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Why the SCOTUS Gets Securities Cases Wrong so Often

Today’s argument in the Stoneridge case is widely hailed as being the most important securities case to be decided by the Supreme Court in at least a decade. It thus seems appropriate to mark the occasion by noting an article my friend Mitu Gulati and wrote back in 2002, How do Judges Maximize? (The Same Way Everybody Else Does—Boundedly): Rules of Thumb in Securities Fraud Opinions, 51 Emory Law Journal 83. The article was broadly about the role heuristics play in adjudication:

Judicial opinions in securities fraud class actions frequently do not conform to standard theories of adjudication. Instead of the complex modes of legal reasoning predicted by standard models, decisions in this area commonly rely on rules of thumb-decisionmaking heuristics or shortcuts. To the extent prior literature has focused on the use of decisionmaking heuristics in adjudication, commentators have emphasized procedural shortcuts, such as the doctrine whereby courts refuse to address issues that have not been squarely argued. In contrast, the heuristics we identify are substantive law doctrinal rules of thumb enabling a judge to avoid analysis of a case’s full complexities. This distinction is significant. Procedural shortcuts do not affect the evolution of substantive legal doctrines, except as to produce no doctrine. Substantive heuristics, however, not only become doctrine but can come to dominate the on-going evolution of substantive law. We suggest that the desire to avoid complexity is an important factor in explaining the emergence of a number of the newer doctrines in the securities area.

Underlying all of these doctrines are assumptions about either, (a) investor responses to information or (b) managerial responses to incentives. The standard approaches used by commentators in the area would be to explain either why the assumptions are accurate or why they are not and how they should be corrected. What we suggest, however, is that the real puzzle thus is that federal judges are claiming-at least implicitly-both a level of expertise about the workings of markets and organizations that, in some areas, not even the most sophisticated researchers in financial economics and organizational theory have reached. Federal judges, however, are far from being experts in these areas. As a group, they have little expertise on the topics of markets and organizational behavior. Further, they are consistently faced with overwhelming caseloads where only a small fraction of cases are securities cases. As a result, there is little opportunity to develop expertise in the area. Finally, judges are known to delegate much of the work of drafting their decisions to their law clerks, who are typically recent law school graduates.

Generalizing from the securities regulation context, we contend that standard theories of adjudication are flawed because they fail to adequately account for institutional constraints. Drawing on the tools of new institutional economics (bounded rationality, transaction costs, and agency costs), we tell a story about recent doctrinal developments in the lower federal courts in the area of securities class actions. The story highlights the link between doctrinal developments and the characteristics of the institutions that produce them. That story is then extended to the contexts of the Supreme Court and the Delaware state courts. Our claim is that the institutional perspective provides insights into the evolution of doctrine that today’s dominant models fail to provide.

In the course of the article, as noted, we also considered the peculiar nature of securities law adjudication before the Supreme Court. The relevant excerpt follows:

There is general agreement that the Supreme Court has not done a very good job in the securities area, especially in recent years. Scholars operating in a wide range of paradigms have criticized the court’s recent securities opinions.  Supreme Court securities law decisions typically lack a broad, consistent understanding of the relevant public policy considerations. Worse yet, they frequently lack such basics as doctrinal coherence and fidelity to prior opinions.

Why doesn’t the Supreme Court do a better job in securities cases? Our model offers an answer. When deciding securities cases, the Court is faced with hard, dry, and highly technical issues. Supreme Court justices and their clerks arrive on the court with little expertise in securities law. One reasonably assumes that neither the justices nor their clerks have much interest developing substantial institutional expertise in this area after they arrive. (Former Justice Powell being the exception that proves these rules.) Accordingly, it would be surprising if the Court’s securities opinions exhibited anything remotely resembling expert craftsmanship.

Under such conditions, we would expect the justices to take securities cases rarely, typically when there is a serious circuit split, which is in fact what we observe.  When obliged to take a securities issue, the Court will seek to minimize the amount of effort required to render a decision. This observation is not intended pejoratively. To the contrary, in terms of our model, the justices are acting rationally.

As we have seen, an actor can economize on limited cognitive resources either by invoking heuristic problem-solving decisionmaking processes (heuristics) or by adopting institutional governance structures designed to promote more efficient decisionmaking. Thus far in our analysis the former economizing move has taken precedence. In applying our model to securities adjudication by the Supreme Court, however, the latter device comes to the fore. Nonetheless, the conception of judges as agents with bounded rationality remains the basic story.

Bounded rationality implies that Supreme Court justices (and their clerks) have a limited ability to master legal information, including the myriad complexities of doctrine and policy in the host of areas annually presented to the court. Specialization is a rational response to bounded rationality—the expert in a field makes the most of his limited capacity to absorb and master information by limiting the amount of information that must be processed by limiting the breadth of the field in which he develops expertise. Supreme Court justices will therefore need to specialize, just as experts in other fields must do. Specializing in securities law would not be rational. The psychic rewards of being a justice—present day celebrity and historical fame—are associated with decisions on great constitutional issues, not the minutiae of securities regulation.

When faced with the necessity of deciding securities law issues, the justices and their clerks doubtless recognize that they lack the expertise necessary to decide such questions with confidence. As specialists in a different field, they may be inclined to defer to specialists in this field. Just as specialization is a rational response to bounded rationality, so too is a nonexpert’s decision to defer to a recognized specialist. Like all decisionmakers, but perhaps more so because of their high level of visibility, Supreme Court justices likely care about their reputation for competence. Because their decisions are highly scrutinized, they have a strong incentive to defer to expert opinion. Recognizing that even a good decisionmaker is subject to the proverbial “act of God,” the market for reputation evaluates decisionmakers by looking at both the outcome and the action before forming a judgment. If a bad outcome occurs, but the action was consistent with approved expert opinion, the hit to the decisionmaker’s reputation is reduced. In effect, by deferring to specialists, a decisionmaker operating under conditions of bounded rationality is buying insurance against a bad outcome.

In a collegial, multi-actor setting members of the decisionmaking body likely will prefer to rely on internal specialists. Deferring to someone else makes one vulnerable. In this context, justices who opt for deference are entrusting their reputation to the specialist to whom they defer. Ordinarily, the resulting vulnerability creates agency costs and, as a result, mandates monitoring the specialist. If the deferring justices trust the specialist, however, they need not expend resources on monitoring. Trust arises out of two primary sources. “Affinity trust” exists ex ante. It is based mostly on shared values and is most likely to exist where there is ethnic or religious affinity. “Learned trust” arises out of repeat transactions in which the players prove consistently trustworthy. In a small but heterogeneous community, such as the Supreme Court, learned trust likely dominates. One will thus be more likely to defer to those who have earned one’s trust, which is most likely to be a fellow justice perceived as having special expertise.

Within a multi-member deliberative body, the potential for log-rolling further encourages deference. A specialist in a given field is far more likely to have strong feelings about the outcome of a particular case than is a nonexpert. By deferring to the specialist, the nonexpert may win the specialist’s vote in other cases as to which the nonexpert has a stronger stake. Such log-rolling need not be explicit, although it doubtless is at least sometimes, but rather can be a form of the tit-for-tat cooperative game. One powerful strategy in an infinitely repeated game is to play on a tit-for-tat basis: Player 1 begins by cooperating, and then chooses in each subsequent round to play as Player 2 did on his previous choice. In effect, tit-for-tat trains the opposing player to be cooperative.  In judicial decisionmaking, deference thus invokes a norm of reciprocation that allows the nonexpert to count on the specialist’s vote on other matters.

If this analysis is correct, the widely shared assumption that Justice Powell received substantial deference from his colleagues in this area has a rational economic explanation. …

In the absence of an internal expert, a situation in which the Supreme Court has found itself since Justice Powell’s retirement, nonexpert judges might well choose to rely on external experts.  In our view, this is the best explanation for the Supreme Court’s widely criticized decision in United States v. O’Hagan, which addressed the validity of the so-called misappropriation theory as a basis for imposing insider trading liability under SEC Rule 10b-5. The misappropriation theory was almost two decades old before the court got around to finally resolving its validity. It did so only after a major circuit split had emerged. In resolving the case, the majority did essentially what the government told it to do—the misappropriation section of Justice Ginsburg’s opinion repeatedly quoted from or cited to the government’s brief and oral argument, almost always approvingly. She framed the case as one involving a “theory of liability for which the Government seeks recognition,” and adopted the central element of the government’s theory.  In other words, she quite blatantly deferred to expert opinion.

The normative payoff of this insight is at least two-fold. First, insofar as adjudication by the Supreme Court itself is concerned, the justices should consciously ask whether deference to specialists is appropriate in a particular instance. Although deference to experts is a rational response by decisionmakers in the justices’ position, such deference may lead them astray when the expert also is a party to an adversarial position. The government’s interest is to win, not to clarify the law. It is important to recall that the government is represented by individual lawyers, for whom winning is itself important.  One therefore would not expect them to devote much effort to helping the court work through the complexities of a given case.

Second, the model implies that lower courts should treat Supreme Court rulings in the securities area with a grain of salt. …

[Lower courts sometimes seem to read] Supreme Court decisions as though (i) those decisions were statutes to be interpreted from strict textualist perspective and (ii) one could ascribe intentionality to the justice’s utterances. Implicit in this approach to interpreting Supreme Court decisions is the notion that the Court is sufficiently aware of the import of the words it chooses to ascribe meaning thereto. A theory of Supreme Court decisionmaking founded on bounded rationality, by contrast, argues for declining to ascribe intentionality to the court. Supreme Court decisions in this area should be interpreted narrowly, as reaching only the specific issues before the court, while dictum should be largely ignored.