Securities Regulation Flashcards
Background
In securities transactions, info = ?
Junk?
what is the key method of securities laws?
info = $$$
* Investors with an informational advantage (e.g., insiders of the company) can earn systematically higher returns from their trades with uninformed investors.
Key method → Encourage full disclosure
* Whatever you are selling, just be sure that you’re disclosing all of the material facts about it! You can sell absolute junk as long as you disclose that it is junk.
You just need to disclose, so that people who are investing know the risks that they’re taking.
* In general, the riskiness of a security is not grounds for the issuance of a stop order. Federal securities regulation is a disclosure-based regime, not a merit-based regime. Issuers can sell extraordinarily risky securities as long as they disclose all required/material facts about the security.
Background
Securities?
NOT Securities
* E.g., Money in the bank account and Real estate
Security
* Common Stock: residual, can receive dividends (but typically do not (Tax consequence). If unhappy with that, elect a new board! HA! (passivity of dispersed shareholders)
* Preferred Stock: Start-ups, Older companies in need of cash infusion. Contracts for rights. Higher liquidation preference than Common
* Bonds: Loans by investors to corp. Maturity, Principal, and interest payments. Priority over equity.
Zero Coupon Bonds
* sold at a discount rate relative to the principal amount of the bond. At maturity, bondholders receive full principal amount.
Background
Benefits of the Capital Market
Most securities transactions take place through organized markets with the assistance of professional securities markets intermediaries (i.e., broker-dealers).
Provide investors with: Liquidity and Transparency
* Without organized markets, individual investors wanting to sell a security may spend a lot of time and money finding an investor willing to purchase.
* Intermediaries may also assist in creating liquidity, standing in to purchase/sell securities when other investors are unwilling.
* Info on trades (and offers) of other investors also flows more easily. Transparency allows investors to determine the best available price for their desired transactions.
Active SM helps issuers in the primary market – why?
* It makes the stock more valuable because for the person who buys it to sell it and turn into cash without having to spend a lot of time
Background
Primary transaction
directly from issuers
Investment banks (aka broker-dealers)
* firm commitment v. best efforts
* how do they make money?
Brokering
* means that you are not buying and selling on your own account – You are bringing together two parties
you take a fee for bringing them together, but you’re not taking any risk yourself.
Dealing
* means that you are buying and selling on your own account
When they are underwriting securities, this is the primary transaction.
* They are standing between the issuer and investors.
* So the investment banks are always going to be involved in this initial sale from issuers to investors.
Firm commitment
* They actually agree to buy the shares in the initial public offering on their own account. So this involves some risk and then immediately turn around and resell (IPO)
Best efforts
* They do not promise to buy the shares, they will broker the sales, they will facilitate the sales and move the shares from the company to the investors
make money on bid-ask spreads
Background
Secondary Transactions
Liquidity
* Active secondary market allows investors to resells securities both quickly and at low cost
Transparency
* the market will reflect the best available price for a particular security.
POLICY
* Investors who can rely on a liquid and transparent secondary market in which to resell their securities will be more willing to purchase securities from issuers in the primary market.
* Without the prospect of a strong secondary market, issuers face considerable difficulty in selling securities to investors, who will demand a substantial “illiquidity” discount.
Background
What risks matter?
what do investors demand? diversification? Beta?
Investors demand compensation for increased risk
(Undiversified, risk-averse) investors will prefer a “safe” investment over a “risky” investment with the same expected return
Diversification helps:
* The category of risks that can be reduced through diversification of investments is called “unsystematic risk” (PROF: “idiosyncratic”)
* Other risks cannot be so easily reduced through diversification. Known as “systematic risks.”
Invest half in each company – the magic of diversification
High beta means highly volatile. The relationship between a stock’s performance and the market performance is measured by “beta.” High betas indicate more systematic risk and correspondingly a greater discount rate.
Background
incentive to provide information?
maybach in yellow envelope
So long as anti-fraud liability lends credibility to a company’s disclosures, a higher value company will want to disclose its inside info to investors when offering securities (otherwise, there is no way to differentiate from the lower valued companies).
* Once one company begins disclosing, investors, if rational, will reduce the value they assign to the companies that opt for silence.
* Among those companies that remain silent, those at a higher end of the valuation spectrum will then have added pressure to disclose their value to investors voluntarily
Background
Why might good companies NOT disclose information voluntarily?
- Might not plan on issuing securities any time soon
- CL Anti-fraud liability may not provide sufficient credibility to disclosures and it is not perfect so incentive to lie and then other companies exit capital markets all together –> Lemon markets
- Managers may profit from a less than fully informed securities market (if the public knows less, easier to do insider trading).
- Firms have incentive to NOT disclose to competitors.
Background
Argument for Mandatory Disclosure
SEC job of bolstering cap formation CAP-DC
Voluntary disclosure has some incentive, but it is not perfect.
Coordination problems
* Need to be able to compare company disclosures; much easier if the information (and format) is standardized
Disclosure plays a large role in controlling agency costs within large public corporations
* disclosure of exec compensation might help shareholders stop them
A positive externality may occur when a company makes a firm-specific disclosure to the public market place. 3rd parties unconnected benefit from these disclosure in two ways:
* More disclosure will increase the accuracy of securities prices.
* Firm-specific info may prove useful to competitors and other third parties → incentive to underproduce…
Duplicative Research
* Mandatory disclosure may short-circuit socially wasteful winner-take-all competition to uncover information…
Note: disclosure is not cost-free!
* Risk of forcing companies to spend lots of money on disclosure that’s not cost-justified
* TCJA
SEC has 3 missions – one is bolstering capital formation, is it possible that some measures aimed at protecting investors might bolster capital formation?
* investor protection can build investor confidence, making it easier for issuers to raise money from investors.
Background
Does anyone actually read the disclosures? Most do not spend time reading, so does this even help?
How does disclosure matter?
* Inform the process of pricing securities. More info = better estimate to price the security.
Argument:
* No, disclosures are meant to help the average investor. But only the sophisticated investor reads so they have a great advantage over the average investor.
Counter-arguments:
* Rely on professionals to help you. Brokers, mutual funds, etc., incur all the costs that the average investor can rely on.
* Investors obtain information indirectly through the recommendation of various intermediaries (“filtering mechanisms”)
* Benefit from the info indirectly if the info is incorporated into the stock market price for securities that trade in an “efficient market.”
Background
The Efficient Capital Market Hypothesis
The ECMH posits that the market price of an actively traded security will incorporate information related to the security.
* the notion of market efficiency (in the ECMH sense) loses its force outside of liquid secondary markets in which fungible securities are traded.
* The weak-form of the ECMH (which is presupposed in the semi-strong form) holds that one cannot predict tomorrow’s price movements based on recent trends – this is the notion of a random walk
Weak form efficiency
* The current market price of security reflects information found in all past prices for that security.
* If this is true, investors cannot earn greater than normal returns based on a security’s past price patterns.
Semi-strong form efficiency
* Builds on the weak version, incorporating a broader range of information all relevant publicly available information.
* It is not that market will be this or not, it is about HOW quickly and accurately prices reflect new information (HOW semi-strong)
Strong form efficiency
* Posits that the stock market price of a company incorporates all information, whether or not it is public. Most agree this is false.
Implications
* Securities regulators have been influenced by the notion that investors who do not read a particular piece of company info may nonetheless “indirectly” receive it b/c the stock market price incorporates the information. See Fraud on the market.
If strong = true, then the price of securities trading in that market is always “right” even if someone is trying to commit fraud!
* Fraud is private info, but that would be reflected in this form
* But then this would make mandatory disclosure and anti-fraud measures entirely superfluous!
Background
Why place any limit on disclosures?
CEC-HPC
- Can become too costly
- Expand scope of legal liability – can be expensive given risk of frivolous suits. Constantly doing disclosures = more likely to make mistake
- Too much info can confuse investors
- Some disclosures may harm shareholders – e.g., secret product launch
- May create perverse incentives for companies to avoid “paper trails”
compliance burdens that don’t pass the cost-benefit test could dissuade issuers from trying to raise money in public markets
Materiality
Why do we care?
there is no single bright-line test for materiality.
- free standing duty?
- Golden rule?
- misstatement/omission?
Rule 10b-5 and some other rules require MATERIALITY
* So if there is an misstatement or an omission, it will only give rise to Rule 10b-5 liability if it was material
Note: For 10b-5 purposes, pure omissions cannot give rise to liability
* The court said an omission is actionable only if you can point to other things that you said that are misleading because of this omission.
BUT → No general, free-standing duty to disclose material facts but may arise from:
* From making an affirmative statement that is materially misleading –> Once you’ve started talking, you have to provide enough information such that anything you said does not mislead the public.
* From the affirmative disclosure obligations of the securities laws
OTHERWISE SILENCE IS GOLDEN
Materiality
RULE
What someone considers material is different than someone else
* But we prefer standards over rules → Bright-line rules will be over- and under-inclusive
- Information is material if there is a substantial likelihood that the disclosure . . . would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available.” .
Substantial likelihood?
* No too low of a threshold – small likelihood that the investor would care
Reasonable investor?
* Objective standard
Total mix?
* The information has to be assessed relative to other information that is already available to the investors
Materiality
Reasonable investor
Reasonableness? and Evidence issue?
US v. Litvak → Reasonable investor
* the question of materiality is a mixed question of law and fact that should ordinarily be determined by the fact finder, but that is frequently ignored
Facts
* Alleged misstatement? → Price misstatement
Reasoning
* Reasonableness ⇒ objective standard
* Standard may vary however with the nature of the specific market
Evidence issue: How does testimony of traders in the market bear on a test for “reasonable investor”?
* we’re not going to judge what a reasonable investor thinks based on the mistaken beliefs of the worst informed person in the market.
- They need to show some nexus between the trader’s testimony and the mainstream thinking within that market
- Everyone in your market knows you do not have agency relationship
- Because admitting Norris’ testimony–that he thought that there was this relationship of trust–that was his own point of view ⇒ Impermissibly prejudiced the fact finder’s view. Belief that Litvak was agent → objectively unreasonable
Materiality
Forward-looking information
Facts and what did they do wrong? Reasoning and test adopted?
Basic v. Levison → Forward-looking information
* what could have basic done?
Facts
* There were three public disclosures by basic denying that they were in merger negotiations.
* S/h: We would have not sold and waited to find out if merger was going forward and mergers are always at a premium and we missed out on a potential payday
Reasoning:
* Probability x Magnitude test
* Materiality will depend at any given time upon a BALANCING of both indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.
What sorts of factors does the Court cite as relevant to assessing probability?
* Indicia of interest (e.g., Board resolutions, instructions to investment bankers, actual negotiations)
What factors are relevant in assessing magnitude?
* The relative sizes of the companies and premium that might be offered to one company over the market value
There’s no free standing obligation to disclose material information. BUT once you start talking, you’re not allowed to say things that could mislead people as to the material facts. They kept denying the merger.
What could Basic have done?
* “It’s our company’s policy that when asked about this specific type of topic, we do not provide a comment.”
Materiality
Total Mix of Information
Facts and reasoning?
Fan v. Stonemore → Total Mix
Facts:
* Fan (P) and other members of the plaintiff class sued StoneMor (D) alleging that StoneMor (D) committed securities fraud by failing to inform investors about its business practices.
* Issued non-GAAP financial statements and held these to be revenue
What events led to the lawsuit?
* Press releases about their financial health that did not go into the borrowing
* At a later press release, they had to do a restatement – which is a big deal for companies because it is saying oops we messed up
Reasoning:
* Court held not materially misleading
* So basically all the material facts that the plaintiffs were alleging were needed to make the statements that were made not misleading – they were already out there – already disclosed
Materiality
Puffery
Court:
* The court says at one point → vague and general statements about optimism (puffery) are not actionable because they are not material
Where do you draw the line though?
* Generally, once you put numbers on something, it’s not going to be treated as puffery
* The more kind of factually verifiable it is, the less likely it is to be puffery.
Emphasize: to the degree you’re saying things that, you would expect people to be able to empirically verify, the less likely it is to be puffery.
* we’re so committed to being one of the leaders in cyber security vs. we are the 2nd best → One is easier to empirically verify
* See Google case where generic statements removed infra
Objective Tests of Materiality
Quantitative rule of thumb:
Stock price movement the same thing?
5% of ___ (Earnings? Revenues? Assets?)
* If more, default is materiality
* If less, look to qualitative factors
Stock price movement % is a separate issue from 5% quantitative analysis of company’s financials
Should we compute the 5% rule of thumb as a percentage of the income? Or the Revenues? Or Assets? Profits?
* if it’s only 2% of earnings, it’s going to be even smaller as a percentage of revenues and as a percentage of total assets.
Objective Tests of Materiality
Quantitative rule of thumb:
More - CCC
qualitative factors?
qualitative factors?
* Mask unlawful transactions or conduct?
* Relate to a significant aspect of co’s operations?
* Lead to a significant market reaction upon disclosure?
* Hide a failure to meet analyst expectations?
* Change a loss to income or vice versa?
* Affect compliance with loan or other contractual requirements?
* Affect management compensation?
[Note: the list is non-exhaustive!]
Objective Tests of Materiality
How does it work?
BLACKSTONE CASE
Litwin v. Blackstone Group → objective test?
Facts
* Blackstone knew of some of their business segments that weren’t doing well. They did not disclose that to their investors
* Why did s/h sue? The fund’s performance is driven by how well the portfolio companies perform. So how the portfolio companies are doing is relevant to shareholders
* Generally no duty to disclose BUT → REG S-K “Describe any trends or uncertainties that . . .
Reasoning
* District court dismissed → It’s only 4% of their total assets! Not material.
* REVERSED ⇒ If you are over the 5%, safe bet it will be material ⇒ Under it, you should go look at the qualitative factors
Court focused on
* Importance of corporate private equity to Blackstone’s business
* Masking of change in earnings or other trends
* Effect on management compensation
Another approach to determining materiality
In re Merck & Co.
Wall st Journal case
Let the market do the work for you → look at stock price reaction
* Not straightforward (e.g., when did the information hit the market?)
* Stock price movements are relevant insofar as a court relies on an event study to determine materiality
Facts
* Their revenue recognition policy was exposed by Wall St. Journal and not by them → They’re reporting copayments of their customers as their own revenue
* What happened on April 17? → there was a 10K where they gave some OPAQUE disclosures but didn’t fully disclose the amount of payments recognized.
* What happened on June 21? → WSJ expose
* What happened on July 5? → Revised S-1 and corrected it
Reasoning
* Held that first, opaque disclosure included all the information necessary for analysts to determine its significance
* No drop in share price → therefore, not material | it increased!
WSJ → made stock price drop
* Court refused to recognize that as an indicator of materiality, reasoning that the relevant info had already been incorporated into the stock price → drop from some other factor!
Is the presence of securities analysts covering Merck relevant to the materiality determination?
* Yes, because that actually bolsters the view that this was an efficient market, which bolsters the view that this is information that was already out there
* EMH analysis here kills them
Another approach to determining materiality
Event Studies
look at market reaction to news to determine materiality?
* [Only works for stocks traded in relatively efficient markets]
* [Very common approach in 10b-5 class action lawsuits → battle of experts]
* Determine “event date” (e.g., disclosure of bad news) and event window (e.g., 1-3 days) then look at Beta
* Courts will often accept this as prima facie evidence of materiality
[Again, other factors that may undermine result (in one way or another):
* Leakage, confounding disclosures!!!!!! → this is important
Statistical Significance?
Zicam Case
Rule?
Facts
* What are the material omissions alleged by P? The link b/w Zicam and losing sense of smell
* Matrix argues there is no statistical evidence showing our product does this
What is the evidence that connects Zicam with the loss of sense of smell?
* Several doctors reported that patients lost sense of smell
* Doctor was going to present results of studies showing link and other evidence
Reasoning
* In determining causal link between drug and alleged side effect, lack of statistical significance is relevant but not dispositive on the question of materiality
* Medical professionals and regulators look to other factors, so reasonable investors may, as well
Supreme Court said no bright line rule, but if you did show a statistically significant relationship, then that’s likely enough
Cybersecurity Materiality?
Google hack case
Often material
Facts:
* User trust/privacy = critical to Google
* Big data privacy leak around Google+ BUT Form 10-K disclosures → They were talking about the risks of data security breaches in the 2017 form. They were very general – “big issue in the industry”
* What did Alphabet say about the 2017 form 10-K risk factor disclosures in the two 2018 Form 10-Qs at issue in the case? They said no material changes
Materiality of omissions? Yes, in the total mix of information, this is something that investors would have wanted to know.
* Fact finders could reasonably conclude that the discovery of the “Three-Year Bug” did involve a material change
What about the other alleged misstatements in the complaint?
* Not materially misleading → Basically, they didn’t say that there was no material change (KEY) → You can still kind of speak in broad terms. Puffery etc
* And that is not as problematic in the same way as pointing to a generic forward looking statement and saying no material change.
Management Integrity
In the Matter of Franchard Corp.
Facts and Reasoning
Reg S-K requires lots of disclosures re: management, e.g.:
* business background, compensation, transaction
Steve Job’s illness, should it be disclosed?
* Obviously highly material
* my sense is that if you have not made affirmative representations about an executives or directors health, then SEC won’t bother you
Glickman’s “withdrawals”
* Required corrective disclosure b/c (a) it’s a form of compensation (loans at below market rate) and (b) affirmative statements indicating cash flows went in the other direction
Bears on Glickman’s
* competence (running other business into the ground)
* integrity (secret; below market rate)
* incentives (creates conflict, e.g., w/r/t cash distribution policies)
Glickman’s pledge of shares
* Required corrective disclosure b/c default would mean Glickman would lose control of company – and shares were sold based on his reputation and assumption that he would retain control
How can his withdrawals, which accounted for less than 1.5% of the gross book value of the registrant material?
* gives valuable information to investors about his personal integrity and his ability to manage it well.
* It says something about his financial state as well, and everyone is investing in Glickman.
* Created conflicts of interest
SEC declines to federalize state corporate law fiduciary standards re: Board of Directors == S/h generally cannot sue for failure disclose a breach of fiduciary duties, except:
* Cases of outright fraud or total abandonment of duties
* Cases where affirmative representations are made by which the performance of the directors may be measured
What is a Security?
If we did not have a catch all term?
For us = Note, Stock, Investment Contract (catch-all term)
It would be easy for lawyers to evade securities regulation by structuring identical sorts of investments
* So one of the uses of investment contracts is to say we are going to ignore legal forms and look at this transaction as a whole, get to the economic substance and determine whether it is a security
Howie, for example:
* They would basically be establishing a precedent that you could divide up a transaction into separate parts and evade the securities laws if court ruled differently
What is a Security?
“What is a security?” = “Do the Securities laws apply?”
what does it mean that Securities laws apply?
If the securities laws apply:
* there are heightened anti-fraud protections.
* Registration requirements = If you’re selling a security, you have to either register it with the SEC (big, long, time-consuming, expensive) OR you need to find an exemption from registration requirements
* Disclosure requirements
* Federal enforcement (SEC & DOJ) & Fed Jxn
If not security → easy the law do not apply
Investment Contract
Rule?
Whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others
* A person invests his money
* In a common enterprise
* Is led to expect profits; and
* “Solely” from the efforts of the promoter or third party
Emphasize substance over form →The economic reality matters more than the form → Regardless of legal terminology in which such contracts are clothed
SEC v. W.J. Howey Co.
oranges! Plus twist on fact pattern – if service contract from unaffiliated money in exchange for oranges 50/50
Strips of land from a warranty deed coupled with an option to enter into a service contract.
* Howey co is saying buy the land and we will then you can enter into the service contract with us, and the service contract gives us a lease on the land for ten years, and we will harvest your oranges.
So is this something covered by the securities laws?
* Each of those by themselves? NO. Both of these are not enumerated in the statute
* combining them together? YES
Result?
* Investment of money? YES
* Common enterprise? YES → there were lots of people investing, pooling money and sharing profits pro-rata
* Expectation of profits? YES
* Efforts of others? YES
What if the service agreement was offered by unaffiliated, with services traded for oranges 50/50? Would service agreement by itself be a security?
* Probably not, the key issue being → the service contract involves an investment of money on its own? NO just the contribution of oranges BUT investment does not need to be money
try this = How close is this to the capital markets?
* If you weren’t doing this, would there be resources flowing into the capital markets in some other respect? And if you’re only looking at the oranges by themselves, that would be a very hard argument to make ⇒ What’s your contribution here? Oranges. If you didn’t enter this service contract, are we confident that you would have sold the oranges and used the money, for example, to invest in Microsoft?
Does it matter that the service contracts were optional?
* The Court says no ⇒ It suffices that all the necessary ingredients were offered!!!!
* Here, they offered them together and it didn’t make sense just doing one
* You need to look at the economic realities
A Person Invests his Money
Rule
Investor must choose to give up a specific consideration in return for a separable financial interest with the characteristics of a security
* Consideration need not be cash
Employee’s choice had a PRIMARY PURPOSE w.r.t the “entire transaction”:
* make an investment? or something else?
A Person Invests his Money
Pension case
International Brotherhood of Teamsters v. Daniel
This involved what’s called a compulsory non-contributory pension plan.
* When you get the job, you’re part of a pension plan, whether you like it or not, and you don’t see anything come out of your paycheck.
* generally, it’s an implicit part of their overall compensation package and here they have to do 20 years continuous service
THIS IS NOT INVESTING MONEY
* So you must choose to give up some specific consideration or some tangible item – what was Daniel’s choice in this case?
* He chose to take the job – so it was to take the job or not take the job → He did not have any choice other than that, w.r.t the pension plan
* SO the choice was to accept the job for which the pension plan was a “relatively insignificant,” non-optional part of an “indivisible compensation package” → SO Daniel’s decision to work does not satisfy the investment of money prong
We have an alternative regulatory scheme!! ERISA covers pensions!
Why don’t the employer’s contributions satisfy this prong?
* The contributions that the employer made were not keyed to any specific employees and they weren’t key to any amount of benefits that an employee would get.
What about “efforts of others” prong?
* Where would the entrepreneurial effort lie?
* With the funds managers but the court says most of the income for the pension plan is from employer’s current contributions – a source in no way dependant on the efforts of the Fund’s managers
How close to capital markets? meaning if you made a different choice, would there be money flowing into capital markets?
* So if there were a voluntary contributory pension plan that you opt into → court says we think that is a security → if you did not opt into it, it is plausible you would invest it in an IRA or mutual fund
* If mandatory noncontributory → your alt is to take another job and there’s no reason to think that you would necessarily by taking the other job take a bit of the money and invest it on your own in securities markets
IN A COMMON ENTERPRISE
Rule
Ponzi Scheme
* a scheme where early investors are paid off not because you’re actually running a productive business of any type, but because you’re able to raise new money and pay off the original investors.
Horizontal: Pooling of assets & sharing by investors in profit/risk
* Court adopts this → correlation of returns if things go bust is enough to satisfy test → Ponzi scheme
Broad vertical:
* well-being of all investors is dependent on promoter’s expertise
Narrow vertical:
* investors’ fortunes “interwoven with and dependent upon the efforts and success of” the promoters or third parties
note that in SG, the returns to the various investors in this stock market game could be wildly disparate depending on what choices they make
* but the court nevertheless holds that horizontal commonality is satisfied because they share in the risk
IN A COMMON ENTERPRISE
SEC v. SG Ltd.
Facts
* fantasy investment game that had a virtual stock exchange. One of those companies had a 10% return per month promise → Somebody who offers you a 10% return per month on a sustainable basis is lying.
* Puffery? NO, you put a number on it.
Reasoning
* Emphasize substance over form!!
* Even if somebody calls it a game, and even if there’s clearly an entertainment motivation, you still have to go through the Howey analysis.
* LOOK AT WHAT THE MARKETING MATERIALS ARE TELLING YOU!!! OBJECTIVE TEST
* Gets remanded → needs to go back down and determine whether the primary motive was consumption or profit making → but given marketing material → probably met = strong arg that profit was enough of a factor
Common Enterprise
* Horizontal met
* Court adopts this → correlation of returns if things go bust is enough to satisfy test → Ponzi scheme
“IS LED TO EXPECT PROFITS”
Rule
Profits:
* means you’re expecting capital appreciation
* OR participation in earning/distribution in profits
What about investments that promise a fixed return?
* These can count as profits
Consumption or profit motive here?
* Key: “the inquiry is an objective one focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant” Telegram.
* So looking at the marketing materials is always going to be central and in a kind of standard Howey analysis. Telegram.
“IS LED TO EXPECT PROFITS”
United Housing Foundation, inc. v. Forman
Facts:
* A co-op in NYC → The point was to encourage private developers to build this co-op housing but they’re basically getting the right to live in the housing → So it is a security deposit basically and it gives them dibs when the housing becomes available
Reasoning: expectation of profits?
* Capital appreciation impossible here because you’re contractually obligated if you no longer want to be part of this, to sell your stock back to the co-op for the same price you pay for it
* rental reductions from income and tax deductions and then savings from subsidized housing would do it → NO does not meet participation in earning/distribution in profits – far too speculative and insubstantial – not the things we would consider profit
P argues it was stock because that is what is was named:
* Label probative but not dispositive
* None of the usual characteristics of stock
* Right to receive dividends, ability to appreciate, negotiability, pledge-ability, proportionate voting rights….
CRYPTO
Are cryptoassets securities?
apply Howie!
Bitcoin not a security
* No “central third party whose efforts are the key determining factor in the enterprise”
Tokens or coins or cryptocurrency issued to support projects MAY be
CRYPTO
Telegram
Facts
* Two transactions → So initially the transactions were an interest in grams (the tokens) → Once the whole blockchain was developed. Those initial purchasers would then sell it to like the general market.
* Part 1 = security | Part 2 = consumption → So basically this token, once it’s out there, is going to be used as a medium of exchange on this Telegram network. Use it to consume! Not hold and make money!
Reasoning
* The gram purchase agreements and the future delivery and resale of grams are viewed in their totality for the purpose of the Howey analysis = look at the economic reality and we see this as a single transaction
Howie
* Investment of money? YES
* Common enterprise? Their money is pooled and going to be used to develop the business. So horizontal → pooling & correlation = coin fails they fail
* Efforts of others? YES = Investors relied entirely on telegram to make grams viable as a cryptocurrency and to allow them to resell at a profit
Expectation of profit? Consumption or profit motive here?
* “The court finds that, at the time of the 2018 Sales to Initial Purchasers, a reasonable investor would have purchased Grams with an investment intent” | Factors:
* Size and concentration of initial purchases [they did not intend to use Grams as a currency substitute]
* Lock-up for first round [no one would agree to extended lock-up if they were buying a substitute for fiat currency]
* Note → Telegram’s marketing material included statements that Grams were not investment products and buyers should not expect future profits
Treatment of Partnership interests
In general:
General? Limited? member LLC? manager LLC?
General partnerships interests → there is a presumption it is not a security
* Does not pass Howey test on the efforts of others prong
Limited partnerships interests → generally presumed to be securities
* Rebuttable → The most common way would be to show that the limited partner was not solely or primarily relying on the efforts of others.
LLC interests?
* Member-managed = general partnership
* Manager-managed = limited partnership
Three-factor test to rebut the presumption of General Partnership
* The partner has little power in his/her hands
* The partner is inexperienced or knowledgeable in business affairs
* The partner cannot replace the manager of the enterprise or otherwise exercise meaningful partnership powers
Non-exhaustive, and the presence of any one of them is sufficient to rebut the presumption
Treatment of Partnership interests
Avenue Capital Management II, L.P. v. Schaden → LLC
Facts
* Quiznos was going under but there were two investment funds – Avenue and Fortress, both had equity – suing because they claim Quiznos misrepresented their financial standing
* Manager-managed LLC so we start with a presumption that this is like a limited partnership and likely to be securities
Reasoning
* Relying on others? Avenue arg = They do not have control of profitability, access to all information (did not know how bad the financial condition was) →This is manager-managed! There are people running it on our behalf!
Court
* You hired managers! Including the CEO!!
* You also have the power to amend the LLC agreement
* You are sophisticated investors, you know what you are doing and should have been able to supervise and ask for financial statements
* you chose 8 out of 9 managers so you had control of who was running the LLC → You can fire them anytime you wanted
Control is absolutely essential here
* Being sophisticated is not enough on its own – You absolutely need to combine that with actually controlling the enterprise
STOCK
Rule
Sale of business doctrine
* If you buy an entire business, the sale of business doctrine says it doesn’t matter how you structure it, it’s not a security.
If it’s called stock and has the characteristics typical of stock, it’s a security
* Dividends, appreciation, transferability, votes
* [Note: you don’t necessarily need all of them]
Sale of all the stock of corporation → securities transaction?
“Sale of business doctrine”?
* Sale of entire business ≠ sale of securities
* Even if all stock
* Recall “unless the context otherwise requires” proviso at beginning of statutory definition
* SCOTUS rejects the sale of business doctrine
STOCK
Landreth Timber Company v. Landreth
The lumber company offered to sell what it called stock (this is in dispute here)
* before it manages to find someone to buy it, the lumber mill burns down and in need of serious repair
* promise that they’re going to rebuild the lumber mill that’s going to make profits, be worth the investment
* It was not rebuilt and eventually the buyers had to sell at a loss and they sue arguing the lumber mill stocks were securities under the Act = rescind the sale
How does the court kind of analyze the stock in this case?
* not only did you call it stock, but it has all of the characteristics
Court also rejects the idea of a single test to determine whether something is a security
* Any other result would make “the enumeration of many types of instruments superfluous”
Characteristics
* the right to receive dividends, the ability to negotiate (you can sell it), the ability to be pledged (use it as collateral), voting rights, ability to appreciate in value
Could have avoided this whole mess if
* You just sell the assets and literally the assets come with everything → avoid securities laws
NOTE
What are the typical characteristics of notes?
- Fixed, periodic, and certain interest payment
- Fixed maturity date
- No voting rights
- if there’s a default, it gives rise to a cause of action → You have a claim for a certain amount of money against the defaulting borrower.
NOTE
Reves test
Start with presumption that note is a security
* See if it “looks like” any one of a number of notes that are clearly not securities (Primarily notes executed in consumer or commercial context)
* If it does, then the presumption is rebutted → not a security
Factors for determining whether a note belongs on the rebuttal list:
* Motivation of buyer/lender (profit?) and seller/borrower (investment in growing biz vs. (e.g.) addressing cash-flow timing issues?)
* Plan of distribution (Common trading market? Offered and sold to a broad segment of the public?)
* Reasonable expectations of investing public (e.g., ads?)
* Presence of alternative regulatory schemes to protect investors?
Plan of dist.
* One is by showing that there’s an active secondary market, that anyone can just come in and buy it on the secondary market; OR
* It was offered to a broad segment of the public
* If it is like a single bank making one single loan → this will cut against being a security
Alternative regulatory regime/risk reduction?
* Here, the court said they were uncollateralized and uninsured and there was no other safety net
* Unlike the next case, infra, where the notes at issue were clearly regulated by federal banking regulators, these were issued by a co-op that was not subject to federal regulation.
NOTE
Reves v. Ernst & Young
Co-op case
So it was an agricultural co-op issuing promissory notes to members and non members of the co-op
* Reasoning: Security!
Motives of sellers (investment in growing biz v. e.g., addressing cash-flow timing issues) and buyers (profit)
* Here, we cut toward finding that it was a security because the people were buying the notes hoping to get some profit and the co-op was selling them to invest in there general business purposes (grow)
Plan of distribution
* It was offered to a broad segment of the public (second way) → there were tens of thousands people who bought
Reasonable expectations of investing public
* Part of it also asking what the kind of general understanding of the average person in this market would be
* Here, the court says there was a reasonable expectation
Alternative regulatory regime/risk reduction?
* Here, the court said they were uncollateralized and uninsured and there was no other safety net
Buyer/lender’s motive
* You ask what the person is going to do with it! → You do ask whether you’re relying on the efforts to be paid back but you’re not asking whether they’re using this to meet cash flow difficulties or investing in new factory
Borrower/seller motive
* Are they using this to invest in the business, basically grow the business?
* If, on the other hand it is more like a revolving line of credit to meet cash flow difficulties or to facilitate the purchase and sale of a minor asset or consumer good (Best Buy TV sale)
* And if it’s not being used to kind of invest in and grow the business it cuts against its being a security.
NOTE
Kirschner v. JP Morgan Chase Bank, N.A.
Millenium is this company and it issues notes, what did it do with the money it raised? It did a few things, but it was mostly paying off claimants.
* None of it was being invested in the business → It was all paying off debt and giving a return to shareholders.
What representations were made to lenders, and what representations did lenders make?
* They used “lender” many many times throughout the document (couple times said investor but vast majority said lender)
* if it’s not a securities-like transaction, you would virtually never call the lender an investor
Easy to sell?
* there were a couple restrictions: no natural persons, a certain amount, any assignment would be more than a million, or they needed their consent.
NOT A SECURITY
Motivations?
* there was mixed motivation, but they landed it mostly on a security motivation → close call but slight edge towards being a security
* Basically the borrower had a commercial, not an investment motive → paying off people, not investing and growing the business but the lenders clearly had a profit motive.
Plan of distribution? this cuts toward not being a security
* Not a broad enough distribution, it was not offered to the general public; the restrictions on reselling are significant enough that it is clear that this is not the type of distribution you would see for a note that is a security
Public’s reasonable perceptions? cuts against it being a security
* They were called lenders, they said they were sophisticated, they should have known this was not a security
Other risk reducing factors? cut against it being a security.
* Secured against millennium’s assets → collateralized → less likely to be securities
* There is an alternative regulatory regime that applies here at the federal level ⇒ Bank regulators
SECURITIZATION
Pooling of income streams and sale of interests in the pool
Fractional shares?
If interests sold are fractional shares of “profits,” use Howey test to determine if it’s a security
* So you buy a shit ton of auto loans → everyone who is paying off those auto loans → that money flows into this common pool
* People have bought interests in this pool and as the money flows in, it is distributed pro-rata to everyone who has invested
Will almost always turn on [managerial or entrepreneurial] efforts of others prong
It can be any income source
* Mortgages, credit card debt, student loans
If interests sold are debt instruments
General Idea?
If interests sold are debt instruments, use Reves to determine if it’s a security
* Pool income streams but then instead of saying we’re going to distribute everything pro-rata, you issue debt securities backed by the pool.
* In fact, this entire segment of the market tends to be referred to as asset backed securities (ASB)
* It will virtually always be a security under Reves
The general idea:
* As long as the payment, as long as the income flows aren’t correlated with each other, it really does work to say the first dollar flowing into this is almost certain to flow in
* We don’t necessarily know who it’s going to come from, but it’s going to come from someone.
* And the first at a claim on that first dollar is extraordinarily safe
Disclosure and Accuracy
Why not mandate disclosure for all companies?
Benefits v. costs
Only public companies are subject to mandatory reporting requirements.
Benefits likely less for smaller companies. Why?
* far fewer investors in a nonpublic company than in a public company – They will typically be insiders too
* VC context → institutional investors aka sophisticated → they can protect their interests
* Collective action problem is less
Costs – largely fixed; much more onerous for smaller firms
Disclosure and Accuracy
How do you become a public company?
If you have an IPO, you will meet all three triggers easily
Being listed on a national exchange (NYSE, Nasdaq etc)
* cannot transact on national exchange unless registered (= reporting company)
Over the counter stocks → need to meet two requirements
* Total assets exceeding $10M, and
* Class of equity securities held by at least 2,000 persons (or 500 investors who are not accredited)
Filing a registration statement under the Securities Act
* subject to Periodic filings and SoX but not subject to proxy solicitation, tender offer, or short-swing profit provisions of the Exchange Act
* For companies that are issuing or making registered offerings of debt securities
Consequences of public company status
* Section 13: Reporting requirements
* Section 14: Proxy/Tender offer rules
* Section 16: Short Swing Profit rules
* S-Ox Act Provisions
Once you’re public, is it possible to escape public company status?
need to check all three routes
Why would you want to?
* So that you would not need to disclose anymore! It is expensive to comply with these filing requirements → 10K, 10Q, the 8K
* Also you might not want to open up the company to the world at large
* Less legal risk of being sued!
Delist
12(g) (OTC) –> Two ways to deal with that
* The first is → bring the number of shareholders below 300 OR
* Get below 500 (so b/w 300 and 500) shareholders AND below $10 million in assets for three years
15(d) — filed registration statement
* Less than 300 shareholder & no earlier than the next fiscal year; OR
* Get below 500 shareholders AND below $10 million in assets for three years AND you have to wait at least a full year after your registration in order to no longer have to file periodic reports.
Regarding number of holders
* Example → microsoft is a shareholder of OpenAI, it has millions of shareholders
* We won’t use this in counting BUT
* If we think you’re creating a vehicle solely to get around this requirement, we won’t let you do it
Employee stock options → exempted
Form 8K
BOD-APC
A report is to be filed or furnished within four business days after the occurrence of the event, which triggers the filing requirement
* Bankruptcy
* If you enter into an off balance sheet arrangement
* National Securities Exchange lets you know that they are going to delist your security.
* Change in auditor and accounting firm → disclose why
* Previously issued financial statements should no longer be relied on
* Change in control/directors
Anything that the issuer thinks, at its option, would be of importance to SH
* That basically says that you’re not limited to these triggering events.
In the Matter of Stephen J. Easterbrook → issue with material misstatements
8k filing
Easterbrook was a former McDonald’s CEO and he had engaged in inappropriate personal relationship with an employee
McDonald’s filed 8-K disclosing that Easterbrook was terminated
* [This is required when a principal officer steps down] → but DID NOT need to say why → BUT they did (forgot golden rule)
Not disclosed:
* Fact that McDonald’s exercised discretion in not terminating Easterbrook “for cause”, allowing him to receive a severance package worth more than $40M
* Led to violation of proxy solicitation regulations → “Compensation Discussion & Analysis” was materially misleading
Not disclosed:
* Easterbrook himself violated, and caused McDonald’s to violate, various securities regulations requiring disclosures to be materially accurate and complete
Easterbrooks conduct was not illegal but did violate McDonald’s company policy. Does the lack of illegality make Easterbrooks conduct immaterial for investors?
* Basically, the fact that this was not illegal does not mean it was not material ⇒ Going back to chapter 2, management integrity is one of those qualitative points that is often highly material for investors
Other disclosure forms
Form 10K
* Tons of disclosure requirements
Form 10Q
* Basically your quarterly report = Less onerous ⇒ Biggest thing is you do not need your financials audited
S-oX section 302
* CEO and CFO must certify 10Ks and 10Qs
S-Ox purposes?
* Focus their attention on the need for accuracy in reporting
* Reduces their ability to claim ignorance if there is a material mist statement or omission in the periodic report
Disclosure of Cybersecurity → not materiality analysis, disclosure
In the Matter of Blackbaud, Inc.
Company disclosed breach, but erroneously claimed no one’s bank account info or social security numbers were compromised
* August 4th of 2020, they filed the 10Q but still didn’t clarify or didn’t disclose the scope of the attack.
* September 29th, they filed the 8K and finally informed their customers that bank accounts were released
Error found but not reported to officers responsible for disclosures = Did not go up the chain
Company liable for materially misleading periodic filings
* once they disclosed it, it had to be materially accurate and complete.
Company liable for failing to have adequate controls/reporting
* If you’re a public company, not only do you have to make these mandated disclosures, but you need to have internal control over what’s going on in your company to ensure that the disclosures are accurate
Executive Compensation and Disclosure
Disclosure required for public companies’ CEOs, CFOs, and three other highest paid executive officers
Must disclose compensation, including:
* Bonuses, stock, and options-based compensation
* If stock was “in the money” when issued
* Retirement benefits
* Golden parachutes
* Perks
Emerging Growth Companies
Provides for ECGs to face lower compliance burdens for up to five years after going public
* Reflects recognition of trade-off in disclosure requirements
The more you require to disclose, the more that you require expensive third party auditing type of things
* Thus, the harder it is to be public, the more expensive it is to be public, the less attractive it is to be public.
Accuracy
FCPA §13(b)(2)(A) → requires public companies to keep accurate books and records
- No scienter requirement → STRICT LIABILITY provision
- No materiality requirement with respect to the requirement to keep accurate and fair reflections of transactions
- “In reasonable detail”
FCPA §13(b)(2)(B) = looks at the processes that are in place AND
two others
* FCPA §13(b)(4) & (5) → (only knowing violations give rise to criminal liability)
* S-oX § 404 ⇒ The public auditor of your company has to attest to the internal controls and has to attest to the fact that there are no material deficiencies or weaknesses in your internal controls
Requires public companies to devise and maintain internal accounting controls sufficient to provide reasonable assurances that books and records are accurate and transactions occur in accordance with management authorization
Internal Controls?
* Information systems → Track and accurately label expenditures, sales etc
* Internal audit function = on a random basis with enough frequency that you’re likely to catch mistakes
* Segregation of duties
* Clear Policies and Procedures
* Selection and training of good personnel
* Company code of conduct/ethics policy
So it’s not just that you’re strictly liable for ensuring that you have accurately reported all the transactions of the business in reasonable detail
* You’re responsible for ensuring that there are processes in place to make that happen.
In the Matter of BHP Billiton
* No training on filling out applications = lots of cut and paste
* No updating ⇒ Most forms were filled out a year before Olympics
* No external check for accuracy
REG FD
Rule
prohibits “selective disclosure” by domestic Exchange Act reporting companies and those working on behalf of such companies and restricts disclosures to individuals and entities likely to trade on the information
Only SEC can enforce violations
REG FD
When does it apply?
Applies to disclosures by the issuer or any person acting on behalf
* It applies to only public and domestic companies
person acting on behalf?
* “Senior official” or other officer, employee, or agent of the issuer who regularly communicates with certain parties
* Note: inside trader would not be violating Reg FD → not acting on behalf of issuer
Applies to material non-public information
Certain parties?
* brokers/dealers, investment advisers, investment companies and holders of securities IF it’s reasonably foreseeable that the securities holders will transact based on the information.
If disclosure is intentional, must be disclosed publicly at same time
* If disclosure is inadvertent, must publicly disclose within [one business day]
REG FD
Exceptions
- Persons who owe a duty of trust or confidence to the issuer
- A person who expressly agrees to maintain confidence.
- certain communications from most registered securities offerings. See later.
SEC v. Siebel Systems, inc.
SEC brings enforcement action against Siebel for a Reg FD violation after its CFO made optimistic statements to a private group of analysts that were less qualified and conditional than prior public statements by CEO
* The CEO said that their business was tied to the overall economic health of the country. (some cautionary language)
* But the CFO absolutely was like, no, we’re actually doing fine regardless = CFO did not include the same sort of cautionary language = It was a vibe, a tone that was different
* After CFO, analysts traded heavily immediately afterward, driving up stock price → SEC brought action
No actual contradiction in the info provided by the CFO and CEO
* “Regulation FD does not require that corporate officials only utter verbatim statements that were previously publicly made.” = not intent of rule to scrutinize every word
* This type of enforcement risks chilling, rather than facilitating, the flow of information
Could the people who traded based on the info be in trouble?
* So the first thing to note is that Reg FD only regulates companies. ⇒ It does not purport to regulate the recipients of the information.
* Could be in trouble for insider trading but not here because the CFO was not releasing information in violation of the duty to confidentiality to the company in exchange for a personal benefit
Rule 10b-5
Negative effects of fraud on the wider market
Without effective enforcement/penalties, costs might include:
- Lemons markets
- Misallocated capital = Pouring money into Enron instead of Apple
- Impeded monitoring = It impedes the ability of shareholders and others to monitor what companies are doing, to monitor how good they’re being with their business
Lemon markets?
* Has to do with the fact that if sellers are unable to credibly and completely communicate quality → Then buyers will discount what they’re willing to pay in the market generally because there’s always this risk that they’re going to get a lemon instead of a well functioning car
* That will harm capital formation for good companies, it will make it more expensive for them to raise money to do good, productive things for the economy, and it will hurt the economy overall.
Rule 10b-5
Elements
Recall:
* 10b-5(b) = misstatement / omission
* but we can have (a) or (c) = fraudulent device scheme
- Material
- Misrepresentation or omission
- Scienter
- Reliance
- Causation
- Damages
- Transactional nexus = “in connection with the purchase or sale”
2-year SOL from discovery of facts constituting violation
5-year statute of repose from occurrence of violation
Rule 10b-5
Class action mechanism
Sorting the Good from the Bad → You want cases of actual fraud to be brought and weak cases to be dismissed, filtered out, relatively quickly
* Why might a company and its management sometimes settle a suit that is weak on the merits?
* Why might plaintiffs’ attorneys sometimes not want to file some meritorious suits?
* Why might plaintiffs’ attorneys sometimes have an incentive to settle meritorious suits for too little money?
Why might a company and its management sometimes settle a suit that is weak on the merits?
* Litigation costs are so high that it’s probably better upfront to just settle something than have to go through years of ongoing litigation.
* it looks bad for ongoing relationships
* They want to be able to get on with the business
Why might plaintiffs’ attorneys sometimes not want to file some meritorious suits?
* the size of a company is a much better predictor of how attractive it is for plaintiff’s attorneys
Why might plaintiffs’ attorneys sometimes have an incentive to settle meritorious suits for too little money?
* So the idea is to avoid incurring the extra costs, they will take that settlement early and move on to their next case in situations where it is better to go to trial with a meritorious claim
PLSRA added to help with this:
* Pleading with Particularity
* Stay on Discovery until after Motion to Dismiss
* Early Class Notice
* Lead Plaintiff Presumption
* Court Review for Reasonable Attorney’s Fees
* Forward Looking Information Safe Harbor
* Proportionate Liability
Rules
“In connection with…” [Transactional Nexus]
Blue Chip Stamps et al. v. Manor Drug Stores
* is that the plaintiffs have to have traded in the relevant securities if they sue in private lawsuit
* Defendants can be sued under 10b-5, even if they didn’t transact in the security.
* the SEC can sue under rule 10b-5 without showing that they transacted in any security.
Menora Mivtachim v. Frutarom
* Under 10b-5, private parties can only sue for misstatements if the misstatements were about the company in whose shares the plaintiffs transacted
SEC v. Zanford
* Where the sale of securities and the deceptive behavior/breach of duty coincide
* So the key word that you take from this, which adds to the “in connection with” is “coincided”
* These were not independent events, It was the sale and the sale of the securities in the theft were basically one transaction, he sold the securities so that he could steal the money.
Menora Mivtachim v. Frutarom
* 10b-5 cases can be brought against people who have no connection to the company → What the court here seems to be saying, though, is it has to be a misstatement about that company.
* SO it could be that if bad bribing company had made misstatements that were directly about acquiring company, then you could go after bad bribe company for making a material misstatement BUT bad company statements about themselves
PSLRA and lead plaintiff in 10b-5 class action
Rationale?
* Shift control from attorneys to plaintiffs
* Addresses possible agency problem
Rebuttable presumption that lead plaintiff will be the person or persons who:
* Make a motion
* Have the largest financial interest in the relief sought
* Otherwise satisfy the requirements of Rule 23 of the FRCP (typicality and adequacy)
But courts will try to ensure that the group was not kind of pasted together by a plaintiff’s attorney to try to satisfy the second prong (having largest financial interest)
* Presumption that group larger than 5 will not be able to adequately represent the class
* You want it to be a small enough group so that there will not be collective action problems with policing and monitoring the litigation
Lead plaintiff rebuttal?
In re Cendant
Disgruntled class members may try to rebut the presumption by arguing the presumptive lead plaintiff
* Won’t fairly or adequately protect the members of the class
* Is subject to unique defenses that render such plaintiff incapable of adequately protecting the interests of the class
Class members’ arguments that Calpers group cannot adequately protect interests of class fail
* Conflict due to large continued holdings in Cendant? They have a lot of shares, maybe they would not want to hurt the company too much = Theory rejected → basically look at how many shares they traded during the class period
* Fact that plaintiffs negotiated lower fee with different counsel? = No, not a comparative analysis – the question isnt whether they could have done a better job
* Pay-to-play allegations? [Evidence of donations, but not of quid pro == we need actual evidence of quid pro quo; mere donations are not enough
once a lead plaintiff is selected, choose lead counsel, there is a question of, if there is a settlement, what the lawyer’s share is
In re Stericycle Securities Litigation
In assessing the reasonableness of a fee award, court must attempt to approximate the fee the parties would have agreed to at the outset of the litigation without the benefit of hindsight
* Should try to approximate market price in light of the risk of nonpayment, complexity, quality of performance, and amount of work
* This ex post estimation is inherently conjectural, but district courts can look to actual fee agreements, data from similar cases, and class-counsel auctions to guide their analysis
Here, circuit court vacated 25-percent (of $45 M settlement) fee award, finding that the district court failed:
* To consider an actual ex ante agreement b/t one of the lead plaintiff funds and its counsel [which would have led to an award about half as large]
* To give sufficient weight to the prior litigation involving Stericycle, which substantially reduced the risk of nonpayment = dirty laundry already aired
* To give sufficient weight to the early stage at which the litigation settled = not that much work
Misstatement
Deception
short-form merger case
A breach of fiduciary duties without deception ≠ Rule 10b-5 violation
* Policy concerns (re: federalizing corporate law)
* Note: Violation of a fiduciary duty can give rise to a 10b5 violation if it involves deception, if it involves lying to shareholders.
Court:
* There is no intent to fraud or deceive and no material misstatement or omission so we reverse 2nd circuit
Misstatement
Duty to correct and duty to update
U.S has a system of periodic, not continuous, disclosure mandates – Policy?
If a public company’s disclosures were materially inaccurate when they were made, the company has a duty to correct the disclosures
* If a public company’s disclosures were correct when they were made, but new developments have make them no longer accurate, the company has no free-standing duty to update the disclosures
There is a trade-off
* Advantage → if there is a material development, it is good for the market to know it
Disadvantage → time and money, lawyers fees = What will count as material? Huge amount of uncertainty
* Sometimes holding something back is a competitive advantage =Finding copper mine and buying land without disclosing the mine
Forward looking statements
and safe harbor
The term “forward-looking statement” means—
* Projections of financials
* Statement of the plans and objectives for future operations or products or services of the issuer
* any statement of the assumptions underlying or relating to any statement described
Safe harbor
* No Rule 10b-5 liability for forward looking statements that are wrong if the statement is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially… or immaterial
* Even without meaningful cautionary language, no Rule 10b-5 liability for forward looking statements that turn out to be wrong if plaintiffs fail to prove the defendants had actual knowledge the statement was false or misleading
* [Safe harbor does not apply to non-reporting issuers or 3rd parties not acting on behalf of the issuer; or in the context of tender offers, GAAP covered financial statements, or IPOs]
What counts as “meaningful” cautionary language?
* Boilerplate cautions won’t do
* But it’s also not required that the specific risks that wind up affecting the business are foreseen and identified = prescience not required
* The risks identified must be the principal or important ones from an ex ante perspective
the safe harbor applies only as a defense against private causes of action, not against government enforcement.
Tesla Case
Statements about present or past facts are not protected by forward-looking safe harbor
* But statements of the assumptions underlying future projections are covered by the safe harbor
* This includes statements like “we are on track” and “there are no issues” with meeting the projected timeline
So what sorts of things wouldn’t be covered by the forward looking safe harbor?
* If you are describing specific, concrete circumstances that have already occurred
* If you say we’re confident that we can meet this goal, because we’ve seen that our production numbers have risen by 75% quarter over quarter ⇒
Another line of attack a P could take
* The district court assumed that “if Plaintiffs had adequately pleaded that the relevant Tesla officer knew that it was impossible to meet the company’s forward-looking projections, and not merely highly unlikely
* then any accompanying ‘cautionary’ language that failed to reveal this impossibility would not be ‘meaningful.’”
Policy?
* Forward looking statements are especially valuable to investors because stock price is based on discounted cash flows
* litigation risks would be way higher if we did not have the safe harbor because of the uncertainty
Scienter
No PLSRA for SEC
Scienter requirement for 10b-5 liability = “intent to deceive, manipulate, or defraud.” => Recklessness does satisfy the standard
* Mere negligence is not enough to ground 10b-5 liability
PLSRA
* PSLRA requires private plaintiffs to plead with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind
* A complaint must plead facts from which a “reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.”
How can someone, how can a plaintiff plead with particularity facts that give rise to a strong inference of scientific prior to discovery?
* As we saw with Terracycle, maybe there have been prior enforcement actions that make public a lot of things that the plaintiffs lawyers can use to develop those arguments.
* Media reports
* whistleblowers/confidential witnesses – could be discounted
Some factors courts will look to in determining if PSLRA’s heightened pleading standards are met:
* Divergence between internal reports and external statements on same subject
* Evidence of bribery by a top company official
* Existence of an SEC Enforcement Action
* Sheer magnitude of a misstatement (i.e., how could a mistake so large occur without scienter)
* Accounting Restatement
Corporate, or collective, scienter?
Smallen v. The Western Union Co.
The scienter of the senior controlling officers of a corporation may be attributed to the corporation itself to establish liability under s. 10b-5 when those senior officials were acting within the scope of their apparent authority
* The scienter of lower-level corporate officers that play no role in alleged misstatement may not be imputed to the company for purposes of liability under PSLRA
Corporate scienter?
* Requires a sort of super-dramatic disparity between statement and reality…. Res Ipsa
* You need something along the lines of a statement that we sold a million trucks when you actually sold zero trucks rather than a statement like we have really good compliance systems where when the fact is your compliance systems are mediocre.
Reliance!
Affiliated Ute
Remember: the SEC does not have to prove reliance when it brings a 10b-5 enforcement action
The duty to disclose combined with an omission is enough to establish a presumption of reliance
* The Affiliated Ute presumption of reliance does apply if there was a free-standing duty to disclose a material fact – arising, e.g., from a fiduciary-like relationship or from SEC disclosure mandates – and the defendant failed to disclose
You can’t turn an affirmative misrepresentation into an omission with a duty to disclose by the mere fact that once you’ve made a misrepresentation, you do have a duty to disclose
Does pure omission rule undermine this case?
* And so I think that there was a general presumption that duty plus an omission, just full stop established reliance.
* But in order for that to hold after Macquarie, you would have to anchor it to subparagraph A or subparagraph C
* anchoring it to the idea that they were engaged in some sort of fraudulent scheme
Fraud on the market
rebuttable presumption of reliance on material misstatements in 10b-5 lawsuits if they can show that:
* The misstatement was public,
* The misstatement was material,
* The securities traded in an efficient market, and
* The plaintiff traded the shares between the time the misrepresentation was made and the time the truth was revealed
The presumption may be rebutted with any showing that “severs” the link between the alleged misrepresentation and
* (i) the market price (misrepresentation did not impact market price) or
* (ii) the plaintiff’s decision to trade
(ii) is limited because in most cases, the defendant isn’t going to have access to information about the plaintiff’s motive and the plaintiff’s decision
Process of litigation for 10b-5 class actions and Halliurton
Process
* You have the complaint
* Then selection of the lead plaintiff
* You have motion to dismiss – kill scienter
* If you get past that motion to dismiss, then you get to the discovery phase – why scienter so hard
* then you get to the motion for class certification.
from the company’s point of view, is that the value of the settlement will go up, after each point.
Halliurton
* the rebuttal is almost always going to come down to an effort to show that the misrepresentation didn’t actually affect the market price
* allows a defendant now to submit evidence of lack of price impact at a class certification stage as a way of rebutting the presumption
the actual litigation at the class certification stage for fraud on the market extends to:
* whether the stock is trading in an efficient market
* whether the market for this particular stock is efficient, and
* whether the statement itself was public.
What are some other types of evidence of market efficiency?
* How many analysts
* What is the market capitalization of this firm
* What’s the average trading volume of this firm?
Price Maintenance
There is an argument that courts have accepted. the idea is that you made statements that prevented the truth from coming out earlier
* that maintained or that were in line with the market’s earlier beliefs but which themselves were false
* And because they were in line with the market’s early prior beliefs, the market price didn’t react to them.
* But so once you made those misstatements you were preventing a drop
“Generic nature of an alleged misrepresentation often will be important evidence of price impact”
* “Price maintenance theory” requires an inference about the “inflation” in the stock price due to an alleged misstatement based on the back-end price drop following corrective disclosure →
* Price maintenance theory requires a “match” between the misstatement and the corrective disclosure because the misstatement has to be about what caused the price drop, about what the correction was.
There will often be a mismatch between a generic misstatement and a specific corrective disclosure
* This can undermine the inference upon which the price maintenance theory relies if there is a mismatch
* The take home is just trying to match the alleged misstatement with the eventual kind of disclosure of the truth in a way that makes sense.
* the closer that link, the better
So the statement → “We have extensive procedures and controls that are designed to identify and address conflicts of interest.”
* And so the question is, can you use a generic statement like this as a what would be an alternative specific statement
* Like → We never allow people who are taking the short position and a synthetic CDO to participate in the selection of the underlying bonds for the credit default swaps.
Loss Causation
Dura
Loss Causation → fraud is the proximate cause of the loss
* Fraud caused the loss → e.g., no loss causation if stock tanked due to market decline
Reliance is called transaction causation
* The idea is but for the fraud plaintiff would not have invested or sold on those terms.
* So there’s got to be a face to face lie or fraud on the market presumption or the affiliated ute presumption
What do you think needs to be shown to establish causation in a fraud on the market context, in the securities class action context?
* a stock price drop after or like in conjunction with the misstatement → You show that, when the truth was revealed to the market, the market reacted in a way that caused losses for you.
* Loss causation is easiest to establish when a corrective disclosure occurs in a short period of time and the price subsequently changes by a significant amount.
Transaction causation (i.e., reliance) but no loss causation?
* Investor buys and sells while the price is inflated due to a material misstatement
* There may have been other factors that like general market things that made the stock go down and not the false or misleading statements.
Loss causation but no transaction causation?
* Investor knows the statements are false, but buys stock anyway (say, b/c s/he [incorrectly] believes the stock is undervalued despite the misstatement) – truth revealed before investor sells and stock plummets
* Someone was forced to sell, but by a court order and antitrust issues and they were forced to sell at a time when good news was being fraudulently hidden from the market
Corrective Disclosure
A corrective disclosure occurs when “information correcting the misstatement or omission that is the basis for the action is disseminated to the market.”
* A corrective disclosure can come from any source, including knowledgeable third parties such as whistleblowers, analysts or investigative reporters
A corrective disclosure need not reveal the full scope of the defendant’s fraud in one fell swoop
* The true facts concealed by the defendant’s misstatements may be revealed over time through a series of partial disclosures.
A corrective disclosure “need not precisely mirror the earlier misrepresentation”
* It is enough if the disclosure reveals new facts that, taken as true, render some aspect of the defendant’s prior statements false or misleading
In re BofI Holding Inc. Sec. Litig.
* blog post and whistleblower reveal
* it qualified as a corrective disclosure because the market reacted after that truth was revealed.
* And you don’t need an admission from the issuer in order for the market to BELIEVE that the allegations are true and to react to it
Secondary liability under Rule 10b-5
Central Bank remains the law with respect to private lawsuits under Rule 10b-5
* No “secondary” or “aiding and abetting” liability
* So you cannot go after someone under a claim that they aided and abetted a primary violator.
PSLRA reinstated aiding and abetting liability with respect to SEC enforcement actions
* So the take home is aiding and abetting liability with the scienter standard of recklessness is still possible under 10b5 if the government is bringing an enforcement action but not in private lawsuits.
Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.
cable company with boxes from mfc
Cable company had a scheme where they would buy these from MFC and we will pay you extra more than more than you would otherwise charge us
* inflated revenues
Rule
* Conduct can be deceptive
* But for there to be reliance in a FOTM private lawsuit under 10b-5, deceptive act or statement must be public
What are the two circumstances in which courts have found a rebuttable presumption of reliance? Fraud on the market and affiliated Ute
* Neither apply because Suppliers did not have a duty to disclose
* And their deceptive facts were not communicated to the public aka no publicity → They had no relationship with the investing public at all.
What must plaintiffs show for reliance, then?
* They have to show that they actually were aware. They have to show that they actually saw or heard the defendant’s deceptive conduct
They have visibility into the ultimate misstatements by charter, of course → But the whole point of this litigation is that they are looking for other deep pockets to go after
* But they did not see anything
Scheme liability
* You yourself didn’t do anything that anybody can claim they relied on, but you were part of a scheme that ultimately led to a primary violation.
* No scheme liability b/c financial misstatements by Charter were not the “necessary or inevitable” result of sham transactions
* rejects scheme liability
Who makes the statement for purposes of Rule 10b-5
So the long in the short with respect to Janice and Lorenzo is Janice makes it much harder to go after people based on a theory that they made a material misstatement ⇒ narrows who is the maker of a statement
* But Lorenzo, seems to open things up again to the degree that someone is involved in disseminating false information that they know is false
* that can be deemed to be deceptive conduct that falls afoul of 10b5 a or c
* and it can also establish reliance to the degree that they’re doing things that are visible to the public and to the investors etc
“For the purposes of 10b-5 the maker of a statement is the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.”
* “One who prepares or publishes a statement on behalf of another is not its maker”
* Although JCM officers wrote JIF prospectuses that contained misleading statements, JIF itself, not JCM, was the maker of the statement – therefore, no primary liability for JCM under Rule 10b-5
BUT see Lorenzo
* jist of it = that Lorenzo can be primarily (not aiding and abetting) liable under rule 10b-5, EVEN IF he’s not the maker of these statements because of his decision to disseminate the false statement, knowing that they were false – afoul of Rule 10b-5 (a) and (c)
* [Furthermore, Lorenzo’s email was a public, and therefore we may presume that investors would be able to show reliance] but SEC does not need to
Why might it be of interest to the SEC to go after Lorenzo in a case like this as a primary violator, rather than just say that he aided and abetted the primary violation?
* The answer is that in order for somebody to be secondarily liable, you have to have a primary violation in the first instance. That might be hard
* So it’s useful for the SEC still to be able to go after someone like Lorenzo, who disseminated information that they knew was false = as a primary violateor
Section 20(a) control person liability
P must show:
* That a primary violation occurred = need to show all normal elements;
* That the alleged control person actually exercised control over the general operations of the primary violator; and
* That the alleged control person possessed the power to control the specific transaction or activity upon which the primary violation is predicated, but need not prove that this latter power was exercised.
[D then bears the burden of showing they acted in good faith and did not directly or indirectly induce the violation….]
Lustgraaf v. Behrens
* KCL owns sunset | Behrens operates his fraud through national investments inc → He is basically able to register public exchanges through sunset | So sunset is a registered broker dealer. Behren is registered representative of sunset.
* Behrens runs a ponzi scheme
Claim against Sunset can go forward b/c of presumption that broker-dealer actually controls the general activities of its registered representatives
* fairly defined legal obligations to monitor and provide oversight of the registered representatives that it is providing access to markets for
Claim against KCL cannot go forward b/c complaint fails to allege actual control by KCL
* They pleaded things like they were sharing offices. They say that that’s not on point.
* They shared directors ==> Relevant but not enough on its own to show KCL was actually controlling sunset’s general operations
10b-5
Damages
Damages are based on a number of factors:
* primarily how many shares were transacted in, how large the inflation ribbon was as established by expert evidence at the moment when the trade occurred
* But you also have to take into account what then happens to the market price, because the market price could go up or it could go down.
Limitations = the first one is you are not allowed to recover a total amount that’s in excess of the actual damages that you suffer.
* For example, what it basically means is you paid too much for the stock and you paid $20 when it was really worth $15 → But after that, other good news comes out and it raises the stock price considerably, such that it’s still much higher than $20, even after the corrective news has come has come out → you cannot recover
Section 21D(e)(1) limitation:
* You can’t recover more than the difference between what you paid or sold for (as appropriate) and the mean stock price over the 90 period following revelation of the truth
* So basically you bought it at 20 → it was worth 15. It stays at 20 → And the corrective disclosure comes out and it drops to 15 → If it goes up after that, over the next 90 days, it can limit the amount that damages that you can get
Insider trading
Classical Insider Trading
- rule 10b5 plans
- big boy letters
Stock trading on the basis of material nonpublic information creates liability under § 10(b) and rule 10b-5 only if it is done in violation of a fiduciary(-like) duty
* the duty is owed to the shareholders of the corporation whose shares are traded
* involves that duty of employees to the shareholders of the corporation
Temporary insiders
* corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciary of the shareholders.
* they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes
Chiarella owed no duty to the shareholders of the target company whose shares he traded – therefore, not liable
* He got the information from the company giving the offer, but that wasn’t the target company = so not temporary insider = could be temporary insider of acquiring company
Rule 10b5-1 plans
* affirmative defense for insiders who want to trade in the company’s securities to set up these plans
* So what the ten B five plans allow them to do is to say over the next year I’m planning to sell shares on this date, this date and this date and I promise that I don’t possess any material nonpublic information now and then
* Led to abuse –> so now: 3 month cooling off period; no discretion to planner; modification resets cooling; no multi plans
Big boy letters
* letters allowing institutional investors to transact but they say we are big and sophisticated and we might have material info, figure it out you cannot sue us
* SEC still can
Tipper/Tippee liability
Tippees (Dirks) → those who “inherit” the duty from insiders or temporary insiders
* Tippee liability is derivative of tipper liability
* Tipper must breach duty of trust/confidence in exchange for a personal benefit, and tippee must know or have reason to know this breach
Anytime you have tippee liability, you have to show that the tipper breached duty of trust and confidence in disclosing the information in return for some personal benefit
Dirks
* Dirks (tippee) was not an insider or temp insider of the bad company
* Secrist (tipper) did not disclose for personal gain nor did he intend to make Dirks a gift of the info
* Therefore, no breach by Dirks!
Personal benefit?
Two ways to satisfy this test
Quid pro quo, which doesn’t necessarily need to be a direct bribe
* (It can be some sort of more subtle or implicit sort of quid pro quo, but it has to be something tangible, at least provide the PROSPECT of something tangible)
* But some sort of possibility of material gain on the part of the tipper = A pecuniary gain or reputational benefit that will translate into future earnings
Or the gift/close personal relationship
* you are making a gift in a way that is identical to your doing the trades yourself, which would be forbidden, and then giving a cash gift to the recipient.
* Salman = Reaffirms that a gift to a [close relative] counts as a personal benefit even absent any tangible (direct or indirect) quid pro quo
* Martoma = Intent to benefit tippee = personal benefit can be inferred from a lack of corporate purpose for disclosure + expectation that tippee will trade → majority
* Dissent did not like this = Without a “meaningfully close personal relationship,” there should be no inference that a gratuitous tip functioned as a gift under the Dirks personal benefit test
Salman – How close does that personal relationship have to be in order for it, by itself, to satisfy the personal benefit test?
* brothers who have a close relationship
* spouse
* kid
* parents
* friend of 50 years that you see everyday
Misappropriation theory
cute CEO and wife case
SEC provides a non-exclusive list of three situations in which a person is presumed to have a duty of trust or confidence for purposes of the misappropriation theory → non-exhaustive
* When someone agrees to maintain information in confidence
* When two people have a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain confidentiality
* When one receives information from a spouse, parent, child, or sibling
Even if a trader owes no duty (direct or “inherited”) to the shareholders of the company whose shares are traded, there may still be 10b-5 liability if such trading breaches a duty of trust or confidence to the source of the information
Deception/nondisclosure key in finding liability under misappropriation theory
* recall short form merger case – no deception no liability
permission from the source of the information to trade can cure the problem under misappropriation theory, but not under classical theory.
* Kosinski = It was more of a relationship. Part of that relationship was the explicit agreement. But there was more here → whole FDA process
Is it enough if someone just says, I’ll maintain this in trust and confidence? Mark Cuban
* So still an open question → SEC would be okay with it & A court may want something more like in Kosinski and the FDA
THE BREACH IS TO THE SOURCE OF INFORMATION
CEO (insider) disclosed MNI to spouse, who tipped brother for trading purposes
* No tippee liability under classical theory because the CEO, when he disclosed, had expectation of confidentiality (he told her to not trade!→ no breach of duty by CEO)
* under misappropriation theory –> CEO wife said she fully disclosed she was going to tip her brother after getting info
But court gets around this and holds there were two distinct potential points of deception:
* When she acquired the information, and
* When she tipped her family member
* either at these points, deception is enough
CEO wife disclosure made #2 non-deceptive, but not #1 → when she acquired the information
* the fact that she didn’t tell him prior to his disclosure of this material, nonpublic information, that she wasn’t going to keep it confidential → that was deceptive
* The court reads O’Hagan’s language to require that any disclosure insulating against insider trading liability under misappropriation theory must occur at a point when the source can still take remedial action and that did not happen
insider trading in context of tender offer
Rule 14e3-a (O’Hagan) → prohibits trading on MNI in the context of a tender offer, in the target’s shares, if the trader knows MNI comes from a source within the target or acquirer
* Note: no requirement that the trader breach any fiduciary(-like) duty in order to be held liable
if you overhear a conversation about a tender offer because somebody is speaking a little too loud on his cell phone in a public place, and you go buy the target’s shares → you’re not going to be liable under 10b-5 as a tippee because the loud mouth did not breach any duty in exchange for a personal benefit
* you probably would be liable under 14e3(a) because it’s a tender offer, because you’re buying the target’s shares and because you know or should have reason to know that the information is coming from a source inside, or working on behalf of, either the acquirer or the target.
Final way to get at insider trading
That basically applies to the computer hacker scenario, where if they don’t owe any duty under any theory, but you can still get them by showing that they’ve made these affirmative misrepresentations in obtaining the information
* The affirmative misrepresentations are not related to the value of the securities themselves, but they are related to how the information was obtained. → Hacking techniques that themselves involve deception
connection with Sanford
* which was the case that we read where the broker had sold his clients securities and stolen the money.
* And the court said that that that even though he hadn’t made any misrepresentations about the value of the securities, even though he hadn’t defrauded the counterparties of the securities trades
* because it was all part of one scheme to steal money from his client, which required the sale of securities
* The fraud, which was against his client, was in connection with the purchase or sale of a security.
Consistent with this case
Section 16 (of the Exchange Act) ➔ the original insider trading law
Strict liability ➔ disgorgement of profits
Applies only to insiders of public companies trading equity securities
* Insiders: D’s, O’s, 10% shareholders
Profit?
* if insider purchases X number of shares
* within six months of selling X number of shares,
* and the price paid in purchasing the shares is lower than the price paid in selling the shares
* The insider must disgorge the profits = (sales price – purchase price) * X
officers and directors
* Trades that occur before one becomes an officer or director are exempted
* Trades that occur after one steps down from a position as officer or director are not exempted
10% shareholders
* the relevant moment is immediately prior to a trade → if you are not a 10% shareholder, the purchase that gets you above 10% is not subject to section 16
It does not matter which comes first: the sale or the purchase
* You just look at the purchase price, you just look at the sale price
* And if the sale price is higher than the purchase price. Boom. you have profits that must be disgorged.
Your knowledge is completely irrelevant about any inside information.
* Material nonpublic information is not relevant at all to section 16.
* Strict liability, no scienter
Filing a registration statement
Rule
Part of the process of going public is filing a registration statement.
* If you file a registration statement and there is a materially misleading statement or omission → that can give rise to liability under section 11
* You’ve registered and sold a security ⇒ But what if there’s a material misstatement or omission in the registration statement?
§ 11 liability for material misstatement or omission in a registration statement:
Strict liability for issuer
* Others can be liable subject to a due diligence defense, which essentially establishes a negligence standard
experts w/r/t expertised sections → think accountants w.r.t the audited financials
* No liability for experts w/r/t other sections
* So the auditor’s liability is limited to material misstatements or omissions within the audited financials
For directors and underwriters:
* Negligence standard for non-expertised sections
* Liability for expertised sections only if they knew or had reason to know of inaccuracies (but otherwise may rely on experts)
§ 11 due diligence defense: Checking matters “easily verifiable”
* e.g., comparing descriptions of material contracts in the prospectus with the actual contracts
Who is an expert? Narrow view wins:
* The narrow view is that only the audited financials (in this case) and if it is a technical thing, you get engineers that give appraisals and shit etc → here, only audited financials are expertise
Escott v. BarChris Construction Corp
all fail lmao
bowling alley case with tons of material misrepresentations in the registration statement. Issuer is insolvent. Went for everyone else
CEO → he not only didn’t do any reasonable investigation, he knew that there were misstatements.
President & VP (also co-founders) ⇒ claimed ignorance → failed
* Court = not as naive as they claim to be → they could not have believed that the registration statement was wholly true and that no material facts had been omitted
CFO → He knows numbers but not securities law and that he honestly answered all the auditor’s questions → The court says, in fact he withheld information
* He had reason to believe the expertise portion of the prospectus was incorrect.
* So even though not an expert, he had reason to believe that the audited financials were incorrect. And so he’s liable → it was not a question of due diligence
Young lawyer, not an executive in any sense but became secretary and director and signed later amendments → Court says he must have appreciated some of the inaccuracies, for example, in the descriptions of key contracts.
* He made no investigation and relied on others to get it right, so his due diligence defense fails.
Outside director who joined board late → He’d done general due diligence on the company.
* He asked the auditor and asked around
* But did no investigation into the accuracy of the amendments that he signed. So he also didn’t establish his due diligence defense.
Outside counsel → (outside lawyers are not directly liable under this but he was also a director) → drafted prospectus
* Court concludes he was honest but no due diligence defense did not check matters easily verifiable
Underwriters → underwriters, other than the lead underwriter, did not do any investigation → lead delegated investigation to law firm → but they did no investigation ⇒ they were an agent
* If the agent fails, the underwriter is liable as the principal. fail due diligence defense
Auditors → the court says only liable with respect to the expertise portion.
* But the court finds that they had not followed generally accepted accounting principles and did not meet industry standards –> fail defense
Note: directors and underwriters delegate their due diligence to lawyers
* If the lawyers fail to establish that they exercised due diligence, § 11 liability falls on the directors and underwriters, not the lawyers
* But the lawyers may be sued for malpractice
* But the lawyers themselves, unless they are also directors, or they also sign the registration statement for some reason → they are not directly liable under 11
Public offerings
Policy
IPO is main thing
alternative ways of going public
Why go public? In other words, why register a sale of securities such that the shares can be traded on public exchanges afterwards?
* Need $$$ for investment project; project is not a good candidate for debt financing → (i) a significant risk of failure and/or (ii) a significant delay between the required investment and the payoff if successful
* Provide a liquid market for shares = Compensate employees who had equity and want to liquidate
Downside
* Going public is expensive; being public is expensive
* Mandatory disclosure; heightened exposure to fraud liability
Alternative ways of going public
* Traditional merger
* Reverse merger = Operating company (already making and selling products, want to go public and do not want to do IPO process) finds blank check company (already did IPO process, but no operations, just sitting there)
* Special Purpose Acquisition Companies (SPACs) (kind of reverse merger) = Look for a company to take public; A successful acquisition is usually accompanied by a PIPE (private placement by public company)
* Direct listings → Spotify did one
Role of underwriters
Role
* Interface b/t issuer and public investors; classic role of Wall Street investment banks
* Underwriter serves as a reputational intermediary; provides advice, network, etc ==> The underwriter stands between the company and the public investing market.
Firm commitment
* Firm commitment → underwriters purchase shares (at a discount!), resell them to institutional investors
Risk
* Once they sign the underwriting agreement, which they will do right before the company goes public, they are on the hook to buy the shares
* Things move fast in markets so it is possible that the people who have been lined up to buy the shares from the underwriters (they have no legal commitment, not allowed to under gun jumping rules, infra) suddenly bail
Best efforts → underwriters broker sales, and charge a commission
* No same risk
* They don’t promise to buy the shares for themselves. They promise to commit to brokering sales.
* They’re not on the hook themselves. They never own the shares for any moment in time. They simply facilitate a direct sale to the investing public and take commission
Underwriters usually form syndicate with one lead underwriter taking primary responsibility
Persistent IPO “pop” → On average, over time, most IPOs trade up immediately after going public.
* Might leave money on the table → If it’s going to trade up to $120 on day one, why are you selling it at $100?
* Why not sell it for $120 and then you get the money, the underwriters get a bigger cut → so it is not the institutional investors who are the initial buyers who are getting the windfall
* Bad: underwriters looking out for interests of institutional investors
* Good: b/c of lack of robust market-based discovery prior to IPO, purchasing involves extra risk that must be compensated
Registration statements
S1 & S3
Form S-1 → use in an IPO
* Available to all issuers
* Company information
* Transaction-specific information
Form S-3 → already public companies = Available to issuers that:
* (i) have been a reporting company for > 1 year;
* (ii) are current in their SEC filings (If you’re late filing a 10-K or 10-q, you cannot issue new securities using form S-3); and
* (iii) have a public float > $75 million
S-3 primarily includes transaction-specific information; company information from SEC filings incorporated by reference
* Cheaper and more straight forward, disclose less info
[public float = share price * shares held by nonaffiliates]
* Affiliates would be directors, parent companies etc
Gun Jumping Rules
5(a) & 5(b) & 5(c)
Securities Act § 5(a)
* Can’t sell prior to effectiveness → when the SEC signs off on your registration statement and it is a go
Securities Act § 5(b)
* The offers you make during that period prior to effectiveness but after the registration statement has been made → have to comply with requirements
Securities Act § 5(c)
* before you file a registration statement, you are not allowed to offer to sell the securities
Remedy for violation = **rescission **
Timeline
* pre-filing period —— waiting period——post-effective period
* 5(a) the whole time
* 5(c) prefiling period
* 5(b) waiting period
Categories of issuer
Non-reporting issuer:
* the issuer is not a reporting company under the Exchange Act → not a public company (rules apply the hardest)
Unseasoned issuer:
* the issuer is a reporting company under the Exchange Act, but does not satisfy the requirements for Form S-3
Seasoned issuer:
* the issuer is eligible to use Form S-3
Well-Known Seasoned Issuer (WKSI):
* principal requirements ⇒ Eligible for S-3; Issuer has public float ≥ $700 M; Issuer is not otherwise disqualified (e.g., by not being up to date on Exchange Act filings)
5(c)
what is an offer?
Concern: preventing a “speculative frenzy” in the shares
* ALSO When does the pre-filing period begin? “In registration”
Not just actual offers, but communications that could “condition” the market → broader definition
* Even if offer not explicitly mentioned
Some factors (from other SEC guidance)
* Motivation (e.g., was the communication prearranged prior to the financing decision?)
* Type of information (soft, forward looking information more likely to be deemed an offer)
* Breadth of distribution (the broader the distribution the more likely an offer)
* Form of communication (written makes it easier to reproduce so more likely to have a broad distribution)
* Whether the underwriter is mentioned by name
prefiling period?
* At least from the time an issuer reaches an understanding with the broker-dealer which is to act as managing underwriter
* Preliminary negotiations with underwriters (even if it does not pan out) are excluded from the definition of “offer” for 5(c) purposes
* Including discussions b/w managing underwriters and prospective underwriter members of the syndicate
5(c) safe harbors
Rule 163A
KEY one
Communications made by the issuer more than 30 days prior to the filing of the registration statement are excluded from the definition of “offer” for purposes of § 5(c)
* To qualify, the communication may not mention the offering
* If those “talking up the company” statements that are optimistic statements about your company’s prospects occur at least 30 days prior to the filing of the registration statement → you are okay
mentioning offer example
* Mentioning the price per share, for example
5(c) safe harbors
Rule 163
WKSIs have broad latitude to make offers during the pre-filing period (even within the 30-day pre-filing window) ⇒ basically completely exempt
Policy
* viewed as a way to try to prevent speculative frenzy in a new company stock.
* If you are a WKSI, the general sense is that the market knows you well enough
* They been trading you for long enough that there likely won’t be a frenzy around your shares that could exist with an unknown shiny thing
5(c) safe harbors
Rule 168
Reporting issuers may continue the regular release of “factual business information” and “forward-looking information” (even within the 30-day pre-filing window)
* In the ordinary course of business
* whether you qualify for S-3 or not
5(c) safe harbors
Rule 169
Non-reporting issuers may continue to disclose “factual business information” (even within the 30-day pre-filing window) (but forward-looking information is not covered under the Rule 169 safe harbor)
* may not mention the offering
In order to use Rules 168 and 169 →
* This is really about the release of information in contexts which have nothing to do with raising money through the sale of securities or potential sale of securities → It has to be about selling your products, building up the actual operational side of your business.
5(c) safe harbors
Rule 163B
All issuers can communicate with qualified institutional buyers or institutional accredited investors at any time during the public offering process.
A qualified institutional buyer (QIB) ≈
* entity that invests on a discretionary basis ≥ $100 million
An institutional accredited investor (IAI) ≈
* an institution with ≥ $5 million in assets ⇒ Not individuals
They are large sophisticated investors who are unlikely to fall prey to speculative frenzy in the stock
5(c) safe harbors
Rule 135
a safe harbor for short, factual notices of a proposed registered offering
May include nothing more than:
* Identity of issuer;
* Amount and basic terms of offered securities;
* Purpose of offering; and
* Anticipated timing
[Any other information, including the identity of the underwriter, removes the protection Rule 135]
5(b) – the waiting period
what is prohibited?
We filed our registration statement! Now waiting period, we can start making offers, still cannot sell
prohibiting the transmission, through interstate commerce, of any “prospectus” not meeting the requirements of the statutory prospectus as set forth in § 10 of the Securities Act
* What’s a “prospectus”? A written or broadcast offer
So what communications are permitted during the waiting period?
Oral offers
* that aren’t broadcast, aren’t written → not covered by 5(b)
Regularly released information in the ordinary course of business
* Rule 168 and Rule 169 still apply, exempting these communications from the definition of “offer” (and thus from the definition of “prospectus”)
“Tombstone” ads
* Rule 135 is still available, and issuers can also avail themselves of Rule 134 during the waiting period
* Rule 134 permits more information than Rule 135, above all the identity of the underwriters
* Rule 134 notices must include a boilerplate legend with info on how to obtain statutory prospectus
* For example, no financial statement from last 3 years not explicitly allowed
R134 Solicitations of interest
* Must be accompanied or preceded by delivery of statutory prospectus (which may be accomplished via hyperlink like in an email)
* Must include boilerplate legend that indications of interest involve no legal obligation
* From example, mentioning it is a “good investment” = bad
The preliminary statutory prospectus under § 10!
* Your main offering doc, main disclosure doc
5(b)
Free writing prospectus
a written offer that meets various requirements; an issuer FWP must generally (inter alia):
* Be accompanied or preceded by a statutory prospectus (for nonreporting and unseasoned issuers) ⇒ Can do it with link
* Contain a legend stating that the registration statement has been filed and where to find it
* Contain no information that is inconsistent with the registration statement
* Be filed with the SEC no later than the date of first use
“Written” includes written, printed, broadcast, and graphic communications = Graphic includes “all forms of electronic media”
* issuers have not made extensive use of FWPs; one possible reason is that heightened antifraud liability applies to FWPs (section 12(a)(2) provides a remedy of rescission for material misstatements or omissions in any prospectus or oral offer, subject to a negligence standard)
The process of going effective w.r.t IPOs
Once the registration statement is effective, the issuer can begin to sell securities
* The default: the registration statement automatically becomes effective after 20 days = [The clock resets with any amendment]
* No issuer uses this option – instead they file a delaying amendment, and request that the SEC accelerate effectiveness at the end of the process
Reasons?
* Don’t want to go public with a stale price
* The review process with SEC may help protect against liability under heightened anti-fraud provisions
* The SEC can issue a stop order if it finds the registration statement materially deficient
Shelf registration
Baseline rule: issuers may only register securities intended to be offered immediately or in the near future
subject to various conditions and requirements, shelf registration allows issuers to register securities and “leave them on the shelf” for a while before selling them
* Automatic shelf registration → available only to WKSIs
* Under applicable rules, an automatic shelf registration statement, and any post-effective amendment, becomes effective upon filing. The issuer need not wait for SEC review
* Provides something close to “company registration” status for WKSIs
What is the purpose of the gun jumping rules in the first instance, it’s ensuring a sane, calm, relaxed, smart process of assessing the value of securities when an unknown company is bringing securities to market
* preventing the speculative frenzy that could arise from people getting excited about bullish statements on new companies.
* Once you are a WKSIs, the assumption is that these speculative frenzy risks do not happen
this can be a double-edged sword for WKSIs – makes selling securities much faster and cheaper, but to the degree the issuer avails itself of this, it becomes harder to perform adequate due diligence
Exemptions from §5
Two broad categories of exemption →
Violating § 5 is more expensive! → Recission
Compliance with § 5 is expensive –
* Mandatory disclosure
* Gun jumping rules
* Stringent antifraud liability
* Heightened exposure to § 10(b)(5) liability
* Direct costs of offering, including auditor’s fees, attorney’s fees, and the underwriter discount
* Delay of at least several months
§ 3 exempts securities, including:
* Entire categories of securities, such as Treasury bills
* Securities sold in offerings under a particular $ limit (see infra Rule 504)
§ 4 exempts transactions–our focus is § 4(a)(2), but FYI:
* §4(a)(1) exempts transactions by “any person other than an issuer, underwriter or dealer”
* §4(a)(2) of the Securities Act exempts “transactions by an issuer not involving any public offering”
§4(a)(1)
* Note: if you have bought a security in a private placement and try to sell it, you may be deemed to be an “underwriter” – much broader term than investment banks in sec reg
Public offering?
SEC v. Ralston Purina Co.
§ 4(a)(2) exemption applies when there is no practical need for the gun-jumping rule protections – i.e., where investors can “fend for themselves”
* “executive personnel who because of their position have access to the same kind of information that the act would make available in the form of a registration statement.”
Case:
* But that said, 500 employees got offers this way
* Some of them were artists, bakeshop foreman, child-loading foreman and so on
* Yes some were executive, which fit, but others def were not.
* We want “fend for themselves” limitations
Factors for § 4(2) exemption:
Number of offerees and their relationship to each other and the issuer
* They need to show not just that the people who actually bought BUT everyone who was offered had available to them the same sort of information that was in the registration statement.
* It’s about the relation of the offerees to the issuer.
Number of units [# of (e.g.) shares]
* if you’re selling a single security, that’s $1 billion that, well, that’s unlikely to be liquid and traded
Size of offering [$$]
* the larger the offering, the more likely it is to be public
Manner of offering
* [general solicitation?]
Key thing to look for general solicitation
* Whether you’ve engaged in an offer that’s kind of open without really targeting it at particular people who are able to fend for themselves
Doran v. Petroleum Management Corp.
partnership interest gone wrong (did howie test to show yes security)
Most elements of the offering cut in favor of PMC’s argument that the offering was private → no remedy of rescission for violation of sec. 5
* Small number of offerees, small amount, small number of units sold, no general solicitation….
* Note, too, that Doran himself is undoubtedly sophisticated → oil engineering degree, invested lots before BUT
For an offering to qualify for a § 4(a)(2) exemption, the issuer must show that all offerees (even if sophisticated!) received the necessary information
* Note: this goes to the “relationship of offeree to issuer” factor
To satisfy the information requirement, issuers must make the same substantive information that would be contained in a registration statement available to the offerees
Availability can be satisfied by:
* Disclosure or
* Effective access
Effective access, in turn, can be shown by:
* The position of the offeree == Executive, who by virtue of their position, has access to that kind of info; OR
* The issuer’s promise to open appropriate files and records, as well as to answer inquiries regarding material information
If the issuer relies on access rather than disclosure, the offerees’ sophistication (ability to “fend for themselves”) takes on greater significance
* A promise to answer questions is meaningful only if the offeree knows what to ask . . .
* All the offerees could be given access but did they have the sophistication to know what to ask?
Reg D
Two Reg D safe harbors pursuant to two different provisions of the Securities Act:
§ 4(a)(2) leaves substantial areas of uncertainty for issuers
Rule 506, pursuant to the § 4(a)(2) exemption for private offerings
Rule 504, pursuant to § 3(b)(1), which authorizes the SEC to exempt offerings up to $10 million from § 5
Eligibility (subject to disqualifications):
* Rule 506 is open to all issuers
* Rule 504 is not open to: Reporting companies, blank check companies, investment companies = mutual funds
Regulation D – Aggregate offering price
* Rule 506: no limit == Raise as much money as you want in a private placement
* Rule 504: $10 million limit == Upshot: if an issuer sells $10 million in a Rule 504 offering, it must wait for one year before it can avail itself of Rule 504 again
Regulation D – Number (and type) of purchasers
Rule 504: no limit on number (or type) of purchaser
* Not relying on private placement exemption
* It’s relying on a different statutory exemption, which just says the SEC can exempt securities up to $10 million.
Rule 506:
* No limit on the number of accredited investors
* Under Rule 506(b), up to 35 non-accredited investors (in addition to accredited investors)
* Non-accredited investors must meet sophistication requirement
* most issuers using Rule 506 will sell only to accredited investors because sophistication requirement
Accredited investors are defined as:
* Institutions with total assets ≥ $5 million, or
Natural persons that
* Are directors, executive officers, or general partners of the issuer,
* Have a net worth (individually, or jointly with a spouse) of at least $1 million, exclusive of a primary residence, or
Regulation D – General Solicitation prohibition
* This prohibition applies to Rule 506(b) offerings
But what counts as a “general solicitation”?
Recall that Doran focused the § 4(a)(2) analysis on the sophistication and information made available to all offerees–not just to the ultimate purchasers
* The Rule 506 safe harbor analysis is focused on purchasers
So just remember that rule 504 could allow general solicitation, but other requirements have to be met basically state law
But what counts as a “general solicitation”?
* (1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
* (2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising….
All doctors in CA Case
* failed 4a2 easily = number of offerees and relationships to each other
Reasoning: How does Reg D apply?
* They can try to show that all the purchasers were accredited.
* But the key is something that would have also been potentially probably fatal under 4a2 alone → the SEC says this is clearly not limited in any meaningful way to ensure that its toward sophisticated people
* So the upshot is that this did amount to a general solicitation and that the Reg D safe harbor did not apply.
insurance guy offerred securities to his existing clientele (600) and most are likely to be neither sophisticated nor accredited
* It’s true that the existence of relationships b/t an issuer and offerees is an important factor in determining whether an offer is a general solicitation or not
* But the types of relationships that may be important in establishing that a general solicitation has not taken place are those that would enable the issuer (or a person acting on its behalf) to be aware of the financial circumstances or sophistication of the persons with whom the relationship exists [or that otherwise are of some substance and duration]
More generally, if you hire investment banks, the investment banks have relationships with investors that enable them to basically find that private money without involving a general solicitation
* In a series of no-action letters, the SEC has indicated that brokerage firms may actively solicit investors with a general interest in investing in private placements -> may not mention particular offering
506c v. b
Jobs act change
Rule 506(c) offerings may only be sold to accredited investors
* the ban on general solicitations was removed only for offerings under (the new) Rule 506(c)
Cf. Rule 506(b), which permits sales to up to 35 non-accredited (but sophisticated) investors
* Recall that most large issuers avoid non-accredited investors entirely even when relying on Rule 506(b)
It seems, then, that Rule 506(c) is better Rule 506(b)?
* You’re just selling to accredited investors. But under rule 506c, you don’t have the ban on a general solicitation.
* But there is a big drawback that makes issuers largely avoid Rule 506(c): it requires the issuer to verify each investor’s accredited status.
* Rule 506(b) permits issuers to rely on investors’ self-verification and therefore remains the preferred approach
RESALES
In general
So we have safe harbors! what does it depend on?
Assume you buy stock in a valid Rule 506 offering
* To resell the stock, you must either register the security or find an exemption
* § 4(a)(1) exempts transactions that do not involve an “issuer, underwriter, or dealer”
* If you turn around and sell after purchasing in a private placement, you may be found to have purchased “with a view to” distribution – thus you would be an underwriter, and the § 4(a)(1) exemption would be unavailable….
Whether the re-seller is an affiliate of the issuer
* An affiliate = “a person that directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with” the issuer
* SEC guidance: “An affiliate is a person, such as an executive officer, a director, or a large shareholder, in a relationship of control with the issuer.”
Whether the security is restricted or not
* “Restricted” = “acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering”
* So: shares sold in an IPO are unrestricted; shares sold in a Rule 506 offering are restricted
Whether the issuer is an Exchange Act-reporting issuer or not….
* Public company selling private shares
Requirements for non-affiliates selling restricted securities:
If you’re a non affiliate and you buy a non restricted security, you basically don’t need 144 at all.
Holding period
* a one-year holding period if the issuer is not a reporting company under the Exchange Act
* a six-month holding period if the issuer is an Exchange Act reporting company
* Note: the “clock” starts from the later of the acquisition of the securities from (1) the issuer or (2) an affiliate of the issuer
Information = [What information must the re-seller either provide or ensure is available to the purchaser?]
* After one year, no information required
* Before one year, information must be provided:
* This applies only when the non-affiliate reseller wants to sell the securities of an Exchange Act reporting issuer after the six-month holding period has expired, but before one year has passed
* If the issuer is not an Exchange Act reporting company, then the holding period is a year and once one year passed, the nonaffiliate is under no obligation to ensure that info is available to purchaser
The information requirement is satisfied if the information is “available”; the info is deemed available if the issuer:
* Has been a reporting company for ≥ 90 days, and
* Is current in its Exchange Act periodic disclosure filings for the past year
NOTE
* If the security is unrestricted, you are good to go.
NOTE
* Purchaser of restricted securities receives securities that are not restricted securities - cleansed
Requirements for affiliate sales under Rule 144:
If you sell in a Rule 144 offering, the person who buys the securities from you has now bought unrestricted securities.
* So these securities are no longer restricted
Holding period
* No holding period for unrestricted securities;
* the rest of the requirements under Rule 144 for affiliate resales apply to transactions in restricted and unrestricted securities; and apply to resales of restricted securities even after the one-year holding period expires
Holding period restricted securities:
* One year for non-Exchange Act reporting issuers
* Six months for Exchange Act reporting issuers
* [Note: this is the same rule as for non-affiliate resales]
Information
* So no matter what, if you’re an affiliate trying to sell shares of the issuer, you have to ensure that: information is available.
* Exchange act reporting just make sure they’re up to date.
* Non Exchange Act reporting make sure that the issuer has made this required information public.
Limitations on trading volume
* Rule 144(e) restricts the amount of affiliate resales of restricted and unrestricted securities in any three-month period
Manner of sale
* Affiliates, and those selling on their behalf, can only resell equity securities in certain manners – most typically through unsolicited “brokers’ transactions” (i.e., the way brokers ordinarily operate, and with customary compensation to the broker)
Notice of proposed sale
* Affiliates (and those selling on their behalf) must file a Form 144 with the SEC
* lots of disclosures: identity, relation w/issuer, info on all securities that investors sold past 3 months, a lot more
* de minimis exception (sales do not exceed 5k shares for aggregrate sales < 50k)
RESALES
Rule 144A
R144A no cleansing
If certain requirements are met, Rule 144A exempts resales of restricted securities to qualified institutional buyers (QIBs)
* A “Rule 144A offering” → issuer sells to investment bank under Rule 506, and the investment bank immediately resells to QIBs under Rule 144A
* They could not do this under R144 because holding requirement
* But R144A, no holding period
There are four basic requirements for the application of Rule 144A:
* Sales must be to a QIB → large institutional investors = not individuals
* Purchasers must be notified of the exemption
* Non-fungibility
Disclosure
* Exchange Act reporting issuers are exempt from (further) disclosure requirements under Rule 144A
* Private issuers must commit to providing prospective Rule 144A purchasers with various disclosures upon request = no sunset provision for this commitment
But issuers routinely make the commitment, because:
* The obligation is not that onerous, and
* If the issuer did not make the commitment, purchasers would likely demand a much larger liquidity discount when they buy from the issuer
Non-fungibility
* Restricted securities (e.g., sold in a PIPE) that are of the same class as securities listed on a national securities exchange are not eligible for Rule 144A resales
* So if the pipe offering is simply common stock of a company that’s already public, you cannot resell them under rule 144, because that’s the same thing that’s already being sold on public exchanges.
Issuers will often sell convertible securities – e.g., preferred shares that can convert into common stock, when the common stock trades on a national securities exchange
* These are only eligible for Rule 144A resales if the “conversion premium” is at least 10 percent at the time of the initial sale
Note that non fungibility is never going to be an impediment to a rule 144A resale if the issuer is not a public company.
* Because if it’s not a public company, then the shares aren’t going to be traded on a national securities exchange.
