The Shifting Purpose of the Rule 10b-5 Private Right of Action

Private Rule 10b-5 lawsuits have inspired volumes of academic literature, much of it focused on the suits’ social benefits (or lack thereof, depending on the author’s perspective). In a chapter for the forthcoming Research Handbook on Representative Shareholder Litigation, I introduce readers to this aspect of the Rule 10b-5 literature, which is best understood in light of the historical and doctrinal evolution of Rule 10b-5.

In its early years, the implied right of action under Rule 10b-5 operated as essentially a federalized version of the common law fraud cause of action focused on securities transactions. The service of process provisions attached to Rule 10b-5 were more generous, but otherwise there was little difference between Rule 10b-5 and common law fraud claims. The elements of a private Rule 10b-5 claim were interpreted more or less co-extensively with the elements of a common law fraud claim—requiring, inter alia, a plaintiff to prove actual reliance on the defendant’s misstatements. Typical factual allegations were also similar—both types of suits tended to involve face-to-face dealings and privity of contract between the plaintiff and the defendant. Neither type of claim was susceptible to aggregation in a way remotely similar to the modern opt-out class action. Not surprisingly, then, the early version of the Rule 10b-5 private right could be justified in much the same way as the common law fraud cause of action: as serving (to some extent at least) the goals of both corrective justice and deterrence.

In subsequent decades, doctrine evolved in ways that unmoored the private Rule 10-5 cause of action from its common law roots. These changes facilitated the emergence of the “fraud-on-the-market” class action that dominates private Rule 10b-5 litigation today. The first doctrinal development of note was the abandonment of any privity requirement. Beginning in the 1960s, courts began to recognize the right of plaintiffs to sue defendants under Rule 10b-5 even if the defendant was neither a counterparty to the plaintiff’s trade nor a contemporaneous trader. Thus, courts interpreted Rule 10b-5 as permitting suit by a secondary market purchaser or seller against a non-transacting corporate defendant for misstatements made by the corporation’s agent, assuming (at first, at least) that the plaintiff actually relied upon those misstatements in entering into the secondary market transaction.

The need to prove actual reliance was the next feature of the common law to be modified. In Basic v. Levinson, the Supreme Court recognized a presumption of reliance in private Rule 10b-5 cases involving securities that trade in efficient markets. According to Basic, plaintiffs are entitled to this presumption if they can show that:(1) the alleged misrepresentation was publicly known, (2) it was material, (3) the stock traded in an efficient market, and (4) the plaintiff traded the stock between the time the misrepresentation was made and when the truth was revealed. The presumption Basic endorses is not that the plaintiffs actually relied on the alleged misstatement itself, but rather that they relied on the integrity of the stock’s market price, which is itself presumed to have been distorted by the fraud through the operation of the efficient capital markets hypothesis. The reliance presumed by Basic is therefore very different from the reliance that had traditionally been required in common law fraud cases. Basic, combined with the Supreme Court’s earlier recognition of a presumption of reliance in certain omission cases, thus extended the right to sue non-transacting corporate defendants under Rule 10b-5 to all secondary market purchasers of the company’s stock, at least if that stock was listed on an exchange and actively traded. This includes passive investors who pay no attention to corporate disclosures and thus would be unable to state a common law fraud claim.

Of course, most passive investors have (and, according to modern portfolio theory, should have) only a small amount invested in any particular firm. Therefore, it would be uneconomical for most passive investors to enforce this right in an individual suit. But another innovation served to remove this barrier to enforcement. Revisions to the Federal Rules of Civil Procedure introduced in 1966 made it possible for plaintiffs to aggregate claims in an opt-out class action under Rule 23(b)(3), assuming that common issues predominated over individualized ones. Allowing investors to access this procedural device was a major goal of the Supreme Court’s decision in Basic. By eliminating the need for plaintiffs to prove individual reliance, that decision both expanded the universe of investors who can state a claim and facilitated the aggregation of their claims in a class action.

Thus was born the modern “fraud-on-the-market” (FOTM) class action, by which I mean a Rule 10b-5 class action brought on behalf of secondary market traders against a non-transacting public company defendant for alleged misstatements or omissions by corporate agents, upon which the plaintiff class did not directly rely. The FOTM class action bears little resemblance to early Rule 10b-5 cases or to traditional common law fraud cases. In addition to involving an expanded set of plaintiffs and defendants, an altered set of elements, and the aggregation of claims, FOTM class actions involve defendants with different motives, raise different stakes, and create different incentives to sue and settle than existed in the early years of private Rule 10b-5 enforcement.

These differences represent more than a curiosity: They fundamentally disrupt the traditional social justifications for private Rule 10b-5 enforcement. Whereas the early private Rule 10b-5 cases could be defended as socially worthwhile under both corrective justice and deterrence theory, the purpose of the FOTM class action is more difficult to discern. My chapter explains why, and in so doing introduces readers to the meta questions that expressly or implicitly animate much of the scholarly literature focused on Rule 10b-5. It thus provides a useful framework for understanding that voluminous body of literature, as well as the ongoing political debate over the social desirability of Rule 10b-5 class actions.

This post comes to us from Professor Amanda M. Rose at Vanderbilt University Law School. It is based on her recent book chapter, “The Shifting Raison d’être of the Rule 10b-5 Private Right of Action,” forthcoming in the Research Handbook on Representative Shareholder Litigation (Edward Elgar Publishing) and available here.