Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior! Part 2
Welcome Back.
Last week we discussed the first part of the “Fraud by Hindsight” study. As we learned, the FBH doctrine is utilized in securities litigation cases. In learning about the FBH doctrine we reviewed the Debiasing Hypothesis and the Case Management Hypothesis. According to the Debiasing Hypothesis, FBH is used as a tool to “weed out” hindsight bias in order to focus on legal issues at hand. The Case Management Hypothesis, on the other hand declares that FBH is used to dismiss securities fraud cases in order to facilitate judicial control over them. This week we will strive to analyze how Fraud By Hindsight has evolved, meaning, how the courts apply the doctrine (in real life), which differs markedly from the doctrine’s theoretical meaning.
Click Here To Access The Original Fraud by Hindsight Case – Part II
History
The first mention of FBH was in 1978 with Judge Friendly in the case Denny v. Barber. The plaintiff in this case claimed that the bank had “engaged in unsound lending practices, maintained insufficient loan loss reserves, delayed writing off bad loans, and undertook speculative investments” (796). Sound familiar? Anyway — the plaintiff plead that the bank failed to disclose these problems in earlier reports and instead issued reports with optimistic projections. Judge Friendly claimed FBH stating that there were a number of “intervening events” during that period (i.e. increasing prices in petroleum and the City of New York’s financial crisis) that were outside the control of managers and it was therefore insufficient to claim that the defendant should have known better when out-of-the-ordinary incidents have occurred. The end result of the case provided that “hindsight alone might not constitute a sufficient demonstration that the defendants made some predictive decision with knowledge of its falsity or something close to it” (797). Friendly established that FBH is possible, but that in this case the underlying circumstances did not justify a judgment against the bank.
The second relevant mention of FBH was in 1990 with Judge Easterbrook in the case DiLeo v. Ernst & Young. Like the prior case, DiLeo involved problems with loans where the plaintiff plead that the bank and E&Y had known but failed to disclose that a substantial portion of the bank’s loans were uncollectible. This case was different, in that there were no “intervening events” that could have blind sighted managers from issuing more accurate future projections. Still, Easterbrook claimed FBH and said, “the fact that the loans turned out badly does not mean that the defendant knew (or should have known) that this was going to happen” (799-800). Easterbrook believed that the plaintiff must be able to separate the true fraud from the underlying hindsight evidence in order to prove their case.
Easterbrook’s articulation of the FBH doctrine set the stage for all future securities class action cases. As the authors state, the phrase was cited only about twice per year before DiLeo but it increased to an average of twenty-seven times per year afterwards. Unfortunately, the courts found Easterbrook’s perception of the phrase to be more compelling. Instead of providing that the hindsight might play a role determining if fraud has occurred, Easterbrook claimed that there simply is no “fraud by hindsight”. This allows the courts to adjudicate cases solely on complaint, therefore supporting the Case Management Hypothesis.
The results of many tests provided in this case proved that courts were using the doctrine as a means to dismiss cases. Of all the tests, I found one to be most interesting: The Stage of the Proceedings. The results of the test shows that “over 90 percent of FBH applications involve judgments on the pleadings” (814) stage rather than at summary judgment. In the preliminary (pleading) stages, the knowledge of information is not provided, meaning that it is less likely that hindsight bias will affect their decisions. The more the judge delves into the case, the more they are susceptible to the hindsight bias. If the judge is utilizing the FBH doctrine mostly during the pleading stages where hindsight bias is “weak”, then the Debiasing Hypothesis is not valid.
The authors point out the problems with utilizing the FBH doctrine in this way:
“The problem, however, is that the remedy is applied at the pleadings stage, not the summary judgment stage. At the pleadings stage, a bad outcome truly is relevant to the likelihood of fraud. At this stage, the Federal Rules do not ask the courts to make a judgment on the merits, and hence the remedy of foreclosing further litigation is inappropriate. By foreclosing further proceedings, courts are not saying that they do not trust their own judgment, but that they do not trust the process of civil discovery to identity whether fraud occurred” (815).
Because cases are being dismissed so early in the litigation process, courts are not allowing for the discovery of fraud that may be apparent even though hindsight is a factor in the case.
By gathering this and other evidence, the case concludes that judges utilize FBH as a case management tool. They cited that the development of the FBH doctrine could be described as “naïve cynicism”. Though judges understand that hindsight bias must be taken into consideration, they express the belief that the problem does not affect their own judgment. The courts are relying on their own intuitions and gathering the necessary facts to prove fraud by hindsight. The authors note a paradox here saying, “Judges simultaneously claim that human judgment cannot be trusted, and yet they rely on their own judgment”.
The problem is that the naively cynical (FBH) approach has led to securities fraud cases to be governed by moods. The authors say that “In the 1980s and 1990s, as concern with frivolous securities litigation rose, courts and Congress simply made it more difficult for plaintiffs to file suit. In the post-Enron era, this skepticism about private enforcement of securities fraud might have abated somewhat, leading to lesser pleading requirements” (825).
Recap & Implications
Overall the case proves that the courts have not yet been able to establish a sensible mechanism for sorting fraud from mistake. It therefore allows cases that really involve fraud to potentially be dismissed. In cases since DiLeo, the win rate for defendants in FBH cases is 70 percent, as compared with 47 percent in those cases that did not mention it. The mere declaration of “Fraud by Hindsight” gives the defendant an automatic advantage over the plaintiff. Now, the defendant may in fact be innocent – but the current processes are not able to determine who is or isn’t guilty. Remember, judges spend much of their time in these cases separating the hindsight bias from the fraud. This task can become very complex and time consuming.
In sum, the increasing use of FBH has been beneficial for (1) judges because they don’t have to listen to these complicated cases and (2) defendant’s because they are likely to win the case by using the doctrine. The only ones who don’t benefit from doctrine are the plaintiff’s who may truly have been victims of fraud. It is crucial that the judiciary revise the way the FBH is interpreted in order to protect the innocent and convict the guilty.
Have any ideas on how to fix the FBH problem? Send me an email at fraudgirl @ simoleonsense.com.
See you next week.
- Fraud Girl
