Avoiding the Parade of Horribles: A Revised and Unified Fraud-Created-The-Market Theory of Presumptive Reliance Under Rule 10b-5
Zachary M. Johns | 2012 U. Ill. L. Rev. 1299
The Fraud-Created-The-Market theory of presumptive reliance (FCTM) has reemerged as a way for plaintiffs to recover for securities fraud in inefficient or primary markets. Broadly speaking, FCTM presumes reliance when plaintiffs show that a security would have been unmarketable absent a scheme to defraud. Without a theory of presumptive reliance in private securities fraud actions under Rule 10b-5, plaintiffs are required to show actual reliance—a requirement that typically has the practical effect of eliminating an otherwise valid class of defrauded securities purchasers. Despite the theoretical support and practical appeal of FCTM, the theory has suffered a tortuous development. Presently, circuits are split over whether to recognize FCTM. Of the circuits that do recognize the theory, courts articulate three distinct variations of when FCTM should be applied.
This Note argues that courts should recognize FCTM generally and adopt the economic unmarketability variation of that theory specifically. Economic unmarketability under FCTM permits plaintiffs to rely on the integrity of the inefficient or primary market to assure that a given security is not “patently worthless.” FCTM’s use of the phrase “integrity” is distinct from the established Fraud-On-The-Market (FOTM) theory of presumptive reliance for efficient markets. The economic unmarketability variant of FCTM envisions that the integrity of the market is based on the presence of a variety of players whose attendance collectively guarantees that there will be some value underlying a security offered in a given market. Thus, economic unmarketability assumes that an inefficient market would not contain wholly empty or sham securities. Unlike FOTM, FCTM’s theory of integrity is justified solely on the basis of statutory intent, common sense, and fairness.
Economic unmarketability is not a theory without limits. Courts, in applying FCTM, however, are unclear as to the outer bounds of the theory, thus prompting criticism. This Note proposes three clear limits derived from precedent: First, the alleged fraud must have existed prior to the time of sale and have been so pervasive that its concealment was the only way the security was able to be marketed. Second, to ensure that FCTM does not protect investors from poor investment decisions, potential plaintiffs are only permitted to rely on the integrity of the market to the extent it provides that securities will have some underlying value. Third, the presumption is rebuttable, which permits defendants to weed out investors who purchased knowingly or after the revelation of fraud.
The Note begins by examining the historical background of presumptions of reliance. Next, the Note examines recent legislative and doctrinal changes in securities laws affecting the relationship among reliance, presumptions of reliance generally, and loss causation. The examination of recent developments is then contrasted against treatment of FCTM. The Note next analyzes the arguments against FCTM and shows how these arguments are misplaced in light of recent developments in securities laws and are based on an unnecessarily broad interpretation of the theory. To conclude, the author recommends a unified approach to FCTM with accompanying theoretical limits that extinguish many of the now-dated concerns about the presumption.