The "Reasonable Investor" of Federal Securities Law: Insights from Tort Law's "Reasonable Person" & Suggested Reforms.

• Author: Rose, Amanda M.

1. INTRODUCTION II. THE REASONABLE PERSON III. THE REASONABLE INVESTOR A. Who is the Reasonable Investor? B. The Role of Context C. Companies' Plea for Bright-Line Rules D. The Impact of the PSLRA IV. THE REASONABLE INVESTOR VS. THE REASONABLE PERSON V. IMPLICATIONS FOR REFORM A. Identify the Reasonable Investor B. Create an Early, But Evidence-Based, Decision Point VI. CONCLUSION I. INTRODUCTION

   Securities class actions have been called the "800-pound gorilla that dominates and overshadows other forms of class actions" in the United States and for good reason. (1) They constitute nearly half of all class actions filed in the federal courts, (2) claim a disproportionate amount of judicial time and attention due to their procedural complexity, (3) and are responsible for the "vast majority of the money involved in class action settlements" (4)--averaging over $5 billion annually for the past ten years, based on data compiled by Cornerstone Research. (5)

   To say securities class actions have been controversial is an understatement. For decades public companies have argued that the enormous damage awards they threaten renders settlement of even low-merit cases rational, promoting the filing of frivolous suits. (6) This argument convinced Congress to enact, over the veto of President Clinton, the Private Securities Litigation Reform Act of 1995 (PSLRA). (7) The PSLRA includes a variety of measures designed to deter the filing of weak cases. (8) Most importantly, the PSLRA heightened the standard for pleading scienter in securities fraud cases brought under SEC Rule 10b-5, while simultaneously denying plaintiffs the right to discovery until after resolution of a motion to dismiss. (9) The PSLRA did not, however, heighten the pleading requirement for materiality, a notoriously vague element of plaintiffs' prima facie case under not only Rule 10b-5, (10) but also Section 11 of the Securities Act of 1933, (11) and which serves to define the scope of public companies' disclosure obligations more generally. (12) Today, materiality is the main fodder for merit-based critiques of securities class actions.

   Materiality's vagueness stems from its definition: material information is information that a "reasonable investor" would consider important. (13) The "reasonable investor" is at best a shadowy figure, described only generically in judicial opinions and--in doctrine if not in practice--someone for the fact-finder to identify case-by-case. (14) Public companies have long bemoaned the reasonable investor test, arguing that materiality should be judged instead by reference to quantitative or other bright-line measures, so as to simplify companies' disclosure choices and provide a basis for dismissal of securities litigation at the pleadings or summary judgment phase. (15)

   Neither the SEC nor the Supreme Court has been receptive to companies' pleas. To the contrary, in 1999 the SEC released a Staff Accounting Bulletin flatly rejecting their preferred quantitative approach to materiality. (16) And the Supreme Court has repeatedly rejected other bright-line tests advocated by defendants, fearing such tests would create a roadmap for fraud. (17) Far from jettisoning it altogether, as companies would prefer, the Supreme Court recently reaffirmed the reasonable investor's role in securities litigation, holding in Omnicare Inc. v. Laborers District Council Construction Industry Pension Fund that whether an omission of a material fact renders a statement made misleading must, like the materiality determination itself, be judged from the reasonable investor's perspective. (18)

   The lower courts have proven more sympathetic to company concerns, adopting a variety of "immaterial as a matter of law" doctrines that allow for pretrial dismissal of securities class actions. (19) These doctrines have been berated by scholars and plaintiffs' lawyers alike. Not only do they permit decisions based on little more than judicial hunches about "reasonable investor" behavior, the argument goes, but they also conflict with Supreme Court precedent teaching that materiality determinations are highly fact-intensive and thus should rarely be made before trial. (20)

   The persistent disagreement surrounding the reasonable investor test is hardly surprising. The dispute has always been framed in terms of the perennial "rules versus standards" debate--with critics of the reasonable investor test complaining of the uncertainty the test generates and defenders warning of the under-inclusiveness of the bright-line rules offered as alternatives. Such debates tend to prove intractable: an accounting of the tradeoffs occasioned by the choice between rules and standards rarely reveals a clear victor. (21)

   This Article approaches the issue in a different way. The point of departure is the observation that the "reasonable investor" is not without kin in the law. To the contrary, the reasonable investor has a well-known legal antecedent: tort law's storied "reasonable person." The reasonable investor standard shares the same basic justification as tort law's reasonable person standard: whether information is important or misleading requires an objective but at the same time highly contextualized analysis, making it difficult to craft ex ante rules on point that are not grossly over- or under-inclusive. Since the earliest uses of the reasonable person standard, defendants have complained about the uncertainty that surrounds its application, and the room this leaves for inconsistent and even biased decision-making. But the perseverance of tort law's reasonable person standard over the course of centuries of common law development suggests that its benefits likely outweigh its costs. This raises the question: does the reasonable investor standard differ from tort law's reasonable person standard in ways that suggest it is less efficient?

   The question is a natural one to ask. In interpreting the liability provisions of the federal securities laws, the Supreme Court regularly seeks to bolster its decisions by drawing analogies or distinctions between modern securities litigation and the common law tort of misrepresentation. (22) Scholars, too, have long engaged in such analysis. (23) Yet the relationship between the reasonable investor standard and tort law's reasonable person standard remains unexplored.

   A comparison of the two standards reveals at least three notable differences. The first concerns the need for expert testimony in a securities case and the concomitant decreased importance of the jury. In a simple tort case the indeterminacy of the reasonable person standard is mitigated by the use of the jury, which can channel its collective wisdom as to what constitutes reasonable behavior in deciding the outcome of the case. (24) Indeed, the jury is viewed as uniquely competent to perform this task; assigning such work to a single judge would present legitimacy problems that jury resolution avoids. When a case involves a specialized activity like securities investing, by contrast, a lay jury is unlikely to have any collective wisdom to offer; rather, expert testimony should be utilized to educate the fact-finder. Judges are arguably better positioned than juries to evaluate expert evidence, or at least as well positioned. (25)

   The second important difference flows from the first: whereas it is tolerable and even desirable to leave the identity of the "reasonable person" vague in a simple tort case, because the jury can be trusted to imbue the concept with an accepted social meaning, the same cannot be said about the identity of the "reasonable investor." Whether, for example, the reasonable investor is a retail investor or a market professional is not a choice that should be made by juries on a case-by-case basis. Nor, for that matter, should they be made by unaccountable judges. Rather, the identity of the reasonable investor is a policy choice that should be made by the SEC in rulemaking or by Congress in legislation, so that companies understand how to think about their disclosure obligations and experts in securities cases understand just what it is they should opine on.

   Tort cases alleging professional negligence provide a good analogue. The common law does not ask juries in such cases to provide normative content to the standard of care, and to apply that standard based on social intuition. The reason is obvious: a lay jury would be wholly unsuited to those tasks. Instead, the standard of care is defined by law as the care that would be taken by a reasonable professional in the same field as the defendant, and the jury is required to apply that standard based solely on the expert testimony received. (26)

   The reasonable investor standard differs from the reasonable person standard in another important way. Federal securities law doctrines, foreign to the common law tort of misrepresentation, have expanded the universe of investors who can sue and have facilitated the aggregation of their claims. (27) As a result, the stakes in federal securities fraud cases are dramatically higher than at common law. The uncertainty generated by the reasonable investor standard therefore creates a stronger pressure to settle cases that are not dismissed pretrial than does the uncertainty generated by the reasonable person standard in traditional tort cases. It also creates a stronger pressure for potential defendants to distort their behavior in socially undesirable ways in order to avoid litigation. In the securities context, such distortion manifests when companies fail to disclose information that may be helpful to investors, out of a fear it will be deemed misleading, or burden investors with trivial information, out of a fear that its omission will give rise to liability.

   The distinctions identified indicate that use of the reasonable investor standard is, in all likelihood, more costly than the prototypical use of the reasonable person standard in tort. They...