Worldcom Litigation

							Securities Act - Liability
     Section 11
     • standing
     • “due diligence”


                         (last updated 23 Feb 09)
September 12, 1938
                 Drafters of Securities Act of 1933




                                  Thomas G. Corcoran {}
James M. Landis {}                    SCt clerk OWH (1927)     Benjamin V. Cohen {}
•   S Ct clerk, Brandeis (1925)   •   WS lawyer (1927-32)      •   FDR’s “brain trust”
•   Chair, FTC (1933-34)          •   Bureaucrat (1932-35)     •   Genl counsel PWA
•   Chair, SEC (1935-37)          •   Lobbyist par excellent   •   Dumbarton Oaks (UN)
•   Dean, HLS (1937-1946)
       Investor protection in public offering
• Disclosure (market protection)
    – Mandatory
    – Managed (“gun-jumping” rule)

• SEC oversight (regulatory protection)
    – Review and comment
    – Acceleration authority
    – Investigation / stop order /
      enforcement (§17)

• Private liability (court protection)
    – §11: material misinformation in RS
    – §12(a)(1): §5 violation (non-
      exempt, unregistered sales)
    – §12(a)(2): other material misinfo in
      offering
Compare §11 to Rule 10b-5?


       They differ!
             Securities fraud action
Rule 10b-5
• Transactional nexus
• Plaintiff
• Defendant
• Elements
   – Material misrepresentation
     or omission
   – Scienter
   – Reliance
   – Causation
   – Damages
• Procedure
§11 Civil Liabilities on Account of
     False Registration Statement

(a) Persons possessing cause of
     action; persons liable. In case
     any part of the registration
     statement, when such part became
     effective, contained an untrue
     statement of a material fact or
     omitted to state a material fact
     required to be stated therein or
     necessary to make the statements
     therein not misleading, any person
     acquiring such security … may,
     either at law or in equity, in any
     court of competent jurisdiction, sue-
     -
§11 Civil Liabilities on Account of
     False Registration Statement

(a) Persons possessing cause of
     action; persons liable. In case
     any part of the registration
     statement, when such part became
     effective, contained an untrue
     statement of a material fact or
     omitted to state a material fact
     required to be stated therein or
     necessary to make the statements
     therein not misleading, any person
     acquiring such security … may,
     either at law or in equity, in any
     court of competent jurisdiction, sue-
     -
          Abbey v. Computer Memories, Inc
                             (ND Cal 1986)
                                                                  Plaintiff

                          Market                         Fidelity
                        (NASDAQ)                        Brokerage
                 sell                     buy
 Mayer &                                            DLJ
                         Depository              (Pershing )
Schweitzer
(market maker)           Trust Co.

                          2 MM shs
                    (of 11 MM shs outstanding)
                                                     Is “tracing” a hyper-
                                                          technicality?
                            Issuer
  Who can be defendants?
What is “due diligence” defense”
         Escott v. Bar-Chris Construction Corp.
                       (SD NY 1968)


                          Market
                        (plaintiffs)

                      Retail group

   UW counsel        Managing UW       UW   UW      UW

              $$         Board of        build
Factor                                             Bowling
                         directors                  alleys
             notes                      notes
                         Signing
                          officers
Accountant                                       Company
 (auditor)               Issuer                   counsel
§11(a) Persons possessing cause of
  action; persons liable.
… any person acquiring such security …
  may … sue –
   (1) every person who signed the
       registration statement;
   (2) every person who was a director of
       … the issuer …;
   (3) every person who, with his consent,
       is named in the RS as being … a
       director…;
   (4) every accountant … who has with his
       consent been named as having …
       certified any part of the RS … with
       respect to the statement in such RS
       … which purports to have been …
       certified by him;
   (5) every underwriter with respect to
       such security.
      Escott v. Bar-Chris Construction Corp.
                    (SD NY 1968)


                       Market
                     (plaintiffs)

                   Retail group

 UW counsel       Managing UW       UW   UW    UW


                      Board of
                      directors
                      Signing
                       officers
Accountant                                Company
 (auditor)            Issuer               counsel
What is “due diligence” defense?
                 Expertised              Non-expertised

         After reas investigation,
         reasonably believes                  No liability
Expert   information is true                [see §11(a)(4)]
         (ignorance no defense)


                                     After reas investigation,
         No reasonable ground to
Non-     believe was untrue
                                     reasonably believes
                                     information is true
expert   (ignorance is excuse)
                                     (ignorance no defense)
Rule 176 -- Circumstances Affecting the Determination of What
    Constitutes Reasonable Investigation and Reasonable
    Grounds for Belief Under Section 11 of the Securities Act
    In determining whether or not the conduct of a person
    constitutes a reasonable investigation or a reasonable ground
    for belief meeting the standard set forth in section 11(c),
    relevant circumstances include, with respect to a person other
    than the issuer.
(a) The type of issuer;
(b) The type of security;
(c) The type of person;
(d) The office held when the person is an officer;
(e) The presence or absence of another relationship to the issuer
    when the person is a director or proposed director;
(f) Reasonable reliance on officers, employees, and others whose
    duties should have given them knowledge of the particular
    facts ;
(g) When the person is an underwriter, the type of underwriting
    arrangement, the role of the particular person as an underwriter
    and the availability of information with respect to the registrant;
    and
(h) Whether, with respect to a fact or document, incorporated by
    reference, the particular person had any responsibility for the
    fact or document at the time of the filing from which it was
    incorporated.
Directors                            “Due diligence”?
Insider insiders
• Russo (D / CEO)
• Vitolo, Pugliese (Ds / founders)
• Kircher (D / CFO)
Outside insiders                                         What would you
• Birnbaum (D / secy)                                   advise each to do?
Inside outsider
• Grant (D / outside counsel)
• Coleman (D / UW partner)
Outside outsider
• Auslander (D / banker)
Non-directors                        “Due diligence”?
Issuer
Underwriter
• Drexel Burnham (managing UW)
• Drinker Biddle (UW counsel)
   – Ballard
   – Stanton
Accountant
• Peat Marwick (auditor)
    –Berardi
Due diligence
(in shelf registration)
                    Shelf Registration
                           SEC RULE 415
•   Q: What exactly is a shelf registration, and why is it useful for securities
    issuers?
    Shelf registration permits an issuer to file a registration statement for any
    securities that will be offered on a continuous or delayed basis under the
    Securities Act. Shelf registration, in short, lays the regulatory groundwork in
    advance for future sales of securities, which, in turn, allows issuers to gain
    access to capital in a more timely manner.
    Q: How do the new rules change the shelf registration process?
    The new rules significantly streamline the shelf registration process for the
    largest and most active issuers which have an established track record of filing
    Exchange Act reports with the SEC. These issuers are now defined as "well-
    known seasoned issuers," or WKSIs. WKSIs are permitted to file registration
    statements that will become automatically effective without SEC review, which
    is a major change. The rules also liberalize certain existing restrictions to the
    shelf registration process that are applicable to both WKSIs and so-called
    seasoned issuers which are non-WKSIs.
             Shelf Registration
• Q: How can an issuer qualify as a WKSI?
  In addition to having timely filed all required annual, quarterly
  and current reports for at least the prior year, a WKSI is
  required to either have a market capitalization of at least
  $700 million or have issued at least $1 billion in non-
  convertible securities - other than equity securities -
  registered with the SEC at the time they were first offered
  during the previous three years.
  About one-third of publicly listed issuers in the US fall into the
  WKSI category. The rules exclude from this category
  companies that have engaged in certain "disqualifying"
  behavior during the last three years, as well as voluntary
  filers, asset-backed issuers and investment companies, among
  others.
WorldCom Financials

                                   Revenues
Assets   Liabilities
                                   Costs
                                   Net income
         Sh equity




                Phone line costs
                  ($3.8 billion)
                           •   What is S-3 shelf registration?
                           •   What is UW defense? CSM?
WorldCom Financials        •   What was Andersen’s role?
                           •   Reliance vs due diligence?

                                           Revenues
Assets   Liabilities
                                           Costs
                                           Net income
         Sh equity




                Phone line costs
                  ($3.8 billion)
         WorldCom Securities Litigation


Underwriters may not rely on an
   accountant’s comfort
   letters for interim financial
   statements. … Comfort
   letters do not “expertise
   any portion of the RS”

(1) Audited: prudent man in
    management of own $$
(2) Unaudited: look at context
    (WorldCom deteriorating)       Judge Denise Cote
                                        (SDNY)
Rule 176 -- Circumstances Affecting the Determination of What
    Constitutes Reasonable Investigation and Reasonable
    Grounds for Belief Under Section 11 of the Securities Act
    In determining whether or not the conduct of a person
    constitutes a reasonable investigation or a reasonable ground
    for belief meeting the standard set forth in section 11(c),
    relevant circumstances include, with respect to a person other
    than the issuer.
(a) The type of issuer;
(b) The type of security;
(c) The type of person;
(d) The office held when the person is an officer;
(e) The presence or absence of another relationship to the issuer
    when the person is a director or proposed director;                   SEC (1981): Underwriters
(f) Reasonable reliance on officers, employees, and others whose            should arrange their
    duties should have given them knowledge of the particular               due diligence
    facts ;                                                                 procedures over time
(g) When the person is an underwriter, the type of underwriting             for the purpose of
    arrangement, the role of the particular person as an underwriter
    and the availability of information with respect to the registrant;     avoiding last minute
    and                                                                     delays [in shelf
(h) Whether, with respect to a fact or document, incorporated by            offerings] … Nothing
    reference, the particular person had any responsibility for the         compels underwriter to
    fact or document at the time of the filing from which it was
    incorporated.
                                                                            do deal without due
                                                                            diligence.
The end