The “Reasonable Investor” of Federal Securities Law

Amanda Rose is Professor of Law at Vanderbilt Law School. This post is based on a recent article by Professor Rose.

For decades public companies have complained that the enormous damage awards threatened in securities class actions renders settlement of even non-meritorious cases rational, promoting the filing of frivolous suits. This argument convinced Congress to enact the Private Securities Litigation Reform Act of 1995 (PSLRA), which includes a variety of measures designed to deter the filing of weak cases. Most importantly, the PSLRA heightened the standard for pleading scienter in securities fraud cases brought under SEC Rule 10b-5. 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, but also Section 11 of the Securities Act of 1933, and which serves to define the scope of public companies’ disclosure obligations more generally. Today, materiality is the main fodder for merits-based critiques of securities class actions.

Materiality’s vagueness stems from its definition: material information is information that a “reasonable investor” would consider important. 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. 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. Neither the SEC nor the Supreme Court has been receptive to companies’ pleas. The lower courts have proven more sympathetic, however, adopting a variety of “immaterial as a matter of law” doctrines that allow for pretrial dismissal of securities class actions. 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.

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. 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 and has been subject to the same set of critiques. 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?

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. 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.

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.

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. 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.

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 do not, however, support abandoning the reasonable investor standard in favor of bright-line rules, as critics have long advocated. Such a move would create loop-holes that could be exploited to defraud investors, and the net effects of this tradeoff are impossible to measure or predict. The distinctions do, however, suggest a package of reforms capable of producing more certain social welfare gains.

The first reform that flows from the analysis has already been alluded to: the identity of the reasonable investor should be elucidated through SEC rulemaking or federal statute. Unlike in a simple tort case, there is no justification for leaving the standard of care ambiguous when it comes to corporate disclosure obligations. Rather, as in professional negligence cases, the standard should be defined by law. The second reform proposal is both bolder and more contestable. The analysis suggests that a mechanism should be developed that would allow judges to apply the reasonable investor test before trial, but with the benefit of evidence. Swayed by companies’ complaints about the intense pressure they face to settle, district courts today often do apply the reasonable investor test to dismiss securities class actions pretrial. But they do so using judge-made “immaterial as a matter of law” doctrines that are applied without the benefit of expert testimony. Creating a procedural mechanism that allows judges to consider such testimony in applying the reasonable investor test would result in more principled decision-making. While the effect of this approach would be to formally take the issue away from the jury and place it in the hands of the judge (at least preliminarily), unlike in a simple tort case there is no compelling policy reason for reserving this issue to the jury in the first place. Moreover, the reality is that the jury will never decide the issue anyway: if the case is not disposed of by the court pretrial, it almost inevitably will settle. What form should the proposed mechanism take? This Article argues that the most promising approach would be for Congress to adopt a statute tying class certification of securities claims to proof of a material misstatement, omission, or misleading half-truth.

The full article is available for download here.

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