Securities Regulation.docx

Securities Law Introduction The Basics Purpose of securities laws protect investors from abuses by company insiders and professionals reasons for passage Encourage full disclosure and deter fraud full disclosure get full information to investors information money sources insiders issuers analysts not as good sources Lack access Institutional pressure to provide optimistic advice fraud correct the agency problem with respect to disclosure response to Great Depression stock market crash Mechanics Regulate transactions involving securities common stock preferred stock bonds Two types of transactions primary issuer offers and sells own securities to investors Act secondary investor resells securities of an issuer to another investor Act information is paramount allows investors to invariably get higher returns insiders have the most information without regulation they could profit on their own stock regular investors get information from analysts who have less info than insiders Laws regulating disclosure and promoting information exchange Exchange Act of focuses on secondary transactions regulates intermediaries BD and exchanges established SEC develops rules and regs to interpret and implement securities laws and enforce statutes and regulations Securities Act of focuses on primary transactions Bodies Securities and Exchange Commission SEC develops rules and regulations interpreting implementing and enforcing securities laws What makes securities special why not regulate other things preferences are somewhat homogenous expectation of profits risk makes providing information easy economies of scale centrality of capital markets to our economy shift money from low to high-value use high stakes for getting the right price intangible difficult to assess value without help value in voting rights profits investor irrationality frenzies Theme is regulation that was justified in s still justified today Types of Securities Common instruments interests in a corporate entity types of ownership attributes rights to cash flows assets in liquidation voting power different instruments contain different combinations of these rights Security Cash Flow Rights Liquidation Rights Voting Rights Common Stock Residual and discretionary dividends Residual Yes Preferred Stock Fixed and discretionary dividends Medium Contingent on non-payment of dividends Debt Fixed and certain interest payments High None Common Stock no legal requirements on rights produced by market high voting power ability to elect the board board and officers owe a fiduciary duty to the common stockholders duty of care and duty of loyalty to pursue their best interests No fixed monetary claim residual claim on dividends share of profits only after all other ownership claims are satisfied NO requirement to distribute money to common shareholders board may approve asset distribution to common shareholders issuing dividends or repurchasing stock dividends must be pro rata repurchases may be through private transactions not pro rata except for tender offers must be pro rata why distribute fiduciary duties of care and loyalty provide a weak impetus for board to declare dividend BJR protects board decision not to declare dividends it may be better to invest the money shareholder passivity often prevents any real consequences tax consequences old ordinary tax paid by s h on dividends Corporation would retain new preferred capital gains rate Big distributions assets in liquidation absolute priority rule order of payouts on liquidation Contracted creditors preferred shareholders common shareholders not always followed Chapter g s h may bargain for higher claims Preferred Stock Not in all companies Second class of stock senior to common a k a Class A common Not mandated by state law Typically negotiated by contract and are highly variable Why issue Startups high risk need fast infusions of cash Venture capital firms provide major sources of funding Preference over common s h ing entrepreneurs tradeoff some upside return but not as much as common stock solution to tradeoff convertible preferred converted at s h will into common at a predetermined price Useful for IPO Established firms sometimes need fast infusions of cash VC companies like BerkHa Buffett invest in preferred stock to give cash and limit downside risk Types of stock convertible preferred participating preferred often used by VC give right to residual distributions as if they hold common shares but with higher liquidation rights Features of preferred shares no fiduciary duties unlike common dividends priority in fixed dividends which cumulate if not paid Preferred must be paid in full before common liquidation senior to common receive any cumulated unpaid dividends contracted-for share of assets before common gets anything voting rights typically none unless divs unpaid for a contractually-specified of quarters then some preferred shares get voting rights privately negotiated contractual provisions Bonds loans from investors to company forms notes short term debt years indentures long term debt mechanics initial investment principal fixed interest payment on and until maturity date types zero-coupon no interest Sold at a discount to principal but paid in full at maturity can raise money w o requiring periodic payments others periodic interest payments why have provide investors with high financial security features absolute priority rule priority over equity in liquidation though bankruptcy sometimes works around contractual protection senior notes have contractual priority over junior notes asset-secured bonds highest priority on those assets covenants for bondholder protection for example to avoid liquidations where assets will not cover their debts requires an equity cushion Capital Market Transactions can take place in private negotiations or through organized markets with BDs Organized markets provide liquidity ability to find investors easily and without cost Intermediaries step in if no side of investors don t go to park to sell shares buyers there will want discount transparency improves info flow can see last trade price and gauge the best price Primary Market Transactions Used when co needs large cash influx unnecessary if have high retained earnings Mechanics direct with public by negotiation issuing rights to purchase shares to current s h Rare Public offerings using intermediaries like CSFB and commercial banks Intermediaries Underwriters Investment banks assist issuers in making a public offering provides expert advice sometimes takes on financial risk firm commitment offering e g u w syndicate buys shares at discount but bears full risk in selling shares Compensated by the spread Attorneys assist with the regulatory issues Draft disclosures for SEC Accountants audit the books of an issuer so helps s h determine future value expected return based on past value Ensures investor confidence lowers cost of capital highly dependent on their reputations due to some high-profile missteps like Arthur Andersen Congress passed Sarbanes-Oxley in to regulate accounting and oversight Institutional Investors Dominant force in the securities market Mutual Funds aggregate small investor sums and invest in portfolios index funds reinvest funds into a defined broad-based basket of securities actively-managed funds research investment opportunities to determine where to put investor money More expensive to invest in for investors but oftentimes greater returns Pension Funds insurance Companies Regulatory consequences of mutual funds in primary market benefit sophisticated investors do not require protection drawback use leverage to cut sweetheart deals IPO laddering e g Secondary Market Transactions Like primary markets rely on transparency and liquidity Encourages investors to invest money otherwise they demand illiquidity discount Venues for transactions one on one transactions - large investors selling or buying large blocks small investors use brokers Types of order market order I will buy sell at market price limit order I will buy sell for no greater less than X price Matching brokers will match buy trades with sell trades for the same price to execute a transaction they will first look internally to their own customers failing that they go to a trading forum exchange Nasdaq or ECN Securities Exchanges Largest NYSE Others AMEX pacific Philly etc Purchases and sales made in a physical location by floor brokers at trading posts with either specialists or other brokers Specialists act as agents of the brokers matching orders between brokers If there are not enough matching orders short-term imbalance NYSE specialists required to trade from their own portfolio They maintain a book of limit orders Specialist scandal interpositioning If two brokers approach a specialist and broker B wants to buy for more than broker S wants to sell for both parties can gain from the transaction In interpositioning specialist buys from S sells to B and pockets the profits NYSE imposes listing standards companies must have board where majority of directors are independent NYSE monitors market for securities law violations requires broker-dealers to be members Nasdaq Three types NMS Small cap BB NMS - most demanding listing requirements Market Makers continuously willing to purchase and sell a security for own account at publicly quoted prices They post a bid and an ask offer If they calculate correctly bid MP and ask MP Too high and everyone will want to sell to them Too low and everyone will want to buy from them BAS compensates MM for providing liquidity bearing risk Competition amongst MMs narrows bid-ask spread reduces transaction costs Nasdaq Level II Workstations every broker has one shows the current quotes on the market the inside quote and the last few transactions to show market direction NASD is a shareholder in Nasdaq and is a SRO self-regulatory organization SEC makes sure it actively protects investors ECNs Electronic Communications Networks - separate from NYSE NASD no intermediaries They match up buyers and sellers directly maintain limit order books if there are no matching orders Investment Decisions Two factors in valuing an investment risk certainty better than uncertainty timing immediate better Price Present value of expected return Present Discount Valuation Interest Why discount monetary value impatience deferring consumption you may die and not get your return inflation erodes purchasing power uncertainty of getting return based on risk of default or overall risk of investment you will require a risk premium be paid to you Present Value Amount of money the market would pay today to receive the future money Components expected value expected net profits and expected return from net profits discount time value of money riskiness of investment What Risks Matter Most investors are risk averse given equivalent expected values in two investments investors will choose the one with lower risk less variation between winning and losing returns combined with S D the shift of investment towards risk-free instruments will raise those prices and lower prices of risky investments Lower price of risky investment compensates investor for taking on risk However if the risk is diversifiable typical for the stock market then there will be no risk premium paid Risks that can be reduced through diversification are unsystematic risks does not affect all companies in a similar manner Systematic risks cannot be diversified like the fed interest rate which affects everyone the same Capital Asset Pricing Model CAPM - return for any given stock is the function of the risk-free rate R f and the beta relationship of security s return to the overall stock market return R m CAPM R R f beta R m R f High beta high systematic risk high discount rate Who Provides Investor Information Informational advantages lead to more profitable trades and disadvantage the outside investors Primary goal of Securities regulations - fix this disparity Incentives to Provide Information Value of info depends on number of traders who know it Inverse relationship widely-known info is already incorporated into stock price and even unwitting consumers are affected by it Two types of info Outside Inside Incentives to disclose inside information boost up your primary market price if nobody discloses investors will invest at the average value Some companies win some lose high-value companies will attract purchases by disclosing that company is above average if subject to antifraud liability then their disclosure has some credibility Disincentives if you don t have an offering any time soon however you will still disclose if that generates a good rep in the secondary market which will make future investors more likely to engage in primary transactions in your security antifraud liability does not help for low value companies lemon effect low value companies commit fraud forcing high value companies to sell capital in other ways leaving only lying low value companies on the market managers can profit from inside information SEC regulation only triggered if info is material incentive to disclose information applies only to inside information but outside also creates disparities Market Solutions third party certification u w and auditors rent their good reputation and credibility counter-example Arthur Andersen and Enron Research analysts research and disclose both inside and outside information buy-side analysts work for mutual funds and tell them how to invest sell-side analysis work for brokerages and their analysis is sold to clients built into their commissions recently commissions have been deregulated dropped substantially lower profitability for analysts shift towards analyzing companies undergoing offerings but this creates a conflict of interest between the investment bank and the analysts Argument for Mandatory Disclosure Incentives above not perfect Mandatory disclosure may increase investor welfare affirmative benefits listed below Coordination Problems problems arise when investors cannot compare two competitors Similar accounting standards and disclosure requirements will fill this gap Existing issues Foreign accounting requirements German differ from US GAAP in that foreign requirements allow reserves companies can shift profits from good to bad years Nevertheless the market may penalize companies who do not use a standard non-conformity could be evidence of a problem Agency Costs Disclosure keeps costs low allows investors to assess the performance of managers financial performance compensation packages insider trading all help investors determine which managers should be replaced Without mandatory disclosure incentives for managers to keep quiet on these topics For IPOs much potential for mischief unless mandatory disclosure Positive Externalities There is clear public benefit from disclosure helps investors to accurately assess the stock price it also subsidizes the efforts of analysts giving them info to work with useful to competition either neutral or bad for the issuer They will not consider this benefit incentives may induce to disclose for s h benefit may induce not to disclose or competition benefit Problem no guidance on the optimal level of disclosure Why is SEC any better than market Duplicative Information Research Investors expend huge amounts of money to get an informational advantage costs are duplicative many investors spend money on the same information insiders are the lowest-cost source of inside information and can curb this wasteful expense Costs of Mandatory Disclosure Regulators may not achieve the optimal level of disclosure for several reasons Behavioral biases optimism in own abilities tunnel vision Agency capture some regulators may act to help firms and bankers Moves to increase SEC authority bureaucratic politics model How does information disclosure matter Even with full disclosure the cost in terms of time and complexity is immense for investors Smaller individuals don t pay attention larger better equipped to take advantage They still benefit filtering of information by intermediaries efficient markets incorporate all public information Filtering Mechanisms Brokers tell their clients relevant info Some clients just pay money to active-managed mutual funds to invest for them Both situations lead to high agency costs and can be bad for investors boiler room brokers may cold call investors tout hot investments and take commissions while investors lose Efficient Capital Market Hypothesis Actively traded securities will incorporate information related to the security into its price Three versions dependent on level of incorporated info weak semi-strong strong Weak ECMH Current price reflects information in all past prices Because past price information is very cheap and easy to find this version seems to work Therefore knowledge of past prices do not help investors predict future prices random walk Semi-Strong ECMH stock market price reflects all relevant publicly available information actively traded stock this information is costlier to find than stock price but still relatively easy if everyone knows the information the market will reflect it If some people know the information they will trade and others can depend on their trading because they re risking their money Strong ECMH stock market price includes all information empirically false insiders still manage to profit more than average investors this would not be true if strong ECMH holds if true we would not need securities regulations at all Implications of ECMH semi-strong version influences SEC regulation financial disclosures are allowed to be incorporated by reference which presumes that the market already knows them Basic v Levinson fraud on the market theory defense show the market is inactive or isn t tracked by many analysts Arguments against ECMH investors are irrational noise trading substantial amount of trading is random Institutional investors ride the wave rather than arbitrage the noise they hope to profit from it over-optimism by investors in their own ability to make rational choices loss-aversion and over-pessimism in investors can deflate prices bubbles over-enthusiasm raises stock price Two types of efficiency Fundamental efficiency price represents discounted value of future cash flow suggests that we should not have regulation Investors would incorporate everything and pay less for stock where the information is false Incentives to disclose true information Informational efficiency underlying value is wrong but the relative changes in stock price accurately reflect new information on the market works its way into damage measures Regulatory Apparatus Federal Securities Laws Securities Exchange Act of Exchange Act Act Regulates secondary market transactions intermediaries and institutions periodic reporting requirements for publicly traded companies Exchange Act reporting issuers Disclosures Periodic reporting -K -Q - descriptions of business directors and officers ownership structure past financial statements -K major events bankruptcy change in control Antifraud Liability b- prohibits fraudulent disclosures and insider trading implicit private cause of action encourages attorneys to file suits with only minimal evidence of fraudulently disclosed materially misleading information defendants often settle non-meritorious claims to avoid a suit PSLRA passed in response Anti-manipulation provisions e g of manipulation stock pool members buy a stock to generate upward momentum and sell before the price drops Broker exchange and dealer registration with SEC required Regulates shareholder voting by mandating disclosure in connection with the solicitation of proxies Securities Act of Securities Act Act primary market transactions mandatory disclosure documents for initial public offerings registration statement prospectus repeats part I of registration statement disclosure requirements same as those under Exchange Act integrated disclosure - info on business property material legal proceedings d o financials shares offering price use of proceeds offering procedure regulated gun-jumping rules goals wide distribution of prospectus sent to investors before other written information prohibition on additional information quiet period heightened antifraud liability for material misstatements in public offering documents material misstatements omissions creating half-truths Investment Company Act of and Investment Advisors Act of Investment Company Act regulate mutual funds directors managers and advisors certain investment companies must register with the SEC requirements on the governance of the fund the capital structure and insider transactions regulates disclosure to fund investors mandatory for fund objectives risks performance Investment Advisors Act advisers must regiser with the SEC avoid fee arrangements and maintain books and records Limited advertising allowed no testimonials Trust Indenture Act of regulates contractual terms relating to publicly issued debt bonds notes debentures formal agreement between issuer and holder called a trust indenture must provide for appointment of public trustee to represent bondholders Public Utility Holding Company Act of PUHCA Regulates electricity interstate natural gas holding companies etc Cannot take funds generated by regulated business and use them for non-regulated activities SEC can use rate regulation governance restrictions and transaction regs to affect utility size rarely used anymore Sarbanes-Oxley Act of Recent major legislation response to Enron Worldcom Adelphia GLBX Tyco regulates all significant capital market players Establishes Public Company Account Oversight Board to regulate accountants Prohibits auditors from undertaking certain non-audit tasks Requires company audit committees Rule-making authority to SEC to encourage objective analysts Reg AC Certification requirements for information in filings and internal control structures increases fines and criminal penalties for white-collar crimes Securities and Exchange Commission SEC Tasked with monitoring market enforcing securities laws and developing new regulations established by Exchange Act Governance commission commissioners w as chairman President appoints commissioners but from same political party Divisions Corporate Finance handles information disclosure by issuers to investors reviews periodic filings from Act and IPO filings reviews all forms reviews and proposes changes to the regulations and forms provides guidance on complying with the rules and forms Division of Market Regulation Regulates securities professionals on the public capital markets regulates broker-dealers SROs including NASD NYSE definition of broker-dealer unclear after Internet where entrepreneurs made websites to help effect private placement offerings B-D registration required if website is in the business of effecting or including transactions in securities Division of Investment Management Regulates investment companies and investment advisors mutual funds included which were thought to be clean but are now scandal-plagued late-trading NAV calculated at pm Late-trading means you purchase at pm today and you get today s pm NAV which should not be allowed it should be tomorrow s NAV Division of Enforcement investigates securities law violations often results in negotiated settlements large settlement in with wall street firms related to analyst research and investment banking analysts cannot receive comp for banking activities or be involved in roadshows research dept s budget and analyst comp not tied to revenues from IB Methods of Influence over Capital Markets Formal Rulemaking Divisions propose ruls commissioners have ultimate authority to approve new regulates after notice and comment period Enforcement Actions brings civil enforcement actions for violations of the securities laws No Action Letters letter stating that the staff will take no action if a target company complies with certain details spelled out in the letter written by staff not commissioners Does not preclude private litigation Communications Commission s releases announcing enforcement actions setting forth interpretations proposing and explaining rules Self-Regulatory Organizations SROs quasi-private regulatory entities like NASD and NYSE SEC may approve or modify SRO rules as it deems necessary or appropriate to insure the fair administration of the SRO - Act NASD established in Private non-profit membership-based org composed of broker and securities dealer members regulated B-Ds in the US and primary OTC market in which the trade Nasdaq SEC requires it to adopt rules designed to prevent fraudulent and manipulative acts and practices to promote just and equitable principles of trade and in general to protect investors and the public interest imposes suitability requirement on brokers Rule must have reasonable grounds for believing recommendations are suitable for the customer on the basis of facts disclosed by the customer as to his other holdings and needs brings enforcement actions against B-Ds provides a disclosure system to check up on broker backgrounds and disciplinary history maintains arbitration system for brokers and clients broker sold unsuitable securities to investor broker churned investor s account for commissions failed execution of orders resulting in customer loss provides speed and low cost in exchange for possible fairness and consistency NYSE and NASD listing requirements minimum capitalization and asset requrirement minimum corporate governance requirements including director independence rules establishment of audit committees executive compensation committees and director nominating committees consisting entirely of independent directors PCAOB created in SOX -member board two of whom can be CPAs oversees audit of public companies and establishes auditor independence requirements registration of public accounting firms SRO so subject to enforcement and oversight of SEC Materiality What Matters to Investors disclosure is a focal point because shareholders need to evaluate performance of management Material Info Info important enough to warrant regulation b- covers disclosures filed with the SEC and voluntary disclosures like press releases untrue statement of material fact half-truths omitting to state a fact necessary to make the statements made in light of the circumstances not misleading Statement made Duty to tell the whole truth MUST BE MATERIAL burden on P or SEC Generally silence is golden no duty to volunteer information Except Insider trading under b- fraud of pure omission duty to disclose all material facts before buying and selling in the company s securities Beyond antifraud liability materiality still matters SEC mandates disclosures in -K and -Q with Regulation S-K ex ante materiality little discretion in what to provide regardless of true materiality some of the info in S-K is required only if material as specified in S-K b- in addition to S-K requires that anything should be disclosed to not make any other disclosed statements not misleading i e half-truths also Rule Standard of Materiality TSC Industries v Northway material if substantial likelihood that the disclosure would have been viewed by the reasonable investor as having significantly altered the total mix of information made available who is reasonable what is total mix what is significantly alter Balance require what s important to shareholders avoid information overload expense to company of providing useless information b- public and private antifraud liability in securities transactions unlawful for any person b to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made not misleading in connection with the purchase or sale of any security b- half-truths In addition to the information expressly required to be included in a statement or report there shall be added such further material information if any as may be necessary to make the required statements in the light of the circumstances under which they are made not misleading Rule half-truths in registration statement otherwise same as b- Forward-Looking Information Basic v Levinson p Outlines general standard of materiality and guidance for forward-looking information clear issues of how a company can assess what is material ex ante Facts Basic denies any merger negotiations December it tells the NYSE to suspend trading and announces that it has been approached by another company The next day it endorsed a merger offer Those who sold stock after the first public statement and before the suspension sue for damages Allegation sold at artificially depressed prices for a loss in a market affected by misleading statements and respondents reliance thereon Discussion TSC Northway set the reasonable shareholder standard for proxies but tried to balance this against an overabundance of trivial information in order to bury important info Substantial Likelihood reasonable shareholder would think it alters the total mix This court adopts the TSC Northway standard in the b- context Particular to forward-looking statements impact is contingent and speculative rather than certain and clear and thus difficult for a company to ascertain significance to a reasonable investor Purpose of Act protect investors against manipulation Full disclosure Competing tests Court rejects rd Circuit Agreement in Principle not material until a price is set why don t overwhelm investors with info on things that may collapse protects confidentiality of merger discussions Bright-line reason for rejection investors know that a merger is not guaranteed Disclosure not paternalistic withholding of accurate information is the policy chosen by Congress secrecy rationale does not apply here we re talking about accuracy of information and not its timing Don t permit lies investors will expect them and discount the stock price bright-line ignores Congress s intention and would be over- or under-inclusive Reasonableness is the standard not ease of application Rejects th Circuit tries to set a bright-line rule that once any statement is made about lack of mergers all subsequent discussions must be disclosed because otherwise the initial statement is untrue court rejects because the fact of the merger must be material Adopts nd Circuit Probability Magnitude test from Texas Gulf Sulphur Probability indicia of interest by board e g board resolutions instructions to investment bankers and actual negotiations Magnitude size of the entities potential premiums over market value VERY ANTI-PATERNALISTIC Notes reasonable shareholder objective standard TSC said this is to be determined at the trial level though many courts ignore forward-looking info soft info SEC assumes investors particularly vulnerable to overly-optimistic info Also useful to investors - Congress protected w Safe Harbor from PSLRA issues to consider if you want to keep it secret don t say anything which rule is best for shareholders depends on what maximizes corporate wealth mergers not necessarily material that s what the court said reasonable v unreasonable investor this is not very scientific hindsight after the event investors no idea of prob or mag Historical Facts Different from forward-looking because they are definite nevertheless their materiality is questionable because they can be murky particularly in fuzzy areas like accounting Ganino v Citizens Utilities Company d p Court rejects common-law rule of thumb based on for determining materiality Facts Citizens tried to run their books to make it look like they increased earnings Lost major client and entered into a loan transaction with another but reported the earnings from that transaction the year after they occurred to boost earnings for that year Reported huge boost in earnings but almost entirely due to the misbooking Decision material Reverses DC s bright-line - rule on market impact here Discussion Pleading stage materiality satisfied by alleging a statement omission and that a reasonable investor would have considered it significant RULE Under b cannot be dismissed for immateriality unless the fact was so obviously unimportant that reasonable minds could not differ no need to assert that the investor would have acted differently without the statement Basic v Levinson rejected the use of bright-line materiality tests Ease of application is not an excuse for ignoring the purposes of the Securities Act SEC Staff Accounting Bulletin No on financial stats non-binding qualitative factors may cause quantitatively small financial misstatements to be material Factors to consider whether the misstatement masks a change in earnings or other trends here Citizens had posted straight years of increased earnings whether the misstatement hides a failure to meet analysts consensus expectations for the enterprise Application magnitude of misstatements upwards of in all cases Court will not say they were immaterial different from saying they were necessarily material the fact that these were intentional deceptions and accounted for all of the reported earnings in that period would make it significant Market Response there was no stock price movement Earnings per share dropped Drawing all reasonable inferences against the moving party the court determined that they cannot conclude that the price did not drop undermining market response confounding facts information leakage Note trends important because they give investors a sign of what to expect problems with bright line rule using earnings rather than revenue may distort test management integrity is important NO CASE YET ON WHAT HAPPENS IF IT S OVER THE THRESHOLD Harken Energy problem of relying on stock price movements Different Rules for Materiality Rules of thumb rejected by Ganino but many courts still refer to them e g Food Lion Event Study stock price reaction around the date the information was released one way the courts handle the ambiguity set forth in TSC s materiality standard but remember Harken Energy stock price drop stock price increase Which is the true market reaction Total Mix if it s already in the total mix it s not material Food Lion Meditation not a legal term of art Judges just ask themselves whether this is something a reasonable investor would find important No real benchmark Opinions Virginia Bankshares v Sandberg p Facts BOD sent out proxy statements to minority shareholders urging approval of a cash freeze-out merger BOD urged approval because of high value and fair price of offer Allegation that BOD did not believe this Issue Proxy rules but analogous to b- Even if material are mere opinions actionable Defense said this would lead to wasteful litigation courts only want litigation when there s objective corroborative info not under plaintiff control not true because the underlying facts behind the opinion are provable Holding knowingly false statements of reasons may be actionable even though conclusory Materiality not big issue generally shareholders assume that directors have knowledge and expertise So a s h will find D s beliefs important in a proxy question Rule Opinions may be actionable if underlying objective facts available how are the statement factual underlying substance statement that directors believe what they are saying the statements high and fair are conclusory but P may interpret them to rest on factual basis If that basis is not there then the statements are misleading Because based on prices numbers are provable in the sense that there could be a valuation Ibanker thought the market was closed and dominated And evidence that shares were worth more Rule disbelief or undisclosed belief without facts insufficient for action under a no objective evidence that the statement expressly or impliedly asserted something false or misleading about its subject matter that this will not narrow the causes of action because the two will not often arise separately but the alternative disbelief alone would give rise to strike suits a very bad idea Rule if factual information that would render the depends on materiality misleading statement not misleading then no action if the factual info has capacity to influence the reasonable shareholder for immaterially misleading statements combined with truthful statements the misleading may no longer risk deception Here defendants truthful statements did not eliminate materiality of false statements directors did not disclose that they had no expectation of keeping their seats without supporting the merger disclosure failed to mention the dominated market everything was a half-truth Total Mix Leads to the truth on the market defense courts use total mix formulation to dismiss suits that they perceive to be weak or non-meritorious Info that s normally significant may be immaterial if already part of the total mix Longman v Food Lion th p Court applies the truth on the market defense ABC News broadcast a story about labor law abuses by Food Lion Grocery Stores Stock price fell Shareholders sued alleging that Food Lion failed to disclose that their stock price was inflated due to misrepresentations and omissions about some labor violations Three main events Annual Report saying nothing Complaint filed by Union on on labor violations response to union Complaint - FL has a clear policy against working off the clock FL EEs reject the unions efforts Second Press release FL launches investigation Argues that illegal employment practices or off-the-clock work that contribute to FL s success and low prices ABC News Report leading to price decline Settlement with DOL cost M or per share Stipulated that it was not material Issue did Food Lion make a false statement a factual statement or omission that is demonstrable as being true or false Was it material Definition of materiality would have led a reasonable investor to consider the info important in deciding whether to buy sell the security would have viewed the total mix of info to be significantly altered by disclosure Three issues of materiality total mix Plaintiff s labor claims cannot succeed FL denied the charges after the broadcast but the information was already known to the market after the complaint was filed in Market had full opportunity to research claims interestingly complaint one-sided v penalty not one-sided court ok with saying that the complaint incorporated the info Experts also agree that the complaint was not material because the impact settled two years later was on stock price seems like a rule of thumb as defense attorney you d argue that this was incorporated right after broadcast Questions to consider how far has the information permeated the market would a reasonable investor know if the market already has information seeing it a second time makes no difference is the total mix the investor the broker or the market what if info comes on two different documents who needs protection sophisticated or unsophisticated Puffery the market has to not care about a statement we will earn per year for the next years Arguable Inst investors know it s BS but ordinary investors may not we will earn trillion next year Puffery Nobody believes it Definition of Security Securities Act a definition of security Any note stock bond investment contract or any interest commonly known as a security Exchange Act a definition of security Same as above except but shall not include any note which has a maturity at the time of issuance of not exceeding nine months Do Securities Laws Apply definition of security is expansive but less so after enumerated list stocks bonds etc unless otherwise required narrow exception for alternative regulatory schemes see Daniel and Weaver catch-all provisions investment contract TESTS if name unclear go to Howey test if name stock go to Landreth Forman name generally dispositive Then to Howey if fails characteristics of stock if name note must see Reves factors before determining Defining a security is a threshold issue to be covered by securities laws consequences Act b- SEC monitoring enforcement sanctions Act registration prospectus delivery and gun jumping rules in - Anti-fraud Public offering exemptions Policy question should the securities laws apply to this transaction savings account not a security for example historical justifications for laws Great Depression patch holes in state blue sky laws correct for information asymmetry is the company and market pro better able to value the security than an outside investor Can they exploit the info advantage lag time in being able to realize disappointment in a security wait for price to drop as opposed to a tangible good you know right away strong national market is investing a substitute option in your plan Daniel mandatory disclosure are there collective action problems investor irrationality frenzies lots of people seeking same information congress concerned with regulating investment market not creating general cause of action for fraud Investment Contract Economic Reality substance over form Catch-all provision defined by SCOTUS in the Howey test Test must meet all four factors Contract transaction or scheme Investment of Money in a Common Enterprise with the Expectation of Profits Solely through the efforts of another promoter or another third party SEC v WJ Howey p Facts securities offering so Howey-in-the-Hills offers prospective customers slices of land land sales contracts warranty deed services contracts to most customers HitH has skilled personnel and with service contract they harvest your orange grove You have no right of entry to market the crop w o consent HitH then allocates net profits Issue Do land sales contract warranty deed and service contract together quality as investment contract RULE see test above Rationale investment contract was already a term of art in Congress knew its prior judicial interpretation the test above statutory purpose compels full and fair disclosure for securities flexible rather than static principle adaptable to meet various schemes devised to use others money with promise of profits application offering here is opportunity to contribute money and share in profits of citrus enterprise operated by another Residents far away no equipment and expertise to cultivate or market nor desire attracted solely by prospects of a return individual return without the full organization is economically infeasible common enterprise essential for profits notes nomenclature does not matter in this test irrelevant whether enterprise is speculative or not or whether it has intrinsic value statutory purpose broad protection to investors if one party sold real estate and another sold service agreement all elements are there but we have no case law saying whether or not this is a security Person Invests His Money International Brotherhood of Teamsters v Daniel p Issue noncontributory compulsory pension plan Is it a security Facts to qualify for pension benefits EE must work years continuously One year gap for P Denied benefits He sues as a material misstatement under b- Decision Not an investment contract fails the investment of money test all other factors are there he has expectation of profits through efforts of another and a common enterprise Rationale look at the entire transaction was the pension plan a separate investment from the employment contract or was it a part of it Court decides Powell that he is selling labor for a livelihood not investment look for a separable financial interest what was the primary purpose of entering this contract employment or investment form of consideration services not cash Notes Alternative Regulatory Schemes now it would be covered under ERISA Powell says this is evidence that it was not covered under securities laws filling a regulatory void Weaver case in the notes If Daniel had received a security in his pension plan that would be covered RULE mandatory non-contributory pensions are not securities SEC believes that voluntary contributory plans are securities type of consideration matters alternative federal regulatory scheme not a security In a Common Enterprise common enterprise with who investors managers SEC v SG Ltd st p Facts shares existed only in cyberspace Fantasy investment game Ponzi scheme Privileged investment advertised no risk Share price supported by influx of new owners Eventually it fell apart Investors want money back company won t give it to them Issue is this a common enterprise Rules court rejects distinguishing between commercial investment contracts and games Howey does not make such a distinction Nomenclature does not matter two types of commonality horizontal commonality pooling of assets from multiple investors that all share in profits and risks vertical commonality investor s fortunes tied to promoter s success broad vertical well-being of all investors dependent upon promoter s expertise Promoter bears no risk narrow vertical investors fortunes dependent on efforts and success of those seeking the investment or of third parties Promoter bears risk Circuit Split on which measure to use or both Court endorses majority view horinzontal commonality rationale horizontal comports with the fact pattern in Howey limits types of instruments covered under securities laws makes predictable application pooling here SG advertised that all client funds were in a single account share in profits and risks Ponzi schemes inherently have this feature requires investors to find others pays them for it the scheme depended on finding others for influx infusion of capital implies sharing here b c SG devoted profits from website to prop up the stock this bond ties all investors together other elements investment of money depends here on whether invested for profit purposes or entertainment purposes on motion to dismiss court assumes former Notes horizontal commonality is a good element because it speaks to the collective action problem requiring mandatory disclosure most investors want same thing none willing to spend the referral fees in SG suggest that it could be vertical idiosyncratic fewer idiosyncratic aspects to horizontal commonality most investors will fare same economies of scale example of vertical leasing company maintains manages collects rent and oversees sales of real estate Broad vertical commonality Individual returns may differ Leasing company gets profit no matter what Is Led to Expect Profits inquiry what are the reasonable expectations of the individual offerees three situations participation in earnings Forman capital appreciation Forman fixed return Edwards Timing if you invest for profit but you use profit for consumption where to draw line United Housing Foundation v Forman p Facts shares of stock entitled purchaser to lease a co-op Operator is nonprofit Sole purpose of purchasing shares is to enable purchaser to get an apartment Non-transferable tied to apartment cannot be pledged or encumbered no voting rights Must sell back to co-op board on termination Decision NOT securities RULE just calling it stock is not enough to wedge it into the securities laws Substance Economic Reality over form sometimes an investor can justifiably rely on the name given If the transaction embodies significant characteristics associated with the instrument even though this was called a stock the court used the investment contract test defined profits capital appreciation or participation in earnings resulting from use of investors funds investor attracted solely by prospects of a return court of appeals profits rejected by SCOTUS interest deductibility of mortgage rental fee substantially below market cannot be liquidated into cash not from managerial efforts of others closer to welfare benefits possibility of income derived from commercial leases by coops which will reduce rent - speculative characteristics of a stock right to dividends upon an apportionment of profits are negotiable can be pledged or hypothecated confer voting rights in proportion to shares owned can appreciate in value application here inducement to purchase was to acquire subsidized living space not for profit when is real estate a security not when you occupy it and generate profits yourself yes when you don t occupy it and have a general partner manage it and pay you a share of the rent in the middle if you occupy it for a portion of the year and a management agency is in charge of renting it for the rest of the year are they sold with emphasis of economic benefits derived from managerial efforts participation in a rental pool arrangement offering of a similar arrangement where the purchaser must hold unit available for rent for any part of the year use an exclusive rental agent or is materially restricted in his occupancy or rental of the unit Notes investment for consumption does not count important step in profits is there uncertainty maybe the stock characteristics above do not match well with howey test worry that the substance over form doctrine would swallow securities law SEC v Edwards p Facts payphone sale-leaseback arrangements Fixed return Issue if it offers a fixed return is it a security Decision yes Fixed return Security Major holding expands the Forman test to include fixed contractual rates of return Rationale against fixed returns district court said that expectations of profits does not include fixed Nor does it satisfy derived solely from the efforts of others if return is contractual for fixed returns purpose regulate investments broad definition of security solely from the efforts of others refers to profits investors seek on investment not profits of the scheme in which they invest includes dividends low-risk investments are also attractive to individuals vulnerable to fraud would allow fraudsters to structure investments as fixed to avoid securities regime Solely From the Efforts of the Promoter or a Third Party Fourth element of Howey the investment scheme must generate returns solely from the efforts of the promoter or a third party out-of state purchasers of orange grove strips e g tougher question what to do if there s a modicum of effort like one day s labor a look for undeniably significant efforts essential managerial efforts affecting success Common application Partnerships and Franchises investors are involved in management but level of control varies Franchises whether they re securities depends on the terms Franchisor sells right to establish business in a location takes cut of profits Franchisee typically invests startup costs and money to run the business Franchisor spends money on advertising and oversight Franchisee has day-to-day control but maybe not over some national policies Limited Partnerships Presumptively securities unless limited partners exercise effective control over the enterprise Rivanna Trawlers Unlimited v Thompson Trawlers Inc th p Case about a general partnership Facts R as GP acquires boat leases Entered management contracts with T R replaces external and original managers R partners sue T alleging interests are security interests Issue are appellants GP interests securities under federal law Decision No Rule GPs generally not investment contracts too much control by investors partners Ability to Control is also enough removes uncertainty prior to transaction exception only when the partners are so dependent on a particular manager that they cannot replace him or otherwise exercise ultimate control not w in the exception if you choose to remain passive Delegation of rights and duties alone not enough to establish dependence Inquiry were the powers possessed by the partners in the partnership agreement so significant that regardless of the degree to which such powers were exercised the investments could not have been premised on a reasonable expectation of profits to be derived from the management efforts of others rebuttable presumption of non-security for GPs negatived only by a showing of impossibility to exercise powers if controlling powers allocated to GPs individual power is not necessary can be power as a group Rationale purpose of securities laws congress didn t intend a federal remedy for all common law fraud GPs have influence which provides them access to important information and protection against a dependence on others Application This agreement gives broad control to dissolve to set policy power to sell borrow hire agents appoint successors to managing partners required to transfer legal ownership of interests or change distribution of profits Such authority renders unnecessary the protection of the federal securities laws An investor who has the ability to control the profitability of his investment either by his own efforts or by majority vote in group ventures Is not dependent upon the managerial skill of others Further proof they exercised their power Notes Solely is read out of the test to cope with franchise arrangements with incentives like pyramid schemes Cope with manipulation workarounds Timing issue If promoter s efforts all happened before the sale of the investment this matters SEC v Life Partners life insurance policy profits after sale depend purely on the life span of the insured Presumably disclosure will not affect investment any more so securities laws unnecessary Reason for control proxy for access to information proxy for good negotiating position Stock RULE all investments named stock that bear its features are securities Landreth Timber Company v Landreth p Stock is not part of the Howey investment contract test but the test informs the inquiry as to what s stock Facts Family owns of stock in a timber company Offers to sell to public Before sale fire damages equipment Family still sells advising purchasers of damage but arguing that it could be overcome Issue is sale of all stock in a company a securities transaction Defense sale of business doctrine court rejects application Decision security Rule Do not apply the Howey Investment Contract test unless it fails the stock test If Forman stock characteristic test applies the inquiry is over Why Some instruments are easily characterized as securities A stock can be a security merely because it purports to be applying Howey to non-investment-contracts would render the other language superfluous my q does the Howey test define a security well if so-called obvious securities fail the test securities laws can apply to passive investors and entrepreneurs otherwise it would contravene the purposes of various provisions include tender offers etc Policy rationale sale of business does not necessarily transfer control the parties had no intention to control and preferred to remain passive is this actually enough under Rivanna xx probably why we can t apply Howey find situations where the investor would believe he was covered by securities laws don t want to have securities regime apply or not dependent on of stock sold Counterargument isn t purchaser buying stock to control company i e consumption Application this contains all five features additionally the context sale of stock in a corporation investor much more likely to think he was covered under federal securities laws Notes LLCs limited liability of a corporation tax advantage of a partnership Not in the statutory definition list use investment contract analysis member-managed LLCs more like GP i e not securities manager-managed LLCs more like LP i e securities This case contravenes substance over form Stock sale should be same as asset sale but it is not there s no efforts of another here no collective action problem Forman is the only exception to the presumption that what s called a stock is a stock INVESTOR EXPECTATIONS distinguish Rivanna Trawlers partnership not stock Note Characteristics of notes specified interest rate principal amount maturity term a has special provision about maturity months Reves v Ernst Young p Decision notes in this case are securities Petitioners are note-holders in an ag co-op Variable interest rate adjusted monthly Uncollateralized uninsured Decision securities RULE Unlike Landreth label for NOTE is not dipositive look to economics of transaction why too many varying types of notes to allow this Various approaches to identify a covered note Investment v Commercial look at all circumstances surrounding the transactions investment security consumer or commercial security family resemblance nd cir rebuttable presumption that any note with a term months is a security can be rebutted with proof that the note bears a family resemblance to any on a judicially crafted list of exceptions basically same approach as above Apply the Howey test Court rejects this approach even if not an investment contract may be a note don t render the enumeration in a and a superfluous The reverse is not true undecided if called a note and it fails Reves do not apply Howey otherwise we will conclude that when Circuit City lends me money to buy a TV they need protection RULE Adopts family resemblance presumption rebuttable because Congress did not intend to regulate all fraud list of non-securities note delivered in consumer financing note secured by a mortgage on a home short-term note secured by a lien on a small business or some of its assets note evidencing a character loan to a bank customer short term notes secured by an assignment of accounts receivable note which formalizes an open-account debt incurred in therodinary course of business particularly if note is collateralized court expands the list and identifies qualities that make the items on the list non-securities adopts standards to determine what a strong resemblance is Examine buyer seller purpose seller wants to raise money or finance substantial investments buyer wants profits security exchanged to facilitate the purchase sale of a minor asset or consumer good correct for cash-flow difficulties advance some other commercial or consumer purpose likely not security here sold to raise capital bought to earn profits Evident from efforts to beat competitors rates Plan of distribution is there common trading for speculation or investment sec here broad distribution is enough K people Reasonable expectations of the investing public If public expects protection then even if not a security economically it will be considered as one here they were advertised as investments Existence of regulatory scheme that renders the instrument less risky Risk-reducing factor less risk sec uncollateralized and uninsured raises risk Would escape regulation entirely if sec Nine-month exception in a Doesn t violate demand notes instant liquidity not dispositive against security Doesn t eliminate riskiness stocks are also securities liquid maturity date at best ambiguous could be immediate but by same logic could be months may not be demanded until then purpose of provision to eliminate short-term notes Dissent disagrees here maturity and Note are terms of art Notes This family resemblance test is a balancing test unlike Howey like Forman Disclosure and Accuracy a Exchange Act a Exchange Act Securities are listed on National Exchange Termination delisting and either a s h or b s h m assets for years Requirements periodic filings proxy rules annual report tender offer rules insider rules g Rule g- Exchange Act - M in assets and sh Requirements periodic filings proxy rules annual report tender offer rules insider rules Termination same as a d Exchange Act Periodic Reporting Requirements for Public Offerings Registered public offerings are automatically public ONLY REQUIREMENT periodic filing Termination sh no earlier than next fiscal year after offering b Exchange Act g Exchange Act Form -K Episodic Reporting See Below Form -K Periodic Disclosure Annual -Q quarterly See Below Regulation FD no selective disclosure Operative Provision - a intentional disclosures of material nonpublic info to b parties require simultaneous disclosure according to e non-intentional disclosures require prompt e disclosure - measure materiality using Basic Food Lion Ganino - b parties - brokers or dealers investment advisors institutional investment managers investment companies shareholders who reasonably foreseeably may trade on this info - DOES NOT APPLY IF duty of trust or confidence express agreement to maintain confidence to credit rating agencies or certain disclosures related to securities offerings definitional - a intentional person making disclosure knows or is reckless that info is material and nonpublic - b who is an issuer - registrants d filers closed-end investment companies - d promptly as soon as reasonably practicable no later than hours or commencement of next day s trading on NYSE after senior official learns of a non-intentional disclosure - e furnishing an -K is a good public disclosure or disseminating info in method reasonably designed to provide broad nonexclusionary distribution to public - f senior official director officer etc - g offerings for b iv exception you can disclose to your underwriter DOES include shelf registrations Excludes private causes of action does not affect exchange act reporting status this includes S- the short registration forms Mandatory Disclosure and Accuracy Purposes of Mandatory disclosure Standardization - facilitates comparable disclosures by different companies market may do on its own helps reduce agency costs w in the firm force managers to release info that makes them look bad disclose enough so that investors don t discount your stock helps overcome externality problem for firms disclosing info reduces duplicative research by investors and analysts May be necessary to bring disclosure to socially optimal level adopted in Act to curb insider abuses Drawbacks what s to say the SEC will be able to do any better at achieving optimal level SEC uses disclosure as a cure-all e g executive compensation disclosure has led to Lake Woebegone effect CEOs actually demand higher salaries as a result maybe market check investors will discount stock price for non-discloser Threshold Issue for Disclosure - Define a Public Company When must company disclose What To whom SEC promulgates rules with measures to promote accuracy and penalties for inaccuracy Types of regulatory requirements disclosure choice made by congress to address information asymmetry ndary and ary accuracy antifraud liability as a mechanism of ensuring accuracy in particular private causes of action brought as class actions gun-jumping regime for ary transactions only quiet periods What is a Public Company private companies manager owned small number of investors personal relationships with management trust in management enough investments sought from small of venture capitalists who are sophisticated and diligent in their reviews public companies personal relationships impossible collective action problem exists partly fixed by state corporate law and fiduciary duties information asymmetry difficult for sh to assess management or whether they re obeying fid duties cost of negotiating with management outweighs increase in share values purpose of securities laws provide info to investors in Cos with dispersed ownership Public Company Status book p for chart a Exhange-Listed public narrow definition prohibits B-Ds from transacting a security on an exchange unless it s registered b described registration process Form d a bit broader If you have a public offering then mandatory disclosure for at least one year however no need to abide by proxy rules or insider trading rules makes private placements attractive g bases public on a nexus to interstate commerce minimum assets - M Rule g- AND minimum s h so broad that it effectively limits d to only debt rare that offering w sh measurements for the thresholds taken at year end if registered on an exchange need not meet thresholds to be public effect you could accidentally go public by giving too many other people your shares like employee benefit plans and stock options Escaping public Company Status Going Dark For a g- company you must de-list AND certify to the SEC that you have fewer than shareholders g- Alternatively certify that you have fewer than s h and under M in assets for past years OR have a going private transaction For a d company only need to show the s h Requirements based on public status a and g periodic filings comply with proxy rules and annual reports comply with tender offer rules comply with insider trading rules d periodic filings When Must a Public Company Disclose and to Whom xx a gives SEC authority to require disclosure Periodic Documents - -K -Q Episodic -K Content Regulation integrated disclosure SEC decides that everyone wants same info Reg S-K for non-financial Reg S-X for financial both cross-referenced by -K -Q -K and other types of filings like S- S- Item k Form S- and Item of -K references Item of S-K on D O compensation Purpose of cross-references common set of desired investment related info identical disclosures across all firm SEC Enforcement makes disclosure credible -K SOX amends Act to require rapid disclosure for certain changes in financial condition close to real-time disclosure days helps with accuracy over days materially definitive agreements filing of bankruptcy off-balance sheet arrangements response to Enron which would move stuff off its books even though it knew it would buy it back later material impairments to assets if goodwill is worth substantially less than its acquisition price bad deal Delisting adding securities modification of rights to warn shareholders directly of potential big impact to their liquidity etc Changes in audit firms and cause for change relevant to s h if b c of a disagreement changes to directors no reasons why reasons for auditors privacy not as big an issue for auditors don t want to deter officers from joining maybe officers leaving is innocuous Restatement of prior financials typically leads to price drop Statement of code of ethics if have any disclosure required to comply with Reg FD Voluntary disclosures anything believed relevant to shareholders no time limit like the above mandatory disclosures benefit Edgar makes the news widespread -K -Q -K content regulated under Reg S-K - - - Info on business properties legal proceedings market for common stock MD A D O Exec Comp Security ownership of Certain Beneficial Owners and Mgmt Certain relationships principal accounting fees outcome of any matters submitted to s h vote Firms encouraged to combine -K with annual report if required to file i e s l a not a d registrant a- Form -F same idea but for foreign filers content not regulated by S-K but similar Financial content either US GAAP or another accepted system but must detail differences Financial Statements Audits expensive stuff Reg S-X GAAP compliance and audit requirements Reg S-K Item MD A requires discussion of known trends or uncertainties that you reasonably expect to affect liquidity capital resources net sales revenues or income susceptible to hindsight about what should have been reasonably expected CEO and CFO must certify under SOX a- a d- a individuals somewhat protected by Safe Harbor in E Item a post-Enron disclosure of off-balance-sheet arrangements Supplementary disclosure of guarantees and contingent obligations if they are reasonably likely to affect registrant s financial situation -Q no audits for financials must still be GAAP-compliant Still requires CEO CFO cert a- a and d- a certification reviewed report it does not contain material misstatements or omissions to their knowledge financial statements fairly present condition in all material respects to their knowledge responsible for establishing and maintaining internal controls designed controls so that material info made known to them evaluated effectiveness of controls w in days of report presented conclusion of evaluation in report disclosed to auditors any weaknesses in controls and fraud by persons with role in controls changes to internal controls are disclosed in the report Purpose of cert focuses CEO CFO on need for accuracy personal liability reduces ability of CEO and CFO to claim ignorance of misstatements or omissions by stating there are no misstatements they make an additional misstatement Note that pre-SOX they were also required to sign the documents ACCURACY In the Matter of WR Grace Co Exchange Act Release p Pre-SOX case i e pre-certification Finding -K and Proxy filing dates did not disclose CEO retirement benefits for Grace Jr Benefits the same as he had when working Knowledge of benefits by recipient chairman o the Board CEO and one outside officer CEO chairman signed documents no bad faith shown BUT responsibility to go beyond procedures to inquire about reasons for nondisclosure by both Bolduc then CEO and Pyne outside director Retiree dead not subject agreement in principal about benefits signed before then shown to others only non-manager directors knew but Bolduc made aware of it in Grace Jr incorrectly reported retirement benefits on a questionnaire -K prepared by internal counsel did not disclose most of the benefits RULE cannot make assumption that legal counsel has verified info If an O or D knows or should know that his or her company s statements concerning particular issues are inadequate or incomplete he or she has an obligation to correct that failure An O or D may rely on procedures for determining what s required only if he or she has a reasonable basis for believing that those procedures have resulted in full consideration of those issues Dissent supports a red-flag doctrine D O only responsible if they saw patterns of wrongdoing or differences from normal CEO compensation Grace Jr would have been liable for lying but holding the others liable is like SL Question of what to disclose is a legal one for securities lawyers and the directors have a right to rely on counsel s determination B P knew counsel had all relevant facts counsel reviewed language b c question is legal and lawyers had all relevant info should not be requirement for B P to do more Notes who does this get The intentional fraudster Those who don t pay much attention or Those innocent people who rely on others to do their jobs Problem of Selective Disclosure Voluntary Disclosures e g earning statements not regulated like mandatory disclosures are still can lead to antifraud liability can be material Problem sometimes released selectively to covered traders i e analysts brokers individuals likely to trade on the info without releasing it to all s h Solution SEC makes Reg FD if intentional selective disclosure then must be released to entire market immediately if unintentional then within hours No private liability for violations Exchange Act C Cease and Desist SEC s enforcement mechanism Critique Who cares Don t only analysts look at this stuff anyway Rationale Fairness get info to everyone Investor confidence in level playing field Leverage - avoid informational asymmetries and avoid analysts paying for info with good ratings Enforcement quite difficult how can you monitor selective disclosure could get around with high penalties but this didn t happen In the Matter of Siebel Systems Inc SEC Release p selective disclosure by Siebel CEO to analysts at a conference contents of meeting Q A with CEO Talking points reviewed by IR Director to insure that nothing s material nonpublic CEO had info on sales pipeline that looked rosier than Q predictions mentioned this in the meeting Meeting not webcast no press release or -K made IR director knew there was no webcast did not tell CEO AM info release heavy trading stock up around from last price volume high PM public disclosure stock up from day before volume double bad earnings release for Q made public Outlook said not to be promising Purpose of Reg FD level the playing field provide equal access to investors to improve investor confidence in capital markets Elements Selective Disclosure rules only apply if disclosure made to covered persons Broker dealers investment advisors investment companies any shareholder likely to trade on information Must be intentional knowledge or recklessly doesn t know that info is material and nonpublic Materiality same def as in b- Sharply contrasted with press release so CEO knew it was material non-public Nonpublic prior knowledge was given of the ID of the attendees informal information generated by in-house software Combine CEO s knowledge of materiality and nonpublic plus IRD knowing it was not webcast COMPANY liable SEC gets cease and desist both pieces of knowledge imputed to the company even though held by distinct persons Siebel Systems Inc Kenneth A Goldman and Mark D Hanson SEC litigation p Two more after the above cease and desist company made two more material non-public selective disclosures one-on-one meetings with institutional investor Comments contrasted with negative public statements about business Investor traded on info Notes on Reg FD imposed on issuers officer would be an aider and abettor not antifraud violation only selective disclosures to covered persons journalists lawyers fiduciaries road shows all excluded inadvertent disclosures may be corrected with a timely -K filing or press release Reg G if financials in any disclosure are non-GAAP compliant then same disclosure must include a directly comparable GAAP financial measure and reconciliation of the two Rule b- Antifraud b Exchange Act It shall be unlawful for any person by use of any means or instrumentality of interstate commerce b to use or employ in connection with the purchase or sale of any security any manipulative or deceptive device or contrivance in contravention of such rules and regulations Rule b- public and private antifraud liability in securities transactions unlawful for any person b to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made not misleading in connection with the purchase or sale of any security E Exchange Act Safe Harbor for Forward Looking Statements Jurisdictional Nexus instrumentality of interstate commerce the transaction must have been communicated through an instrumentality of interstate commerce Very easy to meet we won t discuss Transactional Nexus in connection with the purchase or sale of securities Elements materiality already covered in Basic etc misrepresentation of fact or opinion that is readily verifiable omission for which there was a duty to disclose scienter D must have requisite state of mind recklessness or actual knowledge of the statement reliance P must demonstrate they relied on the fraud including Basic v Levinson presumption causation Loss causation fraud must be causally linked to the loss suffered by P damages more precise Demonstrated after you ve won The Economics of Securities Fraud and Private Rights of Action purpose of sanctions for false statements avoid the lemon effect like adverse selection truthful issuers driven out of the market and liars remain s h discount shares and have no confidence market collapses entirely in the extreme How fraud affects the market influences how investors direct their capital might lead to an inefficient direction of capital to companies that don t need it or can t use it merely because their stock price is inflated keeps firms in business longer than justified will eventually lead to a higher cost of capital overall ruins s h ability to monitor keeps managers in place for too long deterring fraud makes managers more accountable to their shareholders How we attack fraud Financial audits by reputable accounting firms overseen by audit committee of directors Rating agencies to assess creditworthiness SEC enforcement and criminal prosecution private rights of action necessary supplement to SEC policing fraud Why fraud Can be a play to gain time maybe you are bankrupt now but think you won t be in a few months Trials are extremely rare most settle companies want to avoid cloud over the company reputational harm worry about giving depos time money deterring frivolous lawsuits most action pre-discovery Blue Chip Stamps limitation to actual transactions maybe securities are special intangible collective action problems central market Rule b- Private Cause of Action b- is the catch-all antifraud provision intended to have narrow scope but courts have enlarged it no explicit private cause of action like of the Act Courts recognized an implied private cause of action in Kardon v National Gypsum thus most of the doctrine has developed through the courts underlying question How b- implied cause of action compares to express cause of action Herman MacLean v Huddleston et al p Answers the question of the relationship between R b- and RULE you can bring both a b- and claim for misstatements in the reg statement Facts TIS has stock offering Says it will use money to build a speedway Corporation goes bankrupt one year later Plaintiffs sue the company and its accountants Rationale Section and b- are distinct causes of action meant to address different wrongdoing purchasers can sue certain parties when false or misleading info is included in a registration statement purpose comply with disclosure provisions by imposing strict standard of liability showing material misstatement or omission establishes a PF case minimal burden on P limited scope of action b- drawback compared to heavier burden on plaintiff to establish a cause of action benefit over any purchaser or seller of any security can bring it against any person who employed a scheme or artifice to defraud Securities Act s purpose of providing protection to purchasers of registered securities Purpose of act to impose requirements necessary to make securities regulation and control reasonable complete and effective Thus we made a broad b- Restricting its use would undercut the intent for broadness Interpret securities laws flexibly to effectuate their remedial purpose Notes state law preemption a preserves state causes of action f SLUSA preempts class actions under state law involving the securities of issuers listed on Nasdaq-NMS or exchanges Derivative actions are excluded from preemption Class Action Mechanism private placements to wealthy investors individual investors may bring b- action public placement to all investors or fraud on the secondary market individual investors can bring it but won t because it s too expensive Class Actions are the economically feasible means Sorting the Good from the Bad class actions may fall short of optimal deterrence business reversals may look like fraud stock price drops may look like fraud with relatively little information on internal business decisions substantial stock price drops following contradictory news may be sufficient for a lawsuit suits with no merit strike suits worry hindsight makes it difficult to distinguish Motion to dismiss is where the action is If D fails then they will usually settle case per year goes to trial expense of litigation is due to costs of proving scienter Expensive doc production depos lost productivity ruined relationships enormous potential damages even weak cases get settled weak cases getting settled deterrent effect of class actions is diluted more strike suits PSLRA Private Securities Litigation Reform Act of meant to correct these problems rebuttable presumption that the lead plaintiff in a class is the s h with the largest financial interest requires high pleading standards plead with particularity to show a strong inference of scienter court reviews attorney s fees for reasonableness see Cendant stay on discovery until after the motion to dismiss safe harbor for forward looking statements E c limits liability for parties not committing intentional fraud to proportion of damages helps accounting firms who have deep pockets Empirical evidence on PSLRA has not diminished lawsuits reason didn t change damages Damages are out of pocket very expensive Who can Sue under Rule b- - Standing In Connection With Requirement Clause requires that the fraud be in connection with the purchase or sale of any security In connection with but for causation is not enough tort theory foreseeability deterrence sometimes you will see this It must be foreseeable to the person committing the fraud that investors will trade on it intrinsic value some courts say the fraud must be about the intrinsic value of the security i e I say it s worth more less than it is context coincides with a securities transaction contractual privity always works but not required per Zandford necessary step Zandford Compare a a only purchasers can sue not sellers Blue Chip Stamps et al v Manor Drug Stores p Facts stock offerees try to bring a private cause of action They chose not to purchase stock based on fraudulently bad information from company RULE private right of action for b- limited to purchasers and sellers Allows us to get rid of case at motion to dismiss Rationale Textual rationale wording of b contrasted with a fraud in the offer or sale purchasers and sellers have a demonstrable number of shares for damages Who is barred under Birnbaum potential purchasers who did not purchase based on available information s h who did not sell b c of available information s h creditors and others who lost value of their investment due to corporate insider activities in connection with purchase or sale of securities which violate b- policy considerations arbitrary restriction damages are caused But would increase vexatious litigation no reasonable expectation of producing relevant evidence traders have objectively demonstrable facts non-traders could just sit on the sidelines without risk Notes SEC can obviously have standing w o purchase or sale For injunctive relief circuit split on whether purchase sale needed derivative actions still available if company purchased or sold we eliminate the most vexatious litigation but with a rule that s not narrowly tailored SEC v Zandford p Q how close must the connection be between the fraud and the purchase sale of security Facts broker sold customer s stock and used the proceeds for his own benefit w o consent Issue is this just a case of fraud and theft separately This is a case about fiduciaries because of the relationship and the need for protection of these accounts there was a duty to disclose Here an omission Tests for in connection with Affects intrinsic value of securities not here privity not here broker not officer of company coincides with was the securities transaction a necessary step in completing the fraud yes respondent needed to transact the securities to secure the profits Notes broad interpretation of in connection with doctrine quite unclear if I sell you the Brooklyn bridge and use proceeds to buy stock fails Zandford temporally fraud is done before securities transaction if you change the facts of Zandford such that the broker was instructed to make the transaction then all he s doing is stealing cash no violation Lead Plaintiff in a Class Action D Exchange Act a A early notice to class members days after complaint mass publication required a B iii I rebuttable presumption for Lead Plaintiff most adequate P is person or group filing complaint or responded to notice has largest financial interest satisfies Rule FRCP a B iii II may be rebutted by proof by classmember that P aa will not adequately protect interests of class or bb is subject to unique defenses a B iv Discovery discovery for who is most adequate plaintiff limited unless moving party has a reasonable basis to show inadequate not best a B v Lead plaintiff gets to choose counsel subject to court approval a B vi No Pro Plaintiffs Cannot be LP in more than securities class actions in years a Court reviews attorney s fees for adequacy this question is not about who can sue but about who can represent the class of those suing lead plaintiff controls according to PSLRA two questions how does the court determine who should represent the class how does the court determine how much the attorney for the class will be paid In Re Cendant Corp Litigation rd p Court appoints lead plaintiffs CalPERS NYCPF NYSCRF Held auction to determine lead counsel candidates would submit a bid for fees DC approved B settlement against Cendant and E Y M legal fees Both on appeal Also on appeal selection of lead plaintiff under PSLRA selection of lead counsel fees Lead Plaintiff issue CalPERS not inadequate because held too much stock during settlement negotiations Conflict between getting maximum recovery while protecting ongoing investment rejected by PSLRA presumes that P with largest stake is the most adequate RULE Two step process for courts establish a presumptive lead plaintiff BY THE COURT party must have filed the complaint or a motion to be lead plaintiff party must have the largest financial stake in the suit must otherwise satisfy requirements of FRCP Rule PF showing typicality are the circumstances or legal claims of LP markedly different from the others adequacy ability and incentive to represent the class vigorously obtained adequate counsel bargaining power did they have the willingness and ability to select competent counsel don t select inexperienced counsel to negotiate a fair retainer sophistication intention ability to monitor negotiate reasonable fees this results in everyone choosing Millberg Weiss For group lead plaintiffs - NO HARD AND FAST RULE ON THIS rule of reason prevails too large and they cannot effectively monitor or operate well together presumption may be rebutted by a putative member of the class show that LP cannot fairly or adequately protect class interests ONLY after the court already established a LP OR is subject to unique defenses rendering such P incapable of adequately representing the class This is not a relative inquiry even if some better lead comes along Application CalPERS OK On Group Status all are sophisticated no evidence that it was artificially created by lawyers no reason to doubt they can operate effectively together On rebutting presumption even though other plaintiffs negotiated lower fees this is not enough P argued that CalPERS had a pay-to-play agreement with attorneys who donated money to a political campaign this would be enough to rebut but not enough evidence presented On the Auction One power of lead plaintiff select counsel would be strange to cut off that one power inquiry here is again not relative court can only ask whether the LP s selection was reasonable considerations quantum of legal experience sophistication of LP manner of choosing firm process of slecting final choice qualifications and experience of counsel evidence that the retainer agreement went through a serious negotiation Court can institute an auction if it determine LP s LC selection unreasonable Fees Court has an independent obligation to ensure reasonable inquiry is common law because court is only disinterested agent capable of protecting class from lawyers agency problem Presumption of Reasonableness of fee between properly selected LP and LC To rebut factual or legal developments arising afterwards materially alter the agreement Must be unusual and unforeseeable changes have a PF showing that the fee is clearly excessive here fee would have been M as negotiated M in auction Lodestar would have been M thus the fees may be clearly excessive and district court should review on remand Notes Lodestar definition number of hours attorneys expended reasonably on the matter reasonable hourly rate multiplier to this amount including riskiness of litigation complexity of case performance of attorneys Percentage approach no monetary recovery no fee like Lodestar Congress s intention with D a get big companies to be lead plaintiffs Backfired companies wanted to maintain liquidity and can t dump shares if lead Elements of the Cause of Action similar to common law fraud material misstatement scienter reliance loss causation PSLRA affects ability to prove elements timing is important dismissal prior to discovery hurts chances of proving scienter Instrumentality of Interstate Commerce seems that everything should involve it today Statute of Limitations Exchange Act Earlier of years after discovery or years after violation USC b years is a statute of repose inconsistent with equitable doctrines years inquiry notice when the plaintiff knew or should have known Misstatement of a Material Fact untrue statements Virginia Bankshares of material facts materiality Basic v Levinson Ganino Food Lion omissions that in light of the circumstances make other statements misleading materiality total mix of info reasonable investor significance misstatement of fact or opinions need deception Santa Fe duty to disclose duty to update circuit split if prior disclosure is still alive and has become misleading duty to correct Gallagher if statements were misleading when they were made duty to avoid half-truths b- itself codifies this once you start speaking you must tell the whole material picture periodic disclosure requirements impose additional duties in the forms -K -Q -K Deception proof of deception limits the type of conduct actionable and the list of potential defendants language device scheme or artifice to defraud any act practice or course of business which operates or would operate as a fraud or deceit upon any person Santa Fe v Green p facts short-form merger transaction to eliminate minority stock interest Can a b- apply cash out merger for Kirby Lumber underpriced stock by about Minority shareholders had appraisal rights and were given information showing that MS appraised stock at a price under the price they received Assets however were valued at if liquidated allegation Santa Fe knowing the appraised value of the physical assets obtained a fraudulent appraisal from MS and tried to give s h the false impression that they were getting a fair price Finding no material misstatement or omission Can a b- still be supported NO RULE PURPOSE OF SECURITIES LAWS TO PROMOTE DISCLOSURE MISSTATEMENT OR OMISSION NECESSARY Application not manipulative or deceptive no omission or misstatement The choice was fairly presented and they were furnished with all relevant information on which to base their decision Alternative policy considerations Don t expand the implied private cause of action state law remedy available the rationale required to fit this short-form under b- could easily be applied to all types of corporate transactions Except where federal law expressly requires certain responsibility of directors with respect to stockholders state law will govern the internal affairs of the corporation Notes If P alleges that they have lost their state law remedies as a result of D s misrep then the nd Circuit has allowed a feeral remedy Goldberg v Meridor oral misstatements are also valid for the federal cause of action Duty to Update and Duty to Correct If a statement was true when it was made no duty to correct Gallagher v Abbott Laboratories th p Facts Abbott sold diagnostics that didn t meet FDA regs Continuous FDA warnings heightened FDA warning threatening consequences Abbott press release detailing FDA s insistence on penalties Stock drops consent decree M fine remove products from market Stock drops Allegations Abbott fraudulently deferred release of FDA info But P points to no false or materially misleading statement Rules No duty to disclose unless one is created by positive law No continuous duty to disclose Act duty to disclose for offerings to purchaser Act periodic reports Nothing in Reg S-K requires continuous disclosure a ii requires disclosure in -K of known trends and uncertainties assume for the moment this includes the FDA problem even though the company revealed its being subject to regulation even assuming that the above statement is not enough the FDA letter was sent after the last -K filing date Duty to correct the -K in light of the new info Court distinguishes between duty to correct and duty to update Duty to correct applies only to statements that are incorrect when made Duty to update does apply to registration statements but only until the point they are used to sell the stock No similar need for the -K Notes duty to correct misstatements applies even if the issuer thought the statements were true when made meant to correct for lack of scienter NO DUTY TO UPDATE no duty to correct third party misstatements duty to update prior projections - circuit split th circuit no duty to update nd circuit duty to update under certain circumstances Time Warner arises when a corporation is pursuing a specific business goal announces that goal and an intended approach obligation to disclose other approaches when those approaches are under active and serious condsideration real time disclosure a and d filers must disclose rapid and current basis disclose additional info concerning material changes in the financial condition or operations if the commission determines by rule it s necessary or useful to protect investors Forward Looking Statements E a Applicability it applies to exchange act or public company status issuers E b Exclusions from a IPOs Tender Offers Financial Statements GAAP offering of securities for a blank check company going private transactions etc E c Safe Harbor Two possible paths for written soft information also covers oral A identify as forward looking statement and give meaningful cautionary statements identifying important factors that could cause actual results to differ materially or the forward looking statement is simply immaterial OR B plaintiff fails to prove that person making disclosure had actual knowledge - but sec will interpret this as requiring disclosure of principal risk if you had intent to commit fraud E f Discovery Stay Stay of discovery during pendency of motion to dismiss or summary judgment where complaint based on forward-looking statements and exemption under E may provide relief E i Definitions A financial projections B plans and objectives of management for future operations c statement of future economic performance D any statement of assumptions underlying statements materiality would the information be important to a reasonable investor in deciding whether to purchase or sell the security PSLRA special standard for forward-looking statements - E of Exchange Act FLS are important because investors are looking for indications of profitability Purpose of the safe harbor is to dismiss the case pre-discovery Strangely in Asher Easterbrook remands case for discovery Asher v Baxter th p Facts sales and profits less than expected Price drops sh allegations of materially misleading projections in Question of whether Baxter s projections come with the PSLRA safe harbor Content of projection stated many times prior to business would yield revenue in the low teens mid teens for EPS and that operational cash flow M P alleges statements too rosy and Baxter knew this Authority E Statutory Safe Harbor - forecloses liability if the forward-looking statement is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement meaningful is undefined application difficult must identify some factors but not all otherwise the whole purpose of a cautionary statement is undercut you cannot predict everything ECMH Angle P argues cautionary statement was not published alongside press releases and thus should not get the safe harbor under E c A i and c Aii for oral statements this argument would have merit only if this were a traditional securities suit But because P never heard the statement or read the press release then they must believe that there was fraud on the market i e that other traders heard the statements and let the statement influence the price but not the caution catch- if the market is efficient then all info is in the price If not then the suit doesn t work On listing factors boilerplate warnings are not enough but prevision is not required RULE pinpoint the principal contingencies that could cause actual results to depart from the projection principal contingencies material too much complexity will cause companies to go silent for fear of competition Incomplete info is better than nothing analysts can put it in context Decision information incomplete No evidence shown to prove that Baxter disclosed factors it thought were important And they did not change their statements in light of new events Scienter D b b complaint must state with particularity of facts each false statement and explain why it was misleading b in any private action you must prove or state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind b A dismissed if requirements in and not met b B discovery is stayed pending motion to dismiss unless P pleaded particularized facts State of Mind Actual Motive intent to defraud Knowledge knowledge facts and appreciation of how the market will be misled Recklessness so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent obvious that the defendant must have been aware of it MOTIVE OPPORTUNITY TEST Florida see circumstantial evidence factors in case RESULT most case are built on publicly-available information Ernst Ernst v Hochfelder p Issue can a b- be brought without an allegation of intent to deceive manipulate or defraud i e w o scienter Decision a private b- cause of action will not lie without an allegation of scienter Facts Broker firm pres robbed investors also wouldn t allow anyone to open his mail Ernst Ernst was auditor didn t discover this mail rule and P alleges that had they they would have reported it to the SEC caused an investigation revealing the fraud E E was only negligent Rationale Language the words manipulative or deceptive used in conjunction with device or contrivance strongly suggest that b was intended to proscribe knowing or intentional misconduct Purpose SEC says purpose of Act is to protect investors against injury and that the effects will be the same regardless of negligence or intent Court says this disregards clear language Statutory Scheme and Congressional intent Congress has stated in other sections when defendants are liable for negligent behavior i e if we made a negligence CofA then all suits under and would be brought under b- instead Notes Recklessness counts Supreme Court has not addressed the question but every circuit court which has addressed the question has adopted the rule Red flags notice Plaintiffs required to plead state of mind with particularity of facts give rise to a strong inference that D had requisite state of mind under D b This is all before discovery Knowledge used as proxy for intent and easier for evidence Florida State Bd of Admin v Green Tree Fin Corp th p allegations Ds overstated Green Tree s financial value Used unrealistic and unreasonable assumptions in its gain-on-sale revenues method of accounting booked pofits when it sold the securities but expected profits not made yet and the amounts wre variable alleged motives for statements CEO comp ties to financial result incentives to falsify earnings maintain high credit rate to bolster loan securitization pool demonstrate exemplary financial performance in light of a pending derivative suit Discussion Issue - D b P must state with particularity facts giving rise to a strong inference that D acted with the scienter required for the cause of action BIG CIRCUIT SPLIT nd Cir rd Cir motive and opportunity test or circumstantial evidence originally any motive to make money and an opportunity to do so now narrowly common motives disallowed desire to maintain high credit rating boost up stock price to increase exec comp or officer entrenchment motive to profit on insider trading is closer the evidence of the timing of an insider trade is circumstantial showing that D probably had some sort of knowledge Different from exec comp where no such circumstantial evidence exists Even Ins trad evidence must be unusual Must find a concrete and personal benefit accrued to D st th th th th supposed middling standard though actually not so different from narrow reading above M O are not substitutes for recklessness but can be catalysts to fraud and so serve as external markers th high standard On M O need to show something that makes this motive atypical or need to show circumstantial evidence of fraud Application CEO motive for comp enough though not normally why unusual facts CEO comp on of earnings and his contract expired at end of year making it urgent to maximize earnings in that year even though he gave money back to company years later the ultimate profitability of a course of conduct is not conclusive of intent However motive for other executives not enough contracts not about to expire Compensation not comparable to CEO falls short of alleging concrete and personal benefit need to boost credit rating common to all companies not proof of scienter on need to show exemplary performance in light of derivative suit derivative suit not started until year into class period this timing issue undercuts the motive though in certain circumstances a derivate suit would be enough Circumstantial Evidence Sources insider trading particularly if unusual volume profits and timing divergence between internal reports and external statements on the same subject closeness in time of an allegedly fraudulent statement or omission and the later disclosure of inconsistent info evidence of bribery of an officer existence of an SEC enforcement action accounting restatement sheer magnitude of a misstatement how could a mistake so large occur without scienter Reliance a J S liability for CP and A A violations good faith defense for J S liability Every person who directly or indirectly controls any person liable under any provision of this title shall also be jointly and severally liable to any person to whom such controlled person is liable unless the CP acted in GF and did not directly or indirectly induce the acts constituting the violation SEC needn t prove it but private plaintiffs must Reliance transaction causation omissions rebuttable presumption of reliance misstatement ECMH reliance under Basic fraud-on-the-market Affiliated Ute Citizens of Utah v United States p issue reliance when there s privity and omission security shares in an Indian Tribe s O G interests restriction on sale for mixed-blood Indians must offer to tribe first then to outsiders at no lower price than to tribe members Facts plaintiffs mixed-blood sold stock to defendants white bank managers D had standing orders from non-Indians Sale price from P to D was much below resale price from D to P Court finds no need for reliance in cases of omission the defendants had a course of business that operated a fraud They possessed the affirmative duty to disclose this fact to the sellers D may not stand mute while they facilitate sales to those seeking to profit if they developed and encouraged that market Sellers had a right to know that D was gaining financially Rebuttable Presumption that you don t need reliance in the fraud of omissions to rebut show that p would have continued course of conduct had he known the omission is fact material Basic v Levinson p Issue affirmative statements made to the market generally Is there a rebuttable presumption that P relied on the market price generally Basic made statements over year that claimed no merger negotiations even though they were engaging in merger negotiations for a full year by that point P alleges that they sold at an unfairly depressed market price in reliance on the misstatements Fraud on the market theory based on ECMH market price determined by available material information misleading statemtns defraud purchasers of stock even if they do not directly rely on the missatements Requiring individual proof of reliance would undermine class actions could never find enough individuals to form a class rationale FOTM provides a practical resolution to the problem of balancing the substantive requirement of proof of reliance in securities cases against the procedural requirement of FRCP competing rationale effectively eliminates proof of reliance this requirement is necessary in light of the lack of face-to-face transactions contemplated by earlier fraud cases The market stands in the middle and transmits info to the investor in the form of MP consistent with purpose of the Act securities markets are affected by information and that people purchase in reliance on the market price To rebut Any showing that severs the link between the alleged misrep and either the price received paid by P or his decision to trade at a fair market price will rebut i e if market makers knew about merger that would rebut because it would be incorporated into MP If D can show that P would have sold shares without relying on market integrity this rebuts as well Summary Semi-Strong ECMH Market incorporates all the information For omissions and half-truths nclear results Some courts require proof of reliance on the half-truth Abell v Potomoic while others apply the Affiliated Use presumption Chris-Craft v Piper Aircraft Affirmative misstatements and half-truths that have been disseminated into efficient markets presumption of reliance under Basic Basic presumption does not apply to inefficient markets ot those that are thinly-traded - i e pink sheets Under Slotnick v TIE Communications the rd circuit rejects using the Basic presumption for short sellers because they are not relying on the accuracy of the market price but believe it is overvalued If fraud did not affect market price then there s no reliance because traders were not affected practically speaking the presumption is never rebutted Problems with FOTM investors have behavioral biases tendency to trade too often hold on to losing stocks too long pay too much attention to more recent salient information Face-to-face Open Market Omission with Duty to Disclose No reliance requirements Affiliated Ute No reliance requirement Affiliated Ute Affirmative Misrepresentation Investor must show individual reliance Presumption of reliance Basic Loss Causation codified in D b in any private action arising under the Exchange Act the plaintiff shall have the burden of proving that the act or omission of the defendant alleged to violate the Act caused the loss for which the plaintiff seeks to recover damages distinguish from transaction causation and damages Dura Pharmaceuticals Inc v Broudo p Facts Dura alleged to make false statements concerning its drug profits and future FDA approval of a device On the last day of the class period Dura announced that its earnings would be lower than expected Stock then lost half their value months later Dura announced FDA would not approve stock price temporarily dropped but recovered w in one week Issue must prove an economic loss under D b can P satisfy this by alleging that the price of the security on the date of purchase was inflated because of the misrepresentation Decision No Rule inflated purchase price alone will not constitute or proximately cause the relevant economic loss must have caused loss rationale on proof a the moment the transaction takes place P has suffered no loss because at the instant of purchase he possesses something worth what he paid for it subsequent sales after info has seeped into market may but do not necessarily reflect losses other info could cloud or take up of the price difference court specifically does not consider what happens when a share s higher price is allegedly lower than it otherwise would have been the longer between P S the more likely other factors caused the loss securities laws not insurance to market losses but to protect against misrepresentations on allegations Rule allegations must show a short and plain statement of the claim showing hta the pleader is entitled to relief Fed R Civ P a here P had no indication other than inflated purchase price for their loss would allow P to bring a groundless claim and take up the time of a number of people and impose an in terrorem increment of the settlement value Notes see the connection between this and materiality one standard for materiality is whether the market price dropped though it s not the only standard P may want to argue leakage onto the market if no single obvious price-drop Rule b- Defendants no laundry list of defendants any purpose D f Proportionate Liability A J S liability if knowingly violated B proportionate liability if not A Jury answers interrogatories w r t each covered person Secondary Liability Can we get auditors attorneys and other deep pockets NO AIDING AND ABETTING LIABILITY IN B- Private Actions After e A A liability for SEC actions must be knowingly Third party s relationship with fraudster descending order of possible liability control person with full knowledge full knowledge but veto power over only some deal aspects full knowledge but only contractual relationship full knowledge but no contractual relationship no knowledge of the fraud or risk of fraud Central Bank of Denver v First Interstate Bank of Denver p issue of whether Bank s outside appraiser can be A A liable for misevaluation of bonds Rule no aiding and abetting liability in b- Rationale if congress wanted it they could have written aid and abet into the statute WWCD the other express causes of action under the Securities and Exchange Acts do not have A A either A A would undermine the reliance element There is CP liability in some cases Congress did not impose it here must be deliberate Policy considerations will not override structure of the act Epilogue e allows A A liability for SEC enforcement who is indirectly liable Two tests in Circuit Split Substantial Assistance Substantial Participation note that this is still primary liability Note also that it basically reverses Central Bank Bright-Line D misstatement must be directly attributable to him used in Wright You must say something that the market can attribute primarily to you Who is a Primary Violator Post-Central Bank this is where the inquiry is See blue above Wright v Ernst Young LLP nd p RULE Unaudited Information in Press Release means that P cannot recover from outside auditor E Y noticed some accounting probs that it thought were immaterial Accounting statement went out unaudited and didn t mention E Y Reliance Court adopts bright-line test from above Because E Y s assurances were never communicated to the public directly or indirectly there is not liability Notes if we were in a substantial participation jurisdiction th Cir P should argue that E Y substantially participated in the fraud by assuring BT that the statement was OK and that but-for this assurance it never would have hit the market Damages in reality we never get to this stage Alternative measures restitution disgorgement of profits rescission you get your stock back Open Market Damages out-of-pocket is typical measure price paid value of security at time of purchase does this underdeter shouldn t sanctions be higher than expected value of course D doesn t really gain the money from the fraud so maybe there s plenty of overdeterrence no net wealth transfer away from the investors in the aggregate transfer from investor A to investor B compensation has two purposes deter management from committing fraud deter investors from expending resources to discover fraud Face-to-Face Damages Courts not limited to out-of-pocket measure disgorgement applicable at court s discretion - Pidcock even if unforeseeable at time of fraud so long as a but-for cause of D s profits rescissionary measure Garnatz if purchaser defrauded the P return the securities if seller defrauded the P return the money take back securities OR subsequent sale price original sale price if sold Pidcock v Sunnyland America Inc th p Partners in company talked one into selling share to them painted fraudulently gloomy forecast Lied about future intentions persuaded others to lie One partner sues for difference between the price he sold to the others and the alleged FMV at that time had he known about the possibility of sale to P he would not have sold Disgorgement if defrauding purchaser s profits are greater than seller s loss he must disgorge all profits i e if seller acquired property by fraud then the eventual sale is a proximate consequence of this it is more appropriate to give the defrauded party the benefit even of windfalls than to let the fraudulent party keep them equity Limits P cannot recover anything due to D s special or unique effort aggressive and enterprising management activities extending personal guaranties on bank loans introducing new lines or business modernization passage of time if long enough may cap regular responsibilities of D even if they increase the value of the investment are not sufficient to limit Garnatz v Stifel Nicolaus Co Inc th p P defrauded by company who induced him to purchase bonds Bonds were billed as low-yield low-risk but they were not Problem if out-of-pocket measure used no damages Bonds were worth exactly what D said they were So court fashions rescissionary damages the fact that P got what he paid for does not mean that he did not suffer a legally cognizable injury resulting from D s fraud Merely means fraud did not relate to price returns parties to status quo ante the sale P can recover decline in value of his bonds until his actual or constructive notice of the fraud any other losses attributable to D s wrongdoing Fraud in the inducement a limits damages to Actual Damages and thus not punitive damages Proportionate Liability D f Accountants won big victory with this damages used to be J S if only reckless the proportnate share Exceptions D J S liable to P who is entitled to damages exceeding of net worth if net worth K D must make up any shortfall due to a codefendant s insolvency which comprisesup to of their own liability KNOWING violators Public Offerings Securities Act a what s required in a Registration Statement Look at Schedule A s l a not foreign government commission may eliminate certain requirements by rules and regulations if it determines that disclosure fully adequate for the protection of investors is still required written consent of auditors professionals etc required if they certified any part Commission may add to requirements if necessary or appropriate in the public interest for protection of investors Securities Act a effective date automatic days after filing registration statement SEC may determine earlier If amendment filed prior to ED then reg stat deemed filed as of amendment date except with consent of SEC then no date change b SEC can reject statement or request amendments if incomplete or inaccurate in any material respect SEC gives notice w in days of filing opportunity for hearing Then issues an order requiring an amendment c effective date for amendments if after effective date of reg stat SEC determines effective date d untrue statements or omissions If SEC determines reg stat has untrue statement of material fact or omits a material facts not misleading SEC may give notice and then issue a stop order Suspends reg statement Rule Issuers can vary order of info in prospectus Must insure that order does not obscure any required info Info must be presented in clear concise and understandable manner and follow plain English principles Short Sentences active voice avoid legal and technical terminology Form S- See B Form S- See B Three major features mandatory disclosure gun-jumping rules construction and distribution of S- and S- and prospectus anti-fraud liability On uncertainty SEC gives little guidance would be a roadmap to fraud may lead firms to over-report Sections of Registration Statement and their purposes Cover Page u w discount lead underwriters Risk Factors teach investors what factors to discount on specific not general risks to the company gets things into the total mix so good way to fend off anti-fraud liability critique oftentimes boilerplate use of proceeds item and dividend policy item supposed to help investors assess the nature of the investment typically companies just write general corporate purposes MD A item focus for investors narrative insightful forward looking provides known trends and uncertainties anti-fraud safe harbor xx Business Description Management Principal stockholders and underwriting Items and ps you don t want to be a minority shareholder in a controlled corp uw investors may have trust for certain uw Economics of Public Offerings Potential Sources for funding if you need fast cash infusion typically for capital assets bank loan downside need collateral most likely need to guarantee regular payments internal financing using last year s profits e g self-financing but rare because who has M private placements we deal with this later public offerings equity capital benefits flexible no fixed payment downside dilutes potential business upside due to residual returns must structure business into off-the-shelf form to earn investor trust so that they know you won t self-deal costly - K - M typically of offering ongoing costs of filing time-consuming risk of takeover Timing problem for capital-intensive businesses products eventually generate revenue but need fast cash now Brief Description of Public Offering Process find Ibanker or if you re hot they ll find you market for IPOs ebbs and flows hot periods no problem finding one IBankers work as underwriters provide advice on structure on securities offered amount and price help cast firm in good light simplify capital structures preferred by capital markets easier to value one class of stock e g corporate governance features Guide through registration process file and distribute mandatory disclosure documents company info management financials offering info securities u ws discount number of shares price restrictions on discussing offering and disseminating information that would condition the market Marketing assist in public sales wealth of contacts with investors Different Types of Offerings Firm Commitment Underwriter guarantees sale of the offering Group of underwriters syndicate purchse entire offering from issuer then sell to public Ensures entire amount is purchased If not then u w takes the hit Makes money on the underwriting discount typically around benefit to firm certainty Helps ensure value of offering all investors know company will get full money actually increases likelihood of investment Best Efforts IB does not purchase entire block of shares Acts as agent for commission IB assumes less risk Issuer retains risk Greater risk to investors less confidence if IB not putting money on the line IB has no incentive to ensure that it s priced correctly Issuer may not sell entire issue Usually only smaller more speculative companies Fix for investor risk conditional best efforts everything rescinded if not fully sold Direct Public Offering Issuer sells directly Rights offerings e g to existing shareholders RARE issuers lack expertise network of investors IB s also play gatekeeping role for investors Dutch Auction Offering Google did this Issuer and u w do not fix a price Investors bid Issuer chooses highest price for all bidders of shares owned by retail customers Rare that it should be so high Calms speculative fervor Gives issuer the benefit of the market demanded price rather than initial investors who get it through capital appreciation after the pop Underwriters definitions bulge bracket the group of underwriters at top of hierarchy tombstone after securities issuance u w publishes ad of details Lists underwriters in brackets Placement depends on reputation of u w amount underwritten bake-off IBanks who want to underwrite for an issuer make sales pitches involving analysts promising high ratings Definition Securities Act a any person who has purchased from an issuer with a view to or offers or sells for an issuer in connection with the distribution of any security direct or indirect participation in the undertaking EXCLUDES anyone whose interest is limited to a commission not in excess of usual sellers comm issuer includes an issuer and any person directly or indirectly control ed ing an issuer DIFFERS FROM LAY UNDERSTANDING of U W role Starting point for offerings source of advice source of contacts source of financing in firm commitment offerings gatekeeping role they sell their reputation attract investors can charge high amounts Underwriting Process underwriters form syndicate spreads risk but reduces profit one managing underwriter book-running manager responsible for allocating shares typically takes of gross spread for this role performs due diligence prices offering handles registration filing letter of intent specifies size of underwriting discount overallotment option of allocation does not specify price then registration statement filed then lead gathers the syndicate signs an agreement gross spread selling concession to lead for costs counsel due diligence road show formal underwriting agreement signed sets forth terms of offering shares told price gross spread overallotment option Underpricing first day pop high then gradually the price goes back down money left on the table dutch auctions can eliminate underpricing but not good for investors if underpricing is because of frenzies that eventually settle then buyers who pay max price for shares lose in the long run Why have a low price antifraud worries reduce damages in suit risk-averse don t want to undersell in a firm commitment offering market exuberance could actually be priced fairly corruption IPO laddering scandal Capital Structure companies do not often sell entire capital stock to public they have assets otherwise investors will not trust them if they don t invest own capital CEO often holds stock or some insider investors prefer simple structure as opposed to something like a LP with a corporation as GP Public Offering Disclosure shareholder informational asymmetries lead sophisticated shareholders to discount shares Securities law responds with required disclosure registration statement filed with SEC antifraud liability due diligence defense for non-issuers Forms S- and S- S- available to all issuers Comprehensive transaction-related info company info exhibits and undertakings limited incorporation by reference allowed if company is reporting and current in filings backward incorporation by reference S- eligibility check both registrant requirements and transaction requirements registrant requirement reporting companies for year and over million capitalization in the hands of non-affiliates or d reporters US comp cannot have missed filings transaction requirement primary offerings the M in non-affiliates condition investment grade debt securities secondary offerings if securities in same class are exchange-listed rights offerings conversions of existing securities investment-grade asset-backed securities broad incorporate by reference company-related info not just backward incorporation by reference must include material changes to periodic filings not required to give investors an annual report statutory prospectus Part I of the registration statement distributed to investors a antifraud liability reasonable care defense for sellers Incorporation by reference including information from prior public SEC filings -K -Q -K into Forms S- and S- Assumes that markets are efficient Made possible by integrated disclosure S- and S- require items from S-K and S-X just like -K Q and -K Plain English Disclosures Rule see above Critique unclear whether it makes a difference who s the target audience Sophisticated or non Sophisticated make up the bulk of IPO purchasers Unsophisticated often rely on advice of sophisticated intermediaries jargon is actually a useful way to standardize for people who know what they re looking for Benefits still some unsophisticated investors do read the prospectus ex ante deterrence against fraud finding fraud after the fact is easier Small Business Issuers Public offerings are expensive attorneys auditors reorganization u w commission delay between prospectus drafting and security sales smaller companies often go for private placements SEC passed incentives to make public offerings easier for them Form SB- less disclosure years of audited income statements one year of audited balance sheet eligibility issuer with M revenue in most recent FY No Reg S-X requirements though still GAAP-compliant compare S- fy of audited statements reg S-X requirement less disclosure of non-financial info Reg S-B instead of S-K Form SB- SBI s with offerings up to M in -month period Also Reg S-B More streamlined than SB- Q A format same audited financial requirements as SB- Is streamlining good for small business issuers seems like they may have higher capacity to defraud investors fewer analysts following them though fewer investors also Gun-Jumping Rules Securities Act a Definition of Sale Offer important for pre-filing period c Sale contract of sale or disposition of security or interest in security for value Offer any offer to dispose of or solicitation of an offer to buy a security for value see notice exception in Rule CONDITIONING THE MARKET MAY BE CONSIDERED AN OFFER EXCEPTIONS does not include preliminary negotiations or agreements between issuer and u w who are or are to be in privity of contract with issuer so any final underwriter or potential underwriter even if not accepted can negotiate with issuer does not include discussions among underwriters so if one wanted to they could form the syndicate during the pre-filing period THESE exceptions do not apply to dealers just a limit on how much info gets out there s a clear need for discussions with u w so we allow that Securities Act a Definition of Issuer every person who issues or proposes to issue any security Securities Act a Definition of Prospectus important for waiting period b prospectus any prospectus communication written or broadcast offers any security for sale or confirms the sale Exceptions communication after effective date other than a b prospectus is not a prospectus if at or prior time a written a prospectus was sent or given to the person receiving the communication AND only states price identifies security identifies by whom orders will be executed and contains other info the SEC deems necessary and appropriate b Securities Act a Definition of Underwriter See A supra Securities Act Transactions by any person other than an issuer underwriter or dealer are exempt from Securities Act Describes the time periods in an offering