Guest Post – Fraud Girl: “Fraud by Hindsight”- How Wall Street Firms [Legally] Get Away With Fraudulent Behavior!

Welcome back.

Last week we discussed the credit rating agencies and their roles the financial crisis. These agencies provided false ratings on credit they knew was faulty prior to the crisis. In defense, these agencies (as well as Warren Buffet) said that they did not foresee the crisis to be as severe as it was and therefore could not be blamed for making mistakes in their predictions. This week’s post focuses on foreseeability and the extent to which firms are liable for incorrect predictions.

Like credit agencies, Wall Street firms have been accused of knowing the dangers in the market prior to its collapse. I came across this post (Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities) via the Wall Street Law Blog that discusses how firms could assert that they can’t be blamed for events they couldn’t foresee. It’s a doctrine known as Fraud by Hindsight (“FBH”) where defendants claim “that there is no fraud if the alleged deceit can only be discerned after the fact”. This claim has been used in numerous securities fraud lawsuits and surprisingly it has worked in the defendant’s favor on most occasions.

Many Wall Street firms say they “could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of fraud by hindsight”. Was Wall Street able to foresee the housing market crash prior to its collapse? According to the writers at WSL Blog, they did foresee it saying, “From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone – even after adjusting for inflation – housing prices rose by more than 70%”. Wall Street must (or should) have foreseen a drastic change in the market when rises in housing costs were so abnormal. By claiming FBH, however, firms can inevitably “get away with murder”.

What exactly is FBH and how is it used in court? The case below from Northwestern University Law Review details the psychology and legalities behind FBH while attempting to show how the FBH doctrine is being used as a means to dismiss cases rather than to control the influence of Wall Street’s foreseeability claims.

Here’s a link of the paper: Fraud by Hindsight

I’ve broken down the case into two parts. The first part provides two theories on hindsight in securities litigation: The Debiasing Hypothesis & The Case Management Hypothesis. The Debiasing Hypothesis provides that FBH is being used in court as a way to control the influence of ‘hindsight bias’. This bias says that people “overstate the predictability of outcomes” and “tend to view what has happened as having been inevitable but also view it as having appeared ‘relatively inevitable’ before it happened”.  The Debiasing Hypothesis tries to prove that FBH aids judges in “weeding out” the biases so that they can focus on the allegations at hand.

The Case Management Hypothesis states that FBH is a claim used by judges to easily dismiss cases that they deem too complicated or confusing. According to the analysis, “…academics have complained that these [securities fraud] suits settle without regard to merit and do little to deter real fraud, operating instead as a needless tax on capital raising. Federal judges, faced with overwhelming caseloads, must allocate their limited resources. Securities lawsuits that are often complex, lengthy, and perceived to be extortionate are unlikely to be a high priority. Judges might thus embrace any doctrine [i.e. FBH doctrine] that allows them to dispose of these cases quickly” (782-783). The case attempts to prove that FBH is primarily used for case management purposes rather than for controlling hindsight bias.

The psychological aspects behind hindsight bias are discussed thoroughly in this case. Here are a few excerpts from the case regarding this bias:

(1)“Studies show that judges are vulnerable to the bias, and that mere awareness of the phenomenon does not ameliorate its influence on judgment. The failure to develop a doctrine that addresses the underlying problem of judging in hindsight means that the adverse consequences of the hindsight bias remain a part of securities litigation. Judges are not accurately sorting fraud from mistake, thereby undermining the system, even as they seek to improve it” (777).

(2) “Judges assert that a company’s announcement of bad results, by itself, does not mean that a prior optimistic statement was fraudulent. This seems to be an effort to divert attention away from the bad outcome and toward the circumstances that gave rise to that outcome, which is exactly the problem that hindsight bias raises. That is, if people overweigh the fact of a bad outcome in hindsight, then the cure is to reconstruct the situation as people saw it beforehand. Thus, the development of the FBH doctrine suggests a judicial understanding of the biasing effect of judging in hindsight and of a means to address the problem” (781).

(3) “Once a bad event occurs, the evaluation of a warning that was given earlier will be biased. In terms of evaluating a decision-maker’s failure to heed a warning, knowledge that the warned-of outcome occurred will increase the salience of the warning in the evaluator’s mind and bias her in the direction of finding fault with the failure to heed the warning. In effect, the hindsight bias becomes an ‘I-told-you-so’ bias.” (793).

(4) “In foresight, managers might reasonably believe that the contingency as too unlikely to merit disclosure, whereas in hindsight it seems obvious a reasonable investor would have wanted to know it. Likewise, as to warning a company actually made, in foresight most investors might reasonably ignore them, whereas in hindsight they seem profoundly important. If defendants are allowed to defend themselves by arguing that a reasonable investor would have attended closely to these warnings, then the hindsight bias might benefit defendants” (794).

Next week we’ll explore the second part of the case and discuss the importance of utilizing FBH as a means of deterring the hindsight bias. We’ll see how the case proves that FBH is not being used for this purpose and is instead used as a mechanism to dismiss cases that simply do not want to be heard.

See you next week…
-Fraud Girl