Last week, I had the pleasure of attending one of my favorite conferences: NBLSC, hosted this year in Knoxville by Joan Heminway and by Eric Chafee.  While there, I took part in a panel discussion of Adam Pritchard and Robert Thompson’s new book, A History of Securities Law in the Supreme Court.

Much of the book is based on the recently-public papers of Justice Powell, and argues that his presence on the Court reshaped the direction of securities law from the deferential approach applied in the early years of the New Deal to the much more skeptical view we often see today.  In particular, the book highlights how Justice Powell, with his experience as a corporate lawyer, exhibited particular sympathy and concern for businessmen who might be caught in an uncertain liability regime (twice, Justice Blackmun accused Justice Powell of continuing to represent his corporate clients from the bench, see pp. 85, 163).

In elucidating their argument, Pritchard and Thompson highlight a string of cases authored by Justice Powell where the Court adopted narrow constructions of the securities laws, after a run of broad constructions (both at the Supreme Court and in the lower courts).  One of those cases was Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), where a securities broker had stolen his clients’ money, and the clients sued his auditor under Section 10(b), claiming its negligent audit had aided and abetted the scheme.  Justice Powell was particularly concerned about “expansiv[e]” readings of Section 10(b), p. 183, as well as its application to third parties, and so, writing for the Court, rejected negligence as a basis for 10(b) liability and held that Section 10(b) requires a higher standard of intent.

The book’s discussion of Ernst was something of a puzzle for me, because in many ways I find the logic of the opinion so compelling that it’s difficult to see how the case represents a turn towards narrow constructions of the securities laws – rather than, say, a push back against plaintiff overreaching.  The core textual argument is that Section 11 imposes strict liability, or something like liability for negligence, but only for a specific set of documents (registration statements) against a specific set of defendants (the issuer, directors, signatories, experts, and underwriters).  If Section 10(b) were read to include negligence-based false statements, it would entirely swamp Section 11, with its careful limits on negligence-like liability.

But as I was preparing my remarks for the conference, I thought more deeply about the history of the securities’ laws development.

Ernst was decided in 1976.  That was 12 years before Basic v. Levinson, 485 U.S. 224 (1988); though the Supreme Court had presumed reliance in cases of fraudulent omissions, Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128 (1972), and proxy fraud, Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970), for general affirmative misstatements, the fraud on the market doctrine was only just being developed in the lower courts (Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975) had been decided only a year earlier).

In 1968 – just 8 years prior to Ernst – the Second Circuit suggested for the first time that Section 10(b) claims might not require privity between the purchaser and seller in SEC v. Texas Gulf Sulfur, 401 F.2d 833 (2d Cir. 1968) (en banc), which created the possibility of liability to the entire universe of traders for open-market frauds.  See David S. Ruder, Texas Gulf Sulphur—The Second Round: Privity and State of Mind in Rule 10b-5 Purchase and Sale Cases, 63 Nw. U. L. Rev. 423 (1968); Donald C. Langevoort, From Texas Gulf Sulphur to Chiarella: A Tale of Two Duties, 71 SMU L. REV. 835 (2018).  In 1976, the law in that area was only beginning to get off the ground, which is why it is not surprising that, according to Pritchard and Thompson’s history, Justice Powell was troubled by the lack of privity between the plaintiffs and the accounting firm in Ernst.  See p. 183. 

In other words, in 1976, the door was still open to using privity, and perhaps an “eyeball” reliance requirement, as a basis for distinguishing Section 10(b) and Section 11, rather than the negligence/scienter distinction that the Court actually chose.  Certiorari had not been granted on that basis, however, and so Justice Powell was unwilling to make privity the foundation of his reasoning; he went with scienter instead.  See p. 183.

Viewed through that lens, yes, Ernst was something of an activist decision that was not necessarily driven entirely by the statutory text; it was a choice to narrow Section 10(b) on one particular ground, but not on an alternative ground.

So let’s imagine that alternative world, where the Court had, in fact, permitted negligence-based Section 10(b) claims.  I wonder if future courts (including the Supreme Court) would have been so quick to endorse open-market Section 10(b) actions, let alone the fraud on the market presumption of reliance.  In a world where negligence, rather than scienter, is enough to state a Section 10(b) claim, I think it’s possible courts would have been more circumspect about paving the way for securities class actions. 

In other words, the ironic implication of Pritchard and Thompson’s history is that Justice Powell, in his attempts to narrow the reach of the securities laws, ended up opening the door to the modern securities class action bar.