"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. …