Chapter 10

• Jurisdiction: United States

Chapter 10 Section 10(b) of the Exchange Act and Rule 10b-5, Part Two

Reliance or Transaction Causation

In order to understand the genesis of the requirement for "transaction causation" or "reliance" in cases alleging violation of Section 10(b), it is worth recalling three cases in which the Supreme Court, either directly or by implication, held that Section 10(b) came from the common law of deceit. In Ernst & Ernst v. Hochfelder, 425 US. 185 (1976), the Supreme Court held that because it used the words "manipulative or deceptive device or contrivance" the statute must be read to proscribe only intentional or knowing misconduct. That being the case, said Justice Lewis Powell for the majority, the statute must require proof of scienter for a violation. Similarly, in Basic v. Levinson, 485 U.S. 224 (1988), the Supreme Court held that the common law of deceit required "reliance" and since most cases under Section 10(b) did not include face-to-face transactions in which reliance could easily be proved, the court created a "presumption" of reliance in cases involving "fraud on the market." Finally, in Dura Pharmaceuticals v. Broudo, 544 U.S. 336 (2005), the Supreme Court, once again recalling the common law tort of deceit, required that "economic loss" and "loss causation" be proven as elements of a Section 10(b) violation.¹

Accordingly, "transaction causation" or "reliance" is a required element of proof in private Section 10(b) cases unless the "misrepresentation" is a pure omission, which obviously cannot be "relied on" since it is not apparent. To prevail "[a] plaintiff must allege that but for the fraudulent statement or omission, the plaintiff would not have entered into the transaction." Suez Equity Investors v. Toronto Dominion Bank, 250 F.3d 87 (2d Cir. 2001). The "but for" test was repeated in Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336 (2005).²

As noted, the requirement of reliance is an entirely judicial-made requirement; it does not appear in any statute or rule. Even though the Supreme Court did not say explicitly that this requirement of proof came from the common law tort of deceit, there was an exchange of correspondence about reliance between Supreme Court Justice Harry Blackmun and Justice William Brennan referring to the common law fraud antecedent of securities fraud and the three cases cited above certainly reflect that lineage, even though later, in Zandford, 535 U.S. 813 (2002), and Stoneridge v. Scientific Atlanta, 552 U.S. 148 (2008), the Supreme Court stated that Section 10(b) did not "incorporate common law fraud into federal law." It is hard to reconcile these statements but there is no need to do so, since the requirement for proof of transaction causation is clear.

Stoneridge holds that transaction causation is related to the "in connection with" requirement. Is it? Is this part of the confusion between the two concepts, or is the Supreme Court correct? If so, how do we explain the fact that when the SEC is the plaintiff, there is no requirement to prove transaction causation?³ I believe that a better reading of Stoneridge is that the Supreme Court overstated somewhat the relationship between the two concepts. They clearly are related if the result of the reliance is a purchase or sale, but in common law deceit, without the reliance there would be no fraud. In a fraud-on-the-market case where there is no face-to-face transaction, the causal link between the fraud and the decision to buy or sell is attenuated at best and non-existent at worst. Most people buy stock because they think that it is under-valued by the market, not because it is correctly priced.

Nevertheless, "transaction causation refers to the causal link between the defendant's misconduct and the plaintiff's decision to buy or sell securities. It is established simply by showing that, but for the claimed misrepresentations or omissions, the plaintiff would not have entered into the detrimental securities transactions." Emergent Capital Investment Management v. Stonepath Group, 343 F.3d 189 (2d Cir. 2003). This was not a class action. Does that make a difference?

The issue is whether or not the purchaser or seller relied on the defendant's fraud in making the purchase or sale. You will sometimes see transaction causation referred to as "causation in fact," although that characterization is not particularly helpful.

As noted, the requirement for transaction causation first appeared in Basic v. Levinson, 485 U.S. 224 (1988), although lower courts had discussed it for some time. The Supreme Court has said that the reliance element "ensures that there is a proper connection between a defendant's misrepresentation and a plaintiff's injury." Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 568 U.S. 455 (2013). However, that appears to sound more like loss causation rather than transaction causation.

Consider whether, as a matter of policy, reliance should be required at all. If, as we will see, reliance is presumed in an efficient market, what does it add? It is, of course, a rebuttable presumption but it is rarely rebutted. Some have suggested eliminating the requirement of reliance entirely.⁴

As noted, courts (especially the Second Circuit in Emergent⁵ and Suez⁶) have said that transaction causation is a "but for" test. That is, "but for" the misrepresentation, the plaintiff would not have purchased the stock. Can this be understood to mean "would not have purchased the stock at that price" or does it mean not at all?

Does this make sense? The misrepresentation causes the price of the stock to be inflated, and yet the plaintiff still purchased it. In a perfectly efficient market, wouldn't the purchase decision be the same with the misrepresentation plus inflation as without it, at a correspondingly lower price?

Remember that the reliance requirement comes from common law tort of deceit. It works something like this: assume that I want to buy your car, and I ask you whether it was ever in an accident. You lie and say no. I buy the car. Without the fraud, I would not have bought your car. The fraud caused me to buy the car. So far, so good. But what if I did not ask you about accidents, but you volunteered during our price negotiations that the car had never been in an accident. Have you committed fraud or just lied? In this scenario, there is no evidence that I relied on the misrepresentation or even cared about it. Can it be said that "but for" the fraud, I would not have purchased the car? Probably not.

The fraud we are talking about in the securities context is fraud that impacts or "inflates" the price of stock and thereby induces the purchaser to buy the inflated stock. The amount of inflation in the price of the stock should exactly correlate with the fraud (or so the experts say, which is another topic entirely). This theory is not without its problems, however. If the purchaser was willing to pay a higher price for the stock than its true value would suggest, wouldn't the purchaser also be willing to pay a lower price if there was no price inflation caused by the fraud? How can it be said that "but for" the fraud, the purchaser would not have bought the stock when without the fraud, the price would have been lower. Don't purchasers like to "buy low and sell high"?

Assume that a mining company announces, falsely, that it has just discovered gold in Alaska. Let us further assume that on the day after the disclosure, the price of the company's stock went up $2, which was an increase of about 1 percent. Let's further assume that that price increase was statistically significantly higher than the increase in the market as a whole and similarly higher than the increase in the prices of comparably situated companies. In securities law terms, this increase would be called a "price inflation" due to the fraud. Does that daily increase, in and of itself, cause purchasers to buy the stock? Is it a "but for" cause? How would we know? How could that "but for" cause be proved in court? Do we really think that most purchasers bought their stock on the day in question because of the announcement of the discovery of gold in Alaska? Almost certainly not.

Dura says that the fraud caused the purchaser to buy the stock and pay $2 more than she should have. She was willing to do that because of the fraud, even though it caused the stock to be priced $2 more than it should have been. But without the fraud, the stock price would have been $2 lower. Why didn't she buy the stock when it was selling for $2 less? The true values, at least hypothetically, were exactly the same in either case.

Let's take this hypothetical a few steps further. Let's assume that on the day that the gold strike in Alaska was announced, the price of the company's stock did not change. More precisely, let's assume that there was no statistically significant change in the price of the stock when compared to the market as a whole or to comparable companies. Three years later, the company issued a press release stating that its disclosure of the gold mine three years ago was not true, that it had been manufactured by a rogue employee who has since been fired. The next day, the price of the stock declined $2, which was statistically significant when compared to the market and to comparable companies. Was that $2 drop caused by the disclosure of the fraud? Securities plaintiffs lawyers would say that it was. They even have a theory that the $2 drop in the price of the stock—the elimination of the $2 inflation—can be traced back to the day of the fraudulent announcement. That tracing back is called a "constant ribbon" and operates on the theory that the inflation has been in the price of the stock for three years.

There are at least two problems with this theory that should be addressed. First, Dura held that price inflation dissipates over time. Assuming that the original inflation was $2, shouldn't at least some of it have dissipated in three years? How...