Securities & Regulation Law:
Author: Philip Larson
Intellectual Property: Class notes
Table of Contents
1. Lecture 1 ....................................................................................................................... 3
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Intellectual Property: Class notes
1. Lecture 1
1.1 What is Securities and Regulation Law?
Focus will be principally on what they know and can teach the best. They will teach the whole b readth but
there are 8 volu mes of text. Their goal is to survey the area and provide practical experience to the course.
Classes on IPOs – we’ll get a guest speaker.
Class participation – attendance is importance. It will affect your grade.
You play like you practice and you practice like you play.
They work for a law firm – most clients are high-tech companies. They represent Krispy-Kreme and work
in the Reston, VA office.
Motivating hypothetical – Yingko, $10 million market capitalizat ion
Market capitalization - # of outstanding shares times the share price.
Trades on the NASDAQ, s mall-cap market.
Makes healthy sports drinks.
Three most common types of ownership interests can you have: Most common types of ownership
1) common stock
a. most voting control
b. put in the directors of the company
c. core owners
d. they are owed fiduciary duty.
e. Co mmon stock holders don’t have any right to the cash flow o f the company. Only
residual interest. You only get paid off after everyone else gets paid off. You are
entitled to a future share of the cashflow through dividends, if the co mpany wants to pay
dividends. This has become more significant. There was a tax change in 2004 that
encouraged companies to provide dividends. Microsoft, for example, provided billions of
dollars of div idends. Personal wealth went up 3.7% and a lot of it had to do with
Microsoft that year.
2) preferred stock
a. receive a fixed div idend. That is part of their K-ual right. They don’t vote for
b. venture capitalist wants to be able to convert to common stock so that they can receive
the benefit if the co mpany does well but if you have to liquidate you get paid out before
the stock holders.
c. Usually used to raise cash quickly fro m a specific set of investors. The preferred stocks
are controlled by K, rather than corporate law (o ften Delaware law). Delaware is the
preferred venue of choice because they have very developed corporate law.
3) debt – bonds
a. Fixed terms paid on maturity. This is the best position to be in to get money out of the
b. Zero-coupon bonds – instead of getting a constant payment, you are taking a discount
now for a guaranteed payment later… ??
c. They get paid before common stock and preferred stock holders.
One of the big issues in securities law is “what is a security”?
Two types of securities transactions
1) primary transactions
a. company offers securities directly to investors. They want to raise money. This is
essentially an Init ial public o ffering
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2) Secondary transactions
a. Trading on the exchanges. This is the bulk o f what we are talking about. The co mpany
itself is not involved at all in the transaction.
Gingko has $10 million it raised fro m the IPO. It ’s market capitalization reflects what it raised in that IPO.
If you want to invest, you have to buy from another investor. Ho w do you do that? There are three
mechanis ms of doing this through third-parties.
1) Organized exchange – NY Stock exchange, Ph iladelphia, Boston stock exchanges,
a. NY Stock exchange has a physical trading floor. Each stock has a trading post and a
specialist. The specialist is there to maintain liquidity by matching orders as well as use
his own inventory in the stock to cover short-term imbalances.
b. NY Stock exchange is hard to get on and hard to get kicked off. They work with you
through your troubles.
2) NASDA Q (electronic means),
a. NASDA Q has three exchanges. They have different requirements. You pay NASDAQ a
listing fee. They can switch by asking to be moved up and paying another fee.
Therefore, the co mpanies are both the clients and the regulated entities. This creates
some interesting issues. They have a clear bifurcation of the sales guys and the corporate
governance guys. Regulators view themselves as regulators and completely separate
fro m the sales guys.
i. 1. national market, - must meet a certain market cap, certain # o f shares
ii. 2. cap ital market, - like the national market but less requirements.
iii. 3. bulletin board (OTCBB) – electron ic bulletin board without listing standards
and fewer corporate governance standards.
b. NASDA Q now has additional corporate governance guidelines to ensure traders have
faith in the system.
c. NASDA Q has market makers (about 8 – Merrill Lynch, etc.) who hold themselves out to
buy and sell the stock at any time. They put out the ask and bid for any s tock. They
might say, I will buy 100 shares at $9.90. I will sell at $10.10. They therefore earn the
difference. The co mpetit ion drives this spread down. The bid/ask spread is often larger
for smaller co mpanies that aren’t traded as frequently.
d. The NASDA Q is easy to get on but also easy to get kicked off.
3) Electronic Co mmun ications Networks – instanet,
a. No market makers. Simply matches buyers and sellers. I say I want to buy at $10.10. If
no one is willing to sell, it holds the order and I can withdraw it at anytime.
Gingko sells for $10 per share. How do investors decide whether to buy at this price? They love the
company? Expected return on investment? People invest for many reasons which is why people can make
money on the stocks. The irrational investors are good because they help everyone else. What do we mean
when we say “expected return”?
- You have a lot of options with your money. There is the bank. (low rate of return but you are
pretty sure to get it) Treasury bonds (a little better than the bank that is pretty sure to pay off).
- You want to get a rate of return greater than treasury bonds.
- If you need a better return, how do you figure out if Gingko will be better. You need information.
You need information about the company.
o All investors need information.
- Suppose you find out that Starbucks is going to sell Gingko lite…You could profit fro m that
o Gingko has an incentive to make this informat ion public because it wants to make the
company look better fo r future share offerings.
o Therefore, there is an incentive to share the information when it is doing an offering.
However, what about when it is not doing an offering? There can be less incentive…
Insider trading problems, for instance. He may not want to give out the
informat ion so he can trade his personal shares.
What is the value of this information? Is informat ion just money?
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How can one fairly use informat ion and how do we incent companies to talk
about these types of deals (like with Starbucks).
- TRUISM – investors armed with better info rmation can systematically get higher returns on the
market. In formation is the key to securities regulation. The CEO knows more about Gingko than
everyone else. He could buy up shares b/c he knows about the Starbucks deal. Moreover, he may
be willing to unload his shares if he knows they are making false advertising.
Insider trading – the law is expanding to include more and more people under the u mbrella here. The SEC
is increasing this. The SEC’s view o f the law and the established caselaw can differ pretty greatly.
- SUMMARY: the entire regulatory scheme is to prevent insider trading. The primary goal o f this
law is to get rid of the informational d isadvantages and informat ion asymmetries.
o We do this in two ways:
1) Mandatory, periodic public d isclosures – we require co mpanies to disclose
informat ion on a periodic basis. We don’t yet have a continuous disclosure
policy, yet. A lthough we are moving closer and closer to this. Technology is
driving this. The SEC is driving this.
2) Antifraud liability – there are ways to go after people who are trying to do
benefit fro m the informat ion. SEC civil suits, etc.
o Analysts at Merrill Lynch are there to get the informat ion, tell Merrill Lynch customers
about it, and give their customers and informational advantage. The SEC is trying to get
rid of this process by passing regulation FD (fair disclosure). It says that companies can’t
give out information to Merrill Lynch without notifying everybody.
The Securit ies Acts only allows the SEC to bring a civil action for securities fraud. Ho wever, almost fro m
the beginning courts have read into this a private cause of action for investors to bring actions if the
company screws up. This is like Worldco m, Enron, etc…Private investors sue the company for securities
- Sarbanes Oxley created a new entity just designed to review public audits. It is regulat ion of the
auditors. There are lots of layers of regulation imposed upon everyone, now including the
- Lay people vs. experts in accounting – often accounting requires application of judgment over a
set of facts. Conservative accounting vs. aggressive accounting. Auditors incentives, innocent
mistakes and differing judg ments that in hindsight might be incorrect.
o Put 4 auditors in a roo m you might get 4 answers. (just like lawyers) – choosing between
them is a business decision.
Why have mandatory disclosure about what has to be disclosed and when? There are really four academic
1) Coordination problems – you need the government to coordinate the information. Otherwise, the
companies will put it out however they want and it will be d ifficult to co mpare cross companies.
Gingko might want to put numbers out like revenue per case which may be difficult to co mpare to
2) Agency costs – common shareholders own the company. If we own 100 shares of Gingko, that
doesn’t mean we can call the CEO and find out what is going on. Therefore, how does the agent
monitor what is going on? One way is a mandatory disclosure requirement …
3) Positive externalities – more accurate securities prices. The market will work mo re efficiently.
Also, there will be more info rmation out in the open.
4) Avoid duplicative research – it is highly duplicative if we have 100 people try ing to get the
informat ion on their own, calling the CEO, talking with company officials. This information
gathering is duplicative co mpared with mandatory disclosure.
What problems exist with mandatory disclosure schemes?
- Do the regulators even know what they are doing? Does the government know what the public
needs to know and what it doesn’t need to know? The government may overdisclose (CEO eating
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candy from the front desk) or underdisclose. The regulators may be captured by special interest.
Perhaps the SEC is captured by special interest that lobbies the SEC, etc.
How does the SEC work?
- Congress passes laws giving the SEC broad capabilities. Perhaps Congress is beholden to political
o Sarbanes-Oxley was passed in record speed in response to Enron, etc. You can find 1000
articles about whether Congress was too hasty in putting in regulation that really doesn’t
help investors at all.
o This Act was put through based on political pressures, in reaction to the headlines about
Enron, Worldcom, etc.
o Moreover, after the Great Depression there were problems with the securities markets.
Therefore, there are Acts enacted right after the Great Depression in the 30s.
- The 10k is the annual disclosure form for public co mpanies. These are quite in-depth documents.
If you look at IBMs 10k, it is probably 300 pages. Does anyone read this stuff? Therefore, by
overdisclosing you can create information disadvantages. Perhaps the better investors actually
have the time to read this stuff so they may actually get an advantage over smaller investors.
Investors bear the cost when regulators get it wrong.
- Summary : Mandatory disclosure is an assumed good. It is the cornerstone of the Act of 1933 and
Act of 1934.
o In the end, is it a net good? Probably. But in so me instances, it can be difficult to tell. It
is certainly not a universal good.
Why is it important that we get the informat ion out into the market and how does this affect the price?
- There is an important hypothesis that affects how everyone approaches this.
- Efficient Capital Market Hypothesis
o All information is incorporated into the price of a security.
This informs the notion of why you want mandatory disclosure.
Almost all of fraud liability re lies on the idea that investors can be affected by
informat ion they have relied on. If a co mpany puts out a false statement about
their products, their stock price incorporates that information. Therefore, if we
buy stock, we can say we were defrauded, even if we never saw the
advertisement, because it was incorporated into the price. Th is explains why
some investors may need to be recompensed in situations even if they never
heard about the misrepresentation.
o Weak, Strong and Semi-Strong
Weak Form – market price reflects everything in the past prices of the stock.
The price incorporates everything fro m the past. This is the concept of the
random walk. You can’t pred ict prices in the stock market. There will not be
any repeating pattern because all past informat ion is incorporated into the stock
Strong Version – says all public and non-public informat ion is incorporated into
the stock price. (this is a hypothesis that is not very supportable…)
Semi-strong Version – all publicly available information is incorporated into the
stock price. Th is argues that the price reflects the public informat ion. Th is
assumes that investors are rational. There is also a time lag. Therefore,
companies that are thinly traded might not have the changes reflected as quickly.
If a stock isn’t traded frequently, it is harder to say the market is
NYSE – is very efficient. Courts have questions, even on the
NASDA Q, for national market co mpanies, whether the market is
o Say we have all these irrational investors, driving up the price. People say that you
shouldn’t think of the stock price as the fundamental, underlying value, relat ive changes
in the stock price are nevertheless important. Therefore, even if Gingko lovers are
driving up the stock price, the relative changes in stock prices
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- Some people think insider trading is okay because it is helping make the price accurate by
signaling to others what the true price should be. While there is some logic to this, securities law
is premised on the idea that mandatory disclosure is a better means of achieving the accurate stock
price than insider trading. Insider trad ing is too inefficient.
- All lawyers are rent-seekers. Similarly, SEC is growing and is bringing more and more cases.
No one has advanced in the SEC by not filing cases. Therefore, perhaps the more regulators you
put in the pot, the more regulat ion you get.
- NY Stock
- Mandatory Disclosure prong
- Fraud liability prong
What are we going to cover in this course? Here is the list of major leg islation….
- Securities Act of 1933 (the 33 Act)
1) Init ial public offering (primary transactions)
2) Reg istration and prospectus – gives people information about the IPO, why
they want the money, etc. so that people can see whether to invest.
3) Gun ju mp ing rules – ensure the prospectus goes out before other information
goes out. You aren’t supposed to provide a shiny brochure before they get the
prospectus. The communications process is highly regulated.
4) Antifraud provision – creates liability for misstatements in prospectuses, etc.
The 33 Act creates essentially strict liability in reg istration and prospectus
misstatements. You don’t have to prove fraud. There doesn’t have to be a state
- Securities Act of 1934 (the 34 Act)
1) secondary market transactions
2) the bro kers (market makers, specialists) helping with secondary transactions.
3) Periodic d isclosure requirements (10k, etc.)
4) Section 10B – fraud – not allowing misstatements or omissions. This is
designed for SEC to sue the company but courts have read in a private cause of
action as well. Th is requires a state of mind. You must prove they tried to
5) Antin ibulation provisions – pump and dump scheme – I run around telling
people how great the stock is, then I get out of it and leave everyone stuck. This
has become a problem with online message boards, etc.
6) Pro xy disclosures – one way management connects with ownership interests
of the company is through proxies.
- Sarbanes Oxley Act
o Meant to beef up the 33 Act and 34 Act for co mpany disclosure.
1) New regulat ions on disclosure
2) New regulators
- The SEC was established in the 34 Act. It has five commissioners and a fair amount of autonomy.
It is overseen by Congress and the executive branch.
- Four major div isions
o 1) Court finance – review public disclosures to make sure everything is okay.
o 2) Market regulation – regulates brokers, Also regulates the exchanges, NASDAQ, etc.
Figures out who is a broker and who isn’t. Are you in the business of affecting securities
transactions? If so, you have a lot of regulations you must follow.
o 3) Investment management – regulates investment companies and investment advisors
o 4) SEC En forcement – these guys bring civil act ions. They are about the enforcement.
They can’t bring criminal actions. If they decide insider trad ing has occurred, they have
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to give this to the department of justice. Often you will get a jo int investigation between
the DOJ and the SEC. At the end of the day, they decide whether they bring civil or
criminal actions, or both.
1) Definition of a security – (e.g. are condos a security? Are timeshares a security?)
2) Materiality – perception equals reality;
Our next meeting is January 23rd . At our next meeting, we will have a fu ll syllabus.
Assignment for next week: P98-104, P561-628
Green Bag Toys, Inc. – they make Supreme Court Justice bobble head toys.
Why do we care what a security is? 1) We want to protect investors. They may be uneducated, they may
be spread out around the country, etc. 2) The capital markets have a central role in the economy so we need
to regulate it. We need to define what they are selling and regulate that. Find things that look like stoc ks
or bonds, etc.
What do Acts 33 and 34 provi de?
Definition of securities
1) laundry list – stocks, bonds, etc.
2) Exclusion: limits coverage if “the context otherwise requires”. Th is gives courts a fair amount of
discretion in determin ing the scope of securities law.
3) What is an “investment contract”? Courts have used this as the catch all.
- Waiver – why can’t you contract around the definition of a security?
o 1) We are trying to protect unsophisticated investors. Securities law applies to both
sophisticated and unsophisticated investors. For the purposes of antifraud liability, there
is no distinction at all between the two.
o 2) Protecting the capital markets. We’re not just concerned with the transaction, we are
concerned with protecting all of the capital markets so that there is consistency to how
the capital markets are regulated.
- What is at stake by having something defined as a security or not a security?
o Antifraud laws
o SECs resources
o Mandatory disclosure requirements
o Federal jurisdiction and nationwide service of process
- There are lots of costs to security regulation.
o If a g lass of lemonade were a security, lemonade would be $10 per glass. Therefore, we
want to be careful about what we define as a security to prevent too many regulatory
o You want to protect investors but you don’t want to burden the economy. There is a g ive
and take between the benefits of securities regulation and the costs of enforcing securities
Enforcement costs - Taxpayers pay the bill fro m their wallet – SEC has to
Pro moter costs – registering your securities, put out a prospectus, give
informat ion out to investors, etc. This makes it more expensive for you to do
Co mmissions cost – broker has to comply with all the regulations. Brokers,
under Rule 17, have to keep all of their co mmunicat ions.
- What is a security?
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o Supreme Court has said it is an “economic realit ies” test. What are the economic
1) co llect ive action – if there are many people involved, rather than a one-on-
one transaction, this is something to be concerned about. It may lead to
2) unsophisticated investors – if it is available to unsophisticated investors, it is
more likely that we want to regulate it. Think about “dentists” plunking down
3) relationship to the public trading markets – how similar is this to NASDAQ
or NYSE, etc.
4) close substitutes – does it look like investing in a co mpany?
5) other regulatory regimes – is there another regulatory regime involved? If so,
perhaps there is less reason to get securities law involved.
o What the underlying item is, doesn’t matter. You have to look at the context around the
transaction to determine if it is a security.
- HYPO: checking out prices of bobble heads and
o Looks like a standard employ ment K.
- HYPO: for every month you work, they’ll g ive you a free bobble head but he gives you the
rejects. You are getting paid by bobble heads.
o Still doesn’t make this an investment K. Other than the fact that he’s not giving you the
right ones, there is a cap on the upside.
Does it matter if the bobble head pricing changes ? Perhaps they are going up
Does the informational d isadvantage matter (e.g. that the person is paying you
with shitty Scalia dolls with blond hair and you don’t know they are rejects)
o NOT A SECURITY: this doesn’t look like something that would happen on the capital
markets. You aren’t investing, they are paying you.
- HYPO: what if he is getting paid in stock in exchange for work. This is the same as if you had
taken the cash compensation and gone out and purchased the stock. Therefore,
o Therefore, this IS a security.
- HYPO: what if he pays you in bobbleheads that say “Stock” on the heads of the dolls.
o NOT a security.
Economic reality test – if it looks more like an emp loyment agreement, then it is NOT a security. If it
looks more like purchasing stock, then it IS a security.
SEC v. WJ Howey Co
o The purchasers are people who don’t know much about the orange grove business. They
sold them to non-residents of Florida who are tourists of the area.
o What is being offered? They are being offered p ieces of land in the orange grove that
comes packaged with a service agreement. The services company deals with the land,
sells the fruit, etc. The purchasers can’t go onto the land. However, they get a percentage
of the profits.
o They have an option to enter the service agreement. 85% o f the people enter the service
- Issue: is this an “investment contract”?
- Test: An investment contract is one in which the purchaser 1) invests money, 2 ) common
enterprise, 3) is led to expect profits, 4) solely from the efforts of a 3 rd party.
o HYPO: if you just bought citrus trees, is this a security? No, it is not a common enterprise
and profits don’t come solely fro m the efforts of a 3rd party.
How much does your own effort matter regarding?
o Main point: buying cit rus trees fails, buying a service K fails. However, buying both
together does constitute an “investment K.”
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o The percentage of people
- Instead of a situation where there may be an informat ional disadvantage, you are now in a much
better position to create new Ks, etc.
- Does the level of speculation matter? He’s buying citrus trees. The land is good.
o The lower court said the intrinsic value of the land meant that it was not an investment K.
The fact that there is intrinsic value doesn’t matter. It doesn’t matter if you are investi
- What is Howey about? It is about land deals in Florida. The history of land deals in Florida is not
good. It is the quintessential scam. Sell them swamp land and then they can’t do anything with it.
Perhaps if you tell them there are citrus trees on it, it may be easier to get investors to put money
- Regarding co mmon enterprise: the court says “it is enough that the respondents merely offer the
essential ingredients of an investment contract.” This would make the law a lot cleaner.
- Offering an unregistered security is also a violation of Securities Law –
- If you have only one investor, does that mean they should be deprived of the benefits of securities
- NOTE FROM HOW EY: should the SEC be in the business of regulating orange groves? This
puts them into the business of looking at land deals that may have a services component. This has
a lot of costs, etc.
- Why would the investors that were defrauded care about this? Why does the SEC care that people
are selling these things? If you put it under securities law, you have a lot mo re remed ies available
to you. You might get C/ L fraud damages, for instance. However, if it is a security you can
obtain rescission as a remedy. You can get your money back. They may simply want the full
range of remedies …
- HYPO: What if Green Bag Toys sold 18 foot strips of the factory and gave out a percentage of the
profits? This is why you need an “investment contract” as a catchall.
INVES TMENT CONTRACT – Reviewing the Elements
1) INVES TING MONEY
o Investing time doesn’t count.
o Does investing require conscious will? Do you have to have a choice? The court
examined whether participating in a co mpulsory pension plan was a security. Is a
pension plan listed as a security in the Acts? No, a pension plan is not listed in the
definit ion of a security. Is it a security because it is an investment contract? No, it is an
insignificant part of the total compensation the person will receive. Is he selling his labor
to get his pension plan? He’s not really investing his labor…
Why does it matter if he is not choosing to participate?
Is it a substitute for something you could be doing in the capital markets? No,
this doesn’t look like anything in the capital markets. He’s not making any
choices like he would in the capital markets.
o Does the fact that there is another alternative regulatory scheme is a justificat ion for not
protecting him? On its own, it is not enough because you don’t know for sure whether it
o Key takeaway : there has been a lot of turf battles between the SEC and the Co mmod it ies
2) COMMONALITY – the Common enterprise (p35 and p36)
o Three approaches to this:
1) horizontal co mmonality – this is what we saw in Howey. Investments are
pooled and profits are prorated. This suggests there is a co mmon enterprise of
2) b road vertical co mmonality – pro moters effo rts effect every investor
separately, and the promoter doesn’t necessarily share in the risk. The pro moter
doesn’t necessarily share in the risk. (e.g. our securities law teacher is helping
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us learn securities law. We will succeed to varying degrees but he does not
share in any of that risk – hub (pro moter) and spokes (investor) model)
3) narrow vertical co mmonality – a situation like b road vertical co mmonality
where the pro moter does share in some portion of the risk.
You can buy and sell shares in 11 fictit ious companies. SG sets the price based on some fict itious basis.
The participants are putting real money into the game. If they recru it other players, they get payments.
One priv ileged co mpany will go up every month. Players can cash out of their positions.
- Howey Test:
o 1) Is there an investment of money? Yes.
o 2) Co mmon enterprise?
Look at the 10% part of it. If you are investing to get your 10% return in the
privileged company, this is like a horizontal co mmonality.
You also get money by bringing in new people. This is more like broad vertical
o 3) Expectation of profits
o 4) Solely fro m the efforts of others?
Not entirely. You get a fee for bringing in others. You also can make money
fro m your fict itious investments themselves.
HYPO: d istributors pay $10,000 for right to sell Green Bag Toys. Say Davies gets $1000 for every
distributor that comes in and every referral gets the distributor $1,000.
- Davies makes money fro m the $1000 that comes in.
- This looks like vertical commonality because I may earn more than other investors if I am better at
referring new distributors.
- You don’t have a prorated profit scheme like you do in horizontal commonality. They aren’t
getting a prorated share of the profits.
If this is the case, how does the court find horizontal co mmonality in S EC v. S G (p38)? The court says that
if the cash runs out, everyone goes to zero. That is true of vert ical co mmonality as well, so this is not that
- If we have the return on your investment comes 100% fro m the co mmonality, it is pretty easy to
find horizontal co mmonality. Courts don’t usually require 100% that the pro moter do everything.
Who is doing the work?
How is the money distributed?
3. IS LED TO EXPECT PROFITS
- Perhaps you are investing m
- United Housing Foundation v. Forman
o Facts: investors invested 18 shares per desired room. It had to be resold if you moved. It
didn’t appreciate in value. People were essentially investing in having houses for a period
o Issue: whether shares entitling a purchaser to lease an apartment in Co -op city are
o Howey Test: This doesn’t really suggest that you will get profits. These people are not
participating in appreciation or part icipation in earnings (except that their rent might get
Howey is supposed to be about investment contracts. Therefore, the fact that
Forman is trying to figure out what a stock is. It is a “what is a s ecurity” test,
not just a “what is an investment contract” test.
HYPO: stock, that is called stock, that doesn’t have all the characteristics of stock. If the Ho wey
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- If Howey gets applied to everything, you don’t get capital appreciation or earn ings. You have no
voting rights, no dividends.
SEC v. Edwards (2004)
- Issue: Can fixed returns be considered profits? Held : Yes.
- This had to go against Forman, which basically said the Howey test had to apply to everything.
Black letter law: SEC v. Edwards – capital appreciation, fixed return, and one other.
4. SOLEL Y FROM THE EFFORTS OF OTHERS
This overlaps with “Co mmon Enterprise”. What does “solely” mean? What if I try to help out in the
investment? Just because I am help ing out doesn’t mean I h ave any control.
- Courts look to the level of control you have over the endeavor.
The spectrum is something like the following:
Security Investor does nothing investor picks one orange investor relies on managers but doesn’t
have any real control investor relies on managers but has ultimate control Investor does everything –
Not a security.
The courts try to avoid the protection of being a security if you are unsophisticatedPassivity
This acts as a proxy for the informational asymmetries of the investor.
Franchising typically not a security
Tax right offs typically it is a security
Forman appeared to suggest that the Howey test should be applied to everything. Edwards says that this
isn’t quite right.
If you buy all the stock in a business is there horizontal co mmonality? No, there is no common enterprise.
This is the sale of business doctrine. After Forman, they said the Howey test applied to everything.
Therefore, even if you are buying stock, if you are buying all of it it doesn’t count because there is no
commonality. It is nice that you bought all the stock, but you could have simp ly bought all the assets and
had the original co mpany fold. Therefore, it is not the same type of thing you should be worried a bout in
the capital markets.
What happens in Landreth Timber Co. v. Landreth (1985)? There is an unsympathetic plaintiff. They buy
all the stock in a lu mber mill. They get the old owner to stay on as a consultant. Regardless, the mill does
badly. The investors file suit seeking rescission. The judge does not apply Howey, like he did in Forman.
Rather, he says it is defin itely a security because it is stock. It says stock, there are voting rights, etc.
The lesson of Landreth, is that you can’t apply Howey to everything. You have to look to different tests for
the different aspects of the securities law. This is okay fro m a certainty perspective. If everytime we had a
transaction involving stock, we had to sit down and decide whether the Howey test was met, th is would be
a pain. Instead, it is nice to know that it is a security because it looks like stock.
What matters? Why are we all here?
- The meaning and mechanisms of market efficiency… (p99)
o What matters? What is material? What does materiality mean outside
Philip Larson Page 12
Intellectual Property: Class notes
What information is material? What information actually matters?
- Avoid information scarcity and avoid information overload.
- You can say things that are technically true but are nevertheless mislead in g.
- What is the point at which you have to disclose versus the point that you don’t have to disclose?
Antifraud rules hinge on materiality.
10(b)(5) – can’t lie about a material fact or o mit to inform someone of a material fact.
- What is the line at which this is drawn?
We can have false statements, misleading statements, etc.
What are the factors that can affect materiality?
- Availability of information to people in the market. (Can the market figure things out even when
the company says something to the contrary…)
- For examp le, you often are only held liable for things you say about yourself, not what you say
Materiality – informat ion a reasonable investor would consider important in making a securities based
decision and a substantial likelihood that the information would affect an investor’s decision.
- Materiality can be contextual.
Who is a reasonable investor?
- Is a reasonable investor standard…Is this targeted at
How hard is it to lie about something that is widely disseminated? Much harder than in one-off
transactions. The market can work in certain circu mstances. Where the informat ion is more robust, the
price-setting function can work mo re effectively .
Wielgos v. Commonwealth Edison Co.
- Facts: A company makes nuclear power plants. They put out their 10k that had some informat ion
that had already been completed. They talked about five p lants they were creat ing. They had
some cautionary wording in the 10k. The stock went up, a bunch of people sold shares, and then
regulators made things stricter and said they had to tear down one of their plants. The stock price
o Market disclosures: things are on track. These are our expectations with respect to the
business. The power plants are going to be great.
o Regulators: they say this one can’t open.
o Market cap: decreases $1 billion. The investors therefore sue alleging that they violated
Section 11. Basically, that they omitted material in formation and that they made
inaccurate future predictions despite contrary internal knowledge.
- Held : Professional investors would have seen that since all the information this company puts out
was wrong, everyone should have known that it would be wrong, and therefore the information
was not material.
- Rule: just as a firm needn’t disclose that 50% of all new products vanish fro m the market within a
short time, so Co mmonwealth Ed ison needn’t disclose the hazards of its business, hazards
apparent to all serious observers and most casual ones.
o Forward looking info rmation: projections are not material. The market knew the
statements were not correct and the estimates were too low.
Truth on the market Defense – Wielgos is referred to as the “truth on the market” defense. If a co mpany
has an omission and you argue that the omis sion didn’t make anything false because the market knows
what is really going on. Therefore, disclosure problems can be harmless in light of information already
within the public domain.
Materiality is a question of law. Judges typically decide what is materiality as a question of law.
- HYPO: missing earnings by 4.5%. Is this material? Could be.
Philip Larson Page 13
Intellectual Property: Class notes
- 5% used to be the rule of thumb. More than 5% is usually a red flag that they have made a pledge
to the market and yet they are going to be wrong and they know about it. Now, the staff bulletin
99 came out and removed the 5% ru le. No w they said the percentage depends on the context.
(e.g. is it a key business)
o Quantitative materiality vs qualitative materiality:
If they’ve made previous statements…
Conflicts of interest, historical financial statements
Most of these only have to be disclosed if they are material.
We will have to figure out if p ieces of information are material.
What are the questions you should ask?
- Question 1: Is there a duty to disclose? Barring that duty, there will not be liability.
- Question 2: Was the informat ion material?
Rule 408 and Ru le 12(b)(2)
Financial results, comp leted business transactions, executive co mpensation and shareholdings,
Substanti al likelihood test – past information with a change in stock price imp lies something is material.
Past information without a change in stock price may not be material.
Duty of honesty – co mplete honesty is required.
- Three elements
1) duty not to make material false statements
2) duty to not make materially misleading statements
3) duty not to omit material informat ion
Eisenstadt v. Centel Corp.
- Facts: asdf
- Facts: Basic Inc. denied being in merger talks and then they merged. They adopted the
substantial likelihood test. They establish a probability/magnitude test that says you have to look
at the probability the informat ion would affect the company and multip le that by the magnitude of
the effect it would have. This is how you determine whether speculative informat ion is
o Balancing of the probability that the event will occur.
- What is the test in the Third Circu it? There had to be an agreement in principle. They wanted a
bright line rule. Th is has the benefit of being a clear rule.
o What if the company says “no comment”. Are you in merger talks? No co mment.
- What does the Supreme Court say are factors that should be used to determine how you have t o
respond to analyst questions regarding the probability the event will occur?
o 1) when you come to the conclusion that the deal is serious.
o 2) When you bring in investment bankers to determine whether the deal is fair.
o This is different than “the CEO has played golf with them again.
- How do you determine the magnitude of the affect?
o You are calcu lating the e xpected impact. If the probability is low but the magnitude is
infinite, you should probably disclose it.
o Would you disclose the likelihood of a co met hitting the earth? Probably not.
Supreme Court rejects the agreement i n princi ple test. It requires soft information to be included
because investors can process all of this type of information.
- What is soft information? It is in formation that you aren’t sure about…
- The Supreme Court basically wants you to use the probability/magnitude test.
Philip Larson Page 14
Intellectual Property: Class notes
- Puffery statements are inactionable because anyone selling a house is going to say good things
about the house. People who sell things fib and puff a litt le in order to sell things.
- The 4th Circuit is particularly loose on forward-looking information. Therefore, in the Fourth
Circuit puffery is out. The fourth circu it says that no serious investor takes forward looking
comments seriously when making investments because predictions can be wrong.
- Other courts make a distinction between puffery statements (which they agree no one can rely on),
and very factually based forward looking statements. These statements are not immaterial as a
matter o f law. They may find the forward looking statement immaterial based on the
probability/ magnitude test.
We are talking about the historical t reat ment of forward looking statements.
Cauti onary Language
HYPO: every podiu m, 100,000 sales were sold for $3 each. However, if I have other info rmation like I
know there will be a podiu m shortage.
To be liab le fo r security fraud fo r forward looking statements, the speaker needed to know that the
statement was false. If you simply make a mistake, and the mistake wasn’t reckless or knowingly false you
have safe harbor. Moreover, some informat ion can be too soft to be material. Pu ffery, general trend
statements will be deemed immaterial. Moreover, forward looking statements are not actionable if they are
accompanied by cautionary language. This cautionary language also creates a safe harbor.
Affirmati ve Misrepresentations
Harris v. IVAX
- Facts: stock rose, press release said they would have a loss. Loss was much larger than expected.
They were sued by purchasers of stock. The P said that the statements weren’t forward looking.
The court said the information was mixed. The tense of the statements didn’t necessarily indicate
whether they were forward looking or historical in nature.
Plans and objections of future operations. Oral statements are covered. They want to use boilerplates on
the call to associate the call with meaningful cautionary language.
- 7th Circuit – Ashton v. Baxter – said that in the motion to dis miss stage, it is virtually impossible to
determine what is meaningful regarding cautionary language.
- Legislat ive history isn’t perfect – it just says that boilerplate isn’t enough. However, it doesn’t tell
you what is meaningfu l.
- Courts struggle with figuring out what “meaningful cautionary language” means. You don’t have
to hit it right on the head. You don’t have to say a hurricane will be a problem. You could say
that there are environmental factors that might blah, b lah. Courts have to decide how close you
have to come. In Baxter, the court said you can’t figure it out without discovery to determine how
mean ingful informat ion is.
- The problem of all this is that the Reform Act is meant to restrict liability. If you can’t get out of a
suit at the Motion to Dismiss stage, this is a real prob lem. Most of the time you’ll end up settling.
Therefore, the Reform Act is not achieving its purpose.
Courts don’t like the safe harbor because it allows co mpanies to lie. Fro m a purely cynical, pract ical view,
that is why courts are more restrictive to protect against all out lies.
What doesn’t the Reform Act cover?
- Harris v. IVAX – even statements that
- They do not cover things
- Doesn’t apply to investment companies
- Doesn’t apply to OTC market
- Doesn’t apply to IPOs
Philip Larson Page 15
Intellectual Property: Class notes
- Doesn’t apply to tender offers, private transactions, beneficial o wnership reports.
The point is, look at the Reform Act provisions and beware of things in the list. The Refo rm Act
Buyer beware courts make forward looking and soft informat ion actionable Congress provides a safe
harbor that effectively amounts to a license to lie courts restrict the license to lie in things like Ashton v.
Baxter where it says they can’t determine meaningfu l cautionary language.
Efficient capital market hypothesis – it is impo rtant in materiality as well.
Materiality is a subjective test. Courts are grappling with determin ing whether statements are material.
- There are three fo rms of the efficient capital market hypothesis. Courts use the semi-strong
version which says that all information available to the public is incorporated into the price.
- When it comes into the market, did the stock price move?
- The 3rd Circu it takes the semi-strong market hypothesis theory very seriously.
o Merck was going to IPO a co mpany. It revealed during the process something about
Medco’s accounting that investors later sued Merck for. It was how they accounted for
copayments by consumers. When they first revealed how they accounted for these
copayments, the stock price went up. Then it went up for about 5 days. 2 months later,
the Wall Street Journal said that when you look at how the copayments are done, it has
about this impact on the financials. (they did some basic arith metic) – the stock price
then drops about $2. What does the court say about this? It says that this information
about how revenue fro m copayments is calculated is not material.
o Therefore, the 3rd Circuit said that since the informat ion came out and the stock price
went up, it cannot be material. The court did say that Merck was treading a fine line
given that the informat ion was somewhat cloaked in …
o By contrast, the Fourth Circu it does things differently. Fourth Circuit said that it is not
necessarily material just because a stock price went down. Ps were incensed. Restating
of the CEO’s resume. The Ps said, who are we to decide it is not material. The market
seemed to think it was material.
o 3rd Circu it is the purest form of this factor (did the stock price move). Usually, you check
to see if the informat ion went down.
TS E v. Northway
- there has to be a substantial likelihood that the omitted informat ion would affect the total mix of
informat ion availab le to the investors.
- We have some cases that suggest that statements made that are false or misleading can be
immaterial if they are counteracted by analyst statements. That is, the ma rket can sustain liars if
we all know they are liars.
- Weigloss – truth on the market defense – this is pretty fact intensive – therefore, it is difficult to
get a case thrown out because of the truth on the market defense.
- The “bespeaks caution” doctrine – cautionary disclosure can counteract an unduly optimistic
forward-looking statement or o mission.
o In the semi-strong model, no price change suggests that something was not material.
Suggestion: keep in mind that the semi-strong form does not imp ly that the market is flawless, just that it is
- Koffman v. State capital funding – since there were cautionary statements elsewhere in the
prospectus they were saved.
Materiality relating to management integrity
- In the Matter of Franchard Corp.
o Requires disclosure of management’s co mmit ment to the company.
o The SEC maintains that this informat ion is material. If the CEO lies about his resume,
that in some way might reflect upon his management integrity. Management integrity is
Philip Larson Page 16
Intellectual Property: Class notes
o Quantitative vs. qualitatively material – when you see these kinds of issues, think about
whether they are qualitatively material. If they lie about their resume, what else will they
o The SEC says informat ion about management integrity are high ly material. Court
decisions have not always agreed with this. Therefore, it is not necessarily the law.
o You can read fro m the enforcement posture what the Govern ment thinks
The test of materiality (US v. Matthews – 2nd Circu it 1986 – said you didn’t have to disclose criminal
- criminal behavior of the executives didn’t have to be disclosed.
- 8th circuit held that fiduciary breaches did not have to be disclosed.
- For SEC purposes, perfect honesty is required. In terms of defending cases where there are
allegations that something was o mitted, there is some caselaw to suggest that some informat ion is
not material and doesn’t have to be brought up.
Roder - co mpany had authorized a bribe. 1st circuit found that it was material but that there was no duty to
- Forward looking info rmation
- Reform Act changed the standard to encourage forward looking and soft informat ion
- Semi-strong market hypothesis
Private, fraud liability –
- is this an omission, or a mislead ing statement.
- In these cases, there is a strong materiality requirement. There are other categories. Is there a
duty to disclose.
- What does the SEC require you to disclose?
Question 1: Duty not to make materially false, materially misleading statements, and a duty to correct false
or misleading statements.
Question 2: Was the informat ion material?
NEED TO GET NOTES
Chapter 17, p 973
Regulati on of the Securities Markets and Broker-Dealers
- Backg round
o Role of disclosure
Prohibit ion against fraud.
o Problem of “filtered” disclosure through brokers and investment advisors
1) those who advise investors might have conflicts of interest (they themselves
might have positions in securities or could benefit fro m resulting purchases)
2) they could be secret agents of issuers hired to “tout” the securities in question
3) there may be incentive to get investors to buy or sell actively because they get
paid on a per transaction basis.
- Structure of Regul ation and Evolution of Securities Markets
o The exchanges
Philip Larson Page 17
Intellectual Property: Class notes
1) Securities exchange (e.g. NYSE) – all national securities exchanges are under
federal supervision as of 1934,
All t rades go through a specialist at an exchange.
Section 5 of the ’34 Act: unlawful for a broker-dealer to effect a
transaction that operates as an exchange unless the exchange is
registered with the SEC (or exempted).
Once registered, an exchange is by statute responsible for its own
regulation (both governing rules and member d iscipline). Therefore,
they are self-regulatory organizations (SR Os) with quasi-
governmental authority. This entrusts the important responsibility of
regulation in an organization whose members self-interest will often
diverge fro m that of the public.
2) Over the counter (OTC) markets – no physical location, trading is dependant
on the telephone and internet. A market maker maintains an inventory of
particular securit ies and publishes quotes at which it is willing to buy and sell.
Not init ially covered by the ’34 Act but self-regulat ion was soon
extended to it in 1938.
Market makers always maintain both buy and sell prices. Market
makers make money through the spread. They buy lower than they
You can be both a market maker and a bro ker/dealer in the broader
Bottom line: all stockbrokers and dealers of any significance must be members
of the National Association of Securit ies Dealers (NASD) wh ich is reg istered as
an SRO subject to self-regulation.
o Market Frag mentation
Alternative trading systems : in addit ion to regional exchanges, there are now
ATSs that also trade NYSE and NASDAQ securities. These include electronic
communications networks (ECNs).
Section 11A(a)(1) of the ’34 Act: Congress said the national market system
should promote the “economically efficient execution of securities transactions”
and “linking of all markets for qualified securities.”
Effect: this led to the proliferat ion of co mpeting trading sites and the
fragmentation of the markets.
ATSs: are not fully integrated into the national market system. Activity
on them is not fully disclosed and available to investors. The trading
activity may not be adequately surveilled fo r market manipulation and
ATSs act as both broker dealers and exchanges : As exchanges, ATSs
centralize orders and give participants control over interaction of their
orders. Like bro ker dealers, they are proprietary and maintain trading
Co mmission in 1975 (“1975 A mend ments”): purpose was to promote 1)
economically efficient execution of securities transactions, 2) fair co mpetition,
3) t ransparency, 4) investor access to the best markets, 5) execution of investors’
orders without a dealer.
NOTES FROM CLA SS
Most recent form 10K: http://www.SEC.gov/Archives/edgar/
We are going to talk about:
1) Securities Market Regulation
Philip Larson Page 18
Intellectual Property: Class notes
2) Broker/Dealer regulati ons
This content is usually skipped in most classes. However, we are studying it to understand why markets
are regulated. Moreover, understanding broker/dealer regulat ion is because these are the kinds of cases you
get. Situations where investors think their broker misled them. Therefore, it is practical for the real work
of securities lawyers. Moreover, technology has caused disruptive change in the industry (70s –
development of ATSs, and more recently, 90s, with ECNs – internet)
- OTC vs. Exchange
- What is the difference between an OTC and an exchange?
o 1) an exchange has a physical location. OTCs do not have a physical location.
Exchanges were centralized clearinghouses. You went to Wall St reet…OTCs function in
a much more decentralized fashion. You can have more market makers. However, the
OTCs might be less liquid.
- How are they regulated differently?
o Exchange listed stocks are higher quality. They have larger requirements fro m the SEC.
o OTCs have fewer requirements and is less heavily regulated. OTCs allo ws trading of
securities that are NOT on the exchanges.
o If it is NOT LISTED but is STILL TRADED it is probably an OVER THE COUNTER.
- Why bother regulating these exchanges?
o 1) to prevent fraud
o 2) the net utility for society will be better, even if we subtract out the cost of regulation.
o 3) ensure that there is not an incentive to cheat or defraud, and imp rove the transparency
of securities transactions.
- In the eyes of the SEC, are broker/dealers any different as compared to lawyers in their fiduciary
o The law does not draw a distinction between the relationship between a lawyer and his
clients and a broker and his client. The responsibilities may differ, but it is still a
relationship of trust.
- What is the difference between a broker and a dealer?
o A dealer is a person engaged in the buying and selling securities for his own account. (A
dealer sells fo r himself not for others)
o ’34 Act: A bro ker is a person who helps in effecting transactions in securities for the
accounts of others. (This sounds like a fiduciary – one, such as an agent, that stands in a
relationship of trust.)
- Are there people who are only bro kers or only dealers? Are there any organizations?
o There are some co mpanies that do. However, you aren’t going to find very many.
o When you sell for yourself and you sell for others, what happens? There is a conflict of
- Why don’t we just say that if you buy or sell for yourself, you can’t buy and sell for so meone else?
This presents a principle/agent problem because sometimes their interest as a broker will be
inconsistent with their interests as a dealer.
o If they both buy and sell, they can make the markets more liquid.
o Having market makers that both buy and sell (and make money on the spread, or on their
own account), this is very efficient. You don’t have to go out to the market.
o Therefore, one reason is that it is cheaper than the alternative.
o We deal with these conflicts by imposing a duty that the broker, as an agent, act on behalf
of their princip le by getting the best deal. What does the text say is the best deal? It
could be the best price.
o One of the goals is to align the interests of the brokers and their clients.
o Having a broker/dealer, we can get lower transaction costs. We can have transactions
where the consumer doesn’t care because the end cost is the same, but where a
broker/dealer gets a different amount of money. Therefo re, we regulate to ensure the
transactions most efficiently.
- What kind of regulation do we have? How do we regulate this exchange?
Philip Larson Page 19
Intellectual Property: Class notes
o 1) self-regulation – we let the exchanges and members of the exchanges regulate
themselves. We have a system of self regulatory organizat ions (SROs). The NASD
regulates the OTC markets.
o 2) SEC – oversees the self-regulat ion.
There have been critics saying that people who work for the SEC are the same
people who work in Wall Street. Therefore, they may cycle through and help
out their friends.
- What is the relationship between the NYSE, the NASD as an SRO, and the SEC? Where does the
SEC belong in the drawing?
o Do they regulate in parallel or in series? They regulate in parallel…
o SEC regulates the NYSE. Ho w?
Directly: SEC can regulate SROs directly to ensure they are enforcing their o wn
rules. The SEC must approve any rule change of an SRO and may, on its own
motion, modify the SRO’s ru les. Therefore, it can regulate both directly and
Indirectly : SEC can let the NYSE regulate itself but indirectly regulate with the
“shotgun behind the door” aspect…A policy decision has been made that NYSE
is best positioned to regulate and to ensure that no one cheats because it reflects
poorly on the exchange. Ho wever, the SEC maintains the ability to regulate
o Therefore, it used to look like a serial circu it. Now it looks more like a parallel circu it.
We believe that the SEC regulatory scheme is now more parallel than it used to be. What
happens when the NYSE beco mes a publicly t raded company?
Then it is controlled by shareholders and it might not see the value in putting
more funds into enforcement rather than taking dividends. If other exchanges
aren’t treated as an SRO, you may relax your enforcement to lower your cost
structure to compete effectively. Reduce transaction costs through reduced
This regulation acts as a “NICE GUY PENA LTY” that other markets may not
- Self-regulat ing organizat ion (SROs) have the follo wing requirements (p995)
o 1) no burdens on commerce
o 2) fair representation of members
o 3) rules to prevent fraud
o 4) enfo rce exchange act provisions
o 5) p rove that they can do their job
- These are the costs of being an SRO. These represent the “nice guy penalties.”
- What is best execution?
o Finding the best price for your customers given the circu mstances. It doesn’t always
mean the lowest price because their may be hidden costs.
- Which case tells us what the broker/dealer’s requirements are?
o Newton case: A fiduciary has to use reasonable efforts to maximize the financial returns
for his client. So metimes fiduciaries don’t go out and do that. They might do what is in
their own interest, or do very little.
- Is everyone who wants to be a broker/dealer required to reg ister?
o Yes, they have to register with the SRO, unless they are specifically exempted. Who
might be exempted? 1) Intrastate only basis – Congress can’t regulate intrastate
commerce unless it has a substantial effect on interstate commerce. 2) dealing with
exempt securities, 3) firms whose contacts with the US are only ind irect, so that you
don’t meet the jurisdictional requirements .
- Why have these rules?
o Ensure the members of the exchanges enjoy high standards of honor and fair trade.
o (e.g. if we keep ripping off the members , no one will enter the markets.)
- What is just and equitable?
o The standards by which the actions of each petitioner must be judged are strict. He
cannot recommend a security without an adequate and reasonable basis for the
Philip Larson Page 20
Intellectual Property: Class notes
recommendation. He must disclose facts which he knows and those which are reasonably
o Duty to investigate: how is it that a failure to investigate becomes a fraud?
- How does the SEC actually regulate if a bro ker is doing a bad thing and the NYSE is not acting?
o SEC has independent authority to bring claims against broker dealers. This means they
can bring independent administrative proceedings without going through the NYSE.
o The SEC can convince itself that it found a violation of securities laws and act. The
threshold for proof can therefore be lower.
o If there is a willful violat ion of securities laws or if the person willfully aided or abetted
violations or made false statements to the SEC. This doesn’t say a “material” stat ement.
Therefore, if I lied in a filing about what color socks my CEO likes, accord ing to the SEC
they can act on this…For private liability and fraud liability, you won’t get them because
it is not material. When it co mes to the SEC, any deliberate fals ehood is material.
o Absolute honesty requirement:
- What is willfulness?
o 1) willfulness can be found if a bro ker/dealer who is aware o f several facts suggesting a
suspicious transaction proceeds to facilitate the sale with reckless indifference to such
facts, and ignores the obvious need for further inquiry.
In a civ il case, the standard is the preponderance of the evidence. The SEC can
effectively regulate by virtue of civil act ions that have a lower burden of proof.
Steadman 450 US 91.
What are the SEC penalt ies? Restrictions on activities, civ il penalties, sanctions,
o Fraud has to be proven by clear and convincing evidence. This is harder than
preponderance of the evidence.
o Admin istrative proceedings under 15(b)(4) are to discip line bro ker/dealers. (p995)
- In the Matter of John Gutfreund
o Facts: A broker had a supervisor. The broker was submitting false bids for $3.15 billion
dollars. Th is was not a small amount of money. The supervisor found out about this and
the attorney became aware of it as well. So meone in the chain of co mmand finds out that
someone did something stupid and they call the lawyers. The lawyer said they should
report it to the government.
o ISSUE: lawyers learn about lies. What are their duties? Do they become supervisors for
the purposes of Sections 15(b)(4)(E).
o Held : The supervisor of the person who committed fraud has a clear duty to report the
problem. Lawyers have a duty to take affirmative steps to ensure the appropriate action
is taken to address the misconduct. Lawyers are not just advisors.
SEC argues: lawyers become supervisors who should effect the conduct of the
emp loyee at issue. They can be deemed a supervisor if they could affect the
person. You can bring an action against supervisors. The SEC says lawyers can
be associated persons. They are asking the Court to create a duty to disclose
fraud to the government.
Why are lawyers more than just advisors? Why are they on the hook for these
In the wake of Sarbanes-Oxley, the SEC expects that not only the CEO will fix
the accuracy of the statements made to the SEC, but that independently
Simp le Technologies , TYCO: CLO’s were considered active
participants. Even in situations where the CLOs weren’t involved in
the fraud itself, the general counsel can be on the hook. The bar is very
§ 307 of SOX was going to have a “noisy withdrawal” requirement.
You do not believe representation of the company is consistent with
your ethical obligations. This ru le is on hold indefin itely because it is
very controversial. Regulation of ethics of lawyers is probably a state
matter. If you follow the SEC rule, you may be subject to violations of
Philip Larson Page 21
Intellectual Property: Class notes
state disciplinary rules because of conflicts with attorney/client
o You have to talk to both the CEO and the CFO.
Up the ladder notification – if the CLO learns, the CLO has a
responsibility to go to the CEO. A lternatively, they could notify the
o Doesn’t apply when there is not an attorney/client privilege. If
they aren’t your client, you don’t have a duty.
o This becomes triggered when a lawyer gets evidence of a
material vio lation of a securit ies law or si milar violation.
o The SEC removed the writ ing requirement that all of these
conversations be done in writ ing.
o Inside and outside counsel both have the same requirements
under this disclosure requirement.
o Supervising attorney’s –
QLCC – purpose is to be the conscience of the corporation with respect
to these types of issues. They typically reside in the audit co mmittee.
An attorney can reveal information to the extent necessary to prevent
the issuer fro m co mmitt ing an illegal act or rectify a situation in wh ich
a material v iolation was committed and the attorney knew. Therefore,
attorney’s can breach their attorney/client privilege under these
o Why care? It defines the lawyer’s responsibilities when securities infractions take place.
When you have to choose between your client going to jail and you going to jail, you
send your client to jail. That means you lose your law license if you breached your
- If you become known as someone who does not provide solutions but only creates problems, you
don’t get a seat at the table anymore.
- SHINGLE THEORY
o When you hold yourself out as a broker/dealer, you have a fiduciary duty to disclose all
the financial stuff in the transaction and act in the best interests of your client.
o Problem: there
o Shingle theory: you have to treat your customers fairly.
o 10-b-5 – there is an imp lied representation.
o Should risks be disclosed? P1001.
Under the shingle theory, brokers have to act in the interests of their principles.
o Hanly v. SEC (Know your security)
The level of sophistication of the buyer doesn’t matter. A dealer has a special
relationship with the buyer. You have a duty not to take advantage of your
You can’t reco mmend a stock unless there is a reasonable basis for it.
Therefore, if you lack info rmation, you need to disclose that.
o What is a suitability requirement?
You have to know your security and you have to know the sophistication of your
client. To lay out a claim fo r suitability you have to establish that the securities
were unsuitable and that the broker recommended them anyway with scienter if
that recommendation is relied on (e.g. “this is a perfect investment for you”
knowing fu ll well that it is not) (p1011 – sophisticated investors usually require
less information. To figure out if it is a sophisticated investor, look at p 1018)
o Who are sophisticated investors?
Based on salary, investment experience, p rofessional status, education, age,
business background, etc. There is a conclusive
Philip Larson Page 22
Intellectual Property: Class notes
Mandatory disclosure – why this is a good thing. There are four general arguments:
Reasons mandatory disclosure is good:
1) facilitates comparable disclosures between companies (we, as investors, can compare between
2) Helps reduce agency costs for shareholders – shareholders own the company and vote for the
board. Mandatory disclosure lets them all get the information they need.
3) Externalities – the more informat ion that gets out, people will gain co mpetitive informat ion,
allo wing the markets to operate more efficiently.
4) Reduces duplicative research – there is a net loss to society if lots of analysts are trying to figure
out the same basic information that we might just require the co mpanies to disclose.
Reasons mandatory disclosure is bad:
1) maybe the SEC will get the appropriate amount of disclosure wrong – too much and it is
inefficient and too little doesn’t help the investors.
- HYPO: “in the recent past” our revenues are the best in the industry. We have gotten an
additional $100 million in revenue.
o Problems: we need a sense of time period. If they say “recent” and Yahoo says they
brought in money “recently” that might not help us.
o Can the market provide this? We can imag ine a reg ime where people d iscount stocks
that don’t provide the information.
- HYPO: Our CEO has a new co mp package that pays at the same level as those of other successful
o Problems: what is “co mparable”? What are “successful companies”? What composes the
o Incentives: there is an incentive to disclose good company revenues but there is less
incentive for managers to disclose their own personal compensatio n packages. There is a
self-interest aspect of disclosing his personal compensation. Therefore, info rmation that
would be difficult for some private entity to get across the board is ripe fo r securities
o All CEOs think they are above average: therefore, this creates a cycling upward effect.
CEO salaries are way out of whack with the salaries of other peo ple in the organization.
- MOTIVE: people allege that the motive of the officers for artificially inflating the revenue
numbers are because they have stock options that they want to cash out. Therefore, the same way
you try to entice them to align incentives (stock options) becomes the motive for their abuse of the
numbers in securities fraud litigation.
- Prime use of regul ati on: when there is self-interest not to disclose something.
- HYPO: what if Google’s goal is to try to take over Yahoo. Should they be required to disclose
o There are times where there may be positive externalities to NOT disclosing certain
informat ion. We want to encourage businesses to make plans and go after new
businesses. Too much disclosure may make it too difficult to develop and act on their
strategic plans. Therefore, you don’t want to force companies to disclose all information.
Is there a duty to disclose?
1934 Act and its requirements for disclosure:
- centered around public entities.
- The SEC does not require that all types of companies have to file 10Ks, etc. We don’t go into
every business, only public companies. What drives companies to go public? Primarily to raise
money to accomp lish some set of goals. (e.g. restaurant chain may need capital to open
restaurants all around the country). The greater the init ial financial investment needed, the more
likely you will try to raise the money by going public.
- Does it make sense to have different disclosure requirements for public and private companies?
Philip Larson Page 23
Intellectual Property: Class notes
o If you and 10 buddies get together to start a laundry chain, why not force the same level
of disclosure? Going public can be expensive. The costs of going public for a small
company may be prohibitive. Regulatory burden may be h igh. Moreover, if it is just you
and 10 buddies you probably have more o f the information. In a s maller venture, there
will be mo re in formation available. Therefore, there is a collective action problem. 1000
people can’t get on a phone to decide how to run the company. They need some other
- Section 13 of the ’34 Act tells who has to disclose. There is a narrow range of three categories:
o 1) Listed on a National Securit ies Exchange (this is somewhat limited …part of the
NASDA Q is national but the small cap market is not a national exchange) – 12(a) and
o 2) Over the counter companies (e.g. not listed on an exchange) with 500+ shareholders
and $10 million in assets – this is where the SEC sees the collective action problems
begin. 12(g )
Note: there are a lot of ways to hold stock. Owners of record mean your name is
on the stock certificate. Others put the broker’s name. Antimanipulation
provision in 12 to say you can’t manipulate record holder names to get below
the 500+ shareholder level.
o 3) You filed a ’33 Act Reg istration Statement – what is this category trying to capture?
Co mpanies that sold debt in an IPO but kept the equity themselves. These companies
would also be
- Why would you want to avoid being a public co mpany?
o 1) It is expensive – particularly after Sarbanes Oxley. This has doubled the regulation
o 2) Reduces legal liability – your 10 buddies probably won’t sue but 1000 strangers might.
There are mo re people who might bring suits and more informat ion to bring suits about.
o 3) May not want to reveal competit ive information.
- In the wake of SOX, there are questions about whether companies are likely to go private.
Depending on which surveys you believe, some people argue there is a push towards becoming
private, particularly for s maller public co mpanies. Therefore, SEC is considering how it might
revise the regulations b/c the smaller co mpanies are overburdened by the requireme nts.
o How do you go private?
1) You have to delist your company fro m the exchange.
However, you are still caught by the other two standards. Therefore, under
12(g)(4) you have to get the shareholders less than 300. Th is would
automatically work. A lternatively, you can show that you had < 500
shareholders and < $10 million in assets for three years.
Under 15(d ), if you have fewer than 300 shareholders and it is after the fiscal
year you filed a ’33 Act Reg istration statement.
- HYPO: co mpany has $13 million in assets. More than 600 shareholders. Therefore, they do a
buyback of $4 million in assets . Problem: This is not enough, you have to wait for 3 years. Is
there a problem with the fact that Google is doing this deliberately? Having made a policy
decision that 500 is the cutoff that is the cutoff. It is better to have a clear ru le rather than an
KEY FORMS REQUIR ED – Corporate Lawyers have to get these disclosures right.
- Counseling companies: look at the Form 8-k categories (ha ndout in class)
- Types of Forms:
o Form 8-k: for material developments or extraordinary events.
Anti-Enron provision: any creation or triggering of an off-balance sheet
arrangement, you must file an 8-k.
Goodwill: material impairments to assets such as goodwill. What is goodwill?
It is the intangible assets associated with the company, such as the value of the
brand, or the general goodwill that the company has built up (e.g. users, etc.).
Why would a material impairment to this matter to the public? Impairments
Philip Larson Page 24
Intellectual Property: Class notes
provide some info rmation about how the acquisitions are doing. Co mpanies
often do big write-downs on the goodwill.
Notice of delisting: if NASDAQ co mes and says they are going to delist you, the
SEC has said you have to tell the investors quickly with an 8-k (w/ i 4 business
Code of Ethics: the SEC does not require that a company have a code of ethics.
They just encourage you to. If you change or waive your code of ethics, you
have to tell people. Th is is an anti-Enron statute.
o Form 10-q: Quarterly report. Requires less baseline informat ion. The financials don’t
have to be audited by the auditor. Just looked over.
o Form 10-k: Annual report. Requires all info rmation and the financials must be audited.
Categories: Legal proceedings, description of company, listing of directors and
officers, accounting fees and services, known trends and uncertainties.
Requirements that the company predict aspects of the future.
Sarbanes Oxley : requires that CEO and CFO have read the report and is
accurate. They sign off and certify the financials, etc. Th is is indicative of why
Sarbo x was passed too quickly. It has always been the case that they have to
sign the 10-k. For private liab ility purposes, it really doesn’t make much
difference. As a signatory of the 10-k, you are going to be charged with
ensuring the accuracy of the 10-k. It has made CEOs and CFOs paranoid of
signing the certification. The DOJ gets enhanced penalties if CEOs certify and
they turn out to be false. Therefore, it hasn’t done much about private litigation
but it has done quite a bit regarding public litigation. It is rare for CEOs to have
to go into their own pockets to pay private litigants. (Enron is a b ig exception.)
However, public litigation can get inside your pocket.
- Where are they located: On the SEC’s “Edgar” system.
- Why limit requirements of the 8-k at all? What if you required all material information rather
than just these categories. What would be the problem? 1) cost, 2) co mpetit ive in fo rmation, 3) it
is tough to figure out what is material on-the-fly. Determin ing this on a rolling basis is not easy.
- What about all the information on the 10-k and 10-q : Why not require this to be distributed in 8-
k’s? 1) enormous additional costs, 2) the information may not be accurate (ppl would be
scrambling around – most of the stuff for the 8-k are p retty straight forward so accuracy is more
likely), 3) timing – 4 days is pretty arbitrary. Why not an hour or a day? We are most concerned
with everyone getting the information at the same time. The SEC has made a judgment call about
the amount of time required by the co mpany to assimilate the information. There isn’t a clear
social benefit to doing this a lot faster.
- 8-ks vs press releases: if a co mpany doesn’t want to disclose information they have to, they may
use an 8-k and not do a press release.
o Trend: the trend is that more and more things must be disclosed in 8-ks.
In the Matter of W.R. Grace & Co.
- Facts: WR Grace looked at the retirement benefits and the sale of a subsidiary to his son. Was it
legal to provide these benefits to his son? No, there was nothing illegal about it. Why wasn’t the
compensation disclosed? The SEC was worked up because the CEO and the Chairman of the
Co mpensation Package failed to put this in the public filings. Why did they fail to question this?
They assumed that legal counsel would have addressed this. Why didn’t the lawyers say
anything? It suggests that the lawyers didn’t say anything because there wasn’t any change fro m
when he was the CEO. It was the same package except he was no longer the CEO. What does the
SEC say they should have done? They should have looked at the procedures and inquire to see if
the lawyers had the information. Th is is a heavy burden - is it the right approach?
- Note: this is not an action the SEC b rought. Here, one of the SEC co mmissioners writes a dissent
fro m the cease and desist order. Why didn’t the SEC bring an action and go for fines, etc? It is a
thin case. Who benefited fro m this? Only the old CEO who is now dead. Should the chair of the
compensation packages be treated differently than the CEO?
- Dissent: The dissent said this was the responsibility of the lawyers. The lawyers know what the
SEC requires. The CEO shouldn’t be required to understand everything about securities law.
Philip Larson Page 25
Intellectual Property: Class notes
- Boards are made of inside directors and outside directors. So met imes the CEO will sit on the
board. He is an inside director. An outside director is supposed to be an impart ial observer. Is
there a problem of go ing after outside directors? If you are too aggressive about what outside
directors have to know, people may not want to be outside directors. This is a big theme today in
securities law. The upside is you get paid $50,000/yr. The downside is that the SEC might sue
you and get into your personal assets, etc.
Regulation Fair Disclosure
- Has the SEC ignored things you might want to say to people? No, the SEC is not just concerned
with what is required but are also concerned with situations when you selectively disclose to some
groups but not others.
- How does the SEC p rotect against the creation of these types of informat ional asymmet ries?
o There might be an incentive to tell securities analyst’s information about the company
early. If the analyst likes you, he may be inclined to give better ratings to the stock. Th is
could influence investors, etc.
o The SEC doesn’t want the smart money to get an advantage.
o The SEC passed a Fair Disclosure provision preventing domestic investors . Who are
Analysts. Anybody who is likely to trade on the informat ion (e.g. anyone who
holds the stock). It is targeted at broker/dealers, etc.
You can’t have a conversation in which the CEO is offering up informat ion that
has not already been offered to the market as a who le. How do you avoid Reg
FD prob lems? Avoid one-on-ones. One-on-ones are fraught with danger b/c
you are asking the CEO, on the fly, to limit themselves just to what the company
has disclosed. That is a tough road to hoe.
Advice for how to solve Reg FD p roblems:
1) Eliminate one-on-ones
2) Webcast everything – this is not considered a selective disclosure.
o What happens if the CEO screws up? They just have to disclose it to everyone
“promptly”. Usually, this means 24 hours. Does this solve the problem if the CEO
meant to say it? No, because the SEC can still bring an action.
o Reg FD is strict liability. It doesn’t matter whether you thought you were being
webcast. State of mind doesn’t matter.
o What if everyone you tell has agreed ahead of time that they won’t trade on the
Yes, it is okay for anyone who has agreed to abide by a confidentiality
o Who can bring the actions? Only the SEC. It says in the Reg FD writeup that
- Siebl 1: invitation only Go ld man Sachs conference. CEO says two things: 1) Ks are getting
signed, I’m seeing a return to normal buying patterns for IT. 2) this quarter looks like it will be
like prev ious quarters.
o Problem 1: Th is was invitation only conference.
o Problem 2: The information was not inline with informat ion the company had given
o Outcome: SEC gave Sieb l a cease and desist order.
- Six months later, Sieb l’s CFO did a one-on-one and he said some things about the company. They
bring a second action against the IR o fficer and the CFO. This time, Siebl does not agree to a
cease and desist. Therefore, the SEC has to bring a full act ion. Siebl then challenges the SEC
decision in an Article III court. The Southern District of NY said this is WAY to persnickety.
The court said this was basically equivalent and that the IR and CFO are not linguistics.
Therefore, the court was highly crit ical o f the SEC and Siebl got off scott free.
o This was a little embarrassing for the SEC. Perhaps the SEC will lighten up some.
Books and Records Requirements: Sect ion 13 of the ’34 Act requires companies to keep books and
records that accurately track the assets of the company. Also, the accounting requirements that these assets
Philip Larson Page 26
Intellectual Property: Class notes
are tracked. This arose fro m the foreign pract ices act. This is because American co mpanies had slush
funds to bribe foreigners to grease the wheels of commerce. This § 13 was meant to get at this. The SEC
can come after you if it thin ks you are being dishonest with your reporting. This can be used for
immaterial issues that create ethical questions. Therefore, if the issue is smaller, this is a means for the
SEC to come after you for smaller things.
- There is strict liability for books and records require ments.
- What constitutes internal controls? 1) information systems, 2) segregation of duties, 3) training of
personnel, 4) co mpany code of ethics. All these would go into the organization’s financial
controls. Will that stop all fraud? A ll the prevention in the world won’t prevent fraud that
someone really wants to do.
- SOX 404 – auditor needs to evaluate all of these internal controls. If you are a partner in Ernst &
Young or KPM G, these are the golden years b/c you are in charge of whether you are g oing to say
whether the internal controls are in place. SOX also did other things for auditors. 1) they have to
be independent. Auditors cannot provide non-audit services. Arthur Andersen was paid money
for $Y auditing services and $X for non-auditing services. Therefore, they might have
compro mised their auditing if they thought they would lose their non -auditing services. Also, the
lead audit partner has to rotate every 5 years so no cozy relationships develop. Auditors have to
- Public co mpanies get hit by the SEC, they get hit by the States, they get hit by the stock
exchanges. Therefore, corporate governance becomes a real problem.
Mark Fit zgerald (703) 734 3105
- A private placement is an offering of securit ies to a small group of sophisticated investors. There
are fewer rules to comp ly with, though the investment bank must show that the investors comply
with certain criteria. The d istribution of other types of investment, other than securities, is usually
also done through a private placement. Th is could include investments in venture capital or private
equity, acquisitions and other strategic investments by companies.
Recap fro m last week
- 1) Private placement: know problem 5-10 and different iterations. What do you have to consider
when figuring out
o # of offerees – even a small number can prevent a 5-2
o Sophistication of potential investor of securities
o Access that the investor has to information – imbalance of informat ion based on the
Purina case. This goes to the sophistication
o Relationship to the issuer – is the person in a position to know (even if not sophisticated)
this would favor a private placement.
o Note: whether something is a
- 2) What is the safe harbor?
o 506: co me up against this more frequently. Most common exemption. Unlimited amount
of accredited investors, up to 35 credited investors. Must comply w/ 501 and 502
(adequate informat ion, no general solicitation)
- 3) How do you get the benefit of the exemption? Filing a Form D wh ich is a notice that you have
privately placed securities based on this exempt ion. This has to be filed within a s mall period of
time (30 days?).
Philip Larson Page 27
Intellectual Property: Class notes
- Public o fferings: start out as a private company and you sell securities to venture capitalists first
(private offerings). Then, you have public offerings and secondary offerings (although secondary
is really just a resale of securities that have already been issued.
o IPOs – init ial public offerings for private co mpanies
o Follow on offerings – made by public co mpanies to raise more money. Just a subset of
- Secondary distributions – reselling of securit ies. In part icular, Rule 144 which is one of the most
important rules for corporate attorneys.
- Public Offerings
o Section 5 of the 33 Act wh ich talks about registration. It is unlawfu l to sell a security
prior to reg istering the security and making sure the registration is active.
o Section 5 – you can’t sell or offer securit ies without a registration statement. How does
anyone raise money then? There are private placement exemptions.
o Registration process –
Prohibit ions regarding interstate commerce in mailings. Federal gov’t can
regulate anything regarding interstate commerce. If it is solely within the state,
the federal government can’t regulate it. Typically today, with the Internet, the
Intrastate exception will beco me less and less relevant.
Today we will d iscuss what the law used to be and what it is now. Private place ments, 402, 506 are
important. Today, we will discuss more on a business level than on a legal level.
- Flipping, spinning, etc.
- Rule 144 we’ll get into substantive law
What is the IPO process about?
- Section 5c – pre-filing, you can’t make written offers. it is unlawfu l for any person to make use of
any means…in interstate commerce…to offer to sell or buy any security unless a registration
statement has been filed.
o Applies prior to the filing of a registration statement.
o Prohibit ion on any offers unless you have filed a registration statement.
o Registration statement – basically a disclosure document with the name of the company,
the number of shares, the price of the shares, etc. Below that is the prospectus which is
the offering document. It talks about what the company is, etc. It tells investors what you
are buying. Then you have to disclose the fees, indemn ification provisions, and a list of
things the company covenants to provide to the SEC under certain circu mstances.
- 5b(1) – after filing, you must accompany a prospectus that can exclude pricing informat ion .
unlawful to carry or transmit any prospectus relating to a security for which a registration
statement was filed unless it meets the requirements of section 10. After you file, you can’t use
interstate commerce to transmit the prospectus unless it meets rules set out by the SEC.
- 5b2 – when selling, you must provide a prospectus that includes pricing information . says
basically the same thing. However, it also says you can’t sell any security through interstate
commerce unless the sale is accompanied by a prospectus that meets requirements of section 10a.
You have to deliver a prospectus with a sale. Therefore, you can’t have a draft document. You
must have a final prospectus that is complete, with accurate pricing information. Th is prospectus
has to accompany any closures of any sales of a security. Final prospectus must be delivered.
What type of informat ion can you leave out of a 5b1 prospectus? Pricing informat ion.
- Red herring prospectus – not a final p rospectus. It says they want to sell a certain nu mber o f
shares of stock but it leaves out pricing informat ion.
- 5a – reg istration must be in effect when selling a security. unless a registration statement is in
effect (meaning it has been declared effective by the SEC) it is unlawfu l to sell such security
through any means.
Bobble head is trying to raise capital. They have a few rounds. Venture banks are approaching them.
Forward looking revenues.
Philip Larson Page 28
Intellectual Property: Class notes
- Banks are looking for co mpanies that are profitable.
- There is a To mbstone ad on p118. There has been a lot of consolidation of the banks.
- There is a lot of prestige with going with the right bank. There is a lot of positioning and
jockeying. There is no agreement with the bank until just before you go effective. You are
relying on relationships with the banks. You select an underwriter and they don’t have anything
that keeps the company fro m switching to another bank. Most transactions, if you are going down
the path of a merger, you’ll execute a term sheet (letter of intent) which lays out the general terms
of the contract. While these are non binding, there is usually an exclusivity requirement for some
period of time. In public offerings, these typically are not done. There is nothing preventing
- The prestige value of the bank is to be up on the upper left of the cover. At the bottom, it says
who the lead underwriters are going to be.
- After you file your registration statement, investment banks do their book writ ing. They try to
find people who would be willing to buy the securities. That way they have certainty that they can
sell their shares. They get on the phone to figure out how hot the offering might be. If you have
someone that is not a top tier bank with enough connections with outside investors, they might get
- Lead – managing underwriters get a bigger percentage of the fee. Moreover, they get to continue
doing business with the company (follow-on business, additional mergers and acquisitions, etc.).
Then, you are dealing with success fees, not the measly 7% you get on the initial public offering.
- Registration statement starts once you’ve chosen an underwriter who is going to take you out.
Once you are in registration you aren’t supposed to do anything to effect the market (e.g.
interviews with playboy, press releases, etc.) – the reason is they don’t want to overinflate the
values. Moreover, the SEC takes the view that once you are in reg istration, if you do any thing that
seems to pump up the company, that constitutes an offer. The co mpany has made the decision to
go forward. Are they making an offer before filing a reg istration statement. Even if it is not an
offer (and a violat ion of 5c), if your press release doesn’t meet Section 10 then you violate 5b
saying this information needs to be in a prospectus.
- The SEC will allo w you to communicate things that don’t meet Section 10 as long as you provide
a Section 10 prospectus with that informat ion. If you deliver informat ion in a prospectus, they
have to see the prospectus first.
o What about private meetings with potential investors? Prio r to filing a registration
statement, you can’t have any offers without an exempt ion.
Steps of the IPO
- Initial org meeting: Management gives a presentation, walking through their business and their
financials. After you’ve selected investment bankers you get legal counsel involved, auditors and
accountants get involved. You get an IPO working group together and you have an org meeting
(someplace secret). It is the first time the working group meets together. The co mpany’s senior
management, outside counsel, investment bank, everybody who will be on the cover (not just the
lead). These meetings can escalate in size. The banks will have their own legal counsel.
Somet imes, the accountants will be there as well.
- Due diligence and drafting the registration statement: data dump of everything. Every K, the
organization chart, any lit igation the company has been a part of. Anyone who is going to sign the
registration statement, any directors at the time it is filed, any person named in the reg istration
statement who is about to become a director, the underwriters, any experts, etc. These are all
subject to subject 11 liability. If there are any misstatements in the prospectus they can be
personally liab le. Right after the org meet ing you go into due diligence. As underwriters counsel,
you want to find out everything you can about the company to ensure there aren’t any
misstatements. Corporate counsel also must see everything. Usually they don’t have access to all
the information until the IPO meet ings start. (Dataroom – is an electronic records management
system for managing mergers, acquisitions, etc.)
- Start drafting the registration statement: co mpany counsel drafts this. You take all the information
fro m due diligence and put it in this book that can’t have any misstatements in it. The bankers
want to say how they want to market it but the company may have other ideas. Therefore, the
bankers try to frame it in ways that investors understand. Counsel makes sure there is nothing
Philip Larson Page 29
Intellectual Property: Class notes
incorrect as the language gets worked out. Legal counsel on both sides try to confirm the
statements are true. (“we are the leading provider of bobble heads…” – how can you justify this?)
Underwriters counsel will circle all the numbers in the book to ensure they are reviewed.
o Co mfort letters: Say that they have looked at the numbers and they can be traced back to
something that has been audited. This comes fro m the accountants.
- Filing: file the registration statement and you no longer have to worry about 5c. Now you can
start making offers. 100% of IPO filings are co mmented on by the SEC within 30 days.
- Offers: the banks start making phone calls. The co mpany gets ready for the roadshow. The
lawyers scramble to get everything done that they haven’t previously. Laywers put together audit
charters, ensure that financial controls are in place to meet Sarbanes -Oxley requirements, etc. You
try to take care of this during the Waiting period between filing and the prospectus.
- Roadshow: have the CEO talk to a powerpoint and read a script in a way that is engaging. So me
private company CEOs don’t have experience speaking to large grou ps of investors. There can be
a good deal of training.
- SEC responds to filing: somet imes they’ll ask for backup regarding any of the statements (e.g.
how do you know this is the leading bobblehead maker?). Another common co mment is “cheap
stock.” The SEC will look at what you valued your stock option price.
- Prospectus: You work on the prospectus and file a number of amend ments with the SEC. You
have more drafting sessions, file the prospectus with the SEC. By the time you get to the “red
herring” prospectus you start getting close. Then, they’ll go on the roadshow and talk to
institutional investors. Under 5b1, the only written information you can give during the roadshow
has to meet the requirements of the prospectus. Therefore, you can’t leave copies of the slides,
you don’t publish a transcript. There are new ru les on this now. The rules are somewhat relaxed
so that you can provide free-writing prospectus’s. Webinar roadshows are now allo wed. After the
roadshow, bankers can gauge how much interest there is and start understanding the appropriate
- Pricing Call: the CEO and CFO give a pricing call. After the market closes, they decide what they
are going to price at. That is the day that the pricing is finally decided. (T+3 – you have to settle
a sale of a transaction within 3 days) – you price, you start creating and then you close three days
later. On the day you price, you sign something with the underwriters that they agree to buy a
certain amount of shares that are going out to the public. The pricing day is when they sign the
underwrit ing agreement. When they close, they issue a global stock certificate for however many
shares. Immed iately, electronically, the shares get distributed to everyone who has purchased
them during the 3 days.
o Green shoe: sometimes the purchasing agreement says that they may have the option to
buy more shares.
- S-1 – Form of Reg istration statement that includes prospectus : They are registering the shares they
are offering. That doesn’t necessarily involve the secondary markets at all. To reg ister the trading
of those shares, you have to fill out a Fo rm-8a saying that this is a class of stock securities that you
want to trade. This gets filed at closing. This means that the company becomes lia ble for the
reporting requirements under the 34 Act. This basically says that public co mpanies on these
markets must file a 10k, 8k’s, etc. With Sarbanes -Oxley, they have to file a form 8k anytime there
is a material event influencing the company.
- Gun ju mping: making offers before you have filed the registration form. Th is is a 5c failure.
What is gun ju mping? There is a new safe harbor now (Rule 163a) that says that within the 30
days prior to filing you don’t do any press releases out of the ordinary or any other puffery, you
won’t have a gun-jump ing issue. If the SEC does find that you jumped the gun by providing
offers prior to filing. When Google filed their IPO, a year befo re that the founders had an
interview with Playboy. It wasn’t published until after they filed the registration statement. This
was during the wait ing period. The question was whether it was an offer and whether it was an
offer that met the requirements of section 10. The SEC said it was an offer and that they should
include it in the registration statement. Google had to include the entire text of the Playboy article
as an exhib it. What does that mean as liability to the company? They are responsible for any
misstatements made in the interview. That is one possible penalty the SEC can make.
o This is a big issue: the first big meeting after a co mpany picks the investment bank, a
very large discussion takes place going over gun jumping.
Philip Larson Page 30
Intellectual Property: Class notes
The Law Part of this
- Secondary distributions: read the law and the statute and the rules. We talked last week about
exemptions of the registration requirements. When the company wants to raise money without
going through the expense of an IPO. This is Rule 4-2. Another exemption is under 4-1-
transactions by any person other than an issuer, underwriter or dealer. Therefore, someone who
buys the stock of a company that hasn’t gone public can sell the stock.
- Section 4 are transactions that are exempt.
- What is an underwriter? Underwriter will buy the shares and resell the shares. W hat happens if I
buy the shares 5 years ago, and we have a private with Gerry transaction later. What happens if
Gerry wants to buy more stock fro m bobble head after that and goes up to bobblehead and asks
but the company can’t find a private placement transaction (because he is unsophisticated).
Bobblehead would not be able to sell because it is a private placement. Instead, they say why not
do a private placement to Mark and Mark will sell to Gerry. Since Mark is not an underwriter,
dealer, or issuer. Section 2(a)(11) says this counts. This says an underwriter is anyone who has a
“view to a d istribution” of the securities. This means that the stock hasn’t come to rest in my
hands. The securities laws are pretty clean (few loopholes). The 4.1 resale exempt ion is focused
on this as well. There are questions of how long it takes for stock to rest in my hands. People
want to know how quickly they can make this stock liqu id. That’s why the SEC created Rule 144.
- Rule 144: A safe harbor. If you co mply with 144 you will not be considered an underwriter. You
will have the resale exempt ion availab le to you. It applies to two types of resales.
o Resales of restricted securities: stock issued in a private transaction. Bobblehead, private
company, had a VC investor, complied with only having accredited investors, complied
with 501, 502 and filed Form D and now they have shares of Bobblehead. If they then go
public, they will o ffer shares to the public. Those shares aren’t registered. Ho w does the
VC sell its shares into the market? It can sell them under 4.1 if it is not an issuer,
underwriter, etc. How can they find a safe harbor to ensure they aren’t an underwriter
(using the Rule 144 exemption). Rule 144 says that if you are holding restricted
securities you can sell them into the market if you meet certain requirements. These
1) Volu me requirements – you can’t sell a lot of stock if it is traded only thinly.
You don’t want someone holding stock to be able to get out of th e market
quickly in situations where there is only a litt le trading (this would put
downward pressure on the stock price). 1% o f the weekly average trad ing
volume. You also have to sell through a standard broker transaction.
2) Hold ing period requirement – If co mpany sold to me and I sold to Gerry, that
is a conduit and I would be an underwriter. In itially, the SEC said that as long
as they met these other requirements, two years was long enough. The SEC
back in the mid-90s amended Ru le 144 and changed this to 1 yr. Therefore, the
holding requirement is now 1yr.
4) Co mpany must be filing 10ks, 8ks, etc.:
o Resales by affiliates of the company: for examp le, if the founder (who may own half the
company) sells his shares to Gerry and take the money to use for the company’s capital
purposes. Therefore, Rule 144 can prevent getting around this.
If you are not an affiliate and you are a VC fund, you have to comply with the
Vo lu me Requirements and Holding Period requirements unless you have held
them fo r a real long time. Ru le 144(k) gets rid of all the restrictions. It says if
you are not an affiliate of the company and you have held the securities for a
long enough period of time, why should the SEC care if you sell those way
down the road. At some point, the company is clearly not using you as a
conduit. It says that if you are not an affiliate and haven’t been for 3 months,
then you can sell under Rule 144 if you have held it for 2 yrs. (this used to be 3
yrs). This means that if you are a VC and you bought shares 1.5 yrs before the
IPO, and then you have the 6 month lock up, you can sell without worrying
about restrictions. This is important b/c 144(k) also says that 144(c) does not
apply. Therefore, 144(k) actually allows VCs to sell funds after 2 yrs regardless
Philip Larson Page 31
Intellectual Property: Class notes
of whether the company has actually gone public. Most VCs wouldn’t want to
do this anyway because it will p robably have a low valuation since there is less
liquid ity. (it is private stock without an active market).
Securities and Regulat ion law basically co mes down to:
1) DISCLOS URE
2) FRAUD LIAB ILITY
Today we start talking about Fraud liability and securities act liability.
- Section 11 – liab ility for misstatements or omissions in registration statements
- Section 12 – liab ility for misstatements made in connection with sales or prospectus of offerings.
- 17(a) liability – SECs something.
We are going to focus almost entirely on Section 11 tonight.
- HYPO: Ging ko, Inc. puts out healthy drinks. They have decided to go public. W. Good man is
CEO, M ichelle Jones are the CTO. Offering will be $10 million shares at $20/share. They won’t
say that 1) Michelle Jones was convicted of securities fraud and 2) they are overstating their
- In a typical fraud on the market (usually brought under 10(b)(5)), you typically have one group of
outsiders benefiting at the expense of another group of outsiders. That is NOT the case with
public offerings. Sect ion 11 is important because it goes most directly towards a situation where
an issuer has an incentive to engage in fraud.
o In 10(b)(5), Ps are always struggling to exp lain a motive for art ificially inflat ing the stock
price by providing bad information to the market. (Usually they say people internally
inflate the price so they can sell and then give the informat ion to the market).
o In Section 11, fraud will raise the offering proceeds. This is a clear incentive to engage
- Section 11 of the 33 Act – a material misrepresentation or omission in a reg istration statement will
subject the issuer and a variety of persons associated with either the issuer or the distribution to
damages in a suit brough by any person who bough securities issued pursuant to that registration
o This is a very lo w bar. There was debate about whether this would drive everyone out of
the public markets. What is so easy about this? Anyone who buys stock can sue. There
is a large pool of potential Ps.
o What does the stockholder have to show?
There are very few th ings for the Ps burden. 1) misstatement or o mission, 2)
Everything else the D has to show. Therefore, burden on P is pretty low.
What does P NOT HA VE to show?
1) Scienter – the state of mind of the individual Ds. They don’t have to
have knowledge of wrongdoing or recklessness or wilfu ll blindness.
2) Reliance – you don’t have to show that Ps suing actually read the
registration statement. Just that they purchased the securities.
3) Lost causation – P does not have to show their losses were even
caused by the misstatement. That is left as an affirmative defense of
At the end of the day, P has to show 1) standing to bring suit, 2) that he is
bringing it against an appropriate category of D, 3) misstatement or omission, 4)
material, 5) damages (assuming D pushes this affirmat ive defense). As long as
Ps can show the formula for damages is met in some way, they achieve #5.
- Section 11 is therefore a powerful tool for purchasers of securities. Because there are so few
elements and because it creates a s trict liability standard, at least on the issuers, the judges have
found ways to limit these types of suits.
Philip Larson Page 32
Intellectual Property: Class notes
Standing is a significant barrier to Section 11 claims. Anyone who buys stock
issued pursuant to a defective registration statement has standing. This can
become a problem if there are mu ltiple registration statements.
Tracing – it is difficult to show which of your shares came fro m which
registration statement. You get a mixed pool of shares in the market. Tracing is
a real problem. p475
You can only get damages for securities that you can trace back to the specific
Judges take this tracing requirement seriously and use it to limit Section 11
claims. (e.g. Krim v. pcOrder.com p 475 – 91% of the stock issued pursuant to a
misleading reg istration statement – this is not sufficient. You have to actually
be able to trace them back).
Typically, when you are buying stock you aren’t buying it directly fro m the
underwriters. You are buying it through a broker who is holding a bunch of
shares and attributes some portion of them to you. Therefore, you never actually
hold the stock certificates.
So what does this mean for who a typical Section 11 p laint iff is? It is the
purchaser of IPO shares, right after the IPO, and before any insiders come in and
there is a follow-on or secondary offering (e.g. the insiders take their shares to
market). Or, a d irect sale of the underwriters in a secondary offering.
Therefore, if you are buying directly fro m the underwriters , you can pretty easily
trace it back.
This tracing requirement effectively limits claims to IPOs.
Hertzberg v. Dignity Partners, Inc. – p473 – th is is a rare, cooky kind of case.
- Theory behind Section 11
o Ps have heartburn because of the tracing requirement
o Ds have heartburn because the Ps burden is so low for bringing claims.
o Does a lack of reliance requirement justify the tracing requirement?
Tracing creates a connection to someone tied to the registration statement.
The problem with this argu ment is that it is both underinclusive and over-
inclusive. People who buy the securities that are not traceable may have read
and relied upon the misinformat ion. People who d id not read and rely on the
informat ion may have a Section 11 case if their shares can be traced back.
Therefore, tracing is not a very good proxy fo r lack o f reliance but that is how it
seems to be used.
o Why do we distinguish between the initial public offering and follow-on and secondary
There is a major information asymmetry the first time because the market has
very litt le information about the company compared to after the IPO when there
are all the standard disclosures available.
o Problem: There is nothing in Section 11 that limits it to registration statements of IPOs, it
goes towards all reg istration statements. Moreover, it also applies to bonds which are
very easy to trace. Therefore, co mmon stock holders are kind of getting screwed here but
people who are buying bonds, even years later, it is very easy to trace back. This
undermines, in some ways, the policy behind all of this.
- Difficult concept: if you looked at Section 11, you looked at Section 11(g) – damages are limited
to the entire offering proceeds. Therefore, if you sold 10 million shares at $20 million a share, you
are limited to $200 million in damages. What is the problem with extending damages to all
plaintiffs in addit ion to the initial investors? There may not be enough money to go around.
- What is the best answer for the rationale for the tracing requirement? It is a backdoor method to
reduce the number of plaintiffs fro m secondary and follo w-on offerings. Another reason why this
is okay is that these people can always try to bring a 10(b)(5) claim as well. Look at these judicial
decisions recognizing that judges want to discourage frivolous suits, etc. Securit ies class actions
are difficult to defeat. Issuers are under the gun if they have a Section 11 claim b rought against
- Tracing examp les:
Philip Larson Page 33
Intellectual Property: Class notes
o HYPO: Ging ko. Supposed you purchase 10,000 shares directly fro m Hooligan securities
(underwriter) on the day of the IPO for $20/share. Can you bring a Sect ion 11? Yes.
What if you bought the shares fro m your broker two months later, do you have standing
then? Only if no more shares have entered into the market. Have any other shares
entered to create a pool making tracing more d ifficult .
o Rule 144 sales by insiders. Typically there is a lock up period for about 6 months so
that anyone who purchased shares in those first six months is going to be okay.
o HYPO: Drink Risk has 40% of the stock and ½ the board seats. Let ’s say they sell
Enough on tracing. Moving on
What defendants can be sued under Section 11
- Defendants – who can you sue under Section 11. Unlike 10(b)(5), there is a very well defined list
of who can be sued.
o 1) Anyone who signs the registration statement, including the issuers (CEO, CFO,
o 2) NOT attorneys – this is important b/c typically the attorney’s will be in charge of
putting together the registration statement. They are not
o 3) Underwriters
o 4) Section 15 o f the 33 Act gives liability to anyone who is controlling. Section 405 –
controlling means anyone who can influence things. It does not have to be 51%, it can be
anyone who seems to be able to influence the company.
- Founders, Officers, Inhouse counsel who is also a director
- Escott v. BarChris Construction
o They sued the CEO, the CFO, outside directors, in-house counsel (also a director)
o Say Megacorp owns 70% of BarChris stock. – they can probably be sued because they
are probably a control person of the company.
- Why have a list of people who can be sued rather than an open ended standard?
o Reduces uncertainty. Arguably, you are creating more deterrence by being clear.
o What about attorney’s and suppliers to the company? The list appears to cover the key
gatekeepers. In that way, we avoid lawyers and suppliers having to do a complete audit
of the company to ensure they are covered w/ Section 11 liability. This would add
excessive costs to the process.
- There is an affirmative defense that people knew that the misstatement was made. This is virtually
impossible to prove.
- Everyone has a due diligence defense except the issuer.
- There is a different standard of care for experts and non-experts.
- Why not have strict liability fo r everyone? Why just the issuer?
o In the BarChris case, how does the court describe the financial state? By the time they
are sued, they are bankrupt. Therefore, who is the most attractive defendant? One reason
not to have strict liability is to protect the deep pockets if they weren’t in a position to
protect against the fraud.
o Facts: they were creating bowling allies. There were too many bowling alleys and they
started losing money. The registration statement falsely represented that all loans to its
officers had been repaid, and offering proceeds. There were misstatements in both
expertised portions and non-expertised portions.
o Issue: all the defendants tried to use the due diligence defense against Section 11
o Rule: The court applies the reasonable investigation standard to determine whether each
individual followed due diligence.
o Russo – CEO – why couldn’t he sustain a due diligence defense? Russo knew all the
relevant facts and could not have believed there were no untrue statements in the
Philip Larson Page 34
Intellectual Property: Class notes
o Kirchner – CFO – same as CEO. He knew everything.
o Birnbaum – he is found liable for all of the non-expert ised portions.
o Auslander – This is the “Johnny come lately” – regarding the non-expertised portion, the
court said that he didn’t do any investigation and that a prudent man would not act in an
important matter w/o knowledge of the relevant facts, in sole reliance on these strangers.
o Grant – He is an outside director, but he is also a partner in the outside counsel and more
is expected of him. Regarding the registration statement, he is one of the drafters of the
document. The court almost applies a special scrutiny to him. Is this inconsistent of the
court to disregard Auslander’s lack of knowledge but then look to Grant and say he had
all this special knowledge regarding the non-expertised portion.
Is there an inconsistency between Auslander and Grant? It can be reconciled
because neither of them really did anything. No investigation.
o Underwriters and Coleman – they did not make a reasonable investigation of the truth
of the portions of the prospectus which were made on the authority of Peat, Marwick, etc.
as an expert. Therefore, they were liable for the expertised portions of the prospectus.
o Peat, Marwick – peat, Marwick d id not establish due diligence either. They did not
have to make a complete audit but they shouldn’t have
- HYPO: gingko is being sued under Section 11. Why not sue Michelle? She is the CTO and the
CTO is not on the list. Therefore, even though Michelle is culpable for being a convicted felon, he
is not liable under Section 11.
o Non-expertised porti on – (M ichelle was convicted of securities fraud)
o Expertised porti on – (overstated earnings)
- Hoolihan securities reviews the registration statement, reviewed the bios and asked to make sure
everything was okay, and they checked out the numbers.
o Underwriters probably won’t be liab le for the non-expert ised portion.
o Underwriters are probably fine on the expert ised portion as long as they looked over it to
- Drink Risk, has a partner on the board, he’s aware of the extra earning but CEO tells him they
don’t have to be disclosed.
o Expertised portion – expert tells them it doesn’t have to be disclosed. They may be in
pretty good shape. They are a control person (40% stock and a partner on the board).
o Non-expertised portion – they should be fine if they know nothing about Michelle.
- damages are laid out
- difference between offering price and either 1) value at time o f suit, 2) resell p rice if sold before
the suit, or 3) resale price
- D’s are joint and severally liable. You can sue anyone of them.
- A few special rules
o Underwriters can’t shift everything to the company using indemnification policies.
Therefore, Underwriters can’t use this to shift all liability to the company. Th is is void as
a matter of public policy.
o The underwriter’s liability is capped at their allotment (if there are mu lt iple underwriters)
o Outside directors only have proportionally liab le.
LOS T CAUS ATION
- Section 11(e) – people can reduce damages by showing that some reduction in price was caused
by something else.
- HYPO: I purchase 100 shares of Gingko at $20 and it goes down to $1 0/share? $1000. What are
damages if t wo months after the IPO I sold them to someone else for $30/share? Nothing. For the
person who bought them at $30/share, how much can he get if it falls down to $10? The only thing
you can get is the difference between the offering price ($20). Damages are capped out in the
offering price. What if you sold to someone at $15/share (below the offering price), I can sue for
$5 and the other person could sue for $5 as well. $1000 is still the damages. Therefore, the
maximu m damages never go above the $1000. What if I sold them at $5/share? I could sue for
$15/share, even though the damages are $1500, and the other person couldn’t sue for anything.
Philip Larson Page 35
Intellectual Property: Class notes
The D’s are going to claim that $10 is the true price and say that you can’t go after the $5. Even
though the statute allows it.
Lost Causation defense – term in statute says “value” not “market price”. The statute doesn’t equate
these. Therefore, people can argue that the market price and the value are not the same. What loss was
caused? They look at the events that have occurred. Looking at the overall market and how other markets
like ours. Akerman v. Oryx – argument of experts for what causes the markets. In Ackerman it was early
recognition of revenue making it look like the company was growing faster than it was. The court said this
was barely material and might have been an innocent mistake. It also rejected the studies as unreliable.
- Was the court’s reasoning persuasive? Not really, the court shouldn’t have been asking if it was
innocent. This is irrelevant to a Section 11 claim.
Fraud in Connection wi th Purchase or Sale of a Security
- Rule 10 b-5: main provision for punishing misinformation and fraud in connection with securities.
It generally p rohibits using instrumentalities of interstate commerce (e.g. mail, media) to defraud,
make materially false/misleading statements/omissions, or engage in fraudulent/deceptive
o Interpretation: courts typically consider 10 b-5 in light of Securities Act § 17(a)’s
parallel language and the Exchange Act § 10(b)’s broad mandate to punish “any
man ipulative or deceptive device or contrivance” “in connection with the purchase or sale
o Most frequentl y litigated: this is the most frequently litigated provision of the securities
laws because it is widely applicable to many types of deceptive claims, and b/c it is
enforceable by an imp lied private right of action as well as by SEC enforcement actions.
o Usually settle: securities cases usually settle, especially class actions
Class started (p629) – why need the rule?
- Rule 10 b-5: bars using instrumentalities of interstate commerce 1) to employ any device, scheme
or artifice to defraud, 2) to make any untrue statement (or omission) of a material fact, or 3) to
- History of 10 b-5:
- Why is deception a bad thing?
o It could be used to facilitate insider trading.
o Protect the integrity of the markets.
o We have a mandatory disclosure scheme. If they are allowed to lie, it affects the market.
- What about secondary markets?
Texas Gul f Sul pher
- Rule: A false or misleading statement/omission violates Rule 10b-5 if made by a device
reasonably calculated to cause investors to buy/sell securities, even absent scienter or
simu ltaneous securities trading.
o Insider tradi ng: even though there wasn’t insider trading, this doesn’t matter.
o Unintenti onal reci pients of misinformation: (e.g. investors) have standing. The
statement need not have been made with the purpose of influencing investors.
- Arguments: asdf
o SEC argued: press release painted a misleading and deceptive picture of the drilling
o TGS argued: press release could not violate Rule 10b-5 because 1) it was not issued “in
connection with the purchase or sale of any security, 2) had no effect on share price and
was not intended to assist insider trading, and 3) was not deceptive.
- Rationale: TGS put out an affirmat ive, overt act (press release) that was materially misleading
(and they knew it to be misleading), that was reasonably calculated to cause investors to buy/sell
Philip Larson Page 36
Intellectual Property: Class notes
- Notes: who got defrauded? Anyone that would have bought or sold based on the press release.
While each sentence may not be misleading, the release as a whole was misleading.
o Why are most securities fraud brought as class actions? An individual investor
doesn’t have incentive to bring the case. Typically they are brought as class actions.
Amalgamating all the investors into a group makes it easier to make it financially worth
o Express Private Right of Action: this action is not granted by the rule. It is judicially
o Research analysts: they can be liable for misstatements they make, part icularly if they
are in the pockets of the companies. E.g. the analysts might deliberately lie in order to
beef up the stock prices. They were liab le for 10b-5 things. Are we really trying to get at
research analysts or just the companies? There is no bar to bringing an action against
third parties. They have more defenses and varied defenses, but they can still be sued.
o Ds: usually officers and directors of the corporations.
Why don’t you just sue the company? You don’t want to bankrupt a viable
company. You want to hurt the bad seed, which are the people putting forth the
informat ion. Most 10b-5 actions are settled – therefore, the net effect to the
company is often the same because it is paid by the company. There has to be
scienter and intent. Therefore, in a 10b-5 claim you have to go after these
people b/c they had to act with fraudulent intent. It’s never the company alone
that is sued. You have to tag someone with fraudulent intent.
- Policy considerati ons:
o 1) Integrity of the information entering the market
- Why have pri vate rights of action?
o SEC may not be good at enforcing.
o SEC might take the funds they obtain and put them in the federal treasury rather than
compensating the investors themselves.
o Private actors have their own incentives to police, part icularly the SEC’s limited
o This was established in Kardon v. National Gypsum Co. (p637)
o “Private attorney general model” where you empower private citizens to enforce
regulatory actions. Usually, there is some toehold in legislative system. However, there
seems to be a thin read for why Congress intended a private right of act ion.
- Isn’t this double recovery?
o Investor’s may actually be getting back more than there losses.
o The typical settlement is about 10 cents on the $1. Therefore, this would be a pretty
theoretical than a practical argu ment.
o Transaction costs – there are double the defense costs, etc. If you have to do depositions
with the SEC and then do mo re depositions with a private class action, there is double the
work. If the SEC has done all the hard wo rk, how can the lawyers demand their big
settlement fees when most of the work has already been done.
- Companies are more cauti ous:
- READ: ENRON: THE SMA RTEST PEOPLE IN THE ROOM.
o Enron claimed they were fo llowing the accounting rules. (duck is yellow, with a beak
and has webbed feet. Paint a dog yellow, put a beak on him and gave him webbed feet).
- Problem: If on settlement day, you are holding stock, there will be a cost to you. You might see
shares distributed in the company, etc. Who pays the freight? The people who are still the o wners
of the company. Th ink about the environment where co mpanies are afraid to make mistakes. Is
that how we want people to operate. The goal is the creation of more information. If we punish
people for speaking, we may have less speech.
- You can have concurrent, cumulative claims.
- Secion 27 of the ’34 Act assumes only federal courts have jurisdiction over these actions.
- This is almost exclusively a federal systems.
Philip Larson Page 37
Intellectual Property: Class notes
“The 10b-5 Daily”
- devoted to security class action.
- EXAM QUESTIONS – PROBABLY TAKEN FROM THE BLOG.
- The US is very unique by having the class action system we have. Particularly unique in the
securities context. We have been the venue of choice. German investors that invest in Deutche
Teleco m would sue them here in the US based on its listing on the NYSE. There are a lot of
foreign co mpanies that are on the US Exchanges. There are a nu mber of Israeli co mpanies that are
listed EXCLUSIVELY in the US (on NASDAQ).
- South Korea (notorious for accounting fraud) has passed a securities class action regime.
- Germany is also looking at class actions because Deutche Telecom engaged in accounting fraud
and there have been 7000 indiv idual claims.
o Therefore, even if they encourage frivolous suits, at least you won’t have 7000 indiv idual
- US Plaintiff firms have many connections to foreign investors. In turn, there seems to be some
cross pollination where US Plaintiff Firms are teaming up with lawyers internationally.
- this is a good snippet.
- There are Enron’s and WOrldcom’s, but there are not 210 of them per year, wh ich is the typical
filing rate per year. Therefo re, there is some disconnect b/w the big frauds we hear about and the
fact that there have been some 2000 cases in the last 10 years.
Co mmon elements
- some truth being revealed, some effect on the stock price.
- A financial restatement – you are basically ad mitting that your previous statement was false. You
are basically ad mitting a material misrepresentation.
- 89% of cases last year involved financial misrepresentations. Stock price drop comes along with
- Insider trading during the class period. Un loading their personal shares.
- If you see this in a fact pattern, it is more likely a suit will be brought. It will be easier to show
- If you see these three factors, there is a very high likelihood of someone bringing suit.
o 1) insider trad ing
o 2) financial restatement
o 3) so me effect on stock price.
Standing to Sue
- Who has standi ng to sue? You don’t have
Blue Chi p Stamps v. Manor Drug Stores
- Rule: Ps who have been dissuaded from purchasing or selling securities by misrepresentations do
not have standing. It cuts out the whole class of people who could easily say they would have
bought the stock but for the misrepresentation.
Cowin v. Bresler
- Issue: Can a P who has not sold or purchased securities sue under Rule 10b-5 for an injunction?
- Rule: Reaffirms the ru le in Blue Chip saying they can’t even have standing to sue for injunctive
- Hel d: No. Ps that have not purchased or sold securities cannot sue under Rule 10b-5, even for
- Rationale: Congress said it is limited to fraud “in connection with the purchase or sale of a
security.” Adopting a wider conception of standing would imp roperly expan d the statutes’
intended scope. They were also bound by the SC hold ing in Blue Chip (Ps who were dissuaded
fro m purchasing/selling securities lack standing).
Philip Larson Page 38
Intellectual Property: Class notes
Deutschman v. Beneficial Corp. (held that options traders should have standing even though they haven’t
bought or sold the stock. They are not mere speculators contributing nothing. P647)
Internati onal Brotherhood of Teamsters v. Daniel ( interests in pension plans that are noncontributory
and involuntary are NOT securities) – typically, the claims are not as large and involve claims of breach of
- EXAM: if you are evaluating a security, and it is a pension plan, it might not be a security.
However, that won’t necessarily mean there won’t be a class action filed.
The practical e ffect of the start of discovery is typically a settlement. Co mpanies are less inclined to pay
the expensive discovery costs.
- Half a percent of cases filed will actually go to trial. Why is this so lucrative? Because settlement
values are so high.
- Because there is no discovery process off the bat, you may go a year or mo re with nothing but a
motions practice including a motion to dis miss, etc. A typical case may go several years before
going to discovery. Therefore, these cases can really be long and drawn out.
- Meeting most of the Rule 23 requirements for class actions is pretty straight forward.
- Opting in and opting out; what is the requirement …the class certification is not usually up front.
After the mot ion to dismiss part, that’s usually when the class certification is done. You also have
to see if there was an efficient market for the stock. If not, then the market wasn’t taking this
informat ion and plugging it into the stock price. What does a P have to show to prove that the
market was efficient enough for a class action lawsuit to make sense? This all co mes up under
class certification. Then, only then, do you have the opt in versus opt out requirements.
SCIENT ER REQUIR EMENT
- Another significant li mitati on on P’s to succed i n cases.
- Scienter Definiti on: a mental state embracing the intent to deceive, manipulate or defraud” and or
actions “other than in good faith.”
Ernst & Ernst v. Hochfel der (accountants’ negligence in overlooking client’s securities embezzlement is
insufficient for 10b-5 liability.)
- Why didn’t they just sue the guy involved in embezzlement? He died, and the co mpany went
bankrupt. Therefore, they sued the auditors.
- Issue: is negligence enough scienter for a 10b-5 mot ion? No, there was no intent to deceive.
- Note: Section 11, of the ’33 Act has a Negligence standard. 10b-5, there must be desire to mislead
or knowledge there is deception. Most courts demand some showing of severe recklessness, or an
extreme departure fro m ord inary care. They should have known, or should have known.
o Intent: usually when you intend, this judicially created realm of recklessness, is not
inevitable. It is judicially created and sewn into securities law. Th is is judicially created
law, particu larly in the area of securities fraud.
o Recklessness: is recklessness the appropriate standard?
o NegligenceRecklessnessKnowledgeIntentional Action
- Historically, for fraud, we would typically draw the line at knowledge. Prior to the PSLRA, and
even afterwards, there was an active debate about where this line would be drawn.
- Note, Congress has also created a safe harbor for forward looking statements. This is based in
statute. Therefore, if you use puffery or give forward looking statements, you are probably
protected. Another question is whether the person relied on his lawyer. Therefo re, somet imes
getting the advice of counsel is evidence that he was not being reckless. Can you sue the lawyer?
Not well litigated …Ho w far does the string of liability go?...
Duty to Disclose
Tie up loss causation and (we’ll skip most of the PSLRA stuff).
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Intellectual Property: Class notes
Exam: three questions and three hours. Open book exam.
1) heavy policy question
2) exhaustive coverage of the offering process. E.g. what happens when offerings go wrong. How
things might happen with litigation.
3) 10b-5, fraud “fiesta”
- we talked about loss causation. Tonight, we want to talk about measure of recovery and
remedies. P’s want to maximize recovery. The enactment of the PSLRA means that there are
incentive issues b/c maximizing attorney fees may be d ifferent than incentives to maximize for P.
- ’34 Act § 28 – you can only recover actual damages. Not punitive damages.
- Normal 10b -5 does not provide disgorgement. You can’t get your money back if the co mpany
didn’t benefit fro m the fraud. Disgorgement only applies where the company made a profit. If it
appears the actions weren’t intentional you get out-of-pocket damages. (difference b/w X and X-
- In a closed corporation, if I misrepresent the future prospects of the company and as a result you
sell me your shares at a lower price, Rowe
- Disgorgement is remedial, not punitive.
If there are no punitive damages, how else do we deter fraud? Criminal charges, additional civil litigation,
and enforcement suits from the SEC.
Rescissionary measures – give the stock back.
Restitution – variation on disgorgement
Unjust enrich ment – P’s will say they are penalized by D’s who are being unjustly enriched.
Contract damages – usually in closed corporation situations (When you see an “orange groves” type case
that involves “what is a security” you will o ften also have a situation involving rescission or K damages)
Who is liable for primary and secondary securities fraud?
- accountants, lawyers and investment bankers benefit fro m Central Bank .
What does the SEC th ink?
- SEC still has aiding and abetting. They can still go after the accountants, lawyers and investment
- SEC wants to be able to deter the repeat players. There is a deterrence value. The SEC is arguing
that the SEC should have this authority. In the PSLRA, the SEC is
Policy pieces on broad secondary liab ility vs not
- reasons broad secondary liability is good
o 1) p rovide compensation for investors
o 2) fairness – D’s had control and benefited fro m the fraud (fees, etc.)
o 3) p recautions gives incentives to take worthwhile precautionary measures. These third
parties are often best positioned to monitor and manage risk.
o 4) incentives to get liability and risk management in p lace.
- Reasons against having secondary liability
o 1) d ifficu lt to say they are a willing participant.
Wright v. Ernst & Young
- Rule: court refused to follow the “substantial participation” test but rather created a bright line
test in which primary vio lators must actually make a material misstatement or o mission in order to
be liab le.
Why are control persons liable but secondary actors aren’t? Why are CFOs liable but not the lawyers and
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Intellectual Property: Class notes
- the policy reason is not necessarily clear. Ho wever, the answer is clear. That’s what the statutes
say. §20(a) says control persons are liab le and the SC said that secondary actors aren’t liable for
aiding and abetting. Central Bank of Denver If there is no 10b-5 claim, the § 20 claim will have to
fail as well. Remember this fo r the exam.
1) Who is bringing the claims? SEC (there is aiding and abetting), private suits (no aiding and
2) Are they a primary v iolator? Only if they have a statement.
3) Did they substantially participate in the fraud?
4) Are they secondary actors? There are a lot of cases worth putting in your outline.
5) Are they control persons? These will be senior emp loyees and directors.
6) Are there other claims (like § 11)…Is there aiding and abetting liability under that claim?
a. There is aid ing and abetting under other claims.
b. Attorney’s, investment bankers, etc. run them all through this.
- Thus far, we talked about securities, how they are created, what they are, and how they are sold.
- For the most part, the last few weeks have been about private enforcement. Private lit igation
reform act (even though they may be public securities). Typically, they are looking for damages.
They bought the stock, it went down, they were defrauded, they want X-Delta in damages.
Tonight, we talk about public enforcement of securities laws.
DOJ does not have to tell you they are targeting you for investigation.
SEC does not have to tell you they are targeting you for investigation.
If the SEC does tell you, there is a question about whether you should file an 8k.
The SEC and DOJ share in formation freely. These guys cooperate regularly. Practical consideration: when
they are cooperating and the DOJ has brought a criminal indict ment, the mo ment they are convicted, the
insurer flipping the bill for their defense, is going to stop paying the bills. Therefore, the Ds will have an
acute interest in how the cases proceed. If you get convicted by the DOJ, you aren’t going to get funded in
the SEC. If you are criminally convicted, we won’t insure fraudsters.
- In the context of an SEC investigation, frequently the DOJ and SEC cases will proceed in tandem.
DOJ may sit in on SEC depositions, etc.
SEC has two mechanisms to enforce securities laws:
1) administrative proceedings – SEC is setup with 5 co mmissioners. Admin istrative proceedings
SEC can act as both prosecutor and jury. The co mmissioners are kept apart fro m the prosecutorial
staff. SEC can also bring civ il actions.
2) Civil proceedings –
DOJ – criminal prosecutions are not typically about fin ing people. They are about sending people to jail
based on willful acts. The mens rea is higher under the criminal things tried by the DOJ. DOJ brings
- RICO: 20 years ago you would get a RICO claim whenever a securities clas s action was filed.
They could get three times the damages.
- PSLRA got rid of RICO fo r private claims. PSLRA was meant to get rid o f strike suits.
- You can be civilly liable under RICO if you are convicted in the criminal trial.
These three trials can take place at the same t ime.
P v. Co mpany/Executives
SEC v. Co mpany/Executives
DOJ v. Executives.
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Intellectual Property: Class notes
When you get
P: what are you going to allege? You see a RICO claim? We don’t give whether there is a criminal
prosecution? Ask yourself if there was, because
The SEC has broad admin istrative powers – they can impose disciplinary sanctions against broker dealers,
they can execute them over mun icipal dealers, and gov’t dealers. They have oversight over the regulatory
process and the SROs and rulemaking. E.g. SEC could bring a case against a company saying they violated
a NYSE o r NASD rules.
Unless the SEC says so, and agrees, the DOJ case can’t go along with that. Under Section 21(g ) of the ’34
Act, cases can’t be consolidated unless the SEC consents.
- SEC has limited resources. One of its regulatory functions is to encourage companies to self
report to ensure efficient markets. You can incent companies to self report.
2001 W L 1301408
p775 they lay out the Seaborg factors…
Creating incenti ves of self reporting
Factors to consider in determin ing whether to take enforcement action or lesser actions against the former
controller. The SEC did not bring an action against the company because of the steps and measures the
company took. What are the factors of whether to use leniency? Seaborg factors determine whether SEC
should be lenient. The DOJ has a separate memo with similar factors that determines whether co mpanies
should be charged with white co llar crimes.
1) what is the nature of the misconduct? Did it result fro m honest mistake, simple negligence,
reckless or deliberate indifference, willful misconduct or unadorned venality? Were the
company’s auditors misled?
2) How d id the misconduct arise? Is it the result of pressure placed on employees to achieve specific
results, or a tone of lawlessness set by those in control of the company? What compliance
procedures were in place to prevent the misconduct now uncovered? Why did those procedures
fail to stop or inhibit the wrongful conduct?
3) Where in the organizat ion did the misconduct occur? How high up in the chain of co mmand was
knowledge of, or part icipation in, the misconduct? Did senior personnel participate in, or turn a
blind eye toward, obvious indicia of misconduct? How systemic was the behavior? Is it
symptomatic of the way the entity does business, or was it isolated?
4) How long did the misconduct last? Was it a one-quarter, or one-time, event, or did it last several
years? In the case of a public company, did the misconduct occur before the company went
public? Did it facilitate the co mpany’s ability to go public?
5) How much harm has the misconduct inflicted upon investors and other corporate constituencies?
Did the share price o f the company’s stock drop significantly upon its discovery and disclosure?
6) How was the misconduct detected and who uncovered it?
7) How long after discovery of the misconduct did it take to imp lement an effective response?
8) What steps did the company take upon learning of the misconduct? Did the company immediately
stop the misconduct? Are persons responsible for any misconduct still with the company? Are
they still in the same positions? Did the company pro mptly and co mpletely d isclose the
informat ion to the public?
9) What processes did the company follo w to resolve many of these issues and ferret out necessary
informat ion? Self policing.
10) Did the co mpany commit to learn the truth, fully and expedit iously? Did it do a thorough review
of the nature, extent, orig ins and consequences of the conduct and related behavior? Did outside
people participate in the rev iew? Learn from its mistakes.
11) Did the co mpany promptly make available to our staff the results of its review and provide
sufficient documentation reflecting its response to the situation? Did the co mpany identify
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Intellectual Property: Class notes
possible violative conduct and evidence with sufficient precision to facilitate pro mpt enforcement
actions against those who violated the law?
12) What assurances are there that the conduct is unlikely to recur? Did the co mpany adopt and
ensure enforcement of new and more effect ive internal controls and procedures designed to
prevent a recurrence of the misconduct? Did the company provide our staff with sufficient
informat ion for it to evaluate the company’s measures to co rrect the situation and ensure that the
conduct does not recur?
13) Is the company the same company in which the misconduct occurred, or has it changed through a
merger or bankruptcy reorganizat ion?
The SEC likes to see the silver bullet document because it means they have a plan in place to self regulate.
What is the SEC’s view of the SOL? SEC argues that there aren’t statute of limitat ions and that having
them would be a conflict of interest with their goals of making the markets work effectively.
DOJ – care about punishment. retribution and punishment
SEC – care about the markets. ensuring efficient markets
P – care about the people. getting paid damages for co mpany’s misconduct
- broad injunctive authority – must be for continuing or prospective behavior. standard for SEC is
that it shall appear to the commission that any person is engaged or is about to engage in
standard for injunctive relief – likelihood of irreparable harm
SEC gets the facts considered in light most favorable to them. What this means is the SEC alleges high
probability and high harm, they are likely to get the benefit of the doubt. They will get reasonable
inferences. It will be hard to oppose a preliminary injunction by the SEC for this reason. They get the
facts in the light most favorable to them and therefore it is difficu lt to fight a preliminary in junction.
In addition to injunctive relief, courts and the SEC have provided additional ancillary relief (e.g. addit ional
reporting, disgorgement of profits, etc.). If the court can fashion an equitable remedy or the SEC proposes
one, they may be able to get it. So me o f these ancillary forms of relief have been sanctioned by courts and
the SEC because it makes the market mo re efficient.
Bar orders can be both on the administrative side and civil side. Civil penalties are also available on either
side. The SECs authority
What is the difference between formal and in formal investigation? In formal investigation, SEC has power
When an informal investigation by the SEC is going on, does the company have a duty to disclose this to
the market? This is a thorny issue. Somet imes you should, sometimes you shouldn’t. The company
should file an 8-k. The SEC can call witnesses, subpoena them, under a formal investigation. This
happens after they look at documents.
Last day of class
The problem with Carpenter is it disincentivizes gathering information and using it. We want people to go
out and talk to companies. RegFD prevents getting some of this type of informat ion.
Duty: is there a duty to abstain or disclose?
Misappropriation: is there some kind of duty they are violating by using the informat ion.
Philip Larson Page 43
Intellectual Property: Class notes
Anyone you do business with, you can get an NDA in p lace.
- Carpenter – outsider trading case. It is not tipper/tippee liability. It is not an investment banker,
an accountant, or anything else.
- Factual continuum:
o § 16 - o fficers, directors, beneficial owners of 10% or more o f the stock they must
abstain or disclose. The SEC requires they disclose. Form 4 requires continuous
disclosure. Form 5 requires annual disclosure.
o Attorney, investment bankers, accountants – are they fiduciaries? Yes. They are in a
position of trust. You automatically are for any information you’ve gotten from your
clients. What about informat ion you get that is not from your clients? Maybe not.
o Doctors, psychiatrists: doctors and psychiatrists have a duty not to act on information
they get from their clients. What about nannies? Doctors and psychiatrists are further
removed fro m the issue but are also people who work everyday in a situation where they
are expected to observe confidence of informat ion. Th is is different than the nanny. We
want to think (it’s just the nanny…)
o Janitor, etc: Just overhearing something is not enough.
o SEC Hat : when it looks like the person with the informat ion was in a position of trust and
they knew or should have known
o *********Look up Rule 14e3************:
- Misappropriation theory:
- Chiarella v. US – when one tells someone else something, that information is not confidential.
Just because I share with you doesn’t mean you have a duty to limit how you use that information.
The reason officers have a duty is because they are fiduciaries of the company.
o Rule 14e3 – today, Chiarella would be based under this rule which manages tender
Scale fro m real insiders over to real outsiders.
Also think about tipper/tippee questions. Don’t think about them on this continuum. When you analyze
tippee liab ility, just analyze it based on where the information came fro m.
Dirks – what is the key piece about this fiduciary relationship?
US v. O’Hagan – partner in a law firm was hired to represent Grand Metropolitan PLC
Is the use of nonpublic information in and of itself a v iolation? No. You have to have a duty for there to be
When one trades, do you have material nonpublic information?
HYPO: I call my bro ker and say I want to sell 1M shares in 30 days. Then, I find out some nonpublic
material informat ion. Do I have to stop the trade? Traders cannot
10b 5-1 – no liab ility for sales contracts, etc. entered before the insider acquires the information even if the
- it must have the amount and the price. It must have a written formula that says the amount and
price and it must prevent the person from having any other influence in how it is decided. (e.g.
fire and forget).
PSLRA – strong inference of scienter -
I didn’t have knowledge to act on the material nonpublic informat ion.
10b5-1 pl an – slo w and steady wins the race. A plan showing consistency and a desire to diversify. If you
create a plan and automatically reduce your shares by 50% and then the stock drops, are you safe?
Philip Larson Page 44