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Securities Regulation Outline – Manns – Spring 2011
I. Basic Principles and Policies
 A. Rationale: Why should we regulate securities?
 Issues with Regulation and Mandating Disclosure
o (1) Extremely Costly
 Creates Transaction Costs
 The larger the regulated pool, the less costly per unit it is
 Securities make up a huge pool
 If smaller market, not national scale…case to regulate is worse
o (2) Regulation is easier if there is a goal in mind, but not easy to come up with a goal
 With a clear goal/consensus on why, better reason
 However, with lack of clear goal, regulation may lead beyond initial reason…spreading it too thin, wasting
resources, and getting involved in things without reason
o (3) Amount consumers have a stake is relative
 Potential harm with securities is vast
o (4) Too much regulation may reduce our welfare Where is the line drawn to avoid over/under regulation
 Companies leaving the Public Market
 Overregulation  Leads to:
o Capital Markets drying up
o going private transactions
o leaving country
 Chills Best People from entering that industry/public companies
 Chills risk taking, if liability ensues
o (5) Cost/Benefit of It:
 We may mandate many disclosures, but in reality, they may actually hurt shareholders
o See 10-K mandates and financial costs to shareholders
 Why should we regulate Securities:
o (1) Intangible:
 Provide Value By: Give right to (1) Cash Flow, (2) Assets in Liquidation, and (3) Voting Rights
 The Stock, for instance, itself is valueless
o It gets value from “something else”
o We should provide information of what that ‘something else is’
o Paternalistic
o (2) Different than Tangible Goods:
 A. Greater Chance of Fraud:
o Because there is much $ involved, they offer better forum for greed
o Moral Hazard:
 That investors interest may not be in line with promoters interests
 B. Greater Danger to Capital Markets:
o Capital Markets are more important to Economy then others
o In an efficient market, poorly made goods get eliminated while Securities in Capital markets are vital to the
economy
o Need to preserve their viability
o Consumers have large amount at stake justifying Regulation
 C. Collective Action Problem:
o Market, made up of large groups of people who want similar information
o But cost/effort of getting information will only lead to temporary advantage…not worth effort
o Therefore, collectively, Market will not engage in action that would have benefitted all and information is vital
to securities
 D. Information Asymmetry
o (3) On a National Scale
 Therefore, not as costly to regulate per unit
 Goal is easier to develop
 Stake Market has is larger the normal goods
 Just determine amount of regulation
 Overall Distinctive Features of Securities and their Markets
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o (1) Capital Markets and investing are important to Economy; Vital
o (2) Investments effect many decisions (Life, home, kids, day to day events)
o (3) Investing may make people act irrationally (Emotion rather then reason)
o (4) Collective Action problems exist and Information Asymmetry
o (5) Intangible and hard to value
 Should Securities Laws be Optional  Opt In (See discussion, infra on Voluntary or Mandatory Disclosure):
o Yes:
 If company didn’t, its price would be adequately discounted
 Easier to use “Bright Line” Rule
 Easier for SEC to govern
 Private Body may emerge
o No:
 Collective Action issue
 Lack of Standardized System would exacerbate collective action issues
 Information Asymmetry Issue
 Effects On Capital Markets: Chilling of investing as not all information available (Caveat Emptor)
 B. Capital Markets, Securities and Participants:
 1. Primary and Secondary Markets
o Primary:
 Issuer sells securities to raise capital
 1933 Securities Act applies
 SEC oversees
 Intermediaries in Primary Market:
o Effect:
 Reputation of intermediary enhances the transaction
 Eases Market Concern
 Legitimacy added to transaction, that IPO may not otherwise have
o Underwriter:
 Investment Banks that provide advice, expertise to Issuers of securities
 Syndicate
 Disperses Risk taken
 Leverages abilities of all
 Anti-trust issues
 Types of Underwriting:
 Firm Commitment Offering
o Underwriter commits to purchasing securities at discount
o Guarantees sale of certain number
o Underwriter resells at higher price “Makes the Spread”
 Best Efforts Offering
o Underwriter commits to trying his best to sell shares
o No guarantee
o Attorneys:
 Assure Regulatory Compliance
 Reputation is key
o Accountants:
 Certify the statements are accurate
 Reputation is key
o Institutional Investors:
 Mutual Funds, Pension Funds, Insurance Companies
 Purchase large amounts of IPOs
 Adds Liquidity
 Adds Legitimacy and reassurance
o Secondary:
 Resale of security to other investors
 Issuer gets no benefit, and are not involved
 1934 Securities Exchange Act applies
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 SEC oversees
 Intermediaries in the Secondary Market:
o Block Transactions: Huge amounts of trade typically done by Institutional Investors
o Brokers:
 Facilitate trading for smaller, more typical investors
 Market Order or Limit Order
 Because Limit Order is automated, off fluctuations may trigger automated limit order
 Trading Forums:
o Type of Self Regulatory Organization, or “SRO”
 Exchanges will have their own rules that further regulate securities
 Rules on Capitalization Requirements, Voting Requirements and BOD
o Traditional: NYSE, AMSE
 Physical trading and electronic trading
 Floor Brokers with Specialist per security
 Specialist maintains liquidity and a market for the security
 If need be, will make trades from his own account to meet supply and demand
o NASDAQ
 Electronic market
 Market Maker: Dealers who buy and sell securities to create market
 Promotes liquidity
 Make $ through the Bid and Ask spread
o Electronic Communications Network, or “ECN”:
 Solely electronic market
 Simply link up buyers and sellers through computer
 Promote liquidity but not necessarily price transparency
 Liquidity and Price Transparency
o These issues are vital to having an efficient, and working secondary market
o Liquidity:
 Ability of an investor who desires to buy or sell to do both, quickly, finding opposite position at market
price
 Liquidity maintains prices and promotes stability Avoids Volatility
o Price Transparency:
 Ability of investors seeking to transact to observe the price of transaction, and bid/ask offers across
markets
 Market Participants need immediate access to this information
 Shows what stock is worth that second
 Information which gives ability to make decisions
 2. Types of Securities:
o Differentiated by:
 Voting Rights
 Cash Flow Rights
 Liquidation Rights
o 1. Common Stock:
 Voting Rights
o Based on risk taken, and last in line in bankruptcy, shareholders are given ability to vote to control Business
o Are not secured, like debtors, so compensated for risk with Vote
 Owed Fiduciary Duty of Care and Loyalty
 Residual Liquidation Rights
o “Absolute Priority Rule”
o They are last in hierarchy of priority
o But, can be nuisance in holding up bankruptcy proceedings
 Residual and Discretionary Dividend
o Not mandated they get one and if they do it is after interest on debt and dividend to preferred shareholders
o 2. Preferred Stock:
 Fixed and Discretionary Dividend
o Dividend set in contract, but discretion to pay one out or not
o “Cumulative Dividend” accumulates unpaid ones
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 They must be paid prior to CS getting anything
o “Participating”
 Adds potential to earn with earnings of company
 Medium Liquidation Rights
o Prior to CS but Post Debt
 May have voting rights
o “Right of Election:” May contract to contingent vote if missed dividend
 Convertibility
 Contract is controlling
o 3. Debt:
 Fixed, certain interest payments
 Highest Liquidation Rights
o “Equity Cushion” may be required to protect creditor
o Contract will specify, and if breached may “Accelerate Payment”
 No Voting Rights
o Their protection for risk profile is in the contract and priority in bankruptcy
 Contract is controlling
 3. How should we Regulate Securities?
 A. Generally:
o Above, we conclude that, ok, securities need to be regulated
o What should the regulation entail and should it be Voluntary or Mandatory?
 B. Value of Information:
o There are basic things we would want to know to alleviate the concerns Securities bring (discussed infra)
 The Security is intangible, but what about that ‘something else’ that gives it value
o Financial Statements
 Detail of past data, projections
o Management
 Members, experience and compensation
o Business
 Strategy
o Industry
 Competition, Barriers to Entry
o Regulation
 Tax Risk and Regulatory Risk
o Risk
o Note:
 With a Primary Market (IPO) transaction, we want more information (the reputation of underwriter will
help), but with Secondary Market, we still want information, but the track-record will certainly help
o How Information Helps Investors
 Investors can do “Self Help”
o While investors could read it, analyze it—not very common
 Prohibitive cost, time and ability
 Inability to get same access to same information as larger investors
 But—just because individuals don’t actually look at directly, they are still benefited
o Indirect Access
 Filtering Mechanisms, like newspapers, magazines, brokers, will read the reports and break down
 Financial manager will make decisions for them (Mutual Fund) benefiting individual
 Institutional, and Large investors will use
 Efficient Market Hypothesis then takes over
o Efficient Capital Market Hypothesis
 The idea that information is priced into the security, almost immediately
 Weak Form: Only past information is incorporated into price
 Semi-Strong: All Publicly available information is incorporated into price
o **Strongest argument
o Idea that even if self help doesn’t happen, sophisticated filters and players do, so price
changes
b. Strong: All information, public or private is in price
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o Doesn’t make as much sense, given that profit can be made off of insider trading
o Combining the Two:
 The indirect access + ECMH means that the individual investors’ share is affected by the information
o But Should it be Voluntary or Mandatory?
 A. The Argument for Private Sector (Voluntary) Regulation:
o Private sector could regulate itself:
 Companies have an incentive to voluntarily disclose information
o The Market would view non-disclosure as ‘something is wrong’ and would discount price of stock
o Investors value info, and Company would see that disclosing increases share price
o Voluntary disclosure positively influences share price
 EG: Telling what earnings will be = higher price
 Incentive to Continue disclosure
o If issuer needs to go back to capital markets, incentive would be to continue disclosure so as not to depress
share price
o That way, when he goes back, prices are still up and Market is receptive to sale
 Disclosure by few creates pressure for others to disclose
o Investors would discount those who had less information
o Other business would see this, and begin to disclose too
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 3 Party Added Reputation is Private Sectors method of legitimacy
o 3rd party lawyers, accountants, and IBs establish credibility
 Analysts research and interpret information provided
o Once information was given by few, who had incentive to, analysts would validate
o Methods to make it viable:
 Anti Fraud Liability
o Creating a floor of anti-fraid liability could help ensure accuracy
 Contract—Self Regulation
o The market may begin to regulate itself, through contract of covenants of accuracy and anti-fraud
o Even if Anti-fraud liability would voluntary, the market would discount those firms who did not opt into it
o May create its own centralized authority to create standardization
o The Problems with Private Sector (Voluntary) Regulation:
 Firms may not issue securities
o If no securities were trading, no incentive to disclose as market won’t determine value of shares
 Anti-Fraud liability doesn’t necessarily mean credibility
 Managers may profit from less then total disclosure and informed Market/Agency Costs
o Engage in insider trading, if no mandated disclosure
o Bias would be towards the firm
 Firms would not disclose certain things to avoid Competition
 Would lack standardization/Coordination Problem
o Without mandated system, disclosures would be different and would be difficult to compare ‘apples to apples’
 Firms may issue duplicative research, and investors would also compete for duplicative information
o A Mandatory system reduces waste, and gets information from the source
 B. The Argument for Mandatory Disclosure
o Generally:
 We see above that, theoretically, the private sector could regulate itself, but the problems associated with that are
quite vast and could be avoided with mandatory disclosure
 Mandatory disclosure improves marketplace, investor welfare
o Mandatory Disclosure is Best
 1. The more wrong with Voluntary disclosure, better argument for Mandated
o See supra, issues with voluntary
 2. Overcomes Collective Action problems meeting investors needs
o Because the Securities Market is large, and efficient, arguably, if one party does all the work to discover
information, all will benefit while 1 will bear all the cost
 There is a general problem of Collective Action—that no one will do the work
o Standardized disclosure makes comparisons and coordination issues end
 Better decisions because standard disclosure (EG: The 10-K)
o Mandatory disclosure sustains standardization
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 Collective Action creates issue that all will not combine to make 1 system (Effort and Cost v. Benefit)
 If it were voluntary, the issuer would benefit
o The more people use the standard, better and more valued it is
3. Agency Costs
o Mandatory disclosure allows stockholders to control costs of management
 If it were voluntary, management would disclose that which was pro-management
o Keeps managers accountable
 If voluntary, they may wait to disclose negative information or hide altogether
o Promotes accurate ability to vote
4. Federal or State
o Although corporate law is traditionally state, ‘race to bottom’ concern is evident
5. Positive Externalities
o By mandating disclosure
 Investors are helped but so are competitors
o If it were voluntary, firms would not disclose due to competitors finding out
 So while Competitors get free-ride…all do and
 Investors are benefited by disclosure, and information to make decision based on accurate information
6. Reduces Duplicative Research
o By mandating disclosure, from the source, the law reduces the duplicative effort of many parties
 If voluntary, the first to find out about info wins
 But as second party tries, market has already incorporate and his effort is wasted
o Mandated disclosure serves to eliminate wasteful efforts by giving standard information to all at same time
 Reduces waste of temporary gains
7. Reduces Information Asymmetry
o Issues with Mandatory Disclosure
 1. More disclosure is not always better
o The proper balance is not easy to ascertain
 If too much, firms may go private, leave country
 Best candidates for jobs leave which puts us worse off
 By requiring too much information, we actually get less because companies go private
 If too little, under informs investor
 2. Government may not adapt to new needs
o EG: derivatives
o If government too slow to respond, perhaps private sector would have been faster?
 EG: The derivatives market has regulated itself, creating standard documents, and a central system
 The Regulators have been slow to respond, only responding after financial meltdown
 3. Private sector may know better what it values
o Is more in tune then Fed, as to what market needs
 4. “Regulatory Capture”
o With lobby, there is risk that regulator will be influenced by regulates
o If so, benefit will be to SEC person who gets job later or to industry
 Investor, the beneficiary of disclosure, actually would bear the cost
 How Does US regulate Securities:
o (1) Mandatory Disclosure
 Promotes Efficient Market
o Allowing investors to make their own decisions
 Effects:
o Cures many of issues with Securities
o Decreases Moral Hazard
 By mandating certain things be disclosed, disclosures align the interests of the investors and promoters
o (2) Anti Fraud Liability
o (3) Gun-Jumping rules avoiding advantage (in IPO)
o Note:
 The procedural nature of our rules, and non-merit regulation
o We do not “Merit Regulate” or tell investors what is good or bad
 Merit Regulation risks government’s poor choice and excluding certain things that may be beneficial
 Non-Merit Regulation, provides certain information’s to the Market allowing Market to decide
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 Government does not educate—but is Paternalistic in that it requires information
o Effect of our System:
o 1. Promotes the Free Market Capitalism that is Efficient Market
o 2. Cures issues with securities
o 3. Avoids Moral Hazard
o 4. Certainty in Marketplace
o 5. Enhances overall capital markets
II. Materiality
 A. Generally:
 Above, we determined that (a) Securities need to be regulated and (b) There should be Mandatory Regulation
 We also determined that information is what is needed
 What is Material:
o The type of information we want Valuable to investors
o TSC Industries Definition:
 Information is material “if there is substantial likelihood that the reasonable investor would find information
significant given the total mix of information”
 The “Reasonable Investor”
o One could argue that investors are not reasonable, and that the unreasonable investors should be focused on
 Many lack capability
 Over-confident…without reason for acting
o Why don’t we focus on Unreasonable Investor (they need paternalistic protection):
 If they are unreasonable, and stink…more disclosure or rules for them won’t help
 With so many ailments, difficult to craft Regulations to help each need
 With irrational investors, tough to craft Regulations to help
o So, Presuming reasonable is easiest, most efficient way to operate Regulatory Regime
 B. Policy Arguments for Why “Material Information”
 Generally:
o These are the reasons we want to restrict disclosure to ‘material information’ and not have exhaustive disclosure
 (1) Disclosure is costly
o we don’t want to impose too high a cost, as some information isn’t worth the cost
 (2) Disclosure expands legal liability
o we want information for investors, but too much creates liability which is negative for issuers and investors
o Weed out frivolous litigation Increases costs, distracts, and poor reputation
 (3) Flood/Burried
o Too much information is confusing and not helpful
o Easy to bury important things within the flood of information
 (4) Competitive Disadvantage
o some information investors don’t want out, as it puts firm at disadvantage
o May lead to companies leaving public market
o May lead to chilling of innovation…as if work was simply given to competitors…no incentive
 (5) Subversion
o Requirement of too much information may lead to the chilling of keeping records
 (6) Privacy
o Too much disclosure, for instance of Managers personal date may lead to the flight from public companies
o This would have negative effect on Markets, Society, and investors—we want the best to manage
 C. The Duty to Disclose
 There is no ‘general duty’ to disclose all material information
o Absent some mandate, an omission (no statement) does not make you liable (per 10-b 5 anti-fraud)—But:
o See 8-K, and discussion of why no general mandate to disclose all (logistics, inaccuracy…etc…)
 The Duty to Disclose Arises when:
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o (1) Enumerated Mandates of Securities Laws
 The law will specify what needs to be disclosed (may not be material)
 Mandated Disclosures:
o May require disclosure of material and non-material information
o (1) Registration Statement—Rule 408
 Those who issue Securities in Public Offering must Register with SEC
 Information on Securities offered
 Use of proceeds
 Business
 Financials
 Managers and Compensation
o (2) Periodic Reports
 Publicly held companies (’34 Act) must file periodic reports with SEC (10-K, 10-Q, 8-K)
 What is required in forms is in Regulation S-K
o (3) Regulation S-K
 In addition to what it mandates, it also requires disclosure of “material information”
o (4) Affirmative Statements must be materially accurate and complete
 Rule 408 (Registration)—no ½ truths
 12-b 20 (Periodic Reports)
 No Material Misstatements or omissions
 Note:
 If mandated duty to disclose certain things, the affirmative statement duty also arises to perhaps
disclose more….if what was disclosed is not ‘complete’
 Allways must be materially accurate and complete
o (5) Anti-Fraud Provisions
 Once a company begins to disclose, duty to not make material omission
 10-b 5
o (6) Insider Trading
 Insiders must either disclose inside information or abstain from trading, based on that information
o (2) Affirmative Statement
 If made, must be
o (1) Materially Accurate
o (2) Complete
 No material misstatements or omissions
 So, you may not have to talk, but if you do…should be complete and materially accurate
 Duty to Correct:
o If statement made, or mandated statement of SEC made…duty kicks in
 If statement is not both, Duty to disclose whole truth arises for material information (10-b 5)
 If not may be liable for making misstatement or omission of material fact for which you had duty to
disclose
 D. Forward Looking Information:
 Generally:
o The general standard for Materiality, defined in TSC, is applied uniquely to forward looking statements—events that may
or may not occur…that are contingent
 Merger, Sale, etc…
 Future events do affect “total mix” by measuring the magnitude of information, in context and discounting probable
future events into price
 Basic, Inc. v. Levinson (US 1988):
o F: Combustion Corp wanted to buy Basic. Basic, who was in discussions, and made several statements denying the merger,
that it was unaware of why stock was trading at high volume.
o I: Was affirmative complete, and materially accurate, or did it trigger duty to disclose more?
o R:
 1. Duty Triggered: Was not complete or Materially Accurate
o Because of that Affirmative Statement duty to disclose arose
o But again, note that if Silent…Omission is not enough…so staying silent is viable (if no specific duty)
 2. Dislikes Bright Line “when agreement in principle” Rule:
o While more certain, and avoids too much information being given to an investor who may not understand it
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 is over and under-inclusive…may not include fact-specific issues which are material
 Is too paternalistic—Merely requires disclosure of material information, but not to protect/paternalize
shareholders…not good policy argument
 3. Dislikes Idea that All information Affirmatively given is material
o Not all false, incomplete statements are significant to total mix…we want to limit liability
o 10-b 5 specifically says, that only applies to “material information”
 Test of Forward Looking Information: Whether “there is substantial likelihood that reasonable investor would
find information significant given the total mix” in Forward looking statements depends on
o Balance the Probability of event x Magnitude
 Fact specific Inquiry that varies case-by-case
 Examples of Probability: indicia of interest by highest levels, involvement of bankers, negotiations
 Examples of Mag: size, premiums, etc…
 Policy Issues with Basic Test:
o Hard to be objective
 Very much relies on what each judge, attorney, and jury thinks goes into this equation
o Don’t know which facts are important
o Looking back on what happened will taint the ex-ante interpretation (Hindsight Bias)
 So as Court evaluates the equation, it will look at what happened, rather then at that point in time, ex ante,
what would happen
o Could argue that it may actually be “Bright Line” Rule that was rejected
 While this is fact-specific, it may look at a fact as controlling….which in essence is the bright line rule
 For instance, if ‘agreement in principle’ is weightier…that is basically the rule…
 Or…may be so difficult, and courts may say mergers are material…that is also a bright line rule
 E. Historical Facts:
 Generally:
o Facts that have already been given, such as accounting issues, may become material
o Because the affirmative statement was made, historical material facts may need to be corrected to assure they are complete,
but how do we determine if they are material?
 1. Numerical Guideposts
o Ganino v. Citizens Utilities Company:
 F: Citizens hadn’t missed earnings for 50 years, but was about to. So, they entered contract with HTCC and
consulted in exchange for fees. It received them in 1996, but recognized them in 1997 as income. Without
disclosing that these fees were ‘extraordinary’ and not from operations, it said that it attributed growth to profitable
operations. Finally, it missed earnings and disclosed this issue.
 I: Did the duty to disclose kick in to make complete and materially accurate statements—Anti Fraud Liability?
 R:
o 1. Court rejects any numerical bright line ‘rule of thumb’ to determine what is material
 Per TSC, materiality is a question of fact
o 2. Standard to Dismiss for lack of Materiality
 “No dismissal, unless the omitted facts are so obviously unimportant to reasonable investor that reasonable
minds could not differ on question of importance”
o 3. SEC Staff Bulletin 99 (p. 61)  Materiality as to historic facts evaluates:
 Qualitative and Quantitative Facts
 No specified Numerical value is controlling, although can be used to begin the inquiry
 If Company chooses a number as a ‘rule of thumb’ to make it material:
o Lawyers should come up with a paper trail of qualitative data for why it is material or below
that chosen % is not material
o But SEC says no specified number is dispositive
o Lists Qualitative Factors on p. 61
 A small $ amount can be material if qualitative facts surrounding make it so
o EG: intending to meet analysts by fudging number just a bit
 A larger $ amount can be immaterial if qualitative facts surrounding make it so
 Note:
o A Qualitative factor can make a large number (quantitative data) less material
o Look at a 1-time occurrence, or a Recurring event to weigh qualitative factor
o Look at effect on integrity
 Evaluate to determine if ‘significant to reasonable investor as substantially altering total mix’
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o Here:
 The quantitative portion represented large percentage (17%) of income
 Qualitative portion showed that misstatement was intended to mask the failure to meet earnings estimates
 Rejection of bright line rule:
o (1) The court rejects, again, a bright line numerical rule because the qualitative factors may in fact make small
quantities material
 The small quantitative fudging may be used in times needed most
 Shows the qualitative reasoning for small numerical shifts
o (2) Also, numbers can be calculated in many different ways
 Not easy to determine what we should look at: Assets, Income, revenue…etc…
 2. Courts use of Market Reaction to determine Materiality:
o Generally:
 In determining the materiality of historical data, and if a duty to disclose more to make materially accurate and
complete kicks in, we see above that numerical rules of thumb apply
 Here: we look at if a reasonable investor would consider information material by evaluating the reaction of the
market once an announcement is made about some historical issue
 Market shows what is material
o In Re Merck:
 F: Merk owned Medco. Medco’s sales included revenue that did not belong to it. Merck disclosed this on April 17,
but did not disclose the $ amount it was affected by—stock price rose .03 cents. Then, on June 21 a WSJ report
came out and it stated that the deal was worth $4.2 Billion. The stock price dropped about 20%.
 I: Did Merk’s initial statement require additional statement to disclose material accuracy, or was information
immaterial?
 R:
o Efficient Capital Market Hypothesis Analysis of Materiality:
 *Court looks to the “period immediately following the disclosure”
 Here:
 Merck’s initial statement actually raised stock price a small bit.
 Not Material, based on semi-strong ECMH
 Petitioner Argues that disclosure made was not complete, and therefore the second market reaction shows
it was material
 Argument is that Merck, in effect, failed to disclose enough information for market to determine
 No:
o There were many analysts following the stock who easily could have done this type of math
o WSJ did a quick calculation
o Even if the $ amounts were not clearly indicated, they were there to be found…and Merck did
disclose them
o This means that Market did not think they were material
 Issues with Analyst Standard:
o (1) The public/non-analysts may be able to do this…but takes more time and work…unlikely
o (2) Even if analysts could do this…the trickle down effect of information is similar to the ‘burried’ rationale
for material information—we don’t want such information buried, requiring it to be extracted…
 This is contrary to the idea of ‘materiality’ and disclosure
o (3) “Reasonable Investor is the standard” set by SCOTUS
 Although Analyst may be reasonable investor, reasonable investor not necessarily analyst
o Counter Argument: Individuals get their information through intermediaries, so it is feasible view
 Issues with Focus on Stock Price Movement to determine Materiality:
o (1) If initial disclosure only has limited information, stock price may not reflect it immediately
 which is what court looked at
o (2) Market may be a bit inefficient with processing new information
 even if the market is efficient, it may not be immediate that most accurate price is adopted
 The court’s time frame may be off…slow to react
 Idea of disclosure is that company gives information to us to avoid collective action problem
o (3) Company may disclose a lot of good news and a small amount of bad news
 This, in effect, buries the material information, albeit disclosed
o (4) Ok, market response on day of disclosure is plausible
 But market may overreact optimistically or pessimistically
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 If overreaction doesn’t necessarily mean material
 More time to consider, makes more accurate price evaluation
o (5) General market trends may cause stock to fluctuate, rather then the disclosure
 Note on Practice:
o Expert witnesses will be called in to created “Event Study”
 A window, around the ‘event’ of the disclosure is made
 The past performance, and expected return of that window is calculated using historic data
 The expected return is subtracted from what actual return of that window was
 Determination of if it was abnormal or not
 F. The “Total Mix”
 Generally:
o A key part of the Basic case’s definition of Materiality
o Has been used by Courts to dismiss suits that they consider weak
 Meaning:
o If information is already in the total mix, or in the public markets, its failure to be in a disclosure is, in context,
not a misstatement or omission
o It is already out there
o While it may be material, it is not a misstatement or omission—look at context of total mix
 Methods to determine the total mix:
o 1. SEC disclosures
 they are part of the total mix
 “Incorporate by Reference”
o Allows companies to simply reference past disclosed information from prior filings
o Feeds into idea of ‘mix’ as past information is relevant
o 2. Brokers/Financial Advisors
 Whatever information they look at is part
 That is because they advise investor decisions
 Whatever they ‘reasonably’ look at
o 3. Anything else that plausibly affects stock price
 Longman v. Food Lion:
o F: Food lion made statements regarding its employees happiness, being well paid, and the cleanliness of its stores. Its
annual reports continued these statements. In 1992, ABC aired a program documenting the poor quality of the food and
employment issues they had had with the Union. Following the program, shares fell 11%. Prior to the ABC program, Food
Lion had acknowledged allegations of employee issues, and investigated.
o I: Shareholders allege that affirmative statements failed to disclose complete and materially accurate information. Were
there misstatements or omissions?
o R:
 1. Employment Practice
o A. If the information is available to the public…
 Food Lion had already acknowledged the complaint, and complaint was public information
 Market already had opportunity to evaluate these claims…so omission was not material
o B. Quantitative:
 Settlement was a few cents a share experts found immaterial
o C. Qualitative:
 Quantitative versus Qualitative was only 1 time occurrence
o D. Stock price was unaffected
o Overall, the employment information was not material given the total mix
 2. Unsanitary Practices
o Puffery or Opinion is not something the reasonable investor would find in the total mix
 Puffery is language that investors realize is opinion and is not reliable
 A type of opinion, without any fact that is not actionable
 These types of statements cannot be factually accurate or complete…so they are not material
 Not the type of affirmative statement that duty to disclose emanates from
 Puffery is not a ‘materially misleading statement’ that gives rise to Anti-Fraud Liability
 Fact versus Puff
 The more closely something gets to fact/numerical value…the more likely it is reliable
 Stay away from Numbers/Concreteness
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 Analysts or Investors:
o Analysts:
 Tend to be able to view a bigger total mix, and have more ability to determine
 This seems to coincide with the intermediary theory, and potential that securities laws have
o Investors:
 Are not as able, and unlikely to read certain information
 The total mix may be smaller
 G. Management and Materiality:
 Generally:
o One of the controlling intentions of Congress was the idea that disclosure would reduce Agency Costs—that is, make
management more accountable to shareholders
 Promotes Managerial Integrity
 Promotes Managerial Competence
o Regulation S-K:
 This regulation mandates certain information be disclosed regarding management
 1. §401: Past business experience within last 5 years
 2. Management’s past performance, as shown by comprehensive financial and other disclosure
 3. §401: Potential conflicts of interest with Duty of Loyalty
 4. §401: Remuneration and other benefits paid to management
 5. §404: Material Transactions between corporation and its officers, directors…
 Note:
o Because these are mandated affirmative statements, material corrections to make them materially accurate and
complete may be needed…
o Stockholder reaction to Managerial Discslosure:
 If the disclosure reveals troubling information, what are your responses:
o 1. Sell Shares
o 2. Mobilize Shareholders to vote out Directors
o 3. File derivative suit on behalf of shareholders claiming damages
 In Re Franchard Corporation:
o F: Glickman was a big time investor. He formed Franchard Corporation and had voting control of the stock outstanding.
Through a public offering, affirmative statement was made that Glickman was controlling shareholder and that he loaned
the corporation money. However, he eventually began loaning himself money from the corporation, and pledging his shares
as collateral in exchange for loans from other sources. He eventually resigned.
o I: Did Glickman make affirmative statements that were materially inaccurate and incomplete?
o R: Yes…duty arises from mandatory and duty to correct
 1. The Quality of Management is vitally important to shareholders
o Disclosure shows financial ability of manager
o Integrity
o Potential incentive to operate undesirably
o Change of Control potential from pledging of shares
o Mangement’s ability is vitally important, especially when the Manager’s unique reputation is large reason
for investment
 Note an Evaluation of the Quantitative and Qualitative factors
 Although small amounts of $, the qualitative aspect—that it was recurring and that it showed poor
integrity weighed heavily to make it material
 Because of Qualitative factors, small quantitative is not controlling
 Loss of Control, also, due to his reputation was key
 2. The SEC is not empowered to determine the standard of care exhibited by a Board of Directors
o There was no material omission of fact because the performance of the BOD is protected by the Business
Judgment Rule A Function of State Law…not the place of securities laws
o Note:
 Disclosure may become method of enforcing a federal standard of business conduct…eventually
overriding State law on the matter—duty of care and business judgment rule
o Policy: At what point does disclosure reveal Personal Facts, and Should there be a limit:
 1. Potential to scare off talented managers
 2.Your in Public, you should expect disclosure
 Note:
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o Franchard holds that what facts need to be disclosed stems from a Materiality analysis…that is the only
limit on what may or may not be disclosed
 Goes back to very factual analysis
 EG: Steve Jobs may need to disclose more then a typical CEO. His reputation, and connection to
apple is unique—with only few others resembling.
 The standard is malleable to accommodate it
 So, based on an affirmative statement that is misleading or incomplete or a mandated discslosure,
materiality is relative
 3. See Supra, discussion of why we limit information disclosed to Material Information
 H. Duty to Disclose and Criminal Liability:
 Generally:
o The 5th amendment privilege cannot form the basis for non-disclosure of security law violations
 Except (SEC v. Fehn):
o 1. Whether the disclosure targets a highly selective group inherently suspect of criminal activity rather then
public
o 2. Whether disclosure covers an area covered by criminal statute, rather than essential non-criminal regulation
o 3. Whether compliance would compel disclosure of information that surely would prove link to evidence
establishing guilt
o Mandatory Disclosure of Criminality:
 1. §401: Management must disclose formal indictment
 2. Must disclose conviction of violation of securities laws, bankruptcy, or past role in bankruptcy
 3. Must disclose criminal cases, and adjudications during past 5 years and earlier cases if material to understand
disclosed information
 4. Must disclose self-dealing
 5. Note:
o Unadjudicated civil cases against officer or director does not require disclosure, unless material due to integrity
of management
 *And, as always, must disclose all material information to make affirmative statement complete and accurate!
III. What is a Security:
 §2 (a) 1 of Securities Act of 1933
 An Inquiry into, do the securities laws apply?
 Threshold inquiry
 Policy Implications:
 We want to define a security sufficiently broadly to allow to include new, potential schemes to be included within that law
o Basically—it allows for inclusion of things that have same issues as Security, discussed infra
o (1) Information Asymmetry: Because less information available, we want more things in definition of security to mandate
disclosure
o (2) Importance to Capital Markets: We want to include enough things into the definition to protect our Capital Markets
o (3) Collective Action Problems: People are unable to secure enough information regarding something; we want our
definition to include those things that are similar to a security, with similar issues it poses (infra)
o (4) Unsophisticated Investors: Substantial Sums of $ invested; because people often invest themselves, and are financially
illiterate, we want to protect them in some way—Paternalism. Including something in the definition then, mandates certain
things
o (5) Risk: ties into protection of overall economy
o (6) Anti-Fraud
o (7) Intangible
o (8) National Scale
o (9) Effect on Daily Decisions
o (10) Protects overall economy
 If it does apply, regulation has implications:
o Negative:
 Costly to regulatee
o Positive:
 Gives legitimacy to you, as anti-fraud provisions kick in
 Gives Access to Capital Markets
 The Basics:
 3 basic components make up definition of a Security:
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o 1. Something is excluded from being a security if “the context otherwise requires”
 Gives discretion to SEC to exclude certain things
 Prevents from law overreaching, extending securities laws too far away from effects on capital markets
o 2. Lists many things that are securities
 Stocks, bonds, etc…
o 3. Investment Contract
 Purpose:
o Is a term that gives SEC discretion to include something as a security
o Provides a malleable, broadly construed term that may or may not include something
o Allows for SEC to include new things, reacting to issues in the market place and putting them within purview
of federal regulation…especially the latest scheme to defraud people
 Evlautes Substance of Economic Reality over Form:
o In using “Investment Contract” the economic reality, or substance of the issue will be considered over the form
it takes
o Policy Applies Here in Defining Investment Contract:
 Substance of something includes collective action issues, unsophistication of investors, effect on
markets…all the rationales of regulating securities
 So, simply because something is formed one way does not mean the underlying policy rationales of a
security do not exist
 Overall:
o We want a definition(s) that effectuates these Policy Rationales for why securities need regulation in the first place
 A. Investment Contract:
 Generally:
o Apply the Prongs
o Look at Economic Realities
o Argue policy points of why we need to regulate a ‘security’ and how the thing at issue fits in or does not
 1. SEC v. Howey, Co.:
o F: Howey owned citrus plots, and sold them to people who visited a resort. In addition to selling them the plot of land, he
also sold them a service contract, which gave Howey and his business the right to fully control the land, and maintain it. All
the oranges were pooled together, sold, and proceeds return pro-rata.
o I: Is this scheme an Investment Contract, and thus a security within the purview of Federal Regulation?
o R:
 4 Prong Investment Contract Test:
o 1. Investment of Money
o 2. In a Common Enterprise
o 3. With the Expectation of Profits
o 4. Solely from the efforts of the promoter/3P/Other Party
 Evaluate the economic realities and substance over the form
 Here:
o It is an IC
o The Service contract brought this above and beyond a real-estate deal…
o EG:
 Real Estate alone is not an IC
 Not Common Enterprise
 Not solely from the efforts of others
o While theoretically, the value of your land is largely affected by others, it is not solely
affected by others…and you can alter value
o Here, the Service contract is solely from efforts of others
o Note: The Optional Service
 If the service is optional and not chosen, it may lack ‘solely from efforts of others’ although it may have
been offered, even if not sold
 But, if the purchaser can make economically viable use Less likely to be Investment Contract
o Note: The sophistication of investors
 Is not part of the Howey Test
 May be an indirect, policy argument for the economic realities and policy reasons of Securities Law
o Note:
 The intrinsic value, for instance land, that alleged investment already has is not part of Howey Test
o Policy of Investment Contract Approach:
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 1. Provides broad enough test to allow argument, but malleable to exclude things that are not within
purview
o Allows for quick reaction to new, potentially fraudulent schemes that implicate all that is unique about
securities which we discussed, infra, as reason for their being Federally Regulated
 2. Could argue that allows SEC too much discretion, to include things that simply are not securities
o Counter Argument: Court will evaluate economic realities, and because no factor is more weighty, or
prescribed in exactly what it means…very subjective to Court interpretation, which eats away at the SEC
discretion somewhat
 3. “Unless context otherwise requires” also acts as limit…for instance, if other Regulatory Scheme applies
 4. Why don’t we allow Opt-In/out of Regulation? Label instead of having to determine if security or not?
o Arguably:
 People would opt in to get legitimacy and avoid discounting
 Goes back to voluntary system rather then mandatory system and attributes of a Security
 If don’t Opt in, or decide to opt out…all issues with a security are still there…unregulated
o Investment Contract allows malleable approach to regulating those who wish to get out of regulation
o SEC has limited resources
o “Economic Realities”
 5. The Investment Contract Test Focuses on Capital Markets
o If the type of transaction would have otherwise affected the Public Capital Markets
o Focuses the SEC’s efforts, rather then wasting them on things that may not have effected Capital Markets
 So, another way to limit something that may seem like and Investment Contract
 Note:
 See “Expectation of Profits prong” as indicative of effecting Capital Markets
 1. “An Investment of Money”
o Policy standpoints of a security this prong includes:
 1. Lack of Sophistication
 2. Risk
 3. Effect on Capital Markets
o Int’l Brotherhood of Teamsters v. Daniel:
 F: Employer had a compulsory, non-contributory pension plan for Employees—where eligibility occurred after 20
continuous years of service. When employee was denied, he argued that material misstatements about the pension
had been made, in violation of Federal Securities Laws…and that this was an ‘investment contract’ security.
 R:
o 1. Investment of Money:
 The giving up of some specific consideration in return for separable financial interest with the
characteristics of a security
 $ is not only consideration…can also be other thing of value
 Labor, goods and services may apply
 Note:
o If labor is compensated for with some type of ‘risky asset,’ more likely to be IC
o 2. “Context Clause”
 If there is another regulatory scheme that may apply to the issue at hand, covering the thing, the context
clause “unless context otherwise provides” may be used to declare something a non-security
 So take note, that if another regulation exists, securities may not apply
o Here:
 Labor was done for the pay check, not pension
 Employers contribution was not out of his paycheck…
 Not an investment of money
 He had no choice in matter, of $ invested or where…No giving up of consideration for separate interest
 Note:
 The larger the Pension, the more likely the money contributed would have gone to capital markets?
 Effect of Choice: The larger the $ involved, and more likely the pension, or fund will effect or
be injected into the capital markets, the better policy argument there is for the thing to be an
Investment Contract, subject to the regulation and protection of the Securities Laws
o Policy:
 *Effect on Capital Markets:
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 Consideration may be deemed an ‘investment of money’ for purposes of the Howey test, if that
consideration would have otherwise been invested or have affected the Capital Markets
 Per the Policy rationale justifying regulation of securities
o Evaluate Economic Realities
 Effect of Risk in Investment:
 Risk goes back to initial idea of regulation a Security they are risky and effect the capital markets
and many individuals decisions…vast implications require regulation and paternalism
o Something with Less risk, may be even more enticing to public
o Public needs protection, in addition to the allegedly less-risky asset having larger implications
for Capital Markets and economy as a whole
o EG: Money Market funds are made up of Commercial Paper. If, even though market as less
risky, turned out there was rumor of fraud, run on the bank may occur, money removed from
money market account, and then Corporations lack commercial paper needed to run day to
day…
o Although not an element, plays into general policy of including something as a Security or not
 Lack of Sophistication:
 People may not appreciate the risk of investment
 2. “In a Common Enterprise”
o Policy standpoints of a security this prong includes:
 1. Collective Action
 2. Economic Realities/Substance
o 2 Broad Forms:
 1. Horizontal Commonality:
o When returns of all investors are (1) pooled together and (2) share risk (Pro-rated distribution)
 2. Vertical Commonality:
o Connection between investor and promoter
o Broad:
 The promoter’s efforts affect the individual investors collectively (Even if no pooling)
 Different investors may receive differing returns
 Promoter does not necessarily have to share risk with investors
o Narrow:
 Same as Broad
 And, promoter takes risk of investment going up or down with each investor
 Evaluate the contribution of the promoter and the control the investor gets
 Note:
o The types of commonality are not mutually exclusive
 In fact, they will often times overlap, or both be evident
 Look for Horizontal, however, as it offers best argument
o Policy Purpose of Commonality Prong
 1. A common enterprise exhibits the issue of ‘collective action’
o In Horizontal Commonality, all benefit together, and lose together…but if 1 investor works harder, or acquires
more information, then all benefit while he bears all the costs
o So, no one investor will do this
o Requiring a Common Enterprise implicates a basic tenet of securities law then
 Where there is a collective action problem, Securities Regulation should apply…that way, information is
not hidden, but instead given up front
 This is seen in Horizontal Commonality
 But, the greater role you have in the process, and more likely you are to personally benefit from
your efforts, the less need for securities law—No Collective Action Issue
 2. The strongest case for securities regulation is horizontal
o Weaker Case:
 Broad Vertical: if each individual investor gets different return, then they may have incentive to act on
their own behalf…not as much collective action problem
o Weakest Case:
 Narrow Vertical: if each individual bears risk with the promoter, promoter has incentive to see it succeed
 Not as much need for disclosure, paternalism…
 3. In “Economic Reality” many actually, legally compliant funds have Horizontal Commonality
17
o So, the more something resembles a real fund, it should be treated like a security
o SEC v. SG:
 F: Website set up what it considered a game. People could buy shares, received 10%, and advocated it had no risk.
When issues arose of players not getting money back, SEC filed suit alleging there was violation of required
registration.
 I: Was this an investment Contract, creating Federal subject matter jurisdiction?
 R:
o 1. Economic Realities, and substance govern. Not the Form
 Here: Considering it a ‘game’ was not dispositive, but rather it resembled an investment in substance
 May argue that the money wouldn’t have otherwise gone into the capital markets, and thus no need
to regulate…but, it resembles the substance of an investment and for the reasons above, needs to be
regulated
o 2. Common Enterprise
 “Horizontal”
 the court accepted the horizontal approach because
o (1) It is the Majority view
o (2) is easy, ascertainable, and predictable in what is a security and what is not
 Here:
 All monies were pooled together, with all investors risking together.
 Ponzi / Pyarmid schemes will generally meet horizontal commonality, as the investors bear risk
together, if no new people sign up—all lose
 3. “Led to the Expectation of Profit”
o Policy standpoints of a security this prong includes:
 1. Effect on Capital Markets
o a. Redundancy if doesn’t effect capital markets with alternative regulatory scheme like consumer protection
 Thus context may provide otherwise
o b. If effects capital markets, legitimate use of SEC resources
 2. Risk
 3. Lack of Sophistication
o General Policy:
 If something is an investment, one does expect profit
o Thus, this is more closely connected with the idea of the capital markets which is within purview of SEC
 Focus is on the Capital Markets, and the thing in question’s relation to it
 If something is not an ‘investment’ and no expectation of profit exists, then it likely doesn’t resemble a security,
effect the Capital Markets, and is being undertaken for some other reason (Use/Consumption)
o Waste of SEC resources
o Rule:
 Look at Motivation:
 A. If Attracted for return/profit  Security
o Profit/Return:
 Capital Appreciation from development of initial investment or
 Participation in the earnings resulting from the use of the investors funds
 B. However, if motivated for other desire, such as use or consumption of the item purchased  not security
o United Housing Foundation v. Forman:
 F: Housing project was being built. “shares” were sold in it at a fixed cost, with no appreciation, no dividend, and a
right to vote per apartment. The shares did not appreciate even if the complex made money. Buying these shares
gave you the right to that apartment. In initial advertisement the price was declared $25, but as costs grew the price
changed to $36. Suit is brought under Exchange Act anti-fraud provision alleging the initial advertisement was
materially misleading or had omission.
 I: is it a security, to create subject matter jurisdiction? Was there an “expectation of Profit?”
 R:
o The Primary purpose of Securities Law is to protect Capital Markets
o 1. Title is not dispositive: Look at Economic Realities and Substance over form
 Although “stock” is used in listed securities, this does not resemble same stock Act referred to
 Doesn’t have same features as typical stock…so court did not consider it a stock
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 Economic Realities were that it was in fact not a stock
 See Lander (infra) and section discussing stock test
 Note:
 Court used “Economic Substance Test” of Howey to check ‘stock’
o Arguably, such a test should not be used on a constant basis
o Creates uncertainty
 While it is ok to use the Investment Contract/Economic Substance test to those instruments that are
borderline, using a fact-inquiry determination on everything creates a lot of uncertainty as to
whether one needs to comply with Securities Laws or not
 While used here in particular situation, best left to those cases that are clearly questionable rather
then all
o 2. There was no “Expectation of Profit”
 Attracted for return/profit, or consumption and use?
 Here:
 The buyers of the stock were not attracted for a return, which arguably they could not have gotten
anyway
 Rather, they bought them to be able to rent the apartment—consume/use
o SEC v. Edwards:
 F: Pay phone ponzi scheme was developed, where management contract was created and people bought the phone.
The company managed, and paid a fixed rate of 14%, or $82 a month.
 I: Does expectation of profit include both fixed and variable return?
 R:
o 1. There is no reason to distinguish
 Risk:
 1. Although Risk is not part of the Howey Test, those low risk investments are actually more
attractive to investors…so from policy perspective, that money could have gone to Capital Markets
and does resemble the markets
o Risk goes back to initial idea of regulation a Security they are risky and effect the capital
markets and many individuals decisions…vast implications require regulation and paternalism
 Economic Realities:
 This resembles an investment like those in the Capital Markets. The money otherwise invested may
have gone to a fixed income asset in those capital markets
 Forman Test of “Expecation of Profit:”
 Attracted for the return of investment…so passes Forman test
 Return/Proft does occur
 Would create a loophole otherwise, which was not intended
o Fixed Return and Commonality:
 May be less likely to be Horizontal Commonality, as the group does not benefit together
 However unless guaranteed (USA), which most likely isn’t, that fixed interest rate is not risk free
 If the company goes bankrupt, then all investors do lose together…
 Also Collective Action issue—because fixed, there is no incentive to get information…
 4. “Solely from the Efforts of Others”
o Policy standpoints of a security this prong includes:
 1. Information Asymmetry
 2. Risk
 3. Capital Markets
 4. Collective Action issue
o If it is solely from others efforts, your effort will have no effect, so no incentive to acquire information
o Perpetuates information asymmetry
o Policy of Prong:
 Evaluate the degree investors have in managerial control
o A Question of Spectrum
 The Spectrum:
 Investor Minimum control by investor will not negate finding of Investment Contract
 Promoter Per Life Partners, minimum control by promoter in investment won’t create Investment
Contract
o The greater managerial control the investor has:
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 The less there is a need to find a ‘security’
 Expands securities laws too far away from Capital Markets
 The more these unusual schemes appear, the further away we get from true Capital Markets
 The more involved you are the more disclosure and anti-fraud provisions impose excessive
transaction costs
 Overall:
 The more or less control, the more or less information asymmetry exists and Capital market
connection exists
o A. Generally:
 ‘Solely’ is not read literally
 Generally read as ‘primarily,’ ‘predominately,’ or, ‘disproportionate’ managerial control by promoter
o B. Alternative Entities and Investment Contracts:
 SEC v. Merchant Capital, LLC:
o F: Merchant was formed, and was in factoring—buying uncollectable accounts. To create a pool of funds, it
began to solicit limited partners from the general public. 28 RLLPs were created. Pooled $ bought
uncollectable accounts.
o I: Whether a LP meets the ‘solely’ prong of the Howey Test?
o R:
 1. Focus on the dependency of the investor on the entrepreneurial or managerial skills of promoter
 Overall it is a Totality of Circumstances—factual inquiry of the economic realities
 2. Limited Partnerships are presumed securities
 3. General Partnerships are presumed non-investment contracts, and not securities
 Rebuttable presumption
o However, if one of the following factors is met Prong Met
 Determined at the time interest sold but look to actual operation
 Totality of Circumstances looks at Williamson Test:
o 1. Agreement leaves so little power in hands of Partners
o 2. Partner is so inexperienced in business that he cannot exercise powers given
o
- Inexperience looked at of investors in the particular business in question
o
- Not in their overall, general business sense and skills
o 3. Partner cannot replace the manager of enterprise, and is reliant on him
 Here:
 While in form on paper was significant power, in substance not
 Had no experience of this type of business
 Were, in essence, reliant on the managers
 Note:
 Alleged control given to LPs may be to bypass securities laws, while in substance not really giving
them control…Williamson Test does away with this
 Investor Expectations:
o In Merchant, the court focuses on investor expectations at time sold, in addition to facts of actual operation
 While freedom to contract, and waiver of security may lead to show investors expectations
 The reality of the investment may not be what was agreed to  Substance over Form
 So focus on investor expectations may fail to answer policy protections securities laws offer
o D. “Efforts:” SEC v. Life Partners:
 F: Company sells interests in viaticle settlement—buying life insurance of Aids patient, at discount, and when they
die you get the proceeds. SEC argues that these are securities, sold without registration under Securities Act.
 I: Were the efforts ‘solely of others.’
 R:
o 1. Post-Sale, A promoter’s purely ministerial acts are not enough to meet this prong
 The promoter here could not influence the return at all—purely reliant on patient dying
 We only look to the managerial/entrepreneurial efforts of the promoter of the investment
 Ministerial acts are no entrepreneurial or managerial efforts…not efforts intended
 Cannot effect investment at all
o Would be too broad a reading
 Policy of Why: Information Asymmetry and lack of post-sale efforts:
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o Disclosure post-sale would not help Promoter cannot do anything to effect return, so
disclosure of what they are doing is meaningless…lack of information asymmetry
o Not informational superiority, as cannot effect returns, so the fact that all or most efforts are
pre-sale raises policy issue that Securities Laws won’t help
 Effect of Pre-Sale Efforts:
 Pre-sale efforts cannot alone count as ‘efforts of others’
o Note on Franchise Agreements:
 There is a chance that a Franchise Agreement can fit into the definition of an Investment Contract
o 1. There is an investment of $
o 2. Commonality exists, in the broad-vertical form…the promoter’s efforts effect the investors, although don’t
share same risk
o 3. There is an expectation of profits
o 4. “Solely from efforts of others”
 There is a potential that, if franchisor mandates all that franchisee has to do—policies, etc…it may be
solely from efforts of others
 Generally franchise agreements will not fit into the definition of an investment contract
o But, may go back to a spectrum of the degree of effort/control the investor or promoter puts in
 B. Stock:
 Generally:
o One of the specifically enumerated ‘securities’ listed in §2(a) 1
o Unlike the Howey Investment Contract analysis, stock analysis is generally not fact-specific
 Promotes Certainty, and ability to expect the securities laws to apply
 Because so common a security, uncertainty would pose potential issue with Capital Markets
 Landreth Timber Co. v. Landreth:
o F: Dennis eventually purchased Timber company in an all stock transaction. There were issues when he bought the
company, such as the rebuilding of the saw-mill, but he bought anyway expecting them to be fixed. When they were not,
and he sold for a loss, he filed a suit saying that the stock sale was a security, and was not registered—sought disgorgement.
o I: What is a stock?
o R:
 1. If the instrument possess the characteristics associate with a stock and the title of stock, it will be treated
as a stock and a security
o If the Title and Characteristics are that of a stock, justified in assuming security laws apply
o Characteristics:
 Dividends
 Residual value at liquidation after all other
 Voting Rights
 Ability to appreciate in value
 Note:
o There is flexibility, as some shares don’t possess all these characteristics
 2. When an instrument qualifies as a stock—investment contract analysis is not needed
o A. The investment contract analysis—economic substance and factual evaluation—is only used in an
investment contract analysis
 Forman evaluated stock because of the characteristics, not based on the Howey test
o B. Investment contract analysis is used for unusual items, or unclear instruments…not always
 Used as a safety valve, to include potential unusual schemes/items
 Howey limited to Investment Contract
 Landreth limited to Stock
o Bringing the uncertainty of the analysis into each, fact specific inquiry of stock is dangerous to markets
 Would make language of investment contract and Stock superfluous
 Purpose of IC is a safety valve, catch all
 3. The Sale of Business Doctrine is Rejected—Certainty in Markets is Important
o Doctrine is the idea that sophisticated investors, who buy an entire company don’t apply to Securities Laws
 Sophisticated Investors:
 Not as much information asymmetry or collective action issue
 Can negotiate better
 However:
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 The Securities Laws already apply to sophisticated investors in Private placements, anti-fraud,
tender offers
 This implies that Congress intended to regulate them as well as passive/unsophisticated investors
o Sophistication, alone, is not sufficient to exempt
 The laws apply to securities…not particular investors, although used in general to protect investors
 Still chance, on back end, that these securities are sold to unsophisticated investors
 The Securities still exhibit characteristics which need regulation
 Would lead to uncertainty in stock markets
o Maintaining Certainty in Market is Important Goal:
 Line-drawing between sophisticated and unsophisticated is not easy
 Uncertainty in stock-markets of application of securities laws may have negative effect
o Arguments for and against Landreth:
 Against:
o 1. Sophisticated purchaser can negotiate information, less concern with collective action
o 2. Sophistication
o 3. Less concern with information asymmetry
o 4. Waste of SEC time and resources to focus on such a small company, when large frauds occurring in public
markets
 For:
o 1. Original owner kept as manager, so still asymmetric information
o 2. Once exception made based on sophistication or other, line drawing is uncertain
o 3. Maintain consistency with market, and investor expectations
 long thought of that stock is regulated
 If some is and some isn’t, may create uncertainty and lack of consistency
o 4. Protect passive investors
o 5. Securities are regulated to protect investors
 Securities still bear unique characteristics and arguments for regulation even if sophisticated investors
exist (i.e., intangible, lack of all information, risk, capital market effect)
o 6. Even if there are ways around stock purchase (asset purchase), that’s irrelevant as it does not deal with
securities…which (for arguments infra) need to be regulated
 C. Note:
 Generally:
o An enumerated ‘security’ in §2 (a) 1 of the Securities Act
o There are many variations of notes, but have typical characteristics:
 1. Fixed, periodic interest payment
 2. Fixed maturity Date
 3. No Voting Rights
 4. Get payment of interest, and face value back at maturation
 Reeves v. Ernst & Young:
o F: Co-op issued promissory notes, payable on demand. With variable interest rate kept above bank rate, issuer eventually
went bankrupt. Accountant had represented the Co-op as successful and viable, however suit brought alleging the auditor
failed to adequately audit, and violated anti-fraud provisions of the security act.
o I: Whether a demand not is a security?
o R:
 1. Stock is different then note
o Note is a broader category with much more divergent characteristics, as not all are investments —must be
understood in context of why Congress included it
 Potential for Private Negotiations:
 Like Landreth, here investors may contract for added information and thus securities laws in some
contexts may simply not add anything but transaction costs
o But, not surplusage in statute
 2. The Family Resemblance Test:
o 1. Presumed that all notes with a maturity of greater then 9 months are securities (per exemption in statute)
o 2. Rebuttable if ‘bears a strong resemblance’ to one of the listed exemptions, utilizing factors
 a. Motivations of Transaction
 Investment profit versus Commercial/Consumption
 b. Reasonable Expectations of Investors
 c. Plan of distribution
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 Common trading platform, speculation, investment to common public?
 Offering to public is enough
 d. Presence of an alternative regulatory regime that reduces risk making application of securities
laws unnecessary?
o 3. If does not bear strong resemblance, can utilize these factors to convince court to add to the list of notes that
are not securities
 Notes that are not Securities:
 Consumer Financing
 Mortgage note
 Short term business note
 Commercial paper note
o The more investment like, the more likely to be security
o Here:
 Sold to general public, marketed as ‘investments,’ and no alternative regulatory regime
o Policy Of Note:
 In Commercial Sense:
o If the securities laws overapplied to notes in consumer and commercial nature, the effect may be to chill those
activities…no wanted
o The laws may apply by the definition, but the policy reasons for regulating a security may not be as warranted
 Courts are warranted to demonstrate judicial restraint due to importance of debt markets
 Don’t want to oppressively regulate them
 Potential for Private Negotiations:
o Like Landreth, here investors may contract for added information and thus securities laws in some contexts
may simply not add anything but transaction costs
o Due to perhaps increased negotiation, Collective Action, and information asymmetry may not be existent…etc
 In Investment Sense:
o Creates same attributes that all securities manifest
o Investors generally lack same ability as commercial users of notes to get information
 But, not a clear distinction
o So use Reeves Test to determine intention
o Difference between Reeves and Howey:
 1. Motivation Focus
o Reeves:
 Focuses not only on motivation of lender, but also on borrower
 This is due to note being debt-instrument, using contract…so both parties evaluated
o Howey:
 Only looks to expectation of investor of profit
 2. Scope of Distribution
o Reeves:
 Focuses on plan
o Howey:
 Focuses on common enterprise, which is more limited
 3. Expectations
o Reeves:
 Focuses on reasonable expectations of investors
o Howey:
 Focuses on particular investor’s expectation of profit
 Effect on Capital Markets or not
 4. Multi-Factor versus All-Factor
o Reeves:
 Provides a balancing test of the factors listed
o Howey:
 Requires all factors be met for a security to exist
 D. Securitization:
 What is it:
o Securitizing something is pooling together assets, and then selling the rights to the proceeds of that asset to certain parties
 Effects:
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o 1. Liquidity: selling securitized assets gives seller liquidity for what may be, taken alone, illiquid asset
o 2. Diversification: risk of individual assets is now spread out, with other risks balancing it out
 Policy Ramifications:
o 1. Moral Hazard:
 By providing liquidity, and selling security, people don’t care as much once sold
 That carelessness spreads into creating it, so you create poorly functioning securitized things, and sell them
o 2. Expectations Heightened:
 high yields led to increased demand for them
 However, as they began to fail, demand stopped
o 3. Illiquidity Issue:
 froze the market
o 4. Created National debt crisis:
 By Federal Government bailing out
 Securitization and Securities:
o Securitizing something may turn a non-security into a security, potentially:
 May meet investment contract test:
o 1. Investment of Money
o 2. Commonality: investors, whose money is pooled together, or if all depend on promoter’s success
o 3. Expectation of profits: Whether fixed or variable
o 4. Dependent on ‘predominate’ efforts of promoter
 Security Wrap Up:
 Investment Contract  Howey Test (Economic Substance Test)
 Stock  Landreth Test (Traditional Characteristics Test)
 Note  Reeves Test (Family Resemblance Test)
 Effect of Being Security:
o Once considered a security, federal securities laws apply
o Anti-fraud provisions apply
o 1933 Act Registration applies
o 1934 Act Disclosures Apply
IV. Disclosures and Their Accuracy
 Generally:
 Congress created the 1934 Securities Exchange Act to create disclosure requirements
 It delegated the specifics of the disclosure mandated to the SEC
 The SEC has in turn developed and mandated specific items be disclosed
 A. The 1934 Exchange Act:
 1. Generally:
o 1. Determines “Public Company” and Anti-Fraud Requirements
o 2. Creates substance of periodic filing and disclosure requirements for these Public Companies
o 3. Regulation F-D
 When an issuer discloses material non-public information to certain individuals or entities (Analysts, Holders,
etc…)
 The issuer has a duty to make a public disclosure of that information
o 4. Mandates certain mechanisms that exist to ensure that mandatory disclosures are accurate
 2. Policy of Disclosure:
o Smaller Scale
 Contract: On a smaller, private scale, investors may be able to contract for certain rights, such as what information
they may get
 Trust: Also, on smaller scale, parties may know each other and trust each other in process
o On Bigger, Public Scale:
 Solves Issues of why securities are unique, and why disclosure will help (infra)
 The ability to contract and trust really don’t exist
 Information Asymmetry
 Collective Action Problem
o Federal Securities Laws, the 1934 Act provide a fix to these issues (discussed infra)
 Takes into account:
 1. The Scale of the Enterprise
o In $ amount
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o The Amount of people
 Both of these have implications for capital markets
 3. Three Ways a Company Becomes “Public” :
o 1. §12 (a): Companies listed on a National Securities Exchange
 it is illegal for a broker-dealer to trade in securities listed on a national exchange unless registered
 §12 (b) is registration
 Policy Reasons:
o Open to the Public Capital Markets
o Information Asymmetry and Collective Action issues
o Disclosure helps these people
o Anti-Fraud liability
 The laws applying make the Exchange and traders feel more secure
o 2. §12 (g) Companies with >500 Shareholders and at least $10M in assets
 Policy Reasons:
o The size of people exacerbates the collective action issue and information asymmetry
 While 500 is somewhat arbitrary, it is a number used to exemplify these issues that plague securities
o Amount of $, while too arbitrary, is possibly used to exemplify the ability to pay for the disclosure
o 3. §15(d) Companies that have filed a 1933 Securities Act registration Statement to make Public Offering
 General:
o Typically occurs now with debt offerings
o This is largely in part because those companies filing to make a public offering will be listed on an exchange,
or have the threshold Assets and Shareholders—thus they will register under §12(a) or §12(g)
o Do not have to comply with §14 Proxy Rules
 4. Ways to Avoid Public Company Status:
o Purpose:
 1. Expensive: 1934 Act compliance and disclosure requirements are very costly
 2. Exposure to Excess Liability
 3. Public Scrutiny: some companies and managers may simply not want to deal with it
o Duties to be materially Accurate
o Negative Externalities of giving competitors your information
o Methods:
 1. To Avoid §12(a): Delist from Stock Exchange
o Note:
 Even if one does delist from an exchange, and 12 (a) no longer applies, typically the company will be of
sufficient size to have to report under §12 (g), or under §15(d)
 So, have to check those rules too
 2. Deregistration under §12 (g):
o Either:
 1. Certify that you have less then 300 shareholders (if assets >$10M) or
 Purpose:
o The even less shareholders is there as a prophylactic rule
o Provides excess cushion in case inadvertently cross the 500 mark
o Inadvertent public company is avoided
 2. Certify that you have less then 500 shareholders and <$10M in assets for last 3 years
 3. Deregistration under §15(d):
o Must certify that you have less then 300 shareholders after first year following registration
 4. For Foreign Issuer:
o §12(6) Exemption
o Show that less then 5% of trading volume is in US or <300 shareholders are within US
 B. The Public Company Disclosures:
 Generally:
o Policy:
o There are 3 forms that are required to be disclosed in certain times
 Form 8-K:
o Disclosure of ongoing disclosure for specifically mandated material and non-material developments or events
o Must occur within 4 business days of event that triggered the 8-K
 Form 10-K: Annual Report
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 Form 10-Q: Quarterly Report
 Form 20-F: Foreign Report equivalent of 10-K and 10Q
o The Contents:
 Each form is required to have the contents of Form S-K (Non-financial) and Form S-X (Financial)
 “The Integrated Disclosure System” uses these common forms for all disclosures for consistency
o Overarching Policy Themes:
 This is the disclosure Securities laws provide to curb information asymmetry, collective action issues
 In 10K, 10Q, and 8-K, as well as maintaining the accuracy of these documents:
o Cost-Benefit Analysis can be employed to interpret the policy implications
 Overall, while disclosure is intended to help shareholders, for each, an argument lies in their chance of hurting SH
 1. Form 8-K:
o Generally:
 Used for specified, particular events that effect a company
 “Real Time” disclosure that must be made within 4 days of the triggering event
o Events that Trigger Disclosure:
 1. Registrant’s Business Operations:
o 1. Entry, material amendment, or termination of Material Definitive Agreement
 Policy:
 Why do we wait until its material and definitive?
o If speak too soon, may impose duty to come back and correct (Per Duty requirements)
o If transaction, disclosing too early may eat into the profit the target gets (as stock price
increases, and eats into the premium you are paying)
o Alerts Competitors of transaction (negative externality)
 Note:
 Letters of Intent, in Merger, only needs to be disclosed if enforceable
 2. Financial Information:
o 1. Completion of Acquisition or sale of assets that are >10% of registrants assets
o 2. Results of operations and financial conditions (if prior to 10Q, 10K)
o 3. Creation of Off-balance sheet arrangement:
 Derivatives
 Sale of liabilities to Subsidiaries
 Channel Stuffing or Extraordinary Contracts to gain revenue
o 4. Material Impairments to Assets (Good will)
 For instance, if the value of a transaction is not as high as you thought—correcting that triggers 8-K
 3. Securities & Trading Markets:
o Delisting Notice
o Unregistered sale of securities
 4. Matters of Accountants & Financial Statements:
o 1. Changes in Auditor and reasons why you changed (including any disagreements)
 Policy:
 While this mandates reasons why
o It is in the best interest of both parties to make up a story
o Corporation Won’t raise investors concerns
o Auditor Won’t end its future prospects of work (as others may be weary)
 Telling that you changed and why you changed:
o Allows investors to perk up, and get interested that something might be up, but reasons given
may not be wholly accurate
o So merely tells investors “something’s up, look out”
o 2. Notice that previously issued Financial statements cannot be relied upon
 5. Corporate Governance & Management:
o 1. Change in Control of Registrant
o 2. Departure of or appointment of directors and officers
 In the Matter of HP Co.,
 F: An internal investigation was ongoing to determine which director leaked secret information to
press. A director disagreed with the way an internal investigation was being held, and decided to
resign. HP filed an 8-k, but did not tell “the circumstances in which the resignation occurred.”
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 R: Item 5.02
o 1. Must disclose the facts and circumstances that surround resignation—disagreement
o
Briefly described them , if relates to operation, policy or practices
o 2. Must give a copy to resigning director
o 3. If he disagrees with representation, he may respond by letter—attached to 8-K
 Policy:
 Disclosure may have negative effect:
o As with auditor, even though 8-K mandates it should tell what disagreement was about, both
the Corporation and director have it in their best interest to not say
o Preserves future employment of that director (no one likes tattle-tale), and Corporation’s
reputation
o Effect: Disclosure’s effect may actually be to 1. Chill Board of Directors discussion and
action, to avoid dissent, distorting and 2. Encourage recruitment of friendly directors
and overall
o Hurt the shareholder with less information getting to them
 Counter Argument:
o Disclosure of why Director is leaving is beneficial to investors
o Alerts to something that may be amiss
o With anti-fraud liability mandated on any affirmative statement, which the 8-K mandates in
addition to the letter the director may write—unlikely to overly chill typical Board of
Directors, as personal liability is weighty, and shareholders vote
o 3. Amendment to bylaws or AIC
o 4. Amendments to Registrant’s code of ethics
 If you do not have a code of ethics, you must explain why
 Policy:
 Gives another chance to ‘check’ internal control mechanisms
 Opens up to potential liability from π’s attorneys
 6. Regulation F-D:
o Material, non-public information that was disclosed must be made public
 7. Asset Backed Securities
 8. “Other Events”
o Anything that the issuer thinks would be of interest to security holders
o May give the company a preemptive chance to come out, and spin a story
o Policy Questions about the 8-K:
 1. While the 8-K requires certain disclosures—should it require all material information be disclosed?
o No:
 1. Logistics: to continuously disclose all information would be impossible—all effort would go towards it
 2. Cost: The cost alone of doing so would be oppressing and chill public companies severely
 3. Diminished Accuracy: Goes back to ‘burried’ mentality of why we keep to material information
 Eventually, all information would simply be sent right out, inaccuracies and all
 4. Resistance: Liklihood of subversion of documents
 5. Potential to cripple innovation and competition: disclosure on a rolling basis would potentially lead
to negative externalities, alerting competition
 Overall:
 Cost-Benefit Analysis has been employed
 It seems that a compromise has been struck in disclosure
 With all of the costs imposed on companies, balanced against the need of investors of information
o The scheme of Quarterly, Annual and supplemental 8-K seems fair
 Also:
o Although the information in 8-K is mandated to occur within 4 days, a company can release
information sooner if they want
 2. Why 4 Days? Why not Constant?
o Pro-Argument:
 Faster would certainly curb insider trading issues and get information to investors but
o Counter:
 Not clear if getting faster then 4 days would be helpful
 Costly
 Diminished Accuracy
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 Logistically may not be possible in some cases
 3. Should an 8-K, instead of listing things, have a general requirement to disclose all Material information?
o Pro-Argument:
 Again, this may be helpful, getting information quicker, ending asymmetry faster
 Reducing Collective Action issues, but:
o Counter:
 8-K was never intended to be general mandate of disclosure
 Logistically probably not possible
 Costly
 Diminished Accuracy
 Materiality is not clear standard
 The lack of what is material takes time to determine
 May chill companies taking on certain projects if may lead to disclosure
 So, legally, the information listed and time frame are mandated to strike a reasonable point in time that is
flexible to the corporation, logistically, giving it time to meet requirements while giving investors what they
need, while not overburdening the corporation
 2. Form 10-K and 10-Q:
o In General:
 2 forms that are required to be disclosed by public companies, as definition in §12(a), (g), or §15(d)
o A. 10-K:
 Annually Disclosed
 Includes:
o 1. Description of Business
o 2. Properties
o 3. Legal Proceedings
o 4. Market for Common Stock
o 5. Management Discussion and Analysis of Financial Condition
o 6. Directors and Officers
o 7. Executive Compensation
 Must disclose compensation (options, bonus, salary) of CEO, CFO and other 3 highest paid executives
 Perquisites over $10,000
 A. Compensation, Discussion, and Analysis Section
 Discusses the objectives of compensation, and comparison to peer executives
 Disclosure of Executive Compensation Section:
o Mandates certain things be disclosed
 Policy reasons behind it:
o 1. We want management aligned with corporation
o Showing payment may allow evaluation of if this in fact is occurring, based on performance
o 2. May be reputational constraint, as required comparison to peers may embarrass if too high
o 3. Reduction in Agency Costs: Hand-in-hand with this rationale of mandatory disclosure
 Issues with Disclosure:
o 1. Benchmarking: By disclosing, all executives may seek higher pay, so that all look rather
similar and so that when they decide to leave, they are attracted to other companies who pay
similarly
o So, may have negative effect too, actually hurting shareholders
o 2. Companies have incentive to keep high
o so no one looks bad, or reputation tainted
 Methods to avoid issue:
 1. Transparency: require showing of different amount
 2. Taxation: We could tax higher levels of income
 3. Alternative Payment: we could mandate, or prefer stock or option usage
o more payment for performance rationale
 Paradox with using stock as payment:
 While this method tries to better align performance with pay, as management will want to increase
stock price, benefitting shareholder, there are policy issues in it hurting shareholder:
o 1. May encourage focus on short term
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o 2. May take on less risk, to ensure more consistent gain
o 3. May promote fraud, fudging of numbers to reach price
 B. Stock Options and Issues in Compensation:
 Purpose:
o Employee Stock options are used to better align the incentives of the employer, employee,
and shareholder
o The premise is that the manager will make effort to increase his wealth by increasing the
stock option pice, thus increasing shareholder wealth too
o Effect of Giving Stock Bonus rather then Cash Bonus:
o Options have continued upside and incentive to work
o Not automatically realized
o This is unlike $, which is realized automatically
 3 Types:
o 1. “In the Money” Where strike price is below stock price
o 2. “At the Money” Where strike price is equal to stock price
o 3. “Out of the Money” Where stock price is less then stock price
 Policy Issues with Granting Stock Options
o If granted “in the money” option  no incentive to work harder to maximize shareholder
wealth, transfers value directly to employee,
o Stock Option Backdating:
o
-Changing the date of a stock option to when it was not in the money, in essence granting
the person an in the money option, although technically it was not when issued
o
-Lowering the strike price so that a formerly out of the money option is now in the $
 Policy Arguments:
o SH Perspective: granting in the $ options misaligns incentives of employee and shareholder,
looks poorly in corporate governance, may dilute shareholders
o Corporate perspective: if they have low cash, using these types of options is a way to reward
successful employees, and evens out differences in start dates—which may effect if a stock
option was in the money or not
o 8. Shareholder Voting
o 9. Security ownership
o 10. Audited Financial Statements
 the most expensive part of the 10-K process
 The M, D & A Section:
o 1. Contents:
 A specific, narrative of financial data explaining the thoughts of the management
 Will have “Forward Looking Information”
 “Known Trends or Uncertainties that are reasonably expected”
o 2. Policy reasons behind it:
 1. Due to information asymmetry, and collective action issues, the MD&A section allows for the
disclosure directly from the source that has it
 2. Their statements on trends, uncertainties are because they may be able to see what others cannot
 May ease collective action issues, and reduce wasted efforts (See Mandatory Disclosure, infra)
 3. Cost/Benefit Analysis of forward looking information:
 There are costs and benefits to doing this (fear of liability for directors, reliance of investors on
statements)
o However, the benefits are that information is given to investors from the source most likely to
have it
o Outweighs the cost concerns…
 Regulation has dealt with these concerns by:
 §21(e) Safe Harbor:
o There can be no private liability for forward looking statements
 The standard is vague
o B. 10-Q:
 General Mandates:
o Made on a quarterly basis
o Uses much of same information as 10-K, from Regulation S-K on smaller scale
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o Accounting Statements do not have to be audited
 However, does have to comply with GAAP
o Foreign Issuers:
 Form 20-F instead of 10-K, 10-Q
 Almost identical to others
 3. Accuracy of Exchange Act Disclosures:
o Generally:
 As we have seen, disclosures must be accurate, and we do this by:
o 1. Certification by the CEO and CFO under Sarbanes-Oxley amendments to Exchange Act (infra)
o 2. §21(a)/ §21(c) Public Announcement of Securities Law Violation/Reputation Sanction / Cease/Desist
o 3. Internal Control Mechanisms
 The Exchange Act furthers accuracy with:
 1. Requirement of Accurate Disclosure [13(b)2(a)]
 2. Procedures with how to do so [13(b)2(b)]
 Note:
o These provisions are applicable to the disclosures of the Exchange Act, and were promulgated
in 1975 under the Foreign Corrupt Practices Act
o Requires compliance with §13(b)2(a) and (b)
o FCPA prohibits the payment of bribes to foreign officials to obtain business
 §21(c) Cease and Desist
o 4. 10b-5 Anti-Fraud Liability
o 5. 3rd Party Reputations
 Accuracy is key to having these disclosures mean something
o A. Certifications by CEO and CFO of 10-K and 10-Q:
 1. What must CEO and CFO Certify per §13a-14, and §15d-14 (Created under Sarbanes-Oxley)
o 1. Reviewed the Report
o 2. To their knowledge, no material misstatement or omissions
o 3. They’ve established and maintained internal controls to ensure they know material information, and controls
have been evaluated in past 90 days
o 4. Disclosed to auditors and audit committee any weakness in internal controls and fraud
o 5. Any changes in internal controls made subsequent to evaluation are disclosed
 2. Sanctions for violating certification:
o 1. $5M fine and/or 20 years in prison
o 2. Claw Back of bonuses for any period that company must restate financial results from misconduct
o 3. π’s bar may use this information as evidence of 10b-5 violation
 3. Policy Rationale for Executive Certification:
o 1. Re-focuses CEO/CFO on corporation and importance of disclosure
o 2. Prevents ‘ignorance’ claim as they have duty now
o 3. As they are personally liable, criminally, forces them to make information more accurate
o 4. Reputation on the line
 4. Issues with Certification:
o Cost/Benefit Analysis
o 1. Officers will spend more $ to assure they will not be liable
 May over deter inaccuracy, and excessive spending on lawyers, accountants, etc…may hurt the
shareholder
 Incentive to overpay to assure accuracy on the shareholder’s wallet
o 2. Officers will be indemnified from personal liability from Corporation
 The shareholder (corporation) is the one paying for the indemnification of the Officer, if they become
liable
o Overall:
 Although premised on good intentions, Certifications by CEO and CFO may in fact increase cost to
shareholder
 The Costs of this process may exceed the Benefits of holding Officer Liable and assuring accuracy
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 Methods to Fix these issues:
o 1. While indemnification from $ is one thing, there is no indemnification from prison
 Effect:
 Prison will promote accuracy
 Issue:
 Still worry of excessive spending to avoid this punishment
o 2. Reduction in amount Corporation Indemnified to Officer for
 Effect:
 Reduces amount the shareholder pays if there is an issue
 Issue:
 Officer will ask for increased pay
 May go to private
 Overdeter, in that the officer will simply spend more shareholder money up front to assure accuracy
o B. §21 (a) Reputational Sanction for Violation of 10-K Disclosure:
 W.R. Grace & Co. (Exchange Act Release):
o F: CEO, Peter Grace was retiring. He was given a package, where he simply got the same salary and benefits
(jet, apartment, etc…) as before. However, this was not disclosed in the 10-K, which requires disclosure of
executive compensation of CEO, CFO and highest three. The attorneys for company know of package but
believe they are not material, so don’t include them. Other CEO and Officer knew of them too, but did not
inquire into why they were not disclosed.
o Note:
 §21(a) Proceeding allows SEC to Publicly announce securities violation
 In essence, alerting the public to your violation—reputational shaming
o R:
 1. If Officers merely delegate an issue to Counsel –it is not a defense
 1. If the director or officer knows or should know statements may be inadequate or incomplete they
have obligation to correct that failure
 2. They can only rely on company’s internal procedures if there is a reasonable basis for believing
they have led to full consideration of issues
 here:
o They did have reason to know statements were inaccurate because they were involved
 Policy of why delegation to Counsel is not defense:
o Concern over the effect it may have on lawyer’s opinion and practice
o Holding lawyer liable for legal judgment is not what SEC wants to do
o They should be able to exercise judgment without fear of mistake
 Issues with Reputational Sanction: Does it have Effect?
 1. Perhaps it effects that corporation
o Individual officers that are younger may be affected more then those that are older and on the
way out
 2. Maybe not: But, may send message to the industry that a practice is no longer accepted, or was
wrong throughout
 Outside Directors and Liability:
o Outside directors are those who only get payment for being director, but don’t have any connection to the
company they are on Board of otherwise
o They out of everyone represent the shareholder the most then
o Should we hold them liable in the Securities Law regime for mistakes in disclosure to shareholder?
 Yes:
 Liability furthers their position to represent shareholders
 Because they are the better monitors for shareholders, will better shareholders
 They have an interest in preserving their neutral, pro-shareholder reputation
 Creates other set of eyes
 No:
 The more obligation and liability, the fewer qualified candidates will come
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 May not be able to even notice issues with the disclosures
 Cost/Benefit Analysis of the use of 3rd Parties, Director Liability, Etc…
o With the Several Methods of Accuracy Enforcement Avoid Redundancy
o Use of 3rd Party Reputation:
 Outside counsel, accountants, etc…
 Cost-Benefit:
 The Costs otherwise would create redundant practices
 Officers, Directors and 3rd parties would be doing the same thing
 So, utilizing the 3rd party reputation maximizes benefits and cost
o Liability in most extreme violations:
 This would avoid the costs of losing directors, and increasing their responsibilities while also assuring they
will look out, not participate in most egregious failures
o C. Requirement of Accurate Disclosure of Books and Records: 13b(2) (a):
 “Requires a company make and keep books, records, and accounts which in reasonable detail accurately reflect the
transactions and dispositions of the assets of the issuer”
o 3 Effects:
 1. Strict Liability:
 merely having inaccuracy is actionable
o there is no negligence, intent, etc…just having it occur is enough
 2. Materiality is not an issue:
 It does not matter whether flaw is material or not
 Any flaw in accuracy is actionable
 3. Only the SEC can enforce
 there is no private cause of action
o D. Requirement of Internal Controls: 13(b) 2(b):
 Companies are required to create and maintain adequate internal controls and accounting mechanisms to keep track
of business, ensuring accurate disclosures
 §13(b) 2 and 5:
o If person knowingly fails to do so, or falsifies book records may lead to criminal liability
 Policy: What Types of Controls would we want:
o How would CEO and CFO, who have to sign off on their review of internal controls assure that records are
accurate and procedures to assure accuracy are adequate?
 That there is no fudging, or violation of FCPA—that assets are being expropriated?
 No inaccurate or fraudulent practices?
o Objectives of Internal Controls:
 Avoid as much fraud and inaccuracy as possible
 Protects investing public
 Potential issues:
 The costs of such a program of internal controls may increase and increase
 While policies have the benefit of deterring fraud, and ensuring it is not going on, the costs are there
 At what point does Cost > Benefit occur?
 Reduce Redundancy of internal controls to avoid Cost>Benefit
o Possible Methods:
 1. Information Systems: track the expenditures and sales per unit,
 2. Internal Auditing
 3. Segregate Duties
 require multiple parties to sign checks, maximum allowance before permission to do so
 4. Policies and Procedures
 Design a system of clear policy and procedure to avoid this
 5. Training
 6. Company Code of Ethics and Policy
 Goes back to disclosure of it, or disclosure of why you don’t have it
 Oil States International:
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o F: Oil States owned a subsidiary in Venzuela. The subsidiary was dealing with a consultant to contact it
with the local government and a local government owned company. The local company began overcharging,
and the consultant participated. Kick backs were occurring, and eventually Oil States figured out it was losing
money in its Venezuela projects. Oil States corrected its books, strengthened records.
o I: Whether Oil States is liable under §13(b) 2(a) or (b)?
o R:
 §21(c) action brought—cease and desist
 Violation of §13(b)2 (a) because its books were not accurate and fair in reasonable detail
 Violation of §13(b)2 (b) for failing to maintain adequate controls
 Why were they liable??
 The §21 Reputational sanction was available because §13(b)2(a) is strict liability
 Even though they decided to voluntarily disclose—still liable
 FCPA May allow bribery of non-government official:
o The FCPA specifically prohibits the bribing of government officials
 “Government Official”:
 any officer, employee of a foreign government, or any department, agency, or instrumentality
thereof, or any person acting on the behalf of a government
 So: Will need to argue neither employee or working on behalf
 FCPA Policy:
o 1. The FCPA may disadvantage US Companies that operate internationally
 Other countries don’t have this restraint
 Competitive disadvantage
 But: US may be able to point to FCPA, avoiding extortion issues
o 2. The Costs of compliance with internal controls has effect on Corporations
 Audit
 Policies and Practices
o 3. The Benefits of compliance with internal controls is questionable
 The more regulation, the less a business focuses on the task at hand---the business
 All that effort, and still not a complete fix
 Redundancy is an issue too with any internal control scheme
 Could, after these costs hurt shareholder’s wallet
 E. Use of 3rd Party Reputation as Gatekeeper to Disclosure:
o Reason:
 Gate keeping Function
o Ensures accuracy of most important Financial Statements
 Info Asymmetry and Collective Action issues eased as information flows through intermediaries to SH
o Key Issue:
 In all, we are worried that 3rd parties will be “Captured”—no longer independent, making disclosure useless
 So: With Rules, we focus on independency
o 1. The Independent Auditor:
 General Function:
o A. Rule 13a-1 requires a public company to be audited by an independent accounting auditor
o B. Accountants are the gatekeeper of ensuring financial disclosure and integrity
 Their accuracy and good job is key to maximizing the benefit that disclosure offers—i.e., remedying
unique issues with securities…and the ability for intermediaries to funnel the information down the
pipeline
 Post Sarbanes Oxley:
o A. Auditors must be independent
 1. §10A(g):
 Auditors are prohibited from performing other non-audit services for a client
 2. §10A(j):
 Partners must be rotated from account to account every 5 years or less
o Policy:
o Benefit 
o Avoidance of “Capture”
o Cost 
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o May be very costly to the auditing firm, and may instead merely pass along a shiester
auditor to another company
o May potentially hurt oversight, as best partners have to move on
o
 3. §10A(l):
 Auditor cannot audit a company if the CEO or CFO worked for that auditor within last year
 4. Public Certified Accounting Oversight Board
 Created by SOX, the PCAOB creates new rules and standards that Auditors must comply with
 5. Auditor Standards and Sanctions:
 1. Cannot engage in “intentional, knowing or reckless” conduct that results in violation
 2. §4 (c):
o May be barred from practice in front of SEC
 B. Audit Committee
o As a result of SOX, the auditors who annually audit a company are supervised by the audit committee of target
company’s Board of Directors
o Policy:
 Helps in the process that the most important portion of disclosure—financials—are taken care of
o Membership:
 Members must be independent directors, who only get salary for directorship
 NYSE and exchanges require more strict rules, that all members be financially literate
o What must occur:
 1. Auditor Compensation
 the committee is responsible for developing the retention, compensation and oversight
 2. Auditor must
 Report critical policies
 Disclose any alternative treatments of information discussed with management
 Disclose material communications between auditor and management
 Must report on the internal control and evaluate them
 Auditors also must use their practices and skills in an attempt to detect illegal acts
o If found—report to Committee, and if need be to SEC
 C. Potential Issues Remain with Auditors:
o While the above fixes have helped audits become more independent, accurate, and beneficial of overall
disclosure, there are issues
o 1. Oligopoly Problem
 Because of “The Big 4” there is no incentive to compete with each other—rather, sharing the wealth will
benefit all
 However, there is incentive to squeeze the market so that no one can enter
o 2. Partners may seek profits:
 Even with the rules available, greed may fuel fraud
 Thus, the reputation and gate keeping function of the auditor is bypassed
o 3. There is always potential for Capture
o 4. The issue that disclosure of Auditors leaving, it is in the best interest of the company and auditor to spin the
story (see, infra, discussion on 8-K disclosures)
o 2. The Securities Lawyer:
 General Function:
o Lawyers’ expertise and assistance allow for accurate disclosure and compliance with the securities laws
o They enforce and assist in the process
 Gate keeping Mandates:
o Benefits:
 A. Lawyers understand the process the best
 B. Is more Cost efficient and thus the benefits are maximized by using lawyers for enforcement and
compliance in addition to auditors
o Issues:
 A. The Cost of lawyers is high
 This is passed onto the corporation, and in turn the shareholder
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 B. Lawyers are less likely to be privately liable
 C. There is conflict between lawyers gate keeping and representation of corporate client
 D. Capture
o What Lawyer Must Do:
 1. Withdrawal Duty:
 Lawyers confronted with fraud are required to withdraw from representing the client
 2. Whisteblowing:
 Lawyers must report material violations of state or federal securities law to company, or GC
o If not satisfied with the response, lawyer must report to audit committee
o If not satisfied with response, lawyer may go to SEC
o Whistleblowing Function:
 How are lawyers Sanctioned:
o 1. Injunction
o 2. Bar
 Pursuant to §4(c), Lawyer may not be permitted to practice in front of the SEC
 This means virtually any filing
 Note:
a. Potential to end a securities lawyer career as can be for period of time or indefinitely
V. Rule 10b-5 Anti Fraud
 The Rule:
 10b
o SEC has authority to adopt rules governing any manipulative or deceptive device in connection with purchase or sale of
security
 10b-5
o Prohibits:
 1. Fraudulent Devices or Schemes
 2. Misstatements or Omissions of Material Facts or
 3. Act or practice that is fraudulent or deceptive in connection with purchase or sale of any security
 Elements:
o Misstatement of Fact or Omission (Deception)
o Materiality
o Scienter
o Reliance
o Causation
o Damages
 A. General Policy of Fraud
 1. Why We Regulate Fraud:
o 1. Fraud has negative ramifications for Securities Markets
 Effect:
o Negatively influences how capital is used by investors, as overvalued prices eventually lose $
o Waste of Resources as $ could be better used elsewhere
o Undeserving business that should go bankrupt is continued
o Prices Discounted
o Shareholder is hurt by Agency Costs
o Securities are intangible and susceptible to fraud
o 2. Investor Discounting Problem
 Fraud is priced into stocks with slight discount
 As Fraud Continued
o 1. Honest Companies Punished due to lower IPO prices
o 2. Lemons Problem:
 Truthful Companies would be forced to leave markets due to lower capital raising capability
o 3. Fraudulent Companies would remain, as discounting continued
o 3. Unsophisticated Investors Taken Advantage Of
 Typical, everyday investors are more vulnerable
 As irrational investors buy securities, the fraud, and overvalue of them leads to losses
o 4. Increases Accuracy of Disclosure
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 Another method we use in our securities regulation regime to increase accuracy
 2. How do We Regulate Fraud:
o 1. Audit
o 2. 3rd Party Reputation
 Auditors, Underwriters, Investment Bankers, Lawyers
 Concerned with Capture
o 3. Process Controlled with 13(b)2(b)
o 4. Rating Agencies
o 5. Enforcement
o 6. 10b-5 Liability
 Note:
o An overall blanket, like 10b-5 is most likely more efficient, rather then having investors go through other
options to determine if 3rd party is reputable, track record, etc…
o Cheaper
 B. The Use of the Class Action Lawsuit
 Generally:
o A Key Policy Issue of 10b-5 being broader or narrower
o While 10b-5 allows for an interpreted private cause of action, with a small company of relatively few shareholders it may
be feasible and justified
 Benefits> Costs
o Collective Action Issues:
 However, as the company gets bigger, the costs of doing so to go through the process are huge, and impossible to
do while the shareholder only gets pro-rata portion of the recovery
 Costs> Benefits
o The Class Action allows for the aggregation of all shareholder interests
 A. Issues with Target Company and Plaintiffs’ Bar:
o 1. Distinguishing Fraud from merely bad business decision is not easy
o 2. Π’s Bar:
 Cons:
o Like business, π’s attorneys speculate and essentially lend (contingency fee) to shareholder to recover later
o Settlement/Strike Suit
 Incentive to bring settlement suit for huge pecuniary value; nefarious purposes
 Benefits:
o They may be necessary evil, to have trained representation of shareholders, however
o 3. Settlement Usage of Suit—Frivolous versus meritorious suit
 If π attorneys can get past motion to dismiss, they will seek to get past for settlement value
o Company has incentives to settle:
 1. They have insurance to use
 2. Attorney’s fees in the massive process are high
 3. Makes business look bad
 4. Quicker to settle, lower the cost
 5. Massive amount of “Fishing” for documents
 6. Long time
 7. Distracts business from its key purpose
o Frivolous Law Suits:
 Extortion value, nuisance value, brought without belief there is evidence, costs<benefit of settlement
 The same reasons, above, that a company has to settle a viable suit are the reasons Frivolous suits are
brought and have incentive to settle too
o Paradox of the Policy on 10b-5:
 While used as method to protect shareholders, the costs that class action and insurance create may in fact
hurt them
 Increasing expenses
 Literally takes money from one shareholder pocket and puts it in another
 Settlement value/Strike-suit gives reason to limit 10b-5 standing, and litigation potential
 B. Potential Remedies for, and Alternatives to Class Action, Plaintiff Suits—Reducing Likelihood of Nuisance Suits:
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o 1. Change in Compensation
 To avoid cost to shareholders that $ creates (Essentially taking $ from shareholders and giving it to shareholders),
we could:
o 1. Pay In Shares:
 The dilution may show shareholders the effect Class Action has on them
 If large enough, may compensate π’s firms
 Issue:
 Paying with shares of company that your suing seems contrary to what π’s lawyer wants
 The more they push, deeper they dig, the more the share-price could go down—backwards
o 2. Grant Injunction:
 Symbolic that wrongdoing occurred
 Potential Effect:
 Granting an injunction now may have positive effect
 Notifies π’s attorney of potential future issue, with past injunction bolstering argument that
Company defrauded
 1. Deters repeated conduct
 2. Avoids compensation being paid now—saving shareholder $ (avoiding paradox of waste)
 3. Allowing treble damages in the future would further deterrence
o So the idea is that we give injunction now, avoid the huge compensatory cost to deter in the
future, and this would avoid shareholder waste while deterring fraud
 Issue:
 Injunction of past conduct is relatively meaningless, however, to shareholder who lost $
 So, payment of lost $ seems to make them whole again
 $ damages is the deterrence, so not paying them now doesn’t deter
 Fails to compensate for harm done
o 2. Involve Court More:
 1. Lower burden on Motion to Dismiss
 2. Mandatory review of settlements and fees
o Giving Court ability to reject certain settlements
 3. Court Ordered “Loser” pays fees
 4. Only allow trial rather then settlement
 5. Allow portion of damages to go to Court, or Fund, Treasury
 6. Heightened Standing
 Issues:
o These are politically unlikely: Not likely civil trial system will be amended for securities litigation. Likewise,
allowing a portion of the fund to go to the Court may be conflict of interest
o Fees: If we don’t go to trial, and settle—no one pays. Additionally, Corporation has incentive to screw the
shareholder that sues it if it knows it doesn’t have a chance, but keeps litigation going
o 3. Increase SEC, Agency Enforcement
 We could increase funding to SEC, DOJ, and increase jurisdiction
 Pro:
o Focus their efforts
o More efficient due to their continually sticking in that field
 Con:
o “Regulatory Capture” a concern noted, supra, within Mandatory Disclosure
o Increased Funding
o Displacing all private cause of action would burden SEC
 Private Litigation wouldn’t Supplement SEC anymore, and vica versa
o Criminal Jurisdiction would over deter perhaps
o 4. Increase Police of Exchanges
 Exchanges could police themselves, sanctioning when they wanted to
 Doesn’t need additional financing either from government taxes
 Issue:
o Reputation would be constrained
o Conflict of interest, in that they want to attract companies, rather then deter them from joining
o To the Contrary, though, they already enforce requirements…maybe not that far fetched
o 5. Whistleblower Bounty
 Rather then have general ability to sue, have instead, a law that allows pursuance of set fees or bounties
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o In this scheme, reporter gets to keep portion of reported fraud
 We already do this, but, we could make it much more broad
o 6. Heightened Standing
 Discussion, infra, on merits of narrow standing in 10b-5 litigation and prudential application to Courts
o Overall Downside of these Alternatives:
 Fail to address Compensation of shareholder’s loss
 However, these schemes may avoid strike suit/settlement suit and frivolous suit
 C. The Private Securities Litigation Reform Act of 1995—The Actual Reform Undertaken:
o Purpose:
 Designed to address the issues that class action suits present in securities litigation
o Mandates:
 (1) Stay on Discovery until after motion to dismiss
o Purpose:
 Prevents a fishing expedition, of starting a suit that is almost meritless, and looking for anything to use…
 (2) Pleading with Particularity leading to a strong inference of Scienter
o Purpose:
 Avoids nuisance and strike suits, as it is not an easy pleading to show scienter
 (3) Lead Plaintiff Provision
o Rebuttable presumption that the lead π in the litigation should be the shareholder with the largest financial
interest in the class action
 Purpose:
 Avoids including πs that don’t have as much, or anything at stake
 Policy Implications discussed infra
 (4)Reasonable Attorney’s Fees
o Courts may review attorney’s fees for reasonableness, although presumed reasonable
o Purpose:
 Helps assure that attorney is in line with shareholder’s interest
 Not likely used
 (5) Proportionate liability for defendants not engaged in intentional fraud
o Statistical Effect:
 Although designed to address issue, data has not shown class actions have declined since it was enacted
 C. PSLRA Reform Pleading Requirements:
 A. The Lead Plaintiff Requirement of PSLRA—Who Represents Those with Standing:
o General:
 Because of the thousands of people involved in a suit, Congress created this requirement
 Policy:
o Reduces Agency Problems between class members and attorneys
o Reigns in Attorneys
o Reduces Information Asymmetry between Class and Attorneys
o 1. Requirements:
 1. Early notice to the class
 2. Rebuttable presumption that lead plaintiff will have largest holdings of class
o To rebut, evidence needed
o Limited discovery
 3. Lead Plaintiff selects lead counsel
 4. Court Review of Attorney Selected
o Court retains the right to Approve or Reject Attorneys
o 2. Lead Plaintiff Selection Requires:
 1. Largest Financial Interest:
o Litigant with largest financial stake in the company in question
 2. Typicality:
o Must face same type of losses as the class
 3. Adequacy:
o Lead plaintiff must have the ability and incentive to represent the claims of the class vigorously
o Obtain adequate counsel
o No inherent conflict of interest with other classes or shareholders
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 To Rebut:
o Show
 “Lead plaintiff will not fairly and adequately protect the interest of the class”
o 3. Court Review of Attorney Selection:
 Review Selection based on:
o 1. Legal Experience and Sophistication
o 2. Manner lead π chose the firms considered
o 3. Process lead π selected final choice
o 4. Qualifications and experience of counsel selected
o 5. Evidence that agreement with attorney was result of serious negotiation
 Review of Fees:
o Presumed reasonable
o Policy of Why Reviewable:
 While Courts are less likely to look into the fee, it allows the court to again assure agency costs are not
excessive and that the class of πs and attorneys are further aligned with each other
o Can be reviewed:
 Rebutting presumption is possible if the fee is clearly excessive
 EG:
o Fee of $187M was reduced to $8M
 Possible Policy Effect:
 While altruistic to help π, this may simply encourage attorney’s to bill the same, while keeping
paper trail and evidence of what they’ve done so that they can prove to the court
 Encourages wasteful work
o 4. Merits of Lead Plaintiff Requirement:
 1. Is having the largest shareholder, one with most at stake good idea?
o Pros:
 Easiest to Manage Cost
 From policy perspective, good to have those with most to lose controlling litigation
 Efficiency, as these shareholders are more sophisticated, with more open to them at their discretion
o Cons:
 Institutional Investors have reason not to rock the boat—may not be vigorous in pursuing
 For reasons class-actions are bad
 This is costly, takes away from focus on business…etc…
 Reputation to uphold
 These banks and large institutions offer a variety of services to other public companies
 Suing one, as lead π, may end their future business. I.e., getting financing, etc…
 Conflict with bringing suit against the shares they then sell to customers
o Those with the most at stake—institutional investors—may not want to rock the boat
o While the law sets it up for them to be involved, they may have reason not to
 2. If PSLRA was intended to combat frivolous lawsuits, does lead plaintiff help?
o 1. Having those with the most to lose may in fact lead to meritorious law suits
o 2. Due to reputation concerns, there may not be suits unless meritorious
o 3. Ongoing reputation, and stake probably negates need to pursue frivolous settlement suits
 So, in all, it may combat frivolous lawsuits, although statistics have shown no decline in class actions
o 5. Alternatives
 Securities Case Auctions:
o Theory:
 Securities Fraud Claimants can hold an auction for their claim
 Plaintiff’s Attorneys would bid for the right to bring it
 The highest bid wins, and that is the investor’s recovery
 Effect:
o Reduces Agency Costs as Attorneys now have 100% of claims
o Issues:
 1. May encourage desire to settle, rather then litigate meritiroious claims
 Goes back to the problems with Frivolous law suits…this may encourage them for settlement value
 2. All Risk borne by attorneys may make this system unviable, and claims go unlitigated
 3. Valuation Concern
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 Either may be windfall to the attorneys who pay very little for large claim or
 Pay too much, thus chilling future ability to bring suit by attorneys failing to bid in auctio
 B. PSLRA Pleading with “Strong Inference of Scienter” Requirement:
o Generally:
 As we see infra, scienter is not an easy element to infer or prove, and PSLRA grabs scienter to use as a barrier to
entry
o You must “state with particularity facts giving rise to a strong inference of scienter”
 Effect:
 Inference of scienter can be made with evidence and circumstantial allegations but
 Mere allegations, or assertions, without evidence, will not meet particularity requirement
 Policy Implications:
 Due to stay on litigation until after dismissal stage, this is a formidable barrier
 Serves as area to dismiss easily
 Leads π Attorneys to:
o 1. Get Private investigators
o 2. Disgruntled Employees
o 3. Whistleblowers
o In an attempt to get past pleadings, motion to dismiss to get to discovery
 Tellabs Inc v. Makor Issues & Rights (US):
o F: Manufactured equipment, and allegedly made misstatements reassuring product demand, and was channel
stuffing, and overstating revenues. Π’s brought class action suit against them in violation of 10b-5. Alleged
Scienter by using “Anonymous employees”
o R:
 Must plead facts which reasonable person would deem inference of scienter cogent and at least as
compelling as any opposing inference one could draw from facts
 1. Congress intended to raise standard of pleading
 2. Court must consider the other plausible, non-culpable inferences that could be drawn as well
 3. Scienter inference must be at least as strong as non-culpable inferences
o Policy Implications:
 1. Heightened Pleading Standard in addition to discovery stay make it more difficult to enter court for securities
litigation
o May be a good thing, given potential settlement value of securities suit and fear of frivolous litigation
o However: May leave out worthy claimaints that have actually been harmed and deserve compensation
 2. What Factors lead to “Strong Inference”
o Insider Trading (Higher share volume, etc…)
o Divergence between internal reports and public documents
o Evidence of bribery of officials
o Existence of lawsuit that was settled quickly
o Sheer magnitude of accounting restatement
 Overall:
o The inference drawn from facts, or what little evidence is gathered before discovery make it difficult to show
“strong inference”
o While it may lead to a lower mens-rea, like recklessness, merely alleging circumstantial facts may not be
enough
 D. 10b-5 Rule Background
 Generally:
o 10b-5 serves as an overall, broad, blanket catch-all supplement to anti-fraud scheme
o The broadest number of ∆s
o Judicially Determined Private Right of Action
 While the rule does not state who has standing to bring suit under 10b
 Kardon v. National Gypsum Co., interpreted that 10b-5 is private cause of action
 However Supreme Court has reigned in overbroad ability to bring suit with limited standing
o 10b-5 compared to other Causes of Action:
 See Table in Folder
 A. §11: Registration Statement
o Purchasers of Securities may bring suit against material misstatement or omission in registration statement
 B. §12(a)(1): Offering non-exempt Security without registration
40
o Purchasers of securities may bring suit against person who sells/offers non-exempt security w/o registration
 C. §12(a)(2): Prospectus
o Purchaser of Securities may bring suit against any person who offers/sells security, with material misstatement
or omission in the prospectus or an oral statement
 10b-5
o Material misstatement or omission in connection with purchase or sale of any securities
 Herman & Maclean v. Huddleston:
o R:
 1. §11 and 10b-5 differ in scope
 10b-5 has a much broader scope and thus is a different standard of liability—catch al
o 10b-5 has scienter/intent element
 §11 only applies to registration statement violations
 2. “Securities laws combating fraud should be construed flexibly to effectuate their purpose, not
technically and restrictively
 Because of the broad purpose of the Exchange Act, securities laws must be construed to effectuate
their purpose…and these two statutes have two different purposes
o Why bring both?
 1. Claims may be plausible under both
 2. 10b-5 has longer statute of limitations
 3. Using both allows the bringing into suit of more ∆s
 4. Damages are Different
 E. Standing to Bring 10b-5
 “In Connection with the purchase or sale of securities”
o 1. Actual Purchase or Sale Requirement
 Blue Chip v. Manor Drug Stores (U.S. 1975):
o F: πs bring suit in conjunction with an offering that they decided not to participate in due to statements in the
prospectus. They allege statements were materially fraudulent.
o I: Who has standing to bring suit?
o R:
 1. 10b-5 is limited to actual buyer or sellers of securities
 Birnbaum Test
 Lack of Congressional Intent to expand beyond this
 Policy Considerations as to why limited:
 Negative:
o While yes, the bright-line rule of actual buyers or sellers excludes (1) investors who decided
not to buy or sell (2) actual shareholders to decided not to sell and (3) others who were
harmed by it
o Arbitrary limit, there are advantages
 Advantages:
o 1. Overextending 10b-5 increases chance of frivolous settlement suits
o
This delays normal business (Infra, reasons why bad)
o 2. Verifiability
o
It is clear who actually owned or sold a stock, and damages are determinable, but those
who say they would have or decided not to buy or sell are speculative, and cannot be verified
o
Can’t prove otherwise
o
However, actual buyer/seller—we can simply look at share price to determine loss
o 3. Administrable/Prudential Rule: More practical as it is verifiable
o 4. There are Other regulatory schemes that help non-actual buyer/seller
o Effect of Blue-Chip:
 Does it, in fact, solve litigation problem it was concerned with?
 Perhaps—it does narrow class of π’s that can bring suit, so less likely for suit to be filed then
o Adds evidentiary element to who can bring suit, bolstering standing
 No—even though limited pool, those who sold or bought may concoct a story anyway to solve their
loses, even if no fraud occurred
 Overall, because damage to those who actually bought or sold is verifiable—more administrable rule
o 2. “In Connection With”
 SEC v. Zandford:
41
o F: Respondent was stock broker, who’s client was an old man and mentally retarded daughter. They
invested $400K. ∆ began selling stocks in their account and keeping the proceeds for himself. 10b-5 brought
by SEC.
o I: What “connection” must there be between the fraud and sale or purchase?
o R:
 1. 10b-5 does not involve every fraud that by chance includes securities
 For instance: If broker validly sold stock, and later decided to simply steal the $, that is not ‘in
connection with’
 Or thief coming and stealing $ from your brokerage account
 2. The Fraud must “Coincide with the sale/purchase of securities”
 Look to the facts to see if the transaction furthered, was part of the deceptive scheme
 On one extreme:
o Does not have to be limited to privity between two parties
 One other extreme:
o But does not expand so far as to involve fraud not related to securities transaction
 Here:
 While the time was apart—sale and stealing, the two coincided
 The sale of stock furthered his deceptive scheme to keep the money sold
 It was 1 scheme of misappropriation
 Examples:
o 1. Corporation Advertisement says car goes for 100 miles, but lies as it only goes 25 miles. Investors see the
advertisement, buy stock in it, and the lie being uncovered kills stock price
 Standing to bring 10b-5?
 1. Actual Purchase
 2. “In Connection with?”
o The fraud may have ‘coincided’ with the purchase of securities as the deceptive scheme
coincided with sale of stock
o However: Ads are not directed for stock, although knowledge that investors watch them.
Company may know investors watch, see announcements of products and buy stock based on
future potential returns of successful products
o To Contrary: This is not transaction that doesn’t involve securities—its akin, in major
corpoation, to announcement of new product…investors react to
o Policy: Gets too far away from securities markets? Overchills disclosure, Other regulatory
schemes to protect. Overextends SEC to other contexts?
o 2. Closeness of Transaction and Fraud:
 Old Man puts $1M into brokerage account, places order. Broker sells stock. Then, goes broke and takes
client money for himself
 This may not be 10b-5 “in connection with”
 It is not 1, missapropriation that coincides or furthers scheme. Rather, it is 1 valid stock sale that
later is stolen from.
 Similar to what Zandford cited as not being anough
 Policy: Anti-fraud in brokerage promotes capital market certainty…
 3 Different Variations that can apply:
o 1. Accepted Narrower view of “In Connection”
 Contractual Privity
 Where a transaction between two parties, and 1 party makes a misrepresentation upon which the
other buys or sells
 Effect:
o This is easiest finding of “In Connection” and will be found if other elements there
o However, Zandford did not limit to Contractual Privity…and may be more expansive
 Why Zandford Does not Limit to only Privity:
o While is easy to apply, may not capture all frauds actually in connection with securities
o However, we don’t want it expanding too far away—allowing over expansive 10b-5
o 2. Accepted Broader View of “In Connection”
 Outside of Privity
 Where person who actually bought or sold is not suing the counter-party, but some other ∆
connected
42
 ∆ include any person whose fraud was in connection with
 Effect:
o Zandford allows this, based on the facts—but may be more and more tenuous
o EG: Old man didn’t sue the counter party who bought, but the broker who performed
transaction
o EG: President of company lies in press release, you actually buy/sell…may be enough
o 3. Too Broad-Non-Accepted:
 Would have/could have bought or Failed to sell
 The hardest case—Blue Chips ends this possibility
 Fraud simply not dealing with securities—anyone who is harmed by any fraud
 Over expansive view, as 10b-5 is limited to securities
 Policy reasons, above, making narrow view more feasible
 Policy of Broad or Narrow Standing 10b-5
o Should be Narrower Argument:
 1. Don’t want to overburden SEC
 2. Don’t want to flood courts
 3. Don’t want to extend too far from Capital Markets and Securities
o Wasted effort
 4. Not Verifiable
 5. Was not intended to be a broad, general anti-fraud requirement/Investor Insurance Policy
 6. There are other Regulatory Schemes to Protect
o A. State Derivative Suits
o B. Bondholders have contract
 Avoids redundancy
 7. Paradox of Shareholder Compensation
o Excessive Damages actually do more harm then good to shareholders
o Waste to take from shareholder and give to shareholder
 8. Chills information disclosure
 9. Frivolous Suit Issue
o See Infra
o Companies have incentive to settle “strike” suits
o Too broad 10b-5 encourages settlement value suits
o Should be more Broad:
 1. Arbitrarily limiting standing excludes deserving claimants
 2. Having more πs keeps corporations in check better
o Rather then limiting standing, we should re-evaluate overall scheme (injunction or whistleblowing)
 3. Stopping Fraud is good
 4. Compensate wronged investors
o Overall:
 While we should distinguish between fraud in general, and fraud in connection with securities, the distinctions are
not that easy and are rather tenuous
 Thus, constraining 10b-5 has good policy reasons (Frivolous suits, etc…) Standing is not easy to determine
 “In Connection” with Standing can be argued to be restricted to privitiy, or beyond
 Include Policy in argument
 SEC and DOJ:
o Neither needs to show actual purchase or sale to bring 10b-5
 F. Elements of the 10b-5 Cause of Action
 Include:
o Materiality
o Misstatement or Omission (where there is duty) that is deceptive
o Scienter
o Reliance
o Loss Causation (Damages Caused by ∆)
 1. Materiality
o See discussion, infra
 2. Material misstatement of fact or omission (Where Duty Exists)
43
o A. Deception:
 Santa Fe Industries v. Green (US 1977):
o F: During appraisal proceeding in merger, stockholders brought suit alleging that Santa Fe knowingly used a
fraudulent, misstated value and simply added a few dollars to it to defraud shareholders. They allege that a
breach of fiduciary duty is actionable under 10b-5.
o R:
 1. 10b-5 Requires Deception, Misstatement or Omission
 The text states it
 The purpose of the ’34 act is disclosure, if fully disclosed then no misstatement or omission
 2. Breach of Fiduciary Duty, alone, is not enough
 If the breach of fiduciary duty alleged is deceptive, misstatement or omission with other 10b-5
elements, it is actionable
 Federalism Concern:
o But mere breach of Fiduciary Duty is state claim…not enough to meet 10b-5 elements
o No indication Congress wanted to federalize state corporate law
 Here:
 There was no misstatement or omission—no deception. It was fully disclosed
o EG:
 If Corporation makes representation that it reviewed a Proxy statement and mails it out, but has not—
breach of fiduciary duty would be misrepresentation/deceptive and may be actionable under 10b-5
(assuming other elements)
o B. Misstatement of Fact versus an Opinion/Puffing/Soft Information
 Virginia Bankshares v. Sandberg:
o F: Merger occurred where Directors appoved, and stated that the value of $42/share was “high” and value was
“fair.” Respondent disagrees and brings suit alleging that they didn’t really think that, and that they made
misstatement of fact or omission.
o I: Whether statements of fact are actionable, and what difference is of opinion?
o R:
 A. False Statements of Reasons, Opinion, and Beliefs are actionable if:
 1. Fraudulent and
 2. Objectively Verifiable based on evidence underlying the reason, opinion or belief
o Note: The underlying factual evidence that an opinion is based on can determine if that
opinion is a misstatement of fact…
o *Not Often Opinion will be unverifiable by underlying fact
 Opinions can be factual in 2 ways
o A. You are acting for the reasons given
o B. Making statements about a matter believed
 However—If not Verifiable based on evidence that Opinion was False—not Actionable
 Puffing/Opinion is not actionable, without objectively verifable underlying fact
 Here:
o Their opinion, or belief was that $42 was “high” or “fair” but the evidence underlying their
opinion showed that the fair value was closer to $60—therefore, their opinion was a
misstatement of fact as underlying verifiable evidence showed
o Based on clear facts—was verifiable
 Note:
 The Company argued that there was enough information within the “total mix” to allow for the
deceptive, or misstated information to be irrelevant because all information was disclosed
 The Court stated that “if it would take an analyst to spot the tension between statement and other
information out there, its not enough to be in ‘total mix’”
 What is “Verifiable Evidence”
 Look for more concrete, factual scenarios
o No Matter the scenario—there is the statement of belief and the underlying fact
o What matters is the ability of the outside party to verify the accuracy
o More Quantitative, concrete things are more verifiable (see infra on fact versus puffery)
 The more abstract, less factual—less likely to be actionable
 EG:
44
o CEO says that “development of project is promising” but he knows there has been issues
with creating it
o May or may not be actionable as it is an opinion, but underlying facts are not clear
o More abstract and less facts to substantiate it
 Policy Implications of Virginia Bankshares:
o Broad Liability Possible:
 This is a very broad test that potentially opens up any statement to liability
 The more opinions are opened up to liability, the more we get into the policy issues of a broad 10b-5 claim
 Encourages Frivolous suits
o However:
 Opinions should not be given at random, and should be accurate
 Still, other elements of materiality, misstatement/deception, and scienter will limit claims
 Although Broader—Scienter trips up many claims
o C. The Duty to Correct:
 General:
o If there is no mandated duty to make a disclosure, then remaining silent is not an actionable omission
 There is no general duty to disclose material information
o If there is a duty, or affirmative statement made must not be materially misstated or omitted
o Duties:
 1. Periodic Disclosures: 10K, 10Q, 8K
 2. Duty not to make ½ truths/mistatements in affirmative statements (whether voluntary or mandated)
 3. Duty not to omit material information in affirmative statements (whether voluntary or mandated)
 3. Duty to correct statements made (whether voluntary or mandated)
 A duty to correct is a duty to fix a prior disclosed information that was incorrect at the time of
the prior disclosure
o We Do not have a general mandate to disclose all material information from all parties
 1. Logistics
 2. Cost
 3. Materiality is an unclear standard
 4. May create subversion of records
 5. Diminished Accuracy
 6. Protects property rights of those doing the research
 avoiding disclosure by all protects those researching, and their property right to use that information
 6. May chill undertaking of certain projects—negative externalities
 We only say in our securities regulation regime, If it is a mandated disclosure, or you make a
voluntary affirmative disclosure or statement is must be materially accurate and complete
o Do we want continuous disclosure?
 Would reduce information asymmetry further
 Information Quicker
 We are almost there with internet, or 8-k
 But:
 See arguments for why only material information (Materiality)
 See arguments for why not all material information…Why Continuous or all material information
would be difficult (8-K)
 Duty to Update:
o We do not utilize a Duty to Update:
 Unlike a duty to correct prior incorrect information, a duty to update requires an update when past
information, correct at that time later becomes misleading
 This is similar to continuous disclosure/general duty to disclose
 We do not have this scheme for reasons aforementioned
o See Essay Question Outline
o Duty to Update and 8-K as potential conduit for it
 While we do not use the duty to update system, one could argue the 8-K as a source for continuous
disclosure (see 8-K discussion, infra)
 Benefits:
45
 1. Cheaper to have company disclose constantly to investors rather then them going to find
information
 Reduces Waste, and Collective Action issues
 2. Information asymmetry would be reduced
 3. Reduces chance of insider trading
 Costs (See 8-K Discussion, supra, for why no continuous disclosure)
 Materiality is not clear, and uncertainty may turn to inaccuracy
 Logistically difficult and costly
 May lead to $ leaving Capital Markets
 Oppresive to corporation to constantly evaluate past information
o Distinguishing Duty to Correct and Update
 One is more in line with periodic disclosures
 One is temporally bounded, where as other is more constant disclosure
 Gallagher v. Abbott Laboratories:
o F: 10b-5 class action suit brought against Abbot. The FDA was inspecting them, and Abbot was in settlement
negotiations. Abbot released its 10K, and a week later the FDA sent letter about issues which Abbot then
settled.
o I: Did Abbott have a duty to update or correct its disclosure ?
o R:
 1. We do not mandate Continuous Disclosure
 2. We only have periodic disclosure
 The Duty to Correct applies only when the initial disclosure was incorrect
o Correction due on next filing date of statement
 Here:
 The initial statement was accurate at the time. Because we don’t have duty to update, there is no
duty to correct in this scenario
 False Statements and Scienter:
 There are 2 possibilities
o 1. If material misstatement or omission was made with scienter at the time
o  There is duty to correct, and if not 10b-5 action may be brought
o 2. If material misstatement or omission occurred without scienter (innocent)
o 10b-5 cannot be brought for initial statement
o 3. If material misstatement or omission without scienter, and later, company finds out
o  duty to correct when finds out, as has scienter and 10b-5 could be brought
 Note:
o If the ∆ can show it did not know the misstatement was wrong, and never subsequently found
out—lack of scienter would make material misstatement not actionable per 10b-5
 General Policy:
o Should we mandate duty to correct 3rd parties?
 While Company would be best positioned to know truth, incorporate cost, and thus reduce wasted efforts
of investors and collective action concerns
 We do not mandate duty to correct 3 rd parties
 Logistically unfair
 Cost is unfair
 Unfair because company did not disseminate misleading information
o So, while company is free to do so, there is no duty to
 Issues with expansive 10b-5 liability rule
o Stock Exchanges do mandate heightened disclosure rules:
 For instance, the NYSE expects that “release of information reasonably expected to affect market”
 Does have duty to respond to rumors or unusual market trading activity
 Exchanges may not have incentive to enforce/More form over substance:
o A. They may not be able to enforce—what is the remedy?
o B. Delisting seems harsh
o C. Courts have not enforced this rule
o D. Exchange has incentive to regulate enough to give the appearance of anti-fraud while
attracting issuers to its exchange
o D. Forward Looking Statement Safe Harbor
46
 §21E
o Safe harbor:
 1. Identify something as a forward statement and
 2. Give meaningful cautionary statements identifying important factors that could cause actual
results to differ materially or
 3. Π fails to show scienter requirement in 10b-5 claim
o Discovery Stay:
 If complaint is based on a forward looking statement, stay on discovery until after motion to dismiss stage
o Applies to:
 Exchange act reporters
o Excludes:
 IPOs, Tender Offers, and Financial Statements
 Note:
o This is ue to the lack of history, and ability to validate
o Easiest to defraud in IPO, as incentive is jack price up and potential
 A. General Policy of the Rule
o Benefits of the Rule and why we have it:
 1. Getting information and foresight from those with the driver’s seat is beneficial
 Discourages Waster Effort, Collective Action issues
 Decreases Information Asymmetry
 2. Discourages frivolous litigation potential
o Issues with Safeharbor:
 1. Potential to abuse
 if statements are safe, then more chance of less credible statements, making investors worse off
 2. May increase chance of fraud
 Forward looking information is biggest chance of fraud
 Not easy to verify it, so overoptimistic statements may harm investors
 3. Hindsight Bias
 Statements may be used to argue that they made statement to hedge against certain events they knew
of…statements made and safe-harbored to be fradulent
 Vica-Versa—May be given too much ex-ante protection
 Asher v. Baxter International:
o F: Baxter Corp projected revenues and growth in company. Actual results, however varied and the price of
stock dropped. Πs allege that the projections were materially false, and that their forward looking statement
under §21E was inadequate
o I: What are “meaningful cautionary statements identifying important factors that could cause actual results to
differ materially from forward looking statements?”
o R:
 1. They are Not:
 A. Simple statement of “this is forward looking”
 B. Boiler Plate such as “all business is risky”
 2. However, they do not have to predict all that will go or could go wrong
 Fraud on the Market Theory
 Here, cautionary statements were in the 10-K, rather than oral statements or press releases
 Because this is Fraud on the Market Theory, the market incorporates all information Publicly
available
 So, was the substance of the forward looking statements safe-harbor enough
 3. Meaningful Cautionary statements must identify important factors that could cause actual results
to differ materially from those in forward looking statements
 This means firm specific information of projections that posed the greatest possibility of
undermining projections
 Principal Risks of statements made, that are more factually specific
 Here:
 Not enough information to show that important factors were specific enough
o Overall Effect:
 1. We do not know exactly how much is enough
47
 2. This may open up 10b-5 claims to more broad base, going against what PSLRA and policy reasons
show is negative
 Allowing discovery on the issue goes against PSLRA which specifically addressed this issue
 Court’s interpretation is contrary to what Safe Harbor is supposed to do
o Opens up to Frivolous Suit Issues
 3. However, the broad construction may be due to the fact that there is a fear of safe-harbors being used
fraudulently
 2. Scienter:
o Policy:
 Often used as a method to avoid discovery…easily used as bar to suit and discovery
 PSLRA’s requirement of pleading with particularity is not easy
o Establishing Scienter:
 1. Intent to Defraud
o Issue:
 While getting the smoking gun is great, it is not likely to occur
 2. Knowledge of the facts and appreciation of how market will be misled
o Using evidence to show they knew what was going on
 3. Recklessness
o “So unreasonable and extreme of a departure from standard of care as to present danger of misleading the
plaintiff to the extent that the defendant must have been aware of it”
 Issue:
 Unclear
 Not easy to distinguish from knowledge
 “Should have known”
 Use of circumstantial evidence to infer scienter is available, however, inference of recklessness may
not pass PSLRA “pleading with strong inference of scienter”
o Ernst & Ernst v. Hockfelder:
 F: Auditor failed to find an issue in a brokerage firm audit. Can 10b-5 be based on Negligence claim?
 R:
o Negligence is not enough for liability under Rule 10b-5
 There is no Congressional intent to have this low a standard
 Other statutes clearly show and allow negligence
 For instance, §11
 The statutes that do use negligence had restrictions on them, while 10b-5 does not
 3. Reliance:
o Generally:
 Reliance prong of 10b-5 shows a causation between the misrepresentation/omission and an investors decision to
buy/sell
 Policy
o The Court has accepted the view that because reliance is simply a difficult prong to prove, and weight of
difficult to enter securities fraud litigation is already on scienter, there is no need to make it impossible to bring
o So the Court has effectively used economic theory to avoid reliance prong
 Court has also accepted Fraud on the Market to preserve some Private Suits in light of other difficult
requirements of Scienter and PSLRA
 However: Justice White’s concern is that they may not be relying on the market price, because it may not
actually show the true value…
o Omissions Reliance in Fraud by Omission:
 Affiliated Ute Citizens v. US:
o F: Company was made to finish all suits by Indians, distribute shares to shareholder Indians. It worked with a
bank to facilitate stock transfer. However, to people working at bank were purchasing from Indians for several
hundred dollars below what shares were trading for by non-Indians. They were paid to facilitate below market
value sales.
o R:
 When there is a fiduciary duty to disclose, and omission occurs  Materiality of omission satisfies
reliance prong
 Only have to show materiality of facts withheld
 Why:
48
 Otherwise, you could not show the statement was relied on as it was not said
 Otherwise, fiduciary’s duty to disclose would be eliminated
o Applies In:
 Face to Face or Open Market
o Affirmative Statements:
 Reliance in Open Market and Fraud on the Market Theory:
o 1. Stock price reflects all Publicly available information
 Based on Semi-Strong Efficient Market Hypothesis
 2 Versions:
o 1. Fundamental Efficiency: Stock Price represents “value” of company based on publicly
disclosed information
o 2. Informational Efficiency: The reaction to the information will be in right direction,
however the right value will depend on if information evaluated accuractly
o 2. False Information disseminated into markets is reflected in price
o 3. Thus, Investors are negatively effected due to reliance on the integrity of market price which is
skewed
 Whether they read information or simply buy/sell at the price, they rely on the market which is defrauded
o Basic v. Levinson (US 1988):
 F: Company was in process of buying Basic, and stated that it did not have any merger negotiations
ongoing. Trading was erratic, and then Basic announced the pending merger. The π argues that trading a
security in an efficient market where an affirmative misrepresentation was made creates reliance on a
fraud on the market
 R:
 1. There is a Rebuttable Presumption of Reliance in securities traded on efficient market for
Fraud on the Market Theory
o Why:
o The Effect on the “integrity of the market price” is what you relied on and it was tainted
o 1. The market is like the other party in the face-to-face transaction, misrepresenting the price
of the security based on fraudulent information
o 2. Requiring each π in a class action to prove evidence of their actual reliance on the market
would be significant evidentiary burden
o 3. Presumption is appropriate judicial tool where proving evidence is more difficult for one
party—fair, judicially economical, and in line with policy of statute
o 4. Efficient Market is empirically tested
 2. To Invoke the Presumption of Reliance you must show:
o 1. ∆ made public misrepresentations/misstatements
o 2. They were material
o 3. Shares were traded on an efficient market (An exchange)
o 4. Π traded between misrepresentation and time truth revealed
 3. To Rebut the Presumption
o Simply need “
o Any showing that severs the link between the misstatement and market price OR
o Plaintiff’s decision to trade
 White (Dissent):
o The market price representing the value of stock is not accurate
o So how can investors “rely” on the market price that already may not be accurate?
o Stock “value” may not be represented accurately in the market price
o Thus, overextending 10b-5 liability to broader scheme of litigants, by presuming reliance may
go towards a “investor insurance scheme” should be done by Congress
o What Rebuts the Presumption?
 (1) You can prove the misstatements did not effect the price
 Show accurate information came out, negating any impact of misrepresentation
 This may also negate finding of materiality if information is already in “total mix”
 Market Noise:
o There is other information out there: market momentum, economic events that occur which
also effect the price of a stock
o This “Noise” may undercut the idea that price is effected
49
o Further, Noise may also undercut the idea that the plaintiff’s decision to trade was based
on misstatement
o However:
o Even if noise exists, the markets do react in some way to the material misstatement…while
may not be most accurate reaction, it is incorporated in correct direction (informational semistrong efficient market hypothesis)
o How Can we Prove Noise/Severing of Misrepresentation and Price/Decision?
o Use of Event Study to show noise affected decision, and not the misrepresentation
 (2) You can prove π bought/sold for other reasons then misrepresentation
 EG:
o Π had decided already to buy.sell shares prior to misstatement
o Π shorted shares, thus not beliving the market price was accurate
 (3) You can argue that the presumption should not have been invoked
 Thinly traded stock is not efficient
 No or little analyst
 Little Volume
 May show lack of efficient market, and therefore no invocation of presumption
 Note On Public Companies:
o For public companies, especially larger ones it wont be easy to rebut the presumption
o The market will probably be efficient, and most efficient with bigger company
o Unlikely to find evidence of π’s trading desires
o Only real way is to show information was not material—that total mix already had
information public, negating materiality of affirmative misstatement
Reliance Overall
Face-to-Face
Open Market
Omission with duty to disclose
Reliance met if material (Ute)
Reliance met if material (Ute)
Affirmative Misstatement
Have show individual reliance
Rebuttable Presumption of Reliance
(Basic)
 4. Loss Causation:
o Generally:
 Loss Causation is the idea that the misrepresentation or omission caused the pecuniary loss of the π
 §21D(b) 4:
o Congress codified
o Π has burden of proving the act or omission of ∆ caused the loss the π seeks recovery for
o Separate from Reliance:
 Reliance implies the misrepresentation led to the decision to buy or sell To invest
o “But For” the ∆’s fraud, the investor would not have transacted
 Loss causation implies that the mistatement caused pecuniary losses
o Did the ∆ cause a loss and should he be liable
 Both are required elements of a 10b-5 Action
o Key Issue:
 While misrepresentation occurs, there are many other things that lead to changes in price
o “Noise” may have caused change in price
 Economic Events, Poor Earnings, Market Risk, etc…
o Dura Pharmaceuticals, Inc. v. Broudo:
 F: Respondents bought stock and prior to and during their ownership misstatements were made. They alleged that
they relied on the market prices that were artificially high, which caused their loss.
 PH: 9th circuit held that pleading “inflated price” was enough to show cause of drop in price, and loss
 R:
o 1. Inflated Price on date of purchase is not enough to show causation
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 At that moment of purchase there is no loss, as stock = MV
 If sold immediately after, he may actually make a gain if it continues to rise
 When actually sold, myriad events may have led to the loss, separate or in addition to misstatement
 Events:
o Changing economics, investor expectations, supply and demand, new competition, etc…
 Policy Ramifications:
 If Inflated Price were enough on its own:
o May be recovering for other reasons then misstatement (Economic, Social, Market Risk)
o Would be similar to investment insurance versus anti-fraud liability
 Would encourage frivolous law suits in hopes that discovery would reveal more
 Here:
 Π only alleged the price was high, but not that the price drop was due to the misstatement
 §21D(b) 4: While there is no additional pleading requirement, you do have to plead facts leading to
elements…this fails to
o Purpose of Loss Causation Requirement:
 1. Loss causation serves to help ensure the anti-fraud recovery compensation is due to the fraud alleged
 2. If not, becomes what Justice White warned of in Basic, which is “investor insurance”
o The myriad events that could case losses are due to the inherent risks in the market, not necessarily fraud
o We do not regulate the merits/risks…merely fraudulent practices
o So we need to assure that that is what recovery is for
o 10b-5 is not general insurance…it is for securities fraud that causes loss
 3. We do not want to encourage frivolous litigation, which may occur if loss-causation is used sloppily
o Otherwise, π’s attorneys would simply await any stock price drop, file a suit and hope to find something in
discovery
o Effect:
 Negative:
o Shareholder who is deserving wont be able to plead enough of loss and will be barred from rightful recovery
o Others who are not as deserving may get windfall because of their recovery for slight loss, and because of
other economic events that precipitate loss
 This Windfall will be due to the misrepresentation + other typical stock market issues
 Ways to Establish Loss Causation:
o Event Study:
 An evaluation of the stock price reaction to certain market events and revelation of truth
o Will look at date and drop in price
 Note on 10b-5 Cause of Action:
 You must allege the elements from one issue, not several different issues
o For instance:
 You cannot allege scienter, misstatement from one statement, and loss causation from another
 Dura Pharma ensures this, holding that the loss causation must come from the misstatement, and not other potential
factors or events
 G. Defendants of 10b-5 Cause of Action:
 Generally:
o There is no private cause of action for secondary/Aiding and Abbeting Liability
 You simply must prove the standard elements for 10b-5 Primary liability for that party in your sights
o Reliance Element is Limited for 3rd party
 If no public misstatement has been made, must show that 3rd party’s actions made the misstatement
“necessary or inevitable” by primary party
 However:
o The SEC May: §20(e) allows for the SEC to bring aiding and abetting liability
 “Any person who knowingly provides substantial assistance in violating a securities law”
o Policy Implications:
 Should we have Secondary Liability on 3rd parties not directly fraudulent?
o Depends on the goals of liability, and scope of 10b-5
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 Goal of Liability is Compensation
 Effect:
o Anyone can provide compensation, if they have the Money
o Perhaps then, broader 10b-5 with more ∆s is suitable
o On the contrary, we want to also punish and deter those who performed the fraud, rather then
using 10b-5 as a general broad anti-fraud
 Goal of Liability is Deterrence
 The broader ∆ pool allowed, the more deterrence
 3rd parties are a key component of our regime, and they must be trustworthy and accurate
o However: of too broad, or over broad there is an issue of chilling behaviors which may have
negative ramifications for the securities market in general
o This negative externality is not what is wanted
o Rather, we want to police the disclosures and securities regime we have created so that the
disclosures are accurate, deter inaccuracies/fraud, thus remedying the general flaws with
securities and securities markets (infra)
 In Our regime, 3rd party reputations play valuable role
 Overdeterring may harm them and our regime:
o 1. May chill their desire to participate
o 2. Paradox: May raise costs to do business with them (if they know they will be liable for
client’s fraud), thus raising costs to shareholders in order to protect them
o 3. Reputation at stake
o 4. May put us in worse off position as 3rd parties generally assit in accuracy, and anti-fraud
measures, but this may chill their operation, bringing detriment to overall anti-fraud system
o Policy Arguments For Broad Secondary Liability:
 1. Compensation to investors is compensation to investors
 2. It is Fair
o ∆ did have some connection, control, and benefited in some way
o They should be punished then
 3. Gives incentive to take precautionary measures to be accurate to 3 rd party
 4. Imposing liability to 3rd parties will shift cost incidence to client/public company
o This will increase costs, reducing number of offerings, which reduces potential number of defrauded investors
 5. Gives 3rd Party incentive to get insurance, to monitor at some level
 6. Deterrence furthers our scheme of accurate disclosure
o Bolsters 3rd party’s place in our scheme
o Policy Arguments for No secondary liability/ too Broad:
o 1. Compensation is too broad
 Compensation from those who did wrong, to those who deserve it
 Not compensation from anyone who can provide it
 10b-5 is not general anti-fraud scheme
o 2.Fairness
 They did not do anything
 Scienter/Knowledge is not easy to prove, so they may not have known
o 3. Chill desire to participate
 They provide valuable service already, and we don’t want them being overchilled
 Would actually, if they leave markets, create negative scheme for securities regulation
o 4. Paradox
 Cost incidence passes to company, which passes to shareholder thus harming shareholder in order to
protect
 Costs will pass to shareholders
 This is common ailment of 10b-5
o 5. Increases frivolous suits
 Ailment of 10b-5
 Actually harms companies and markets
o 6. May shift focus of litigants to 3rd parties for settlement value
o 7. Negatively effects reputation
 Central Bank of Denver v. First Interstate Bank of Denver (US):
o F: Bond issuance occurred, with bonds secured by lands. Indenture contract covenant required update 1 time per year on
appraisal value of collateral. If it dropped below certain amount, acceleration clause triggered. Central Bank was one of the
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lenders, but waited past 1 year to appraise. When default, and loss occurred, First Interstate, an indenture holder sued
arguing that Central Aided and Abetted in Fraud
o R:
 There is no Private Cause of Action for 10b-5 for aiding and abetting
o 1. “Indirect” does not stand for aiding and abetting
 of the many places this language is used in 1934 Act, it does not mean aiding and abetting
o 2. Congress of 1934 did not intend it
 Every other cause of action lists potential ∆s, like 10b-5, but has no aiding and abetting
 Congress could have said but didn’t
o 3. Allowing Aiding and Abetting would disregard Reliance element
 Because it is impossible to show reliance of unknown actor at the time, would make this element
superfluous
 To bring cause of action against 3rd parties, you must allege Primary Liability
o Simply allege the elements of a 10b-5 cause of action against that party
o Here:
 They had no duty to disclose, as they had no fiduciary duty No reliance element met
 The Outer Limit of Reliance for 3rd Parties:
o For 3rd Party’s Undisclosed deception to be actionable, must make misleading disclosure “necessary or inevitable”
 Stoneridge Investment Partners v. Scientific Atlanta (US 2008):
o F: Complaint alleged that Charter was going to miss earnings estimates. So, it altered arrangements with Motorola and ∆,
its suppliers. It sold products to them for $20 too much. Then they would send that money back to Charter by buying
advertisement. This increased Charter’s revenue. Thus it met its earnings. False contracts and letters were made to assure it
looked legitimate. The ∆ supplier made no statements at all, and was not a public company
o R:
 1. Reiteration of Central Bank of Denver and fact that only SEC has ability to bring secondary liability in 10b-5
 2. Does the supplier meet the Primary Liability of 10b-5 elements?
o A. Conduct can be deceptive to meet the misstatement or omission requirement
o B. However here, there is no reliance
 The supplier/3rd party owed no fiduciary duty to its customer’s shareholders  Ute does not apply
 The suppler/3rd party made no affirmative misstatement Basic presumption does not apply
 Investors only relied on Charter’s financial statements, not this 3rd party
 Court Holds:
 **A suppliers’ deceptive acts which are not disclosed to the public are too remote to satisfy
reliance element of 10b-5
 Internal Documents of Suppler are not enough
o There was no misstatement actually made to public
o Investors could not have relied on these internal documents
o The only statements the 3rd party made were in internal documents, and contracts that weren’t
public
 Court Rejects “Scheme Liability”:
 The argument that the primary actor and all involved had some affect on the misstatements that
were presented to the public
o Thus, 3rd parties fraudulent efforts, even if not clearly mistated to public did effect the
statements that did effect the public, and therefore reliance can be shown
o Argument Is: These contracts were exhibited in Charter’s financial statements, even if they
weren’t released, their terms affected the price which effected Charter’s statements…so it was
public information
o Shareholders did rely on Charter’s financial statements, and because vendor’s fraudulent
efforts affected the statements, they did rely
o Therefore, can bring Primary 10b-5 Liability claim against them
 Court Rejects “Scheme Liability” as simply too broad a primary liability claim
o Even though we don’t have secondary liability as a private cause of action, too broad a
primary liability, and this tenuous reliance argument may lead to chilling 3 rd parties
o Enters state corporate and contract law realms
 3. “To Be actionable without disclosure to public, the supplier’s actions must make the misleading disclosure
Necessary or Inevitable”
o This is the outer limit of reliance, absent a public misstatement or omission with a duty to disclose
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o Policy Effect of Stoneridge:
 Even though there is no secondary liability private cause of action, Stoneridge could have allowed broad scheme
liability
o The rejection of scheme liability, and imposition of outer limits of reliance without statement by 3 rd parties
somewhat cushions the reach of primary liability to 3 rd Parties
 Scheme Liability may not have had an end
o Would open up to broadest arguments possible against 3P
o Uncertainty as to 10b-5 liability would have negative effect on 3P
o Scienter would than be relied upon to end the frivolous litigation
 Policy Follows the Narrower idea of “Secondary Liability”
o See Slides 51-52 of Week 8 Handout for examples of what potentially would be “necessary and inevitable”
 H. Proportionate Liability of Defendants:
 Generally:
o From the PSLRA Pleading Requirements
o Another response to the issue of frivolous lawsuits targeting 3 rd Parties (which provide important function) was
proportionate liability
o §21D(f) Exchange Act
o Policy:
 1. Further deters frivolous lawsuits
 2. Especially important against 3rd party Reputation Intermediaries who provide important function
 3. By dispersing liability, may reduce negative effects of 3rd party liability
o Reduces liability exposure
 4. More “fair” as 3P is likely less than fully responsible, and less culpable and in most cases is a small piece
of fraud
 5. Assure level of Scienter: In Line with PSLRA purpose of curbing frivolous litigation—our chosen
alternative regime
o Incentive on π’s firms to assure scienter is at appropriate level before they exert resources against 3P, simply
because of deep pockets
o Because Scienter is difficult standard, may serve to deter suits against 3 rd Parties
o Incentive to predict % allocation of liability, second guessing the worth of even bringing a claim against them
 6. In line with avoidance of scheme liability
o Cuts the tenuous connection between 3rd parties and the fraud further, depending on scienter
 §21D (f):
o If party is found to be “reckless”
 Only pay a proportionate share of damages
 Jury determines the % share that ∆ is attributable to
o Will also determine what scienter level ∆ had
o 2 Exceptions:
 ∆ is jointly and severally liable to π who is entitled to damages >10% of net worth, if net worth is <200,000
 ∆ must also pay for up to 50% of their own liability if another party is insolvent
o If Scienter is “Knowing”
 Jointly and Severally liable with other ∆
o Right of Contribution:
 Proportionately liable party can seek contribution of proportionate liability from other parties as well
 I. Damages in 10b-5:
 The Purpose of our Liability and Damages:
o To Compensate and deter fraud, in hopes that statements and disclosures are accurate leading to accurate analysis of
securities
 “Out-Of-Pocket” Damages
o Damages are the difference between the amount paid for the security and its actual value at time of transaction
 Policy Purpose:
o Compensates the defrauded investor for their loss
o Deterrence of Fraud
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 Policy Issues:
o 1. When Face to Face, and the Corporation is selling securities, and is fraudulent This makes sense
 Compensates victim
 Deters corporation
 Reduces unfair gain by the corporation
 Reduces social waste
 Investor does not have to exert resources to avoid fraud as this will compensate him, negating the
fraud
o 2. When Secondary, Open Market, transaction, and Corporation is fraudulent: Fraud on Market
 1. There is no net loss to shareholders
 Transferred from one buyer to one seller
 2. Corporation has no gain
 However, Funds come from corporation to pay compensatory damages anyway
 3. If we want to deter or “crush out” fraud we should provide larger damages
 Damages should include the benefit and probability of detection
 But if Damages are too high
o May chill any disclosure
o May encourage frivolous law suit (see supra, Discussion on Cons of 10b-5)
o Benefit may not be much to the corporation who is paying the damages, but rather, the benefit
may actually go as a windfall to the other party in the transaction (see infra)
 4. Diversification
 One could argue that because investor’s portfolios are diversified, there is no need to compensate
them
 Because they will be benefited by fraud as much as harmed and because of MPT, proper
diversification ends risk of individual companies
 Con:
o Fraud has occurred, loss has occurred, regardless of what your portfolio has done in aggregate
o Unfairly loosed on a particular stock due to fraud and 10b-5 liability should ensue
o 3. Paradox of Shareholder Compensation
 1. The shareholder’s winning compensation is really taking from his one pocket (the corporation) and
putting it in another
 2. In Fraud On Market SH is not getting back his proceeds, but rather, taking more of corporations $
o 4. Windfall to some shareholders
 While the defrauded investor gets “out of pocket loss,” the other party to the transaction may get a
windfall of $ based on the fraud
 Our current system of Damages does not cover this
 Should we ?
 Policy Arguments
 Not practical to reconstruct trades as Volume is huge
 Trading is very dispersed due to volume
 Transaction costs, and expense negate the worth of getting back windfall
 SEC is not in business of compensation, but rather ensures market certainty…damages and liability
create this
 May Clog the Market if trading is reconstructed
 However:
 Modernly with Technology, we may be able to track and reconstruct rather quickly
 This would negate paradox of compensation to shareholder from corporation if the $ was given back
by windfall recipient
 Although  wouldn’t deter or punish the corporation for fraud
o 5. Effect of overdeterrence
 Chilling market
 Chilling corporate disclosure which is contrary to our periodic, mandated disclosure system

o Potential Alternatives and Arguments:
 1. Calculate how much the company gained, and than apply a multiplier based on probability of detection
 2. Cap Damages at some amount
o EG: No damages greater than 10M
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 Issues:
 Would reduce the “paradox” of compensation of shareholders
 May not adequately compensate victim if their need for compensation is above
 May not deter fraud if cap is inadequate
 3. Schedule of Penalties
o Would be based on the average benefit the typical fraud gains
o Similar to Federal Sentencing Guidelines
 Upward Departure and Downward departure would apply to make it more fraud specific
 Issues:
 Subjective creation of guidelines
 What is the average benefit? All Frauds are different
 May not compensate adequately
 However, may be more consistent
 Still may fall prey to windfall issue
 4. Go Back Through Trades, Reconstruct, and Give Back from Party that received
o Avoids Windfall
o May be logistically impossible
 5. Injunctive Relief
o As alteration to paradox of shareholder compensation
 Rescission Damages:
o Effect:
 Returns purchase price if seller defrauded, or
 Returns the securities if buyer defrauded, or
 Difference between original sale price and subsequent sale by the ∆
o Purpose:
 Intended to put π in the same place as if the fraud never took place
 Only applies if face-to-face or fraud in inducement
o ∆ has to be purchasor or seller
 Does not apply to open market, fraud on the market
 Restitution Damages:
o Effect:
 ∆ gives whatever profit she made back to the π
 Similar to rescission
o Purpose
 Deprives the ∆ of the gains he made from the fraud
 However:
o May be difficult to argue 10b-5 element of “loss causation” while also arguing restitution damages
 Benefit of the Bargain:
o Difference between the value received and value promised, and value promised is certain
o Rarely Awarded in 10b-5
 Value promised is unlikely in a security setting
 However, may be acceptable in a face-to-face setting with the appropriate facts
 We do not utilize Punitive Damages in Securities Fraud:
o §28 (a) Exchange Act bars punitive damages
 Why:
o 1. Don’t want to over punish shareholders as paradox of compensation is an issue
o 2. Fines are already issued by the SEC
 This are in addition to the compensatory damages
 §21(a) and (c) may, by public shaming and reputational sanctioning, be considered above compensatory as
well
o 3. In Open-Market Fraud, the Company does not ‘gain’ from the transaction
 However, we get the compensatory damages from the company while we allow windfall to other trader
 So, in essence, while we are compensating the shareholder, it is an amount above and beyond what the
corporation gained—which is 0 from the shareholder—already like punitive damages
o 4. Would seriously infringe on our designed system of Disclosure
 May chill all disclosure
o 5. Would encourage frivolous litigation and flood courts
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VI. Insider Trading
 A. Generally:
 Policy of why Insider Trading is negative:
o 1. Promotes overall Market Integrity
 As some have an advantage others do not, the market is skewed
 Some get benefit of gains, while others are taken advantage of
 Investors do not want to invest in “rigged game”
 Because returns are affected, outsiders will discount amount they will pay
 Less Capital to corporation in raising
o 2. Breaches Fiduciary Duty
 Owing a duty to certain parties should not be breached
o 3. May Cause Subversion of Disclosure
 If investors know they can get an advantage from trading on inside information, they will delay its disclosure
o 4. It is a Misappropriation of Information
o 5. Property Rights View
 Taking someone else’s information is like theft
 Insider trading prohibitions protects property interest
o Misappropriation theory is a large expansion of the “property rights” view and easily could lead to continued
expansion
o 6. Equal Access Theory
 Our system is a system of disclosure of mandated information
 We simply disclose the information to the investing public to cure ills that securities pose
o They then make their decisions based on hard work, research, and skill
o While some may be more successful, sophisticated, or talented all work with the same information
o However:
 Insider information negates the efforts of work, research, and skill
 Unerodable advantage
 Unfair
 We want a level playing field, to simply remedy flaws that a “security” inherently has
 While some are more skilled, more sophisticated, all are using the same baseline of information
 Arguments to legalize Insider Trading:
o 1. Enhances the Accuracy of Stock Prices:
 By insiders trading on information not disclosed, the price more accurately reflects information
 More accurate price and valuation of the company then
 This benefits Market as a whole and Society
o Because more accurate decision can be made, more efficient use of money can be made
o More Towards “Strong Form” ECMH
o 2. Could be method of efficient managerial compensation
 May align incentives of management and shareholders if management may, if successful, trade on inside
information before hand
 Would be type of option
o 3. Equal Access Kills incentive to become informed
 If all have same information, and effort to really utilize information is extreme, costs of utilizing that information
may kills incentive to use it
o 4. More of Continuous Disclosure
 If the price reflects a more accurate version of what the true value of a share is, it is similar to a proxy for
continuous disclosure, without the costs and logistic nightmares to the company
 Basic Background:
o 1. 10b-5 has been construed to incorporate prohibitions on insider trading
 Courts have generally Construed it, as SEC has established through litigation
o Should this be for Congress, rather than Courts:
 Arguably, Enforcement, because it effects society at large, may be better fit for Congress
 However: Much slower with hearings
 Common Law and Courts much quicker to react
 Because Congress hasn’t acted, courts have
 SEC was delegated authority for this reason…speed, and ability to react quickly to new schemes
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o 2. 14e-3 Anti-Fraud in Tender Offer Context
 Does not require a Duty
 Prohibits use of inside information in connection with Tender Offer, where information obtained by the bidder
o 3. Regulation F-D
 If material, non-public information is conveyed to certain participants, must be disclosed to the public
o Purpose:
 Focuses on Analysts
 Analysts may be in privy relationship with large, sophisticated institutional investors
 To avoid unfair relationships being built, Reg. F-D is used
 Why:
 Otherwise, analysts may give favorable rating
 May use information to trade themselves, or their friends
 If only select clients, select clients would benefit over the public market
 B. Classical Theory Insider Trading:
 1. General Theory:
o Corporation’s insiders, utilizing material non-public information obtained from the corporation, trade on their own behalf
and benefit
o The General Rule (Texas Gulf Sulphur):
 You Must
o Disclose or
o Abstain from Trading
 If in possession of material, non-public information
 Chiarella v. United States:
o F: Acquiring company was using a financial printer. Chiarella was an employee there. Looking at the documents, he
deduced what was going on, and purchased shares of the target company. He used this information to trade.
o I: Whether Chiarella is liable under the Classical Theory of Insider Trading
o R:
 1. There must be a Fiduciary duty to the corporation’s shareholders to invoke “disclose or abstain”
o Failing to disclose material information is only deceptive when there is a duty to disclose
o Per 10b, absent a duty, silence alone is not enough to create liability
 To Invoke the “Disclose or Abstain Rule”
 A fiduciary duty, or similar duty of trust or confidence must extend to the party on the other side of
the transaction
o Here:
 Chiarella was merely a stranger, working at the printing company
 He had no duty to the Corporation, and therefore no duty to its shareholders not to trade on the information
 The Court refused to recognize a broad and general duty to disclose all non-public material information
 2. A Deception must occur in the “Classical Theory of Insider Trading”
o The deception is that, in breach of duty, you are utilizing corporation information for your own benefit
o Note on Temporary Insider:
 Per Dirks, one can become a temporary insider (infra)
 3rd Parties can gain fiduciary duty when “special confidential relationship”
o EG: Accountants, Investment Bankers, Lawyers
 What Makes an Insider:
o He may not have been high enough up to have been considered an insider—owing a duty to client corporation
and its shareholders
o Should he have been a “temporary” or “constructive insider”
 1. Perhaps too remote
 Unlike attorney or accountant, a random janitor or employee may be too far away from the idea of
“insider”
 2. Perhaps we look to Agency Law
 Partner in law firm or accounting firm, officer of printer may be liable because client can sue them
and they can be liable, or they can bind the firm
 Perhaps this is what extends the fiduciary duty from client to business to the insider
 However:
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 It is not entirely clear why he, as employee and with inside information, may not owe a duty to
the customer
 In this case, he bought shares of the target company, but the Printer’s client was the acquiror—so,
no duty owed at all by the printer.
 However had he bought shares of acquiror arguably may have found a duty to Chiarella
o Drawing the Line at “Unerodable” Advantages
 In general:
o One main policy objective of prohibiting insider trading is avoiding negation of “equal access” or level playing
field
o The idea that, while everyone has the same information disclosed, those who are sophisticated, exert effort,
talented, and research may do better off
o We want sophisticated analysis
 However:
 Drawing the line here may not be quite as easy, as sophisticated institutional investors have that
advantage, not out of misappropriating any information, but by what they do
 However—sophisticated analysis that is legitimate is beneficial to all
 Unerodable Advantage
o When an insider trades, he has an “unerodable” advantage
 Something that neither work, skill, research, or effort can topple—only privy to insiders
 Prohibiting this type of trading, then, would not chill incentive to generate new information
 While Chiarella finds that there was no Classic Insider Trading, the type of information he had may lead to a
different conclusion
o The Potential Argument for Private Regulation, rather then Federal Regulation of Insider Trading
 While employees can be fired for their trading (like Chiarella), this may fail to compensate defrauded investors
 Investors, thus, may discount shares
 Companies could privately contract around it
o EG:
 Contract with employees that if you trade and make profit, you must disgorge to the company
 Still issue of breaching party being judgment proof for using proceeds for nefarious purposes
 2. Two Insider Trading Liability Schemes under Classical Theory
o (1) Tipper/Tippee Liability and (2) Temporary Insider Liability
o Dirks v. SEC:
 F:Dirks was an analyst. He received insider information from Secrist regarding a company and its fraudulent
practices. Dirks began to investigate, and interviewed and discussed the information with his clients. Sell off
occurred, stock plummeted and SEC investigation began.
 I: What constitutes Tipper/Tippee Liability? What is a Temporary Insider:
 R:
o 1. Tipper/Tippee Liability: Tippees are liable under 10b-5 if they assume the Tipper’s Fiduciary Duty:
 In General:
 Tippee is under no fiduciary duty to the shareholders of the corporation
 Merely getting inside information is not enough to create the duty
 However, if he knows of a breach of duty, they are participants in the breach, and thus:
 A. Tipper/Insider must breach his fiduciary duty to the corporation/shareholders by disclosing
information to tippee and
 The Insider’s/Tipper’s breach of fiduciary duty occurs when “personal benefit”
o If tip was for purpose of “personal benefit”
o Question of fact
o Cash, Gift to relative or friend, profits, reputational benefit
 B. Tippee must know or should have known that there was a breach
 Will Be liable if: he trades, or disseminates it to his customers for increased business
 Effect:
o Tippee assumes the fiduciary duty of the tipper
o If the Tippe knows or should have known Must abstain or disclose
 Purpose:
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o Without Tipper/Tippe liability, the Classic Theory of insider trading provides for an easy
loophole
o Insiders would simply give the information to a 3 rd party, and receive kickbacks or all
proceeds
 Here:
 Insider went to the newspaper first, which disclosed it
 So, he complied with the “disclose” prong of
 Otherwise: Dirks, as a disgruntled employee may have met the “personal benefit,” in breach of his
fiduciary duty by vindication, personal satisfaction,
o 2. Temporary Insider Liability
 In some circumstances, certain parties become in “special confidential relationship” to party
 May be considered temporary insider, and thus the Classic theory of Insider Trading will apply
 Dirks
 Why:
 Accountants, Lawyers, consultants, are given corporate inside information for the sole purpose of
benefiting the corporation. When they breach this fiduciary relationship, fraud occurs
o Policy Discussion:
 1. If the Tippee continues to give information, how far does the fraud go?
o When a 3rd party, like tippees’ client is liable will depend on whether they knew or should have known about
the initial tipper’s breach of fiduciary duty
 Should we ban all tippee trading?
o Effect on Analysts may be negative
 Analysts provide a valuable service to the markets as 3rd party information intermediaries
 Their seeking information, and disseminating it to the market is beneficial
 Potentially chilling their desire to research thoroughly for fear of liability may chill their position
 May inhibit market analysts, then, who help preserve a healthy market
 Thus, by holding them liable to avoid impairment of the market through insider trading, the market may in
fact be impaired due to their function being impaired
o However:
 There is fear that large, institutional investors will capture analysts
 To bypass this, while avoiding chilling of analysts
 Regulation F-D
 Curtails the ability to prefer analysts at the expense of the public
 3. Regulation F-D and Selective Disclosure:
o Generally:
 As discussed above, selective disclosure of some information that was prior to mandated disclosures may prefer
certain parties
 Created to avoid unfairness, and to check corruption of analysts
o EG:
 Currying favor with analysts by giving them information first, favoring them
 Can be a benefit to large institutional investors, or to Corporations who gain beneficial rating
 To bypass this concern, Regulation F-D was created
o Rule
 Company that discloses material, non-public information to covered individuals who are reasonably
expected to trade on it, must also disclose it publically
o Covered Persons
 Broker-Dealers, analysts, investment advisors, institutional investors
 Exclusion:
o Confidential relationships are exempt from Reg. F-D filing
 EG:Attorney, Accountant, Investment Banker
o Per Dirks, treated as temporary insiders
 Effect:
o If Intentional disclosure of material  Must simultaneously disclose to public markets
o If unintentional disclosure of material  24 hours to make disclosure to the market
 Press Release or 8-K
 Enforcement:
o The SEC has sole enforcement authority
o Policy:
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 May lead to companies disclosing more or clamming up to avoid liability
 Options and Puts are a primary method of Insider Trading:
o Generally:
 Purchasing put or call options of one’s company would be a form of classical insider trading
 It is a common form of insider trading
o Margin Allows leveraging of information to purchase more securities
o Allows ability to buy more than simply buying shares outright
 However:
o It is easy to trace
o There is nothing to sell (unlike stock) to recoup losses. You are out the premium you paid
 C. Misappropriation Theory of Insider Trading:
 General Theory:
o In the Classical Theory
 Duty Violated is the fiduciary duty of trust and confidence owed to the shareholders of the corporation
o In the Misappropriation theory:
 Duty violated is the fiduciary duty owed to the source of the information
o **In Leiu of Fiduciary Relationship between company and trader, duty in Misappropriation theory is premised
on fraud and deception to the source of the information
o Effect:
 If a duty exists and you receive material non-public information
o Abstain from Trading or
o Disclose
 Misappropriation theory requires disclosure to the source
 Disclosure negates any deceptiveness, or breach of duty
 United States v. O’Hagan:
o F: Partner in law firm, which was retained by Grand Met to potentially acquire Pillsbury Company. They took precautions
not to announce. O’Hagan, who was not working directly on the deal, purchased a ton of call options and stock. He was
eventually convicted of 10b-5 and 14e-3 violations
o R:
 1. The Misappropriation theory is based on a breach of duty to the source of the information:
o While the misappropriating party does not owe a duty of trust, confidence, and honesty to the traded firms
investors, but he does breach one to the source of the information
 2. 10b-5 requires “deception”
o In Misappropriation the Deception occurs when:
 The pretend loyalty based on the fiduciary relationship while then trading on the information
 If Non-Disclosure of Intention  Deception
 If Disclosed THERE IS NO DECEPTION:
o If the deceiving party discloses his intention to trade before doing so, there is no deception
o Because there is no deception there is no breach of duty and no 10b-5 liability which
requires a “deception”
o The Deception is “in connection with the purchase or sale of a security”
 When, without disclosure, the information is traded on
 3. The Misappropriation Theory Meets Policy of Insider Trading:
o 1. There is a deception to the party who is owed a duty
 Although, if disclosed there is no deception that occurs
 Thus, per the 10b-5 language  liability
o 2. Also:
 Ensures Honest Markets
 Promotes Investor Certainty, and confidence
 It would chill the market if people knew it was a fixed game, and deception was occurring
 It is an unerodable advantage that cannot be overcome with skill, research, or talent
 4. 14e-3 Anti-Fraud of Insider Trading in Connection with Tender Offer
o 14e-3 proscribes “trading on undisclosed information in the tender offer setting”
 It does not require any duty exist
 Much broader authority of SEC, where it can use if “reasonably designed to prevent fraud”
 Why:
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 SEC realized that proof of breach of duty is extremely difficult to do
 Evidentiary burden, then, created need to have rule with no duty required
 SEC v. Rocklage:
o F: Ms. Rocklage was wife of CEO. CEO told her in confidence some bad news about clinical trial that went bad. It had
negative ramifications for the company. The wife, however, had a scheme with her brother of tipping him off to
information the husband told her. They had a confidential relationship, and thus a duty. She told her husband that she was
going to tell her brother. The Husband strongly urged her not to. She eventually di anyway.
o I: Was there a deception “in connection” with the sale of a security or did the disclosure negate any deception?
o R:
 1. Under O’Hagan, The Deception is the Breach of Duty to the Source Disclosure Negates any deception
o here there were two deceptions that occurred
 1. The deception in the acquisition of the information and
 2. The Tipping scheme to her brother
 2. Just Because Disclosure may have ended one acts deceptiveness, does not mean all acts were not deceptive
o Here, the disclosure negated any deception in tipping the brother
o But, her action in inducing the information was still deceptive
 Compared to O’Hagan:
 O’Hagan treated the deception as being the trading
 However, we could argue the trading and acquiring were two different deceptions
 Overall There may be more than 1 deception that occurs
 Note:
o Here, Mrs. Rocklage was the tipper and brother was tippee
 Effect Of Misappropriation Theory:
o Broadens Insider Trading Liability
o Extends police authority of 10b-5 and SEC
o Alternatives and Theories of Misappropriation Theory:
 1. The Source of Information or Insider Traded Firm should Police itself:
o 1. Could used private Contract, with adequate terms to do so
o 2. Although Costly Modern Computers could simply track trading by names of people now privy to
the information
 The Private party may be in a better decision to decide what information may be traded on, as its
shareholders, and insiders will bear the costs and benefits
o Issues:
 Burdensome
 Costly
 Detection would not be easy
 Without enforcing, private parties may simply have incentive to allow insider trading
 May spread rapidly
 SEC has mandate to enforce securities laws
 Although it is underfunded and overwhelemed, and we do rely on third parties in our system, having
a system of source self-enforcement may be unlikely
 2. Property Rights:
o Misappropriation Theory allows you to use your own efforts and skills to create information and use it
 Without this protection may not be incentive to create information in the first place
 Protecting the source’s rights to the information, his property, may induce people to generate their own
information
o Protecting Property rights then, is an argument for expanded misappropriation theory
 Stealing Information, even without a breach of duty, undermine incentive to research, skill, effort
 Encourages information production
 As if you exude your efforts, skills, and research, you may profit from your efforts
 Otherwise, if parties could take that information and trade on it, or unerodable advantages were
allowed
o There would be no incentive to generate information or enter the market
 Even if they disclose, the theft still occurs
 We should not give them a loophole simply because they admitted, disclosed their deception
o Issues with Protecting Property Rights:
 1. Costs, in that public does not get the information priced in
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 2. Fewer people have access to that information
 Therefore, it may be questionable if we want to protect property rights
 This goes back to the original argument of why we regulate insider trading
 3. May not be the best for society
 Competition may be better than allowing certain parties to hoard information, protecting their
property rights
 Competition would result in large cost, but competition would more effectively price the stock
 However, all are able to use the base-line of information to utilize their skill, and efforts
 Better Price of stock
 3. Unerodable Advantage Distinction:
o There is something inherently wrong, in our scheme of Securities Regulation, in giving someone unerodable
advantage
o Equal Access Theory
 Effect on Misappropriation Theory:
 Therefore, it should be limited by expansive Misappropriation liability
 Or: Theory should be limited to when there is an unerodable avantage
 Detriments of Expansive Insider Trading Liability:
o 1. Chilling 3P like Analysts
 But, with Regulation F-D, that is already covered
 Analysts should be required to use same information as all investors to avoid their insider trading
 So, chilling them is one thing, but requiring an ‘equal access’ for all is another
o 2. Expanded Duty in Misappropriation Theory to the source may be more tenuous
 Our system is not a general duty to disclose, but rather mandated or if affirmative statement made
o 3. May expand too far away from policy reasons that insider trading is founded on
 If more and more tenuous, may not be “property,” “material non-public information” or may not have
“tainted the capital market’s integrity”
o Reform Chosen: The Insider Trading and Securities Fraud Enforcement Act of 1988:
 1. Controlling Person is liable for Civil Penalty
o Less of $1M or 3x profits made or losses avoided
 Policy:
 Incentive to create internal control mechanisms
 Deters insider trading activity
 2. Bounty is available for whisteblowing up to 10% of penalty
o Policy:
 Gives incentive to profit, and “rat-out” fraudulent scheme
 But, rational whistleblower will only rat out when benefits> costs
 Ratcheting this % up may be a good thing
 Offsetts costs of chane of never being hired again
 3. §20A Standing to Contemporaneous Trading
o Shareholders who traded around the same time may sue individual trading on material non-public information
 D. Section 16:
 Provides for a 3 Pronged approach to addressing insider trading
o 1. §16(a)
 Required Reporting within 2 days of Trades By:
o 1. Directors or Officers of the Issuer
o 2. Shareholders with > 10% of any class of securities (stock, option)
 File Form 4
 Policy Effect of §16a:
o 1. Curb Take-Over
 As a party who is gradually acquiring stock for a potential takeover, §16 may deter you
 Negative Externality of Disclosing
 Lead to price increases
 Pay more for takeover
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 Leads to competition and putting the target “in play”
o 2. Function as an Anti-Takeover Scheme
 Negative:
 Leads target to continued inefficient operation
o 2. §16(b) Short Swing Profits
 1. Requires disgorgement of profits made in transaction of purchase and sale that occurs within 6 months
o Policy:
 Attempts to bar trading where insider is pursing short-term gains, presumably on inside information with
the company’s stock
 Misappropriation of corporate property
 Avoids officers from changing policies and practices in pursuance of short term profits
o Exception:
 Stock option conversions
 Policy:
o Recognition that options are used as compensation
o Thus, not a surprise that insiders will exercise options to increase compensation
o But, unlike options, taking short term positions in stocks is not aligned with incentives,
especially considering that options are usually out of the money and take time to earn income
off of them
 Standing to Bring Suit:
o 1. Corporation
o 2. Shareholder acting in derivative suit
 Strict Liability
o No scienter is required
o 3. §16(c)
 Bars short sales of the company’s stock by:
o All insiders (Directors, Officers, and 10% more shareholders)
o Policy:
 Misaligns incentives of directors and officers of company
 They are in position to easily profit off of short sale
 Disincentive to tank corporation to their benefit
VII. Public Offerings:
 A. Corporate Finance Background:
 1. Basics
o 1. Capital Needs of the Business
 Immediate, long term
o 2. Types of Financing
 Financing has many different forms that can be selected
 Effect of over regulation:
o Change of Behavior:
 By over regulating certain form of financing, companies can shift financing choice
 Public to private equity as a replacement
 Examples:
o 1. Internal Financing:
 Includes plowback of retained earnings
 Assumes there are cash flows that can be reinvested
 Organic financing may not be available for startups
o 2. Financing from Current Owners
 Venture Capital
 Maintains control of the company
o 3. Bank Financing
 possible, but risk will need assurance of repayment
 With newer companies, unlikely to lend due to lack of records, income, capital, or collateral
o 4. Private Placements
o 5. Public Offering
 Issues:
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 High costs to enter
 Dilution of existing owners
 Disclosure, and securities regulation compliance
o Negative Externalities of competitive disadvantage
 Short term focus of meeting analysts predictions quarter to quarter
 Loss of control
 Non-Economic reasons to Publicly Offer:
 1. Public offering creates liquid secondary market for company
o allows insiders to sell
o allows for secondary offering to occur for added financing
o allows for more sure source of capital for secondary offering
 2. Publicity and Investor Excitement
o May assist company in financing later
o Legitimacy of company
o Promotes products and corporation’s attributes
o 3. Types of Securities
 Debt, Common stock, Preferred stock
o Why do we have 3 elements of capital structure:
 1. Each fulfills different need of corporation
 WACC at optimal level
 Allows for Flexibility
 Options
 2. Fulfills different needs of Investors, who have Differing Risk Profiles and Preferences
 Investors are where company gets financing from
 More options of capital structure allows a company to tap into each investors’ risk preference
 2. Public Offering Process
o The Underwriter
 The main player in the process
 Role and Key Attributes:
o 1. Starting point to determine potential of offering
o 2. Skill
 Advice and experience of structuring offerings
o 3. Reputation and Connections:
 Marketing: Source of many contacts with large institutional investors and
o 4. Financing
 Overall: while skill is one thing the reputation and connections are the biggest factor Almost guarantees
success of the offering and $ to corporate issuer
o Underwriter Legal Documents:
 1. Letter of Intent
o Intent to sell
o Size of spread
o Option to purchase more shares and sell them if demand is available
 2. Underwriter Syndicate Agreement
o How syndicate will divide up spread
o Who is responsible for what
o If Liability ensues:
 Proportionate liability is easy to determine
 Simply look to the % allocation of the profit of the issuance and that will show % allocation of liability
 3. Underwriting Agreement:
o Formal Agreement that lays out terms of offering
o Total Shares, price, gross spread, over-allotment option
o Representations and Warranties
o FINRA Requirements:
 That UW Fees be “reasonable”
 Is a 7% Continent Fee Reasonable:
o UW based on sale occurring
o Exude large efforts and sophisticated analysis to correctly do so
o Π attorneys make 30%
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 UW are different than Attorneys:
o UW are not successful if the IPO does not go through
o An hourly approach to paying them is irrelevant if the IPO fails
o Thus, the contingent fee is in line with the task at hand
o Attorneys, however, should be paid by the hour
o Otherwise, they may abdicate their duty to get the deal through, where their duty is to make
sure it complies with the applicable laws, not whether its successful or not (partially)
o Types of Offerings:
 1. Firm Commitment:
o Process:
 The UW, or UW syndicate commits to purchasing securities
 They purchase a discount of worth, guarantee sale, sell for worth and pocket the “spread”
 All risk on UW, then, to resell so they take on average 7%
 EG:
o UW buys an issuance of 55M for 53M, and sells for 55M
 Benefit:
 Issuer is guaranteed return, they know exactly how much they will get
 They may plan accordingly
 2. Best Efforts Offering:
o Process:
 Underwriter commits to trying his best to sell the shares
 No guarantee
 Receives a commission from shares sold rather then “spread”
 Less risk for UW, but less return to UW
 Syndicate of UW to spread risk of offering “flopping”
o Issue:
 Without reputation and, for instance, backing of Goldman Sachs reputation, may not be as likely
 Red Flag to market that UW did not commit to the offering
o Policy Concern: Firm Commitment versus Best Efforts
 The Underwriter wants to use firm commitment to get return
 While he does take on all the risk, “underpricing” the issuance and purchasing it lower than perhaps is
capable, almost guarantees him the higher return
 Therefore:
 UW and the UW syndicate may be able to influence decision to go with Firm Commitment
o Oligopoly issue
o May implicitly act, or engage in conscious parallelism to benefit each other
 They may give no other option or not really put in “best efforts” to sell
 With less fee they don’t have as much incentive
 Therefore, they may say they are using their best efforts, come back with not a lot of demand, and
then convince the party to enter into a firm commitment
 UW has the ability to manipulate the IPO market to his advantage then
 3. Direct Sale
o Process:
 Does not use underwriter
 Company simply takes its own shares to public
 Issue:
 Lack of reputation of UW, and connections makes it more difficult
 Trade off of keeping more of offering price for themselves, while not selling as much as they could
of and making it more difficult
 Red Flag to market that there is no reputational 3P UW involved
 4. Dutch Auction:
o Process:
 Investors place bids of amount and price
 The highest bids are taken first, slowly depleting the allotted shares for offering
 Continues until all shares are sold at the highest price for that size
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 Issue:
 Removes surplus of gain that may have been given to initial purchasors
 As IPOs typically underpriced, gain to those purchasing may now be gone as offers to purchase at
the price market deems accurate and efficient
 However: May be beneficial that price is accurate rather then set by the UW
 May actually be the best alternative as it accurately prices in the stock
o Underpricing:
 General:
o IPOs are traditionally underpriced, meaning that they afford significant returns on the first day
o This means that, the market believes they are valued higher then the offering price exhibited
o This is partially done due to the spread, and lowered offering of shares to assure profit for UW
 Issues:
o 1. Investor Exuberance
 Investors get excited about a new company they are prospecting on
 This further drives up the stock of an IPO price
 This may argue that there is no under pricing
 Merely that investor exuberance drives up the price above fair value
o 2. Under pricing Affords UW and Institutional Investors built in gain
 They bear the risk
 Their reputation is on the line
 Under pricing assists them in guaranteeing gain on their investment
 Under pricing hedges market risk
o 3. Lower Capital raising for company
 This means company could have offered the shares at a higher price to the market
 Less capital to work with
 Effects shareholder negatively
o Fraud Argument:
 One could argue that by intentionally underpricing, and knowing exuberance will occur to drive up price,
something like fraud / price manipulation
 NO:
 Compensates UW for risk
 Investors are emotionally exuberant in trading no matter offering or consistent trading
 If its too high, UW bear risk of loss
 Statistically, stock prices drift down and IPOs actually lose money
 One could argue that had the IPO been priced above actual value—overpriced—it may drive up
investor exuberance even more as people may feel the value is strong and higher price is morr
attractive—you want it
o Underwriter Liability:
 §11: Fraud in registration statement
o Liability limited to the offering price
 §10b-5
o Change of Capital Structure Formation:
 Typically, when going public, capital structures change to Delaware for incorporation and Corporate Governance
Changes
o Why:
 The market values consistency and expectancy
 The market expects certain things, Delaware Corporation being one of them
 While corporation may want to be a leader, unique actions in IPO may spook the market
o Underwriter as a Gatekeeper:
 Their Role:
o 1. Sell their reputation
 Their reputation speaks volumes about the company going public
 They may not put their reputation on the line if the company were crap
 Benefits their future business
 While UW want to make $, and could simply take anyone to the market to make a quick buck
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o Long run versus short run
o They want repeat business, and long term business
o 2. This Gives Them Incentive to Engage in Screening Function
 Underwriters are successful if the IPO is successful
 Quality of offerings is important then
 Incentive to screen potential candidates to the public market, assuring that they are legitimate, not
fraudulent
 Policy Issues:
 1. Oligopoly Problem
o With few UW, one could argue that they could engage in cruddy behaviors, taking not as
strong companies to the market
o However, with few UW, there is not really competition and therefore, they will still have
repeat business
o Less incentive to screen
 2. Individual Investment Bankers do not care
o As long as they bring a company to market, the I-Banker makes bonus
o The UW, as a whole, may suffer, but the I-Banker Wins
o Therefore, the incentive to screen may not be as strong
 3. UW Could divulge more information than they do from the IPO Company
o Reduces their liability
o May not want to find, and let it come out well down the road
o More Costs for them
o Less profit
 4. Free Riding Problem
o While some UW have reputations and screen, others do not
o These may free ride off of the coat tails, simply by having the title of Under Writer, with IPOs
o Therefore, these lower-class UW may not screen
 B. Public Offering Disclosures:
 Generally:
o The Key policy issue is that
 Insiders have informational advantage
 Information Asymmetry is high
 By disclosing, we curb this to avoid sale of overvalued disclosure, although we restrict disclosures
o 2 Key Disclosures:
 1. Registration:
o §11 Liability
 2. Statutory Prospectus
o §12(a) 2 Liability
 Filed with the SEC
 1. The Registration Statement:
o Information they Contain:
 1. Transaction-related information
 2. Company information
 3. Exhibits and undertakings
o 2 Forms:
 Form S-1:
o Available to all issuers
o Most Comprehensive Disclosure
o Incorporation by reference of past disclosures
 Form S-3:
o Available only to:
 1. Reporting for 1 year
 >$75M of equity in hands of affiliates
 Incorporation by reference to prior SEC Filings
o Incorporation by Reference:
 Policy:
o Instead of requiring the addition and inclusion of all past filings that have been filed with the SEC
o May incorporate by reference to them in the document
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o Utilizes Reg S-K and S-X
o Why:
 Few people read the disclosures anyway
 Increased cost if otherwise
 If we didn’t allow incorporation by reference, cost would be barrier to entry
 Analysts are the real audience 3rd Party Intermediaries will asses it
 They will go and read the documents that need to be evaluated
 This allows for balancing of still giving information to analysts while avoiding too high cost for
issuer
 They will evaluate the information anyway and price it into the stock
 Efficient Capital Market Hypothesis
 The information will be incorporated into the stock price anyway
o “Plain English” Requirement:
 Rule:
o The SEC requires disclosures to be “in clear, concise, and understandable” language
o No sophisticated legal or business jargon
o Specified Font Size and Font
 Policy Issues:
o 1. While altruistic—offering is to institutional investors
 As analysts and sophisticated institutional investors, may be unable to get same point across in plain
language
 Average Joe does not read
 These ultra-techincal terms serve a purpose of giving meaning to something in concise way
 Failure to get complexity of issues across
o 2. Opens up to liability
 Failure to be able to get across information may lead to 10b-5 liability
 So, while intended to benefit may actually harm
o 3. In the long run
 Standards may begin to emerge, and slowly, may lead to consistency in getting across the point
 Increased Cost to translate from legalese to plain English
 Effect:
o For those individual investors that do read this helps
o Done to help these individual investors who really don’t read them anyway
o Small Business Exception:
 Generally:
o Going public affords great access to capital wealth
o However, smaller companies may not be as efficient in eating the cost
o The high costs of doing so may not be financially worth it
o SEC has encouraged small businesses, however, in two forms
 Less stringent disclosure
 Forms:
o SB-1
 Offerings of up to $10M in 12 month period
o SB-2
 Revenues <$25
 Policy Issues:
o 1. Reduces transaction costs for them
 ease of access to the capital markets
o Issue:
 They require less disclosure in their registration statement
 Already don’t have past, or very little disclosed
 Increased fraud potential, with less disclosure
 3P police of analysts typically don’t cover them
 So, may be likely to have more fraud in small-business disclosure
 May warrant an increase in disclosure, not decrease
 On Contrary, larger issuers are more widely followed, have analyst support
 Maybe less fraud
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 Counter argument:
o Enron and Worldcom were enormous
o However, fraud still occurred
 C. The Gun Jumping Rules:
 Policy:
o While much of our focus has been on mandating disclosure, here we restrict Disclosure, and in fact mandate no
communication at time. Why?
 1. Avoidance of Buried Rationale
o In the inception of an offering, it would be easy for a corporation to disclose everything, burying the important
information deep down
o Fraud potential would be easy
 2. Fraud Potential
o There is not a lot of information that is out on many issuers
o We want to avoid fraudulent disclosures until we are certain they are legitimate companies
o IPO is area with most incentive to commit fraud
 3. Information Asymmetry: Dearth of Disclosure and Information
o Because of the lack of information on the issuer, fraud potential and unsophisticated investor can get taken
advantage of
o Holding up communication is in investors best interest
o However, we balance need of company to communicate by allowing limited in waiting period
 4. Awaiting Approval of Legitimate and Valid Securities in Paternalistic Nature ***
o Investors are unsophisticated
o Fraud potential is high due to investor Exuberance at IPO
o SEC is paternalistic and wants to assure the security is legitimate, the company is valid, and that fraud potential
is at a low to protect emotion and unsophisticated investors
o This broad rule protects, and is paternalistic
o Assures that SEC had a chance to evaluated and give “the ok”
 Overall:
o We do give more lenience to WIKSI
o We want securities in the market
o But, we want legitimate and anti-fraud measures in place
o Paternalism gets us there
o Restriction in disclosures help assure accuracy, legitimacy, and that appropriate info. Is out there
 However:
 Given the “Selective review process” this may be more form than substance
Basic Structure:
Pre-Filing Period
|
Waiting Period
|
Post-Effective Period
§5(a)---------------------------------------------- Sales
§5(b)(1) ---------------------------------------------- Limits on non-Statutory Prospectuses
§5(c) ----------------- Offers
o Policy:
 We Focus on “Transaction” of issuing stocks
 However, over time we have moved towards regulating “Companies” in certain context
o Company Registration:
 The issuer registers and then is permitted, in certain contexts, to act without additional approval
 We have slowly moved towards a “Company” Regulation
o As disclosures have been around for quite some time, companies are more and more well
known
o These disclosures have accumulated and thus the Companies are known, and tons of
information is within the market
o 4 Categories of Issuers:
 1. Non-Reporting Issuer
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 an issuer who is not required to report
 2. Unseasoned Issuer
 an issuer that is required to report, but hasn’t filed an S-3 yet due to not filing for 1 year
 3. Seasoned Issuer
 Issuer required to file reports
 Meets S-3 requirements and reporting for over 1 year
 4. Well Known Seasoned Issuer (WIKSI)
 Is Seasoned issuer
 Minimum $700M stock outstanding or has issued $1B in non-convertible securities
 Current in Exchange Act Filings
 Cannot be:
o Shell company, asset-backed issuer, or investment company, or bankrupt in past 3 years
 For instance:
o GE, IBM
o These are large companies, that are well known, and have been followed for some time
 Policy:
 1. We put the burden of registration mostly on “Non-Reporting Issuers”
 Least amount of information is known about them
 Least amount of information already in the market
 Most incentive to Defraud
 Burden on them to disclose more information / Most Information Asymmetry
 Should We:
 Yes:
o Largest incentive, and capability to defraud at IPO
o Least known so most potential harm to unsophisticated and exuberant investor
o Meets the policy reasons for Gun Jumping rules in strongest fashion
o Institutional investors have incentive to “pump up” the mystery
o Exuberance is strongest when there is mystery about silence of new, unknown company and
therefore likely to increase hype…so we do need burden on them
 No:
o Institutional investors are the ones who get the shares first
o Therefore, shares go to UW and then sophisticated parties before going to private markets and
they have been vetted
o May not need burden on non-reporting companies
o Institutional Investors are more sophisticated and don’t need protection
 2. Less Burden on Unseasoned:
 Know more then non-registered, but less then others
 3. Even Less Burden on Seasoned
 4. Least Burden on WIKSI
 Why:
 1. Least Information Asymmetry:
o We know the most about them
o Reputation is already built
 2. Efficient Capital Market Hypothesis:
o Information is already out there, incorporated into the stock price
 3. 3P, UW and Analysts have vetted them, and as intermediaries have also analyzed
o Stock is already priced in ECM
 4. Also: As the WIKSI is already traded, and would be offering a secondary offering, restricting
their communication and limiting disclosure may affect the stock already trading
o While restricting disclosures in IPO market has benefits
o Here, because their stock is already traded, the costs may be greater, hurting the market that
trades
 5. Least incentive to defraud
 1. The Pre-Filing Period:
o Time Period:
 From pre-filing of registration until registration is filed
o Restrictions:
o §5(a): No Sales until registration is effective
o §5(c) No Offers prior to filing in pre-filing period allowed in Waiting Period
 Why:
o 1. We prohibit sales until post-effective period
 The issuer has been checked and information is disclosed in prospectus at that point
 There is adequate information disclosed to make accurate determination
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o 2. We prohibit offers until Waiting Period
 Balance between investor protection and allowing business to get interest and gain momentum to sell once
effective
 Overall we want to fulfill policy reasons for chilling communication and Gun Jumping Rules
o A. What is an “Offer”
 In the Matter of Carl M. Loeb
o R:
 1. An “Offer” is extremely broad
 “Communications that condition the public mind or arouse public interest”
 Examples:
o 1. Formal offers to sell
o 2. Other communication that “conditions” market
o However:
 Normal Conduct a business conducts that advertises products or services
 Customary reports or statements
 Quarterly and annual reports
 Whatever corporation typically engages in may continue
o The impact of these statements is less as they were occurring beforehand
o These are less likely to condition the mind or arouse interest as were occurring before hand
o Key Factors to Look For:
 1. Motivation of the communication
o Was it prearranged, customary or particular to financing of IPO
 2. Type of Information
o While all information may look like offer. Puffery may look more so
 3. Breadth of Distribution
o More widely disseminated, more likely to be offer
 4. UW Mentioned by name
o or other specific facts may “condition the market”
o Effect:
 A factual standards analysis rather then a bright line rule
 Incentive to adhere to caution as issuer
 1. Policy of SEC’s Construction of Broad understanding of Offer:
o 1. Paternalistic and presumes that investors are half-wits or unsophisticated
 Assumes investors will go into frenzy, ignoring information subsequent to an offer or disclosed prior to
 Irrationality will ignore disclosures
o 2. Assumes irrational and in need of protection
 The prohibition on offers
 1. Gives SEC Chance to review and make sure its “legitimate”
 2. Then permits offers once its given the go-ahead
 Rather Than:
 Rational
 That they will discount the offer as marketing fluff and can distinguish and fend for themselves
o Costs:
 Slows the offering process
 May make it more difficult to raise capital for issuer
 Investors may turn to other sources of investments
 May lead to issuers turning to other forms of financing (Bank, Retained Earnings)
 However: with the speed, and size of offerings, IPO will continue to trump
 2. Internet/ On-Line Issues with Gun Jumping:
o Rule 405:
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 Graphic communications (like online information) may constitute an offer
 However, historically archived information if segregated does not constitute an offer
 Why:
o Costly to take them down
o Annoyance to company
o It is historical information that is already in the total mix in ECMH
o Therefore, its already priced in
 3. Safe Harbors for Issuers in Pre-Filing Period:
o 1. Rule 163 A
 Issuer statements prior to 30 days before filing registration
 May not reference offering
o 2. Rule 169 Non-Reporting Issuer
 Regularly released factual information
 May not reference offering
o 3. Rule 168 Reporting Issuer
 Regularly released factual statements and forward looking statements
 May not reference offering
o 4. Rule 163 Well Known Seasoned Issuer
 May make offers during pre-filing period
 Must include legend in written communications advising to see statutory prospectus
 File Communications with SEC
 Policy:
 The well known seasoned issuer gets the most leeway in its communications
o Information is already out there in ECMH
o There is historical information for investors and 3P intermediaries to analyze
 Reputation has been built
 Because securities already trading, don’t want to inhibit their market
o Balance of continuing our previous disclosure regime for already issued securities, not
inhibiting their market
 However: with less known companies, we want to curb speculative investor exuberance
o Not have them taken advantage of
o Policy: WIKSI versus Non-Reporting Issuer:
 While Non-Reporting Issuers need to test the waters more then WIKSI in pre-filing period
 They value the ability to do so
 Large costs associate with it, and would make it easier if they could cut their losses
 However, they are most restricted
 WIKSI does not need to test market as much
 They are already trading
 Pose the least risk
 However: The Gun Jumping rules protect investors
 While non-reporting issuers may be in more need of testing the market, their fraud potential is greater,
information asymmetry is greater
 The exceptions try to ease the damage the rules cause but, in the endinvestor is focus
o Policy of prohibiting UW from making offers
 While the WIKSI can make offers in pre-filing, allowing an UW to do so may nullify any gunjumping rule
 They have massive connections
 Would make registration almost useless, as with WIKSI and UW communicating offers, almost all of
market would get the offer on massive scale
o B. Permitted Communication to Underwriters by Issuers:
 §2(a)(3) Permits communication with underwriter that would otherwise be an offer
o Policy:
 Must be able to communicate with underwriter on deal, negotiations, etc…
 UW must be able to discuss terms with UW syndicate
 That way expertise, logistics, and skill are actually utilized versus neutralized
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 Preliminary negotiations are excluded too
o Issue:
 UW are purchasing the shares from the Issuer
 So, that is an offer and a sale being reached in the pre-filing period
 Then UW is offering the shares to institutional investors
 However: No Communication with Dealers
o While communication with UW is necessary to start and actually negotiate the logistics of a deal
o Communication with Dealers would arguably be too broad
 Word may spread
 Undermine the gunjumping rules
o So, the balance is struck in favor of UW, and practical needs of the process
o C. Rule 135: An Additional Pre-Filing Communication
 Short, Factual notices to public of proposed public offering
 Issuer only
o Can Identify:
 Basic Terms
 Purpose of Offering
 Anticipated Timing
 Cannot identify UW by name
 Policy:
o This seems to negate the whole purpose of investor exuberance
o However, this is simply a small market test
 Again, a balance struck between investor protection and company need for capital formation
o This may be the only way UW will enter firm commitment, as they need to gauge market as well
 This is such a bare-bones statement, however, perhaps it is not surprising and investor exuberance is still
kept in check…simply another IPO
o Purpose of UW Rule:
 If reputation listed, may lead to increased exuberance
 By not listing, this may give access to smaller underwriters
 However:
 With UW oligopoly, it is likely that investors will assume it is one of the big, reputational, UW
anyway, so may not have the same effect as desired
 2. The Waiting Period:
o Generally:
 After the registration statement has been filed with the SEC
 Now, we are waiting for the Division of Corporation Finance to declare the registration “effective”
 Issuers and UW gauge market interest
o Rules:
o Offers are allowed, as §5(c) ends
o Sales are still prohibited per §5(a)
 §5(b)1:
o Offer must have prospectus that meets §10 Statutory Prospectus Requirements (exceptions apply)
o Accepted Methods of Offering and Methods of Gauging Market Sentiment (Safe harbors to offer):
 Generally:
o These are accepted methods of offering
o Investors can revoke their offer prior to acceptance by UW
 1. Safe-Harbors from pre-filing period
o WIKSI may offer per Rule 163
 2. §10 Statutory Prospectus
o Contents:
 Notice
 Advertisement
 Information contained in registration statement
 3. §10(b) Preliminary Prospectus
o Contents:
 Will include all same information as final prospectus, except will not include price
 Policy of Prospectus
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



o These now give information to prospective investors
o Reduces information asymmetry
o Informs them, with SEC mandated information
 Not Including Price:
o Don’t want to put in price too soon as market could shift
o Requires amendment which postpones ability to sell
o Even for WIKSI, prices tend to vary constantly as to what value of share is
4. Oral Offers not broadcast
o So face-to-face communication is acceptable
o Broadcast offers are not
 Policy:
 Less information asymmetry
 Difficult to police/enforce this anyway
 Parties build relationships
5. Roadshow
o Issuers and UW go on the road, offering the shares to many different investors, institutional typically
o This is testing the waters
o Oral offers are made
o Assists in forming the price of offering
o Policy: Could we allow a road-show in pre-filing period:
 Would be beneficial:
 Would assist issuers in avoiding costs if cannot sell
o Reincorporation
o Filing costs
o Travel
o UW detainment costs
o So, testing the waters would be beneficial for all companies
 However:
 Information asymmetry exists, with the most asymmetry being in the pre-filing phase
 Even institutional investors, who are extremely sophisticated are vulnerable
o Without any information to go by, their sophistication is useless
o Exuberance strikes even most sophisticated investor
o Fraud potential is high without any information
o Especially given relationships built between UW and institutional investor
 So we wait until filed with SEC
o Creates liability, deters fraud
o SEC reviews and gives the ok
o Then information is given to investors in waiting period, who can make an informed decision
6. Tombstone Advertisement
o Similar to Rule 135 Factual statements
 Contents:
 Basic Terms
 Purpose of Offering
 Anticipated Timing
 Business plans of issuer
 Price
 Name of All underwriters (begin use of leveraged reputation)
o Offer can occur with Tombstone if:
 Send Statutory Prospectus with the tombstone ad, or before it
7. Free Writing Prospectus (Rule 164)
o Generally:
 An exception that allows offers without meeting the exact requirements of prospectus
 Applies to Issuer, and Underwriter
o Requirements :
 Any written communication that offers to sell or solicits to offer to buy security
 Does not meet §10 prospectus requirements
 Cannot contain information contrary to Statutory Prospectus
 May need to file the Free-writing prospectus with SEC
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o Contents:
 1. Legend
 Indicating that registration has been filed
 Indicating where investor can get statutory prospectus from
 To meet legend requirement or inclusion of a statutory prospectus requirement
o May simply include a hyperlink with the promotional, free-writing prospectus
 2. Will be more promotional like an advertisement or marketing tool
 Non-Reporting Issuers:
o must include statutory prospectus with it, or have already sent one out
 Seasoned/WIKSI:
o Do not have to include statutory prospectus with it
o Analyst Policy Concerns during the Waiting period:
 Generally:
o Buy Side Analysts
 Work for the large-institutional investor
 Help them in deciding to buy issuer stock
 Reports are not for public, but for their client
o Sell Side Analysts
 Publish and distribute their research to capital markets
 Subsidized by the UW investment bank they work for
 They may work for the UW that is participating in the issuance
 Policy Concerns of Sell-Side Analysts
 1. We don’t want to chill information
o WIKSI has stock trading, so chilling information for them would be negative
 2. However Sell-Side analysts have incentive to:
o Incentive to overly-optimistically rate a stock their company is selling
o The Investment Bank fees subsidize their research, creating conflict of interest in rating
o Additionally, they have incentive to rate something they are not issuing high, in kick back
scheme, so that UW will return the favor when they are underwriting something
 Alternative Solutions:
 1. Separate from Investment Banking
o Chinese Wall
o Limit analyst interactions with what Investment Banking is doing
o Turn it into subscription fee service
 2. Analyze the Analysts
o Analyzing the analysts would give incentive to make accurate, good ratings rather then overrating simply to gain investment banking fees
 Rules and Safe Harbors for Analysts:
o Generally:
 In an effort to avoid chilling information from analysts, who provide very useful intermediary distribution
o Safe-Harbors for Non-Participating Analysts:
 Research Reports are exempt from being an offer they may be used if
 1. Not compensated for by participant and
 2. Report is published in regular course of business
o Note: this allows for test of kick-backs…if report is all of a sudden undertaken, may show
that non-participant is being paid by the participating parties to tout the stock
o Safe-Harbors for Participating Analysts:
 138
 1. Issuer must be an Exchange Act Reporting Company
 2. If issuer issues:
o A. common stock or convertible into common stock
o B. debt or securities not convertible to common stock
o The Analyst may report on the class of securities NOT being offered
o If regularly publishes report on it already
 139
 Report can be specific to an issuer if that issuer is S-3 elligible and Analyst has reported before
o Why:
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o
o
o
o
o
Like the WIKSI, the S-3 eligible issuer is one who has been reporting for 1 year
Information asymmetry is at its lowest point
ECMH exists to properly value this information and incorporate it into the market
Greater Trust of that company
Analysts have been evaluating already, so less fraud potential
o Going Effective Process:
 Generally:
o While the issuer is in the waiting period, the SEC is evaluating its disclosures through selective enforcement
o SEC Evaluates in Approving/Accelerating
 1. Adequacy of prospectus
 2. Plain English requirement
 3. Whether issuer under investigation
 4. FINRA objections to UW Compensation
 Timing:
o The registration statement becomes effective automatically at 20 days post-filing
o However, if there is any amendment, 20 day period resets
 Effect:
 To get the 20 days, all must be included in the registration and prospectus, meaning price is set
 Policy Issues:
o 1. Parties do not want to lock in price for almost 1 month
o 2. Issuers want to take advantage of SEC comments and review
o taking advantage of comments mitigates chance of private litigation
o 3. Liability potential if inaccurate, so take time to assure accuracy
o 4. If SEC is unhappy they can stop registration or refuse to evaluate until complete
o May Request Acceleration:
 So, take the time to have SEC review and availa of benefits of waiting period
 Then:
 Acceleration request to get the issue out there as fast as possible
 Takes advantage of setting price, and becoming effective soon after
 3. The Post-Effective Period:
 Generally:
o §5b(1)
 Offers must include Statutory Prospectus
o §5b(2)
 Sale must include Statutory Prospectus
o Effect:
 Communications must:
o Be a Final Prospectus or
o Be preceded or include a Final Statutory Prospectus
 The Final Statutory Prospectus:
o Includes all information and price
o Incorporates SEC amendments
 Access and Delivery:
o Generally:
 The only way that these disclosures are actually meaningful, reducing information asymmetry is if they get to the
investors
 Even though they may not be read, information is there to make a sound decision
 So distribution to shareholders must either include or be preceded by prospectus
 Exception: Rule 172:
o If the effective registration and final prospectus are filed with SEC delivery of them is not required
o Able to access on EDGAR
o Premised on the idea that “Access equals delivery”
 Applies in oral offers/road shows as a method of constructive delivery
o Policy Reasons:
 Technology is taken advantage of
 Otherwise, would be redundant to include paper copy when internet has it right there
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 Does not apply:
o Free-Writing Prospectuses/written offers must include statutory prospectus
 Policy Reasons:
 Again, we include the statutory prospectus as a standardized method of disclosure
 It contains information that free-writing may not, as free-writing is more of marketing tool
 Updates and Amendments:
o 1. There is no general duty to update
 Note:
o Except in shelf-registration events, when registration was more then 16 months old
o 2. Duty to Correct
 Information filed must be correct, or else exposure to §11 and §10b-5 liability
o 2. SEC policy
 Update to disclose material changes
o Note:
 Amendments to the registration lead to re-set of §11 liability for that portion
 Remainder of unchanged registration still has original date as date for potential §11 liability
 Post-Effective Trading by Participants:
o Generally:
 Underwriters and other participants have an incentive to jack-up the trading price if they can
o 1. Want/Need to sell their allocated shares
o 2. Have the option to sell additional shares typically
o 3. Reputation to uphold
VIII. § 11 Liability:
 Generally:
 §11 imposes liability for fraudulent registration statements
 Those registration statements that “have untrue statemets of material facts or omit material facts”
 A. Policy of Fraud Potential at the IPO and its Effect:
 Fraud during the IPO Is very tempting:
o 1. Incentive to defraud to raise as much capital as possible
 Company benefits
 Insiders may ‘free-ride’ the inflated price to profit themselves
 Easiest to accomplish as Information Asymmetry at its highest
 Fraud’s Effect:
o 1. Investors leave markets that are “fixed”
 Unsophisticated investors taken advantage of
 Investor Exuberance
 Some investors may engage in expensive, duplicative research to precaution against fraud
 Institutional Investors may be hurt too/Pass along issuance quickly to individual investors
o 2. Investors that do participate may want discount for fraud potential
 Lower capital raising for companies
o 3. Truthful companies may then have to go to fraud to get any chance in IPO market
 If not, will have to engage in high transaction costs to bolster fact they’re not fraudulent
 Hire more accountants and lawyers
o 4. Companies may turn to other forms of financing
 Internal
 Easy to manage, no one to appease, no covenants
 If don’t have it, cant use it, unlikely for new companies
 Venture Capital/Founder Financing
 Covenants to deal with, maybe fewer
 There is a max limit they can provide/may lost control
 Bank Debt
 Easy to get, but many covenants to deal with
 May retain control, but cost of capital is higher
 Public Offering
 Raise money quick and lots of it
 No covenants
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 Lose control, however and must comply with Federal Securities Laws, and liability there under
 For these Reasons:
o We regulate Fraud Overall
o We regulate the IPO Market
 As Market Integrity is key to promoting strong markets
 Key to maintaining IPO market
 IPO particularly susceptible to fraud
 B. §11 Cause of Action:
 Standing
 Material Mistatement or Mission
o There is no:
 Scietner
 Reliance or
 Causation
o Policy Concerns:
 1. Elements are easier for the π
 2. Damages are capped
 3. Standing has been ratcheted up, however due to Judicial Concern of frivolous lawsuits and due to dilution of
damages
 C. Standing to Bring §11 Suit:
 Generally:
o Investor bringing a §11 suit:
 Must trace the securities back to the materially defective registration statement
o Effect:
 1. If sole IPO occurs:
 Easiest to link the shares to the IPO
 The only shares sold will have necessarily been from the IPO
 2. However, if Seasoned Issuer and does Subsequent Offering or Inside Shares already exist:
 1. Shares enter market
o Some are tainted shares and some are legitimate shares having already been traded
o Shares held in street name make it impossible to identify which shares match up to the second
Public Offering versus the first
 Krim v. PCOrder.com Inc.:
o F: Company made an IPO in 1999. Secondary offering occurred later in 1999. 2 investors brought suit under §11 for fraud
in the registration statement. However, shares are held in street name, all registered to the broker and investors simply have
a right to a certain number of those shares. It was impossible to show which shares he was entitled to, and whether those
were from the IPO or SPO.
o R:
 To Meet Tracing Requirement, Must show:
o By preponderance of evidence that all stock you claim damages for is actually traced to the fraudulent
registration
 Probability is not enough:
 Here the investor showed that there was a 99% chance that 1 of his shares was from IPO
 This is not enough
 If it were a matter of statistics that shareholder owned 1 share from the company’s IPO, most
shareholders would have standing to bring suit that was strict liability
o Not Congress’s intent
 Street-Name and Share Depository Institutions:
 Most shares hare held in street name, that is registered to the deposit instutiton or brokerage
 Then, investors have a claim to the number of shares they own
 Effect:
o It is impossible to tell which shares exactly came from IPO, or SPO, or TPO…
o Without paper certificate, or serial code, its impossible
o This effectively limits standing to §11 when there is only an IPO
 Policy of heightened standing in §11 Claim:
o A. Key Policy Concerns:
 1. Frivolous Suit Fear
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o See Strike Suit discussion, supra, 10b-5
 2. Damages are not investor insurance policy
o Here they are limited
o Avoid dilution
 3. IPO fraud is more likely
o Once issuer is ready for seasoned issuance, second offering, chances are much less likely for fraud
o So “Tracing” essentially limits it to the IPO, and avoids it in SPO
o Non-Reporters/IPO:
 Greatest information asymmetry
 Greats incentive to defraud, make as much $ as possible
 Has been issuing already, reporting, and SEC and public has determined legitimacy
 ECMH reflects this information
 Restricting to IPO reduces chance of Frivolous Litigation
 However
 If IPO fraud is most likely, restricting §11 may negate to deter fraud in IPO in first place!
 4. With no elements, reduce it here as other alternative schemes of liability in Securities
 10b-5
 Overall:
o With essentially Strict Liability, and limited damages, standing has been raised
 This curbs the concerns, above
o Effects:
 But may be over and underinclusive
 May miss out on deterrence of §11 Fraud
 Although, 10b-5 fraud always lurking
 Limits to an IPO
 Effect of “Street Name Holdings”
o No one has distinguishable shares with ability to track
o Held in street name, so after IPO, any other offering essentially ends §11 liability
o Thus, §11 Liability has been a proxy to limit §11 to IPO by judiciary for these fears
o Possible Theories and Flaws of §11 Heightened Standing:
o 1. Lack of Reliance:
 Generally:
o Because §11 does not have a reliance prong, perhaps heightened standing is proxy for lack of reliance
o However, if the shareholders never read or got to prospectus
 This view is Over and Underinclusive:
 Underinclusive:
o Those that read the proxy, but cannot trace their shares, do not have standing under §11
o Therefore, even though they read proxy, and relied, they cannot bring §11 suit
o Deserving claimaints excluded
 Overinclusive:
o Investors that can trace their shares to the IPO, but never read or received prospectus
o Overincludes individuals who then meet standing reqiirement, but did not rely
 Reliance View may be inadequate
 However, 10b-5 is still available
o 2. Tracing may be used as a method of limiting liability:
 Generally:
o Due to lack of scienter, causation, and reliance, there is concern that §11 may open up floodgates to litigants
o Heightened standing, and rejecting the probability argument may be a method of curbing these concerns
 Avoids chilling behaviors of issuers and other participants
 Issues:
o 1. Reduces “deterrence” of liability as restricts who can bring and against who
 If market participants know it is almost impossible, they can do things to nullify §11 (offer again)
 Dilutes Liability
o 3. Damages Cap Justification:
 Generally:
o §11 Damages are capped to:
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 1. The price which was offered to public (Cannot be greater)
 2. Under Writer Damages are limited to “price offering offered to public” (FC offering)
o Therefore, the pool of damages is limited
o Increasing # of litigants to take a piece of this damages pie, dilutes everyones share of damages
o
 Issues:
o Deters Frivolous Suits
o Avoids use of investor insurance policy
o However, may not deter fraudulent parties in IPO
o 4. Limited Standing may focus on IPO rather then Secondary/Seasoned Offerings:
 Generally:
o IPO Fraud is the most likely, and not as likely in secondary offerings
o Because of possibility of frivolous law suits, heightened standing may be method of focusing on IPO
o So, Standing may re-focus litigation on the IPO, which otherwise would have been more expansive
 Issues:
o Yes, deters frivolous suits
o However:
 This is a decision for the Legislature
 Chills meritorious suits undericlusive
 Under deters in secondary/seasoned offerings that still may contain fraud
 Effect:
o Tracing to IPO is essentially only way
 After a seasoned offering, almost impossible due to street name holdings
 There are no stock certificates anymore
 No serial numbers
o 5. Effect of Under deterrence
 General:
o We may be concerned with flaws above, but it would be bad to underdeter fraudulent parties
o Investors may not be able to seek relief underincliusive
o Fraud may be more prevalent if likely that investors will lack standing to sue
 Effect:
 Because of Cap on damages, one may be able to count probability of those who can trace, and may
be able to still profit from IPO fraud
 D. Statutory Defendants:
 Generally:
o Unlike 10b-5, which simply requires proof of primary liability on a potential ∆, §11 liability restricts defendants to a list
 List:
o 1. Those who sign registration statement
 Issuer, CEO, CFO, others
o 2. Directors
o 3. Experts who prepared certain portions
o 4. Underwriters
o 5. Controlling parties of the above
 Policy of Having Enumerated Defendants:
o 1. Certainty:
 §11 list of defendants provides for predictability for potential ∆s
 Focuses parties on their due diligence responsibilities to police the accuracy of registration statement info.
 Almost a proxy for secondary liability
o 2. Parties listed are in best position to have knowledge of registration statement
 These parties are intimately involved in the IPO
 They are in position to know or uncover fraud at lower cost (they are already there)
o 3. Gatekeepers
 The listed parties are liable, and therefore have incentive to “Gatekeep”
 Reputation on the line otherwise
 Underwriters especially may reap rewards of reputation for issuing high class/quality offerings
 Incentive to do so, if they will be liable
 Why not have a Wider class of Defendants:
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o Arguments that List is correct:
 Costly to parties
 May force parties to engage in costly research of company to monitor fraud
 Tenuously connected parties, however, would bear high cost
 Redundant with the parties that are already intimately connected with the IPO
 These outside, unlisted parties may not benefit from the fraud
o Arguments that list should be broader:
 Deterrence of fraud
 Redundancy is good when IPO has incentive to be fraudulent
 E. Distinctions between §11 and 10b-5:
 §11:
o No scienter
o No reliance requirement
o No loss causation
o §11 Liability determined at the “effective date”
 Registration may be effective at certain points
o Amendments alter effective date for various portions
 Different portions of the registration may have different effective dates
 Liability, then, begins at various dates
 The Least important distinction:
o Absence of Reliance
 As the 10b-5 requirement is met, essentially by assumption of fraud on the market, it is not a key element
 Most Important Distinction:
o No Scienter required:
 10b-5:
o Requires Scienter and
o PSLRA requires “strong inference of scienter” to bypass pleadings and enter discovery
o This poses substantial burden and was promulgated to negate strike suits and frivolous litgation
o However, without discovery, establishing scietner is not easy
 §11
o avoids any dealing with scietner
o Hightened standing, however, is barrier to entery
 PSLRA does apply:
o 1. Stay on discovery until after motions phase
o 2. Lead π requirement
o 3. Reasonable attorney’s fees
o 4. Proportionate Liability
 F. § 11 Defenses:
 Generally:
o While many of the elements of §11 are relaxed, elements from 10b-5 come into play when raising defenses for §11
 Defenses include:
o 1. Actual Knowledge:
 ∆ may show that π knew of the misstatement or omission at the time π acquired the security
o 2. Loss Causation:
 ∆ may demonstrate that the drop in share price is caused by other factors
 Use of Event Study to demonstrate
 Therefore, loss causation is a method of defending §11 claim
o 3. The Due Diligence Defense:
 Generally:
o The most important defense available
o Available to all ∆, except the issuer who is strictly liable for all misstatements or omissions in the registration
 Bifurcated Liability:
o Experts:
 Are only liable for their Expertised Portion
 “reasonable investigation, ground to believe and did believe it was true”
 Not liable for non-expertise portion
o Non-Experts:
 Non-Expertised Portion:
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 Defense if “reasonable investigation, reasonable ground to believe it was true, and did believe
so”
 Expertised Portion:
 “Reasonable ground to believe and did believe it was true”
 Policy Effect:
 Increased paper trail and redundant work to ensure “reasonableness” can be shown
 “Reasonable” process is uncertain
o Over-cautious with process to ensure defense is available
o Incentive to assure it is accurate
 However, due to the complexity of the registration statement, and different parts
o May not be as easy to develop defense for all parts as non-expert
 Policy: Should we hold all participants Strictly Liable for §11 Violation
 Yes:
o The IPO process is very easily fraudulent, and all should contribute and be responsible for any
fraud, regardless of their efforts
o This will ensure accuracy, and if not, compensation for shareholders
o Easier for Courts, as no need to determine culpability
 No:
o With potentially large liability, may chill participation
o Strike-Suit potential with strict liability provides great incentive to settle
o Strike-Suit will simply target 3P with deep pockets
o Regardless of culpability, π will seek any $ they can get
o This fails to deter the corporation, then, because πs will target less culpable parties
o Valuable 3P reputational intermediaries will leave the market
 The due diligence defense provides 3P, in addition to the enumerated ∆s list, with predictability and
incentive to vett the documents they work with
 Increases accuracy, which is what we want
 Also, does not overchill, with draconian liability, leading to vast exodus of the market
 Outside Directors and Liability:
o The question becomes, outside directors provide a valuable service in objectively evaluating issues
o Should we hold them to as high a standard, from a Policy Perspective?
o Benefits:
 Broad policy goal to reduce fraud at the IPO
 1. They provide objectivity, and should even be held to higher standard as the shareholders predominate
source of evaluation
 2. We want them to do their due-diligence
 While may be difficult, as they are on several boards, travelling, etc, and perhaps unrealistic to
evaluate all registration, puts incentive on them to check it
 3. Incentive for accuracy
 4. They owe a fiduciary duty to the shareholders
 They should have obligation to evaluate the registration
 5. Deters Fraud further
 6. Incentive to do investigation, reasonable inquiry to avoid liability
 They are sophisticated, and in position to investigate, rather then simply rely on other parties
 7. Incentive to double check as well
 This is beneficial at IPO where fraud potential is highest
o Qualitative and Pecuniary Costs:
 Outside directors will seek a way to ensure they acted “reasonably”
 At some point, this added incentive will be redundant/wasteful, however
 1. They will seek Director/Officer Insurance
 2. Indemnity by the Corporation
 3. Due to “reasonableness,” Directors will obtain their own outside counsel for inoculation
 Policy Effect:
 1. Over-protection and caution in the process to ensure safety
 2. Wasteful/Redundant spending
o Fear of liability will lead to checking, double checking, etc…
o other parties are more in line to evaluate, and will be doing the same thing
 3. Increased Costs
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o Lawyers, and other counsel as people “Lawyer up”
o Simply to create paper trail
 4. Reputational Effect may chill Board Members Desire to Participate
o for many board members, their reputation and future employment on boards could be tainted
due to §11 claim, and liability
o This potential damage to reputation may chill their desire to participate
o Cost to SH as lack of Outside director participation
o May lead to less educated/less than best directors participating instead
 5. Shareholder Protection paradox:
o To protect shareholders, Directors will be liable
o However, they will seek insurance, indemnification, or higher salary to compensate for higher
risk
o This will be paid by the corporation
o So, we are charging shareholders to protect themselves
 Attorneys and Liability:
o Attorneys are not considered experts for the entire registration statement, even though they are largely
responsible for drafting it all
o They are not held responsible for expertised portions of other experts
o Should They:
 They understand law, can research it, and are in charge of the whole thing
 They are, in hierarchy of creating registration, capable of seeing whole process
 Another set of eyes evaluating, and having incentive via liability to check further legitimizes the process
 Additional Gatekeeping function
o Policy of Why Not:
 1. Liability on all would chill their participation, and they provide Gate-keeping function from legal
perspective
 2. Would chill information flow from company to attorney
 The less information attorney has, the more potential for fraud
 Can simply blame attorney then
 3. Relieve other participants of their gatekeeping function and “reasonable investigation” need
 Would be very easy to simply rely on the attorney to review it all
 So, we would need to impose additional requirements on others if we did this for attorneys
 Potential Alternatives to §11
o 1. Whistleblowing Mandate for all participants
 Benefits:
o 1. It makes small employees effective deterrents against fraud
 Adds another gatekeeper to the mix
o 2. May reduce the amount of fraud in public offerings
o 3. Protect Gatekeepers with appropriate retaliation watch
 Detriments:
o 1. Employees may lack incentive to whistleblow
 Impair their future employment
 Better make the bounty high enough
o 2. Large burden on employees to do so
 They may not be privy to the information
 Companies may avoid information disclosure beyond a certain point
o 2 Complete Audit:
 We may encourage 3P involved in the IPO to do a full audit, as this would further negate the possibility that fraud
occur
 Incentive to ferret out fraud
 However:
o 1. Costly
 Audits are expensive
 At some point, the costs of avoiding fraud outweigh its benefits
 Redundancies occur
 Barrier to entry to public capital markets
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o 2. Indirectly increases costs of going public
o 3. Shifts to alternative forms of financing
 Overall: Balance Struck between participating Parties Doing Nothing-----Due Dilligence----Complete Audit
o Costs and benefits of each, but we’d like to keep benefits > Costs
IX. §12(a)1 & §12(a)2:
 1. §12(a)1 Liability:
 Generally:
o Prohibits the offering or selling of a non-registered, non-exempt security
o Not an Anti-Fraud Statute:
 This is designed to get you to register, then sweeping you into the securities ambit which includes §12(a)2, §11 and
10b-5
 As you cannot sell unregistered securities that are not exempt, this pushes you to register
o Elements:
 Anyone who offers or sells unregistered, violation of §5
 Violation of §5
 Strict Liability
o Does not require:
 Mateirality
 Scienter, Reliance or Causation
o Damages and Defenses:
 Defense:
o There are no defenses available
o The only possible shield is showing it is an exempt from §5 transaction
 Damages:
o Rescission:
 If security has not been sold, and held
 Π can recover the purchase price from the ∆
o Damages:
 If the security has been sold
 Difference between the purchase price and sales price
 §12(a)1 Damages Acts like a Put Option:
 If an investor purchases shares that appreciate
 Unlikely that he will file suit under §12(a)1
 However, if the IPO loses $, the investor will seek damages and because this damages scheme
recoups his investment, similar to a put option
 A. Standing for §12(a)1:
o Pinter v. Dahl:
 F: Pinter was selling securities, that were unregistered. Dahl bought some and began soliciting people as well. Suit
alleges that Dahl was a seller of securities as well
 R:
o 1. Those who offer or solicit, doing so out of motivation for one’s own financial interest or the issuer’s
are statutory sellers for §12(a)1
 Not solely restricted to the party who passes Title
 This is in line with the Statutory Purpose of the Securities Act
 To promote full and fair disclosure of information
 However:
 Those that solicit solely for the benefit of the buyer are not included (Broker)
o 2. Standing limited to those who actually purchased
 Policy:
o The Court rejected a broader test that looked for “substantial participation”
 1. Unpredictable amount of defendants
 2. Concern is the reach to participants like lawyers, accountants, etc… who are participating in a
peripheral way
 3. Court’s test is more in line with the purpose of §12(a)1
 Designed to prohibit unregistered offers or sales
 Those who are soliciting will likely know if it is unregistered or not
 Policy Distinction between §11 and §12 Defendants:
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o 1. By not using a delineated list, §12 gives courts flexibility to apply the law based on the function the
person plays
 What §12(a)1 is dealing with is much more advertising like, much broader reach to the public
 Solicitation can be broad, and done by many different parties
 Thus, Flexibility may be best in the Courts’ hands
o 2. Solicitation, and Marketing invokes our concern of “Investor Irrationality”
 Unlike §11, which deals with a registration statement filed with the SEC
 Here, we are concerned with investor protection
 Therefore, wider ∆ range promotes wider deterrence of fraud and increased investor protection
 Policy issues with §12(a)1:
o 1. Somewhat Draconian Liability
 There are no defenses and no elements required
 Pure Strict Liability
 Even if §5 liability only affects 1 party, §12(a)1 liability ensues
o Provides a strong incentive for the issuer to comply with §5
o 2. Damages akin to a Put
 The downside protection is covered by §12(a)1 damages
 However, this put option gives even stronger incentive to comply with §5
 1. §12(a)2:
 Generally:
o An Anti-Fraud Provision
o Prohibits offer or sale if material misstatement or omission in the prospectus or oral communication
o Standing:
 Pinter definition of “statutory seller” is applied to §12(a)2
o Those who further the financial interest of their own or the person who passes title
 Issuer is a statutory seller
o This gives Institutional Investors ability to bring §12(a)2 against Issuer
o Elements:
 An offer or sale of security
 “By Means” of prospectus or oral communication
 Material Mistatement or Omission
 What is a Prospectus:
o Gustafson v. Alloyd:
 F: Private stock transaction, where π sold Alloyd Corp to ∆. In the agreement, certain representations that were
fraudulent were made. Π sued π under §12(a)2, arguing that the purchase agreement was a prospectus.
 R:
o 1. A prospectus is only documents that relate to a Public Offering
 Only public offerings require a registration and prospectus
 Therefore, prospectus is confined to that area of the law as well for purposes of §12(a)2 liability
 Policy:
 Given the lack of elements, limited to public offering makes sense
 Excludes Private transactions and secondary market transactions
 In Private Transactions, per the Regulations that Exempt:
o Investors are more sophisticated
o Perhaps more rational with their sophistication
o Less information asymmetry exists
o Post-Gustafson:
 §11: Deals with material misstatements or omissions in the registration statement
 §12(a)1: Deals with offering or sale of a non-registered security
 §12(a)2: Deals now deals with material misstatement or omission in Prospectus for Public Offering
o What is available for Private Offerings:
 §10b-5
 State Common Law Fraud
 Negotiate for Private Contract Protections
 In the private, face-to-face transaction the parties may be able to negotiate for more protections
 Self-Protection is available
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 Not as large a collective action issue
 Negotiate for information disclosure
 Other Limits on §12(a)2:
o In Re Valence Technology:
 12(a)2 Only applies when there is an obligation to distribute a prospectus
 Limited to Public Offerings
o Sanders v. John Nuveen:
 There is no reliance requirement
o In Line with Strict Liability of §12(a)2
o In line with Protection of Investors
 Defenses:
o 1. Plaintiff Actual Knowledge:
 π knew o misstatement or omission at the time of her acquisition and bought anyway
o 2. Reasonable Care:
 If the ∆ lacked knowledge and acted with reasonable care
 Essentially, as long as ∆ is not negligent, they are ok
 ∆ bears burden of proof
o 3. Loss Causation:
 ∆ may reduce damages or all if can show that decline in value of shares was due to other than prospectus issue
X. Exempt Offerings:
 A. General Policy:
 1. IPO Detriments: There are many forms of financing, of which the IPO is one
 Detriments of IPO (We allow other options rather then 1 size fits all/Arguments against the IPO)
o 1. Costly
o 2. Stringent Rules and regulatory scheme
 Gun Jumping Process
o 3. Somewhat draconian liability with §11 and 12
o 4. Loss of control over a corporation
o 5. Mandatory Disclosure Requirements once public company
 Public Scrutiny
 Negative Externalities of disclosure to competition
 Cost
 Liability
 May disclose too much, leading to best individuals leaving the public markets
o 6. Underpricing phenomenon
 negative ramifications for issuer
o 7. Time Delay
 may be issue if company needs quicker access to capital
o 8. Costs of restructuring corporation in Delaware to go public
 may be too high for some companies
 2. What benefits does Exempt Offering Afford:
o It is one of the alternative financing methods
 Benefits:
o 1. Reduced Costs
o 2. Increased speed
o 3. Avoidance of disclosures
o 4. Avoid Gun Jumping Rules (§11, §12 along with it)
o 5. Really, essentially avoids all of the above detriments with an IPO
o 6. Sophistication and Information Asymmetry may be less in certain situations
 Ability to negotiate may exist
 Sophisticated parties may exist with less information asymmetry
 Less Collective Action Issues
 Therefore, there may be less need of Securities Laws Regime application
 Redundant otherwise
 Waste of Resources
 Costs:
o Investor Point of View:
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



Reduction in investor protection
Information Asymmetry
Lack of Protection for Irrational Investors
Investor Frenzy/Exuberance still exists without Securities Laws Protections
 Unlike our gun jumping laws which restrict, and quell frenzy slowing the process down
 Sophistication
 This may help, as the securities may lack the exact protections as registered ones
 But
o Even sophisticated investors need information to make decision
o May still need protection
o May still be irrational/exuberant in their decisions despite their financial ability
o Information is still key to them
 Closer Transaction may lead to Increased Fraud:
 In exempt transaction, parties may have more access to information
 However, parties that are closer may lead to more fraudulent behaviors
 Flowback:
 Resale of “restricted securities”
 Investor who has information asymmetry, collective action issues, and lacks sophistication could get
ahold
 Exacerbated use of 10b-5
o Issuer Point of View:
 10b-5
 Stringent §11 and §12 liability if fail to comply with exempt rules exactly, in violation of §5
 Section 4(2) Exempt Offerings:
 Generally:
o Exempts offerings that do not involved the public
o SEC Release of 1935 Defined “Public”
 Number of offerees
 Relationship of parties
 Number of units
 Size of offering
 Manner of offering
o Overall evaluation of participants, scale of units, and manner of distribution
o Most important:
 Nature of participants relationship and access to information
Pre-Regulation D:
 SEC v. Ralston Purina:
o F: Ralston Purina sold $2M of stock to its employees. Offers were made to its key employees. ∆ claims that the transaction
is exempt per §4(2) as not involving a public offering
o R:
 1. Purpose of Securities Regime is to protect investors by promoting full disclosure of information
o If the purpose of the securities laws, information disclosure, is already met—protection not needed
 A “public” offering is when parties do not have access to this information
o Determination:
 Do the parties involved need the protections of the registration?
 Can they “Fend for Themselves”
 If individuals already have the information the registration can provide not public
 If cannot “Fend for Self”
 Vulnerability exists
 Paternalism is legitimate
 Protection the registration affords is needed
 2. Burden of Exemption is on Plaintiff to show it is exempt
o Must show that the offerees do not need the protections afforded by the registration statement
o Policy Of Employers offering shares to Employees Do Employees need protections?
 Employees may be offered shares by employer
 This may be a transaction that registration is not needed
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o They may have access to information
o Issuer/employer motivation may be different
 May be to encourage hard work, to reap returns rather than to defraud shareholders
 Share in company success
 However:
o 1. Still vulnerable to corporation propaganda
 EG:
 Enron/Worldcom encouraged employee share ownership
 Information asymmetry led to massive shareholder losses
o 2. Lack of Diversification
 As diversification can be used to argue that no loss inured to shareholder
 Here, when employees are encouraged to own corporate stock they may not be diversified
 Therefore:
o Loss does exist, and potential for loss exists due to information asymmetry
o In need of protections registration affords
o Policy of Bright Line Test:
 A bright line test of what is “Public” would be beneficial:
o 1. Certainty to issuers
o 2. Ease of enforcement for SEC and efficient use of SEC resources
o 3. Ease of Court review
 However:
o 1. Under inclusive and over inclusive based on who comprises that quantity
 Investors may be extremely sophisticated
 On contrary, investors may be lacking in any financial sophistication, yet fit under “private” quantity,
failing to get protections of the Securities Regime
o 2. Arbitrary number would be assigned
o 3. Ease of Fraud with bright line rules
 Form of something may be to fall under a quantity
 But Economic Reality/ Substance may be in need of protections the Act affords
 Overall:
o The Court rejects a bright line rule as dispositive of what is “Public” or “Private”
o Focuses need of protections Securities Laws provide
 Doran v. Petroleum Management Corp:
o F: Doran bought shares of an oil drilling LP. He was sophisticated. He eventually lost $ on the private placement, and sued
arguing that §4(2) did not apply, and arguing that this was in violation of §5 as a public offering.
o R:
 4 Factors are relevant in considering whether an offering is “Public”
o 1. Number of Offerees:
 Can be few or many
 If 1 offeree is in need of the protection the registration affords, will make the offering public
o 2. Number of Units
o 3. Size of the Offering
o 2. Relationship of the parties:
 Evaluate the information that is available
 Sophistication:
 Pure sophistication is not enough to substitute information available
 Must also be sufficient information that investor who is sophisticated could evaluate
 Available Information:
 Access: those in position to access information that registration would provide
 Disclosed: when offerees actually got the information the registration would provide
 Overall:
o When investors have information that is available either by having access or disclosure,
is a necessary but not sufficient precedent
o In addition, evaluate other attributes
 Policy of Sophistication:
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o Should sophistication, alone, give enough bargaining power to give “access” to information?
o More sophisticated may lead to argument that less protection is needed?
 Yes:
 Sophistication leads to financially sound purchases
 Rationality/ Sophisitcation lead to discounting where need be
 On other hand, leads to smart purchases of good investments
 Could argue that “Caveat Emptor” or sophisticated party is negligent if didn’t ask/seek information
 May give issuer incentive to disclose, knowing that sophisticated parties will not invest otherwise
 No:
 Sophistication, alone, is not enough as Doran held
 Still may lack acess to information
o Information still needed to make decision, regardless of Buffet or Joe-Shmoe
 Access to information is what the Securities Laws are about
o Securities laws do not necessarily focus on investor sophistication, but rather disclosure
o Our laws are premised on investors that are irrational and unsophisticated having equal access
to information on which to make an informed decision
o Skill/Effort then makes the differenceregardless of skill or effort, however, if no
information you cannot make any decision
 May still lack ability to bargain for information disclosure
o Unless very small offering
o With lack of ability to negotiate information asymmetry still exists
o Therefore, key ailments of securities still exist
 Regulation D:
 General Policy:
o Fixed Court’s flawed tests, as SEC clarified exempt offerings
o As a result of:
 Key Policy Issues with Pre-Regulation D Framework:
o Test:
 Courts combined the Ralston Purina, SEC framework, and Doran balancing of access and information
o Effect:
 1. Lack of Certainty and Clarity
 Issuers unclear on whether an offering may or may not be exempt
 2. Liability
 §12(a) 1 draconian liability follows
 3. Court’s Tests Impractical
 Issuers must entertain several analysis and tests that are inconsistent, hoping they don’t screw up
o Complies with Policy Rationales for regulating Securities:
 1. Information Asymmetry still in question
o Less parties, and closer connection gives opportunity to negotiate
o Less need for ’34 Act disclosures
 2. Collective Action still may an issue
 3. Parties more sophisticated
o 506 offering
 4. Not as large effect on Capital Markets in restricted size
o 504 and 505
o 506 has large amount, but decreased risk to capital markets due to sophistication or AI
 5. Fraud Potential remedied by 10b-5
 6. Restrictions on resale deal with flow back and chance that the restricted securities end up in hands of nonsophisticated investors with information asymmetry
o Key Benefits of Regulation D/Exemptions:
 1. Avoid costs of IPO
 2. Avoid registration, gunjumping, and §11 and §12 liability
 3. Avoids redundant protections for sophisticated parties who have the information already
o Key Detriments of Regulation D/Exemptions:
 1. Unfair to smaller investors who may not participate
 2. Even sophisticated parties may need information protections afforded by our Securities Regulatory Scheme
 3. Adds level of regulation that may provide confusion to investors in differing offerings
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 4. Information Asymmetry still exists
 5. Lack of Uniformity
 6. Fraud Potential
XI. Regulation S:
 A. Generally:
o Exemption for Foreign Securities offerings
 Exempt from registration requirement
o Avoid Gun Jumping, §11, §12
 Other securities laws may apply
o 10b-5
 If sufficient contact with US markets exist
 B. Policy Rationale:
o Why do we have it (Given that Issuer may have commercial US presence)
 1. Comity:
o Foreign Country may not respect US laws, if we try to govern an offering far away
o Investors choose which countries’ securities they invest in, and therefore which legal scheme applies
 2. Enforcement Limited
o Difficult for US to enforce foreign transactions
o Requires other countries to apply our laws
o They will certainly want to apply their laws
o What remedy?
 Seizure of US assets?
 Fine in US for something that occurred abroad?
 3. Stretch of US resources
o SEC is busy enough here
o Regulation S transactions make up smaller portion
 4. Impact on US is tenuous
o While capital markets are global, and connected, may be less than direct effect
 5. Reputational harm to US Markets/Companies is low
 6. Harm to US investors:
o A US investor, investing in US markets knows and understands US laws apply
o Investing in foreign, Voluntarily Assumes Risk of foreign laws applying
o Should Regulations follow funds?
 Yes:
 Securities still pose ailments (supra)
 Very protective
 No:
 Reasons above
 Redundant with foreign laws
 Impractical
o Overall:
 Balance of investor protection against what is redundant/waste of resources
 C. Two Basic Regulation-S Requirements:
o 1.Offshore Transaction:
 Offer must not be made to person physically in US
o If So, US laws apply
 Purchase must be either
o 1. Physically outside US
o 2. Executed on foreign exchange
 Policy of Territorial Approach:
o Location of the buyer makes administrable
o Objective evidence is easy to determine of whether onshore or offshore nature
o Clear rule for company to apply and SEC
 Avoids uncertainty of whether §5 applies or not and negative liability schemes
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 Alternative:
 1. Merit Regulation
o We simply don’t allow foreign investing
o No: too paternalistic, and our system is not merit regulation…allow investor choice based on
equal access/don’t limit their opportunities/just a matter of whether our system applies to that
decision or not
 2. Location of Company
o Would also be clear cut rule and more expansive as all companies in US would be subject to
US securities schememore investor protection, as then couldn’t merely offer overseas
o May lead to companies incorporating overseas in “race to bottom,” losing jobs and revenues
o Redundant use of resources
o Limits ability to raise capital
o No clear connection with our capital market/US investors
 Policy of Why we do not always protect US investors:
o 1. If US investors go abroad, they are on constructive notice US laws don’t apply/different laws exist
o 2. Difficulties described, supra
o Contrast with Gun Jumping:
 GJ is premised on irrational/over-optimistic/unsophisticated parties
 Paternalism at its highest
 Why do we remove these protections when securities bought abroad?
 Such investors may be more Rational/Informed investors
o Those that are rational/sophisticated will price this into the stock
o Investing in foreign markets takes more effort than US markets, which are easy for US
investors
o May show that these investors are thus more rational/sophisticated
o With ample opportunity to by US registered securities that directly invest in foreign markets –
ETFs, Mutual Funds, ADRs….its not as common to go directly overseas
o Diversification
 Administrability Need
o The investors may indeed be the same irrational/unsophisticated ones we protect here
o Can’t target
o Voluntarily Assume risk that going overseas, like many things, US laws don’t apply
o But we need clear rules, line drawing at some point—boarders seem it
o SEC has limits to its capability of paternalism
 Foreign Laws do exist
o Comity provides reason to let foreign laws apply
o Foreign Countries are counseled by SEC and have laws—its not that they are lawless, so US
investors buying abroad may even be more protected in certain countries (and less in some)
o Don’t want to be unfair to US companies:
o
Negative to all investors if they leave US for being too burdensome scheme without any
added benefit
o Where would we draw line otherwise? (Non-US companies subject to US regulation?)
 Resource Conservation
o 2. Cannot Target US Citizens Abroad:
 General:
o If offers and sales are “specifically targeted” at US citizen groups, §5 will apply
o Policy:
 Protects vulnerable/unsophisticated/irrational investors
 Paternalism still exists
 Avoids loop-hole, of US companies targeting US investors abroad, unregistered
 What they couldn’t do in US
 Directed Selling Efforts:
o Similar to Gun Jumping “Offer—“ conditioning the market
o Allowed Communications:
 1. Required Advertisement in newspaper
 cannot include any more than legally required boilerplate
 2. Limited Tombstone
 With factual/non-soft information
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 Policy:
 Foreign companies need to advertise/communicate with US customers/investors
 Analogous tension to Gun Jumping Rules
o WIKSI continuing need to communicate with secondary market
o Here, foreign issuers need to legitimately advertise in US, but this may constitute a Direct
Selling effort
o Internet:
 Foreign Issuers;
 Foreign issuer must implement procedures to avoid targeting US investors (disclaimer or get address
prior to sale)
 Domestic Issuer:
 Domestic Issuer selling securities abroad should implement “password-type” procedures that are
designed to ensure only non-US citizens can access the offer
 Policy:
 The internet poses a policy concern, as vast amounts of information flow through it
 Is it even worthwhile to control, or should simply focus on territorial concern
 Control:
o Internet otherwise would be loophole to scheme
o Easily condition market otherwise
o While issuer needs to communicate with its customers/ limitations regarding the offer are
reasonable
o Virtual Boarder is needed to supplement physical territorial boarder
o While we should focus on physical location of US citizen, if we fail to police internet
transactions, may erode physical concern as information would easily reach into US
o Overall:
 If outside US/Purhcased on foreign exchange US Securities laws don’t apply:
 Policy of Foreign Exchanges:
o 1. Investing directly on foreign exchanges
 May clearly be VAR, as they may be more aware that US laws simply don’t apply
 More sophisticated an investment to do so, so more reasonable to think they are aware of this
 Unsophisticated/Irrational investors may be unlikely to do so
o 2. Foreng Exchange
 Is a regulated foreign body, typically, so laws clearly exist in this context
 Arguments for Regulation S, then, are at their strongest
 D. Potential Alternatives to International Securities Regulation:
o 1. International/Uniform Securities Regulation:
 Scheme:
o An international regulatory body, regulating securities globally
 Benefits and Detriments:
o Benefits:
 1 Consistent system of regulation
 Predictable to Companies and Administrable by 1 regulatory body
o Detriments:
 Politically Unlikely
 Getting agreement would be difficult to harmonize regimes
 EG:
o IFRS, accounting standards
 Regulatory Body
 More complex to organize, and may be logistically impossible to react to hundreds of countries new
securities issues, local languages of disclosures, etc…
 Capture would be more easy, as only need to capture 1 body (no check on the system)
o 2. Issuer Nationality
 Scheme:
o Issuer’s home country law regulates transactions
o Similar to Delaware Internal Affairs Doctrine
o Regardless of where transaction occurs, consistent predictable set of laws applies
 Benefits and Detriments:
o Benefits:
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 Predictability to Corporation
 If rational investors
 Foreign investors would be able to price into security the differing securities regimes
 If security laws are not strong enough, investors may discount significantly
 Company cannot raise capital, and therefore cannot grow and hire
 May give incentive for country to adequately regulate securities then
o Detriments:
 Home country may not have incentive to protect foreign investors
 Investors may be unable to discount appropriately
 Enforcement Issue
 Logistically infeasible to police US companies dealings with foreign investors per SEC
 Race to Bottom
 If Countries laws are what applies, similar to Delaware, race to bottom may occur for securities
regulation
 Avoidance of costly regimes, incorporating in foreign country
 May lead to overall investor welfare decrease, as securities regulations erode
o 3. Issuer Choice
 Scheme:
o Issuer checks the box of countries’ laws they wish to apply to them
 Benefits and Detriments:
o Benefits:
 Competition among countries for securities regulation
 Freedom to select increases competition, like competition for state corporate charters
 Allows corporation certainty in what laws apply
 Corporation’s interest to select viable country
 Rational investors would discount scheme otherwise
 May chill capital raising ability
 Reputational effect on corporation too
o Tradeoffs:
 Investor inability to price discount into stock/unsophistication of understanding significance of different
countries securities regimes
 Enforcement Difficulties
 Race to bottom concern
 Competition may not necessarily be the best thing
 Like Opt-In Securities Regime
 Laws may benefit corporations and lack in investor protection
 E. 3 Categories of Regulation-S offerings:
o 1. Category 1:
 A. Foreign issuer may use with no substantial US market interest
o US Market Interest:
 1. US exchanges cannot represent largest market
 2. 20% of securities of trading occurs in US, with less than 55% in foreign countries
 If so Category 1 does not apply
 Policy:
o <50% number shows that trading is more likely than not to have US market interest
o Simply line drawn. If greater than 50% foreign—more likely than not foreign interest
o If less than 50% foreign, not more likely than not foreign
 B. Overseas directed offering in single foreign country
o Offering in foreign country
 Policy Concerns:
o 1. Flowback
 We are largely concerned with the flowback of unregistered foreign securities into US markets, and the
hands of US investors
 With less trading, or minimal trading in US markets, less likely that flowback will occur
 Shares would be:
 Illiquid in the US markets
 Marketability Discount in US markets
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 Therefore, with another liquid market trading elsewhere, shares would gravitate there
o The further removed from US market effect
 Less Policy reason to regulate
o Category 1 provides the least risk of flowback from Foreign Issuers
o 2. Category 2:
 For companies with substantial US presence that want to sell in more than one country
 1. Foreign Domestic Issuer versus Domestic Issuer
o We give more latitude to foreign issuer:
 Decreased Risk:
 1. US investors would be interested
 2. Flowback into US markets
 3. Greater likelihood of conflict with foreign markets
 2. Exchange Act Reporting or Not:
o Exchange Act reporting foreign may issue equity/Non-reporting may not
o Exchange Act reporting domestic may issue debt/non-reporting may not
 Policy:

Exchange Act reporting issuers are more likely to have:
 1. US investor interest and
 2. Flowback, and if does occur, disclosures will ease harm to investors
 3. Debt versus Equity
o Domestic issuers may only use Category 2 for debt
 Policy:
 Debt has less risk and more safe to investors
 As they are more widely known in US, flowback occurring would be less risky with debt
 Less information asymmetry than equity
 Equity, however has more information asymmetry and is more difficult to value
 Restrictions:
o 1. 40 Day distribution compliance period
 Ensures that during offering period, issuers are not making unregistered non-exempt distributions into the
US markets
 Must agree in writing that all offers/sales during period will be in compliance with exempt transactions
o 2. Disclaimer
 Each document must have disclaimer that unregistered securities may not be sold in the US or to US
person except under exempt Regulation S
o 3. Category 3:
 Catch All Category for issuers who cannot meet category 1 or 2
o Applies to US issuers seeking to sell equity overseas
o Foreign Issuers selling equity that cannot meet category 1
o Comply with:
 Category 2 requirements
 Largest risk of flowback
o More liquid exchanges exist
o More chance that securities will make their way there
o Greater risk to investors then, if unregistered securities flowback
o Therefore, Category 3 is the most restrictive
 Restrictions:
o No sales must be made to US person or US person’s account
o If issuer sells to a distributor, must send notice to them that they have to comply with Regulaton S
 F. Resales:
o Regulation S creates restricted securities
 They cannot be resold unless exemption applies
o Exemption 904:
 Can resell as long as no direct offering in US
 Offer or sale must take place in offshore transaction, where buyer “reasonably beleieved” to be outside US
 Or resale on foreign securities market recognized by SEC as Legitimate (LSE, NEIKEI)
 Policy of Regulation S:
o Advantages:
 1. US issuers may sell offshore without regard to sophistication or size, like Regulation D
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 2. No specific information requirements
 3. Advertisement allowed offshore, if not directed sale
 4. Speed of offering and access to foreign capital
o Disadvantages:
 1. Flowback risk
 2. Decreased investor protection
 3. Unsophisticated/irrational investors are underprotected
 4.There is argument that flowback justifies expanded US regulation
 5. Overlapping regulations may increase costs for issuers and conflict
 6. Enforcement is an issue
 7. Foreign Countries may expect comity, resenting extension of US laws