PRENTICE.DOC 8/20/2003 10:27 AM CONTRACT-BASED DEFENSES IN SECURITIES FRAUD LITIGATION: A BEHAVIORAL ANALYSIS Robert Prentice* In this article, Professor Robert Prentice takes issue with the trend of courts honoring contract-based securities fraud defenses and advocates the maintenance of a tort-based approach. Contrary to the arguments of contractarian theorists who argue that investors should be able to contractually negotiate their desired level of risk, and con- sequently that disclaimers and no reliance clauses should be honored, the article uses behavioral principles to undermine the assumption that humans rationally contract. Pointing to Carr v. CIGNA Securities, Inc., in which a contrac- tual disclaimer of oral representations precluded a successful fraud suit, and Rissman v. Rissman, wherein a “no reliance” on oral repre- sentations clause was found dispositive, as examples of courts allow- ing contract-based defenses, Prentice argues that such defenses run counter to congressional intent. Securities fraud suits were intended to be tort-based and Congress intended to limit contract-based de- fenses. As evidence of investors’ need for a purely tort-based securities law that cannot be contracted away, the article points to various be- havioral instincts that advise against reading or questioning form con- tracts and support reliance on oral representations. The article then argues that such behavioral tendencies support not only preventing a contract-based defense for small investors but also eliminating the de- fense for sophisticated and institutional investors, who are equally susceptible to human behavioral tendencies. In recognition that courts are reluctant to allow investors to break contractual promises and argue fraud, Prentice offers some be- havioral tendencies that would compel investors to wrongly feel de- frauded. Such tendencies are balanced by the tendency of juries to side with the defense. As alternatives to complete prohibition of con- tract-based defenses, Prentice suggests reviving the fraud exception to the parol evidence rule or requiring plaintiffs seeking to overturn no- * University Distinguished Teaching Professor and Ed & Molly Smith Centennial Professor of Business Law, McCombs School of Business, University of Texas. 337 PRENTICE.DOC 8/20/2003 10:27 AM 338 UNIVERSITY OF ILLINOIS LAW REVIEW [Vol. 2003 reliance or merger clauses to support their position with objective evi- dence. “[P]aper and ink possess no magic power to cause statements of fact to be true when they are actually untrue.”1 I. INTRODUCTION In a series of recent articles, I endeavored to use behavioral analysis to demonstrate that corporate officials and outside auditors have more motivation to defraud and investors have less ability to protect them- selves from that fraud than is presumed by the law-and-economics advo- cates and contractarians who have been so persuasive in the securities regulation field in recent years.2 The unfolding Enron/Arthur Andersen (WorldCom, Global Crossing, Tyco, Adelphia, and so on) scandal is surely illustrating my arguments more vividly and persuasively than I was able to do myself.3 Involving apparent corporate securities fraud and reckless auditing that cost investors and employees tens of billions of dollars,4 the Enron scandal has prompted Congress and the Securities and Exchange Com- mission (SEC) to make broad-ranging reforms of the securities laws.5 Overlooked in the current media frenzy and unaddressed by Enron- generated reforms, however, is a large amount of retail-level securities fraud that also undermines investor confidence in the securities markets, yet is currently largely shielded from liability by a string of arguably im- prudent court decisions. 1. Arthur L. Corbin, The Parol Evidence Rule, 53 YALE L.J. 603, 620 (1944). 2. Robert A. Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for Its Future, 51 DUKE L.J. 1397 (2002) [hereinafter Prentice, Whither Securities Regula- tion?] (using behavioral analysis to critique a proposal to essentially deregulate the securities industry and regulate investors instead); Robert A. Prentice, The Case of the Irrational Auditor: A Behavioral Insight into Securities Fraud Litigation, 95 NW. U. L. REV. 133 (2000) [hereinafter Prentice, Irrational Auditor] (delving into twenty-five years worth of empirical behavioral analysis of accountants to dem- onstrate that auditors are not as constrained by reputational bonds from reckless activity or outright fraud as economists have argued); Robert A. Prentice, The SEC and MDP: Implications of the Self- Serving Bias for Independent Auditing, 61 OHIO ST. L.J. 1597, 1604–53 (2000) [hereinafter Prentice, SEC and MDP] (using the self-serving bias as a lens to examine how auditors are often influenced to audit recklessly and even fraudulently). 3. For an indispensable look at a major slice of the Enron/Andersen scandal, see WILLIAM C. POWERS, JR. ET AL., REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATIVE COMMITTEE OF THE BOARD OF DIRECTORS OF ENRON CORP. (Feb. 1, 2002), available at http://news.findlaw.com/hdocs/ docs/enron/sicreport/sicreport020102.pdf [hereinafter POWERS REPORT]. 4. The biggest impact of the Enron scandal is its undermining of general investor confidence in the American economy. See Bruce Nussbaum, Can You Trust Anybody Anymore?, BUS. WK., Jan. 28, 2002, at 31 (“The scope of the Enron debacle undermines the credibility of modern business culture.”). 5. Most importantly, Congress passed the Sarbanes-Oxley Act of 2002 that made numerous changes in the federal securities laws and authorized the SEC to issue new rules and to study various issues that will lead to even more changes in the near future. However, a reading of the many provi- sions of Sarbanes-Oxley convinces me that the problems that I discuss in this Article were not reme- died or even addressed by Sarbanes-Oxley. PRENTICE.DOC 8/20/2003 10:27 AM No. 2] CONTRACT-BASED DEFENSES IN SECURITIES FRAUD 339 Assume a scenario in which a promoter (or stockbroker) makes false oral representations to an investor about the bright prospects of ABC Co. and thereby induces the investor to buy ABC stock. Given the salience of the Enron scandal and the fact that $100 billion of fraud oc- curs annually in the financial services industry,6 this should not take too much imagination. Assume further that at the same time, the seller places in the written contract a provision stating: “ABC Company (or XYZ Brokerage Firm) makes no representations other than those con- tained in writing in this document. Investor acknowledges that he or she relies on no other statements by XYZ’s employees or representatives in entering into this transaction. This document represents the entire agreement between the parties.” Should the combined disclaimer (defendant “makes no representa- tions other than those contained in writing in this document”), no- reliance (plaintiff “acknowledges that he or she relies on no other state- ments by XYZ’s employees”), and merger (“This document represents the entire agreement between the parties”) clauses bar a subsequent se- curities fraud suit by the investor? At a pragmatic level, this is a very important issue. Investors in stocks and consumers of products commonly sign written contracts con- taining one or more such clauses. Many courts give effect to such provi- sions.7 It seems unfair to allow fraudsters to hide behind boilerplate pro- 6. Rachel Witmer, Antifraud: House Panel Divides on Antifraud Bill over Privacy, Confidential- ity, Fairness, BNA SEC. L. DAILY, May 10, 2001 (citing estimate of the Financial Services Roundtable); see also Steven A. Ramirez, Arbitration and Reform in Private Securities Litigation: Dealing with the Meritorious as Well as the Frivolous, 40 WM. & MARY L. REV. 1055, 1091 (1999) (noting a “pervasive run of [securities] fraud, theft, and malfeasance [that has recently] imposed astounding costs upon our economy”); Alison Beard, Complaints Against Stockbrokers Likely to Reach Record Levels, FIN. TIMES, Dec. 13, 2001, at 26; Kip Betz, SEC Brought 484 Cases in FY 2001; Financial Fraud, Reporting Top Agenda, BNA SEC. L. DAILY, Dec. 17, 2001. These numbers predated the En- ron/WorldCom/Global Crossing/Tyco scandals of 2001–02. Fraudulent activity has clearly been accel- erating in recent years. “[A]ccounting write-offs in excess of $148 billion erased virtually all of the profits reported by Nasdaq companies between 1995 and 2000.” Eugene Spector, Fraud Made Easy, NAT’L L.J., Sept. 23, 2002, at A17. 7. See, e.g., Harsco Corp. v. Segui, 91 F.3d 337, 345 (2d Cir. 1996) (finding that plaintiff cannot sue based on misrepresentations expressly excluded by writing); Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1033 (2d Cir. 1993) (holding that disclosure of risks in prospectus forecloses 10b-5 suit claiming security was unsuitable); Davidson v. Wilson, 973 F.2d 1391, 1401 (8th Cir. 1992) (holding that plaintiffs were not justified in relying on contradictory oral representations when the contract con- tained disclaimers); Ambrosino v. Rodman & Renshaw, Inc., 972 F.2d 776, 786 (7th Cir. 1992) (hold- ing that written statements control oral statements in securities law); Assocs. in Adolescent Psychiatry v. Home Life Ins. Co., 941 F.2d 561, 571 (7th Cir. 1991) (same); Jackvony v. RIHT Fin. Corp., 873 F.2d 411, 416 (1st Cir. 1989) (same); One-O-One Enters., Inc. v. Caruso, 848 F.2d 1283, 1286–87 (D.C. Cir. 1988) (same); Kennedy v. Josephthal & Co., 814 F.2d 798, 805 (1st Cir. 1987) (holding that plaintiffs cannot justifiably rely upon oral misrepresentation at odds with written disclaimer); Teamsters Local 282 Pension Trust Fund v. Angelos, 762 F.2d 522, 530 (7th Cir. 1985) (same); Zobrist v. Coal-X, Inc., 708 F.2d 1511, 1518–19 (10th Cir. 1983) (same); AES Corp. v. Dow Chem. Co., 157 F. Supp. 2d 346, 351–53 (D. Del. 2001) (same); Am. Bankcard Int’l, Inc. v. Schlumberger Techs., Inc., No.