Lon Fuller (1930–1931, p. 516) once suggested that ‘a fiction is intended to escape the consequences of an existing, specific rule of law’.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)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.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.

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’.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’.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.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.’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,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.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’.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’.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?

In Basic, Inc. v. Levinson , the US Supreme Court faced this very problem—and solved it with a fiction.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)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)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.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.

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.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