UPDATE
Securities Enforcement & Litigation
WINTER 2001
Federal Judges Slam Door on Antitrust
Claims Against Underwriters and Exchanges
by Glenn R. Reichardt (greichardt@kl.com)
After many leading firms in the securities industry
agreed to pay more than one billion dollars to settle
antitrust claims against Nasdaq market-makers (In re
Nasdaq Market-Makers Antitrust Litigation, S.D.N.Y.),
plaintiffs’ counsel became increasingly creative in
devising new antitrust theories to attack long-standing
practices in the securities industry. Since December,
three different District Judges in the Southern District
of New York have thrown out such claims, holding that
the defendants’ conduct was immune from antitrust
attack or that the plaintiffs lacked standing to bring
their antitrust claims because the plaintiffs had not
suffered “antitrust injury.” These recent opinions
should dampen the enthusiasm of plaintiffs’ counsel
Contents
Antitrust
Federal Judges Slam Door on Antitrust
Claims Against Underwriters and Exchanges .................. 1
Supervision
The SEC’s Campaign Against Supervisors
Suffers a Setback ................................................................ 3
Private Actions
Supreme Court Will Soon Decide Scope of
Rule 10b-5’s “In Connection With” Requirement —
SEC Urges a Broad Construction ....................................... 5
Mutual Funds
The Piper Case: Fund Risk Disclosure
Tied to Fund Volatility ....................................................... 8
The Internet
SEC Turns Up the Heat on Hyperlinks ............................. 10
who may have hoped that antitrust litigation
would supply a path around the hurdles raised by
the Private Securities Litigation Reform Act of
1995.
The Implied Immunity Doctrine
In two cases, the plaintiffs’ claims ran aground
on the shoals of the implied immunity doctrine.
In Friedman v. Salomon Smith Barney, Inc., the
plaintiffs brought a class action against eighteen
underwriters, alleging that they had violated
Section One of the Sherman Antitrust Act by
conspiring to restrict the ability of retail
brokerage customers to “flip” (i.e., promptly sell)
shares acquired in “hot” initial public offerings,
so that favored institutional investors not subject
to anti-flipping restrictions could sell their shares
at artificially inflated prices. The plaintiffs
accused the defendants of using two particular
anticompetitive practices, “penalty bids” and
“privilege revocation,” to combat “flipping.” In
an opinion handed down on December 7, 2000,
District Judge Naomi Reice Buchwald dismissed
the plaintiffs’ claims on the basis that the
defendants’ anti-flipping practices were subject
to regulation by the SEC under Section 9(a)(6) of
the Securities Exchange Act of 1934 and,
therefore, immune from antitrust attack.
Judge Buchwald noted that, when Congress
passed the Exchange Act, it was fully aware of
the price stabilization practices used to combat
flipping, but instead of outlawing those practices,
Congress decided to make them subject to SEC
regulation. In the decades since enactment of the
Exchange Act, the SEC has studied, analyzed and
Kirkpatrick & Lockhart LLP
regulated price stabilization practices, like penalty bids,
with full appreciation of their potential anticompetitive
effects. Indeed, as recently as 1996, the SEC adopted
Regulation M, which reaffirmed the legality of penalty
bids and other stabilizing activities. The SEC also
implemented ten rule changes that facilitated the
adoption of a “flipping tracking system.”
encouraged the exchanges to work together to develop
joint plans and procedures for the listing of options. In
his view, given the SEC’s active regulation of options
listing decisions, allowing the plaintiffs to proceed with
their antitrust claims might subject the defendants to
different standards, one imposed by antitrust courts and
another imposed by the SEC.
Judge Buchwald held that, in light of this legislative
and regulatory history, “it is clear that the conduct
plaintiffs challenge is immune from the antitrust laws
[because] . . . the defendants’ conduct is a species of
the ‘pegging, fixing or stabilizing’ of securities over
which the SEC has exclusive jurisdiction.” In the
court’s view, the SEC’s “conscious decision not to
prohibit this activity over which it had explicit
authority ‘implicitly authorized’ the conduct and,
therefore, ‘to permit an antitrust suit to lie against [the
conduct] would conflict with the proper functioning of
the securities laws.’”
Judge Casey reached this decision even though the SEC
and the U.S. Department of Justice filed amicus briefs
that argued implied immunity was not warranted
because the SEC’s current policy favored multiple
listing of options and, therefore, both the SEC and the
antitrust laws proscribed the same conduct. Judge
Casey dismissed this argument, holding that it is the
possibility that defendants might find themselves
subject to different standards—now or in the future—
that determines whether there is a conflict justifying
implied immunity. Judge Casey observed that “the
SEC has adopted different regulatory approaches at
different times, sometimes banning multiple listing and
more recently permitting multiple listing subject to
SEC oversight.” Judge Casey subtly chided the SEC,
noting that in the closing line of its brief it reserved its
authority to “revisit” its current policy on multiple
listing: “The SEC thus implicitly acknowledges the
very real possibility that courts applying the antitrust
laws may circumscribe the SEC’s regulatory authority
in this area and hinder the operation of the securities
laws.” Judge Casey reasoned that “[i]f as plaintiffs
suggest, the conflict inquiry is confined to one moment
in time, defendants would be subject to constant
uncertainty as to whether the SEC’s regulation at any
given date is sufficient to support a repeal of the
antitrust laws. Such a result would disadvantage both
defendants and investors.”
In a more recent decision issued on February 14, 2001,
District Judge Richard Conway Casey rejected claims
that the major stock exchanges, the Chicago Board
Options Exchange and market-makers and specialists
involved in options trading had violated Section One of
the Sherman Antitrust Act by conspiring to confine the
listing and trading of certain options classes to only one
exchange at a time. In re Stock Exchanges Options
Trading Antitrust Litigation.
According to the plaintiffs, by conspiring to prevent the
multiple listing of options, the defendants had stifled
competition and increased transaction costs for the
sellers and purchasers of options. Judge Casey
dismissed the plaintiffs’ claims on the ground that
“[b]ecause the listing and trading of options classes
falls within the purview of the regulatory scheme
devised by Congress to govern the securities industry,
and the active exercise of that authority by the [SEC]
conflicts with the operation of the antitrust laws, the
Court cannot proceed to adjudicate this matter”
because “the antitrust laws have been repealed by
implication regarding the circumstances at issue here.”
Like Judge Buchwald’s opinion in Friedman, Judge
Casey’s opinion described the legislative history of
Section 9(b) of the Exchange Act, which conferred on
the SEC “broad, plenary authority” over options
transactions, and the long history of SEC study and
regulation of options trading. Judge Casey noted that
the SEC had repeatedly considered the subject of
“multiple listing” of options and had specifically
2
Standing
In another recent decision, issued on February 9, 2001,
District Judge Kevin Thomas Duffy rejected plaintiffs’
claims that twenty-five underwriters of initial public
offering (“IPO”) shares had conspired to fix, at “supra-
Securities Enforcement & Litigation Update is published
by the Securities Group of Kirkpatrick & Lockhart LLP for
clients and colleagues in the securities field and should
not be construed as legal advice concerning any specific
circumstances. The contents are intended for general
information purposes only. You are urged to consult legal
counsel concerning any specific situation or legal issue.
© 2001 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.
KIRKPATRICK & LOCKHART LLP SECURITIES ENFORCEMENT & LITIGATION UPDATE
competitive levels, the fees” paid by members of the
plaintiff class when they bought and sold such shares.
In re Initial Public Offering Fee Antitrust Litigation.
Judge Duffy dismissed plaintiffs’ claims, holding that
they lacked standing to assert antitrust claims because
they were neither competitors nor purchasers in the
market for underwriting services, the market the
defendants had allegedly restrained.
T
hese recent opinions should
dampen the enthusiasm of plaintiffs’
counsel who may have hoped that
antitrust litigation would supply a
path around the hurdles raised by the
Private Securities Litigation
Reform Act.
The plaintiffs claimed the defendants had conspired to
fix a seven percent “IPO Fee” for the underwriting of
IPO shares. As evidence of this conspiracy, the
plaintiffs cited statistical evidence that “defendants
charged exactly seven percent fully 95% of the time”
for offerings between $20 million and $80 million
during the period from 1995 through 1997. Although
Judge Duffy expressed strong reservations about the
merits of plaintiffs’ antitrust claims, he dismissed them
on the ground that the plaintiffs had not paid the so-
called “IPO Fee.” As Judge Duffy noted, this “fee” is
more accurately described as “the discount that
underwriters take from the overall purchase price when
proceeds of an offering are turned over to the issuer.”
Since the plaintiffs did not suffer the kind of “antitrust
injury” required to confer standing upon them under
the antitrust laws, Judge Duffy held that they were not
proper parties to bring the price-fixing claims they had
alleged.
In Friedman, Judge Buchwald never had to reach the
question, but she expressed skepticism that the
plaintiffs there could have demonstrated antitrust injury
since they bought their IPO shares at the same prices as
institutional investors, prices generally set below the
shares’ estimated market value. In the Options Trading
Antitrust Litigation, the defendants also moved to
dismiss on the ground that the plaintiffs lacked
standing to sue to recover the transaction costs they had
alleged. As in Friedman, Judge Casey never had to
decide that question.
Conclusion
This recent trio of opinions from District Judges in the
Southern District of New York suggests that plaintiffs
will face many hurdles in bringing antitrust claims
against securities defendants, particularly when the
practices at issue have been reviewed and regulated by
the SEC or plaintiffs cannot demonstrate that they have
borne the economic consequences of those practices.
GLENN R. REICHARDT
Glenn R. Reichardt is a partner in the Securities Enforcement and
Litigation Practice Group of our Washington, D.C. office. Mr.
Reichardt is also a member of the American Bar Association’s Section
of Antitrust Law.
The SEC’s Campaign Against Supervisors
Suffers a Setback
by Michael J. Missal (mmissal@kl.com)
In recent years, one of the SEC’s enforcement priorities
has been the adequacy of the supervisory policies and
procedures of broker-dealers and the actions of
supervisors. The speeches and statements by
Commissioners and senior SEC staff have repeatedly
warned that where there has been a violation of the
federal securities laws, the questions will be asked:
were the supervisory procedures of a firm adequate to
prevent the violation, were there red flags that were
ignored, and did the action or inaction of the supervisor
contribute to the violation? Once a violation has been
determined in an investigation, the SEC staff seems to
shift the burden to a supervisor and firm to establish
that there was not a failure to supervise. This analysis
is done with 20/20 hindsight, sometimes making it
difficult to avoid an enforcement action for a failure to
WINTER 2001
Kirkpatrick & Lockhart LLP
supervise. Scores of enforcement actions against
supervisors and firms for failure to supervise have been
brought in the last few years.
Section 15(b)(4)(E) of the Exchange Act sets forth the
standard for the SEC to bring an action against a firm
or associated person for failure to supervise. That
provision has general language that finds a failure to
supervise if there is a violation of the federal securities
laws and that a firm or person “has failed reasonably to
supervise, with a view to preventing violations of the
provisions of such statutes, rules, and regulations,
another person who commits a violation, if such other
person is subject to his supervision.” Section
15(b)(4)(E) contains a safe harbor for firms and
associated persons if there are procedures in place
“reasonably” designed to prevent and detect violations.
The SEC’s standard for what constitutes adequate
supervision rarely gets challenged because most firms
and supervisors settle charges of failure to supervise,
without admitting or denying the allegations. The costs
and disruptions to litigate against the SEC are high, and
many firms and individuals have found the sanctions
offered to settle a case are an acceptable alternative to
litigating with the SEC. However, as the harshness of
the sanctions required to settle any type of enforcement
case, including a supervision case, steadily increases,
the SEC will be required to litigate more cases.
Recently, an SEC Administrative Law Judge, in a
detailed opinion that serves almost as a primer on the
law of supervision, rejected the Division of
Enforcement’s attempt to determine the reasonableness
of a supervisory system on the basis of whether, in
hindsight, additional measures could have prevented
wrongdoing. In the Matter of Dean Witter Reynolds,
Inc., et al., Admin. Proceeding File No. 3–9686 (Jan.
22, 2001).
The Division brought the proceeding against a
securities firm and two of its branch managers for their
alleged failure to supervise an account executive. Prior
to the institution of the proceeding, the account
executive had consented to both a permanent injunction
against future violations of the securities laws and an
administrative order barring him from association with
a securities firm in the future. He was no longer
employed with the broker-dealer. One of the branch
managers also settled before the hearing commenced,
consenting to a three-month suspension from
association with any broker or dealer, a nine-month
suspension from association in a supervisory capacity,
and a $10,000 fine.
4
The two respondent managers successively supervised
the office in which the accused executive worked
during the alleged wrongdoing. The allegations against
the account executive were garden-variety suitability
and churning claims involving elderly clients. As a
result of these alleged violations by the account
executive, the SEC alleged that Dean Witter’s
supervisory procedures were inadequate and that the
branch managers had failed to supervise him.
T
he ALJ noted that the
reasonableness of the supervisory
procedures should not be judged in
hindsight, but in light of their
perceived effectiveness prior to the
challenged wrongs.
The Division relied heavily on the fact that the activity
in the accounts had come to the attention of the Dean
Witter Compliance Department through normal
surveillance. The Compliance Department had
followed its procedures and brought this information to
the attention of the branch managers. The Compliance
Department responsibilities were informational and
advisory only; it did not have the authority to take any
corrective action. Instead, that authority resided with
the branch manager and his or her superiors. The
Division contended that the branch managers reviewed
the accounts at issue, but did not take any significant
steps to stop the activity. Thus, the Division alleged
that, even though the problems were identified by the
Compliance Department, and reviewed by the branch
managers, the supervisory system was unreasonable
because it failed to stop the violations. The SEC
offered the testimony of an expert witness to support
these contentions.
With respect to Dean Witter, the ALJ found that the
firm was entitled to the safe-harbor protection provided
by Section 15(b)(4)(E) of the Exchange Act because its
procedures were reasonably designed to prevent and
detect violations. The ALJ found that the Compliance
Department followed its procedures by identifying the
questionable trading and reporting it to an experienced
branch manager, who adequately answered the
questions raised by the Compliance Department.
KIRKPATRICK & LOCKHART LLP SECURITIES ENFORCEMENT & LITIGATION UPDATE
Significantly, the ALJ reasoned that the standard was
not whether Dean Witter’s supervisory systems would
prevent wrongdoing in every case, “but whether it was
reasonably designed to detect and prevent [the account
executive’s] churning and unsuitable trading.” Given
that the trading was identified by the procedures in
place at the time, the ALJ found these procedures
reasonable. The ALJ noted that the reasonableness of
the supervisory procedures should not be judged in
hindsight, but in light of their perceived effectiveness
prior to the challenged wrongs. Further, the ALJ
explained that the Division’s expert’s testimony
focused on ways that the broker-dealer could have
deterred the account executive’s improper conduct and
did not opine that the procedures were unreasonable.
The ALJ’s repudiation of the SEC’s allegations with
respect to the non-settling branch manager’s
supervision was even stronger. The ALJ found that the
account executive committed no violations of the
securities laws while the individual respondent was the
branch manager. The analysis could have ended there,
but the ALJ continued that, even if there had been
violations under that manager’s watch, his supervision
was reasonable. The ALJ found that he complied with
Dean Witter’s procedures and that the discharge of his
duties under those procedures was reasonable. While
the SEC offered evidence that the branch manager could
have done more to prevent violations, the ALJ found
that this was merely “hindsight speculation of additional
actions [the manager] could have taken.” The ALJ
noted that a branch manager’s supervision is not
required to be exemplary, but rather reasonable under
the particular circumstances.
Supervision will remain an enforcement priority for the
SEC. However, the language in the Dean Witter
decision makes it clear that the SEC will not be allowed
to use 20/20 hindsight to show that more could have
been done to prevent a violation. Thus, even in a
situation where a rogue broker or employee engages in
an egregious violation of the law, the SEC will not be
able to hold firms or supervisors strictly liable for
failure to supervise if proper procedures are in place.
Firms should review their compliance and supervisory
policies to ensure that they are adequate and reasonable
so that if there is a problem in the future with an
employee, they can fall within the safe harbor to rebut a
failure to supervise charge.
MICHAEL J. MISSAL
Michael J. Missal, formerly Senior Counsel, Division of Enforcement,
U.S. Securities and Exchange Commission, is a partner in the Securities
Enforcement and Litigation Group of our Washington, D.C. office.
Supreme Court Will Soon Decide Scope of
Rule 10b–5’s “In Connection With” Requirement —
SEC Urges a Broad Construction
by Paul Gonson (pgonson@kl.com)
Section 10(b) of the Exchange Act and SEC Rule
10b–5 require that, in order for a securities fraud
violation to be established, the fraud must be “in
connection with the purchase or sale of any security.”
There is no legislative history that explains the clause,
nor is it defined in statute or rule.
The Supreme Court may soon provide a definitive
construction. In The Wharf (Holdings) Limited v.
United International Holdings, Inc., it granted review
of these questions:
1. Are only the material misrepresentations or
omissions concerning the value of the security
itself or the consideration to be paid deemed to
be “in connection with” the purchase or sale of
the security for purposes of applying Section
WINTER 2001
10(b), or does the law also reach
misrepresentations about a person’s intention to
sell a security?
2. Does Rule 10b–5 reach an oral contract to
purchase or sell a security?
Wharf, a Hong Kong company, learned that the Hong
Kong government would seek bids for an exclusive
cable TV franchise. Wharf wished to bid but did not
have much experience in the cable TV business. It
approached United, a Denver-based cable TV consulting
and investment firm with a long history of experience in
that business in six countries. United provided
extensive assistance to Wharf, which was awarded the
exclusive cable TV franchise.
Kirkpatrick & Lockhart LLP
United brought suit against Wharf in federal court in
Denver, for violation of Rule 10b–5, and for state and
common law fraud, contract and securities claims, with
respect to Wharf’s failure to honor an alleged oral
agreement in which Wharf granted United an option to
purchase ten percent of Wharf. This oral agreement
was never put in writing nor referred to in any
contemporaneous document, but can be inferred from
subsequent documents.
United asserted that Rule 10b–5 applied because the
option was a security as defined in § 3(a)(10) of the
Exchange Act and Wharf deliberately deceived United
with respect to its intentions to perform on the grant of
the option. After an eleven-week trial, the jury
awarded $67 million in damages to United together
with punitive damages of $58,500,000. The U.S. Court
of Appeals for the Tenth Circuit affirmed.
The Positions of the Parties and the SEC
Wharf makes three arguments in its opening brief
before the Court: (1) historically, disputes over
ownership of securities are governed by state law; (2)
no misrepresentation going to the value of a securities
purchase was made and, thus, the “in connection with”
requirement was not satisfied; and (3) as a matter of
policy, Rule 10b–5 should not reach claims of an oral
agreement to sell securities, because that would invite
bad faith claims based on unreliable proof that led the
Supreme Court in Blue Chip Stamps v. Manor Drug
Stores, 421 U.S. 723 (1975), to reject a securities fraud
claim asserted by persons who claimed they were
fraudulently induced to hold securities, rather than to
purchase or sell them.
United argues that courts have upheld Rule 10b–5
claims where the misrepresentation had nothing to do
with either financial information or value. It argues
that Blue Chip does not restrict this case because Blue
Chip was concerned with strike suits by plaintiffs
basing claims on hypothetical transactions that they
decided not to pursue, whereas in this case there was an
actual transaction.
The SEC’s amicus curiae brief generally supports the
positions asserted by United. The SEC agrees with
United’s argument that a § 10(b) action based on a
misrepresentation about the intention to sell a security
does not impermissibly federalize state law actions for
breach of contract. The SEC explains it this way
(citing cases):
“If a person enters into a contract to purchase or
sell a security with the intent to perform and
subsequently fails to honor the contract, the
6
failure to perform gives rise to an action for
breach of contract, but there is no action under
§ 10(b). If, however, a person enters into a
contract to purchase or sell a security but
secretly does not intend to honor the contract,
an action can be brought under § 10(b) based
upon the misrepresentation.”
This is so, explains the SEC, because § 10(b) “trains on
conduct involving manipulation or deception,” so that
such an action “premised on deception presents no
improper federalization of state law.” It also supports
United’s arguments for a broad construction of “in
connection with” and that Rule 10b–5 reaches oral
contracts for the purchase or sale of a security.
The SEC’s Position Has Special Implications
for Broker-Dealers
The SEC’s position as to the broad reach of “in
connection with” is of particular interest to brokerdealers. The Commission has taken the position in its
own cases and in amicus briefs in other private actions
that the “in connection with” requirement is satisfied
whenever a broker-dealer makes a misrepresentation or
omission to a customer that relates to the customer’s
brokerage account, irrespective of whether it relates to
a securities transaction.
In furtherance of this position, the SEC has argued that
it is not even necessary that the deception could be
expected to influence a securities transaction. It
reasons that the very purpose of a brokerage account is
to buy and sell securities, so any misrepresentation or
omission relating to that account should be regarded as
inherently “in connection with” the purchase and sale
of a security.
Thus, the Commission has argued that Rule 10b–5
covers deceptive practices in a brokerage firm’s
misrepresentations concerning the qualifications of a
sales person, the risks of margin trading, the terms of a
margin account, a brokerage firm’s insolvency, and the
level of trading in a customer’s account. The SEC has
even argued that conversion of a customer’s cash or
securities from a brokerage account could be explained
as a violation of the firm’s implied representation that it
will not convert those assets.
Beyond the broker-dealer area, there are many
examples of cases that have upheld the “in connection
with” requirement on misrepresentations other than
with regard to the value of the security or the
consideration being paid for it.
KIRKPATRICK & LOCKHART LLP SECURITIES ENFORCEMENT & LITIGATION UPDATE
The Dispute Over the Sufficiency of an Oral
Contract Focuses on Blue Chip
Case Law Seems to Support United’s and the
SEC’s Position
In their briefs, the parties battle about whether Blue
Chip precludes claims based on oral contracts. In Blue
Chip, the Court held that, in order to have standing to
assert a § 10(b) claim, a plaintiff must have purchased
or sold a security. The Court held that being
fraudulently induced to hold (i.e., not to sell) would not
be sufficient. Wharf urges the applicability of language
from that decision which protects persons against
lawsuits that “turn largely on which oral version of a
series of occurrences the jury may decide to credit.”
Wharf’s brief further quotes portions of the Blue Chip
opinion which generally prefers “matters which are
verifiable by documentation and do not depend upon
oral recollection.”
These Supreme Court decisions in the securities field,
while not on point, seem favorable to a broad
construction of “in connection with”: Superintendent
of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 12
(1971) (“touching” satisfies that phrase; there, insiders
stole the proceeds after the bonds were sold); U.S. v.
O’Hagan, 521 U.S. 642, 655–666 (1997) (“in
connection with” is satisfied when the
misrepresentation and the securities transaction are part
of the same fraudulent scheme); and U.S. v. Naftalin,
441 U.S. 768 (1979) (Defendant’s failure to pay broker
for short sale of stock, when the price rose before the
settlement date, was a fraud “in the offer or sale of any
securities” under Section 17(a) of the Securities Act;
the court found “in the offer” to be coterminous with
“in connection with.”).
T
he SEC appears to be concerned
that an unfavorable ruling in this case
would apply to the Commission’s
own actions.
United and the SEC counter that the Court’s concern in
Blue Chip was not about oral testimony per se but
about the potential for abuse and proof problems in
suits by investors who did not buy or sell, but claimed
they would have traded absent fraudulent conduct by
others. The SEC points out that in the case pending
before the Supreme Court, the plaintiff must establish
not only what was in his mind but must also prove the
defendant’s intention not to honor the contract’s terms.
The crucial facts, says the SEC, are far from “unknown
and unknowable to the defendant,” quoting Blue Chip,
because the defendant can present his own testimony
and evidence in rebuttal. The jury can then weigh the
plaintiff’s version against the defendant’s version, as in
any other lawsuit.
On a policy basis, the SEC notes that fraud often
occurs through oral misrepresentation, and that a large
part of the business of the securities markets is
transacted orally. “If a plaintiff could not bring a
securities fraud action without a written contract,
unscrupulous brokers could keep all dealings with
purchasers oral, or fail to follow through on
commitments to memorialize oral agreements in
writing, in order to preclude liability under § 10(b).”
WINTER 2001
Courts of appeals and district court decisions generally
support United’s and the SEC’s arguments for a broad
construction of “in connection with” and the
sufficiency of an oral contract to purchase or sell a
security. But it is fair to note that even virtually
unanimous agreement in the courts of appeals has not
always deterred the Supreme Court from reversal of
such unanimity. For example, in 1994 in Central Bank
of Denver, the Supreme Court overruled “hundreds of
judicial and administrative proceedings in every Circuit
in the federal system” when it held that there is no
implied private right of action for aiding and abetting
under § 10(b) and Rule 10b-5 (see dissenting opinion
of Justice Stevens).
Possible Impact on the SEC If the Ruling Is
Unfavorable to Its Position
The SEC appears to be concerned that an unfavorable
ruling in this case would apply to the Commission’s
own actions. The Commission has not always agreed
that rulings by the Supreme Court in private actions
would apply to it. After the Supreme Court handed
down its ruling in Ernst & Ernst v. Hochfelder, 425
U.S. 185 (1976), that scienter is required in a private
action under Rule 10b–5, the Commission took the
position that the ruling did not apply to its cases. It
persuaded the U.S. Court of Appeals for the Second
Circuit, but the Supreme Court reversed in Aaron v.
SEC, 446 U.S. 680 (1979), holding that the SEC must
plead and prove scienter in its 10b–5 actions.
Similarly, when the high court handed down its
decision in Central Bank, holding that there is no
implied private right of action under § 10(b) and Rule
10b–5 for aiding and abetting, the Commission argued
Kirkpatrick & Lockhart LLP
in two then pending appeals in its own cases in the
Ninth and Eleventh Circuits that such a ruling did not
apply to Commission actions. Neither court reached
that issue. (Later, Congress expressly provided in the
Private Securities Litigation Reform Act of 1995 that
the Commission could pursue aiders and abettors.)
In Wharf, the Commission appears to accept that the
ruling will apply to it. It states in the opening
paragraph of its brief that the Commission “has an
interest in the case because of its potential impact on
government enforcement actions” and because of the
important role private actions have in supplementing
government enforcement and compensating injured
investors. Further, the SEC argues that restricting
claims to misrepresentations about value “would
remove from the Act’s purview many pernicious kinds
of fraud, including insider trading based on
misappropriated information.”
Oral argument is scheduled for March. A decision is
expected before the Court recesses, usually around the
end of June.
PAUL GONSON
Paul Gonson, formerly the Solicitor of the Securities and Exchange
Commission, is counsel in our Washington, D.C. office. His practice
focuses on the federal securities laws and includes litigation and
enforcement. Mr. Gonson was counsel for the Commission in most of
the cases referred to in this article.
The Piper Case: Fund Risk Disclosure
Tied to Fund Volatility
by Michael J. Quinn (mquinn@kl.com)
An investment objective that seeks “a high level of
current income consistent with the preservation of
capital” is common to many mutual funds, particularly
fixed income and conservative stock funds. A recent
decision by an SEC Administrative Law Judge (“ALJ”)
held that a fund’s portfolio which materially deviated
from that objective without obtaining shareholder
approval violated Section 13(a)(3) of the Investment
Company Act of 1940 (“1940 Act”). Significantly, the
decision also held that, in the context of a material
deviation from investment objectives, generalized
disclosure of portfolio changes and their attendant risks
is not a defense to antifraud violations of Section
17(a)(1) of the Securities Act of 1933 and SEC Rule
10b-5. In the Matter of Piper Capital Management,
Inc., Initial Decision Release No. 175 (Nov. 30, 2000),
appeal pending.
The Fund
8
conservative investment and marketed as a money
market alternative with high quality securities
supporting a AAA Standard & Poor’s rating.
In the early 1990s, in response to declining interest
rates, however, the Fund began to shift its portfolio
composition from simple pass-through mortgagebacked securities to potentially volatile CMO
derivative securities that included “inverse floaters”
whose value fluctuated inversely to underlying interest
rates. The CMOs propelled increased returns for the
Fund. By March 1993, more than 90% of the Piper
Fund’s net assets were invested in CMO derivatives,
and the Fund performed extraordinarily well.
When the Federal Reserve, with unprecedented speed,
raised interest rates multiple times in early 1994, CMO
values came crashing down, and the Fund plummeted
in value.
Piper involved an institutional government income
fund (the “Fund”) first offered in 1988. Its stated
investment objective was “a high level of current
income consistent with preservation of capital.” As the
prospectus noted, this objective could not be changed
without shareholder approval, which, the ALJ found,
was never sought.
The ALJ’s Section 13(a)(3) Findings
At the outset, the Fund’s portfolio was comprised
mostly of simple pass-through mortgage-backed
securities with returns of principal and interest
guaranteed by federal agencies such as Fannie Mae and
Ginnie Mae. The ALJ found that the Fund was
“systematically and uniformly” presented as a
The ALJ held that changes in the risk of a fixed income
portfolio should be evaluated on the basis of the
changes in the potential implied volatility of the
portfolio at the time the challenged securities are
purchased, assuming adverse interest rate conditions.
The ALJ opined that Piper’s method of calculating
The ALJ accepted the position argued by the SEC Staff
that a determination whether the Fund manager
materially deviated from the “consistent with
preservation of capital” component of the investment
objective turned on whether the Fund’s “investment
risk profile increased to any significant degree.”
KIRKPATRICK & LOCKHART LLP SECURITIES ENFORCEMENT & LITIGATION UPDATE
volatility, implied duration, which relied on historical
correlations between securities prices and interest
rates, was inadequate for a portfolio predominately
invested in CMO derivatives. He found that it did not
account for the potential volatility attributable to the
cash flow uncertainties caused by the potential for
prepayment of the mortgages underlying the CMOs.
. . . in the context of a material
deviation from investment
objectives, generalized disclosure of
portfolio changes and their
attendant risks is not a defense to
antifraud violations . . . .
The ALJ determined that volatility instead should be
determined based on the combined effect of a variety
of factors such as duration, convexity, average life,
diversification, and leverage on the portfolio’s
sensitivity to interest rates. The ALJ concluded that,
while potentially none of the factors individually was
material enough to increase risk of the Fund
significantly, each factor “reinforced one another,
compositely increasing Fund risk and volatility.” He
found that “[i]n combination, they certainly had
profound material impacts on Fund performance and
volatility.”
Based on that analysis, the ALJ determined that the
Fund manager violated Section 13(a)(3) of the 1940
Act because it materially deviated, without
shareholder approval, from the “consistent with
preservation of capital” component of its stated
investment objective, even though it adhered to the
“high level of current income” component. The ALJ
thus concluded that changes in the portfolio
composition, though within the same family of
securities, caused significant changes in the overall
risk of the Fund. These changes to the overall risk
required a shareholder-approved change in the stated
investment objective of the Fund in order to comply
with Section 13(a)(3).
The Antifraud Findings
The Fund manager expressly disclosed the CMO
investments to investors and their general risks. The
ALJ found that: (1) the prospectuses and cover letter
highlighted the Fund’s new investment in CMO
WINTER 2001
derivative securities; (2) the prospectuses provided
descriptive information regarding CMO derivative
securities; (3) the prospectuses indicated that CMO
derivative securities could increase portfolio volatility
and potential losses under specific market conditions;
(4) the prospectuses incorporated statements of
additional information (“SAIs”) by reference that
included lists of individual Fund securities grouped into
investment categories; (5) the annual reports noted that
the Fund introduced CMO derivative securities into the
portfolio; and (6) the Fund manager issued a
memorandum to investment executives recommending
client reviews to ensure that the Fund remained
appropriate in light of client investment objectives and
risk tolerances.
The ALJ’s findings suggest that Piper took substantial
steps to inform investors of the change in portfolio
composition and risk. Nonetheless, the ALJ held that
the respondent’s disclosures were inadequate and
violated Section 17(a)(1) of the Securities Act and SEC
Rule 10b–5. The ALJ ruled that, to avoid antifraud
violations, the Fund’s prospectuses, annual and semiannual reports, and marketing materials should have
disclosed “in general narrative terms” that: (1) the Piper
Fund was predominantly invested in CMO derivative
investments; (2) the Piper Fund’s superior performance
was primarily attributable to those securities; and (3) the
proportion of CMO derivative securities contained in the
portfolio significantly increased volatility.
Conclusion
The Piper decision, now on appeal to the SEC, stands
for the proposition that compliance with a preservation
of capital investment objective will be measured by the
implied volatility of a fund’s portfolio as a whole. It
will not turn simply on whether the constituent securities
are permissible investments. Further, it suggests almost
a strict liability standard for Section 13(a)(3) violation—
even good faith analysis of volatility and generalized
risk disclosure regarding portfolio changes will not
insulate a fund manager from a violation, if it is later
determined that changes in portfolio composition in fact
significantly increased potential volatility. The decision
also contains a further cautionary tale for fund counsel:
when portfolio changes may significantly increase
implied volatility, prospectuses will need to include the
most particularized type of risk disclosure to withstand
attack under antifraud provisions.
MICHAEL J. QUINN
Michael J. Quinn, formerly an attorney with the SEC’s Division of
Enforcement, is a member of the Securities Enforcement and Litigation
Group of our Los Angeles office.
Kirkpatrick & Lockhart LLP
SEC Turns Up the Heat on Hyperlinks
by Eileen Smith Ewing (eewing@kl.com)
One of the most significant issues for public companies
and securities industries professionals is the potential
liability from hyperlinks in their websites and
electronic filings to information in third-party websites,
if those sites contain inaccurate information. The SEC
Staff’s guidance of November 14, 2000 on EDGAR
filings published on the SEC’s website appears to
enunciate a significant expansion of the scope of
potential civil and anti-fraud liability under the federal
securities laws for such hyperlinks. SEC Website:
EDGAR Filer Information: Electronic Filing and the
EDGAR System: A Regulatory Overview (November
14, 2000). The Staff’s November guidance, if
followed, extends the standard for liability for
misinformation in linked websites well beyond that
stated in the agency’s May 2000 release, Use of
Electronic Media, Release no. 33–7858 (May 4, 2000).
Liability for Hyperlinks
The SEC’s May 2000 Release made clear that issuers
who give investors access to misinformation via
hyperlinks may be liable for inaccurate or misleading
information in them because they may be deemed to
have “adopted” or “ratified” the misinformation. In
other words, the affirmative act of creating the
hyperlink to a third party’s information is equivalent to
adoption or ratification of the third party’s information.
The SEC suggests that it may be worthwhile for issuers
to accompany hyperlinks with a clear and prominent
statement disclaiming responsibility for, or
endorsement of, the associated third-party information.
However, the SEC clearly cautions that statements and
disclaimers will not insulate an issuer from liability if
the relevant facts and circumstances otherwise indicate
adoption of the linked information by the issuer. The
May 2000 Release emphasized that EDGAR filers
would be presumed to have adopted any third-party
information they chose to hyperlink in documents
required to be filed with the SEC.
In the November 2000 website guidance, the SEC Staff
indicates that a filer who includes a hyperlink to a
third-party website will be liable not only for any
misinformation found on that third-party website, but
also for any misinformation in other, more remote
websites hyperlinked to the third-party website. The
November guidance states (emphasis added):
Linked material is not part of the official filing
for determining compliance with reporting
obligations. Such material, however, is subject
10
to the civil liability and anti-fraud provisions
of the federal securities laws whether or not
the hyperlink is permitted by the Commission’s
rules. Moreover, if a company hyperlinks to a
hyperlink, which, in turn, links to another
hyperlink, the company will be treated as
making all the hyperlinked material its own.
Also, if a hyperlinked document is corrected or
updated by means of a new filing, the
document containing the hyperlink also may
have to be amended. [Emphasis added.]
This new standard implies that once an EDGAR filer
creates a hyperlink to another website, it assumes
responsibility for the accuracy not only of the other
website, but all other websites that might be connected
to it through a chain of hyperlinks. It is unclear when
the SEC would an extended chain of hyperlinks as
sufficiently attenuated to preclude liability for the
original EDGAR filer.
The November 2000 guidance does not appear to be
grounded in the concepts of ratification or adoption
underlying the May 2000 Release. When a third party
embeds a hyperlink in its website, it is the third party—
not the original EDGAR filer—that has chosen to ratify
or adopt the remote information. Indeed, the third
party may embed the remote hyperlink in its website
after the EDGAR filer has created the link to the third
party website. The EDGAR filer will have no notice of
the change.
It is not clear whether the SEC Staff intends that the
broad standard of liability stated for hyperlinks in
EDGAR filed documents should apply to linked
information in other types of communications with
investors. However, it is clear that hyperlinks found in
documents a public company must file with the SEC—
for example, reports on Forms 10–K, 10–Q, or 8–K,
proxy statements, prospectuses, and the like—will
receive the SEC’s strictest treatment. The SEC has
emphasized that under these circumstances, it will
always deem an issuer to have adopted the linked thirdparty information. There is nothing in the SEC’s May
Release or the Staff’s November guidance, however,
that specifically indicates that the standard for liability
would not extend to hyperlinks in other documents or
websites used to communicate with investors.
Proactive Measures
In light of the SEC Staff’s position, EDGAR filers, as
well as other securities industry participants, should be
KIRKPATRICK & LOCKHART LLP SECURITIES ENFORCEMENT & LITIGATION UPDATE
proactive to avoid treatment of hyperlinks in their
filings that could exacerbate liability concerns.
A variety of measures should be considered. First,
while in registration, an issuer should avoid creating a
hyperlink from the company’s website to any
I
t is unclear when the SEC would
view an extended chain of hyperlinks
as sufficiently attenuated to preclude
liability for the original EDGAR filer.
information that might be deemed an “offer to sell.” In
the SEC’s view, such links can give rise to the “strong
inference” that the issuer has adopted the information
for purposes of Rule 10b-5 liability. Second,
companies should deactivate the automatic hyperlink
function commonly found in many software programs
that convert any uniform resource locator (a URL, or
website address) into an active hyperlink as it is typed
into the document. In the case of a prospectus or any
other document required to be filed with the SEC, the
SEC shifts responsibility for any inadvertently created
hyperlinks squarely onto the issuer, just as if the issuer
had created them deliberately. The SEC offers some
relief from responsibility for an inadvertent,
automatically embedded hyperlink, if the issuer has
taken reasonable steps to ensure the URL was inactive
and states in the document that the URL is a textual
reference only.
Third, from the standpoint of minimizing civil liability,
explanatory text that accompanies a hyperlink should
carefully describe and circumscribe the particular
information in the linked site that is the reason for the
link and disclaim reference to or reliance on other
information or hyperlinks that may appear in the other
website. Fourth, care should be given to whether the
layout of the hyperlink may draw attention to the
hyperlink. Even in the absence of explicit
endorsement, a company may be perceived as ratifying
the hyperlink if it uses any formatting techniques—
size, prominence, location, font, type—to draw the
viewer’s attention to the hyperlink within the website.
WINTER 2001
Fifth, the SEC has drawn particular attention to the
problematic use of techniques like framing or inlining
in company websites. “Framing” enables linked
information from another website to appear within a
frame on the same screen as the original website.
“Inlining” is similar, except that no delineating frame
appears on the screen. Both techniques potentially
could be confusing in that a visitor to a website may be
provided by hyperlink with third-party information
located on another website—without ever getting
notice that he or she has left the original site. Thus, the
visitor might believe the imported information to be
part of the original website. The SEC has stated that
framing or inlining linked information can give rise to
liability under Rule 10b–5, if the information is
materially inaccurate.
Sixth, in the view of the SEC, being selective as to
what information one chooses to link may constitute
ratifying the chosen information. For example, if a
company links a favorable analyst report to its website,
but does not create hyperlinks to the other available
reports about the company, it has, in effect, given its
blessing to the linked information. For this reason, if
an issuer chooses to link to one report, it must carefully
consider what other current reports about the company
should be linked as well. Seventh, to the extent there is
concern that linking information will give rise for
responsibility for its accuracy, it is wise to regularly
monitor the linked site and to update one’s own site to
correct inaccuracies or identify stale information in the
linked site.
Conclusion
The SEC Staff’s November guidance on EDGAR
filings enunciates broad and potentially limitless
standards for liability for inaccurate information
provided by hyperlinks. Until these standards are
modified by the SEC or judicial decisions, persons
using hyperlinks in documents filed with the SEC and
in other communications potentially are exposed to
substantial liability not only for the accuracy of the
linked information, but also for the information
provided through hyperlinks in the third party’s
website.
EILEEN SMITH EWING
Ms. Ewing is a partner in the our Boston Office who counsels public
and private companies on corporate securities transactions, technology
transfers and licensing, and electronic commerce.
Kirkpatrick & Lockhart LLP
Securities Enforcement and Litigation Group
WASHINGTON
PHONE:
FAX:
Erin K. Ardale
202.778.9000
202.778.9100
NEW YORK
202.778.9420
Michael F. Armstrong
Eva M. Ciko
Erin M. Coffer
Warren H. Colodner
Christopher Lewis
Eugene R. Licker
Richard D. Marshall
William O. Purcell
Loren Schechter
Michael A. Stern
John J. Sullivan
Alan J. Berkeley
202.778.9050
James E. Day
202.778.9228
Christopher E. Dominguez
202.778.9404
Charles L. Eisen
202.778.9077
Leigh M. Freund
202.778.9189
Paul Gonson
202.778.9434
Stephen W. Grafman
202.778.9057
Rebecca L. Kline
202.778.9064
Ivan B. Knauer
202.778.9468
Stavroula E. Lambrakopoulos
202.778.9248
Jeffrey B. Maletta
202.778.9062
Gilbert C. Miller
202.778.9085
Charles R. Mills
202.778.9096
Michael J. Missal
202.778.9302
A. Thomas Morris
202.778.9376
Richard J. Morvillo
202.778.9340
Richard M. Phillips
202.778.9040
Glenn R. Reichardt
202.778.9065
Ronald W. Stevens
202.778.9055
Nicholas G. Terris
202.778.9408
Richard L. Thornburgh
202.778.9080
Stephen G. Topetzes
202.778.9328
Joseph P. Vitale
202.778.9207
FAX:
BOSTON
PHONE:
FAX:
Kenneth M. Argentieri
David A. Brownlee
412.355.6446
David R. Cohen
412.355.8682
Thomas R. Johnson
412.355.6488
Michael J. Lynch
412.355.8644
Patrick J. McElhinny
412.355.6334
Mark A. Rush
412.355.8333
Nicholas P. Vari
412.355.8365
PHONE:
Andrew L. Swope
Phone:
Robert B. Galt III
Jonathan B. Morton
Phone:
Richard H. Cooper
Michael J. Quinn
Please visit Kirkpatrick & Lockhart LLP’s web site at
310.552.5000
310.552.5001
310.552.5019
310.552.5046
PHONE:
FAX:
David Mishel
Richard M. Phillips
305.539.3300
305.358.7095
305.539.3311
305.539.3357
Fax:
SAN FRANCISCO
717.231.4500
717.231.4501
717.231.4512
Fax:
LOS ANGELES
617.951.9000
617.951.9151
617.261.3119
617.951.9111
617.261.3223
617.261.3117
617.261.3120
FAX:
412.355.6500
412.355.6501
412.355.8668
PHONE:
R. Bruce Allensworth
Michael DeMarco
Edward S. Horton
D. Lloyd Macdonald
Wm. Shaw McDermott
HARRISBURG
212.536.3900
212.536.3901
212.536.3910
212.536.3905
212.536.4801
212.536.3912
212.536.4047
212.536.3916
212.536.3941
212.536.3922
212.536.4008
212.536.3971
212.536.3928
FAX:
MIAMI
PITTSBURGH
PHONE:
415.249.1000
415.249.1001
415.249.1000
415.249.1010
. From our site, you can learn more about our firm, request
www.kl.com
copies of articles and speeches by our attorneys, learn “what’s new” at K&L, gain access to a number of law related sites on the
Internet, and contact us by e-mail.
E-mail: info@kl.com
Kirkpatrick & Lockhart LLP