An Economic Analysis of Reliance in Market Fraud and Negligent Misrepresentation

31 Pages Posted: 30 Dec 2013 Last revised: 9 May 2014

See all articles by Alon Klement

Alon Klement

Buchman Faculty of Law, Tel Aviv University

Yuval Procaccia

Interdisciplinary Center (IDC) Herzliyah - Radzyner School of Law

Date Written: December 29, 2013

Abstract

A deeply entrenched principle in the law of fraud and negligent misrepresentation provides that damages can be recovered only upon a showing of reliance. To prevail, plaintiffs must not only establish the mere falsity of a statement, but also show that they had acted upon the statement and sustained injury as a consequence.

Despite the intuitive appeal of this principle, this paper argues that the reliance requirement ought to be abandoned. Harm can be caused by a misrepresentation without reliance, and recovery for such loss should not be barred. When a firm misrepresents an attribute of a product, its price in equilibrium typically rises. The inflated price is an injury caused to all consumers, relying and non-relying alike. A rule restricting recovery to only relying consumers results in inadequate deterrence of the firm, which in turn spurs a host of inefficient effects: it may distort allocative efficiency; encourage investments by firms in the production of fraud; induce investments by consumers in self-protection efforts and in detrimental reliance investments; and prompt competing firms to invest excessively in signaling. Furthermore, it undermines deterrence by erecting a substantial barrier to private enforcement through class actions.

While the discussion focuses on consumer markets, it applies more broadly to other markets and other market structures. We explicitly discuss its extension to security markets, in which the requirement has been famously revoked. While the analysis supports existing policy in the domain of primary security markets, it does not do so in the context of secondary markets.

Keywords: reliance, misrepresentation, fraud, consumer protection, economic analysis, optimal deterrence, class actions, fraud-on-the-market, securities regulation

JEL Classification: K12, K13, K19, K22, K32, K41, K42

Suggested Citation

Klement, Alon and Procaccia, Yuval, An Economic Analysis of Reliance in Market Fraud and Negligent Misrepresentation (December 29, 2013). Available at SSRN: https://ssrn.com/abstract=2372922 or http://dx.doi.org/10.2139/ssrn.2372922

Alon Klement

Buchman Faculty of Law, Tel Aviv University ( email )

Tel Aviv
Israel

Yuval Procaccia (Contact Author)

Interdisciplinary Center (IDC) Herzliyah - Radzyner School of Law ( email )

P.O. Box 167
Herzliya, 46150
Israel

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