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					   [4](1): Asymmetric Information in Markets

• Seller offers to sell his shares of a corporation, but for what reason?
   – Cash for consumption, paying off debts, or reinvesting in other assets
   – Or knows that the corporation’s earnings will decline (asymmetric information)
   – Buyer should adjust his offer to buy downward to take account of the latter
• Buyer offers to purchase shares of a corporation, but for what reason?
   – Investing excess cash
   – Or knows that the corporation earnings will increase (asymmetric information)
   – Seller should adjust his to sell upward to take account of the latter
• Inefficient Market - mutually beneficial transactions will not occur
   – Some buyers would be willing to pay a higher price
   – Some sellers would be willing to sell at a lower price
   – Thus, some transactions will not occur

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                 [4](2): Asymmetric Information
                     Lessons for Securities Markets
• Markets are less efficient at determining prices
   – Wider bid-ask spreads
• Investors without confidential information will exit the markets
   – Fewer small investors will participate in the markets
• Market price will be determined the bids and asks of investors with
  non-public information
   – Only investors who believe they have better non-public information will trade
• Participating investors will focus on obtaining better non-public
  information
   – Investors will focus less effort on assessing public information




     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                      [4](3): Common Law Fraud
• Knowing (scienter)
   – Economic loss (contracts): Intentional or reckless disregard for the truth
   – Personal injury or property loss in some states: Negligent disregard for the truth
• Misrepresentation
   – Untrue statement
   – But can be an omission from a statement which makes the statement misleading
        • When the person making the statement has a fiduciary duty
• of a Material Fact
   – Fact is important to a reasonable person considering the transaction
• which induces Reasonable Reliance
   – reliance might be unreasonable if there is easy access to the truth
• and causes Damages
   – actual damages such as economic losses, and possibly punitive damages
     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
[4](4): Non-Disclosure in Securities Markets

• Fiduciary Duty
   – Board of Directors and Management to shareholders and market participants
• Breach of Duty
   – Failure to disclose material information
   – Important for a reasonable person in making decisions to buy or sell shares
   – Plaintiff would not have traded and experienced a loss from trade
• Standard: Intentional and Gross Negligence
   – Liability for intentional deception: actual knowledge that statement is untrue
   – Liability for reckless disregard of material facts and the duty to disclose
   – Some states find liability for negligent disregard of material facts
• Damages: rescission or actual damages (out of pocket loss)
   – punitive damages for intentional deception

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
       [4](5): Securities Exchange Act (1934)
• Section 10(b) and Rule 10b-5
   – Section 10(b) provides the SEC with power to regulate securities markets
   – Rule 10b-5 makes it unlawful to make an untrue statement of a material fact or
     to make an omission of a material fact which makes a statement misleading
• Section 14(a) and Rule 14a-9
   – Section 14(a) provides the SEC with power to regulate proxy solicitations
   – Rule 14a-9 prohibits false or misleading statements of a material fact in a proxy
     solicitation, or an omission of a material fact that would make a current or past
     proxy solicitation false or misleading
• Section 14(e)
   – Section 14(e) provides the SEC with power to regulate tender offers
   – Section 14(e) makes it unlawful to make an untrue statement of a material fact in
     the context of a tender offer, or an omission of a material fact which makes a
     statement misleading
     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                            [4](6): SEC Rule 10b-5
• Rule 10b-5: Employment of Manipulative and Deceptive Practices
   – It shall be unlawful
   – (1) To employ any device, scheme, or artifice to defraud
   – (2) To make any untrue statement of an material fact, or to omit to state a
     material fact which makes a statement misleading
   – (3) To engage in any fraudulent act, practice, or course of business
• History of Rule 10b-5 (1942)
   – Originally designed to filled a gap in the SEC Act (1934) to cover misleading
     statements by a purchaser, rather than a seller, of securities
   – Adopted in response to the case of a corporate president telling shareholders that
     the company was doing badly in order to purchase their stock at low prices
   – Now a catch-all rule against fraud and fraudulent practices that affect
     participants in securities markets

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                 [4](7): Violations of Rule 10b-5
• Creates Duty for Board of Directors and Management to the
  participants in securities markets, not just shareholders
   – Criminal Liability: SEC and Department of Justice
   – Civil liability: Damages for market participants who incurred an economic loss
• Criminal Liability for “willful” violations: 15 USCS 78ff
   – Intentional violation: actual knowledge that statements are untrue or misleading
• Civil Liability: 15 USCS 78r
• What is the minimum standard of care for breach of duty
   – Civil liability for intentional (willful) misleading statements
   – Circuit Courts agree on civil liability for reckless misleading statements
   – Supreme Court has ruled NO civil liability for negligent misleading statements



     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
  [4](8): Standing to Sue Under Rule 10b-5(2)

• Who can sue for damages (standing)?
   – Purchasers or sellers of a security
   – But NOT people who were mislead into not purchasing or not selling
• New Legislation on Class Action Shareholder Lawsuits
   – Private Securities Litigation Reform Act (1995): Section 21D
        • Rules for class formation and selection of attorneys to represent the class
        • Pro rata division of recoveries and settlements
        • Court approval of attorneys fees
   – Securities Litigation Uniform Standards Act (1998): Section 27
        • Class action lawsuits based on securities fraud must be filed in Federal Courts
        • Preempts lawsuits in state courts




     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                  [4](9): Penalties and Remedies
                       Under Rule 10b-5(2)
• SEC Penalties for violations
   – Injunctions against future violations
   – Criminal penalties for willful violations (enforced by Dept of Justice)
        • Corporations: criminal fines up to $25 million
        • Individuals: criminal fines up to $5 million and prison up to 20 years
   – Civil Penalties for willful violations (enforced by SEC action)
        • Corporations: civil fines up to $600,000
        • Individuals: civil fines up to $120,000
• Civil Remedies for shareholders
   – Damages for purchaser = (purchase price - stock value at time of fraud) x shares
   – Reform Act (1995) limits damages for fraud
        • Stock value at time of fraud cannot be lower than the average stock price during the
          90 day period after misleading statement is corrected
   – No punitive damages (unlike common law fraud)
     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
               [4](10): Levinson v. Basic: Facts

• Combustion Engineering (CEI) wants to acquire Basic Inc.
   – Private negotiations begin in 1976 and continue through 1978
   – Unusually high trading volume of Basic stock each year
• October 21, 1977: Basic publicly announces that:
   – “the company knew no reason for the stock’s activity and that no negotiations
     were under way with any company for a merger”
• June 7, 1978: CEI offers $28 per share for Basic
   – Negotiations continue, and stock price of Basic rises
• September 25 and November 6, 1978: Basic issues press releases
   – “management is unaware of any present or pending company development”
• December 19, 1978: Basic announces acceptance of the offer by CEI
  to acquire Basic’s stock at $46 per share
     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](11): Levinson v. Basic: Lower Courts
• What did the District Court decide?
   – Grants defendants (Basic) motion for summary judgment
• The merger negotiations were NOT material facts because they were
  not destined, with reasonable certainty, to become a merger agreement
  in principle
• What did the Sixth Circuit Court of Appeals decide?
   – Reversed grant of summary judgment and remands for trial
• Denying the existence of merger negotiations is a material misleading
  statement if merger negotiations are occurring, even if the
  negotiations would not have been material facts in and of themselves
• Supreme Court accepts appeal of the grant of summary judgment
   – Conflicting decisions by the Circuit Courts of Appeal

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](12): Levinson v. Basic: Lower Courts
• What did the defendants (Basic) argue?
• “Agreement-in-Principle” Test
   – Merger negotiations become material ONLY when the corporations have
     reached an agreement-in-principle to merge
• What are the arguments in favor of this test for materiality?
   – (1) Prevent investors from being overloaded with information
   – (2) Maintain secrecy in order to improve bargaining position
   – (3) Bright-line rule clarifies the corporate duty
• What does the Supreme Court think about these justifications?
   – Rejects all three because the purpose of securities laws is disclosure of
     information to investors



     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
   [4](13): Levinson v. Basic: Supreme Court

• What is the Supreme Court’s interpretation of materiality?
   – Adopts the factual test from TSC Industries v. Northway (1976)
   – TSC involved a proxy solicitation
• Material fact is a fact for which there is a “substantial likelihood” that
  a “reasonable investor” would consider it “significant” or “important”
  in deciding whether to purchase or sell a security
• Facts are more likely to be material when
   – (1)   Higher probability of occurrence:
       •   How serious are the negotiations?
   – (2)   Greater magnitude of the event:
       •   What is the potential impact on market value of the corporation?


     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](14): Levinson v. Basic: Implications
• Agreements in principle are clearly material, and should be announced
• When do friendly merger negotiations become material facts?
   – Suppose one corporation does not have an interest in a merger
        • Phone inquiries from investment bankers are not material facts
   – Suppose both corporations are interested, but no negotiations have yet occurred
        • Probably not material facts since agreement may not be “substantially likely”
   – Suppose the corporations engage in serious negotiations
        • Serious negotiations are material facts because they become “substantially likely”
        • Corporations cannot deny the negotiations
• But can corporations remain silent about merger negotiations?
   – Omissions violate Rule 10b-5 only only when a statement becomes misleading
   – Supreme Court does not create a general duty to disclose material facts
        • There may be legitimate business reasons for secrecy (see footnote 17)

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](15): Disclosure of Merger Negotiations

• Consider the following difficult examples:
• Suppose the corporation made prior true statements that it was not
  interested in being acquired or merging, but it is now engaging in
  merger negotiations?
   – How long ago was the previous statement?
   – How important is secrecy in the merger negotiations now?
• Suppose the corporation made no statements, but the business press is
  reporting rumors that merger negotiations are in progress?
   – Where did the rumors begin? With corporate employees?
• Suppose the corporation made no statements, but that there is heavy
  trading volume in the stock of both corporations?
   – Is the trading being done by insiders or their tippees?

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](16): Levinson v. Basic: Implications
• Agreements in principle are clearly material, and should be announced
• When do friendly merger negotiations become material facts?
   – Suppose one corporation does not have an interest in a merger
        • Phone inquiries from investment bankers are not material facts
   – Suppose both corporations are interested, but no negotiations have yet occurred
        • Probably not material facts since agreement may not be “substantially likely”
   – Suppose the corporations engage in serious negotiations
        • Serious negotiations are material facts because they become “substantially likely”
        • Corporations cannot deny the negotiations
• But can corporations remain silent about merger negotiations?
   – Omissions violate Rule 10b-5 only only when a statement becomes misleading
   – Supreme Court does not create a general duty to disclose material facts
        • There may be legitimate business reasons for secrecy (see footnote 17)

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](17): Levinson v. Basic: Reliance
• The Supreme Court also addressed the issue of “reasonable reliance”
• What is the “Fraud-on-the-Market” Theory?
   – All investors who traded during the period from the time the false or misleading
     statement was made to the time is was corrected, are presumed to have relied on
     the misleading statement
   – Reason: market is reflecting the public information or misinformation
   – No need for each plaintiff in the class to prove individual reliance
• But this theory of reliance is a “rebuttable presumption”
   – Defendant can prove that individual plaintiffs did not rely
        • Plaintiffs knew the true material facts or traded for some other reason
   – Defendant can prove that the market price was not affected by the false or
     misleading statements
        • Enough participants knew the true facts so that the market price was not affected

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](18): Liability for Corporate Advisors
               Under Rule 10b-5(2)
• Can corporate advisors violate Rule 10b-5?
   – YES, if they intentionally (or recklessly) make false or misleading statements
     that they know the corporation will then use to defraud purchasers or sellers of
     securities
        • Accountants can be liable for statements in audits
        • Attorneys can be liable for statements in opinion letters
   – YES, for aiding and abetting the violations of the corporation if they knowingly
     provide substantial assistance to the corporation in making false or misleading
     statements (Reform Act (1995): see 15 USCS 78t(e))
• Remedies and Penalties
   – Damages for shareholders in suits against corporate advisors
   – Reform Act (1995) allows the SEC to bring criminal actions against persons
     who aid and abet violations of the securities laws


     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
                           [4](19): SEC Rule 14a-9
• Creates Duty of Board of Directors and Management to Shareholders
   – For false and misleading statements in proxy solicitations
   – Supreme Court allows private shareholder lawsuits
• Standard of Care
   – Circuit Courts agree on civil liability for intentional and reckless misleading
     statements or omissions
   – Some Circuits (2nd NY and 3rd PA) allow civil liability for negligence
• Opinions and Projections
   – Not misleading if adequately and prominently qualified
   – Can be misleading if not believed OR lack a reasonable basis in fact
• Merger example of false and misleading statements
   – Price and method of payment (bonds or stock) is “fair”


     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
           [4](20): Section 12 of Securities Act
• Civil Liability for false and misleading statements in prospectuses
   – Liability if know (intentional) or should have known (reckless)
• Safe Harbor for forward-looking statements: Reform Act (1995)
• What is a forward-looking statement?
   – Projections of revenues, income, earnings, capital expenditures, dividends, etc.
   – Plans and objectives, or future economic performance
• No civil liability for forward-looking statement IF
   – (1) identified as a forward-looking statement
   – (2) accompanied by meaningful cautionary statements
   – OR if plaintiff fails to prove actual knowledge by the officer that the statement
     was false or misleading



     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
            [4](21): Trump Securities Litigation
• Trump issues $675 million in first mortgage bonds (1988)
   – Purchase Taj Mahal Casino and complete construction
   – Interest rate on bonds = 14% (high grade corporate bonds = 9%)
• False Statement?
   – “The Partnership believes that funds generated from the operation of the Taj
     Mahal will be sufficient to cover all of its debt service.”
• Disclaimers and Cautionary Statements: “Special Considerations”
   – Success of Taj Mahal will depend upon financial, business, competitive,
     regulatory, and other factors, as well as prevailing economic conditions
   – Taj Mahal has no operating experience and is twice as large as any existing
     casino in Atlantic City
   – Casino win in Atlantic City will decline after Taj Mahal opens
   – Risks from delays in construction or obtaining operating licenses

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
     [4](22): Trump Securities Litigation

• Bondholders sue under Section 12 and Rule 10b-5 when they discover
  that Trump Partnership plans to declare bankruptcy
   – Argue that Trump has no reasonable basis for his prediction that Taj Mahal can
     cover its debt service
   – Argue that the cautionary statements and disclaimers were inadequate
• 3rd Circuit Court (1993) rejects civil liability
   – Trump prediction is not a material misleading statement
   – Because Trump made clear and substantive cautionary statements
        • cautionary statements were more than vague or blanket disclaimers
   – Reasonable investors should view these bonds as risky
        • High interest rate clearly reflects the risks
   – “Bespeaks Caution Doctrine”: potentially misleading predictions are not
     material if they are adequately qualified

     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry
         [4](23): Forward Looking Statements
• When does a failure to update forward-looking statements violate
  Rule 10b-5?
• SEC interpretation: Duty to correct prior statements
   – When the corporation knows or should know that persons continue to rely on the
     prior statements
   – (1) that have become false and misleading by subsequent events
   – (2) that are later discovered to have been false and misleading
• Example: updated earnings projections




     Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

				
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