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Business Associations

Klein Ramseyer & Bainbridge

Chapter 5
Section 3.C (I)
Rule 10b-5
Purposes of Securities Laws
 Full disclosure
 Make sure that investors have all the
information they need to make
informed decisions
 Prevention of fraud

© Stephen M. Bainbridge
2006 2
Important Civil Liabilities
 1933 Act § 11  Implied private
 1933 Act § rights of action
12(a)(1)  1934 Act § 10(b)
 1933 Act § and SEC Rule 10b-
5
12(a)(2)
 1934 Act § 14(a)
and proxy rules

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Section 10(b)
It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentality of interstate commerce or of the
mails, or of any facility of any national securities
exchange.—
(b) To use or employ, in connection with the
purchase or sale of any security registered on a
national securities exchange or any security not
so registered, … any manipulative or deceptive
device or contrivance in contravention of such
rules and regulations as the Commission may
prescribe as necessary or appropriate in the
public interest ©
orStephen
for the protection of investors.
M. Bainbridge
… 2006 4
Section 10(b)
It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentality of interstate commerce or of the
mails, or of any facility of any national securities
exchange.—
(b) To use or employ, in connection with the
purchase or sale of any security registered on
a national securities exchange or any
security not so registered, … any
manipulative or deceptive device or
contrivance in contravention of such rules and
regulations as the Commission may prescribe as
necessary or appropriate in the public interest or
© Stephen M. Bainbridge
for the protection of investors.
2006 … 5
Section 10(b)
It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentalityNotof interstate commerce or of the
self-executing
mails, or of any facility of any national securities
exchange.—
(b) To use or employ, in connection with the
purchase or sale of any security registered on a
national securities exchange or any security not
so registered, … any manipulative or deceptive
device or contrivance in contravention of such
rules and regulations as the Commission
may prescribe as necessary or appropriate in
the public interest or for the protection of
© Stephen M. Bainbridge
investors. … 2006 6
Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by
the use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact or
to omit to state a material fact necessary in order
to make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any
© Stephen person,
M. Bainbridge
2006 7
in connection with the purchase or sale of any security.
Rule 10b-5
“a judicial oak
It shall be unlawful for any which
person,has grown
directly or indirectly, by
from little more
the use of any means or instrumentality of interstate
commerce, or of the mails than
or of any facility of any national
a legislative
securities exchange,
acorn”
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact or
to omit to state a material fact necessary in order to
make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of business
which operates or would operate as a fraud or
deceit upon any person,
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in connection with the purchase or sale of any security.
Rule 10b-5
 “It shall be unlawful for any person. . . ”
 Justice Dep’t: Willful violations are a felony
(see Securities Exchange Act § 32(a).
 SEC: Bring civil action.
 Private parties?
 No express cause of action.
 Supreme Court implied private right of action in
Superintendent of Insurance v. Bankers Life &
Casualty Co. (1971).

“The existence of this implied remedy is simply
beyond peradventure.” Herman & MacLean v.
Huddleston (1983).
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Elements
 Jurisdictional nexus

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Rule 10b-5
It shall be unlawful for any person, directly or indirectly,
by the use of any means or instrumentality
of interstate commerce, or of the mails or
of any facility of any national securities
exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact or
to omit to state a material fact necessary in order
to make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
© Stephen M. Bainbridge
fraud or deceit upon 2006
any person,
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Elements
 Jurisdictional nexus
 Transactional nexus

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Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by
the use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact or
to omit to state a material fact necessary in order
to make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,
in connection with the
© Stephen M. purchase
Bainbridge or sale of
2006
any security. 13
Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by
the use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a material fact or
to omit to state a material fact necessary in order
to make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,
in connection with the
© Stephen M. purchase
Bainbridge or sale of
2006
any security. 14
RuleOnly
10b-5
 purchasers or sellers
have standing
It shall be unlawful to directly
for any person, sue – or Blue
indirectly, by
the use of any
Chipmeans or instrumentality
Stamps v. Manor ofDrug
interstate
commerce, or of the mails or of any facility of any national
Stores
securities exchange,
(a) To employ anyChip
 Blue device,plaintiffs
scheme, or decided
artifice to
defraud,
(b) To makeNOT to buy
any untrue due to
statement of fraud
a materialbutfact or
to omit had noa standing
to state material fact necessary in order
to make the statements made, in the light of the
circumstances under which they were made, not
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,
in connection with the
© Stephen M. purchase
Bainbridge or sale of
2006
any security. 15
Rule 10b-5
•White’s dissent in Basic: How
was fraudulent denial
It shall be unlawful for any person, directly or indirectly, by
connected
the use of any means with purchase
or instrumentality or
of interstate
commerce, or ofsale?
the mails or of any facility of any national
securities exchange,•Fraud only needs to “touch
(a) To employ any anddevice, scheme,
concern” or artifice to
a purchase or
defraud,
sale
(b) To make any untrue statement of a material fact or
•E.g.,
to omit to state misappropriation
a material fact necessary in order
theory of
to make the statements insider
made, in thetrading
light of the
circumstances under which they were made, not
liability
misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,
in connection with the
© Stephen M. purchase
Bainbridge or sale of
2006
any security. 16
Elements
 Jurisdictional nexus
 Transactional nexus
 Material misrepresentation or
omission

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Rule 10b-5
It shall be unlawful for any person, directly or indirectly, by
the use of any means or instrumentality of interstate
commerce, or of the mails or of any facility of any national
securities exchange,
(a) To employ any device, scheme, or artifice to
defraud,
(b) To make any untrue statement of a
material fact or to omit to state a
material fact necessary in order to make the
statements made, in the light of the circumstances
under which they were made, not misleading, or
(c) To engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,
© Stephen M. Bainbridge
in connection with the purchase
2006 or sale of any security. 18
Basic Inc. v. Levinson (1988)
 Combustion had been negotiating a
merger with Basic for 2 years
 Rumors about the deal persistently
circulated, but Basic consistently denied
them
 Denial 1: October 21, 1977 (stock price at
$20)
 Denial 2: September 25, 1978
 Denial 3: November 6, 1978
 Merger announced December 19, 1978
– priced at $46
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Basic Inc. v. Levinson (1988)
 Plaintiff class: Investors who sold
stock between October 21, 1977,
and December 19, 1978
 Claim they would have obtained a
higher price had Basic not issued
those denials

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Is Denial Just a River in
Africa?
 Why did Basic deny the rumors?
 FYI: Basic and Combustion agreed to
keep the deal a secret at least until
an agreement in principle had been
reached
 But why?

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Basic Inc. v. Levinson (1988)
 Issues:
1. Were Basic’s statements

materially false?
2. Is this a proper class action,

when proof of reliance is an


issue?

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Materiality
 Side-issue
 Where 10b-5 liability is premised on
an omission of material fact, liability
can only arise where the defendant
had a duty to disclose
 Basic may not have had a duty to
disclose on these facts

Footnote 17

Issue not decided

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Materiality
 Footnote 4:
 Why is company liable for something
President said?

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Materiality
 General standard of materiality?
 “whether there is a substantial
likelihood that a reasonable
shareholder would consider the fact
important” – TSC Indus., Inc. v.
Northway Inc. (1976)
 But how do we apply when faced with
uncertain and contingent facts?

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Materiality
 Basic standard?
 “a highly fact-dependent
probability/magnitude balancing
approach”
Huh?

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Materiality: Parting Shot
 Assume the merger was material
from Basic’s perspective
 Was it necessarily also material
from Combustion’s perspective?

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Elements
 Jurisdictional nexus
 Transactional nexus
 Material misrepresentation or
omission
 Reliance

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Reliance
 An element of claim
 Presumed in omission cases –
Affiliated Ute Citizens of Utah v. US
(1972)
 But Basic is a misrepresentation case
 Class certification implications

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Reliance
 What is the “fraud on the market”
theory?
 Presumption that investor relied on integrity
of market price—so investor need not have
seen misrepresentation
 Basis?
 “The fraud on the market theory is based on the
hypothesis that, in an open and developed
securities market, the price of a company’s stock
is determined by the available material
information regarding the company and its
business.” © Stephen M. Bainbridge
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Capital Markets
 The Primary Market:  The Secondary

 Issuers selling stock Market:

to investors  Investors selling stock

 Distinguish public to each other


offerings (including  Minimal issuer
IPOs) from private involvement (record
placements ownership)
 Investment banks  Exchanges (e.g.,

serve as NYSE)
underwriters  Automated over the
 No formal apparatus counter markets (e.g.,
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NSADAQ) 31
Anatomy of Secondary Market
Transactions
 For NYSE description, see:
 http://www.nyse.com/floor/floor.html
 For NASDAQ, see:
 http://
www.nasdaq.com/about/about_nasdaq.stm

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The Efficient Capital Markets
Hypothesis (“ECMH”)
 Thesis: In an efficient market,
current prices always and fully
reflect all relevant information
about the commodities being
traded
 Lawrence Summers: "The efficient
market hypothesis is the most
remarkable error in the history of
economic theory." P. 74 Lowenestein When
Genius Failed quoted from WSJ without citation detail
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The Efficient Capital Markets
Hypothesis (“ECMH”)
 Thesis: In an efficient market, current prices
always and fully reflect all relevant information
about the commodities being traded
 BWB:
 Larry Summers, Treasury
Secretary “The efficient market
hypothesis is the most
remarkable error in the history of
economic theory."
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Weak Form Efficiency
 All information concerning historical prices is
fully reflected in the current price
 Put another way, price changes in securities

are serially independent or random


 Proof: Nobody has ever shown that

technical analysis (a.k.a. “charting”) is


profitable
 Implication: prices change only in response to
new information

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Semi-strong Form Efficiency
 Current prices incorporate not only all
historical information but also all
current public information
 Implication: If correct, investors can not
expect to profit from studying available
information because the market will have
already incorporated the information
accurately into the price
 Does the semi-strong form test suggest
that prices will not change when the
company announces information?
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Strong Form Efficiency
 Prices incorporate all information, whether
publicly available or not
 If true, no identifiable group can
systematically earn positive abnormal
returns from trading in securities – in other
words, nobody can outperform the market
 Once adjustment is made for risks and
survivorship bias, mutual funds don’t
outperform the market
 But insiders do
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Derivatively Informed
Trading
 The market sometimes behaves as though
it knows nonpublic information
 Often the result of derivatively informed
trading:
 Some market participants observe insider
activity and follow
 Volume and/or price ticks attract other
investors
 Policy question: Should we encourage
insider trading to promote
© Stephen M. Bainbridge market

efficiency? 2006 38
The Mechanism of Market
Efficiency

Supply

P0
Demand
at t =0

Quantity
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The Mechanism of Market
Efficiency
Positive New
Supply Info Released
at t=1
$

P0
Demand
at t =0

Quantity
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The Mechanism of Market
Efficiency
Market
$ Supply reacts at
t=1+

P0

Quantity
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The Mechanism of Market
Efficiency
Market
$ Supply reacts at
t=1+
P1+

P0

New
Demand
at t =1+

Quantity
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The Mechanism of Market
Efficiency
In most cases,
$ Supplythis adjustment
is nearly
P1+ instantaneous

P0

New
Demand
at t =1+

Quantity
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Reliance
 What is the “fraud on the market”
theory?
 Presumption that investor relied on
integrity of market price—so investor
need not have seen
misrepresentation
 Invoked when?
 Material public misrepresentation
 Efficient market
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Market Responds to New
Information
In an efficient
$ Supply market, this
adjustment is
P1+ nearly
instantaneous
P0

New
Demand
at t =1+

Quantity
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Unger v. Amedisys Inc. (5th Cir.
2/23/2005)
 Factors relevant to proof of an efficient market:
1. the average weekly trading volume expressed as a
percentage of total
2. outstanding shares
3. the number of securities analysts following and reporting on
the stock
4. the extent to which market makers and arbitrageurs trade in
the stock
5. the company’s eligibility to file SEC registration Form S-3 (as
opposed to Form S-1 or S-2)
6. the existence of empirical facts “showing a cause and effect
relationship between unexpected corporate events or financial
releases and an immediate response in the stock price”
7. the company’s market capitalization
8. the bid-ask spread for stock sales
9. float, the stock’s trading volume without counting insider-
owned stock
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Reliance
 How can defendant rebut fraud on
the market presumption?
 “Market makers” not deceived
 Corrective statements
 Specific plaintiffs would have sold
anyway

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Elements
 Jurisdictional nexus
 Transactional nexus
 Material misrepresentation or
omission
 Reliance
 Causation

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Two Types of Causation
 Transaction  Loss causation
causation  Akin to proximate
 Closely related to cause
reliance  Fraud caused the
 But for the fraud, loss
plaintiff would not  E.g., market
have invested (or doesn’t believe the
sold, etc….) misrepresentation,
stock tanked due to
market decline

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Presumption of Causation?
 Where reliance is presumed, court
will also assume transaction
causation
 Omissions
 Fraud on the market
 Loss causation not presumed
 How would Basic plaintiffs prove loss
causation on remand?
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Cumulative Abnormal
Returns
 Abnormal returns:
 AR = R - E(R)

where R is the realized return on a given
date

E(R) is the expected return on that date
 Various measures

 CAR = sum of AR over time period of


interest
 Market efficiency implies that CAR
should not be statistically significantly
different from© Stephen
zeroM.–Bainbridge
absent new info
2006 51
Event Studies
 Look for statistically significant
CARs (either positive or negative)
contemporaneous with event of
interest
 E.g., measure impact of fraudulent
statement for damages calculation in
10b-5 cases
 E.g., measure impact of change in law
 E.g., state anti-takeover laws produced
© Stephen M. Bainbridge
negative CARs 2006 52
$60
Dura Pharmaceuticals
Alleged Class Period
$50 Dura lowers FY98
forecast, citing slow
sales of antibiotic
$40 product
Closing Price

Dura announces
$30
FDA denied
approval of
asthmatic spray
$20 Dura reports 1Q97 eps; device
"strong progress" selling
antibiotic product;
expected FDA approval for
$10
new asthmatic spray device

$0
4/15/97 2/24/98 11/4/98
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2006
The District Court’s Ruling on

Motion to Dismiss SAC


 Dismissed asthmatic spray device
allegation, finding that plaintiffs did
not adequately allege loss
causation
 Stock drop in February 1988 was
unaccompanied by news concerning the
device
 “... does not explain how the alleged
misrepresentation and omissions regarding
[the asthmatic spray device] ‘touched’ upon
© Stephen M. Bainbridge
the reasons for the2006 decline in Dura’s stock 54
The US Supreme Court’s
Ruling
 Plaintiffs did not adequately allege
loss causation. Purchase inflation
does not suffice.
 “An inflated purchase price will not by itself
constitute or proximately cause the relevant
economic loss needed to allege and prove ‘loss
causation.’”
 “…the moment the transaction takes place, the
plaintiff has suffered no loss because the inflated
purchase price is offset by ownership of a share that
possesses equivalent value at that instant. And the
logical link between the inflated purchase price and
any later economic lossM.isBainbridge
© Stephen not invariably strong, since
other factors may affect 2006the price.” 55
Elements
 Jurisdictional nexus
 Transactional nexus
 Material misrepresentation or
omission
 Reliance
 Causation
 Scienter
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Scienter
 State of mind:
 Intent to defraud (Sup Ct)
 Reckless disregard of falsity of
statement (all circuits)
 Required in private party litigation
– Ernst & Ernst v. Hochfelder
(1976)
 Required in SEC actions – Aaron v.
SEC (1980)
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2006 57