Fraud by Hindsight*

By Gulati, Mitu; Rachlinski, Jeffrey J. et al. | Northwestern University Law Review, Spring 2004 | Go to article overview

Fraud by Hindsight*


Gulati, Mitu, Rachlinski, Jeffrey J., Langevoort, Donald C., Northwestern University Law Review


INTRODUCTION

"In sum, the complaint is an example of alleging fraud by hindsight."

-Judge Henry Friendly, in his 1978 opinion Denny v. Barber1

Most people today believe that Enron's CEO, Ken Lay, knew his subordinates were rigging the corporate books. Likewise, it is not hard to believe that the managers at MCI, WorldCom, and Tyco knew their businesses were performing badly even as they issued rosy forecasts. It also is hard to believe that twenty years ago the management at Apple failed to predict that the Macintosh predecessor, "Lisa," was a doomed product, whose release was a futile act intended only to boost stock prices. Most of us recognize, however, that hindsight colors these beliefs. Events tend to seem more predictable than may have been the case.2 One could recount this tale for a thousand other corporate failures. What looks today like fraud, in many circumstances might have once been nothing more than misplaced optimism. Small wonder then that courts worry about "fraud by hindsight" in cases alleging securities fraud.

Hindsight blurs the distinction between fraud and mistake. People consistently overstate what could have been predicted after events have unfolded-a phenomenon psychologists call the hindsight bias.3 People believe they could have predicted events better than was actually the case and believe that others should have been able to predict them. Consequently, they blame others for failing to have foreseen events that reasonable people in foresight could not have foreseen.4 In the context of securities regulation, hindsight can mistakenly lead people to conclude that a bad outcome was not only predictable, but was actually predicted by managers.5 Even in the absence of any misconduct, a bad outcome alone might lead people to believe that corporate managers committed securities fraud. The hindsight bias thus creates a considerable obstacle to the fundamental task in securities regulation of sorting fraud from mistake.

Punishing mistakes as if they were fraud undermines the deterrent function of securities regulation.6 If corporate managers are as likely to be punished for bad decisions as for acts of fraud, then the securities laws provide little real disincentive to engage in fraud. The recent financial scandals raise precisely this concern. How could managers at Enron and others who were manipulating revenue reports have thought that they could continue to do so indefinitely? Indeed, given the high likelihood of getting caught, few instances of alleged securities fraud make much sense.7 This question has many answers, but one of them might well be the inability of the courts in securities fraud cases to sort fraud from mistake accurately.8

Courts' difficulties with sorting fraud from mistake accurately is not the result of ignorance of the basing effects of hindsight. Courts cite concerns with hindsight in nearly one-third of all published opinions in securities class action cases.9 As the epithet at the beginning of this Article shows, courts seem generally aware of the problem posed by judging securities fraud cases in hindsight. judges routinely admonish plaintiffs not to rely on hindsight to support allegations of fraud in pleading securities claims. Increasingly, the doctrine against "fraud by hindsight" ("FBH") has become a hurdle that plaintiffs in securities cases must overcome

The FBH doctrine arises from judges' awareness that knowledge of the bad outcome biases judgments in favor of concluding that fraud had occurred, even if it had not.10 Arguably, the FBH doctrine reveals judges to be intuitive psychologists, struggling to correct for the influence of the hindsight bias on litigation.11 A properly debiased system of litigation would accurately sort the cases of fraud from innocently mistaken predictions, thereby maintaining the deterrent function of the securities fraud system. The FBH doctrine might thus reflect an effort to debias the adjudication process in securities cases. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Fraud by Hindsight*
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Welcome to the new Questia Reader

The Questia Reader has been updated to provide you with an even better online reading experience.  It is now 100% Responsive, which means you can read our books and articles on any sized device you wish.  All of your favorite tools like notes, highlights, and citations are still here, but the way you select text has been updated to be easier to use, especially on touchscreen devices.  Here's how:

1. Click or tap the first word you want to select.
2. Click or tap the last word you want to select.

OK, got it!

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.