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					Securities Fraud


    Rule 10b-5


                 Last updated 20 Feb 12
          Securities Fraud Action

William Rehnquist:

  When we deal with private
  actions under Rule 10b-5,
  we deal with a judicial oak
  which has grown from
  little more than a
  legislative acorn.

Blue Chip Stamps v. Manor
  Drug Stores (US 1975)
        Securities Exchange Act of 1934
Section 10 -- Manipulative and Deceptive
Devices

It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentality of interstate commerce or of
the mails, or of any facility of any national
securities exchange--

         (b) To use or employ, in connection
with the purchase or sale of any security
registered on a national securities exchange
or any security not so registered … any
manipulative or deceptive device or
contrivance in contravention of such rules and
regulations as the Commission may prescribe
as necessary or appropriate in the public
interest or for the protection of investors.
        Securities Fraud Action
Rule 10b-5              Transactional nexus
                        • By means of interstate
• Transactional nexus     commerce or mails
• Plaintiff             • “in connection with purchase
                          or sale”
• Defendant
• Elements
• Procedure
        Securities Fraud Action
Rule 10b-5              Plaintiff
                        • Purchaser or seller
• Transactional nexus
                        • Except in SEC action
• Plaintiff
• Defendant
• Elements
• Procedure
        Securities Fraud Action
Rule 10b-5              Defendant
                        • Primary violator (makes
• Transactional nexus     statements on which reliance)
• Plaintiff             • Includes company statements
                        • No aiding & abetting (accts /
• Defendant               advisors)
• Elements
• Procedure
        Securities Fraud Action
Rule 10b-5              Elements
                        • Material misrepresent /
• Transactional nexus     omission
• Plaintiff             • Scienter – not negligence /
                          knowledge, reckless
• Defendant             • Reliance – “fraud on market”
• Elements              • Causation – must be proved
                        • Damages – out-of-pocket
• Procedure
        Securities Fraud Action
Rule 10b-5              Procedure
                        • Statute of limitations (2 yrs + 5
• Transactional nexus     yrs)
• Plaintiff             • Special rules for class actions
                        • Venue (where company has
• Defendant               headquarters)
• Elements              • Worldwide service of process
                        • Federal discovery rules
• Procedure
              Compare to other private actions

              Exchange Act                                  Securities Act

Rule 10b-5      § 18(a)         § 9(c)          §11          §12(a)(1)       §12(a)(2)
Fraud icw      Materially     Specified      False          Offer or sale    Offer or sale
purchase or    false          manipu-        statement      of               by means of
sale of        statement in   lative         in             unregistered,    materially
security       SEC filing     practice       registration   non-exempt       false
                              (pools, etc)   statement      securities       prospectus
Securities Fraud
 Class Action

“when talk is not cheap”
Stanford Class Action Clearinghouse
   Federal Securities Fraud Class Action Litigation
                     (lawsuits filed)




Pre-Reform   Post-Reform


                                  Stanford Class Action Clearinghouse
“King of Pain”
      “Loathed because he's so mean,
      Curriculum Vitae
         1946: because lawyer everyone
      • fearedborn is thehe's so powerful, in
         Bill Lerach in working-class
         Pittsburgh
         Silicon Valley hates.”
      • 1970: U Pittsburgh law grad
                  Fortune Magazine, (San
      • 1976: joins Milberg Weiss Sep. 2000
         Diego)
      • 2004: moves to Lerach Coughlin
      “"In 10 or 15 years you will be holding
         Stoia Geller Rudman & debacle
         another hearing about aRobbins in
         the securities market that will make
         (San Diego)
         2005: $7.2 billion recovery in with
      • you remember the S&L mess Enron
         fondness."
         litigation ($45 over career)
      • 2007: pleads guilty to obstruction of
                                     Bill Lerach,
                                Weiss)
         justice (later Milbergtestimony (1995)
                congressional
      • 2009: disbarred by California State
         Bar
      • 2010: released from prison / “Circle
         of Greed” published
Investigate corporate disclosures …
            Who can be sued …
Press Release:

  The company is today announcing its year-end
  financial results, which continue to look favorable.

                          ***
• Auditor
   – no mention that financials are not audited
   – no mention of auditor, which had advised that
     financials actually “NOT favorable”
• Lawyer
   – no mention of lawyer who helped draft the press
     release
   – no “noisy withdrawal” by lawyer
Identify corporate “fiction” …
2d and 3d Circuits -
• Motive and opportunity
• Concrete personal benefit
• Insider trading
1st, 5th, 6th, 10th, 11th Circuits
• Strong inference of scienter
• M&O is external marker
• Unusual insider trading
9th Circuit
• “Deliberate recklessness”
• Intentional misconduct
 Tellabs, Inc. v. Makor Issues & Rights, Ltd.
                         (US 2007)
                         … PSLRA strong inference of state of
                           mind (scienter) means … “a
                           reasonable person would deem the
                           inference of scienter cogent and at
                           least as compelling as any opposing
                           inference.”

                         … allegations must also be considered
                            “holistically” [isolated insider sales
                            not enough, must have unusual,
                            broad sales]
Ruth Bader Ginsburg
 (civil rights lawyer)   “omissions and ambiguities [in the
                            plaintiffs’ allegations] count against
                            inferring scienter” [discount
                            confidential witnesses]
… followed by “surprise”
… resulting in “price drop”
            Basic Inc v. Levinson (US 1988)

Timeline
 The lies
 – 10/21/77: news interview that “no reason
   for stock activity and no negotiations”
 – 9/25/78: response to NYSE inquiry that
   “management unaware of development”
 – 11/6/78: Quarterly report that “unaware
   of any developments”

 The truth
 – 12/18/78: announce tender offer by
   Combustion
Efficient Capital Market Hypothesis
           Basic Inc v. Levinson (US 1988)
“… in open and developed securities
market .. Misleading statement defraud
purchasers of stock even if the
purchasers do not directly rely on the
misstatements.”

“… reliance is an element of a Rule
10b-5 cause of action.

“Presumptions typically serve to assist
courts in managing circumstances in
which direct proof for one reason or
another is rendered difficult.”
                                          Justice Harry Blackmun
                                                [MN lawyer]

How can presumption be overcome?
            Basic Inc v. Levinson (US 1988)

“… I fear that the Court’s decision
may have many adverse,
unintended effects as it is applied
and interpreted in the years to
come.”

“… Court assumes buyers and
sellers rely on the “integrity of the
market price … which most
mystifies me.”

                                          Justice Byron White
                                        [former football player]
          Big vs small companies




Big companies              Small companies
•   Public disclosure      •   Less publicized
•   Many analysts          •   Fewer analysts
•   SEC investigation      •   No SEC interest
•   Large damages          •   Smaller total damages
Identify “scienter” – such as …
                Plead “scienter” …

PSLRA [Exchange Act 21D(b)(1)]

  In any private action arising under
  this chapter in which the plaintiff
  may recover money damages only
  on proof that the defendant acted
  with a particular state of mind, the
  complaint shall, with respect to
  each act or omission alleged to
  violate this chapter, state with
  particularity facts giving rise to a
  strong inference that the defendant
  acted with the required state of
  mind.
File a complaint




           (e.g. Bay Networks, Inc)
Complaint must tell “fraud” story …
… to withstand “motion to dismiss”
If so, start settlement negotiations …
             Settlement with “corporation”



        Buying shareholders
             (plaintiffs)

     Payment
                        Corporation
Usually nominal
  payments        Insider Corporate execs
                  trading (D&O insurance)
             Settlement with “corporation”



        Buying shareholders      Holding shareholders
             (plaintiffs)              (losers!)

     Payment                                Subsidy
                        Corporation
Usually nominal
  payments        Insider Corporate execs
                  trading (D&O insurance)
               Settlement with “corporation”
Selling shareholders
 (windfall winners!)


          Buying shareholders     Holding shareholders
               (plaintiffs)             (losers!)

       Payment                               Subsidy
                         Corporation
 Usually nominal
   payments        Insider Corporate execs
                   trading (D&O insurance)
        "Index Funds and Securities Fraud Litigation"
                          (Booth)
SFCA doesn’t make sense
• Most investors are diversified
• SFCA settlement : holders effectively pay buyers
• Because of circularity: stock price declines on SFCA filing
Consider index fund
• almost always loses more than it gains when SFCA
• index funds should oppose SFCA
Capturing deterrent effect
• w/o SFCA might be more securities fraud
• Solution: corporation itself claim – against the individual wrongdoers
• subject of a derivative action for the benefit of the corporation – and thus all of
   the stockholders
• constitute a significant deterrent to fraud
Procedure
• rules of civil procedure: derivative claim must be resolved before SFCA
• No SFCA unless certified no other equally good way to litigate
• Caveat: attorney fees are likely to be higher in class actions than in derivative
   actions
                  Sup Ct 10(b) jurisprudence
                         1970s / 1980s               2000s         Gr
Transactional      No privity               Zandford               A
Plaintiff          Blue Chip Stamps         Lead plaintiff*        B
Defendant          Central Bank             Stoneridge             C
Elements
(1) Materiality    Basic                    Bespeaks caution*      B
(2) Misrep         Va Bankshares            Stoneridge             B
(3) Scienter       Ernst & Ernst            Tellabs / reckless*    A
(4) Reliance       Affiliated Ute / Basic   Rebut presumption*     A
(5) Causation/$    ---                      Dura / circularity*    C
Procedural
(1) S/L            Gilbertson / Huddleston SOX / Reynolds          A
(2) Federal/state Santa Fe                  Dabit                  C
(3) Arbitration    Shearson/Am Express      FINRA / D-F*           B

                                                * open questions
             Mechanics of Class Action
             Class Counsel Functions
• Get started
   – identify material corporate misrepresentations
   – find appropriate shareholders to act as class representatives
   – file a complaint in a court of class counsel’s choosing
• Take care of legalities
   – defend the complaint against motion to dismiss (on legal
     grounds)
   – urge the judge to grant class action status to the litigation
   – send notice to class members, giving them an option to
     withdraw from the lawsuit
   – undertake discovery of information from the company and
     other sources
• Close the deal
   –   enter into settlement negotiations with company officials
   –   champion any settlement before the judge
   –   administer settlement funds
   –   appeal any adverse decisions by the trial court judge
             Mechanics of Class Action
             Class Counsel Functions
• Get started
   – identify material corporate misrepresentations
   – find appropriate shareholders to act as class representatives
   – file a complaint in a court of class counsel’s choosing
• Take care of legalities
   – defend the complaint against motion to dismiss (on legal
     grounds)
   – urge the judge to grant class action status to the litigation
   – send notice to class members, giving them an option to
     withdraw from the lawsuit
   – undertake discovery of information from the company and
     other sources
• Close the deal
   –   enter into settlement negotiations with company officials
   –   champion any settlement before the judge
   –   administer settlement funds
   –   appeal any adverse decisions by the trial court judge
             Mechanics of Class Action
             Class Counsel Functions
• Get started
   – identify material corporate misrepresentations
   – find appropriate shareholders to act as class representatives
   – file a complaint in a court of class counsel’s choosing
• Take care of legalities
   – defend the complaint against motion to dismiss (on legal
     grounds)
   – urge the judge to grant class action status to the litigation
   – send notice to class members, giving them an option to
     withdraw from the lawsuit
   – undertake discovery of information from the company and
     other sources
• Close the deal
   –   enter into settlement negotiations with company officials
   –   champion any settlement before the judge
   –   administer settlement funds
   –   appeal any adverse decisions by the trial court judge

				
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