the case because the law is, as are other domains, riddled with fictions. Indeed, the law sometimes borrows fictions from other domains to help it achieve results that would otherwise be unobtainable. One such place is securities law, in which courts in the United States have borrowed the concept of the ‘efficient market’ from economics to make fraud class actions possible. But that concept is—if not wholly—at least in good measure fictional.
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1 Introduction: Fiction as a Mode of Justice
Lon Fuller (1930–1931, p. 516) once suggested that ‘a fiction is intended to escape the consequences of an existing, specific rule of law’.Footnote 1 I think that’s right, but in this paper I hope to show that the matter can be even more complicated. Specifically, I posit that courts often resort to multiple, nested fictions in deciding cases and, moreover, that those fictions may themselves be the result of or required by pre-existing fictions. Put in more common parlance, one falsehood may father a thousand others. To explore this concept, I propose that we adopt a loose, literary definition of ‘fiction’ (i.e. under this construct, a fiction need not be wholly false)Footnote 2 to examine private securities litigation in the US. But first, let me take a brief detour born of personal experience, one that at some level of generality should resonate with most all practising lawyers.
Many years ago, when I practised law in Oklahoma, I was asked to represent an out-of-state defendant in a lawsuit.Footnote 3 He had never been to Oklahoma, other than to have testified several years earlier in an unrelated proceeding involving his divorce (setting aside minor things like being aboard a plane that stopped for fuel). Initially, he asked the family lawyer who had represented him in the divorce proceeding to again represent him and she agreed. At the time, there was a procedural rule that allowed an attorney to file an entry-of-appearance and thereby automatically receive a 20-day extension of time to respond to the petition. She filed such an appearance and also subsequently lodged an objection to the forum, based on the fact that the client had no contacts with Oklahoma sufficient to subject him to the jurisdiction of an Oklahoma court. But the entry-of-appearance rule clearly stated that its automatic-extension provision came at a price: a waiver of all objections to personal jurisdiction. The Court held a hearing and found that it had personal jurisdiction, both because of the waiver and because of the previous appearance in the divorce proceeding. At this point, the client decided to retain new counsel, and the file landed on my desk, presumably because I was a fairly new lawyer and the matter looked like the sort of sure loser that a more senior lawyer in our firm would not like to add to his résumé.
I duly investigated the toxic file, researched the substance, filed a motion to reconsider the decision with the district court, and set it for hearing. Back then, the district judges set aside Friday mornings for motion dockets (which resembled nothing so much as cattle calls), at which each judge would hear cases seriatim. Lawyer after lawyer would approach the bench when called and make his or her argument. I sat for 2 h and was finally called at the heel of the docket, which I took to mean that the judge planned to dress me down but spare me an audience. When my opponent and I arrived at the well, the judge looked at me and said, ‘So, you think I got this wrong?’ I shuffled uncomfortably and offered that ‘Your Honour didn’t have all the law before him when the matter was heard’. He peered down from the bench and said, ‘I’ve read your brief and the case you cite. It’s not that old and it clearly holds that appearance in a prior proceeding is jurisdictionally irrelevant. But what do I do with the appearance she entered?’ I had no good answer, and all I could really offer was a non sequitur: ‘Well, she tried to do the right thing by objecting to personal jurisdiction.’ The judge leaned back in his chair and thought for a few moments. Finally, he said, ‘I had no jurisdiction at the time she entered her appearance, so I’m going to grant your motion. Case dismissed. Please prepare an order in which you cite the cases in your brief.’
He was wrong as a matter of law, of course, and he knew it. The moment that the previous counsel signed her name to the entry of appearance, filed it, and thereby claimed the statutory extension of time, she waived her client’s—my client’s—right to object to personal jurisdiction. That was conclusive. But the judge was wise and saw that it was unfair to drag my client all the way from Florida to defend a claim that had no connection with Oklahoma, just because of a ministerial error committed by a lawyer unfamiliar with general civil practice. So he re-narrated the facts and thereby created an as-if fiction, one in which the jurisdictional objection was filed first and the entry of appearance was merely a motion for extension of time. On the way out of the courthouse, my opposing counsel shook my hand and said, ‘That was the right result’, which goes to show that a good fiction is one that everyone can enjoy. Now, on to matters of greater import.
2 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 4 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
unlawful for any person … (b) [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
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:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
- a.
To employ any device, scheme, or artifice to defraud,
- b.
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
- c.
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
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 5 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 6 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 7 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 8 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 9 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 10
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 11 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?
3 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.Footnote 12 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]’ (Basic, p. 242). 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:
The fraud-on-the-market theory is based on the hypothesis 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 … Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements…The causal connection between the defendants’ fraud and the plaintiffs’ purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. (Basic, p. 241)Footnote 13
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. 243–244). And how best to do this? By deeming the ‘market’ the ‘agent’ of the investor:
In face-to-face transactions, the inquiry into an investor’s reliance upon information is into the subjective pricing of that information by that investor. With the presence of a market, the market is interposed between seller and buyer and, ideally, transmits information to the investor in the processed form of a market price. Thus, the market is performing a substantial part of the valuation process performed by the investor in a face-to-face transaction. The market is acting as the unpaid agent of the investor, informing him that given all the information available to it, the value of the stock is worth the market price. (Basic, pp. 243–244)Footnote 14
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 1930–1931, 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.Footnote 15
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: 15 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 1995, 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 2009, 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.
4 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:
[T]he relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions. (Quoted in Fox 2009, p. 76)
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 et al. 1975, 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 16 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 2007, 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 2009, 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 2009, 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 2009, 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 2009, 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 2009, p. 292; Erdlen 2008, p. 891; Ribstein 2006, p. 139–141). 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 17 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 2009, p. 325). Put in our terms, they resorted to a fiction.
5 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 2009, pp. 157–158). 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 18 That is the tack that the Court has taken with respect to at least some other statutory-fraud claims (like civil RICO).Footnote 19 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. Two commentators have recently suggested that the Court actually did something stronger: viz., it created a new tort (Goldberg and Zipursky 2013). In a nutshell, their argument is that three types of recurring situations cause courts to resort to three corresponding types of presumptions . First, there are compliance-enhancing presumptions. These correct evidentiary asymmetries that—in the ordinary course of litigation—would result in false-negative outcomes for plaintiffs. Res ipsa loquitur is the paradigm here: if a plaintiff had to prove, for example, exactly how a barrel came to fall out a window, he would usually lose for want of precise evidence . The presumption corrects this asymmetry by allowing a jury—in the right kind of case—to infer carelessness (because a barrel doesn’t typically fall out of a window unless the person with custody of and control over it has been careless). Second, there are substance-morphing presumptions. These go beyond evidentiary issues and effectively change the substance of legal rules. The “tender years” doctrine is a good example: in many states, a child below a certain age is conclusively presumed not to have been careless. This is a policy choice that—as a practical matter—removes an entire category of cases from the reach of ordinary negligence law. Third, there are mixed presumptions. These serve both evidentiary and substance-modifying ends. Two-shooter negligence cases give rise to a classic example: a plaintiff is injured by one of two hunters and the evidence is equivocal as to both. This gives rise to the alternative liability doctrine, which is (1) compliance-enhancing because it avoids early dismissals for want of specific pleading or proof and incentivizes those with superior access to evidence (the defendants) to produce it and (2) substance-morphing because it creates a new rule of tort law in which a defendant may be liable to a plaintiff without proof that he caused the plaintiff’s injury.
If we examine the Basic presumption through the lens of this scheme, at least at first blush, it appears to be a simple compliance-enhancing maneuver: absent the presumption, class actions would fail and thereby impair an aspect of securities regulation because it would be impracticable to have every member of a class provide evidence that she relied on the contents of defendants’ misrepresentations. But, as Goldberg and Zipursky go on to opine, the Basic presumption doesn’t address that question: instead, it holds that every purchaser or seller relied that the market price was not distorted. This, they say, marks a change in the substantive rules, one constituting ‘a new statutory tort’ (1799).
We needn’t decide whether this new tort description is exactly right. For our purposes, it’s enough to note that the Court did not explicitly adopt this approach (or one of the others that I suggested above as possibilities) and chose 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 reflection of ‘value’ was at odds with both some prior case-law and some then-current economic studies (Basic, pp. 255–256).Footnote 20
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 2009, 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 2006, 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 21 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 2009, 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 1930–1931, pp. 519–520). 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 (1990, 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
…prefer[red] that such changes come from Congress in amending 10(b). The Congress, with its superior resources and expertise, is far better equipped than the federal courts for the task of determining how modern economic theory and global financial markets require that established legal notions of fraud be modified. In choosing to make these decisions itself, the Court, I fear, embarks on a course that it does not genuinely understand, giving rise to consequences it cannot foresee. (Basic, p. 254)
6 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’ (2001, p. 101)—namely, the popular belief that ‘scientific’ evidence is evidence of truth.Footnote 22 ‘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 1991, p. 763).Footnote 23 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 24 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 25 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 2001, p. 115).Footnote 26
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 1897 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 was 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 27 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
…important finding emerging from the recent law and economics research is that the legal system itself—its doctrines , procedures and institutions—has been strongly influenced by a concern (more often implicit than explicit) with promoting economic efficiency … The idea that the logic of the law is really economics is, of course, repulsive to many academic lawyers, who see in it an attempt by practitioners of an alien discipline to wrest their field from them. Yet the positive economic analysis of legal institutions is one of the most promising as well as most controversial branches of the new law and economics . It seeks to define and illuminate the basic character of the legal system, and it has made at least some progress toward that ambitious goal. (Posner 1975, pp. 763—764)
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’ (2003, p. 78).Footnote 28
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 cases 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 29 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:
Among the delusions which at different periods have possessed themselves of the minds of large masses of the human race, perhaps the most curious—certainly the least creditable—is the modern soi-disant science of political economy, based on the idea that an advantageous code of social action may be determined irrespectively of the influence of social affection. (1881, p. 17)
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).
7 Conclusion: Law, Narrative, Economics (and a Dollop of Irony)
What is at work here is probably nothing more than the human desire for coherence , to make sense of it all. Because humans process, store and retrieve information in narrative form, it is not all that surprising that we have created explanatory narratives to make sense of economic phenomena that we cannot directly or completely observe. And, as with many other instances of socially constructed narratives, ‘myth’ and ‘fiction’ are words that capture at least some of the underpinnings of our economic narratives. So just as our ancestors spun stories about Thor’s hammer or Apollo’s chariot to explain natural phenomena as diverse as the sound of thunder and the movement of the sun, we rely on the narratives of social science to bring sense to things like currency fluctuations and the gyrations of the stock market (Ruskin quipped that, ‘as in the instances of alchemy, astrology, witchcraft, and other such popular creeds, political economy has a plausible idea at the root of it’ (1881, p. 17)). At bottom, then, one way to explain the economic turn in law is to think of it as a double engraftment: the narrative of scientific progress engrafted onto economics followed by the engraftment of economics onto law itself. And as with all hybrids, we will have to see what fruit this new creation finally bears.
In any event, given the ascendancy of law-and-economics thought in the early 1980s, it is not surprising that it began to infect the way that lawyers and judges thought about securities markets. And it is even less surprising that the impetus for efficient-market thinking came from Judge Posner’s University of Chicago colleagues, specifically Daniel Fischel and Frank Easterbrook (who is now Posner’s colleague on the Seventh Circuit). But what is surprising is that, as Donald Langevoort demonstrates, the Basic Court essentially misinterpreted Fischel and Easterbrook’s work, which found reliance ‘trivial in the context of market efficiency’. Their approach requires causation only and their theory is focused on ‘assessing materiality and measuring damages’ (Langevoort 2009, p. 165). And in one of the law’s little ironies, their essentially conservative and scientific approach under which markets are efficient and hard to fool (so genuine fraud cases are rare)—‘staying close to the scientific method thus checks unnecessary litigation’—was hijacked in a way that led to an explosion of litigation (p. 189). In any event, ‘[d]oubts about the strength and pervasiveness of market efficiency are much greater today than they were in the mid-1980s’ (p. 175), and, accordingly, an inevitable backlash set it.
Although the Basic Court intended its question ‘Who would knowingly roll the dice in a crooked crap game?’ to be rhetorical, it turns out that the answer is ‘lots of people’.Footnote 30 This sort of uneasiness about the economic soundness of the fraud-on-the-market presumption, coupled with a widespread dismay at the number of post-Basic securities-fraud ‘strike suits’, led courts and Congress to take action. For example, some courts have found that particular securities do not trade on efficient markets (Mustokoff 2008, pp. 227–228) and almost all courts have declined to extend the Basic presumption to non-securities cases.Footnote 31 Congress, for its part, passed the Public Securities Litigation Reform Act in 1995, which—although leaving the fraud-on-the-market presumption intact sharply curtailed a range of abusive litigation practices.Footnote 32 And just last year, in Amgen, Inc. v. Connecticut Retirement Plans & Trust Funds,Footnote 33 four Supreme Court Justices called Basic into question and suggested that it was time to revisit its holding. Justice Alito went so far as to state that ‘reconsideration of the Basic presumption may be appropriate’ because ‘more recent evidence suggests that that the presumption may rest of a faulty economic premise.’ Even more recently, the Supreme Court granted a petition for writ of certiorari in Halliburton v. Erica P. John Fund; the petition requested the Court to overrule (or at least significantly modify the presumption of reliance endorsed by) Basic, so that specific issue is currently slated for decision.
Not unexpectedly, the petitioners in Halliburton have drawn the Court’s attention to the literature and arguments that we reviewed above. They do so in two ways: first, they object to the way that the Basic Court allowed an economic theory to infect the answer to a legal question; second, they maintain that the situational use of a fiction in the securities context has warped the otherwise consistent standards that the Court has devised for evaluating the propriety of class actions :
The Basic majority erred by substituting economic theory for law—and bad economic theory at that. In the years since Basic, scholars have roundly rejected its approach to market efficiency. Meanwhile, Basic’s legal framework has proven unworkable in the lower courts and inconsonant with this Court’s recent decisions. Relying on an acknowledged fiction, Basic allows certification of internally disparate classes that would not be tolerated outside of the securities-fraud context. As a judge-made rule that generates no societal reliance interests, Basic’s presumption is ripe for reconsideration.Footnote 34
The Halliburton respondent of course tells a different story, one gauged to fit within notions of common tradition and settled expectations: ‘[t]he fraud-on-the-market presumption, adopted by this Court in Basic, has been repeatedly endorsed by this Court, Congress, the SEC, and the DOJ and enjoys widespread support among economists.’Footnote 35 This argument tacitly posits that a fiction—once sufficiently institutionalized—becomes a fact and cannot be undone without doing violence to stare decisis and, thereby, the Rule of Law.
After these latest turns of the screw, we are left with a fiction that is still viable, but under a degree of assault that has probably—and fairly quickly!— put it on one of the two evolutionary paths that Fuller identified. Will it be rejected? Or will it be redefined? It is hard to say. But we can be certain that, as Fuller (1930–1931, p. 366) said more generally of fictions, we should continue to ‘take this skeleton in the family of the law … from its closet and examine[] [it] thoroughly. After that examination we may decide what we ought to do with it’. And that task is one that the US Supreme Court has set for itself in Halliburton.
Notes
- 1.
For the purposes of this paper, it may be helpful to keep in mind a particular type of fiction: viz. a fiction devised to circumvent a procedural difficulty (Del Mar, this volume, Chap. 11, pp. 240-1) (discussing Roscoe Pound’s theory positing that law’s growth comes via distinct modes, one of which is ‘fictions’).
- 2.
I have in mind things like historical or ‘true crime’ novels, which are classified as ‘fiction’ despite being more or less grounded in fact. For example, in 1959, Dick Hickock and Perry Smith murdered Herb Clutter and his family in rural western Kansas. That is a fact. Yet many incidents in Truman Capote’s 1966 telling of that story in In Cold Blood are pure fancy.
- 3.
Given the passage of time, some of what I am about to say may be fictional, though unintentionally so.
- 4.
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 727 (1975).
- 5.
See, e.g. §§ 11, 12, 15 of the 1933 Act, 15 U.S.C. §§ 77k, 77l, 77o; §§ 9, 16, 18, 20 of the 1934 Act, 15 U.S.C. §§ 78i, 78p, 78r, 78t. One might also note that both before and after passage of the primary securities acts, Congress has shown an ability clearly to articulate the existence of a private right of action. See, e.g., Section 4 of the Clayton Act, and Section 1964(c) of the RICO statute.
- 6.
Ultimately, the Court gave up all factual pretences to the issue: ‘Judicial interpretation and application, legislative acquiescence, and the passage of time have removed any doubt that a private cause of action exists for a violation of § 10(b) and Rule 10b-5, and constitutes an essential tool for enforcement of the 1934 Act’s requirements.’ Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).
- 7.
Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1317 (2011).
- 8.
Cf. Mace v. Van Ru Credit Corp., 109 F.3d 338, 344 (7th Cir. 1997) (‘policy at the very core of the class action mechanism’ aims to solve ‘the problem that small recoveries do not provide the incentive for any individual to bring a solo action…’) with Andrews v. AT&T, 95 F.3d 1014, 1025 (11th Cir. 1996) (although ‘Rule 23 is to be applied flexibly, the manageability problems [here] defeat the Rule’s underlying purposes and render these claims inappropriate for class treatment’).
- 9.
Amchem Prods., Inc. v. Windsor, 521 U.S. 591, 614 (1997).
- 10.
Fed. R. Civ. P. 23 (b) (3) (emphasis added).
- 11.
Basic, Inc. v. Levinson, 485 U.S. 224, 231 (1988).
- 12.
In fraud cases, reliance is the usual—though not the only—way of showing that a misrepresentation proximately caused a plaintiff harm. When considered this way, the Basic fiction that we’ll be discussing is just an instantiation of a common judicial move when a court is facing evidentiary gaps or procedural difficulties (see Lee, this volume, Chap. 12).
- 13.
The US Supreme Court fairly recently confirmed the ongoing viability of the theory and also held that—although a plaintiff must plead and prove loss causation (Dura Pharmaceuticals, Inc. v. Broudo, 125 S. Ct. 1627 (2005))—no proof of loss causation is required to invoke the fraud-on-the-market presumption for purposes of class certification. Erica P. John Fund, Inc. v. Halliburton, 131 S. Ct. 2179 (2011). But, as I note at the end of this paper, the Court has once again granted a petition for writ of certiorari in Halliburton, this time to consider overruling Basic.
- 14.
Here, the Court is relying on a lower-court decision, In re LTV Securities Litigation, 88 F.R.D. 134, 143 (N.D. Tex. 1980).
- 15.
Raymundo Gama (this volume, Chap. 16) suggests that one of the functional reasons for a court’s resort to a presumption is ‘to avoid a procedural impasse’ (p. 361).
- 16.
Thanks to Burkhard Schafer for reminding me of this example. Simon Stern (this volume, Chap. 8) elaborates on the parallels between ‘textbook’ scientific models and artificial legal concepts to conclude that the value of these approximations resides in their ability to ‘explain[] phenomena within [a] field’ (p. 162).
- 17.
- 18.
For a Benthamite, though, this would amount to trading one fiction for another because the concept of ‘causation’ is itself a fiction Quinn, this volume, Chap. 4, p. 72).
- 19.
See, e.g. Bridge v. Phoenix bond & Indemnity Co., 533 U.S. 639, 650–660 (2008).
- 20.
See also Dunbar and Heller (2006, p. 523): ‘While there were doubts about the theory at the time, and even the different measures of market efficiency were not necessarily clear, the efficient market hypothesis seemed to have been the right theory at the right time for the purposes that the Court was attempting to address’.
- 21.
See Castano v. American Tobacco Co., 84 F.3d 734 (5th Cir. 1996).
- 22.
For a discussion of these notions of objectivity and law and economics in the context of narrative theory, see Gordon (2011, pp. 160–164, 194–195).
- 23.
Of course, some have argued that science cannot rid itself of the human dimension through which it is practised and so bias inevitably creeps in. For a neat summary of this issue see, Grinnell (2008, pp. 10–18).
- 24.
For this reason (and others) legal language has for some time been under pressure to conform to—or at least accommodate—scientific vocabulary (Petroski, this volume, Chap. 7, p. 149).
- 25.
Berry v. Chaplin, 169 P.2d 442 (Cal. App. 1946).
- 26.
Postema cites Whitney v. California, 274 U.S. 357, 372 (1927) (Brandeis concurring) (we want our society to be one in which ‘deliberative forces prevail over the arbitrary’).
- 27.
Posner’s (1971, 1975) most influential work in the law and economics vein began to appear in the early 1970s. The seminal work in what we now think of as law-and-economics analysis traces to a decade earlier, especially with the work of (now Judge) Guido Calabresi and Ronald Coase; see Calabresi 1961; Coase 1960.
- 28.
Even more recently, Posner (2010, p. 278) has suggested that the current economic crisis has undermined the efficient-market hypothesis.
- 29.
See, e.g. Apani Southwest, Inc. v. Coca-Cola Enters., 300 F. 3d 620, 628 (5th Cir. 2002) (‘Where the plaintiff fails to define its proposed relevant market with reference to the rule of reasonable interchangeability and cross-elasticity of demand, or alleges a proposed relevant market that clearly does not encompass all interchangeable substitute products even when all factual inferences are granted in plaintiff’s favor, the relevant market is legally insufficient, and a motion to dismiss may be granted’).
- 30.
See Dunbar and Heller (2006, p. 521) (listing as reasons, among others, that even rational investors might trade without believing in the validity of the market price if (1) they are reacting to cash flows, (2) there are no close substitutes, (3) they believe that a bubble will continue, (4) they are herding because they weigh the decisions of others more than information about fundamentals, or (5) they use simple strategies like momentum trading).
- 31.
See, e.g., McLaughlin v. American Tobacco Co., 522 F.3d 215 (2nd Cir. 2008) (cigarette market); Sikes v. Teleline, Inc., 281 F.3d 1350 (11th Cir. 2002) (certain telephone services).
- 32.
See Oldham (2002), discussing, among other things, the legislative history of the PSLRA.
- 33.
133 S. Ct. 1184 (2013).
- 34.
Petition for a Writ of Certiorari, Halliburton v. Erica P. John Fund, No. 13–317 at 11.
- 35.
Brief in Opposition Halliburton v. Erica P. John Fund, No. 13–317 at 30.
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Acknowledgments
This chapter has its genesis in a paper presented at a seminar on ‘Legal Fictions’ at the IVR 2011. World Congress. Thanks to Maks Del Mar for organising the seminar and for many helpful suggestions along the way. A version of this chapter was previously published as ‘Fictitious Fraud: Economics and the Presumption of Reliance’ (2013) 4 International Journal of Law in Context 506–519.
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Gordon, R. (2015). Fictitious Fraud: Economics and the Presumption of Reliance. In: Del Mar, M., Twining, W. (eds) Legal Fictions in Theory and Practice. Law and Philosophy Library, vol 110. Springer, Cham. https://doi.org/10.1007/978-3-319-09232-4_18
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