To Be Liable for Fraud, You Have to Have Actually Defrauded Someone

Stream Energy is a retail gas and electrical energy provider whose business model allows prospective salesmen to purchase the right to sell its products and to recruit new salesmen. In 2014, some former salesmen brought a class-action lawsuit against Stream for fraud, alleging that the company’s business model constituted an illegal pyramid scheme.

But unusually for a fraud claim, the plaintiffs argued that they didn’t need to identify any specific misrepresentations made by Stream that might have convinced particular class members to become salesmen. Instead, the plaintiffs claimed that simply offering membership in an illegally structured business would be fraud in and of itself, even if people joined with full knowledge of all risks and benefits.

A federal district court in Texas certified the class, so Stream appealed that decision to the U.S. Court of Appeals for the Fifth Circuit. A three-judge panel reversed the district court, holding that a class could not be certified because each plaintiff must individually prove that he was subject to a misrepresentation. But the entire Fifth Circuit then reheard the appeal and ruled for the plaintiffs. The court didn't rule on whether Stream was in fact engaged in an illegal pyramid scheme, but did affirm the class certification, accepting the plaintiff’s theory that a single proof of illegal structuring would prove a fraud against every one of Stream’s salespeople.

Stream has asked the Supreme Court to review this last question, and Cato has filed an amicus brief supporting that petition. In our brief, we explain why it is dangerous to hold that someone can be liable for fraud without ever having made a misrepresentation. Reasonable judicial limitations on liability are essential to protecting the personal autonomy of all parties in a case.

In the fraud context, the key inquiry has always been whether the alleged fraudster made a specific misrepresentation on which someone actually relied to her detriment. To be liable for someone else’s losses, not only must a particular misrepresentation have been made, but it must have been the direct or “proximate” cause of those losses. By abandoning this proximate-cause rule and holding that misrepresentation isn’t necessary for potential fraud liability, the Fifth Circuit removed an important check on liability.

If individual reliance on a misrepresentation need not be proven, savvy investors may search out multi-level marketing programs, knowingly put their money in such risky ventures, and then sue for fraud if their investment doesn’t yield a profit. This significantly increases the likelihood of improper class-action lawsuits—potentially subjecting undeserving defendants to crushing liability.

Instead of that uncertainty, businesses should instead be secure in the simple legal rule that has worked for centuries: if you don’t want to be liable for fraud, don’t lie about what you’re selling.

The Supreme Court should take the case of SGE Management v. Torres and ultimately reverse the Fifth Circuit.