SECURITIES REGULATION OUTLINE

Securities Regulation Exam: December 12, 2008, 1:30 p.m.

INTRODUCTION
I. SECURITIES TRANSACTIONS:
A. Issuer Transactions: Sales of securities by issuers:
1. Private Placements
2. Primary Distributions
a. Initial Public Offerings
b. Follow-up Offerings
B. Trading Transactions: Purchasing and selling outstanding securities:
1. Secondary Distribution: Previously privately placed securities resold in an amount as great as a public
offering.
II. FRAMEWORK:
A. The Securities Act of 1933:
1. Deals with when issuers sell stock to the public to raise equity.
2. Regulates the registration and sale of stocks through public offerings.
a. Requires a Registration and a Registration Statement, 6, 7, 8.
b. Requires a Prospectus, 10.
3. Structure of Major Provisions:
a. 2 Definitions
b. 3 Exempted Securities
c. 4 Exempted Transactions
d. 5 Registration Requirements
e. 11 Private Right of Action for Materially False Statements Made In a Registration
Statement
f. 12 Civil Liability For:
i. Those who sell securities in violation of the registration requirements listed in 5.
ii. Anyone who sells any security in a public offering by means of a materially
misleading statement in a prospectus or elsewhere.
B. The Securities and Exchange Act of 1934
1. Created the SEC
2. Deals with situation when individuals sell stock on the market.
3. Provided for periodic disclosure and other disclosure provisions:
a. Reporting Companies: Three kinds of companies are subject to disclosure. Reporting
companies are required to register with the SEC and make timely filings of reports as required
by 13.
i. Companies with publicly listed securities on a stock exchange. 12(b).
ii. Companies with assets of greater than $10M and securities held by 500 or more
people. 12(g) and Rule 12g-1.
iii. Companies that have an effective 33 Act registration statement that has become
effective. 15(b).
b. Reports
i. 10-K: Annually
ii. 10-Q: Quarterly
iii. 8-K: When a material development occurs.
4. Provides for anti-fraud measures. See Rule 10b-5.
C. State Blue Sky Laws.
THE SECURITIES ACT OF 1933
I. DISCLOSURE and LIABILITY in THE PUBLIC OFFERING GENERALLY:
A. Sunlight is the best of disinfectants. Louis Brandeis.
B. Information on a registration statement (an S-1) can be divided into four categories (The first three items must
also be included in a companys prospectus):
1. Information bearing on the registrant:
a. Detailed description of the registrants business, property and management.
1
b. In prospectus, information must be formatted into a clear, concise and easy to read document
(no legalese, short sentences, everyday language, active voice, breakdowns of complex
information, no jargon, no multiple negatives)
2. Information on the stock distribution and the use of its proceeds:
a. Underwriters in privity with the registrant must disclose the general terms of their agreement
and compensation (in the aggregate and on a per share basis).
b. The net expected proceeds of the offering must be disclosed, and if the registrant has specific
plans for the proceeds, those plans must be disclosed.
3. A description of the securities of the registrant:
a. The rights, privileges and preferences of the security being offered.
b. Must include any provision that would subordinate the holders rights to other security
holders or restrict the registrants ability to incur indebtedness or the payment of dividends.
4. Exhibits and Undertakings:
a. Articles of Incorporation
b. Bylaws
c. Attorneys Opinion as to legality of securitys registered.
d. Any 10-K or 10-Q reports incorporated into registration statement by reference.
C. The instructions for filling out an S-1 are contained in Regulation S-K:
1. Reg. S-K also contains the instructions for filling out a 10-Q.
2. S-K is the SECs version of what investors need and deserve to know about a company that is making
and maintaining a public offering.
3. When examining whether disclosure of items in S-K line items is required, the key question is whether
additional material information is needed to understand the question in the line item.
D. The Materiality Othodoxy:
1. Materiality is important because the law of fraud is engaged when a company is accused of material
misrepresentations. Section 11 liability hinges upon materiality. Companies have no liability for
misrepresentation of non-material information.
2. Something is material when it makes a difference to a reasonable investor. If a reasonable
investor would consider the information important, it is material.
3. Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970):
a. The first (and an unsuccessful) stab at defining materiality.
b. Court says materiality entails finding that information, might have been considered
important by a reasonable investor.
c. But at the same time, the Court says the test requires that the information have a significant
propensity to affect investors.
4. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976)
a. The 7
th
Cir. applies the might standard from Mills and grants summary judgment. SCOTUS
grants cert. and reverses.
b. Held: An omitted fact is material if there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding how to vote.
c. Put differently: There must be a substantial likelihood that the disclosure of the omitted fact
would have been viewed by the reasonable investor as having significantly altered the total
mix of information made available.
d. A substantial likelihood that someone would have changed his vote is not required; the only
requirement is that the fact would have assumed significance in the deliberations of a
reasonable shareholder.
e. This is an objective standard.
5. Who is a reasonable investor?
a. SEC v. Texas Gulf Sulphur Co. (2d Cir. 1968)
b. Jones v. National Distillers & Chemical Corp. (SDNY 1979)
6. The Buried Facts Doctrine:
a. This doctrine applies to render misleading a document where all necessary substantive
information is set forth, but that information is set forth in such a way that it can only be
assembled with great difficulty.
b. See Kohn v. American Metal Climax, Inc., (E.D. pa. 1970), modified (3d Cir.).
E. The Subjective Test of Materiality:
1. A subjective standard better accounts for he range of investors that may be present in transactions. See
Thomas v. Duralite Co., (3d Cir. 1975).
2
1) Addressed the standard of due diligence necessary for directors and
underwriters. This standard is based upon a sliding scale.
2) Held: Underwriters cannot reasonably rely on what management tells them.
Underwriters have to check once, and then check again.
a) The double check is necessary for proper due diligence by an
underwriter.
b) Post BarChrist, accessing credibility with due diligence is a key for
underwriters to avoid liability.
c) Also, all individuals with potential liability have to exercise due
diligence.
3) Held: Directors of a company are presumed to know what is going on at a
company. If they do not, they essentially become negligent, per se.
4) Draws a distinction between corporate insiders and outsiders, and between
outsiders with expertise and those without.
a) There is a sliding scale of responsibility based on what can be
expected of a particular director.
b) Top managers are held to the highest standard of diligence and are
effectively guarantors of a registration statement.
i. CFOs will almost always be liable.
ii. CEOs are up there too.
c) Outside directors and peripheral participants are judged in a more
forgiving light, although a duty to investigate remains.
5) Bottom Line: Due diligence is not performed by trusting an
individuals claims, but by verifying those claims:
a) Look into contracts in search of inconsistencies.
b) Examine original documents.
c) Interview customers, employees, etc.
d) Read reports from analysts.
e) Find any inconsistencies between registration statement and other
documents.
6) Note: Directors and officers can designate someone else to perform due
diligence, but their signature is still on the form.
iv. The sliding scale approach to 11 culpability used in BarChris is codified in Rule
176.
1) This rule imposes negligence based liability under the 33 Act.
2) A scienter-based liability regime is used with 10b-5 actions.
3) Attorneys are experts only with respect to discrete portions of the
registration statement making them fairly remote from 11 liability.
d. Liability is lifted for a whistleblower under 11(b)(1)
e. PSLRA amended 11(f) to provide for proportionate (rather than joint and severable) liability
for outside directors, in the absence of knowing misconduct.
8. The remedy for a Section 11 violation? Recission.
a. The investor must be made whole again. He gets his money back.
b. This typically creates crushing liability for a defendant issuer. It is fucked.
C. Section 15 of the Securities Act: Control Person Liability: Extends liability to any person who controls a
primary violator.
D. What must be disclosed in the public offering process?
1. First, determine what form what be used to register the offering in question:
a. Integrated disclosure has been created for seasoned companies:
i. This eliminates overlapping and unnecessary disclosure and dissemination
requirements without compromising the needs of investors.
ii. Under the integrated disclosure regime, different registration forms are required
according to a companys status with the SEC.
iii. Note that integrated disclosure creates an incongruence in liability between the strict
liability (for issuer) imposed by disclosures under the 33 Act, and the scienter-based
liability imposed under the 34 Act.
b. Registration Forms
i. S-1:
1) Requires complete disclosure in prospectus.
5
i. Red Herring/Preliminary Prospectus:
1) Prospectus including a legend giving notice that this is not an offer to sell,
that the securities described are not registered, and that sales cannot occur
until the registration statement is effective.
2) Solicitation is ok, insofar as information on the offer may be sent to
prospective buyers.
3) No final pricing information.
4) No hype, no sales literature that could be a form of gun jumping.
ii. Prospectuses meeting strict guidelines of 10.
f. The Road Show:
i. This is not a prospectus, so it is allowed under 5(b)(1).
ii. Basically, oral presentations (allowed) by investment bankers and executive to big
potential buyers:
iii. The larger the audience, the riskier the presentation, insofar as written presentations
are used. When sophisticated small groups are present, the use of written materials is
acceptable, so long as the written materials are discarded after the session.
g. Rule 134: Communications Not Deemed a Prospectus (Tombstone Ads):
i. Essentially a corralary to R.135 but the with the identity of the underwriters and
amount and likely price of the security.
ii. Purpose is to further announce the plan of distribution.
h. All safe-harbors (and the conditions that come with them) created with 2005 securities
regulation reforms carry over.
i. Free Writing Prospectuses are allowed speaking about the sales literature apart
from the disclosure the Securities Act demands. This basically allows an issuer to
talk about an offering in a way that causes others to want to buy the security.
ii. Rules 164 and 433 provide for free writing prospectuses for most issuers, provided
conditions are satisfied:
1) May have to file free writing prospectus with the SEC (This is not part of a
registration statement, so 11 doesnt apply)
a) Key question: Who is using the free writing prospectus?
b) Issuers must file. Underwriters are less likely to do so.
c) See R. 433.
2) Free writing prospectus may have to accompany or be preceded by Red
Herring:
a) Key question: What type of issuer are you?
b) Smaller Companies: Accompany physically with the disclosure
document or provide an active hyperlink.
c) Seasoned Companies: Provide a URL in the brochure along with
sales info.
3) Contain a legend:
a) A legend warns the recipient that the prospectus is preliminary and
ones mind should not be made up until the final document is seen.
4) Free writing prospectus must be retained for three years.
5) Rule 433(f) allows a company to talk to the press:
a) Cant pay for publicity, but thats the only restriction of a free
writing prospectus.
b) Publicity must be filed, but no legend on a preliminary document is
necessary.
c) SEC doesnt want to burden the journalist.
i. Liability under 12(a)(2):
i. No 11 liability is available when were dealing with a prospectus or other
statement NOT in the registration statement.
ii. 10b-5 might reach fraud, but thats going to be harder to prove.
iii. 12(a)(2) provides liability for any material misinformation in a prospectus or
oral communication.
1) Seller will be liable to buyers if this is the case.
2) Reasonable standard of care is a defense for the seller.
3) Sellers can include Underwriters, Pinter; always include issuers.
4) 12(a)(2) is triggered when an investor decides to buy.
10
c. Investment Contracts
C. SEC v. W.J. Howey Co., 328 U.S. 293 (1946), Definition of an Investment Contract:
1. Issue: Whether the contracts in question constituted investment contracts that qualified as securities,
thus enabling 5.
2. Holding: This is a security.
3. The HOWEY TEST
a. Investment of Money
b. In a common enterprise
c. With expectation of profits from efforts of a third party (passiveness is key)
4. Whats really going on?
a. Investors provide the capital and share in the earnings and profits.
b. The promoters manage, control and operate the enterprise.
5. The Relevance of Risk:
a. The last paragraph of Howey suggests that risk is not a relevant factor when evaluating
whether an investment contract exists.
b. However, subsequent cases start to explicitly and implicitly consider the degree of investor
risk when evaluating whether a security exists.
6. Breaking down the Howey Test:
a. What do we mean by an investment of money?
i. In United Housing Coop v. Foreman, SCOTUS held that investment company
analysis stats with the notion that someone is being asked to invest as opposed to
someone being asked to consume.
ii. If the dominant reason for payment is to consume or enjoy, the possibility for
appreciation in value doesnt make something a security. The key? Whether
something is dominantly, if not exclusively an investment.
iii. What is money? Money need not be cash. What about a company offering
employees stock as payment for services? Those are still securities.
b. What types of relationships constitute a common enterprise?
i. Not addressed in Howey (it was obvious) but extensively debated in subsequent
cases. A circuit split exists:
ii. Horizontal Commonality: Like in Howey, where multiple investors, similarly
situated, buy the same instrument. I.e., Investors pool funds with a pro-rata
distribution. Accepted by all courts.
iii. Vertical Commonality: Looks at the promoter and the investor. Multiple investors
are not needed, so long as the promoter and the investor are involved in the same
enterprise with linked fortunes.
1) More things are securities under this view, so more liberal circuits tend to
accept it.
2) Broad Vertical Commonality: Looks at the uniformity of the impact of the
promoter and requires only a connection between the efforts of the promoter
and the collective successes or losses of investors. I.e., Fortunes of investor
and promoter are linked in some way. Accepted by some courts.
3) Strict Vertical Commonality: Requires a directed relationship between the
success (as opposed to efforts) of the promoter and that of the investors;
promoters and investors must share the risks of a venture. I.e., Fortunes of
the investor and promoter are strictly linked. Accepted by most courts.
a) Strict vertical sharing of fortunes cannot be satisfied where returns
are fixed.
c. What constitutes the expectation of profits from the efforts of others?
i. Expectation refers to the expectations from the investments.
ii. Profits focus on whether one will make money in other words, the terms is used
practically.
iii. Efforts of others? The key here is passivity. The tough question is when your own
activity in an investment excludes you from claiming to be an investor.
1) Most courts agree that franchise agreements are not securities, because
franchise owners are doing work to make the money.
2) A franchise might be a security IF the company is doing all the work and
making all the money in a given situation.
D. Marine Bank v. Weaver (1982)
15
b. Firm would implement procedures to ensure no
persons solicited would be offered securities at
the time of solicitation.
iv. Newsletters: 502(c) proscribes general solicitation acts by an issuer or any person
acting on its behalf. This means an affiliate will be covered as well. Newsletters are
no good.
v. Investment Databases: Do not constitute general solicitations.
vi. Internet Solicitations:
1) Placing private offering materials on a web site is against proscription of
general solicitations.
2) BUT where prospective buyers have been identified and given passwords, a
private web site might be acceptable.
3) Key would be the same analysis above and the question: Is this offering
sufficiently restricted?
a) Improper solicitation will occur when those receiving solicitations
are given instant access to offerings, even if offerings are password
protected.
b) Improper solicitation will also occur if a solicitation is not
sufficiently generic.
c) Finally, it will also likely occur if a broker-dealer has not taken
effort to qualify the investor.
d. Rule 135C:
i. Allows reporting companies to provide notice of an unregistered offering.
ii. BUT notice may not be used to condition the market, and notice may not contain
info other than the name of the issuer; class, amount, and basic terms of the security
to be offered; and other limited information.
iii. This is the private offering correlary to R. 135.
7. Limitations on Resale:
a. The buyer of any exempt security must be locked up.
b. This prevents private offerings from being used to circumvent the public offering process.
F. REGULATION A: MINI-REGISTRATION: Rules 251-264:
1. No 11 attaches under Reg. A because this is a different form of offering.
2. General solicitations are allowed with Reg. A offerings.
a. This means web sites have been popular venues for Reg. A offerings.
b. Who actually makes this work? Locally and well-known products looking for investment.
You take name recognition and use that to get people to buy-in.
3. Overview:
a. Has a $5M cap on offering. R. 251(b)
b. Allows for direct offerings from issuer to investors no third parties involved.
c. Reg. A results in unrestricted securities unlike Reg. D.
d. Reg. A is available for secondary offerings of up to $1.5M. R. 251(b).
e. Integration: R. 251(c) provides that Reg. A offerings will not be integrated with either (1)
any prior offerings or (2) later offerings registered under R. 701, Reg. S, or Reg. A and made
more than 6 months after the Reg. A offering.
f. Filing and Disclosure: R. 252 requires filing of an offering statement before a Reg. A
offering may commence.
g. Testing Waters: R. 254 allows issuers to test waters to see if a viable market for securities
exists by soliciting interest from prospective investors.
i. Solicitation may be made via a written document or scripted broadcast.
ii. Solicitation is subject to anti-fraud rules and must be filed with SEC prior to first
use.
iii. Testing of the waters does not qualify as a prospectus.
h. Disqualification: Reg. A is not available when issuer or those closely associated to them
engage in certain misconduct. R. 262.
4. Substantial Compliance: R. 260 states that the failure to comply with the requirements of Reg. A will
not result in the loss of an exemption if the issuer acted in good faith, the deviation was not significant,
and the neglect was not intended to protect the complaining purchaser.
G. RULE 701:
20
i. Same 2 rules as above, but the securities are deemed restricted securities.
Consequently, any reseller faces a potential problem of being deemed an
underwriter.
ii. Foreign purchasers who buy U.S. stock must understand that resales will be
governed by R. 144.
iii. After purchase, stock can dribble back in at 1 year. At two year mark, the securities
cease to become restricted.
THE SECURITIES AND EXCHANGE ACT OF 1934
I. FINANCIAL REPORTING
A. Generally
1. The periodic disclosure requirements of the 34 Act
2. Certain public companies have to file quarterly and annual reports with the SEC
3. Investors depend on independent auditors to attest that certain financial statements have been prepared
in accordance with GAAP.
a. Reports must be accurate and honest
b. Reports must fairly present the firms financial position and operations
4. NB:
a. 34 Act uses the word registrant, while the reforms and in class we will use the words
reporting company.
B. The Disclosure Requirements of Public Companies
1. The Origins and Metrics for Financial Information
a. For whom?
i. Outsiders: Investors and SH are both interested in how a company is performing
financially
a. They rely on accounting and GAAP to get their information.
ii. Insiders: mangers depend on financial info produced by firms accounting systems to
guide them in their stewardship.
b. Although SEC has the authority to prescribe accounting principles, it defers to private sectors
formulation of GAAP.
i. Financial Accounting Standards Board (FASB) currently has authority over
GAAP
a. Prior to 2002, FASB was funded largely by donations from major
accounting firms.
b. Post-Enron and resulting from Sarbanes-Oxley, FASB is now funded from
fees that reporting companies and registered investment companies pay in
connection with their registration with the SEC.
ii. American Institute of certified Public Accountants fills in the gaps for GAAP.
c. Problem: tendency of firms managers to overplay success and downplay failures.
i. First wave of defense: GAAP rule book
ii. Second wave: the outside auditor (the C.P.A.)
a. Who also follow generally accepted auditing standards (GAAS) (now
controlled by the Public Company Accounting Oversight Board, a nonprofit
corp funded by fees paid by reporting companies)
2. The Exchange Acts Periodic Reporting Obligation
a. Three distinct but interconnected initiatives of the 34 Act:
i. To control the trading practices of brokers, dealers, investors, and exchanges to
prevent manipulation and undue speculation.
ii. To regulate certain aspects of the behavior of issuers and their managers whose
stock was traded on the exchanges.
iii. To provide mechanisms for mandatory disclosure requirements for certain publicly
traded issuers ( 13).
a. Initially only applied to securities listed on national exchanges but now
includes certain securities traded in OTC markets.
b. Domestic Issuer Reporting Requirements
i. Not episodic, instead 13 is periodic
a. The annual 10-K (10-KSB for small business issuers)
b. The quarterly Form 10-Q (10-QSB for small business issuers)
25
d. 10(a)(l) now bars an accounting firm from auditing the books of any firm whose CEO or
CFO/CAO in the past year was an employee of the accounting firm.
i. S-O did stop short of requiring public companies to switch accounting firms at
regular intervals
ii. But 10A(g) now requires that the lead audit partner for a client be rotated every five
years.
iii. New SEC R. 2-0(c)(2) limits the ability of an issuers former auditors to become
employees of the issuer
iv. New Exchange Act Rule 13b2-2(b)(2) broadly prohibits directors or officers from
taking any action to fraudulently influence, coerce, manipulate, or mislead the
issuers auditor for the purpose of causing the issuers financial statements to be
materially misleading.
B. The Fairly Presents Requirement
1. The opinion letter of the firms auditor attests that the audit has been conducted pursuant to GAAS
and the auditor has concluded that the financial statements have been prepared according to GAAS
and fairly present the firms financial position and performance.
2. Assume Accountants have finished their work, following GAAP; is it possible for something to be
GAAP compliant and still be false and misleading?
3. U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969), cert. denied, 397 U.S. 1006 (1970)
a. Holding. Accountants testimony cannot be so nearly a complete defense to financial
reporting flaws.
i. Evidence by 8 experts is highly persuasive, but is not conclusive:
b. Key Reasoning: GAAP compliance is not a magic bullet for avoiding fraud.
i. 2
nd
Cir. Held that the judge was entitled not to instruct the jury that GAAP
compliance is a complete defense.
ii. Basic Reason (and dusted off post-Enron): When an Accountant certifies the
financials, the accountant states that it meets GAAP and fairly represents the
financial situation of the company; this fairly represents requirement has
everyone involved going one step beyond GAAP and can be the basis for fraud.
iii. Controversial: no one knows to what extent fairly represents means
4. Executive Certifications and Directors Signature Requirement: adding the fairly represents
requirement to the CEO and CFO.
a. Exchange Act Rules 13a-14 and 15d-14 carry out 302 of S-O by requiring the CEO and
the CFO to each certify each quarterly and annual report filed with the SEC:
i. That the officer has reviewed the report,
ii. That to the certifying officers knowledge the report does not contain any untrue
statement of material fact,
iii. That to the certifying officers knowledge the report fairly presents in all material
respects the financial condition and results of operations of the issuer,
iv. That the certifying officer is responsible for maintaining the firms internal controls
and, among other representations, has within the past 90 days evaluated their
effectiveness, and
v. That the officer has brought to the audit committees attention any significant
deficiencies in the internal controls as well as any fraud, whether or not material,
that involves management or other employees who have significant role in the
registrants internal controls.
b. Certification requirements are now in Forms 10-Q, 10-QSB, 10-K, 10-KSB, and 20-F:
i. SEC expanded disclosures in Form 10-K and 10-KSB to include a formal report
assessing the issuers disclosure procedures as well as its internal control systems. R.
13a-14.
ii. Also, even before S-O, SEC has required 10-K to be signed by at least a majority of
the directors.
a. This is not a hollow ritual:
b. In AUSA Life Ins. Co. v. Dwyer (S.D.N.Y. 1996), directors who signed the
10-K with knowledge it was false where held to violate the antifraud
provision
5. Notes:
a. Fairly Presents Is it a standard or a rule
i. What does it mean?
30
ii. Criminal Activity:
iii. 401(f) disclosed only if adjudication, it does not expressly require pending claims
iv. No reference to settlements either
c. Item 402 Executive Compensation
d. Item 403(c)
i. Requires disclosure of any arrangements known to registrant, including any pledge .
. . the operation of which may at a subsequent date result in a change in control of
management.
e. Item 404 Self Dealing Transactions
i. Disclosure required if transaction exceeds $60,000 and is between registrant and
director, executive officer, a director nominee, or owner of more than 5% of
registrants stock, or immediate family member. (Franchard)
f. Code of Ethics: Item 406 S-O Additions: Disclose companys ethics policies
i. On Form 4-8k, a company must disclose any waiver of your ethics policy
ii. SECs rules expand the scope of a codes mission to include:
a. Avoidance of conflict of interest
b. Prompt internal reporting of violations of the code, and
c. Provisions calling for accountability under the code.
5. Five Years: SEC enforces material violations more than 5 years should be disclosed, but may not
necessarily be required to be disclosed.
F. The Interface of Materiality and Corporate Governance: The Materiality of Being a Bad Citizen:
Violations of State or Federal Law
1. Suppose you have a manager convicted of a crime
a. Item 401(f) of Reg. S-K: Involvement in Criminal activity within the last 5 years that is
material to managers integrity AND has to be pending/conviction (excluding traffic
violations or minor violations).
i. So to not report needs to either be more than 5 years ago or a minor violation.
ii. When your asking whether something should be reported, what you do is go to
competence or integrity.
iii. Can be a complex analysis, depending upon the level of manager, the malfeasance in
question, and the type of crime. See 2006 outline for details.
2. Roeder v. Alpha Industries, Inc. (1
st
Cir. 1987)
a. Corp authorized a bribe to Raytheons contract officer to secure his assistance in winning for
the corp. a valuable subcontracting award.
b. When bribe disclosed, companys stock plummeted in value because the bribe lead to serious
sanctions barred from federal government work.
c. 1
st
. Cir. Held that even though information was material there was no duty to disclose it.
3. SEC v. Jos. Schlitz Brewing Co., 452 F. Supp. 824 (E.D. Wis. 1978)
a. Schlitz bribed officials. He argued it was a small about, de minimus.
b. Court said bribery was material because:
i. Bribery info has direct bearing on integrity of management
ii. Was material from economic standpoint (jeopardized license to sell beer).
iii. Schlitz violated 13(a), 14(a) of the Exchange Act by failing to disclose the bribe
in its annual and quarterly reported filed with the SEC as well as in its proxy
statement.
4. Notes:
a. The Duty to Disclose Bribery
i. Distinguishing Schlitz from Roeder:
a. Roeder was a private action brought by a shareholder.
1) Courts have overwhelmingly denied any monetary recovery in
such proxy-based suits for past bribery amounts.
2) Reasoning: Since the proxy solicitation sought not the
shareholders approval of the bribes, but only the election of the
directors, no causal relationship exists between the defective proxy
statement and the payment of the bribes.
3) In sum, if bribes are material, it is because they bear upon the
integrity and stewardship of the director nominees
b. Schlitz was a public action brought by the SEC
ii. See also Gaines v. Haughton (9
th
Cir. 1981):
35
8. Fiduciary Duties
a. To this list of possible exceptions to the privilege not to disclose, one would also have to add
the situation where there is some preexisting, fiduciary-like duty to disclose.
IV. LITIGATION REFORM
A. What kinds of actions are securities actions?
1. Class Actions!
a. Most are dealt with on a contingent fee basis.
b. Usually 5-35% of the recovery in settlement or a favorable judgment (usually at 25% cut)
goes to the lawyers.
2. Ever since 1970s private actions take off
a. After TGS many law suits filed against TGS
b. Became known as the fraud on the market action: when every investor could form a class
action and sue the company
c. Because the high amount of money involved, a lot of suits are brought that shouldnt be
i. By 1990s Congress and public started to want to hold back the fraud on the market
cases (but didnt abolish); passes PSLRA
ii. Passed overwhelmingly in House and Senate, vetoed by Clinton, then Congress
overrode the veto.
B. Private Rights of Action Under Rule 10b-5
1. Creation and Controversy: how congress is dealing with this (through the PSLRA of 1995)
a. Who gets to control litigation on the Ps side? Who is going to be the named plaintiff?
i. The thought that there should be a client supervising the lawyer is actually a thought
of cutting the aggressiveness (b/c the lawyer is dreaming of the fee)
ii. It also goes to the question of legal fees. A strong client can negotiate the fees down.
iii. The PSLRA: rebuttable presumption that member of class with largest financial
stake gets to be the plaintiff.
a. Largest Stake Holder
1) Consequence:
a) Most likely the largest stake holder will be institutions.
b) They will also make up the majority of the plaintff class.
2) Problem: a vast majority of institutions dont even bother to get
involved with the litigation, they dont even collect on their check.
a) Why?
i. They want to stay on good terms with
management
ii. Another reason is some might even opt-out of
the class because they are pursuing it alone
through 18 (a recent development)
3) What institutions are more than willing to get involved: public
pension funds
a) Ex. NY State Retirement System
b) Why?
i. Votes/Politics
ii. Governor usually appoints the head of the state
or local pension funds
iii. Which all the above leads to big campaign
contributions by law firms to get a piece of the
pie
iv. Notice too it is the blue states that are more
involved (blame or thank the Democrats for
these).
C. Scienter: Hochfelder and beyond [pp. 648-59] (the other major reform from
1. Ps must establish scienter on part of the D
a. What do it mean?
i. Knowledge
a. Not what your motive was, but where you aware when you were speaking
that you spoke falsely
b. If so, you have committed fraud
ii. Recklessness
40
Two Major PSLRA
reforms:
1) A reubttable
Presumption that
member of class
with largest financial
stake
and
2) Scienter
VI. SECONDARY LIABILITY
A. Overview of 10b-5:
1. Fraud
a. You have a serious question of materiality (making known fraudulent statement or actionable
omission)
b. When is Silence actionable (actionable omission)?
c. P must prove
2. In Connection With
a. Standing
b. P must also prove
3. Scienter
a. D acted intentionally or recklessly
b. Pleadings Standard
c. P again must prove
4. Who is a Defendant?
a. Those who commits a fraud
B. Who is the Defendant?
1. Question is on those who commit fraud
2. Speaker/publisher: the person who actually utters the lie
a. Usually we can identify the original source
b. But often times the source is just a mouth piece
3. Aided and abetted jointly and severally liable
a. Fraud with many authors problem
i. You find everyone with scienter and who provided substantial assistance to fraud
ii. This could lead to banks and law firms and many other
4. Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994)
a. In one stroke, the Supreme Court eliminates decades of precedent: After this case, there is
no such thing as implied aiding and abetting under 10b-5.
i. The plain language of 10(b) doesnt say anything about assisting or aiding fraud.
ii. Constructionist court did not want to continue creating rights of action
iii. Policy:
a. Liability is based on reliance in the other part of the act.
b. Way of strike suits and Ps suing everyone with deep pockets
b. Side Note:
i. Equity holders are protected by fiduciary duty.
ii. Debt is protected through contract protections negotiated in the debt contract.
a. A bond will usually contain lots of provisions designed to protect the bond
holders
b. Ex: the company many not barrow up to a certain limit
c. Problem is when you sell bonds to thousands of bond holders, what are the
changes that the bond holders will enforce those contracts?
1) Wall Street Solution: every time bond issuance, there is an
institution assigned as a trustee of all the bond holders, it is the
trustee who enforces the bond agreements
2) Who chooses the trustee? The Company
iii. This is all background for this case because it is the indentured trustee who is being
sued.
c. Had this been a criminal prosecution, it would have been a straight forward case: criminal
code is pretty clear on aiding and abetting.
d. SEC went for a compromise (instead of overturning the S.Ct. ruling through legislature) and
was able to have Congress agree that only the SEC can bring Aiding and Abetting cases
C. What does it mean to commit a fraud?
1. Whats the separation of mere assistance and committing
2. The three tests:
a. Substantial participation
i. Whats the difference b/w this and substantial assistance which is no longer allowed
after Central Bank?
ii. Not clear, but 9
th
Cir. still holds it is alright
b. Wright
45
1) Buyer was short-seller, and was therefore was relying upon the
assumption that the market price was not indicative of its true
value.
v. What is an Efficient Market?
vi. The Desirability of the Theory
D. Fraud on the Market: Some Variations
E. The Reasonableness of the Reliance: Due Care
F. Damages
1. Section 28(a)provides that no person who brings suit under the Act may recover a total amount in
excess of his actual damages on account of the act complained of.
a. Proper damage measurethe net harm that activity imposes on other people divided by the
probability that the activity will be detected and prosecuted successfully.
2. Out of Pocket Measurefind out what the price would have been that daythe trading dayhad the
truth been told.
G. Open Market Transactions
1. Theory
a. In a case involving false publicity unaccompanied by insider tradingthe net economic loss
to marketplace traders is close to zero since the disadvantaged buyer caused an advantaged
seller.
2. Practice
H. Proportionate Liability
1. Problem 12-9
I. Clearing up:
1. The Dura case sums up very little, basically, if you have allegations of a fraud and later the truth
comes out (which is typically what happens); if immediately upon the truth coming out the stock price
drops, it is very easy to prove loss causation (it is proximately caused by the fraud)
a. All the problems come when you dont have that:
i. A flat stock price
ii. Stock price goes up
b. Think about it for a minute, there are a number of possibilities:
i. Truth leaked out before truth official announces
ii. You might have a smart company that releases info on the fraud at the same time
releasing good news; and if the good news is good enough you will have a stock
price going up
c. Once you imagine the possibilities, do you allow this just be pleaded or do you go to trial?
i. These are the issues from Dura
VIII. LAWYERS LIABILITY AND ETHICS
A. Intro
1. Sarbanes-Oxley Act
a. Remember, idea is that gate-keepers will insure better compliance with securities laws
i. So much of the act is making the attorney (not just the accountants) a better gate-
keeper
2. 10b-5: attorney exposure?
a. Remember, under 33 Act, lawyers arent touched: not a part of the D class under 11, and
only sellers are Ds under 12(b)(5)
b. Do realize, however, that if you do screw up in 33 Act provisions, you can be sued for
malpractice; but this isnt in the 33 Act structure
c. Law firms involved have to deliver a 10b-5 opinion stating they have not seen any 10b-5
violation
3. What do lawyers face when they are involved with fraud-based liability?
a. The lawyer has exposure on 10b-5:
i. For aiding and abetting
ii. For primary liability
iii. Cross-reference: SEC could order cease and desist order (which has a negligence
standard)
4. Lawyers as gate-keepers: legal ethics and securities regulation (ethics meets law)
a. Since the 1970s, SEC has taken the stance that it can disbar a lawyer from practicing before
it if the lawyer has either violated the securities laws or demonstrated unfitness
i. Formed under old 2(e), now 102(e)
50
1) Transactions occurring within 6 months prior to the person
achieving such status are exempt from 16(b).
2) Doesnt work for after because the plot to conduct insider trading
could have happened while a person was a director and then that
person retires and then sells
ii. Ten Percent Shareholders
a. Liability will not arise with respect to any matched purchase and sale, or the
sale and purchase of the security involved. This means:
1) The transaction that makes a person 10% shareholder is not a
purchase for purposes of the section.
2) The transaction that brings him below that level is a Section 16(b)
sale, but any subsequent bona fide sales are not covered.
iii. Securities Covered
a. No requirement that the insider bought and sold the SAME stock
iv. Timing
v. Enforcement
5. Executive Compensation
a. Now mostly exempt from 16(b)
6. Pension Blackout Periods: blackouts now apply to executives as well
7. Unorthodox Transactions: The Takeover Problem
a. Texas International Airlines v. National Airlines Inc., 714 F.2d 533 (5
th
Cir. 1983)
i. During attempt by TI to gain control of National, TI purchased shares in open
market. Within 6 months, TI and Pan American World Airways entered into stock
purchase agreement whereby TI agreed to sell many shares.
ii. Held: Section 16(b) applies here. The volitional character of the exchange is
sufficient reason to trigger applicability of the language of 16(b).
8. Is There a Need for Reform?
a. Repeal?
b. Short Sales
X. INSIDER TRADING
A. Intro
1. Based on the premise of finding fraud on the unfairness of allowing insiders to profit from their special
access to sensitive information.
a. Unfairness that frustrates the justifiable expectation of the securities marketplace that all
investors trading on impersonal exchanges have relatively equal access to material
information. Texas Gulf Sulfur
2. History:
a. Congress did not intend to deal with Insider Trading in the 34 Act beyond 16 (which only
covered very limited insider trading)
b. By 1960s, the new SEC Chairman changed policy: started to use 10b-5
i. Felt it had no question authority to prosecute fraud; and if insider trading is a fraud,
then yes, SEC has control
ii. In SEC v. Texas Gulf Sulfur, SEC got to test out its new theory
a. Remember, in this case there was reports of mineral deposits and a lot of
insiders started buying up the stock
b. Court agrees that Insider Trading is a fraud and falls under 10b-6, thus there
was no need of a statutory reform.
c. Why call it fraudulent?
i. SEC and Court: Because it is unfair, because it is abusive
a. When a person is in a position unfairly in a position to take advantage, they
have an affirmative duty
b. Silence can be fraudulent, especially when there is a duty to disclose
3. In what respect is insider trading deceptive?
a. Sure it is deceptive to know information that others dont, but you have to directly deceive
someone
i. But what about a duty to rescue from torts?
b. Its unfair while you line your pockets with information that others dont know
55
Insider Trading:
1) Fiduciary
Duty and 10b-5
(Chiarella)
2)
Misappropriation
(duty to the
source)
3) 14e-3
b. Later FDA tells CEO the drug wont get approved
c. CEO tells family to sell, and he himself sells
1) CEOs stock-brokers biggest client is Martha Stewart
2) SB tells her that CEO and family is trading all stock; she tells him
to sell
d. Case goes on for her lying to the SEC (she made up a story)
e. But is she liable for insider trading?
1) Hard to see CEO trading is a tip to SB
2) SB could be liable for aiding and abetting, but doesnt get Martha
3) SB is trying to impress his biggest client for a personal benefit
4) Misappropriation theory:
a) SB was a misappropriation of the CEOs business, and he
passed on one clients business on to another client for a
personal benefit
b) Martha Stewardt, a former SB who should know better,
knew or should have known info was a tip
iii. 14-4: Where the tippee is an investment analyst
a. Assistant to VP of financeapproached by telephone by analyst
b. He tells her private info about company
c. Does this meet the Dirks test?
1) Is he telling her for personal benefit and breaching fiduciary duty?
a) To get a favorable review for company?
i. Is that selfish?
ii. Counter: it is to help the company not myself
d. If you accept that she is doing it for the company, she is probably right
1) Could argue there is some degree of selfishness by giving this info
to one person, but it is selective disclosure
2) Dominant motivation is the key (so if the person owns some stock,
sure they might benefit too, but need more)
e. Good things about this:
1) This gets the information out there into the market so you have a
better market price
f. Bad things:
1) Away to hide bad things about company: creates a line of
communication of trying to influence analyst, making them more
optimistic about company
2. Selective Disclosure: Reg FD
a. Sec. Act. Release No. 33-7881 (SEC, Aug. 15, 2000)
i. Reg FD is designed to prevent selective disclosure, to shut it down
a. It is not an insider trading rule, even though it is clearly motivated by
insider trading
b. Rather, it is a corporate disclosure rule
ii. It states that no senior executive (anyone in regular contact with market
professionals) pass-on material non-public material information to market
professionals unless it is simultaneously passed on to the public.
a. It is an affirmative duty to disclose based on SECs rule making authority.
b. May not favor someone privately without disclosing publicly.
b. Notes
i. How do you possibly do this?
a. Can you simultaneously submit a document to SEC while disclosing to
market professional
b. In essence it is a ban, unless you have previously filed with the SEC the
nonpublic material information.
c. Methods:
1) File an 8-K the one truly safe way of doing this
a) Can a company transmit its 8-K by e-mail and CC market
professionals at the same time? As long as there is an
instant in time in the SEC receiving the e-mail before
60
is a court somewhere else that could do just as good of a
job if not better?
3) Would argue it should be here:
a) How much conduct?
i. Incorporated here
ii. Investments made here
iii. Lie was made here
b) Again, making reciprocal and reputational ideals for
argument
d. Court says there is jurisdiction but adds that this is the closest possible case
ii. American Issuers
a. What happens if an American lies about being a foreign investor to a
company that wants to stay away from the US jurisdiction?
1) Courts arent friendly to that lying investor and wont give
jurisdiction to that investor to sue the company that has tried its
hardest to stay away from US courts (like making each investor
certify they arent American)
b. What about a wondering American abroad?
1) No case law on this, but speculating that Congress didnt intend to
protect the wondering investor abroad
iii. Which Way to the Barbary Coast?
e. Problems
i. 19-1:
a. German investor buying shares of a German company on the Frankfurt
Stock Exchange.
b. But German citizen discovers that the German company (parent) forced US
subsidiary to sell product even though it wouldnt (called channel
stuffing)
c. No jurisdiction
1) This is a German fraud, even though the US subsidiary was a prop
2) Doesnt meet conduct test in US
ii. 19-2:
a. In Contrast:
b. American forms company in British Virgin Islands
c. All marketing performed outside US
d. Has office in US; where is drafted is fraud, which is sent to Bermuda, and it
is in Bermuda and the British VI where the fraud goes out
e. Effects Test?
1) Even if one US investor, we have him on effects test
f. Conducts Test?
1) Drafted fraud in NYC, he is the American shooting a gun across
the border.
2) He is also American Citizen, but would that alone be enough?
Tough question
a) That alone might turn on where the American citizen does
it?
i. In Bermuda, yes, US should
ii. IN France, no, US shouldnt
g. Court had no difficultly
4. See The Restatement (Third) of Foreign Relations Law of the US
E. Choice of Law Options: The Relevance of Foreign Law in Securities Litigation
1. Suppose someone conducts a fraudulent scheme, and in the documentation and in bold print: purchase
has right to arbitrate in the laws of France. Does this relieve the US Courts?
2. Bonny v. The Society of Lloyds, 3 F.3d 156 (7
th
Cir. 1983)
a. Fraud by Lloyds of London as they are recruiting investors and many are in the US
i. Clarily we have an effect test here
ii. BUT Lloyds made it clear that case to be determined in the laws of England
iii. Should this be upheld?
iv. H: Yes, it should be under the laws of England
65