April 1, 2010
Can an investor reasonably rely on a promise of a return of 4900% in two months?
On March 18, the SEC "charged a South Carolina-based attorney and a cohort with securities fraud for bilking investors in a high-yield investment scheme that promised rates of return as high as 4,900 percent in just two months."
Meanwhile, Prof. Bainbridge blogs on a recently filed case wherein the alleged culprit, "a self-described 'natural psychic, trained Remote Viewer, [and ] intuitive consultant,' was charged ... over his alleged role in a multi-million dollar offering fraud in which he touted his psychic ability to predict stock market movements."
These sorts of cases should pose problems both in terms of reasonable reliance and materiality, which turns on whether a reasonable investor would have considered the misstatement important. As Bainbridge opines: "The mere fact that some investors are idiots does not tell us anything about what the proverbial reasonable investor would have done in these circumstances. After all, as PT Barnum put it, there's a sucker born every minute."
At the same time, a comment to Bainbridge's post reads: "No rogue should enjoy his ill-gotten plunder for the simple reason that his victim is by chance a fool." This seems to express a reasonable sentiment. Can we find a middle ground?
I did a little digging around and found this further explication from a bankruptcy case, Sanford Institution for Sav. v. Gallo, 156 F.3d 71, 74 (1st Cir. 1998):
Title 11 U.S.C. § 523(a)(2)(A) bars from discharge in bankruptcy a debt for money … obtained by false pretenses, a false representation, or actual fraud. In Field v. Mans, the Supreme Court construed this provision to require the creditor to prove that its reliance on the misrepresentation was justified in order to avoid discharge. 516 U.S. at 61 …. The Court rejected the argument that the more demanding “reasonable reliance” standard applied. See id. at 70 … (citing and adopting Restatement (Second) of Torts § 545A, cmt. b, which states that plaintiff's conduct does not have to conform to “reasonable man standard”). The Court adopted the dominant common-law formulation of the elements of fraudulent misrepresentation as set forth in the Restatement (Second) of Torts §§ 537-45 and Prosser and Keeton on Torts § 108, at 750-52. In contrast to the reasonable reliance standard, in order to show justifiable reliance, the creditor need not prove that he acted consistent with ordinary prudence and care. “‘The design of the law is to protect the weak and credulous from the wiles and stratagems of the artful and cunning, as well as those whose vigilance and security enable them to protect themselves' and ‘no rogue should enjoy his ill-gotten plunder for the simple reason that his victim is by chance a fool.’” Prosser § 108, at 751 (citations omitted). The rationale for placing this relatively low burden on the victim of the misrepresentation is rooted in the common law rule that the victim's contributory negligence is not a defense to an intentional tort. See Restatement (Second) of Torts § 545A & cmt. a; Prosser § 108, at 750 …. In such circumstances, the equities weigh in favor of giving the benefit of the doubt to the victim, careless as it may have been, and even though it could have been more diligent and conducted an investigation.
While this all seems quite fair, the reasonable investor standard is in fact the one used under Rule 10b-5, and to date I am not aware of any exception made for cases like those set forth at the beginning of this post. Rather, the SEC and courts have seemingly simply ignored the glaring problem of reasonableness. Perhaps it would be better to craft an explicit exception.