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					                                  SECURITIES REGULATION:
The Economics of Disclosure
Three Basic Questions about Disclosure
        1. Why do we care?
        2. Is legal regulation necessary? Would corps provide optimal disclosure w/o regulation?
        3. Does every investor need all this info?

Three pillars of sec. reg. analysis:
         Efficient Market Hypothesis
         Portfolio Theory
         Noise Theory (a competing view)

Efficient Market Hypothesis (EMH):
         As information becomes publicly available (at least to more than a few outsiders), it becomes
         immediately “fully reflected” in the security’s price
         EMH means that the average investor does not need full disclosure.
         The info won’t help investor “spot a winner,” adjustment is instantaneous. The price is fair.

         Two implications of EMH
         1. The info is reflected in price as soon as it becomes available
         2. As long as the company is established, there is no need to register each sale

Price fairness and accuracy are two different things
          Price fairness means that the price is unbiased. Price is related to mean expected return given all
          available knowledge (All securities have the same expected return, controlling the risk)
          Price accuracy is the expected deviation between current price and actual value. Actual value =
          PV of probabilistically weighted expected future returns
          (So two securities may be fairly priced, but one may be more accurately priced than another)

         Example:
         Sec. B: Exp. Ret. = .25($20) + .50($10) + .25($0) = $10 = unbiased price
         Sec. A: Exp. Ret. = .25($15) + .50($10) + .25($5) = $10 = unbiased price

         A&B are both fairly priced, but A is more accurately priced than B. B has more variance than A
         Infusion of more information increases price accuracy!

         Example 2:
         Corp has .25 chance of gaining new customers, .25 chance of losing customers, and .5 chance of
         no change. Also corp has .25 chance of having a good market for its products, .25 chance of
         having a bad market for its products, and .5 chance of a ho-hum market

         New/Lost customers                            Probable returns                     Stock Price
                                                       .25($20) – boom year
         .25 (gain customers)                          .5($15) – average year               $15
                                                       .25($10) – bad year

                                                       .25($15) – boom
         .5 (no change in customers)                   .5($10) – avg.                       $10
                                                       .25($5) – bad

                                                       .25($10) – boom
         .25 (lose customers)                          .5($5) – avg.                        $5
                                                       .25($0) – bad

         Unbiased price of security without information = 10


                                                       1
         Variance w/o any information = 25
         If we get info about customer increase/decrease, variance drops to 12.5, and unbiased price rises to
         15. SO NEW INFO IS GOOD! It decreases variance and increases unbiased price.

         The importance of disclosure depends on the importance of price accuracy.

Fox article: Price accuracy affects relative efficiency of allocation of scarce resources
         Price accuracy is aided by disclosure (i.e. the quantity and quality of information disclosed)
                  More price accuracy = more efficient allocation of capital resources
                  More disclosure allows professionals to accurately price securities

         Three views of the market:
                  Las Vegas: Disclosure and accuracy don’t matter
                  A place to store wealth: Disclosure + accuracy don’t matter either. Portfolio theory.
         ****** Nerve Center of the Economy: Disclosure does matter to efficiently allocate capital
         Most economists (and Fox) subscribe to the third view

         1. Las Vegas view: more or less disclosure is irrelevant.
                   Whatever is disclosed is reflected in price. Market is always fair, as long as there is no
                   insider trading. Maintenance of fairness is our only goal. Disclosure is expensive and not
                   worth it.
         2. Place to store wealth theory: disclosure is irrelevant too.
                   Greater diversification is a cheaper way of reducing risk (the risk of less accurate prices
                   due to lack of disclosure) than mandating disclosure.

         3. Nerve Center theory: Disclosure good
                  More disclosure plays a role in limiting managerial discretion
                           Mgrs make decisions of economic importance
                           Mgrs look out for own best interests
                           Decisions that maximize share value are in society’s best interests
                           Mgrs incentive is to maximize CURRENT share value, not PV of FUTURE
                                    returns
                  Disclosure plays a role in the efficient allocation of capital

         Managerial incentives:
                How to align managerial incentives and shareholder interests: (use sticks)
                1. Bankruptcy. Mgr will lose his job if corp goes bankrupt, so he will keep corp
                           solvent. This is only a floor though. Mgr can still get away with a lot before
                           corp goes bankrupt
                2. Takeovers. Share price declines if mgr makes decisions that don’t maximize share
                      value. This may invite a takeover attempt. Share price only decreases if public
                      knows of bad decision. If we require disclosure, a raider can come in and take
                      advantage of lower share price. Raider makes $ my maximizing share price after he
                      takes over.
                           a. Risk neutral raider may not take over in a low disclosure world though, b/c
                               he does not know the potential losses and gains of making his move. He
                               won’t act if expected losses > expected gains.
                How else to keep mgrs in check? (use carrots)
                1. Stock options. Risk averse mgrs will be willing to take stock in corp, in a high
                      disclosure world in lieu of cash, because the more accurately priced the shares, the
                      higher the expected compensation.
         Managers have more incentive to make share price-maximizing decisions in a high-disclosure
         world.

Allocation of Capital:




                                                      2
         Mgrs believe that there is an optimal debt/equity ratio. If shares are mispriced, there may be
         inefficient allocation of capital. Too much investing if stock price is inaccurately high, and
         converse.

PORTFOLIO THEORY: UNSYSTEMATIC RISK AND SYSTEMATIC RISK.
      Unsystematic risk = market risk
      Systematic risk = corp-specific risk
      Diversified portfolio minimizes unsystematic risk, but not systematic risk

         Portfolio Theory tenets:
         1. Most people do not only own one stock. They own a portfolio
         2. Investor only cares about the income stream that comes from whole portfolio. Investor does
             not care about the individual stock
         3. Investor will buy/sell individual stocks based on their effects on the portfolio

         Sensitivity of a stock or a portfolio is measured by its Beta:
                  Beta is the slope of the line that measures a security’s relative sensitivity to changes in
                  the broader market.
         Market Model: How to determine Security X’s effect on the variability of the whole portfolio.
                  Look at past years of the stock’s return, and separate out the two types of risk
                  (unsystematic and systematic.) If Security X is adding systematic risk to the portfolio,
                  that’s bad. Adequate diversification will minimize unsystematic risk.
         Return: Total return = Systematic Return + Unsystematic Return.
                  There is a relationship between systematic risk and systematic return. Higher risk =
                  higher return.
         Regression analysis determines risks and rewards. Rx =  + Rx + . Difference between actual
                  risk/return and regression results = unsystematic risk/return.

Does everyone need the information provided by disclosure?
        Anti disclosure:
                 EMH says that investors cannot pick winners and losers anyway. No info needed
                 Portfolio theory. Investors will pick a diversified portfolio
                 Invest in an index fund to get rid of systematic risk. Don’t even need to know Betas
        Pro disclosure:
                 Investors’ diversified portfolios rarely counterbalance the risks associated with other
                           investments (such as houses and other non-securities.) Investors really need to
                           diversify total ASSET holdings, not just securities holdings.
                 Knowledge of Betas will not be sufficient to compose optimal portfolio
                 Investors need information to estimate factors that create risks
                 The past is not necessarily an indicator of the future. Need to know fundamental data.

Will market forces lead to optimal level of disclosure w/o regulation?
        Arguments that regulation is not necessary:
                 Optimal level of disclosure is where cost of disclosure = benefits of disclosure
                 Mgrs want to develop a reputation that it will give adequate disclosure. (Higher prices)
                 Investors will pay more for stocks that have high disclosure
                 Mandatory disclosure regime is subject to political processes. Special interests will
                           demand more disclosure than is optimal.

         Arguments that disclosure should be mandatory: (Market Failure arguments)
                 Disclosing bad info will decrease share price, so bad news will not be disclosed
                 Under mandatory disclosure, we’ll have to disclose, but so will our competitors
         (Fox says) Disclosure aids suppliers and customers, as well as competitors. It helps economy run
                 Positive externalities to others wrt disclosure will give mgrs an incentive to underdisclose
                 Standardization of info makes corps easier to evaluate and compare, and aids price
                          accuracy


                                                      3
                  Less information makes hostile takeover of corp more risky (and less likely.) Also makes
                           mgrs give out less good information when it wants to buy of SHs.
                  Regulation aids communication with the market
                  Mandatory disclosure provides a subsidy to securities analysts, who provide a public
                           good.

         Noise Theory Critique of EMH:
                 Noise traders buy based on trends and fads, not on fundamentals
                 Smart-money traders will buy based on fundamentals
                 The result is that true corp value may not be reflected in price, but smart money will
                          arbitrage the price toward the true value. Smart money will make smart money
                          more willing to arbitrage. Disclosure is an antidote to too much noise.
                 More publicly available information will do even more to improve price accuracy in a
                 world of noise theory.
                          Actions by smart money will de-diversify these investors’ portfolios. The
                          purchase of a share in the arbitraged corp increases marginal risk and total risk.

                  Public disclosure will bring market price closer to actual value and helps smart money
                  arbitrage the market price toward the actual value.

Disclosure in Public Offerings (§5 of 1933 Act.)
        Purpose of IPO: To put securities in the hands of enough of the public to establish a good
        secondary market.

         Process of an IPO: Issuer  u/w  dealer  public
         Issuer doesn’t sell its own shares because:
                  Issuers are not good at selling shares
                  Issuers are not experts with regard to markets and stock prices
                  Underwriters act as insurer of the offering in a sense
                  Underwriters have contacts with holders of capital
         Firm commitment underwriting:
                  U/W guarantees a certain sum to the issuer
                  U/W absorbs the risk
                  §2(11) defines “underwriter as anyone who purchases stock with a view to distribution.
                            Usually includes dealers.
         Dealer’s Role:
                  Selling the securities at retail
                  U/Ws allot dealers stock, and dealers sell them to the public

§5 of ‟33 Act:
         Securities must be registered under ’33 Act
         Two critical dates – filing date and effective date.

                            Filing Date                                  Effective Date
         Pre-filing                           Waiting Period                               Effective
         §5(a)(1)                             §5(a)(1)
         §5(a)(2)                             §5(a)(2)
                                              §5(b)(1)                                     §5(b)(1)
                                                                                           §5(b)(2)
         §5(c)


         Problem 2 in Supp.
         Begin working on reg. stmt. 3 months before statement is to be filed. SEC’s comments are
         generally received by corp 6 weeks after initial registration statement was filed.




                                                       4
        1.   Pre-filing
                 Letter of intent
                 Begin preparation of reg. stmt.
                 File reg. stmt. w/SEC

        2.   Waiting Period
                U/Ws begin offering to dealers
                Dealers begin offering to customers
                          Can communicate in only two ways:
                          a. Orally
                          b. Through Red Herrings
                Respond to SEC comments w/ amendments
                Negotiate price of security and request acceleration of effectiveness by SEC one day
                          before commencement of distribution

        3.   Effective period
                 Issuer files pricing amendment
                 Sign underwriter Agreement and Agreement Among Managers
                 Closing ($ proceeds given to issuer and securities distributed to buying public.)

        §5(a):   Applies during prefiling period and waiting period. Not allowed to sell securities through
                 use of any media (even a prospectus.) Can’t use Interstate Commerce to send a (a)(2)
                 security or a (a)(1) prospectus to potential buyers.
        §5(b):   Applies after filing date. Can’t use Interstate Commerce to send out a prospectus that
                 does not meet §10 requirements (b)(1), or a security that is not accompanied by a §10-
                 compliant prospectus (b)(2).
        §5(c):   Applies to prefiling period. Can’t use Interstate Commerce to sell or offer to buy a
                 security until reg. stmt. is filed.

        Three periods of registration filing:
        1. Prefiling
                  Cannot make any offers to sell during this period (or arouse public interest in security)
        2. Waiting Period
                  Cannot sell security
                  Can put out a red herring prospectus (which is just like the final prospectus, but without
                  the offering price of the security when it goes to market.)
        3. Post effective period
                  Must deliver final prospectus to SHs
                  Corp is still subject to antifraud rules (you are always subject to antifraud rules)


Formal Standards of §5. Problem 3 in Supp.
       PRE-FILING:
       1. Peerless CEO is interviewed in a newspaper. He says that corp is very strong. Says corp has
           strong growth potential. §5(a) and (c) control.

             Is interview an “offer” to sell in contravention of §5(c)? An offer is a solicitation of an offer
             to buy. Securities Act Release No. 3844  Corp may not “condition the public mind” of the
             public in the corp or its securities. Cannot resort to public relations techniques to circumvent
             securities laws. (See Loeb-Rhoades) It might be OK for U/W to use public relations
             techniques, but not corp’s CEO (Id.)

             Did CEO commence a “publicity campaign?”
             Arguments for CEO:
             Just reciting facts
             Just responding to press requests for interview


                                                      5
     CEO talked to local paper, not to a nat’l paper.
     SEC Rel #3844 says that a CEO speech to securities analysts is OK. Just no written material

     Arguments against CEO:
     CEO said that they are going public in near future.
     CEO used puffery
     All stock is now owned by the CEO + his family
     Not the type of info that private corps need to disclose b/c
          Private corps don’t need to bolster share prices
          Private corps don’t need to inform SHs of anything
     Interview was not necessary!
     Intent of CEO is not an issue with SEC (strict liability!)

     How can CEO repair the damage that was caused?
        Delay offering
        Provide prospectuses to all interested parties (as in Loeb-Rhoades)

     Policy:
     Securities laws are the exclusive path of information. Don’t want SHs to start a blind rush to
     buy securities. Want everyone to have the info they need to invest intelligently.

     Why is policy aided by disclosure regime?
     U/Ws, dealers, and customers have an incentive not to renege on their promise to buy
     securities. Repeat player problem  If you welsh this time, you won’t get in on the juicy
     deals in the future. Securities law tries to put an end to this incentive problem.
     One prospectus with good news and bad news put together will allow for corp to publish a
     complete narrative. This produces higher quality disclosure, according to Fox.

     Why is policy hindered by disclosure regime?
     Determining what is or isn’t legitimate communication is tricky. This determination entails a
     high cost. It may even be a waste of resources. The corp’s fear that the SEC will get them if
     they say something wrong might chill the free flow of information. Corp will keep its mouth
     shut!

2.   CEO calls I-Bank to ask if they want to participate in the offering. Is this a violation?
     NO. This is not a §5(a) violation, because §2(3) excludes preliminary negotiations from the
     purview of the definition of “sell” or “offer to buy.” Letter of intent is not a “sale” under
     §2(3).

3.   Press release regarding offering, which tells the proposed price, underwriters, use of proceeds,
     etc. Is this an initiation of a sales campaign? Is it an offer to sell under §5(c)?
     Rule 135 safe harbor doesn’t help Peerless here. Can’t give the price in pre-filing releases.
     Rule 175 safe harbor doesn’t help either. Can’t name the U/W in the pre-filing period.
     It is a violation of §5(c).

4.   I-Bank writes to dealers around the country and invites them to participate in offering (an
     “offer to join the syndicate.”)
     This might be considered a solicitation, but it is not a violation, because U/W and issuer can
     talk to each other, since they are in privity of K with issuer (so §2(3) exception applies)

5.   I-Bank calls dealers and offers shares of Peerless at a 50% discount. Is this a §5(c) violation?
     YES. You may not make an offer to sell to dealers prior to filing. This is not a mere
     invitation to join the syndicate. §2(3) does not provide an exemption here. It is an “offer.”

6.   I-Bank’s research department releases a report that the leisure industry (of which Peerless is a
     part) is a good investment. Is this a §5(c) violation?


                                              6
     YES. It looks like the I-Bank is conditioning the market (a first step in a sales campaign.)
     This is like Example #1 in SEC Release #3844 (pg. 99). Lack of intent by I-Bank is not a
     defense. I-Bank is responsible for coordinating the effort of research and underwriting
     departments. Maybe I-Bank can erect a “Chinese Wall” between research and underwriting.

7.   Corp posts a notice to employees of the offering. Does this violate §5(c)?
     Maybe not. Interstate Commerce was not used to distribute this notice (but SEC might define
     I.C. very broadly.)
     Rule 135(a)(5) allows offerings to employees, but corp may not name U/W under Rule
     135(a)(2).

8.   A customer of a dealer offers to buy the security from the dealer. Is this a §5(c) violation?
     YES. But customer isn’t liable for anything because §5 does not apply to her (under a §4(1)
     exception.) But dealer is liable. Dealer’s wire to U/W is a §5(c) violation.
     Why do we try to stop such a transaction? Policy: SEC Rel. #4697 (pg. 94 n.1),
     Congressional purpose is to keep investors from feeling pressured to “get in first” before
     reading prospectus.
     Why do we get the dealers, and not the customer? Dealers should know better, not customers.

WAITING PERIOD
9. Salesman for U/W calls dealer and offers to reserve 2000 shares of Peerless. Dealer accepts.
   Is there a §5(a) or §5(b) violation at time of offer?
   NO. No sale has yet taken place. §5(b) not violated because there was no writing or
   broadcast. A telephone call is not a prospectus.
   Is there a §5(a) violation when dealer accepts offer?
   YES. This is a “sale” under §2(3) if there is a contract.

10. Announcement of proposed offering in WSJ, including a narration of Peerless’s business, use
    of the proceeds, and asking price.
    This is a prospectus under §2(10), so it must comply with §10 under the provisions of §5(b).
    It would not be a “prospectus” under §2(10) if there is limited information and tells an
    investor where he can get a prospectus (this type of ad is a tombstone ad.) However, corp
    may not advertise how it intends to use proceeds, and must tell investor where to get a
    prospectus.
    Rule 134 safe harbor does not apply here, because no invitation to subscribe may be made in
    the ad. Under Rule 134(d), corp must precede or accompany this type of ad with a §10
    prospectus.

11. U/W sends letters to prospective dealers around the country. Does this violate §5(b)(1)?
    YES. No free writing is allowed at this time. This writing is a prospectus, so it must meet
    §10 requirements. (If this letter were only to other U/Ws, it would be OK, because it is not an
    “offer” under §2(3).)
    U/W may send a letter that simply solicits offers as long as the letter is accompanied by a
    prospectus.

12. Dealer sends letter offering shares to an investor without Red Herring because he knows that
    investor already received one. Does this violate §5(b)(1)?
    NO. As long as the letter meets the requirements of Rule 134(d), then it’s OK. If dealer
    knows that investor already has a Red, he needn’t send another one. If dealer had merely
    called customer, it is not a prospectus under §2(10 and thus it is OK, even if customer didn’t
    have Red.




                                            7
        13. U/W amends Red pursuant to SEC comments. Who must receive a copy of new prospectus?
            Look at §8(a): Issuer wants acceleration here because no U/W will deal with a security that is
            priced a full 20 days before it is issued (a lot can happen in 20 days!) Thus acceleration is
            vital to issuer.
            Under Rule 460, issuer must take reasonable steps to disclose info to public in order to be
            granted acceleration. Thus, issuer must take adequate steps to secure prospectus delivery to
            U/Ws and dealers.
            Rule 15c2-8 (1934 Act): In an IPO, the dealer must send Red to anyone who has shown
            interest in purchasing its securities. Otherwise, it is a “deceptive practice” by the dealer.

        14. Dealer calls customer and offers him 100 shares at the time of offering at $11/share. Customer
            accepts. Does this violate §5(a)?
            YES. An oral offer is OK, but after customer accepts, there is a contract under §2(3), which
            violates §5(a). Even if there is no K, dealer must send Red to customer under Rule 15c2-8.

        15. Research dept of a different U/W not involved in the offering issues a report that lists
            Peerless’s stock as “attractive.” Is this a §5(b)(1) violation?
            MAYBE. Depends on whether this recommendation is a “prospectus” under §2(10). U/W’s
            report will excite interest in Peerless. But can this really be an offer? U/W doesn’t give a
            rat’s you-know-what about Peerless’s success or failure.
            Safe harbors of Rules 137-139 do not apply because it is an IPO (not a ’34 Act corp.)

        REG. STMT. BECOMES EFFECTIVE:
        16. When must a final prospectus be sent?
        a. With a letter offering Peerless stock to a customer? YES. Letter is a prospectus under
            §2(10). If no prospectus, there is a §5(b)(1) violation. However, now free writing is allowed
            with a prospectus.
        b. With a Peerless stock certificate sent to customer who accepted a telephone offer? YES.
            Under §5(b)(2), the prospectus must be mailed along w/ stock certificate.
        c. Same as (b), but where the certificate was sent to the dealer’s office? Probably. But Interstate
            Commerce wasn’t used. Remember the broad interpretation of I.C. though.
        d. With stock certificate being sent to a customer who had received Red before? YES. §5(b)(2)
            requires delivery of final prospectus under §10(a) with delivery of stock certificate. Rule 430
            only applies during waiting period.
        e. With a confirmation of sale to a customer who accepted a telephone offer? YES.
            Confirmation notice is not an adequate §10 prospectus. Sending a confirmation letter alone
            will violate §5(b)(1).
        f. After confirming by telephone a sale to a customer who made a telephone offer to buy? YES.
            Rule 10b-10 of ’34 Act requires a written confirmation to be sent, which in turn requires
            sending a final prospectus.

        17. Can dealer confirm a sale to a customer who was orally solicited to make an offer to buy 100
            shares before effectiveness, but never received a copy of Red?
            YES. §5 is not violated by not sending Red. But dealer violated Rule 15c2-8, so if customer
            decides not to buy the securities, it is unlikely that dealer will sue to enforce the sale.

        18. Dealer mails some Peerless literature with a lot of puffery along w/prospectus.
            Dealer can do this because “free writing” is OK after effectiveness. But antifraud provisions
            of 10b-5, §17(a), and §12(2) will apply, so no material misstatements are allowed.

        See handout for answers to #19-22.

Statutory Summary of 1933 Act:
§2(1): “Security” is defined to include “… any note, stock, bond, debenture, evidence of
        indebtedness, investment contract, option, etc…”



                                                    8
§2(3): “Sale,” “Sell,” and “Offer to sell” is broadly defined. “Offer to sell” includes “every attempt
         or offer to dispose of, or solicitation of an offer to buy a security for value” Definition does
         not include preliminary negotiations and agreements between U/W and issuer.
§2(10): “„Prospectus‟ means any prospectus, notice, circular, advertisement, letter, or
         communication, written or broadcasted over radio or TV, which offers any security for sale
         or confirms the sale of any security.” The term prospectus does not include any
         communication after effectiveness, as long as a §10 prospectus was sent before or
         contemporaneously. Term also doesn‟t include communication does no more than state
         basic terms of the security and from whom to get a prospectus.
§2(11): “Underwriter” means “anyone who purchases securities with a view to distribution.”
§4(1): Exemption from §5 requirements for transactions by someone other than an “issuer,
underwriter, or dealer.” (NOTE: “by” really means “involving.”)
§4(2): Exemption from §5 requirements for “transactions by an issuer not involving any public
         offering.” Basically, a small sale by an issuer to a sophisticated investor is OK as long as
         investor isn‟t a conduit to other investors.
§4(3): Prospectus delivery requirements for dealers. If dealer is in the syndicate, dealer must send
         out prospectuses. If dealer is not in syndicate, he must only give a prospectus within 40 days
         of first sale. NOTE RULE 174.
§4(4): Exemption from §5 requirements for brokers‟ transactions executed upon customers‟ orders.
§5(a)(1): If reg. stmt. is not effective, cannot sell security through use of a prospectus.
§5(a)(2): If a registration stmt. is not effective, it is unlawful to sell that security.
§5(b)(1): No free writing is allowed during the waiting period.” All prospectuses must conform to
         §10. (NOTE: Virtually all written communications are §2 prospectuses.)
§5(b)(2): It is unlawful to deliver a security unless it is accompanied by a §10 prospectus.
§5(c): Cannot make offers to sell or buy unless reg. stmt. is filed, or while subject to stop order.
§8(a): If SEC doesn‟t grant acceleration for effectiveness, company can (and must) wait 20 days
         before statement becomes effective.
§8(d): SEC may initiate stop order proceeding, which suspends effectiveness, if there is a material
         misrepresentation or omission.
§10(a): Statutory prospectuses must be complete – with underwriter‟s name, underwriting discount,
         price, etc. RULE 430, Red Herrings.
Rule 134 (TOMBSTONES): Some communications not deemed prospectuses under §2(10) after
         filing if information is limited to 1) issuer‟s name, 2) title and amount of security offered, 3)
         general business of issuer, 4) price or price range, …, 6) name of the sender of the
         communication and if they plan to participate in the offering, 7) names of managing U/W,
         and 8) anticipated offering date.
Rule 135: Safe Harbor for pre-filing press releases by issuer about offering if they don‟t name U/Ws
         and don‟t disclose prices. (Exception for notices to employees.)
Rule 137: If the issuer is a ‟34 Act company, non-participating dealers can talk about the deal during
         the waiting period.
Rule 138: Participating dealers can make recommendations re. nonconvertible debt or preferred
         stock during the waiting period for a common stock offering, and vice versa.
Rule 174: a) If issuer is already a ‟34 Act reporting company, non-syndicate dealers have no
         obligation to deliver prospectus. b) If dealer is in the syndicate, if the security will be listed
         on an exchange, then delivery is required 25 days after issue. If a ‟34 Act corp is not listed,
         then dealer must deliver prospectus 40 days after issue. If it‟s an IPO, dealer must deliver
         prospectus for 90 days after issue.
Rule 175: Safe Harbor for projections made by issuer or agent retained by issuer – unless the
         projections were made in bad faith.
Rule 430: Issuer may distribute a Red, but it must have a disclaimer and be filed with a reg. stmt.
Rule 460(b)(1): Sufficient number of preliminary prospectus required to be delivered before
         effectiveness to each U/W and dealer who is anticipated to participate.
‟34 Act Rule 15c2-8: Delivery of preliminary prospectuses required to all who have shown an
         indication of interest.




                                                    9
Some SEC Releases:
       SEC Rel. 5180 (pg. 113): Guidelines for issuers regarding communication during registration.
               a. Can still continue to advertise products and services
               b. Can still send out periodic financial reports to SHs
               c. Can continue to publish proxies and notices of dividends
               d. Can continue to make factual announcements to press re. business and financial
                   developments
               e. May answer unsolicited telephone inquiries as to factual matters from press, analysts,
                   and SHs, etc.
               f. May observe an “open door” policy re. responding to items in (e).
               g. Continue to hold SH meetings as scheduled, and answer SH questions

        Release 5009 (pg. 111): If you need to disclose material events during registration, keep
                 statements factual. No puffing.
        Release 3844 (pg.97)
                 a. Unlawful for any issuer, U/W, or dealer to begin a “public sales campaign” before
                      filing
                 b. If publicity raises a question as to whether it is in fact a part of the selling effort, then
                      beware the SEC.
        See Release 4697 (pg. 94) for a summary of the do’s and don’ts during registration


INTEGRATED DISCLOSURE:
      1934 Act: Periodic Disclosure Requirements.
      1934 Act structure:
      1. §12(a)  Brokers may not handle shares on a national exchange (including NASDAQ) unless
          shares are registered under §12(b), which requires Form 10K and 10Q.
      2. §12(g)  Applies ’34 Act provisions to any company with > 500 SHs and > $5 million in
          assets. When a corp is that large, there is probably a lot of trading.
      3. §13 requires periodic disclosure
      4. §15(d)  Assumes that corp is publicly traded after a reg. stmt. is filed under ’33 Act. Then
          corp must report under ’34 Act.

        Old Disclosure Regime:
        All corps, no matter how established, had to disclose fully under Form S-1 when it registered.
        This was expensive and wasteful.
        Also created an inconsistency, b/c ’33 Act says “shut up,” and ’34 Act said “tell all.”

        REFORMS  Differences between an IPO and a ’34 Act corp issue:
        1. Rules 137-139 safe harbors for dealers and U/Ws
        2. Rule 174 regarding prospectus delivery (dealer only needs to give out prospectus 25 days
           after issue, not 90 days.)
        3. Rule 15c2-8: Red is required only for IPO issuers, but everyone who wants a prospectus must
           be provided with one, regardless of whether it is a ’34 Act corp or not.

        REGULATION S-K: Developed a single set of questions for both ’33 and ’34 Act disclosure.

        Short Form Registration (Forms S-2 and S-3) and Shelf Registration (Rule 415):
                Permits public companies to incorporate answers in 10K into registration stmt.
                This reflects EMH hypothesis that market is already informed about public corps.
                S-2: Corp may file S-2 if it has been a reporting corp for 3 years.
                S-3: Corp may file S-3 if it has been reporting for 1 year and has market cap of 75
                         million or more

                 Rule 415: Shelf Registration
                         Allows registration of more securities than you expect to sell


                                                      10
                          Allows registered securities to be sold over a 2 year period (“continuous
                          offering”)
                          Stale info is not a problem due to 10K and 10Q filings and EMH.

What must be disclosed?
      Different treatment for first-time issuers and seasoned issuers. Is this justified?
               Fox’s observations:
               1. Most new issues are purchased by well-informed institutions at retail price
               2. IPOs tend to be sold at a discount with a significantly higher gain in 1st 6 month.
                    Hence everyone wants in now.

        DO WE REALLY NEED A PROSPECTUS FOR IPOs BUT NOT FOR ESTABLISHED
        CORPS? Why the disparate treatment between IPO’s and established corps?
              Argument for no prospectus:
              1. People don’t really read prospectuses. Rather, they listen to the experts (a distillation
                  process.) So maybe we only need to give prospectuses to the experts.
              2. Let little investors take solace in the fact that the big investors are paying as much
                  for the stock as they are.

                 Argument for prospectuses:
                 1. We still need to give prospectuses to the brokers. If we also give prospectuses to
                     customers, it will give brokers an incentive to read the prospectuses. The brokers
                     don’t want to seem stupid!
                 2. There is no guarantee that the large investors are as excited about the IPO as I am. I
                     wouldn’t know whether this is a good investment until I read the prospectus.
                 3. Want to protect people from really bad investments

                 If an established corp wants to issue new securities, it only has to file a reg. stmt.
                 (S-2 or S-3) No prospectus needs to be given to investors, like in the case of an IPO.

        Significance of U/W due diligence…
                 U/Ws will search through a corp much more thoroughly if they are held liable for their
                 mistakes.

        For whom is disclosure intended?
        Ordinary investor? Then write the prospectus in simple, ordinary language
        Securities analysts? Write prospectuses in technical language.
        If we make corps write everything in simple language, the corp may be less likely to keep bad
                 news from investors.


MATERIALITY STANDARD:
     Universal Camera Case (155) (SEC Ruling)
     Warrants: Allow you to buy shares at a fixed price in the future. Warrants are valuable when
     Mkt. Price > Warrant Price
     Original SHs sell out, and receive Class B shares and warrants. Bottom line is that original SHs
     get lots of goodies. Publicly offered shares sold well above book value. It was disclosed on pg 1
     of prospectus that the investment was merely a speculation.
     SEC said that this was inadequate disclosure.
     DISCLOSURES MUST BE PLAINLY UNDERSTANDABLE BY AN ORDINARY INVESTOR

        SEC acted under §8(d): Under this Section, SEC may comment on any perceived disclosure
        deficiencies. SEC requires disclosure to be in plain, ordinary language. The actual language of
        the disclosure doesn‟t ultimately matter. What really matters is how ordinary investors
        would construe the statements. Even if professionals could understand the language of the
        disclosure, the corp didn’t do its job. Ordinary investors need to understand the information. If



                                                    11
corp doesn’t fix deficiencies, SEC may later make a stop order, which delays effectiveness of reg
stmt until after order is lifted.
Seems that SEC was partaking in a review of the investment’s merits in this case. SEC did not
think that this would be a good investment, so it was tough on the corp. SEC thought that no
rational investor would take part in this investment (where investors are really “cashing out” the
promoters.) It is not technically SEC’s job to pass on the merits of the investment. Maybe a
rational investor would want to partake in a risky speculation!

Three triggers of a stop order:
1. Untrue stmt of a material fact
2. Material omission
3. Misleading statements that are technically true
Remember that “misleading to ORDINARY INVESTOR” is a leading theme of this entire course.

Franchard Case (159) (SEC Ruling)
Corp omitted two material facts, according to SEC:
1. Glickman (the head honcho) periodically withdraws funds from corp
2. Glickman has controlling number of shares, but they are pledged for loans.

SEC says that these facts allow investor to pass judgment on Glickman’s managerial integrity.
This is especially relevant in a case like this, where investors are trusting the business acumen of
one dude. (But the withdrawals and pledges are not illegal. This doesn’t seem like a blemish on
his integrity.) Again, it seems that SEC is passing judgments on the substantive merits of the
investment. SEC is concerned with the role that can and should be performed by the disclosure
requirements of the Securities Act in assisting investors to evaluate mgmt. An insider who is
asking the public for funding must relinquish some privacy. Case reads Rule 408 very broadly.

Prof thinks that SEC’s arguments in this case are strained. This is not really a material omission.
The point is that the SEC wants more than formal disclosure. The SEC wants the whole picture.
Registration forms are “guides,” not an exhaustive listing of all that could possibly be disclosed.

Citicorp case (yellow book – class materials pg 107.)
Should Citicorp disclose possibly illegal tax-avoidance transactions? Citicorp was forced to pay
$11 million in back taxes to foreign governments. Is this material? (Remember that Citi’s assets
are more than $1 billion.)
Citicorp said that this is de minimis. Besides, Citicorp took into account the $11M outlay in its
total liabilities section of its financial statements, it just didn’t itemize that particular transaction
SEC said that this was material: It suggests future liabilities (Franchard-type argument –
managerial integrity.)

Fox: This wasn’t really material. Actually, investors benefit from lack of disclosure. More $$ for
them! Disclosure just increases the chances that Citi would get caught. But future SHs might
suffer, since stock price could be artificially higher w/o disclosure. At worst, it is a wash.
Fox thinks that SEC was trying to enforce corporate morality.

Caterpillar case (165) (SEC Ruling)
The point is reinforced that corp cannot simply answer formal questions. Corp must give a full
and accurate picture in its MD&A (Management’s Discussion and Analysis) portion.
(i.e. Forward-looking projections may be required.)
Caterpillar should have fully discussed the Brazilian subsidiary’s impact on Caterpillar’s financial
health in the present and in the foreseeable future.
SEC thinks that Cat’s last year’s performance = this year’s forecast

Reg S-K, Item 303(a)(3)(i): Describe unusual/infrequent events that affected income. “Unusual”
means something that might not happen again in the future.




                                               12
        Reg S-K, Item 303(a)(3)(ii): Describe events that have had, OR WILL HAVE a material negative
        or positive effect on corp.

        Virginia Bankshares (169) (Sup Ct)
        Proxies were solicited for a merger. Board says that the offer is a “high value” and a “fair price”
        and board gets sued for this statement.
        Court holds that “knowingly false or misleadingly incomplete” statements, even if
        “conclusory,” are actionable. Under §14(a), a plaintiff is permitted to prove a specific statement
        of reason knowingly false or incomplete, even if stated in conclusory terms.


FORWARD-LOOKING STATEMENTS: (a.k.a. “soft statements”)
     Historically, SEC viewed disclosure of projections as per se misleading. However:
     1. In fact, companies were being valued in the market based on forward looking statements
     2. Management really did have opinions for the future, and mgmt could have disclosed such
         opinions through press releases not subject to SEC scrutiny

        Beecher v. Able (198) (Dist. Ct. NY)
        Douglas Aircraft mgrs get sued for making this statement when selling bonds: “it is very likely
        that income, if any, for fiscal 1966 will be nominal.” Actually, Douglas lost over $50 million.
        Was this a “statement”? Was this “untrue”? Was it a “fact”? It was a statement, and we can
        assume that it was material.
        Management expressed an opinion. The court said that management’s opinion is a “fact” under
        §11, because what the mgmt believes is a “fact.”

        Is the statement untrue? If you read the statement literally, it is true.
        Literal reading is: Earnings < 0
        “Common Language” reading is: Earnings = 0
        Since earnings = $-56 million, literal reading is true, but CL reading is false.
        Ct said that we look at disclosures through ordinary, common language, so the statement is untrue
        because it tells investors that Earnings = 0. Ct said that an earnings forecast must be based on
        facts from which a reasonably prudent investor would conclude that it was highly probable that the
        forecast would be realized. Ct puts burden of D to prove that statement was reasonable (i.e. “well-
        made.)
        Factors bearing on reasonableness of a forecast:
        1. corp’s record of success in forecasting earnings
        2. the care exercise in the preparation and review of cost and sales estimates
        3. Reasonableness of the assumptions underlying the forecast

        Policy behind Beecher.
        Increased litigation will chill future management projections about what it thinks will happen.
        Ordinary investors don’t generally read prospectuses. Financial professionals do
        Making D have burden of proving reasonableness of statement is not good, says Fox.

        Why is Beecher decision bad?
        1. “Reasonable investor” test is probably too vague. It is hard for corp to comply with that
        standard
        2. Test relies too much on individual investors, when most of the securities are purchased by
        institutional investors
        3. Corps may be deterred from making helpful future statements
        4. Professionals’ knowledge of non-IPO corp is already reflected in stock price. (Easterbrook’s
        EMH theory)
        5. Professionals are better at interpreting prospectuses than individuals. Goal should be to force
        corp to disclose to pros.




                                                    13
        SEC Rel 5992 (pg. 202)
        The fundamental assumptions underlying mgmt’s predictions should also be disclosed by mgmt.
        This gives investors the ability to differentiate between good and bad predictions.
        Investors can independently evaluate mgmt’s predictions when mgmt reveals its assumptions

        Trump case (217) (3rd Cir)
        Court uses “bespeaks caution doctrine.”
        1. As long as corp uses cautionary language in its offering documents, the materiality of
        misstatement or omission will disappear AS A MATTER OF LAW [12(b)(6)].
        2. Cautionary language must be “substantive” and “tailored” to the specific projections in the
        prospectus. Boilerplate isn’t good enough!
        3. Ct used a result-oriented approach. It just wanted to get rid of the lawsuit
        Fox doesn’t like this doctrine. Despite cautionary language, investor will still rely on projections

        Weilgos (207) (7th Cir) (Easterbrook decision)
        It doesn’t matter that the prediction wasn’t well-made, as long as the market realizes and evaluates
        the relevant factors. The forecast only needs to have a reasonable basis in order for corp to avoid
        §11 liability.

        RULE 175 (could’ve helped Beecher) (see SEC Rel 6084, pg 204) (DRUG CO. HANDOUT)
        1. Projections shall not be deemed fraudulent unless P can show that the projections were made
        w/o a reasonable basis or not in good faith
        2. Rule is limited in scope to SEC filings (not a CEO pop-off.)
        3. Here SEC decides that future projections are desirable.
        4. Gets rid of lots of meritless suits
        RULE 175 APPLIES TO IPO’s AND ESTABLISHED CORPS


STATUTORY REFORM:
      Private Securities Litigation Reform Act (1995) (broader than Rule 175)
      §27A of ’33 Act
      §21E of ’34 Act
      Covers SEC filings and disclosures which are not SEC filings

        Safe Harbor for forward looking statements:
        Prong I: Protects written and oral forward-looking statements that are: 1) identified as forward-
                 looking, and 2) accompanied by meaningful cautionary language identifying important
                 factors.
                 Defendant does not need to have identified all the actual factors that caused results to
                 differ from projections. There is no scienter requirement. Only look at statements
                 themselves

        Prong II: D is not liable unless he had actual knowledge that statement was false or misleading.

        D wins if he can succeed if he proves EITHER of these prongs
        No duty to update projections under §27A. (§27A(d).)

        This Act only applies to established corps. Safe harbor doesn’t protect:
        1. statements in financials
        2. IPO registration statement
        3. Statements made in connection with a tender offer

        Committee Report: Shows Congress’s pro-D leanings. Wanted to get rid of lawsuits.

        Why limit protection to established corps?




                                                     14
        1.   There is more incentive for corp to lie in the primary market. (Secondary market = repeat
             players)
        2.   Lying by insiders hurts insiders and outsiders equally in established corp. Lying only hurts
             outsiders in IPO market
        3.   No need to encourage projections in IPO mkt.
        4.   Congress said that it likes “bespeaks caution” doctrine

Drug Company Handout:
       Corp projects that sales and earnings will double because of development of new drug
       It labels such projection as a “Prediction” and accompanies this with cautionary language that drug
                 is subject to FDA approval.
       Mgmt knows that approval could take 5 years (it said 1 yr.), and that its existing technology will
                 not be able to allow it to develop drug commercially.

ISSUE 1: Does safe-harbor offer protection here, even though it doesn’t mention need for corp to
               establish new technology??
               1. D says that it identified important factors. Statute doesn’t say tat ALL important
                    factors! Conference Committee said that the actual factor that lead to projection
                    being wrong doesn’t even need to be identified.
               2. P says that D loses under §27A, because it knew that the “1 yr” statement was
                    misleading
               3. D responds that it only has to win on one of §27A prongs to win suit (D wins on
                    Prong I, but loses on Prong II.)

        ISSUE 2: Suppose mkt knows both about the 5 year FDA approval timeline and the need for new
               technology (see Weilgos case)
               1. Fox says that mgmt projections are not reasonable if mgmt knows that they are
                    biased, even if market knows that the projections are biased as well. (Note:
                    Easterbrook says that disclosure is only for experts.)
               2. Easterbrook is wrong when he says that there is no fraud when the price isn’t
                    affected. Actually there is fraud, but no damages

        ISSUE 3: Suppose corp already knew that FDA approval would be denied forever.
               1. Safe harbor may still protect corp. Prong II of §27A fails, but maybe D can still
                   come up w/ winning argument on Prong I.

        ISSUE 4: Corp finds out 2 months later that they won’t get approval. Is there still a duty to
               update?
               1. No. §27A(d) says that the statute does not create such a duty. But if the duty exists
                   elsewhere, corp must disclose

        Stransky (214) (7th Cir): There is a duty to update historical info, not to update projections
        Backman (216) (1st Cir): There may be a duty to update projections

        Fox’s thoughts on all of this:
        1. No public offerings should have this safe harbor protection
        2. IPO’s create very strong incentives to make overly rosy projections – more so than secondary
            offerings. (Promoter gets to cash out in an IPO.)
        3. The result is allocative inefficiencies since bad projects may get too much capital, and the
            converse.

THE SEC‟s ADMINISTRATIVE REMEDIES:
      1. §6 of ’33 Act: Issuer and others must sign reg stmt, which opens them up to liabilities
      2. §8: Reg stmt becomes effective upon SEC acceleration (which allows for pricing
          amendment), or 20 days after pricing amendment if no acceleration.




                                                     15
     The power to accelerate gives SEC great power in shaping disclosure requirements for a corp.
     because few corps or U/W will wait 20 days after pricing security to offer it
3.   §8(b): Refusal order procedure. SEC may refuse reg stmt effectiveness if it thinks that reg
     stmt is inadequate. Never used, b/c SEC is required to commence this within 10 days of
     filing. SEC doesn’t work this quickly
4.   §8(d): Stop order. If SEC finds material problems at any time, it can issue a stop order
     suspending effectiveness of reg stmt
          §5(c) says that no offers can be made if there is a stop order.

Universal Camera (220) (SEC Ruling)
Defective registration stmt and Red leads SEC to begin §8(d) stop order proceeding during
waiting period. This is a hearing to determine whether the stop order was appropriate. Issuer
amended disclosure to SEC satisfaction in the meantime, so SEC dropped stop order and
proceeding.

Why do we have proceedings like this?
1. Negotiations between issuer and SEC break down, or
2. SEC wanted to publicize this problem with red herrings to the general issuer public.

Doman Helicopter (222) (SEC Ruling)
§8(d) proceeding during waiting period is not dismissed because SEC thought that reg stmt and
red herring were still misleading, and issuer’s amendments weren’t good enough. Fox thinks that
SEC just wanted to send a message to I-banks and law firms, so it strung up this particular issuer.
(i.e. this is a pure sanction, because SEC thought that issuer acted in bad faith.)
Ct stated that statutory scheme does not allow “preliminary filing” and does not establish a right
for the corp to receive a comment letter from SEC. Corp must disclose all information up front in
initial filing.

Franchard (223) (SEC Ruling)
SEC makes a stop order after reg stmt is deemed effective. SEC cites misleading filings. If issuer
does not disseminate to SHs information which would adequately advise them of misleading info
in the reg. stmt., the SEC’s issuance of a stop order is essential for the protection of public
investors in order to dispel the misleading info.

Comment letters: SEC can comment on supposed shortcomings of reg stmt informally. These
letters are confidential. It is a jumping-off point for negotiations between issuer and SEC.
Confidentiality makes negotiating with issuer easier for SEC.

OTHER SEC POWERS UNDER 1934 ACT:
1. §12(j) of ’34 Act: SEC has power to revoke the registration of security, or suspend it for up
   to 12 months if SEC finds after a hearing that issuer violated ’34 Act.
2. §12(k) of ’34 Act: SEC has power to suspend trading in a security for 10 days if public
   interest requires this.

Proposed Reforms:
1. Make comment letters public, so that subsequent issuers know what SEC wants. Present
    issuers don’t want non-confidentiality, though.
2. ABA proposal (case – p235) to amend §8(d) to allow for automatic acceleration after 20 days
    (when pricing amendment would be made.) SEC says that this would lead to lots of stop
    orders being issued (waste of resources.)
    Fox thinks that the ABA reform might be a good idea, so that SEC can’t be so nit-picky, like
    in the case of disclosure of indemnification by issuer against §11 liability (who cares if this
    gets disclosed or not???)
    {If corp has indemnification agreement and it wants acceleration, it must:
    1. Disclose indemnification agreements between corp and its officers
    2. “                 “           “        “        “     “ “ U/Ws



                                            16
             3.   State that indemnification agreements are against public policy and are ineffective at law
             4.   Submit to a court the question of whether an indemnification is OK }

         NOTE: SEC has refused acceleration for a corp that required SHs to submit its beefs about corp to
         arbitration.

CIVIL DAMAGES UNDER §11:
       Outline of §11:
                a. §11(a): If there is an MM or O (material misrepresentation or omission) in reg stmt,
                    any person acquiring such a security may sue certain people, including all those who
                    sign reg. Stmt (issuer’s officers, directors, U/W’s, etc.)
                    NOTE: Standing to sue is limited to those who purchased their securities pursuant to
                    the faulty reg stmt.
                b. §11(b): The due diligence defense. (Purpose of this section is to get corp to gather
                    all relevant information and disclose it.)
                    Insiders of issuer is absolutely liable for MM or O. The only question would be the
                    measurement of damages.
                    Everyone else is permitted an affirmative defense that they investigated the matter
                    thoroughly and that they HAD AN ACTUAL AND A REASONABLE BELIEF that
                    there was no MM or O in reg stmt
                c. §11(c): Everyone is expected to act as a “reasonably prudent man in the management
                    of his own property.”
                d. §11(d): Late underwriters are generally only liable from the time they became U/W’s
                e. §11(e): Measure of damages: Generally the difference between amount paid for
                    security and [ 1) its value at time suit was brought, or 2) the price of the security on
                    the market before the suit was brought.]

         Beecher v. Able (262) (Dist Ct NY)
         §11 suit for damages. The issue was the measure of damages under §11(e).
                  1. P’s say that “value” of security < market price (this means that measure of damages
                       would be higher…) Value is less b/c the buying public was not yet fully aware of
                       the crisis gripping the corp. The full loss was not yet reflected in the price. “Value”
                       really equals what a fully-informed investor would pay. It is not really the mkt price.
                       (P ignores EMH, which says that mkt price reflects the available public information.
                       Prior declines tell us nothing about the steep drop after bad news was made public)
                  2. D’s say that “value” > mkt price, b/c there was panic selling. Securities are really
                       worth more. (But maybe this wasn’t “panic selling.” A sell-off might be perfectly
                       rational.)
                  3. Judge said that D was right and awarded P less damages, but her reasoning was
                       stupid, so don’t analyze it too much for pearls of wisdom. Court should not be the
                       judge of valuations.
                  4. Financial economists’ testimony: Historically, value of stock may be greater than
                       price. Notice quick rises in stock prices even when there is no news.
                  5. Under §11(e), D may show that any portion of the damages really aren’t attributable
                       to the bad Reg. Stmt. If that turns out to be the case, D does not have to pay P
                       damages for that portion of the drop. D has the burden of proving that the drop in
                       price is not attributable to reg stmt. (In Beecher, P’s conceded that most of the price
                       drop was not attributable to bad Reg Stmt, so they lost out on mucho damages.)
                  6. Court also said that no investor who sold his shares before the bad news broke is
                       entitled to any damages.

                  Fox thinks that the best measure of damages could be the tort measure, which equals the
                  difference between price paid and what the price would have been had there been
                  adequate disclosure. This is not the §11(e) measure though (too speculative?)

                  “Value” vs. “Price”: Notwithstanding Beecher, most courts say that Value = Price.



                                                     17
         Akerman v. Oryx (271) (2nd Cir)
         Ct said here that price declines before disclosure may not be charged to D’s. (Fox disagrees with
         this statement.) Ct said that it is a question of fact as to whether D can qualify under this
         exception to §11.

         GENERALLY UNDER §11:
         1. P makes prima facie case my showing that: Price of security at time P bought it > Price
            of security at time of suit
         2. D can do either a) or b) to reduce damages:
            a. Show that mkt price < actual value (Beecher “panic selling” argument)
            b. Show that drop in price drop is due to other factors besides illegal statements

DUE DILIGENCE DEFENSE:
      Escott v. BarChris (275) (Dist Ct NY)
      Corp is in significant financial trouble at time of the offering, but the prospectus is silent on these
      difficulties. Issue is whether defendants established their affirmative defenses :

         1) Russo – the CEO: He’s liable, because he knew or should have known all the material facts
            surrounding corp. He was an insider.
         2) Vitolo + Pugliese – the illiterate president and vice president: They’re liable. Even though
            they couldn’t understand reg. stmt., §11(b) establishes an objective standard, and under
            §11(c), they must act like a prudent man watching over his own property.
         3) Kircher – Treasurer: He’s liable for same reason as Russo. He knew or should have known
            everything.
         4) Birnbaum – the young general counsel: He is liable b/c he did not make a reasonable
            investigation. This seems unfair to Birnbaum, b/c he’d probably get fired if he asked too
            many questions…
         5) Auslander – a new outside director: He’s liable for non-expertised portions of reg. statement
            because he did nothing more than rely on the inaccurate representations by insiders that
            everything was OK. Ct did not rule out the “new outsider defense” here. Auslander just
            didn’t do his job. (Under corporate law, an outsider may rely on insiders. Not the case under
            securities laws. This is because we want insiders and outsiders to talk to each other.)
         6) Grant – outsider director and counsel: He’s liable because he didn’t make a thorough enough
            investigation either. He was supposed to verify facts that were easily verifiable.
         7) U/W’s – they relied on their counsel doing the due diligence, which it didn’t do: U/W’s are
            liable too. Court wants U/W to search through corp’s stuff. An adversarial relationship
            between corp and U/W isn’t such a bad thing, thinks court. (But didn’t U/W act like a
            prudent man looking after his own property by hiring a lawyer who said they’d do their job?)

         RULE 176: Safe harbor for non-lead U/Ws. If lead U/W did decent due diligence, non-lead
         U/Ws can rely on the lead’s job. No need for independent due diligence by all U/Ws in the
         issuing.

         Feit v. Leasco (296) (Dist Ct NY)
         There was a takeover of an insurance company in order to get the insurance co’s “surplus surplus.”
         1) Ct says that the absence of an estimate by acquirer of the amount of surplus surplus held by
              insurance co. is a material omission
         2) Underwriters aren’t liable in this case. (U/Ws as repeat players have other incentives besides
              legal liability to do their jobs well. They need a good reputation.)
         3) RULE: Insiders are held to a “known or should have known standard.” Issuers are
              “guarantors of accuracy.” Strict liability for issuers (i.e. the insiders of the corp.)
              “Inclusion or omission of an item without a reasonable investigation or verification will lead
              to liability for the inside directors just as surely as if they actually knew of the inaccuracy.”




                                                      18
         4) Acquirer’s “rock and a hard place:” Either guess the amount of surplus surplus (if they’re
            wrong, they’re liable) or omit a guess altogether (which might make them liable too, b/c it’s a
            material omission.)
         5) Court seems to say, “Get the estimate right or forget the whole transaction.”
         6) Here, ct imposed liability b/c insiders could have just asked the guy who has the information
            for his information.
         U/Ws will be adversarial w/ issuer if U/W is liable for any screw-ups too.

Integrated Disclosure and U/W due diligence
        Short-form and shelf registration allow established corp to incorporate 10-K and 10-Q statements.
        U/W’s get involved in the due diligence surrounding long-form (IPO) registration, but they don’t
        get involved w/ 10K and 10Q preparation.
        Short form issuing can be done very quickly, so there is pressure exerted upon U/Ws to get due
        diligence done quickly.
        Prospectuses under short-form registration are smaller, so there may be less “ownership interest”
        U/Ws have in prospectus.

         So it might make sense to impose softer due diligence responsibilities on U/W in short form and
         shelf registrations.

         RULE 176: If U/W did not participate in line-by-line preparation of reg. stmt., then U/W’s
         liability is less. Rule 176 is a factor the court may consider when determining the merits of U/Ws
         §11(b) defense.
         SEC Rel. 6335 says that U/Ws should keep reservoir information on possible shelf issuers.

         Gap case (Dist Ct CA) (303)
         Proof that managing U/W performed adequate due diligence may protect all other U/Ws.
         Weinberger (Dist Ct CA) (303)
         Outside director not required to conduct independent investigation, as long as there was reasonable
         inquiry.
         Laven (Dist Ct NJ) (304)
         Reliance on subordinates is OK.

Civil Damages under §18 of ‟34 Act
        This is civil liability for bad 10K and 10Q filings.
        LIABILITY STANDARD:
                  1. Liable if there is an MM or O, unless there is good faith and no knowledge of the
                        false or omitted statement.
                  2. Fox says the §18 is a dead letter (a toothless tiger.)

         Heit v. Weitzen (328) (2nd Cir)
         Annual Reports are not subject to §18 liability, since it is not a filed document.
         There is liability for faulty 10K disclosure only when P can show that he actually relied on the
         deficient 10K.

DEFINITION OF A SECURITY
      §2(1) of ’33 Act defines “security” as “an note, stock, treasury stock, bond, evidence of
      indebtedness. INVESTMENT CONTRACT, etc.” Very broad reading of the definition. We are
      trying to cover as many types of investments as we can here, so that securities laws will apply.

What is an “Investment Contract?”
         It is the catchall phrase in the definition. If SEC wants to regulate an investment and it doesn’t fit
         into the other categories of “securities,” we’ll call it an investment contract.




                                                      19
        SEC v. W.J. Howey (17) (Sup Ct)
        Howey offered units in a Florida citrus grove coupled with a contract for cultivating and
        marketing of the fruit. 85% of the investors (most of whom lived out of state) took the marketing
        and cultivating K offered by Howey. Produce is pooled and corp allocated profits according to the
        share of total land owned.

        HOWEY TEST FOR INVESTMENT K:
        1. Investment of money
        2. In a common enterprise
        3. With the expectation of profits
        4. Solely from the efforts of others

        Fox’s hypothetical A:
        What if only 15% of the investors took the Howey service K? Would there be a security then?
        The offer of the service contract at all is what counts. The SEC will still try to deem this a
        security, because ex ante, it is possible that everybody would take the K. From a policy
        standpoint, it doesn’t really matter whether “solely from the efforts of others” means solely the
        promoter or if it can include other service providers.

        Fox’s hypothetical B:
        What if Howey had not offered the service contract at all? Is it a security then?
        This seems to fulfill the 4 Howey factors above. However, this seems more like a real estate deal.
        Securities laws do not (and should not) cover real estate deals. But see p 34, SEC Release saying
        that the selling of condo units could be a securities offering (also see Hocking v. DuBois, which
        said basically the same thing.) In Teague v. Bakker, court said that a time share interest in a resort
        hotel was a security.

Application of Howey Test: Common Enterprise:
         Brodt v. Bache (22) (9th Cir)
         Broker who works for defendant bankrupts P’s discretionary commodities trading account. Is a
         commodities trading account a security?
         The only issue was whether there was a common enterprise. Ct said that there was no common
         enterprise. Ct uses a VERTICAL COMMONALITY TEST. The fortunes of investor and
         brokerage (promoter) were not intertwined.

        (Strict) Horizontal Commonality Test (7th Circuit): Ct asks whether each investor is in the
        same boat. 7th circuit asks: 1) Is there a pooling of interests? 2) Is there a pro-rata distribution of
        profits. This is strict horizontality.
        This wasn’t the case in Howey. Howey didn’t require strict pooling of profits and losses. Also
        wasn’t the case in Brodt.
        Fox thinks that the strict horizontal commonality test is too narrow…

        Vertical Commonality (gap-filler if horizontal commonality can‟t be met): 5th and 9th
        Circuits:
         Requires that investor and promoter be in a “common venture” without mandating that other
        investors be in the same boat with the plaintiff investor.
        Brodt did not satisfy vertical commonality because there was no direct correlation of profits
        between broker & customer.
        (Koscot case p 23: The critical factor is not the similarity of investor input, rather the uniformity
        of impact of the promoter’s efforts. In that case, a discretionary trading account was seemed a
        security.)

        Hypothetical A: Brodt’s broker gets 20% of the gains, but suffers 20% of the losses. Security?
        Vertical commonality would be satisfied under 9th circuit test. “Fortunes of the investor are
        interwoven with and dependent upon the efforts or success” of the third party/promoter.




                                                      20
        Hypo B: Brodt has the only account at the brokerage. Is this a security?
        Fox says that it probably wouldn’t be a security (but agency and fiduciary law would cover P.)
        Why not a security in a case like that?
        1. In a single investor case, the investor has an incentive to seek out information himself (i.e. no
            free rider problem with other investors.)
        2. Investor and promoter can talk face-to face. (there may be a personal relationship between the
            two.
        3. There is less opportunistic behavior incentive for promoter if he only handles one account.
        4. The investor is more likely to be sophisticated
        5. Cost of mandating disclosure in this situation > Benefit
        Under this logic, vertical commonality doesn’t make much sense!

        Fox: Standard should be a loose horizontal commonality test.
        1. Brodt would have been a security under this analysis. Brokerage house has a lot of accounts,
            and the luck of all of the investors would be correlated
        2. Discretionary accounts may be risky when the broker makes his money on commissions,
            because he has no incentive to make sure that the investments are performing well (is this
            totally true? How about competition among brokerage houses?)
        3. How should we treat discretionary accounts? Maybe we can use other regulatory schemes
            (like ERISA) to regulate these investment contracts instead of using the securities laws.

        Heart & Home Problem (Question 1 in Supp.)
        H&H builds convalescent homes for heart patients, to be operated by subsidiary corps (doctors.)
        1. If profits are shared by doctors according to a formula other than amount of investment, it
            fails strict horizontal commonality. Thus the H&H scheme would not be a security.
        2. If H&H divides profits based on # of patient nights doctors spend at the homes, it could be a
            security under 5th and 9th circuit test for common enterprise.
        3. Is there an expectation of profits here? Look at doctor’s expectation of profits ex ante based
            on H&H’s representations? Is H&H selling this an investment vehicle, or as a chance to do
            good deeds?
        4. Solicitation materials are relevant in determining doctor’s intent for investing.

EXPECTATION OF PROFITS/INVESTMENT OF MONEY
      Teamsters v. Daniel (27) (Sup Ct)
      Daniel (D) was a member of a noncontributory (D did not put in any $ from his wallet – there was
      a deduction from wages), compulsory pension plan. He sued, saying that P made fraudulent
      misrepresentations about the plan (in violation of 10b-5.)

        Is this a security? Sup Ct said no.
        1. No investment of money
        2. No expectation of profits
        3. Not solely from the efforts of others

        No investment of $
        1. It was a noncontributory, compulsory plan (Sup Ct probably thought that this type of
            transaction was covered by ERISA, so we don’t need the securities laws to apply here as well.
        2. D did not put in $. The retirement account is merely a benefit of his labor. “He surrendered
            labor as a whole, and in return receives a compensation package that is substantially devoid of
            aspects resembling a security. His decision to accept and retain covered employment must
            have only an extremely attenuated relationship to the investment possibilities of future
            pension. P is selling his labor to make a living, not making an investment in the future.” (Fox
            disagrees with this assessment. See point #3.)
        3. Counterargument: D really did invest money to the extent that the pension plan played a role
            in his decision about whether to work for that employer (not into his decision about whether
            to work at all; which is what the court thought.) He invested his labor in that employer.




                                                    21
        4.   Case does not stand for the notion that an investor must invest cash out of pocket in order for
             there to be an “investment of money”

        No Expectation of profits
        1. Court says that far larger portion of benefits come from employer contributions that from
           successful management of funds. (That’s dumb.) Ct said that 80% of the money comes from
           new employee contributions, and only 20% comes from appreciation of investment. But ct
           didn’t give us the important statistic: How much money was paid out to the employees.
        2. Counterargument: Each employee is expecting some return on his investment.
        3. Court is result-oriented here. Sup Ct did not want this to be a security.

        Not solely from efforts of others
        1. Court says that he must remain a trucker in order to receive benefits. (weak!)
        2. Counterargument: We are only dealing here with money generated by the pension plan

        Investments covered by ERISA can also be deemed a security as well. See Uselton case. There, a
        voluntary, contributory stock pension plan which is covered by ERISA is also covered by
        securities laws.

        SEC Release dealing with condominiums: If the expected return is in the form of money, then it is
        plausible that you are expecting profits. If you buy a condo to use it though, then it is a mere real
        estate purchase (not a security.)

        Teague v. Bakker (PTL case) (34) (4th Cir)
        Ct looked at PTL’s promotional materials to conclude that investors were investing in a “security”
        when they bought time shares in a hotel. Promotional materials said that investors can save big
        $$$ in the future on hotel rooms.

“SOLELY FROM THE EFFORTS OF OTHERS”
      SEC v. Aqua-Sonic (36) (2nd Cir)
      Investment in a franchise: Two things offered.
      1. Sales license agreement that gives investor the right to sell the product in a given area
      2. Sales agency agreement by which the offeror agrees to do the selling for the investor
      100% of the investors signed the sales agency agreement (which was voluntary, like in Howey),
      but this didn’t matter in Howey. The promoters in Aqua-Sonic seemed to target investors who
      would sign the sales agency K (because they lived far away from their sales area and knew
      nothing about dental products.) Aqua-Sonic advertised the investment as a tax shelter!

        Main issue: Was this investment “solely” from the efforts of others? YES.
        “Solely” is not defined literally. Otherwise, it would be easy for promoters to circumvent
        securities laws by allowing investors to perform nominal duties.
        1. D says that investor here has potential control, because he can determine prices, fire the sales
            agent, and inspect the books.
        2. Court rejects this argument, citing the policy reason for not defining “solely” literally (it is a
            “roadmap for fraud.”) Also, it is likely that the average investor would never exercise these
            powers D says that they have. Ct looks at what the average investor will do, not at the “bare
            theoretical rights” that the investors hold.
        3. Investors’ potential right of control does not overcome the remaining part of this prong of the
            Howey test (i.e. “efforts of others.”)
        4. (Policy seems the opposite of Landreth.)

        Partnerships: (Need to read Aqua-Sonic in light of partnership cases…)
        1. Investment in a limited partnership is a security (Aqua-Sonic was a limited p-ship)
        2. Investment in a general p-ship is generally not a security, (but if it is impossible for a general
            partner to exercise control in the p-ship, the ownership interest might be a security.)




                                                     22
         Steinhardt case (in class materials pg 133): Investment in a limited p-ship was held not to be a
         security.

         Franchises: Generally, franchisees are expected to exert some control over their investment. So is
         “solely from the efforts of others” were defined literally, no franchises would be considered
         securities. However, in reality some franchises are deemed securities.
         Moral of the story: Franchises and p-ships are a very fuzzy area of the law. Lots of litigation to
         come…

MAJOR QUESTION TO ASK ONESELF: Why do we want this particular scheme to be deemed a
     security? What is it about this investment that makes us want to require disclosure?
     Some considerations:
     1. Multiple offerees (then we want it to be a security)
     2. Investors can’t control investment (then we want it to be a security)
     3. Investors can’t ask questions of promoters before investing (then we want it to be a security)

When are stocks/notes not securities?
       They are securities unless “context of investment dictates otherwise.” §2(1)
       (i.e. Mortgage notes, notes on cars, etc are not securities.) So we shouldn’t call all notes
       “securities.” Fox says that it is not a big deal if we call all stocks “securities” though.

         United Housing Federation v. Forman (50) (Sup Ct)
         “Stock” was sold to Ps. Stock was actually a right to live in a co-op apartment. This was not
         stock in the traditional sense… Was this “stock” a security? Court said that this was not a
         security. Not everything that is called a stock is a security.
         This wasn’t a security because:
         1. The inducement to purchase wasn’t potential profit. It was housing. (When person moves
             out, he is obliged to sell stock to promoter at the price he originally paid for it. No capital
             appreciation).
         2. Purchasers took no significant investment risk.

         Fox thinks that we should apply a Howey-type test to stock as well as investment contracts. Sup
         Ct said that Howey test should not be used for stock. Dissent said that these “stocks” were
         actually expectations of profit on the part of the investor. (This is a dumb argument, says Fox)

         SALE OF BUSINESS DOCTRINE
         Landreth Timber Co. v. Landreth (51) (Sup Ct)
         OLD Sale of Business Doctrine: Sale of 100% of the stock in a company is not a security. This is
         because investor has complete control if his investment. Also, there are not multiple offerees.
         Sup Ct rejects SOB doctrine: This transaction involved a security, says ct.
         1. This sale is of stock in its traditional sense (unlike UHF v. Forman). Stock is stock, and
             section 2(1) applies. Do not need to apply Howey test, because we’re dealing here w/ stock.
         2. Not every investment that is labeled “stock” invokes coverage of the Securities Act. Instead,
             cts should use the “usual characteristics of stock” test in order to determine whether it is a
             security.
         3. This is the type of transaction in which the investor would expect protection by the securities
             laws.
         4. Test for “usual characteristics of stock”
             a. right to receive dividends contingent upon profits
             b. negotiability (i.e. transferability)
             c. ability to be pledged
             d. voting rights
             e. opportunity to increase in value
             (All 5 factors need not apply…)
         5. The court will look at the particular stock and examine its characteristics. Using the list
             above, the court will determine whether the stock is a security on a case-by-case basis.



                                                      23
        6.  Ct also rejected the “unusual transaction” argument that was used to persuade cts that the
            stock wasn’t a security. The circumstances surrounding the transaction don’t matter. Just
            look at the stock…
        7. Stevens dissent:
        Securities laws are there to protect small investors, not big investors like Landreth (who only
        entered into this transaction for tax purposes. Aqua-Sonic ct said that securities laws are
        unnecessary to protect big investors.

        Sup Ct has been trying to restrict the scope of the securities laws lately by reading the language of
        the statutes literally.

        Reves v. Ernst & Young (60) (Sup Ct)
        When is a “note” a security? Court adopts the family resemblance test:
        1. When a note is involved, there is a rebuttable presumption that it is a security
        2. Exceptions to the general rule that notes are securities are the “judicially-crafted list of
           exceptions.” These are notes like consumer and student loans which really shouldn’t be
           called securities.
        3. Factors for what other kinds of notes are not securities:
           a. If seller’s purpose is to raise money and buyer’s purpose is to invest, then it looks like a
                 security. If it is a consumer loan, then it is not a security.
           b. Plan of distribution of instrument
           c. Look at the reasonable expectations of the investing public (is the public looking for a
                 profit from this investment?)
           d. If there are other regulatory schemes designed to protect the investor, then it might not be
                 a security
        4. Ct does not apply Howey test to a note, either

        Opinion shouldn’t be construed as THE WORD… So don’t worry too much about this case.
        Fox: If corp has more notes than accounts receivable, then it looks like it is borrowing to finance.
        Then it would be a security.

EXEMPTIONS FROM ‟33 ACT REGISTRATION
     Some transactions do not require registration under Section 5. Section 5 doesn’t apply if:
     1. not a security
     2. exempt

        EXPEMPTION (Sec. 4(2))
        Provisions in Sec. 5 are not applicable for transactions by an issuer not involving a public offering
        (what constitutes a “public offering?”)
        Factors to determine whether it is a public offering:
        1. Dollar size of offering
        2. Manner of offering
        3. Sophistication of offerees
        4. Number of offerees
        5. Information possessed by offerees

        (Number of offerees as a factor in determining public offering vs. private placement:
        1. If there are so many offerees, there is little contact between issuer and offerees
        2. More incentive for offeror to scam offerees if there are a lot of them)
        (Dollar size of offering as a factor in determining public offering vs. private placement:
        1. If dollar size is small, there is less incentive for issuer to exploit investors.
        2. It is expensive to regulate public offerings, and regulating small offerings does not derive
              enough benefit to offset cost.)
        (Sophistication of offerees: Sophistication doesn’t mean lots of education. Doctors in Heart &
        Home are not necessarily sophisticated. Sophistication only means knowledgeable in financial
        matters.



                                                     24
        1.   Ralston Purina case seems to say that “sophistication” only means the investor’s financial
             knowledge that he had BEFORE he enters into deal with issuer.
        2.   Other courts say that investors can get “sophisticated” during the course of the particular
             transaction at bar.)

        Section 4 provides exemptions:
        §4(1)  §5 doesn’t apply to anyone who is not an issuer, underwriter, or dealer
        §4(2)  §5 doesn’t apply to transactions not involving a public offering (big topic in this class!)
        §4(3)  §5 doesn’t apply to a dealer or underwriter not acting as an underwriter later than 40/90
        days after offering
        §4(4)  §5 doesn’t apply to brokers who execute unsolicited transactions on behalf of customers
        §4(6)  §5 doesn’t apply to transactions involving offers or sales by an issuer exclusively to an
        accredited investor, as long as there is no advertising or public solicitation of sale. Maximum
        value of securities to be sold = $5 million

        Burden is on the person claiming exempt status to prove that he’s entitled to it.
        Under Section 12(a)(1) of ’33 Act: Any seller of securities who violates Section 5 is liable to the
        purchaser for the purchase price (this is analogous to rescission.)
        Should not let irrational fear keep lawyer from recommending to the client that he try to claim
        exempt status.

        Policy reasons for allowing exemptions in some cases:
        1. Lenient policy encourages capital formation. Otherwise, it would be tough for the little guy to
            register, since registration is so expensive.
        2. Counterargument: Most fraud is perpetuated by small businesses during an IPO. So maybe
            we should regulate small businesses.

        INTEGRATION: This is when separate transactions with different investors are lumped
        together and deemed to be one big offering. When this happens, the integrated offering will
        most likely be deemed a public offering to be regulated by securities laws

Heart and Home problem: How can this be an exempt offering?
        Factors to consider:
        1. Number of investors (if there are few investors, the offering is likely to be exempt)
        2. Are separate offerings integrated? See SEC Rel. 4552 (pg 338): consider the following
                 a. Whether the offerings are part of a single plan of financing
                 b. Whether the offerings involve issuance of the same class of security
                 c. Whether the offerings are made at or about the same time
                 d. Whether the promoter will receive the same type of consideration
                 e. Whether the offerings are made for the same general purpose

        If H&H in this particular city is a subsidiary of an H&H parent/holding corporation, the big
        question about whether the offerings are integrated is whether the capital raised by each subsidiary
        (each making an offering to 10-20 doctors) is passed through to the parent. See Murphy case.

        If the offerings are integrated, then parent/holding corp (as well as subsidiary) will have to
        disclose information about itself. Same is probably true even if offerings are not integrated. See
        Murphy (holding that when limited p-ship shares are offered, information about the partnership as
        a whole must be disclosed.)

        Doran (344) (5th Cir)
        5th Cir. Says that there is an exemption when a sophisticated investor is involved only if:
        1. Each offeree was given information consistent with the disclosures that a registration
             statement would have made, OR
        2. Each offeree had effective access to such information



                                                    25
If an offeror satisfies either prong 1 or 2, it might qualify for an exemption (disjunctive
requirement.) Issuer must disclose or make available the information that would have been
required on the registration stmt. Sophistication of investor alone does not qualify issuer for
exemption. The requirement that each offeree be furnished the information makes it more
unlikely that an offeror in a big offering would be exempt. One rotten apple (offeree w/o
information) spoils the whole barrel (exemption.) Ct decided case under §4(2), not Rule 146,
because Rule 146 safe harbor doesn’t apply to this case.
The larger the offering, the better chance that one offeree doesn’t have all the information needed.

Ralston Purina (334) (Supreme Ct)
1. Much like Doran, where investors can fend for themselves, the court doesn’t impose the formal
requirements of the securities laws. But there still needs to be access and disclosure.
2. Large number of offerees does not automatically disqualify issuer from exemption. Court says
that the statute does not impose a maximum number of offerees in the definition of “private
placement.” Also, “an offering to those who are able to fend for themselves is not a public
offering.”

Murphy (346) (9th Cir)
Analytical framework of opinion:
1. Number of investors/offerees
         Big number (example = 400) of investors creates a presumption of a public offering.
         We are worried that more orphans and widows can be victimized with a big offering (one
         rotten apple spoils the barrel.) Cites SEC Release 4552.
         But see Purina. There is (technically) no limit to the number of offerees there can be in
         order to have an exemption.
         POLICY: The larger the number of offerees/investors, the less likely it is that all have a
         sufficient relationship to issuer, and a greater chance there is that a market breakdown
         will occur with regard to information gathering
2. Financial sophistication of offerees
         There is a rebuttable presumption that offerees are not sophisticated
         Defendant issuer cannot qualify for an exemption for non-public offering here because it
         did not screen potential investors to ensure sophistication. “One rotten apple may spoil
         the whole barrel.” Even if D only OFFERS (and doesn’t sell) to an unsophisticated
         investor, it loses its potential exemption
         Doran and Purina say that access or disclosure is necessary even if the investors are
         sophisticated (though under Doran, it might not matter if information is late in getting to
         investor.)
3. Dollar size of offering
         Court holds that a $7.5 million offering is large enough to create a presumption that
         it is a public offering, so no exemption. However, court INTEGRATED all the
         separate offerings in order to arrive at the $7.5 million figure.
         A small offering may create a presumption that the offering was not public
         POLICY: Benefits of disclosure vary directly with the size of the offering, but the cost of
         disclosure is the same [so maybe we should require disclosure up to the point where the
         benefit of disclosure = cost of disclosure. This point can be measured by the dollar figure
         of the offering.]
4. Information possessed by offerees
         Court holds that D offeror failed in its burden to provide access or disclosure
         Doran Rule: If investors are sophisticated, then they do not need pre-existing knowledge.
         These investors can be given the required disclosure through an offering memo.

Melchior (353) (Dist Ct Utah)
Promoter oil speculator sold different plots of land to different investors in “cookie cutter” deals.
Ct found that each sale was part of the same plan of financing, so it is a security. Cookie cutter
deals are more likely to be found to be integrable.




                                             26
        Donahoe (contra Melchior)
        Ct said that if the financing and operations pertaining to the different offerings really were
        separate (i.e. not the same general purpose,) then they cannot be “integrated” for the purpose of
        analyzing whether an exemption will be granted.
        Ct adopts a reasonableness standard.

        Why not just register?
        1. Saves hassle with SEC
        2. Don’t need to get audited financials (that’s expensive)
        3. No §11 liability if no §5 offering

        SEC Release 4552 (pg. 340)
        1. Manner of offering:
                a. If an investment banker is used, special care must be taken by issuer to avoid a “public
                offering.” (i.e. use of professionals is indicative of a public offering.)
                b. If there are discretionary accounts or unsophisticated investors involved in the issue,
                then there is no exemption
                c. If there is any advertising, then there is no exemption
                d. If a stock or bond exchange is used to buy/sell, then there is no exemption
        2. Where must securities end up after offering?
                a. RULE: Securities must end up with the initial “informed” group of investors
                b. If any buyer is a “conduit” for a wider distribution, then the buyer is a “underwriter”
                under §2(11). If securities are purchased by a “conduit” with a view to wider distribution,
                then issuer is said to be engaged in a public offering and he assumes risk of liability.
                One solution is to restrict the resale of stock or to limit resale to qualified buyers. (Issuer
                must take care to assess the likelihood that shared will be transferred from sophisticated
                investors to unsophisticated investors.)
                c. Absent special circumstances, an issuer’s employees are members of the “investing
                public” as well. The exemption doesn’t become available simply because employees and
                other offerees are voluntarily furnished information by the issuer. Issuer must go through
                formal SEC disclosure hurdles.
                d. The five integration factors (which were adopted in Reg. D.)
                            i. Whether the offerings are part of a single plan of financing
                           ii. Whether the offerings involve issuance of the same class of security
                          iii. Whether the offerings are made at or about the same time
                          iv. Whether the promoter will receive the same type of consideration
                           v. Whether the offerings are made for the same general purpose

SEC RULES WHICH CREATE EXEMPTIONS:
      Regulation D (Rules 501-506) p. 360-62. Puts together all the exemption rules into a coherent set
      of rules.
      1. First question is whether offerings are integrated:
                a. Rule 502(a):
                “Offers and sales that are made more than 6 months before the start of a Regulation D
                offering or are made more than 6 months after completion of a Regulation D offering
                shall not be considered part of that offering.” Bright line 6-month rule. No integration of
                offerings that are 6 months apart.
                b. Rule 502(b):
                Adopts standard of SEC Rel. 4552 (above)

        2. Second question is size of offering:
                a. Rule 504: Blanket exemption for offerings that aggregate less than $1 million over 12
                   months.
                         POLICY: Scale economies (this may or may not be a good policy justification
                         after all.) Disclosure is expensive. These offerings are a good source of seed
                         capital.



                                                     27
                          Note: State “Blue Sky” laws may have separate requirements regarding these
                          offerings.
                 b. Rule 505: Exemption for offerings of $5 million or less
                          LIMITATIONS: Issuer may sell to an unlimited number of Accredited
                          Investors (A.I.’s), but can only sell to 35 non-A.I.’s. All non-A.I.’s must be
                          supplied with information consistent with that which is found in the Reg. Stmt.

                            There are 6 factors of determining who is an Accredited Investor (See Rule
                            501(a)):
                            1. If investor is a bank, investment company, pension plan, etc.
                            2. Business development company
                            3. Institutions/businesses with assets > $5 million
                            4. Director, executive officer or general partner of issuer
                            5. Any person with net worth >$1 million
                            6. Any person with annual income > $200,000 or couple with > $300,000
                 c. Rule 506: Exemption for sale of an unlimited amount of securities if:
                      1. Only sold to A.I.’s and up to 35 non-A.I.s
                      2. If non-A.I.’s or their representatives are knowledgeable and experienced. Corp
                      must provide pertinent information to non-A.I.’s or their representatives
                      3. Note: All A.I.’s still must receive disclosure consistent with that found in a reg.
                      stmt.
        Regulation A offering (pg. 356): Exempts offerings of up to $5 million
                 a. Do not need to provide audited financials. Simpler than Form S-1 (IPO form.)
                 b. §11 liability does not apply to Reg. A offerings
                 c. Allows issuer to “test the waters.” Issuer can check the interest of potential investors
                 before going into the hassle of preparing an offering (if there was no exemption, any
                 document given by issuer would be a prospectus subject to §12(2) liability.) The Reg. A
                 issuer is still subject to antifraud provisions, though.
                 d. Reg. A is not available to “blank check companies” (i.e. issuers w/o a business plan.)
        Reg. S-B: The small business equivalent of Reg. S-K.
        §3(a)(2): Exempts offerings by U.S. states, territories, etc. as well as railroads and banks.

EXEMPTIONS FOR SECONDARY TRANSACTIONS:
     §5 seems to require registration for all transactions in securities

        But §4 exempts certain transactions (like when my broker sells shares to me, or vice versa.)
        §4(1): Person other than an issuer, underwriter, or dealer is exempt from §5. Broker is exempt
        §4(4): Unsolicited brokerage transactions are exempt (e.g. when I tell my broker that I want to
                buy the shares.) Solicitations by brokers are not exempt.

        Extraordinary secondary transactions:
        1. Sales by control persons
                  Same needs for protecting public exist when a control person sells securities to investors
                  The control person is in a position to have the company register the shares
        2. Sales of unregistered shares by a person acting as a conduit
                  Same concerns for protecting the public exist here too.
        3. Sales in pubic or private context of unregistered shares by a person who acquired them for
        investment purposes (depends on the method.)
                  May or may not have the same policy concerns
                  Sellers are not necessarily in a position to get the corp to register

        Statutory analysis for extraordinary transactions:
        1. §4(1) doesn’t clearly state that not all secondary transactions are exempt from §5. (i.e. it could
        plausibly say that all secondary transactions are exempt.) However:




                                                     28
         §2(11) definition of “underwriter” ensures that not all secondary transactions are exempt.
         a. §2(11) says that an “underwriter includes any person who buys from an issuer “with a
         view to distribution.” (conduit theory.)
         b. §2(11) definition of “issuer” includes any direct or indirect control person, or any
         person in control of the issuer.
         c. Taken together, a) and b) say that a purchase by a conduit from a control person is not
         exempt from §5.

US v. Sherwood (387) (Dist Ct NY)
A holder of 8% of Canadian corp’s shares sold these shares. SEC said that this is a §5 violation.
Ct said that under the facts of the case, §5 doesn’t apply to .
First issue: Is  a control person?
          1. He owns 8% of the stock, but he has a bad relationship with the real control person
          (who owns more shares.) He isn’t even on the board. If  had a good relationship with
          the real control person, they could both be in control (as a group.) But the group control
          theory doesn’t work here, because  and the control person do not get along.
          2. RULE: “Control” is determined by the ability to be an active participant in the
          management of the company (this is the definition of “control” under Rule 405.)
          3. Ct held that he isn’t a control person because he is not on the board of the corp and has
          a bad relationship with the control person. He can’t force corp to register. This is a
          subtle part of the Rule 405 definition of control.
Second issue: Is  a “conduit” (i.e. did he purchase shares with an intent to sell them?)
          1. Ct rejected the ’s conduit theory, because  held his shares for > 2 years.
          2. Rule of thumb: If a shareholder holds security for > 2 years, there is a rebuttable
          presumption that he is not a conduit.
NOTE: If  was a control person, then ’s broker could have been on the hook as an underwriter
too.

Ira Haupt & Co. (391) (SEC case, not a court case)
Schulte family owns 90% of liquor manufacturing company. Over the months, family sold much
of their shares. Dividends were paid out in the form of rights to buy liquor.  was brokerage
house which sold shares in the company.
POLICY: Why regulate a transaction such as this?
1. Schultes could have made company register the shares. They are control people.
2. Investors could have been duped by the liquor dividends (it was just after Prohibition)
3. Stock price was price controlled (share price was artificially high.) EMH doesn’t apply in a
case like this, so market wasn’t acting efficiently, because people would buy more shares than is
efficient to buy.
4. Public needs to be protected in a case like this. Ira Haupt made small commissions per share, so
it might have an incentive to really push these shares to customers so that it can make more $ on
commissions.

Why not regulate a transaction such as this?
1. Schulte’s corp was publicly traded prior to these new transactions. There was already periodic
disclosure to the public, since it is a ’34 Act company.

First issue: Should these offerings be registered?
          1. SEC says that this looks like a public offering, so §5 applies
          2.  says: This is not like an underwriting. No underwriter or brokerage solicitations.
          These shares are being sold a few at a time through unsolicited brokerage transactions (no
          hype perpetuated by .)
Sub-issue: Is this a distribution?
          1. If there is a rapid change of ownership of a large number of shares, then there is a
          distribution.




                                             29
         2. There needs to be a “distribution” in order for ct to find Ira Haupt (the broker) an
         underwriter. If there is no “distribution,” then  can get the §4(4) exemption.
         3.  broker argues that, though they are selling for a control person, they are not assisting
         Schultes with a view to distribution. The broker didn’t know ex ante how many shares it
         would end up selling.
         4. Ct held that securities should be registered. Ct uses an ex post test of “distribution.”
         The final outcome was that  helped control person sell a lot of shares. SEC doesn‟t
         care about the process of the sale, it only cares about the outcome.

Second issue: Is there an available exemption (namely §4(4) brokerage transactions?)
        1. There is no §4(4) exemption where there is a distribution, even though broker didn’t
        solicit the transaction.
        2. Court reads §4(4) very narrowly. Basically §4(4) is used to allow shareholders to sell
        during a stop order. §4(4) is not a general exemption of brokerage transactions.
        3. Basically, §4(4) is a special variant of §4(3) [which exempts transactions performed by
        a dealer or underwriter no longer acting as an underwriter, which occur either 40 or 90
        {for IPO} days after offering.]

Fallout of Ira Haupt:
         1. Brokers became nervous about competing transactions for any control person, because
         the brokers’ activities could be a part of an ultimate distribution.
         2. Loss & Seligman say that as a result of this case, Rule 144 was adopted, which extends
         §4(4) exemption to include agency transactions for control persons if the broker is
         unaware that it is a part of a distribution.
         3. Standard: 1% or less of corp’s “float” (total number of units of the security
         outstanding) sold over 6 months is not deemed a distribution
         4. Rule 144 now governs. There is a safe harbor when the number of securities sold is
         modest and where no special selling incentives exist.

Wolfson case (399) (2nd Cir)
Control person (Wolfson) sells 15% of corp over 18 months by using several brokers. Brokers
didn’t know that control person was doing shady deals. Ct held:
1. The brokers are exempt from §5, even though they were technically “underwriters” under the
facts of the case. Each broker didn’t know that the other brokers were selling Wolfson’s shares as
well.
2. Selling shareholder (the control person) is not exempt. Even if a broker qualifies for a §4(4)
exemption, control person doesn’t necessarily qualify for a §4(1) exemption.

Is an investor an “underwriter”?
Look at §2(11) definition of underwriter.
         1. Underwriter is a person who purchased securities from an issuer with a view to
         distribution of that security
         2. “Issuer” shall also include any person who directly or indirectly controls the issuing
         corp, or any person with direct or indirect common control with issuer.
A broker who has a control person as a customer can be an underwriter.

RULE 144:
Underlying policy (Wheat Report p. 402)
        1. More inclined to give exemption to ’34 Act corps
        2. Use of purchasers as conduits for public distribution must be avoided.
        3. Holding period puts would-be conduits at risk. But holder can still sell if she does it in
        the same manner that the issuer could under §4(2) – in a private placement, not a public
        distribution.




                                             30
Five Requirements of Rule 144 (all requirements must be met.)
This Rule is a safe harbor for brokers and control people if there are no special circumstances that
are indicative of a “distribution” that exist. If Rule 144 applies, then no disclosure or registration
is needed:
         1. Limitation on amount sold: Can only sell < 1% within a 3-month period of the
         LESSER of
                   a. market float (total number of units of the security outstanding), or
                   b. average weekly trading volume
         2. Control person may only hold securities for 2 years (may be reduced to 1 year soon.)
         3. Corp must be a ’34 Act reporting company
         4. Securities must be sold in ordinary brokerage transactions w/o any special incentives
         or solicitations
         5. Must file a notice of each sale with SEC.
Rule 144(k) alternative if the above requirements could not be met:
         If control person hold security for 2 years and the seller was not a control person for the
         three months prior to the time of the sale, there is an automatic exemption. No other
         requirements apply! This is a bog loophole that benefits Palo Alto VC’s who want to get
         out of a bad investment. (Rule 144(k) is particularly helpful for small business, but isn’t
         that where a lot of the fraud is?)

“§4(1½) exemption”
        Non-affiliates of a corp and non-control persons who hold a security for < 2 years need
        not register their sale if the same sale done by the issuer would not have required
        registration. (i.e. it is a private placement.) An issuer would be exempt for the same
        transaction under §4(2). If issuer would be exempt, the outside investor should be
        exempt too.
        §4(1½) exemption is derived from §§ 4(1) and 4(2) exemptions:
                  1. §4(1): Exemption for transactions by anyone other than issuer, underwriter, or
                  dealer.
                  2. §4(2): Exemption for issuer if it is not engaged in a public offering
                  3. Note: A reseller would be an underwriter under §2(11) if purchased with a
                  view to distribution. But SEC is willing to disregard that requirement if issuer
                  could have sold the security without registering. Treat reselling investors the
                  same as you treat issuers.
                  4. Fox says that §4(1½) is merely a reasonable reading of §4(1). §4(1½) says
                  that the investor is not an underwriter under §4(1).

Rule 144A:
        1. This rule contemplates an active trading market for unregistered securities among
        institutional investors. The Rule is available when Rule 144 is not available because the
        security was held for less than 2 years. Rule 144A covers Qualified Institutional Buyers
        (QIBs: e.g. Fidelity Investments) and contemplates an active market in unregistered
        securities among QIBs.
                            Definition of QIB:
                            a. Any entity that owns > $100 million in securities, or
                            b. Any dealer which owns > $10 million in securities, or
                            c. Any bank which owns > $100 million in securities and has a
                            net worth of > $25 million
        2. Rule 144A is not available for any security traded on a US exchange or on NASDAQ.
        But it is available to companies that have other securities traded on those exchanges.
        3. Rule 144A is only available to ’34 Act companies or foreign issuers
        4. Purpose of this Rule is to bring investment money back to USA which originally went
        abroad.




                                             31
SECTION 12 OF THE ‟33 ACT (SANCTIONS)
      1. It provides purchasers of a security with a right of rescission against any person who offers or
      sells a security that should have been registered, but wasn’t.
      2. There are also rescission rights anytime there is a false or misleading statement or omission
      made about the security.

        Statutory framework:
        1. §12(a)(1): (formerly §12(1)) invokes liability for sales in violation of §5 (including failed
        exemption attempts)
        2. §12(a)(2): (formerly §12(2)) creates for the purchaser a right to rescission if there was a
        material misrepresentation or omission in reg. stmt.
                 §12(a)(2) covers offers or sales of registered or unregistered securities conducted by:
                 1. Instruments of interstate commerce
                 2. A prospectus or oral statement which includes an untrue statement of material fact or
                 omission.
        3. §12(b): D may show that the false or misleading statement did not cause any or all of P’s
        losses. So §12(b) may let D pay less in damages.
        4. Two major questions: Who may sue? Who can be sued?

        ISSUE 1: WHO MAY BE SUED?
        Pinter v. Dahl (318) (Sup.Ct.)
        Pinter sells oil and gas leases. Dahl is a big investor. Dahl tells his friends to get into the
        investment. Dahl and friends sue after Pinter investment goes south. Dahl said that the
        investment should have been registered. Pinter countersues for Dahl’s contribution to the
        damages that Pinter must pay. Pinter said that Dahl “sold” Pinter securities to Dahl’s friends.
        Who is liable under §12(a)(1)?
        1. Under §12(a)(1) – Seller is liable to buyer. §12 action may only be brought against the
        person who sold the security to the plaintiff.
                  Did Dahl “sell” security to his friends? He recommended the stock to his friends, but the
                  friends bought directly from Pinter. Dahl never owned their shares, but that doesn’t
                  matter, because under §2, “offers to sell” are also covered by the Securities Act.
        2. Old doctrine: “Substantial factor test.”
                  Seller is liable for rescission if he is a “substantial factor” in the sale. (This would seem
                  to implicate Dahl.)
        3. 5th Circuit test  Seller is:
                  a. The one who parts with the title, or
                  b. A substantial factor in the sale of the security and is not motivated by an incentive to
                  benefit the promoter (instead of the purchaser.) The underlined part was a test fashioned
                  by 5th Cir.
                  (Note: Court is trying to figure out whether Dahl is the seller, not Pinter…)
        4. Supreme Court likes definition #2 of “seller.” Court doesn’t want to make Dahl liable just for
        being friendly. He recommended the securities to his friends benefit the friends, not Pinter.
        5. Court held that Congress didn’t intend to nail people who urge a purchase of a particular
        security, but who are motivated merely by a desire to help the purchaser. There is no need to
        worry about these people’s misrepresentations to their friends (because there is no incentive for
        them to lie.) This is called the MOTIVATION TEST.

        Meyers v. C&M Petroleum Inc. (424) (5th Cir)
         corp. sold securities in violation of §5.  tried to remedy this violation by offering to repurchase
        the securities from the investors. However, the corp only gave the investors 10 days to take
        advantage of the offer.  investors refused to sell the securities back, saying that they are given
        data reflecting the actual value of the securities.
        ISSUE 1: Did investors waive their rights under §12(1) by not selling the securities back. Can 
        even qualify for a waiver by making this offer?
        ISSUE 2: Did the repurchase offer itself violate the registration requirements under the Act?
        (Court dismissed this claim out of hand.)


                                                     32
        1. Court relied on §14, which states that “any condition, stipulation, or provision binding any
        person acquiring any security to waive compliance with any provision of the Securities Act shall
        be void.”
        2. Ct said that  cannot effect a waiver of ‟s §12(1) right to rescission by making this offer.
        3. Majority says that had  unconditionally tendered the refund of the purchase price and
        demanded the return of the securities,  could have won. s would have been estopped from
        making their claim.
        4. Concurrence disagrees that had  made a different offer, it could have won the case on an
        estoppel claim.

        Brokers may incur §12(a) liability even if he only gives his customers advice. Brokers may be
        selfishly motivated to get customers to buy or sell.
        Brokers are always recommending securities, because they have financial incentives for clients to
        buy. So it is easy to imagine a broker being held liable under §12(a)(2) under “substantial factor
        test” or Sup. Ct’s “motivation test” (of Pinter.) This creates more liability under §12(a)(2) than it
        was supposed to originally. This might chill broker recommendations.

        Gustafson (427) (Sup Ct)
        1. Gustafson involved an offering by a privately held corp which was supposed to be exempt
        under §4(2).
                 a. Plaintiffs claimed that the sales K for a security sold by a privately held corp was a
                 §2(10) prospectus and that one of the representations was false in that sales K. Plaintiffs
                 want rescission.
                 b. Ct held that plaintiffs were not entitled to rescission. In an attempt to “read the whole
                 statute,” court read the §10 definition of a statutory prospectus, instead of the §2(10)
                 broader definition of prospectus. Ct should have read §2(10).
                 c. Ct’s rationale: §12(a)(2) is intended to deal only with public offerings. Exempt
                 offerings and secondary offerings are not applicable to §12(a)(2).
                 d. Fox says that this is an inept opinion.
        2. Logical absurdity: Justice Kennedy tries to turn §10 definition of a statutory prospectus into the
        definition of a prospectus overall (which is really defined in §2(10).) Thomas dissent: This is the
        tail wagging the dog.

INTERNATIONAL SECURITIES REGULATION BY SEC
      §5 makes no distinction between foreign and domestic issuers or offerees
      General Rule:
      1. SEC maintains jurisdiction over offerings made by foreign companies within the US
      2. SEC does not regulate US issuers offering abroad. SEC does not really feel the need to protect
      foreign investors, even if they could be duped by US issuers.

        REGULATION S:
        SEC now says that they care about “market protection.” SEC is really there to protect people who
        choose to invest in the US.

        No registration is needed for US securities or foreign securities sold abroad unless:
        1. There are directed selling efforts to people in the US
        2. There is a “flowback” of the securities back to the US after these securities were originally sold
        abroad.
        If US issuer sells abroad, the foreign investor must pledge that he won’t sell the security to an
        American for 1 year. If this SH sells to someone else within a year, the new buyer must also the
        pledge effective until the end of that year. If this doesn’t happen, then Reg. S exemption
        disappears, and issuer will have to register.

        However, if an issuer wants to trade on a US exchange, it must make periodic reports under the
        ’34 Act (because §12(a) of ’34 Act applies.)



                                                     33
        Foreign issuers who are not listed in an exchange will probably not have to register. §12(g)(3)
        says that SEC may make up exemptive (from the ’34 Act) rules for foreign issues not listing:
        Exemption from §12(a) applies, and issuer doesn’t need to make ’34 Act reports, if:
        1. Foreign issuer does not trade on an exchange (including NASDAQ), and
        2. Fewer than 300 investors in the issuing corp are American, and
        3. Foreign issuer must provide SEC with the same disclosures that it gives to their home gov’t.
        (Disclosures to the SEC can even be in the issuer’s native language.)

        A corp may be exempt from reporting requirements if (12(g)):
        1. Issuer is incorporated outside US, and
        2. Issuer has > 50% of the SHs are not American or > 50% of the assets are located abroad, and
        3. Issuer has < 500 total SHs, and
        4. Issuer has < $10 million in assets overall.

        In sum: US based corps might be able to get around ’33 Act registration requirements fairly
        easily, but it is hard for these issuers to sidestep the ’34 Act periodic reporting requirements.

        How to determine who should register under US securities laws:
        1. Issuer nationality approach (Fox likes this one): Under this notion, only US-based issuers must
        register with SEC
        2. Transactional location approach: Issuers who sell and trade in US must register with SEC.
        3. Investor residency approach: Issuers who have US SHs must register with SEC.

        Why does Fox think that Issuer Nationality Approach works best?
        1. Regulatory Incidence Analysis: Must ask who would benefit if the US regulatory regime was
        working properly, and who would be hurt if the US regulatory regime was operating badly.
        If the disclosure regime was good, entrepreneurs who start their own corps and workers who make
        more $ when capital is well-allocated, benefit.
        The expected returns of investors are not really affected by the disclosure regime.
        So US securities laws will help US people under the Issuer Nationality Approach.

        Qualifications to Fox theory about issuer nationality approach:
        1. This approach should not apply to a foreign corp’s IPO in the US. (EMH doesn’t really apply
        in these cases.
        2. This approach should not apply to the secondary trading market of Third World countries’
        corps. These securities should not benefit from nationality of issuer approach. Investing in these
        securities is very risky.
        3. Foreign companies can still choose to disclose under US securities laws, even though they
        wouldn’t be required to.

COMPANY REGISTRATION:
     Wallman Report:
     Wallman Report said that SEC should promote company registration. If an established corp
     already makes periodic reports under the ’34 Act, there is no need for these corps to register any
     new securities. (This idea goes beyond the policies of short form and shelf registration.) Fox likes
     it! IPO regulations would remain the same, though.
     If Wallman Report were adopted, no one will have to deal with exceptions to the Securities Laws
     for established corps or with Regulation S.
     Big Assumption of Wallman Report: The ’34 periodic reporting regime is good enough to ensure
     high-quality reporting.

                 Aircraft Carrier Release (SEC Rel 7606A):
                 This is a total revamping of the Securities Laws, but it doesn’t change what the corps
                 were supposed to disclose in substance.




                                                     34
         5 differences with aircraft carrier release:
         1. What must (and what must not) be done during pre-registration: Corp can talk about
         themselves to a certain extent during pre-registration.
         2. Communications to investors
         3. How effectiveness works.
         4. Delivery of prospectuses
         5. Periodic reporting requirements

REGULATION OF INSIDER TRADING (10b-5):
     Policy considerations: Is insider trading desirable or undesirable?
     1. Split of income stream
               Fairness
               a. Historically, insider trading (IT) was bad. It is morally wrong to let insiders to get an
               unfair share of corporate wealth
               b. Manne thought that the effects of IT was good, with a positive effect on the size of the
               income stream (i.e. insider trading is efficient.)
               c. Rational Expectation Model (Easterbrook & Scott): Fairness is not an issue. Investors
               know whether they live in an IT world or not, and will discount accordingly.
               Efficiency
               a. Risky form of compensation by a corp to its officers. Officers will need a premium
               if they are offered a compensation package that includes the right to partake in IT
               because they are risk averse. IT is an inefficient form of compensation.
               b. Managers are risk averse, because they are unlikely to have a diversified portfolio.
               Other investors are risk neutral, because they are likely to have a diversified portfolio.
     2. Size of income stream
               Bringing prices into line
               a. Manne: IT brings prices into line according to all the information that exists (inside
               and outside) w/o requiring corporate disclosure, because insider will buy or sell
               according to the information he holds.
               b. Critique of Manne: IT delays disclosure because insiders want to profit from inside
               info, and also the information can be manipulated
               c. Manne’s response: There is an incentive to disclose in order to allow traders to lock in
               trading profits. Insiders have a big incentive to disclose big earnings.
               d. Criticism of Easterbrook: Long-term price accuracy may be compromised by IT
               because we don’t know the level of IT and investor’s discount could be miscalculated.
     Incentives
               a. Manne: IT creates incentives to create events that make good news. That’s good for
               insiders and SHs
               b. Critique of Manne: There is actually an incentive to create risky news (and to make
               risky decisions.) Insiders can be short or long on their stock (so it is possible that insiders
               want the price of their corp’s stock to drop.)
               c. Low correlation of profits with personal effort. With IT, there is less incentive to
               spend time making corp great than making sure that insiders can profit through trading on
               stock.
               d. IT also restricts the flow of information WITHIN the corporation, because manager
               who know the info will try to trade on that info before he tells other managers.
               e. Fox thinks that on balance, IT has more downside than upside.
     3. Perceptions of unfairness:
               Not good for public to think that market is corrupt. There are bad effects on investor
               morale. Result will be a lower public participation in market (less capital in the market.)
               a. There will be fewer risk-spreaders with IT
               b. There will be reduced liquidity of securities
               c. Big institutions would be in an unprecedentedly powerful position. That’s
               undemocratic.




                                                     35
§10(b) and Rule 10b-5:
        1. §10(b): It is unlawful for (1) any person, (2) directly or indirectly, to use or employ,
        (3) in connection with the purchase or sale, (4) of any security, (5) any manipulative or
        deceptive device or contrivance. (Can’t violate an SEC Rule.)
        By its terms, §10(b) does not make anything unlawful unless the SEC adopted a rule
        prohibiting it. So there is §10(b) liability for violating Rule 10b-5, which acts to prohibit
        insider trading.

         2. Rule 10b-5: It shall be unlawful for any person:
                  (1) to employ any device or scheme or artifice to defraud
                  (2) 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 not misleading.
                  (3) to engage in any act or practice which operates or would operate as a fraud
                  or deceit upon any person.
                  In connection with the purchase or sale of a security
                  (Note: (1) and (3) are antifraud provisions (scienter requirement, See
                  Hochfelder) and (2) is for misrepresentation.) (3) is broader than (1).
         Rule 10b-5 isn’t just an insider trading rule, but it is a general antifraud rule.

Ernst & Ernst v. Hochfelder (474) (Sup Ct)
RULE: In an action for fraud and deceit under Rule 10b-5, there must be intent. (there is a scienter
requirement.) Court defines “scienter” for purposes of §10(b) as a “mental state embracing intent
to deceive, manipulate, or defraud.”

Hooper (484) (5th Cir)
RULE: Definition of “any person” includes corporations buying or selling securities. This means
that corps can sue and be sued. Statements that affect trading in any way are said to be “in
connection with…” Rule 10b-5 covers defrauded investors so they have a remedy under the Rule.

Texas Gulf Sulphur and Basic
Misleading announcement is a Rule 10b-5 violation even where corporation doesn’t trade on that
announcement.

NY Superintendent of Insurance v. Bankers Life (486) (Sup. Ct) *The high water mark of 10b-5*
Begole conspires to pay for insurance company’s stock with that insurance company’s treasury
bonds upon acquisition.
        1. The board of directors of Manhattan Life Insurance Corp has been deceived. They
        thought they’d get a CD in exchange for the T-bond it issued to New England Note Co
        (an insolvent corp).
        2. President of corporation misled board when he told it that it would get $5 million
        worth of CDs for the $5 million T-bond it issued, when it fact it got nothing after New
        England Corp folded. The problem is that as a result of the transaction, Manhattan assets
        were used to buy Manhattan stock.
        3. Ct used 10b-5 to override normal corporate law. Corporate law imputes to the
        corporation anything which an agent of the corporation knew. The president of
        Manhattan knew that this was a bad deal! So under state corporate law, Manhattan
        Corp knew that the deal was not good. Court said that the president‟s knowledge
        was irrelevant.
        4. Court federalized what would have been a breach of fiduciary case under state
        corporate law. Rule 10b-5 allows creditors of a corp to sue under federal securities laws
        for breaches of fiduciary duties which involve the sale of securities.
        5. Begole (the 100% SH) is not the only injured party. Insurance company’s
        policyholders are also injured, because corp doesn’t have the assets to pay off all claims
        if they came due now. This is why the NY state Superintendent of Insurance sued.
        6. This case recognized a private right of action under Rule 10b-5. Ct said that “when a
        person who is dealing with a corp in a securities transaction denies the corp’s directors



                                             36
         access to material information known to him, the corp is disabled from availing itself of
         an informed judgment on the part of its board regarding the merits of the transaction. In
         this case, the private right of action recognized under 10b-5 is available as a remedy.”

         The language of 10b-5 says nothing about Insider Trading. Clauses (1) and (3) cover acts
         of “fraud” and “deception”. How did 10b-5 get to be used for insider trading?
         At common law, a victim could sue for deceit. 5 elements to the “deceit” offense:
         1. Materially false statement
         2. Scienter as to falsity
         3. Intention to induce plaintiff to act in reliance on false statement
         4. Reliance by plaintiff on false statement (but-for test)
         5. Injury to plaintiff
         NOTE: There must be a relationship of trust and confidence between deceiver and victim
         in order for victim to successfully sue for deceit. Deceiver and victim must partake in a
         face-to-face transaction.
         NOTE 2: At common law, there had to be an affirmative misstatement. Silence was not
         actionable, unless D had a duty to P (e.g. a “pre-existing relationship.”)

Cady, Roberts (616) (SEC Ruling) BIG CASE!
1. SEC case made clear that 10b-5 could be used against insider trading.
2. This was an action against a broker. He sold Curtiss-Wright shares for accounts while he had
inside information. A partner at his brokerage was also a director of C-W. Director phoned the
broker after C-W agreed to reduce dividends (this would decrease the value of the stock). Since
info was delayed in getting to the market, the broker had inside info.
3. Insider at C-W told broker the info about the decrease in dividends. So he had a “relationship”
with the insider in the corp.
4. HOLDING: Broker violated 10b-5, even though broker said nothing to the investors to whom
he sold the stock. Court said that there may be a violation even if perpetrator remained silent (This
was a shocking holding at the time.) But Curtiss-Wright director wasn’t liable because he thought
that the news of the dividend cut was public information when he told Gintel about it. Director
didn’t have the necessary scienter to be liable.
5. Three Basic Questions court will ask in deciding whether there was 10b-5 violation:
          a. Materiality of inside information:
          Definition of Materiality = Information that would affect an investor’s investment
          decisions.
          RULE: Information must be disclosed if a person gains that info by virtue of his position,
          and the information would affect investment judgment generally.
                    Court said that the question of materiality is an objective one. Here the info was
                    material (and thus broker violated the rule) because:
                             1. Stock price changed once information was announced
                             2. Generally, a dividend cut leads to a decrease in stock price
                             3. People who had the info sold the stock (change in pattern of behavior
                             of .)
          b. Kinds of transactions covered:
          Broker made no misrepresentations. He merely used the inside info in connection with
          the sales. (That fact didn’t dissuade the court from finding 10b-5 liability.)

                  Selling vs. buying at common law:
                  Common law would not even provide a remedy when an insider sells shares to
                  an outsider (the theory being that the insider doesn’t owe a duty to someone who
                  isn’t interested in the corp yet). The common law would only impose liability
                  when a director buys shares, because in that case, he would defraud shareholders
                  to whom he owes a duty.
                  Cady, Roberts does away with the distinction between buyer and seller. Even
                  insider sellers can be liable under 10b-5. There is no face-to-face requirement
                  either, because Rule 10b-5 is promulgated under the “Exchange Act.”


                                             37
         c. Who is covered by 10b-5?
         Rule says “any person,” but case doesn’t go that far, but liability extends further than just
         to classic insiders (i.e. directors, officers, and controlling SHs.)
                   There is a duty to refrain from trading devices from two elements:
                             1. Relationship between the insider and the corporation which gives
                             the insider access to inside information which was only to be used for a
                             corporate purpose.
                             2. Unfairness of allowing a corporate insider to take advantage of
                             inside information by trading without disclosure.

         d. Application of Cady, Roberts:
         1. Hypothetical 1: Director sells his own shares when he learns of the dividend cut. Is
         this a violation?
         Under Common Law, there is no liability for director, because he has no duty to buyer
         (he is a potential SH, not an actual SH. SEC rejects this notion. According to SEC, there
         is still liability when a director sell his shares on his own account with inside information.
         SEC said that the common law rule is ridiculous.
         2. Hypothetical 2: Director gets shoes shined while discussing dividend cut. Shoeshine
         guy hears it and sells. Is this a 10b-5 violation?
         Fox says that there is probably no violation. Shoeshine guy probably has no ties to the
         corp.
         3. Hypothetical 3: Joe Schmo walking down the street hears the inside info from director
         and trades on it. Is there a violation?
         Fox says no insider trading here. First element of duty doesn’t exist.
         4. Hypothetical 4: Director buys shares on a national exchange using inside information.
         Under common law, there is no liability for director, because it is not a face-to-face
         transaction. SEC says that director would be liable in this case. To hold otherwise would
         be anomalous to anti-fraud purpose of 10b-5.

Texas Gulf Sulphur (Class Materials 255) (2nd Cir)
Executives of an oil corp knew that oil fields had a whole bunch of oil. Executives bought corp’s
stock w/o disclosing this fact to the public.
1. Ct held that corporate executives who trade on non-public information violate 10b-5.
2. ISSUE 1: Who is covered by 10b-5
          a. Anyone in possession of inside information must either disclose it or refrain from
          trading. This is the disclose or refrain choice. (This was court’s dicta, but language
          seems clear.)
          b. Court cites Cady, which it thought stated that there is no relationship requirement
          between the insider and the corp, which affords the insider access to the information, in
          order for the insider to have 10b-5 liability. This is reading Cady extremely literally.
          NOTE: Chiarella will back away from the total abandonment of the relationship
          requirement.
3. ISSUE 2: Materiality  Court takes three stabs at a standard:
          “Material Information” means:
          a. Information about extraordinary situations which are reasonably certain to have a
          substantial effect on market price if disclosed (very narrow definition of materiality).
          b. Info to which a reasonable man would attach importance in order to determine whether
          or not to invest, and if disclosure of that info might affect the price of the security.
          c. “Probabilistic test for materiality”: Probability x Impact on earnings / Total
          earnings.
                    If: Change in earnings/Total earnings = 5% or more, then as a rule of thumb, the
                    info is material.
4. District Court vs. Appellate Court findings:
          a. District Court relied on statements of mining experts who said that one good “core”
          doesn’t necessarily mean a good “mine.” However, mining experts wouldn’t necessarily
          know about the effect of the drilling on the market.


                                             38
          b. Appellate Court (more soundly) relied on stock experts who said the info about the
          good core would materially impact price.
          c. Appellate Court also emphasized that insiders placed importance on this information,
          so the information was obviously material. This analysis probably goes too far, since
          materiality of information would no longer become an independent requirement for 10b-5
          liability.
5. Three (overbroad) elements to a 10b-5 claim for insider trading under Texas Gulf:
          a. Defendant has possession of non-public information
          b. Information is material
          c. Defendant traded on that material, non-public information
          Why are these elements overbroad?
          a. Corp executives always know a lot of info about corp that the public doesn’t
          necessarily know, and they all trade anyway. Under this case, they need to know which
          info is material, or refrain from trading. If these executives trade in the normal course of
          business, and it turns out that they had inside info, they’re screwed.
          b. No relationship between insider and the corp is required here.
          c. Fox says that the rule should be that if insiders “radically change” their trading
          behavior after they receive inside information, then the inside info is likely to be material.
6. NOTE: Under SEC rules,  could not disclose the fact that the first drilling was so good. SEC
wants to lessen mining corps’ incentive to trump up good drilling results and get investors to
invest more $, when it is possible that there isn’t much mineral underground. So insiders had to
refrain from trading at all under 10b-5.

Investor’s Management (624) (SEC ruling)
Same deal as Beecher v. Able. Douglas Corp properly discloses inside info to their banker,
Merrill Lynch. But ML spills the beans to Investor’s Management, and IM trades on that info.
1. ISSUE: Can tippee be liable where tipper correctly disclosed the inside info?
2. SEC says that there is 10b-5 liability here.
3. Fox agrees with SEC. Bankers probably acquire status as temporary or “pseudo” insiders. Real
duty here should have been found by ML to corp’s SHs.
4. SEC seems to agree with Texas Gulf dicta. Case recasts relationship in terms of relationship of
the insider to the inside information itself.
5. RULE: A quick sale upon receipt of inside information creates a rebuttable presumption that the
trade was based on the inside info (which is illegal under 10b-5). Fox said that rebutting this
presumption is probably pretty hard, because  would need independent info besides his own
testimony that he is trading for a reason other than the inside info he received.
6. Under this rule, an investor can innocently come upon inside info and be frozen out of selling.
The SEC’s theory is that the person acquiring the information “acquires the requisite relationship.”
SEC says that the relevant relationship is between the person who has the inside info and the
information itself. This is different from the notion in Cady Roberts that the relevant
relationship is between the insider and the corporation.
7. SEC used language that would suggest that a “market professional” stranger to the corp’s
insiders who overheard confidential info would violate 10b-5 if he traded on that info. (pg. 627 fn
18). But see the text that precedes fn 18 (which might suggest that such a stranger would not
violate 10b-5 if he traded on the confidential info.
8. Possible defense: The reliability of the information is correlated with materiality. What if you
heard the inside info from a total stranger, and you really don’t believe him?
9. SEC policy:
         a. Inside trader has a clear advantage over other investors
         b. Inside traders may dominate the market, which is unfair to the rest of the investors

SEC v. Adler (supp. 36)
SEC advanced a very broad (and harsh) theory that said if you receive inside info, you cannot
trade at all without violating 10b-5. Ct rebuked SEC’s theory as too broad. So SEC went back to
their Investor’s Management position.




                                             39
Chiarella (Class Materials 262) (Sup Ct)
Financial printer has access to merger offering documents. He traded on this information and was
sent to jail on a 10b-5 violation. Supreme Ct overturned conviction.
3 opinions:
1. Powell: Focuses on the relationship of insider giving rise to a duty
          a. Theory: Insider trading defrauds new SHs because the insider isn’t disclosing all they
          know and the new SH wouldn’t buy at that particular price if he knew that info. There is
          a possible breach of fiduciary duty (if such a duty were to exist in that particular case.)
          b. 10b-5 derives from the common law of deceit in the tort context
          c. Held: Since Chiarella (defendant) had no prior dealings with the target corp and
          dealt with them only through impersonal dealings, he has no duty to anyone and
          there is no 10b-5 violation.
          d. Powell thought that SEC in Cady, Roberts adopted the common law definition of
          deceit (where a relationship of trust needed to exist.) But we know that SEC tried to
          expand past that restrictive definition.
          e. Powell seems to reel in the scope of 10b-5 net from where it was after Cady, Roberts.
          f. Powell says that tippees (like Gintel in Cady, Roberts) can be liable because they have
          a duty not to profit from the use of inside information. But Powell’s application of 10b-5
          to tippees isn’t broad enough to cover Gintel, because he had no relationship with the
          other party in the sales transaction.
2. Burger: Favors “Misappropriation Theory,” which states that the misappropriation of
non-public information leads to a duty of the holder of such information (regardless of who
that person may be) to disclose or to refrain from trading. If you trade, you violate 10b-5.
          a. Burger’s opinion uses a tenet of agency law:  violated his duty to his employer as its
          agent.
          b. Burger’s policy: We want to reward those who perform financial research and find out
          new info through their own hard work. We don’t want lazy people to take advantage of
          inside information.
3. Blackmun: Structural Information Advantage Rule – If you have material confidential
information, then you are prohibited from trading.
          a. Rationale of this theory is that insider trading makes investing needlessly risky (Fox
          says that this isn’t necessarily true)
          b. The focus is on inherent fairness

4. Hypothetical 1: A is a director of Firm X, and knows that X is about to announce a surprise
earnings jump. A buys shares of X.
         Powell: Director is defrauding SHs to whom he has a duty if he purchases shares.
                   Silence may equal fraud if there is a duty to disclose (e.g. through fiduciary
                   duty.)
         Burger: This is a violation
Hypothetical 2: B is also a director of Firm X, and knows X is about to tender for Y Corp. B buys
shares of Y.
         Powell: Director of X owes no duty to Y’s SHs. B deals with target only through
         “impersonal transactions.” (But what about the resultant harm?)
         Burger: This is a violation. Director legally got info but misappropriated it by trading
         without disclosing it. Insider violated his duty to his employer, and that violation
         involved purchase/sale of securities, so 10b-5 applies.
         Fox: Could B be breaching his duty to Firm X by making shares of Y more expensive
         (since he’s going to buy a lot of shares of Y)?
Hypothetical 3: Same a Hypo #2, except Firm X’s board gives B permission to buy Y shares.
         Powell: This is the same as #2. There is no duty. (Isn’t there harm here as well?)
         Burger: Rationale to favor industry still applies. But if Firm X gave its permission, then
         there are no agency problems. But one can argue that a director of an acquiring corp is
         reaping the fruits of acquiror’s ingenuity. (Also, board may not give B the permission to
         buy Y shares, since it may be ultra vires.)
Blackmun would find a violation in all three cases, because the informational advantage is unfair.


                                            40
5. What if a corp’s director sold his shares before the loss announcement?
No relationship giving rise to duty to buyers yet. This suggests no 10b-5 liability under Powell’s
analysis, because a broker who is a temporary insider has no duty to SHs, but may assume a duty –
i.e. if he’s also the corp’s banker.)
But Powell cites cases finding a violation in cases like this approvingly, so he might find a
violation in a case like this.
6. NOTE: Chiarella might have lost if the Court had characterized this as an agency case. As a
printer, he may be said to be an agent of the acquirer.
7. Chiarella expressly does not decide whether or not to adopt the “misappropriation theory.”
8. Bottom line:
           a. Powell is looking for relationships and duties
           b. Burger wants ingenuity (supports Misappropriation Theory)
           c. Blackmun wants fairness (the broadest reading of 10b-5.)

MISAPPROPRIATION THEORY (M.T.):
Proscribes the conversion by “insiders” or other people of material non-public information in
connection with the purchase or sale of securities. Misappropriation is a fraud or deceit against
the source of the information. Person who has knowledge of info must disclose it or refrain from
trading (See Carpenter, citing Materia.)
M.T. was not ruled out in Chiarella.

Materia case (2nd Cir)
This is the same type of facts as Chiarella. A financial printer misappropriated information and
traded on it. Materia had no relationship of trust and confidence with anyone except his
employer, but he was still held liable.

Newman case (2nd Cir)
Investment banker who traded on inside info was held liable under the misappropriation theory.
He violated his duty to his bank as well as the corporation which retained the bank.

Carpenter (Class Materials 277) (2nd Cir)
1. Journalist for WSJ and his friends trade on information they have about a stock just before they
published the info. The nonpublic information they hold is the knowledge that the WSJ would
recommend the stock.  bought stock before the info was published.
2. 2nd Cir uses Misappropriation Theory and upholds conviction, even though the
journalists weren‟t insiders.
3. 2nd Cir stretched to find a duty somewhere. Court says Ds breached a duty to employer (the
WSJ). But is it the function of the securities laws to enforce a company’s internal policies which
protect its reputation? Only WSJ’s reputation was hurt here. So why are securities laws involved?
4. Ct distinguishes Materia and Newman. Chirella was not called into question.
          In those cases, MT was held to proscribe the use of inside info by investment bankers
          who were breaching a duty to their clients. Here, the journalist has no preexisting duty to
          a corporation. But court says that D’s duty is to his employer.
5. Court said that it was really protecting SHs from non-insider misappropriators.
6. Dissent: This isn’t a “securities-related” case, so 10b-5 and misappropriation theory shouldn’t
apply.
7. Fox: This case turned MT into a sham doctrine not related to securities (court ignored what it
said was the purpose of M.T.) MT seems like a “rigged theory” designed to get s, regardless of
whether there was any relationship of trust and confidence at all.
8. The validity of O’Hagan (infra) is unclear after this case.

Dirks v. SEC (Class Materials 294) (Sup Ct)
Case involved “tipping.” Director Secrist was tired of his company’s fraudulent practices. He
talks to Dirks, an analyst, about the fraud. Dirks, the tippee, tells clients to sell corp’s stock,
before he makes disclosures to press.


                                             41
1. ISSUE: Can this tippee be liable under 10b-5?
          Dirks has no relationship to new purchasers of the stock. (If Secrist had sold the stock,
          he’d have violated 10b-5 because he has a relationship of trust and confidence with
          corp’s SHs.) Dirks is off the hook.
2. Powell says that a tippee can be liable though. His theory is that if tippee was a
participant after the fact, he assumes a duty when:
          a. If insider (tipper) breached a duty by disclosing to tippee, and
          b. If the tippee knows or should know that there has been a breach of duty by the
          insider, then
          c. It gives rise to a duty by the tippee to disclose the inside info or refrain from
          trading. Tippee is considered an accessory after the fact in the insider trading scheme.
3. Personal Benefit Test – the preliminary test about whether insider violated 10b-5.
          a. Insider must personally benefit from giving the tip (he must trade for personal gain.)
          b. If there is no breach by the insider, then there can be no breach of duty by the tippee
          under Powell’s rule. (This test adds a new wrinkle to the analysis of tippee liability.)
          c. Blackmun’s dissent: He criticizes the Personal Benefit Test as the addition of a
          motivational element to a 10b-5 violation. He says Secrist should be held liable because
          he intended the consequences of his act. SHs are harmed regardless of Secrist’s motive,
          and securities laws are supposed to be there for the protection of investors. Additionally,
          the Personal Benefit Test is not necessary to satisfy Powell’s policy… As long as tippee
          and tipper have no scienter, they will not be liable under 10b-5. Personal benefit by
          insider is not necessary, and it makes the law more complicated. Only unfairness matters
          to Blackmun.
          d. Fox: The scienter requirement doesn’t really help tipper and tippee (contrary to what
          Blackmun thinks.) “Materiality” is defined objectively, so s really cannot really plead
          lack of scienter and get away with a good faith, but erroneous, determination of
          materiality.
4. Policy of Powell’s opinion  Financial analysts are crucial to the market. He wants financial
analysts to do their job without fear of liability for making an honest mistake.
5. Fox: On the surface, Blackmun’s argument makes more sense, but Powell has the better policy
argument.
          POLICY: General role of analysts:
          1. Market depends on analysts’ asking probing questions. Blackmun’s dissent chills this.
          Under Blackmun. analysts will not be as zealous in gathering info.
          2. Analysts are thus crucial in the pursuit of efficient capital allocation
          3. Powell is willing to be very broad in letting analysts get out of liability
          4. What is “personal benefit” anyway?
6. Blackmun response:
          If there is an accidental spilling of material inside information, there is no liability under
          10b-5. There is a scienter requirement for 10b-5 liability.
7. Fox: Scienter requirement may not really help an analyst. Fox thinks that a clearer definition
of “materiality” is necessary.

Proposed SEC Rule FD: SEC’s response to Dirks
Rule is geared toward corps that make selective material disclosures to analysts.
1. Regulation is violated if you intentionally make selective material disclosures of info.
2. If you unintentionally make a selective material disclosure of info to analysts, you must publicly
disclose that info.
Violation of Reg. FD is not a 10b-5 violation. The SEC distinguished this regulation from Dirks.

O’Hagan (Class Materials 313) (Sup Ct)
O’Hagan is a partner at a law firm, who hears about a deal between Grand Met and Pillsbury. He
buys options in Pillsbury as a result of his knowledge of the deal. He violated a trust
relationship with his law firm and the client.
1. ISSUE: Is this a violation of 10b-5?




                                              42
         2. 8th Cir says no liability, because O’Hagan had no preexisting duty to those from whom he
         purchased the options. (Chiarella rationale.)
         3. 8th Cir rejects misappropriation theory:
                   a. M.T. is inconsistent with language of Sec. 10(b). Supreme Court likes to stick to the
                   plain language of statutes, and language of 10(b) doesn’t support M.T.
                              i. Sec. 10(b) forbids the use of “deceptive devices,” but M.T. is not a
                                  deceptive device. All that misappropriators do is breach fiduciary duty to
                                  the source of the info. They do not “deceive.”
                             ii. M.T. is not “in connection with” breach of duty to individuals not involved
                                  in O'Hagan’s securities trades.
                            iii. NOTE: Fox disagrees with this analysis. O’Hagan was putting a big deal at
                                  risk by doing what he did.
         4. Sup Ct reverses 8th Cir and adopts M.T. though. Chiarella, Newman, and Materia are
         good law. Sup. Ct. said that O‟Hagan “dealt in deception” by feigning loyalty to his law firm
         (Fox disagrees with the Court’s deception theory.) O’Hagan is guilty!
         5. Court said that the bad act was deceiving the employer (his principal.) But it was the seller of
         the security who was being harmed. Court divorces the victim of the bad act from the person who
         lost out financially in the transaction.
         6. Rule 14e-3 argument is rejected as overbroad. Ct said that SEC redefined fraud in this Rule
         14e-3, which they are not empowered to do. The Rule oversteps the Section 10(b) definition.
         7. There is no “deception” if O’Hagan had disclosed what he did. The breach of fiduciary duty
         occurs not when you receive information, but when you trade on it.
         8. Dissent: Outsider investors are harmed by this transaction, regardless of whether O’Hagan
         violated a duty to his employer.
         9. Fox: The focus of the court should be on who is hurt by the particular transaction (seller selling
         options to O’Hagan.) Here, Grand Met is harmed, since Pillsbury stock rises in price.

Government Sanctions for 10b-5 violations:
      1. If you intentionally violate 10b-5 or other securities laws, you go to jail (Section 32 of ’34 Act.)
      2. Sec. 15(d)(4) says that a member of the securities industry can have license revoked if he
      violates law.
      3. SEC can act under Sec. 21(d) of ’34 Act to seek an injunction against further violations
                 But, 2nd Cir in Commonwealth Chemical (496) said that past violations are not enough to
                 support an injunction. SEC must make a showing that a past violation shows some
                 likelihood of future violations (not tough for SEC to do.) Perhaps the SEC has overused
                 their injunctive powers.
      SEC’s criteria regarding how to punish violators:
      a. Scienter
      b. Is this an isolated occurrence, or are future violations likely?
      c. D continues to maintain that he did nothing wrong, when it is clear that he violated law

Private Right of Action under 10b-5: A TORT action
        1. 10b-5 is silent on the right to private actions, but now it is accepted that there is such a right
        2. Kardon (497) (Dist Ct PA): This case gave birth to the now established right of private action.
                  Rationale: If an actor violates a rule, and the purpose of that rule was to protect the
                  injured party, then the violator has committed a tort against the injured party.
        3. Superintendent of Insurance v. Banker’s Life (486): In footnote 9, the Supreme Court
             recognized the private right of action without analysis, citing Louis Loss.
        4. Cannon v. U. of Chicago (499): Supreme Court said that it wasn’t a fan of private rights of
             action, but acquiesced to the discretion of lower courts
        5. J.I Case v. Borak (499) (Sup Ct): Explains rationale for private rights of action. This right
             maintains the ranks of “private attorneys general” who keep actors on the straight and narrow.
             SEC doesn’t have the resources to police everything.
        6. Regional v Financial (506) (5th Cir): Contract made in violation of ’34 Act is voidable by the
             injured party.




                                                     43
7.  Blue Chip Stamps (523) (Sup Ct): Issue is standing to sue.
          Antitrust consent decree mandated that corp make a public offering of its shares. Corp
         didn’t want anybody to buy, so they disclosed falsely pessimistic information. Would-be
         buyers sued.
         a. Purchaser-seller requirement (Birnbaum Rule was enshrined)
         You can‟t be a plaintiff in a private action unless you were actually the purchaser or
         the seller of a security pertaining to the claim.
         b. Rehnquist looks to policy to make a rule such as this (because there is no evidence of
         Congressional intent.)
         c. Birnbaum Rule excludes some who have been legitimately harmed, but is a decent
         weapon against non-meritorious claims.
         d. If Plaintiff said that he “would have bought the security but-for the negative
         statements,” how do we know that they are telling the truth?
         e. Fox: Court really wants to destroy the settlement value of frivolous claims. Get these
         claims dismissed at the SJ stage.
There is no private right of action for misrepresentations surrounding tender offers under 14e-3.

Elements of the common law action for deceit (a tort):
1. *** Materially false information
2. Scienter
3. Intention to induce  to act.
4. *** Reliance by  on the misrepresentation in taking or refraining from action (causation)
5. Damage to  resulting from the taking or refraining from action

Hypothetical 1: When there is a falsely pessimistic statement, when is there standing to sue?
        a. Plaintiff was about to buy, but heard bad info and was induced to refrain from
             purchasing… No standing. This is Blue Chip.
        b. Plaintiff was holding stock, and sold when he heard false bad info… He has
             standing.
        Both are injured, but Birnbaum Rule limits recovery to B (Purchaser-seller requirement.)

Hypothetical 2: Falsely optimistic statement:
        a. Plaintiff was about to sell, but decided to hold on after hearing false positive info… No
        standing.
        b. Plaintiff wasn’t a holder. He heard the false info and was induced to buy… Standing

Central Bank (531) (Sup Ct): Aiding and abetting case.
Supreme Court says that there is no penalty for aiding and abetting under 10b-5.
1. Rationale: Aider and abettor does not have a legal duty that he could breach, and there is
nothing in the statute that gives him a duty.
2. Fox: The same thing could be said about the tippee in Dirks. We should look to the common
law, from which aiding and abetting arises, not the statute.
3. This rule is good for U/Ws, lawyers, and accountants.

List v. Fashion Park (653) (2nd Cir): Fraud by silence
Plaintiff said that had he known two bits of info, he would not have sold his stock. He sued
because he wasn’t given the info that 1) buyer was a director of corp, and 2) the board was going
to sell the corp to another corp.
1. s must satisfy 2 tests to determine whether  was liable:
          1. Materiality Test: Courts ask if info was material (would a reasonable investor
          find the info important?), and
          2. ***Reliance Test: Courts ask if Plaintiff would have acted differently with the
          disclosure.
2. Ct said that this info wouldn’t have influence plaintiff, so no 10b-5 liability even if the info was
material.



                                             44
3. Court said that the aim of 10b-5 is to qualify the doctrine of caveat emptor between insiders and
outsiders, not to establish a scheme of investors’ insurance (s like this quote and this whole
case.)
4. Ramifications: In addition to showing that this info was material, plaintiff must show that the
info would have changed his own investment decision. (This is a very difficult standard for  to
satisfy. Also it is nearly impossible for a class action to be brought against s for a 10b-5
violation because each member of the class must have personally relied on the misinformation.)
         But doesn’t “material” mean that it would have influenced the behavior of the reasonable
         behavior? There is no presumption of reasonableness under this test.

List Hypothetical #1: Insider knows that his company (X Corp) is about to be taken over by XYZ
Corp (and thus the X Corp’s price will probably go up.) He buys 1000 shares from a seller who
MUST sell his X Corp shares because he’s taking a government job.
        1. Did insider violate 10b-5? Powell would say yes. Silence is actionable if insider has a
        relationship of trust and confidence with other party. Here he does.
        2. Does seller have a private right to action? NO!
                  List precludes action unless full disclosure would’ve influenced seller’s actions.
                  Here, seller would have sold regardless. (Test is on pg 657)
        3. Fox: There is an argument that the premium belongs to seller. If insider would have
        done what he was supposed to do (disclose before selling), seller would have sold for
        more $. This isn’t what List says… Prof thinks that List’s reliance test is not a good one.
        We don’t give  damages in Hypo I, but we do give damages in Hypo II (infra.) That’s
        dumb.

Hypo #2: Insider violates 10b-5 as above, but seller sells specifically because he believes that
there will be no merger. He sells to insider who knows that X Corp is merging with XYZ Corp.
         a. Plaintiff will prevail under List reliance test.
         b. NOTE: If insider refrained from trading, but still didn’t disclose the info, seller’s
         injury would be the same, but insider would not be liable under 10b-5.

Hypo #3: Seller says “I wish XYZ Corp would merge,” and sells to someone other than insider
(insider doesn’t trade) because there is no merger in sight. Then XYZ merges.
          a. Clearly, the damages are the same as before and he would have acted differently had he
          known that XYZ will merge. But the insider doesn’t trade. No liability for insider, even
          though seller is harmed. This is not but-for causation for seller’s injury.
BOTTOM LINE: List test is not good, since it is not a good filter of who has been hurt.

“Causation Anomaly”: There are two ways for insider to avoid liability: 1) Don’t trade, or 2)
Disclose and trade. Only one way (#2) doesn’t hurt . So we can’t say that a ’s violation
would necessarily cause ’s injury. Insider’s violation of 10b-5 does not lead to “but-for”
causation of seller’s injury  If insider simply didn’t buy, seller would have sold to someone else,
and he’d be injured even though insider wouldn’t have violated 10b-5 by not disclosing and not
trading.
Causation anomaly suggests that the problem isn’t merely non-disclosure of information, but it is
non-disclosure + insider’s trading.

The List rule was modified in Affiliated Ute (Sup Ct) (659) Now in an insider trading case
where the problem is non-disclosure in a face to face transaction, if non-disclosure is objectively
“material,” then there is a presumption of reliance by plaintiff. Silence = breach in that case.
“Positive proof of reliance is not a prerequisite to recovery: All that is necessary is that the facts
withheld be material in the sense that a reasonable investor might have considered them important
in the making of a decision to buy or sell.” Affiliated Ute doesn’t quarrel with the List theory of
causation, but it took issue with the List evidentiary requirement.
This is now the definitive word where  and  trade face to face. Question is still open as to
whether the List or Affiliated Ute standard applies to trades on the stock market.



                                             45
Affiliated Ute (659) (Sup Ct)
Bank doesn’t disclose to Native Americans that it had an interest in buying securities, or that
whites were getting a higher price.
1. Supreme Court said that based on these facts, reliance is not a prerequisite to recovery.
All that is necessary is that the facts withheld was material. (Bank was obliged to disclose these
facts.)
2. The holding in List was limited. If the info was material, there is a rebuttable presumption that
there was reliance.

Law of Conservation of Securities: If insider purchases shares w/o disclosing info, the public as a
whole is poorer because the public holds fewer shares after the insider’s purchase. (Zero sum
theory.)

Fox’s graph and the Last Word: Do we really know whether the insider has hurt anybody?
1. At the end of the day, insider owns more shares and others own fewer shares. If price goes up,
someone is less wealthy than they would have been.
2. Two groups are hurt, and one isn’t
          Hurt groups:
          1. Actually Harmed: They are sucked into selling because of higher stock prices due to
          insider’s buying. They wouldn’t have sold at the price before the insider entered the
          market. (The marginal sellers)
          2. Refrainers (potential investors): These are the people who would have bought at a
          lower price, but refrained from buying because the stock price is too high because of
          insider’s purchases. Law doesn’t provide remedy for these investors (Blue Chip,
          Birnbaum Rule.)
          3. “Pseudo-harmed”: These are the people who sold at the higher price, but would have
          sold at the market price regardless of the insider’s trades. (Inframarginal traders.)
                    Fox: Impossible to know who wouldn’t have sold at the lower price, but
                    would’ve sold at the higher price. (Impossible to identify actually harmed
                    people.)

Farnsworth (659) (2nd Cir)
D insiders unloaded stock just before disclosing bad news. Plaintiffs purchased D’s shares.
1. Officers and directors of the corp sold stock while knowing about significant negative inside
info about the corp. Insiders also released falsely positive financials.
2. Insiders aren’t liable for the falsely positive financials, because insiders didn’t rely on them.
3. Court enshrined the “semblance of privity” test for insider trading. (This means that  and 
must trade roughly contemporaneously.) This test is consistent with Fox analysis because s n
this case purchased long after ’s entry into the market, so they weren’t induced into the market
by the insider’s transactions.

Shapiro v. Merrill Lynch (660) (2nd Cir)
Douglas tells ML that it will have disappointing earnings. ML tells everyone about it three days
after it sells its position in Douglas.
1. This is a 10b-5 violation
2. HOLDING: D owes a duty to everyone who traded on the market w/o inside info for those
3 days, not just the purchasers of the shares that D owned. (Liability may be limited to cases
where D was a “major factor” in the market.) 2nd Cir seems to be realizing that people who were
actually harmed may not be the same (or limited to) the people in actual privity with Ds.
3. This holding is similar to Farnsworth’s “semblance of privity” standard.
4. NOTE: District Court screwed up on remand. It said that Ds should be liable until there is
equal access to information among investors (this holding would award damages to “pseudo-
harmed” investors.)
5. s sold shares in Douglas (same facts as Beecher v. Able) on negative inside info for a period of
three days.


                                             46
6. Ct held that s owe duty to all purchasers who didn‟t have inside information and who
bought during the period that s were selling. It is not enough for  to disclose info only to
the people who were selling shares to . (The court realizes that not all of the “actually harmed”
investors are ones with whom  has privity. This is consistent with Fox’s theory.)

How to reconcile Merrill Lynch and Farnsworth
In Farnsworth, there was not even a possibility that there was privity between ’s buying and ’s
selling (because s bought after s sold.) There was no “semblance of privity whatsoever.
In Merrill Lynch, there was a very good possibility that most of the s purchases were actually in
privity with s selling. (s selling made up more than half of the total trades in Douglas stock
during the time that s sold.) Allowing all s to recover in this case is good “rough justice.”

In an anonymous market, the question of whether or not you are actually harmed doesn’t depend
on privity, but rather on timing. Courts use privity as a surrogate for timing.

Fridrich v. Bradford (Class Materials 331) (6 th Cir)
With inside info, D bought shares of a privately held corp 2 months before Ps sell. P’s sue,
claiming unequal access to info. D made $96K through the transactions.
1. Ct uses notion of “causation anomaly”: It’s not just the 10b-5 violation that creates civil
liability, it’s the violation AND the trade.
2. RULE in private market trades: The private right of action is limited to face-to-face
transactions.
3. Private civil liabilities do not necessarily reach as far as SEC’s long arms. The damage is caused
by non-disclosure AND trading. A showing of one or the other does not give rise to a civil claim.
4. Celebrezze concurrence: Ds are only liable to the class of Ps who bought during the
period in which Ds were selling. This is consistent with Fox approach (semblance of privity.)
Fridrich:
1. Insiders knew that their corp was going to merge. So insiders bought shares between April 21-
   27. s sold their shares from June 13-15, just a few days before merger was announced.
2. Majority denied relief to s. claiming that ’s trading was not causally connected with ’s
losses. A 10b-5 violation involves both non-disclosure and the insider’s trade.
3. Court dramatically limited private rights of action in 10b-5 cases arising from stock exchange
transactions (what the court called “impersonal market cases.”) Private 10b-5 actions can only be
brought pursuant to face-to-face transactions. Court thought that SEC is the best entity to bring
10b-5 suits. (Court acknowledged that  violated 10b-5, but it thought that SEC should get
involved.)
4. Majority’s policy: If we allow all plaintiffs who sold between June 13-15 recover, damages
would equal $800K. If we allow plaintiffs who sold between April 21 and June 29 to recover,
damages would equal $3.7 million! But insiders only made a $96K profit. Allowing s to
recover would result in “draconian liability.”
5. Celebrezze concurrence: He proposes to satisfy majority’s policy concern by limiting the class
of Ps to those who bought during period that Ds were selling. Celebrezze would cut out s who
weren’t actually harmed by ’s conduct.

Elkind v. Liggett & Meyers (662) (2 nd Cir)
1. Court limits recovery to the class of Ps who were in the market “contemporaneously with D’s.”
2. Court limits damages to the amount of profits Ds made while trading on inside info. If the
amount of ’s gain is less than all P’s damages, the P’s recover in a pro rata amount.
3. Fox: Pseudo-harmed may account for 99% of Ps where Ds are a small % of the market, but this
is good rough justice. (correct harm was done)

Moss v. Morgan Stanley (665) (2nd Cir)
1. Warner Lambert is working with Morgan Stanley on a hostile takeover. M.S. banker hears
about the plan and buys shares in the target corp.




                                            47
       2. Court held that he violated 10b-5 on the Misappropriation Theory (Powell wouldn’t have found
       him guilty under his liability standard of “violation of relationship of trust & confidence.”)
       3. Court did not find for  (a target corp ex-SH who sold his shares on the open market) in
       this case though, because  did not owe a duty to him. Court said that the intent of §10(b) and
       Rule 10b-5 is to combat fraud. Here,  committed no fraud against . Court didn’t want to award
        “windfall damages.”
       4. Court notes that “the people who are hurt are those who intended to trade on the same side of
       the market as the insider,” not those who would’ve transacted directly with the insider.

       STATUTORY REFORMS: Section 20A:
       1. §20A: Any violation of ’34 Act through insider trading is liable to anyone who was
       “contemporaneously” trading the same security on the other side of the market from insider.
       2. Liability under §20A extends to tippers and control persons.
       3. Liability is reduced by amount of any SEC disgorgement.

REGULATION UNDER §10(B) OF PUBLIC ANNOUNCEMENTS BY A CORP THAT DOESN’T
TRADE: (CORPORATE MISSTATEMENTS)
      Rule 10b-5 subsection 2 says that you can’t make a MM or O “in connection with” the
      purchase/sale of any security. Question: What does “in connection with” mean?

       3 questions to ask in a private action against corp alleging 10b-5 violations:
       1. Is there in fact a violation?
       2. Can  recover in a private action?
       3. How much in damages should court award ?

       Under common law actions for deceit,  must show that ’s actions caused him to ACT. ( must
       show that he relied on ’s misstatement.) Forcing  to show individual reliance on ’s
       misstatement can make it impossible for s to bring a class action suit. (Basic deals with this
       issue.)

       Texas Gulf Sulphur (469) (2nd Cir)
       1. Court concluded that it wasn’t necessary that the (defendant) person who made the
       misstatement actually trade in order for there to be liability. The only thing that needs to happen is
       that investors trade in reliance on the misinformation perpetuated by the defendant.
                a. RULE: 10b-5 is violated whenever there are false assertions made “in a manner
                reasonably calculated to mislead the financial markets.” This is still good law.
                b. There are two factors to the above stated rule:
                          i. Intent. (In Hochfelder, Sup. Ct. required scienter as to the veracity of the
                          misleading statement. Most circuits define scienter as “reckless disregard
                          of the truth.”)
                          ii. Corp must have knowledge that investors will rely on the misleading info.
       2. White’s dissent in Basic takes the opposing view to the Texas Gulf rule.
                a. Misleading assertion will lead to equal numbers of windfall winners and losers when
                insiders aren’t trading. The amount gained by the winners equals the amount lost be the
                losers, so society shouldn’t care. Letting some SHs sue will just hurt the other SHs
                (because the damages come from the corporation.)
                b. Criticism of White: We want good information in the market because of price
                accuracy issues. We want people to be confident about the market, otherwise we will see
                fewer investors.

       CORPORATE MISSTATEMENTS WHEN CORP ISN’T TRADING:
       These are regulated under 10b-5 subsection (2), where insider trading is regulated under 10b-5
       subsections 1 and 3.




                                                    48
Basic v. Levinson (Class Materials 340) (Sup Ct)
Basic engaged in merger discussions it wanted to keep secret. Basic made 3 affirmative
statements denying the existence of discussions. The old doctrine (called the “Agreement in
Principle Rule”) said that preliminary merger negotiations were by definition immaterial, so corps
don’t have to disclose that info. Supreme Court rejected the Agreement in Principle Rule and
adopted the “Fraud on the Market” Theory.
1. Case is important because Sup Ct adopted the “fraud on the market” theory, which gives
a presumption that  relied on the ‟s misstatement if that misstatement was about a
material fact.
2. This presumption is rebuttable by . There is no liability if  can show that  did not rely on
the misstatement. (The presumption would be difficult to rebut, though.) Fox thinks that the
presumption of reliance on misstatement should not be rebuttable, though. (Old judges just can’t
think outside the old common law box.)
3. Sup. Ct. said that a merger would be a material fact.
         As a result of this decision, corps answer “no comment” whenever asked about merger
         possibilities. “No comment” = silence.
4. “Fraud on the Market” Theory: (enshrined in Basic)
         a. Market price reflects all information, so an investor who trades will rely on the
         information that is out there (through reliance on the notion that the price reflects
         the correct valuation of stock), regardless of whether the info is right or wrong.
         Trader will trade on the integrity of the market.
         b. White’s dissent in Basic (he hates these lawsuits, while Blackmun loves them)
                   1. Majority opinion depends on EMH, which is merely a new social science
                   theory. We shouldn’t base far-reaching jurisprudence on such a new and
                   untested theory.
                             a. Fox: Majority’s opinion doesn’t rely wholly on EMH. Rather, it
                             relies on the notion that a corporation’s public statements affect its
                             stock price. That’s accepted by most people.
                   2. White doesn’t want to impose liability where the corporation doesn’t trade.
                             a. Fox agrees, since this disclosure is purely voluntary. By imposing
                             liability, the court may chill this voluntary disclosure.
                             b. From a policy standpoint however, White makes no sense. 1)
                             Misleading statements just redistribute wealth in a zero-sum world, and
                             2) These are situations where there is no duty to disclose.
         c. Hochfelder imposes a scienter requirement, so voluntary corporate disclosure shouldn’t
         be chilled.

In re Apple Computer (698) (9th Cir)
1. Apple made glowing reports about its new computer system, but didn’t disclose the risks
involved with it. This was an omission that made the info disclosed misleading.
2. Apple’s defense: Industry commentators did disclose the risks, so that negative information was
public. (This is a materiality defense – the omission was immaterial because the public knew
about it anyway.)
3. Court held for Apple under the fraud on the market theory. The market price already reflected
the info about the risks of Apple’s system.  did not “rely” on Apple’s omissions. Also,  was
not damaged by the omissions because the stock price reflected all information (thus the price that
 paid for the shares was fair.)
4. RULE: We can count the info that was disclosed by an entity other than the corp in determining
the “total mix” of information disclosed.
5. Fox says that the court should have ruled that Apple violated 10b-5, but that  doesn’t get any
damages since he wasn’t injured.

Fox says that the Apple theory shouldn’t apply to IPOs. The IPO corp should not have the defense
tat commentators disclosed the negative info which the corp didn’t disclose. There isn’t enough
public information about IPO corps yet.



                                            49
       Fox thinks that the Apple defense should be allowed for already publicly traded corps who qualify
       for short form registration for new securities, but should not be allowed for publicly held corps
       which don’t qualify for short form.

       DAMAGES FOR 10b-5 VIOLATIONS:
       Most difficult issue is causation. The “fraud on the market” theory resolves this issue in favor of
       plaintiffs. This means that corp can be held liable for material misrepresentations even if it
       doesn’t trade after the misrepresentation.

       Measure of damages: Rescissionary and out-of-pocket.
       a. Rescissionary measure entitles plaintiff to the return of his purchase price, less the value of the
       security he holds. Plaintiff is returned to the position he was in before he bought security. This
       measure fits well with traditional reliance damages. (Perhaps this measure should be used where
        was induced into buying stock solely because of misrepresentation.)
       b. Out-of-pocket measure entitles plaintiff to the purchase price less the security’s true “value” at
       the date of purchase. This corrects the artificial inflation or deflation of the stock that results from
       the misrepresentation. (This measure works well in fraud on the market cases.)
                1. The trend is toward out-of-pocket damages (See Green.)
                2. NOTE: Under out-of-pocket measure, if plaintiff sells before the misrepresentation is
                corrected in the market, the plaintiff isn’t entitled to any damages. This rule is rebuttable
                though, if  can show that the information seeped out over time.) The premium investor
                paid initially is still included in the price of the stock at the sale. (This assumes falsely
                optimistic information.)
                3. One way to measure damages would be to give  the amount that the stock price
                changes when the market learns about the correct information. This measure only works
                when all the corrected information comes out at one time.
                4. Fox: There is no settled law on this issue.

       Green v. Occidental (703) (9th Cir)
       Judge Sneed’s concurrence adopts out-of-pocket measure. The value of the misrepresentation
       may change over time as the stock price fluctuates (e.g. if an oil drilling corp lies and states that
       there is oil underground, the value of the lie fluctuates with the price of oil.)

       §21D(e) OF ‟34 ACT: (Part of Private Securities Litigation Reform Act.)
               1. Limits damages to price paid less the mean trading price for 90 days after the false
               information was corrected.
               2. The effect is to make litigating less profitable to be a plaintiff. This is akin to
               rescissionary damages.
               3. NOTE: If the whole market is moving up and the negative effect of the MM or O is
               less than the amount the market moves up, plaintiff won’t be able to recover despite his
               injury. The plaintiff bears both the upside and the downside risks.
               4. §21D(e) isn’t necessarily the only damage calculation, but it’s a cap.

       §21(D)(e) hypothetical (with out of pocket measure of damages):
        buys stock on Jan 1st, when there is false info out there. On Feb 1, corp discloses the truth.

                I. Without §21(D)(e), just the out of pocket rule:
                Jan 1st         Feb 1st             ’s damages
Price           105             90
True Value      90              90                  15 (105-90)

                II. With §21(D)(e), price increases between 1/1 and 2/1
                Jan 1st          Feb 1st             ’s damages
Price           105              115
True Value      90               100                 5 (105-100)



                                                     50
                 III. With §21(D)(e), price decreases between 1/1 and 2/1
                 Jan 1st           Feb 1st           ’s damages
Price            105               95
True Value       90                80                15 (105-90)

BROKER-DEALER TRANSACTIONS:
     Types of broker transactions:
     1. Primary Market transactions
              a. Firm commitment underwriting  Broker buys securities from IPO corp and sells to
              average Joe for a profit
     2. Secondary Market transactions
              a. Out of inventory  Sales of OTC stocks (including NASDAQ). Broker is a market
              maker.
              b. Riskless Principal  Also on the OTC market. Broker fills customer orders through
              another broker who acts as a market maker.
              c. Broker as agent  NYSE model. Broker buys shares on a trading floor.
     POSSIBLE CONFLICTS OF INTEREST:
     1. Broker/Dealer wants to make a profit, so he wants to sell more stock
     2. Investor relies on broker for advice.

        SECTION 17(a):
        Unlawful for any person in the offer or sale of securities (brokers) by means of interstate
        commerce to:
        1. employ any scheme or device to defraud,
        2. to obtain money or property by means of untrue statement of a material fact or material
        omission, or
        3. to engage in any transaction, practice, or course of business which operates as a fraud or deceit
        upon the purchaser.

        Charles Hughes & Co. v. SEC (845) (2nd Cir)
        1. Broker got order from customer and bought security from marketmaking broker (a “riskless
        principal” transaction.)
        2. Plaintiff sued under Section 17(a) that Defendant charged too much commission (a fraudulent
        markup on the price of the security.) Broker didn’t disclose the substantial nature of the markup.
        3. Court held for Plaintiff saying that once there is “confidence instilled” between P and D,
        there is a duty for D to reveal the markup.
        4. There must be a misleading statement under Sec. 17(a). What is the misleading statement
        here? Brokers are impliedly representing that they are acting in a normal, reputable
        manner. This is called the “Shingle Theory.” (“The law of fraud knows no difference
        between express misrepresentation on one hand and implied misrepresentation on the
        other.”)

        What are allowable markups?
        Rule of Thumb: Markups of more than 5% are suspicious. Markups of more than 10% are
        presumptively excessive.

        Bid Price: Price at which dealers buy from marketmaking dealers
        Offer Price: Price at which dealers sell to other dealers
        Selling Price: Price at which dealers sell to customers
        (How do we calculate markups? Is it Selling Price – Offer Price or Selling Price – Bid Price?)

        Markups should be calculated as Selling Price – Offer Price as long as dealers actually sell to each
        other at the Offer Price. If dealers sell to each other at lower than Offer Price, then that lower
        price should be the basis for calculating markup.



                                                    51
        Shivagi v. Dean Witter (868) (5th Cir)
        1. Broker gets a special 40% commission in addition to regular commission from his employer
        (Dean Witter) whenever he sells a particular stock. Broker didn’t tell P about this special
        commission when he sold P the stock.
        2. Why should D be liable in a case like this? Because broker has a really BIG incentive to push
        the stock under such a commission structure.

        CHURNING: A violation of 10b-5
        If a broker does a lot of trading on behalf of customers, he generates a lot of commissions. We
        must wonder whether this is good, because broker has an incentive to really push people to trade.
        Suspicion arises when there is too much trading on a customer’s account.

        Churning case:
        Mihara v. SEC (890) (9th Cir)
        1. Too much trading on a customer’s account can result in a 10b-5 violation for the broker. Broker
        can have civil liability for 10b-5 violations due to churning.
        2. In order for Plaintiff to win a 10b-5 suit for churning, he must show:
                  a. That the trading on the account is “excessive”
                  b. The broker “exercised control” over the account. (NOTE: Broker can be
                  considered “in control” if the customer always takes broker‟s advice and the
                  customer knows nothing about the market.)
                  c. Broker acted with the intent to defraud (Fox: This is a “throwaway requirement”)
        3. Court held for Plaintiff on the “Shingle Theory” of Charles Evans & Co.
        4. As long as customer is in control of the account (e.g. he always calls broker to trade), customer
        will lose a churning suit.

BROKER’S OBLIGATION TO KNOW THE SECURITY: Otherwise a violation of 10b-5
     Hanley v. SEC (921) (2nd Cir)
     Broker may not recommend a security he knows nothing about. This rule is also justified by
     the “shingle theory” that the broker is knowledgeable and reputable. (Prof thinks that the
     argument for private civil liability for “know your security” violations is shaky.)

        How knowledgeable do brokers need to be? SEC will generally prosecute only the very egregious
        cases, where broker really knew diddly-squat about the security.

REGULATION OF CONTROL TRANSACTIONS:
     Background: Law says that mergers must be approved by both the Board and the SHs. To get
     votes, the target corp must send out proxies under §14(a) of the ’34 Act and Rule 14a-9.
     Tender Offers are regulated by the Williams Act.

        Should we regulate tender offers? 3 schools of thought: (see handout)
        1. Market Price may not reflect the best available estimate of the value of the firm in the
        incumbents’ hands. (Market Price = 30, True value of corp under incumbents = 45, Tender offer =
        forty.) Why would this happen? There might be private info only held by incumbents, or there
        might be general market irrationality.
        2. Market Price reflects the best estimate of firm value, but it is not desirable that the first offer
        succeeds. (Market Price = 75, True Value under incumbents = 75, First bid = 85, Last bid = 95.)
        Law is worried about corp’s SHs, so we try to give benefit to later, higher bidders.
        3. Market Price reflects the best estimate of firm value, and the law should make sure that the first
        offer succeeds. (Same numbers as #2.) Instead of helping SHs like #2, the law is interested in
        giving potential acquirers an incentive to search for targets. This would increase social efficiency.
                 Counterargument to #3:
                 a. We don’t really know the elasticity of supply of search activity. Who says that it’s
                 hard to find undervalued corps? It might be easy.
                 b. There are transaction costs associated with transferring corp to another’s hands.
                 Auctions (#2) are less costly.



                                                     52
         c. If we protect SHs through #2, we might give investors more of an incentive to buy the
         target stock before the tender offer even occurs.

§14(a): It is unlawful for any person to contravene (through interstate commerce or a national
securities exchange) the SEC’s rules and regulations furthering the public interest that deal with
proxy statements.

Rule 14a-9: Proxy statements may not contain a material misrepresentation or material omissions.

Case v. Borak (499) (Sup Ct)
Decision established that where there is a MM or O in a proxy, SHs have a private right of action.

Mills (710) (Sup Ct)
If proxy statement contains a material misstatement, then court will presume that SHs relied on the
misstatement in deciding how to vote.  does not need to make an independent showing of
causation.  doesn’t have the defense that the merger terms were fair.
         In order for  to win on a 14a-9 suit, he must show:
         1. A violation of 14a-9 (a material misstatement or omission)
         2. Corp needed the SH votes to do the transaction

What are the remedies under 14a-9 suits? (Mills)
1.  can’t set merger aside on their own volition, but they might be able to set merger aside if they
sue derivatively (if setting merger aside benefits all the SHs.
2. No rescission remedy if the merger terms are fair.
3. Fairness of deal is relevant in determining the monetary damages awarded to .

Virginia Bankshares v. Sandberg (Sup Ct)
s cannot sue under 14a-9 if corp didn’t need SH vote to perform the transaction. (Corps
regularly let minorities vote even though their vote doesn’t matter.)

Gerstle v. Gamble & Skogmo (724) (2nd Cir)
Judge Friendly concludes that there is no scienter requirement on the part of Ds for 14a-9 suits
based on the facts of the case (where there was a merger and a solicitation by someone already in
control.) Negligence is sufficient.
1. Sections 14(a) and 10(b) distinguished: Language of 14a-9 is almost identical with that of
   10b-5, and Hochfelder says that there is a scienter requirement under 10b-5.
2. But Friendly says that the underlying statutory language of Section 10(b) is different than 14(a).
          a. 10(b) talks about “manipulative or deceptive device,” while 14(a) is silent on deceit.
             Rather, 14(a) only specifies only that it is unlawful to use a proxy in contravention of
             SEC rules.
          b. SEC may pass any rule here that is necessary, appropriate, and in the public interest.
3. RULE: In a situation where a merger has already occurred, all P has to show in order
     to get relief is a violation of 14a-9 and the fact that mgmt needs to solicit proxies to get
     the transaction done.
4. Court didn‟t award rescissionary damages. Too many years have passed between
     violation and litigation to adequately determine the amount of damages. If court
     awarded rescissionary damages here, it would be granting  a long put option. That‟s
     unfair to corp.
5. Court left open the question of whether or not there is a scienter requirement for a 14a-9
     violation in a non-merger situation.

Gould v. American Hawaiian Steamship (728) (3rd Cir)
No scienter requirement for 14a-9 liability where corp seeks proxies for a director’s vote relating
to a merger.




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        Adams v. Standard Knitting Mills (731) (6th Cir)
        In order for an outside director (an accounting firm) to be liable under 14a-9, the plaintiff must
        show scienter.

TENDER OFFERS (TO):
     TOs usually do not involve an agreement between offeror and target’s management or board.
     Acquirer goes straight to the SHs.

        The economics and philosophy of TOs: (3 schools of thought)
        1. The market price may not reflect the best available estimate of the firm’s value in the incumbent
        mgmt’s hands. This might mean that we want strong regulation (through Williams Act) that helps
        incumbents block takeovers.
        2. The market price reflects the best possible estimate of value of the firm in the hands of the
        incumbent mgmt, but it isn’t necessarily desirable that any initial tender offer succeeds. This
        means that we would want a Williams Act that provides restraints that encourage auctions, thus
        getting the best price for SHs.
        3. The market price best reflects the best available estimate of the value of the firm in the
        incumbent mgmt’s hands, and we shouldn’t necessarily discourage the first offer. This means that
        we care less about SHs than we do about getting capital into the hands of the shrewdest mgrs.
        Also, we want to give tender offerors an incentive to seek undervalued companies.

        WILLIAMS ACT: Sections 13(d), 14(d), 14(e) of ’34 Act:
        1. 13(d): An acquirer who gets more than 5% of the corp’s stock must file with SEC. This is the
        early warning system to incumbents.
        2. 14(d): Notice must be given of a “tender offer” where acquirer obtains 5% of stock.
        Under Williams Act, D must file Schedule 13D when he gets 5% of shares, and a Schedule 14D if
        D intends to make a TO.
                  Also: Regulation of substantive terms of tender offers, withdrawal period, pro-rata
                  purchase of shares in oversubscribed offers, and “same price rule” where offeror must
                  pay all tendering SHs the same price.
        3. 14(e): Antifraud rule for tender offers.

        Rondeau (761) (Sup Ct)
        D acquires more than 5% of the corp’s stock, but doesn’t file 13D with SEC until corp tells him
        about this obligation under Williams Act.
        1. Justice Burger said that this was merely a “technical violation,” but corp does not deserve
        “sterilization” of D’s shares and damages. Nobody was harmed by D’s actions.
        2. Burger said that purpose of Williams Act was to protect SHs (by giving them more info
        and more time to think about the offer.) Purpose of Act was not to protect management.
        Court said that Congress did not want to “tip the pendulum” in favor of mgmt. However,
        Fox says that Burger misunderstood purpose of Act, because he ignored §13(d). If the
        requirement to file a 13D is obviated if there is no intent to make a TO (as it is under Rondeau),
        what is the point of having a Schedule 13D at all?
        3. Fox: Burger is wrong to say that there is no injury here. Once schedule 13D is filed, price of
        stock usually increases, making corp more expensive for acquirer. Here, D has not disclosed his
        holdings and harmed sellers of Rondeau shares who would have gotten the premium due to
        increased price. Also, corp has less time to react to offer and communicate with SHs if D decides
        to enact a TO.
        4. Those who were really injured were the SHs who sold and the issuer. But how do we determine
        the amount of damages?

        CASES DEFINING T.O.s
        Kennecott (770) (2nd Cir)
        Company buys 5% of target corp. Company has 10 days to file Schedule 13D. During those 10
        days, it acquires another 5%. Incumbent mgmt says that this is a tender offer.



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1. ISSUE: Is an acquisition of shares in the open market a “tender offer?”
2. The court says that acquisition of shares in open market isn’t a tender offer, because the offer
did not involve the high-pressure sales tactics which usually accompany a tender offer.
3. Was this case decided correctly? Your answer depends on your philosophy of TOs. If you think
that the Act is primarily for the protection of SHs, it was a bad decision. People who sold after
company already acquired 5% lost out on a possible premium. (Your opinion of case depends
upon which of the 3 “schools of thought” you ascribe to.)

Wellman v. Dickinson (773) (Dist Ct NY)
Corp acquired shares through private offers to certain SHs (who together comprised 32% of
shares.) This wasn’t a classic T.O, but court ruled that it was a tender offer. The SHs could not
view the §14(d) filing that offeror was supposed to make. Ruling could be justified if you think
that the Act is there to maximize SH return.

TENDER OFFER DEFINED: 8-part Wellman test, cited in SEC v. Carter Hawley Hale (777)
1. Active and widespread solicitation of public SHs for issuer’s shares that they hold
2. Solicitation made for a substantial % of the outstanding shares.
3. Offer is made at a premium over market price
4. Offer has fixed/non-negotiable terms
5. Offer is contingent on a minimum # of shares being tendered, and is subject to a fixed
maximum number of shares to be purchased
6. Offer is only open for a limited amount of time
7. Offeree (public SH) is subjected to pressure to sell his stock
8. Public announcements of a purchasing program concerning the target precede or accompany a
rapid accumulation of the target’s securities. (Generally, this is operated as a high-pressure sales
situation.)

SEC v. Carter Hawley Hale (775) (9th Cir)
Court uses the Wellman Test for definition of T.O.s to find that a corp’s “self tender offer” (i.e.
stock repurchase plan) is not a T.O. Court rejects the alternative S-G Securities test for definition
of T.O. It said that the test relies too much on hindsight and gives no guidance to s ex ante.
         S-G Test for T.O.
         1. Publicly announced intention by purchaser to acquire a block of stock of target in order
         to gain control.
         2. Subsequent rapid acquisition by purchaser of large blocks of stock through open
         market or privately negotiated purchases.

Hanson Trust v. SCM (780) (2nd Cir)
Offeror was using a T.O to gain control of corp, but then dropped public T.O plan and instead
offered to buy privately from certain SHs. Court examines certain factors in order to determine
whether SHs need the Act’s protection (by defining the offer as a T.O.) Factors include # of SHs
involved, presence of a time limit, sophistication of SHs, amount of pressure exerted by , and
whether SHs approached tender offeror with an offer to sell. Court did not want to use the
Wellman Test. Ct said that this wasn’t a T.O.

REGULATION OF TERMS OF T.O.
McDermott v. Wheelabrator-Frye (787) (7th Cir)
A corp does not make a “new offer” when it increases the size of the tender offer. If there is a
“new offer,” then the offer must remain open for a longer time period.

WHAT DISCLOSURE IS REQUIRED BY ACQUIRER?
Johncamp (790) (2nd Cir)
Judge Friendly says that acquirer must disclose his financial position if it is material to the
SHs. SHs have the right to know whether their new partner is weak.
Why would SHs care about the financial condition of the offeror if he is offering cash? Perhaps




                                             55
1) offeror can’t pony up the cash, or 2) offeror is not willing to buy all the shares, and SHs do not
want to be a minority SH of a corp with bad management. Neither of these is a factor in this case.
Fox: This case is an illustration of the strong prejudice toward disclosure.

CIVIL LITIGATION UNDER WILLIAMS ACT:
Piper v. Chris-Craft Industries (Sup Ct)
 and  were rival tender offerors.  sued  for alleged violations of Williams Act.
Sup Ct denied ‟s standing to sue for damages, because purpose of Williams Act is to
protect SHs, not to protect rival bidders. Had Court granted  damages in this case, the money
would be paid (indirectly) by the very SHs that the Act was supposed to protect.
Fox: Overall, this case would discourage auctions, because bad offerors don’t get punished for
violating Williams Act through award of damages.

Humana v. American Medicorp (801) (2nd Cir)
One tender offeror has standing to sue another tender offeror for injunctive relief for
violating Williams Act. Though damages aren’t available, injunctions are.
(Possible injunction  stop had offeror’s progress until he corrects the violation.)




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