Securities Regulation Outline
Introduction
Cast of characters
·
Traders
o
Lifecycle
traders
§ People who don’t know they are trading in securities; mutual funds,
etc.
o
Informed
traders
§ Sophisticated persons or persons whose main job is trading; people
who trade on true value.
o
Noise traders
§ People who trade on unverifiable information; destabilize the
market.
o
Accredited
investors
§ Wealthy people who can make risky investments
o
Strategic acquirers
§ Usu. companies that purchase a controlling interest in another
company.
o
Financial
acquirers
§ People who buy only to resell soon.
o
Designated
market makers
§ A person assigned to one company’s securities to buy or sell them
when there is no trader on the market who is interested in buying or selling
the security; contribute to the liquidity of the market ensuring an easy
entrance and exit for everyone; make money from high volume of razor thin
margins.
·
Marketers
o
Underwriters
§ Purchase all / most of the newly issued shares and resell them to
distribution contacts first, then to the public.
o
Brokers /
Dealers
§ Facilitate buying and selling for a commission.
·
Discount
brokers (e.g., eTrade, ScottTrade, etc.) offer the bare minimum and have no
research division.
·
Full service
brokers.
o
Speculators
o
Hedge funds
o
Arbitrageurs
§ When dual-listed stock is undervalued on one exchange and
overvalued on another, arbitrageurs purchase the stock on the former and sell
or short-sell it on the latter.
·
Regulators
o
Congress
o
SEC
§ Divisions
·
Corporate
Finance
o
Regulates how
corporations receive money from investors
·
Trading &
Markets
o
Regulates NYSE,
Nasdaq, etc.
·
Investment
Management
o
Regulates
private fund managers (e.g, Madoff)
·
Enforcement
o
Arresting
powers
o
FTC
o
Self-governing
organizations
§ NYSE
§ Nasdaq
Stages / fora
·
Stock exchanges
·
Alternative
systems
o
Algorithms
o
Dark pools
Laws
·
Securities Act
of 1933
o
Regulates how
securities are issued.
·
Securities
Exchange Act of 1934
o
Regulates the
post-issuance aspects of securities.
·
Trust Indenture
Act of 1939
o
Regulates the
contracts for bonds.
·
Sarbanes-Oxley
·
Dodd-Frank
·
JOBS Act
Securities Fraud
Common law deceit – RS2 Torts
·
Liability for
deceit
o
One who makes a
fraudulent
misrepresentation of fact, opinion, intention, or law or, when
under a duty, fails
to disclose a fact for the purpose of inducing another to act or to refrain from
action in reliance upon it is liable to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.
·
Individual
elements
o Fraudulent misrepresentation
§ The speaker knows or reasonably believes that the statement is
inaccurate or, although accurate, materially misleading for lack of qualifying
information.
o Or nondisclosure
§ When under a duty to disclose, particularly in business transactions,
failure to speak can equate to a fraudulent misrepresentation. Disclosure may
be required when:
·
One owing a
fiduciary duty to another has knowledge which the other is entitled to know;
·
When it is
necessary to make previously made statements not misleading;
·
When he
reasonably believed that a previous misrepresentation would not be acted upon,
then subsequently learns that another plans to act upon it; or
·
Whenever
industry standards or course of dealing would normally require disclosure.
o To another
§ The speaker is liable for statements made directly to
another or, when the speaker reasonably expected the statement to reach a third
party, for statements made indirectly to a third party.
o
Who
justifiably relies upon it
§ A person justifiably relies upon a misrepresentation when the
subject matter is material.
·
Subject matter
is material when a reasonable person would attach importance to it in making a
decision or, when the speaker knows the subjective importance of the matter to
the person, what the person would attach importance to subjectively.
·
So a blatant
lie that is not reasonably important to the matter at hand does not create
liability.
§ A person does not justifiably rely on a statement when he knows the
statement is false or its falsity is obvious to him.
o Causing loss
§ Damages are limited to pecuniary losses caused by the
misrepresentation.
§ In a sale, the harmed party may recover the difference in value of
the price paid or received in the transaction and the actual value of the item.
§ In a contract, the harmed party may recover the value of the
benefit of the bargain with the maker.
Misrepresentation
Section 10(b), Securities Exchange Act of 1934
·
It shall be
unlawful for any person, directly or indirectly, by the use of any means or instrumentality
of interstate commerce or of the mails, or of any facility of any national
securities exchange . . . to use or employ, in connection with the purchase or
sale of any security registered on a national securities exchange or any
security not so registered, or any securities-based swap agreement any
manipulative or deceptive device or contrivance in contravention of such rules
and regulations as the Commission may prescribe as necessary or appropriate in
the public interest or for the protection of investors.
SEC Rule 10(b)(5)
·
It shall be
unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of
any national securities exchange,
a)
To employ any
device, scheme, or artifice to defraud,
b)
To make any
untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or
c)
To engage in
any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person,
in connection
with the purchase or sale of any security.
Brascan v. Edper
·
Edper was a
joint venture and a shareholder in Brascan;
·
Brascan was in
negotiations for the acquisition of Woolworth’s, which Edper opposed.
·
Edper began
buying more shares and building up its ownership in Brascan, with an eye
towards obtaining a controlling interest to prohibit the acquisition;
·
Edper made a
large purchase of shares, then said it would not buy any more shares;
o
Brascan moved
forward with negotitations for the acquisition of Woolworth’s
o
The co-owner of
Edper expressed dissatisfaction with the low shareholding in Brascan with the
other co-owner in charge of the U.S. operations.
·
The next day,
Edper buys more shares.
·
Brascan seeks
to enjoin the purchases and prohibit Edper from buying more shares under SEA 10(b)
·
Held: Edper’s
statement that it would not buy any more shares was not deceptive given the
circumstances, but Edper’s subsequent nondisclosure by remaining silent while
purchasing more shares in contravention of its previous statement was an
omission subject to 10(b), failure to make previously made statements not
misleading.
Sharp v. Coopers & Lybrand
·
In July,
defendant sends a letter to investors containing no errors and stating that all
is well with the investment;
·
Later,
defendant discovers fraud within the investment;
·
Thereafter, in
October, defendant sends a verbatim copy of the letter stating that all is
well.
·
The investors
sue, that defendant’s silence in failing to disclose the fraud was misleading,
that the duty to disclose arose immediately upon learning about the fraud.
·
Held: In
dicta, the court notes that the defendant is liable for mailing the second
letter in October without mentioning the fraud, but that there is no
nondisclosure liability for failing to notify the recipients of the July letter
of the fraud immediately upon learning about it in order to make a previously
made statement not misleading. [This is what prof. says / what he is trying to
get at. This is dicta found in one paragraph out of the opinion and I’m not
sure the court even knew they were making this assertion, it could be an
error].
Backman v. Polaroid
·
In October,
Polaroid realizes that the success of the investment was overstated
·
In November,
Polaroid files its quarterly statement, which correctly notes the overstatement,
but maintains that all is well;
·
In February,
Polaroid announces the failure of the project;
·
Plaintiffs sue,
that Polaroid had a duty to update the quarterly statement sometime between
November and February to make the statement that “the success of the investment
was slightly overstated, but all is well” not misleading;
·
Held:
While the quarterly report became misleading between November and February,
Polaroid had no duty to update the statements therein. The report was not a
forward-looking statement, but an isolated description of the circumstances at
that point in time. Plaintiffs’ reliance on the report was thus not
justifiable.
Section 21E, SEA
·
Provides a safe
harbor for forward-looking statements, which are meticulously defined and only
applies to certain speakers.
Santa Fe Industries v. Green
·
∆ owned 95% of
Kirby, remaining 5% held by public shareholder πs.
·
∆ invoked
Delaware’s short-form merger statute which allows a 90% shareholder to merge
with the subsidiary and buy out the minority shareholders, but also gives the
minorities the right to petition the court for a neutral appraisal of the value
of their shares.
·
∆ stated to πs
that their shares were worth $125 each, but it would pay them $150 each.
·
πs went
straight to federal court and sued under SEA 10(b) and Rule 10(b)(5), that
their shares were worth $772 based on the value of Kirby’s total assets and
that the ∆’s statement that their shares were worth $125 was a fraudulent
misrepresentation.
·
Held:
Kirby is a public company, all of the pertinent information is openly available
to plaintiffs, so the lowball offer was not misleading. While this may be
fraud, it is not meant to be in the purview of federal securities law.
Plaintiffs have a state law remedy for fraud and/or violation of fiduciary
duties owed to minorities. Plaintiffs also have the appraisal remedy.
Reliance
Common law deceit requires a proving of actual reliance.
Securities law is different.
Fraud on the market presumption of reliance
Generally
Basic, Inc. v. Levinson
·
Basic and
Combustion Engineering entered into negotiations regarding a possible merger.
·
On October 21
and on two other occasions, Basic lied and said it was not in any discussions.
·
Basic and
Combustion came to an agreement and, on December 18 the next year, Basic
announced the merger.
·
Former Basic
shareholders who sold their shares between October 21 and December 18 brought a
class action suit, that Basic’s fraudulent misrepresentations caused them harm
by artificially depressing the value of their shares when they sold them.
·
Basic countered
that the burden is on plaintiffs to prove that each one individually relied on
the false misrepresentations when choosing to sell their shares.
·
Plaintiffs
asserted that they relied on the integrity of the market to produce a correct
valuation of their shares, that defendant’s misrepresentations artificially
interfered with the market’s integrity.
·
Held:
Plaintiffs have a rebuttable presumption of reliance due to defendant’s
fraud-on-the-market. The presumption can be rebutted by showing that something
severed the link between the misrepresentation and either the price or the
plaintiff’s decision to trade.
Mirkin v. Wasserman
·
Plaintiff
purchased shares of defendant’s stock in several different public offerings
during a three year period;
·
At the end of
that period, the value of the shares had dropped significantly and defendant
had lost several millions;
·
Plaintiff
brought suit in state court for common law deceit alleging that defendant made
several misrepresentations in prospectuses, financial statements, and other
public documents filed with the SEC which artificially inflated the value of
the shares.
·
Plaintiff did
not actually rely on the alleged misrepresentations, but attempted to plead the
fraud-on-the-market theory presumption of reliance in his common law claim,
that the defendant’s fraud on the market artificially inflated the value of the
shares inducing plaintiff to buy.
·
Held: The
court declined to incorporate the federal fraud-on-the-market presumption of
reliance into the common law of deceit, which requires proof of some form of
actual reliance on the misrepresentation. The actual reliance can be indirect
(i.e., when one relies on a misrepresentation conveyed through a third party)
but here, plaintiff did not even read the prospectuses or other financial
documents allegedly containing the misrepresentations which artificially
inflated the value of the stock before he purchased it. The court declines to
hold that the market as a whole conveyed the misrepresentations to him by way
of the market valuation of the shares.
Rebuttals to the presumption
Truth
In re Apple
·
Plaintiffs
brought a class action against Apple and alleged that, during the class period,
Apple’s directors and officers made misrepresentations about the future success
of new Apple products which artificially inflated the value of Apple stock and
asserted the fraud-on-the-market presumption of reliance, that the artificially
inflated value of the stock induced them to buy at a high price.
·
By
the end of the class period, Apple’s stock price had plummeted, causing loss to
plaintiffs.
·
Defendant
attempted to rebut the presumption of reliance, stating that, even assuming the
directors’ and officers’ statements were fraudulent, the market was
well-informed of the risks, producing a fair stock price.
·
Held: Many of the statements were overoptimistic; however, defendant is
saved by the press because news releases containing statements by defendant’s
officers and directors included counter-statements and facts calling into
question the overoptimistic statements. Thus, the market produced a fair value
of the stock and the presumption is rebutted.
Trust in the integrity of the market
Freeman v. Laventhol & Horwath
·
Defendant
issued bonds to finance the construction and operation of a nursing home
facility, which eventually failed.
·
Plaintiffs
who purchased the bonds brought a class action under SEA 10(b) and raised the
fraud-on-the-market presumption of reliance, that defendant’s Official
Statement failed to disclose the risks involved with the project, which
artificially inflated the value of the bonds and induced them to purchase.
·
Held:
The presumption is not extended to bond issues on a primary market. The
presumption only applies on an efficient market because an efficient market
takes into account the totality of the information that is available, including
misrepresentations by a defendant as well as corrective statements by third
parties (e.g., as in Apple). Here, plaintiffs who did not
actually rely on the Official Statement cannot plead a presumption of reliance,
they should have done their homework on the risks involved. The alleged
misrepresentations and omissions in the Official Statement were not
communicated to an efficient market and an efficient market did not set the
value of the bonds. Rather, the value of the bonds was set by the underwriter
prior to the issuance.
Zlotnick v. Tie Comm’ns
|
Stock trading strategies
|
|
|
Buying long
|
Selling short
|
|
The buyer believes that the market has underpriced the value of
the stock, so the buyer purchases the stock now for the purpose of selling
the stock in the future when the market has corrected its undervaluation
error.
|
The trader believes that the market has overpriced the value of
the stock, so the trader borrows shares from a broker and sells them to
buyers today then, when the market has corrected its overvaluation and the
price comes down, the trader makes a covering purchase and pays the broker
for the shares at the lower price.
|
·
π sold short
∆’s shares at the current market price of $16 because he thought the financial
data did not warrant the market value of the shares.
·
Thereafter, ∆
issued several press releases fraudulently misrepresenting financials and
business prospects, which artificially inflated the value of ∆’s stock.
·
π cut his
losses and purchased the shares from the broker at $33.
·
Eventually, the
fraud came to light, ∆’s valuation fell to $4 per share, and π sued under SEA
10(b) and asserted a presumption of reliance, that ∆’s fraud caused him to
purchase at $33.
·
Held:
Short selling is a two-part transaction consisting of 1) the trader’s sale to
buyers and 2) the trader’s purchase from the broker. Here, π asks the court to
presume reliance for fraud that occurred in the middle. But a short-seller is ipso
facto a person who distrusts the integrity of the market; thus, it is
illogical to say that π thought the market was wrong on the short-sale, but
that π then relied upon the integrity of the market and thought it was right when
he purchased at $33.
·
Prof notes:
Note the importance of short-sellers, who contribute to correcting the
overvaluation of the market, and the adverse effect this opinion has on them.
If the short-seller makes the cover purchase involuntarily (e.g., because of a
margin call where the broker says time is up and forces him to buy, or because
of a property settlement in a divorce decree), then the presumption of reliance
should be allowed because the short-seller’s decision to sell is not a question
of an inherent distrust in the marketplace, but is forced via a court order.
|
Costs of Deceit
|
|
|
Real goods
|
Financial
goods
|
|
Effects are temporary because real goods are not intangible and complex,
they are tangible and can be examined easily. The buyer’s dis/satisfaction is
almost immediate.
|
The true value of financial goods cannot be determined
immediately upon purchase; one would have to hire auditors and accountants to
dig into the financial data in the company’s books, which are not always
available to the public
|
|
They are bought and sold locally, usually hand to hand.
|
They are traded on national and international exchanges.
|
|
Manufacturers are inherently disincentivized from making
misrepresentations because it will harm them in the long run.
|
Misrepresentation is incentivized because it allows a company to
grow and, eventually, attain a monopoly by buying out competition.
|
|
The price impact of deceit is low since the supply / demand curve
eventually reaches zero.
|
The price impact of deceit is high because the CAPM scale reaches
to infinity.
|
|
The result of
deceit for both real and financial goods is a waste of resources in
precautions
|
|
|
For real goods, the costs are inspectors, collecting history
reports, doing walk-throughs, buying locks, security guards, etc.
|
Where there is no regulation, people simply refuse to enter the
financial goods market. However, regulation raises the cost of capital to
firms. Thus, we must create disincentives for deceit by, e.g., making class
actions easier, making a “seller disclose” rather than “buyer beware” system.
|
Materiality
Generally
TSC v. Northway
·
Northway was a
shareholder in TSC
·
National
Industries sought to acquire TSC, purchased a significant amount of its shares,
and filled TSC’s BoD with its henchmen.
·
TSC’s new BoD
voted to liquidate, exchanging TSC stock held by TSC shareholders with National
stock.
·
TSC and
National issued a joint proxy statement to their shareholders for the purpose
of encouraging shareholders to approve the transaction.
·
I’m not sure,
but it appears the proxy statement simply said “approve this transaction”
without explaining that TSC shares would be exchanged for National shares and that
TSC would dissolve because π sued, that he was not aware that the vote would
give control over TSC to National and that such an omission was a material
misrepresentation under SEA 14(a) and SEC Rule 14(a)(9) promulgated thereunder
(both of which apply to proxy statements, but the materiality analysis is the
same for fraud in general).
·
SEC Rule 14(a)(9)
o
No solicitation
subject to this regulation shall be made by means of any proxy statement, form
of proxy, notice of meeting or other communication, written or oral, containing
any statement which, at the time and in the light of the circumstances under
which it is made, is false or misleading with respect to any material fact, or
which omits to state any material fact necessary in order to make the
statements therein not false or misleading or necessary to correct any
statement in any earlier communication with respect to the solicitation of a
proxy for the same meeting or subject matter which has become false or
misleading.
·
Held: The
omission was not material. “An omitted fact is material if there is a
substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote. . . . There must be a substantial likelihood
that the disclosure of the omitted fact would have been viewed by the
reasonable investor as having significantly altered the total mix of information
made available. . . . Only if the established omissions are ‘so obviously
important to an investor, that reasonable minds cannot differ on the question
of materiality’ is the ultimate issue of materiality appropriately resolved as
a matter of law by summary judgment.”
·
Policy
rationale of materiality: If the standard is too low, then
companies can be liable for meaningless, insignificant omissions and, thus,
they will flood shareholders with mountains of unnecessary information as a
CYA, which will frustrate the purpose of the “seller disclose” function of
securities law because shareholders would just ignore the information
altogether or, alternatively, the cost of capital will increase because
professional securities traders would have to spend significantly more time
poring through masses of documents. On the other hand, we don’t want the
standard of materiality to be too high because that would defeat the purpose of
securities law.
Basic v. Levinson (again)
·
Basic and
Combustion Engineering entered into negotiations regarding a possible merger.
·
On October 21
and on two other occasions, Basic lied and said it was not in any discussions.
·
Basic and
Combustion came to an agreement and, on December 18 the next year, Basic
announced the merger.
·
Former Basic
shareholders who sold their shares between October 21 and December 18 brought a
class action suit, that Basic’s fraudulent misrepresentations caused them harm
by artificially depressing the value of their shares when they sold them.
·
Basic countered
that plaintiffs did not rely on the denials of merger negotiations when they
sold their shares (supra) and that the misrepresentations were not
material.
·
Held:
The court rejects the “Agreement-in-Principle standard of materiality (that a
misrepresentation or omission of fact is material when the price and structure
of the deal has been locked in) and adopts the TSC standard of materiality,
that a misrepresentation or omission of fact is material if the truth or
disclosure of the fact would be viewed by the reasonable investor as having
significantly altered the total mix of information made available. The court
notes that silence, absent a duty to disclose, is not misleading for securities
fraud purposes and blesses the use of “no comment.”
Exceptions to materiality
The “Bespeaks Caution” exception to materiality
In re Donald Trump
·
Plaintiffs
purchased bonds to finance the construction of a new casino in Atlantic City;
·
When the
project failed, plaintiffs sued under SEA 10(b) and SEC Rule 10(b)(5), that the
prospectus accompanying the issuance was materially misleading.
·
The prospectus
said, inter alia, “funds generated from operation of the casino will be
sufficient to cover its debt service.”
·
Held: In
the “total mix,” the prospectus was not materially misleading for the following
reasons:
o
The interest
rate was higher than the average corporate bond, indicating more risk;
o
Cautionary
statements in the prospectus noted:
§ Intense competition in the casino industry;
§ Unprecedented size of the casino;
§ That the bonds would not be repaid if the project failed.
The
prospectus is saved by the Bespeaks Caution Doctrine.
Immateriality and the safe harbor exception for
prospective statements
The Roots Partnership v. Lands’ End
·
Plaintiffs
allege that material misrepresentations made by Lands’ End artificially
inflated the value of their stock when they bought it.
·
Plaintiffs
allege two material misrepresentations:
o
A prospective
misrepresentation that Lands’ End’s goal for the next year was 10 percent net
pretax profits when the actual internal objective was 9.9 percent.
o
A retrospective
misrepresentation that Land’s End achieved 70-75 percent of its profit in the
second half of the year when second-half earnings historically accounted for
67-73 percent of total profits.
·
As to the
prospective misrepresentation, defendant asserts the safe harbor provision for
forward-looking statements contained in SEC Rule 175, which states:
o
A
forward-looking statement (which is defined as a statement containing a
projection of revenues, income, earnings, dividends, etc.) shall not be deemed
a fraudulent statement UNLESS it was made without a reasonable basis or in good
faith.
·
As to the
retrospective misrepresentation, defendant asserts that it was immaterial
·
Held:
There is no evidence that the prospective misrepresentation containing a .1
percent difference was made without a reasonable basis or in bad faith. Plaintiffs
and shareholders had public access to the financials of defendant which
contained the truth of defendant’s historical second-half performance. Thus,
the retrospective misrepresentation did not affect the total mix of information
available.
Materiality for low information in the total mix
United Paperworkers Int’l Union v. Int’l Paper Co.
·
Social activist
shareholders petitioned defendant to include on its next proxy statement a
resolution to adopt and comply with the Valdez ecological principles.
·
Defendant
included the resolution in the proxy, but included with it a statement
asserting that, although there were a few environmental lawsuits that it had
been sued on, defendant was already above the board in environmental
responsibility and adoption of the Valdez Principles was discouraged.
·
Plaintiff-Union
was aware of several serious environmental violations carried out by defendant
involving felony convictions and hefty fines and sued defendant under SEA 14(a)
and SEC Rule 14(a)(9) promulgated thereunder, that the proxy statement was
materially misleading.
·
Defendant
countered, that details of all of defendant’s entanglements with environmental
lawsuits were publicly available in its 10K report filed with the SEC along
with several news articles, that the “total mix” of information made the
omission of specific details immaterial.
·
Held:
The 10K report is publicly available, but not distributed in shareholders. In
its Annual Report distributed to shareholders, defendant cursorily notes that
the 10K is available for examination. Further, the news reports of
environmental lawsuits were sporadic and in obscure, local sources that would
not be readily available to shareholders. Thus, the omission of specific
details was material given the total mix of information.
Hanon v. Dataproducts Corp.
|
Relation between newsworthiness and news coverage of the transaction and
its surrounding circumstances and the materiality of the misrepresentations
|
|||||
|
|
Apple
|
Trump
|
Lands’ End
|
Int’l Paper
Co.
|
DataProducts
|
|
Newsworthiness
|
High
|
High
|
Moderate
|
Low
|
Low
|
|
Materiality
|
None
|
None
|
None
|
Yes
|
Yes
|
Scienter
[None]
Defining a security
Securities Act of 1933, Section 2(a)(1)
·
The term
"security" means any note, stock, treasury stock, security future,
bond, debenture, evidence of indebtedness, certificate of interest or
participation in any profit-sharing agreement, collateral-trust certificate,
preorganization certificate or subscription, transferable share, investment
contract, voting-trust certificate, certificate of deposit for a security,
fractional undivided interest in oil, gas, or other mineral rights, any put,
call, straddle, option, or privilege on any security, certificate of
deposit, or group or index of securities (including any interest therein or
based on the value thereof), or any put, call, straddle, option, or privilege
entered into on a national securities exchange relating to foreign currency,
or, in general, any interest or instrument commonly known as a
"security", or any certificate of interest or participation in,
temporary or interim certificate for, receipt for, guarantee of, or warrant or
right to subscribe to or purchase, any of the foregoing.
Substance over form
SEC v. Howey
·
Defendant owned
a citrus grove, one half of which defendant cultivated for income.
·
Defendant
offered the other half to the public by selling rows of trees with a real
estate contract.
·
Along with the
real estate contract, defendant heavily encouraged buyers to execute a service
contract that would:
o
Give
defendant’s personnel the sole right to cultivate, harvest, and market the
fruit from each buyer’s row;
o
Forbid buyers
from entering the land;
o
Pool all of the
produce from the serviced land together and give each buyer with a service
contract a portion of the profit.
·
Because the
terms of the service contract were fair and provided for the most
cost-effective way to realize a profit from the trees since defendant’s
personnel were already onsite, the majority of buyers chose to execute a
service contract in addition to the real estate contract.
·
The SEC sued to
enjoin defendant from its activities, that it was selling unregistered
securities to the public, that – specifically – the real estate and service
contract together constituted a service contract under SA 2(a)(1).
·
Held: The
statute says an “investment contract” is a security. The historical meaning of
an investment contract is 1) an investment of money; 2) in a common enterprise;
3) for the purpose of making a profit; 4) from another’s efforts. Thus, a
security is any scheme whereby a person invests money in a common enterprise
and is led to expect profits solely from the efforts of the promoter or a third
party. Here, the buyers who executed a service contract do not have any
subjective preference in which row they buy because all the produce is pooled
together and profits are distributed pro rata. And this is all from the efforts
of defendant’s personnel.
·
Substance over
form; the transaction is not termed as a sale of securities, yet it is.
United Housing Foundation v. Forman
·
Defendant
received a grant from the city for the responsibility of overseeing a
subsidized housing project, Co-Op City.
·
Defendant
created Riverbay Inc. to own and operate the building.
·
Eligible
tenants had to purchase shares in Riverbay in order to get an apartment in the
building; apartments with more rooms required the purchase of more shares, less
rooms required less shares; nonetheless, each tenant was entitled to only one
vote regardless of shareholding.
·
The shares
entitled tenants to a reduction in rent from a pro rata distribution of profits
realized from the leasing of commercial space to businesses on the ground-floor
of the building and from the coin laundry facilities.
·
When the rent
increased, plaintiff-tenants sued defendant for rescission of the sales of
shares under SEA 10(b), that defendant made fraudulent misrepresentations
inducing the sales.
·
Defendant
countered, that the transactions were not covered under securities law because
the tenants did not buy securities when they purchased “shares,” but they were
just purchasing the right to live in the building and share in a few
insignificant cooperative benefits.
·
Plaintiffs
replied, that they were shares because they had an expectation of profits in
the form of:
o
Rental
reduction from the commercial leasing and coin laundry;
o
Tax deductions
since some of their rent would go to paying mortgage interest; and
o
Savings from
being able to live in subsidized housing.
·
Held:
The “shares” sold in this transaction were not securities for SE or SEA
purposes. They bear no similarities to the common appearance of securities:
o
The shares are
non-negotiable. They can’t be pledged or mortgaged and they can only be sold
back to defendant.
§ Even so, their value cannot appreciate because tenants can only
resell the shares to defendant at the initial purchase price;
o
The voting
rights attached to them are not proportional; and
o
There are no
dividends
§ The “profit” alleged to be the motivation behind plaintiffs’
purchase of the shares is not income, they are just subjective benefits that
tenants have no control over. The only possible way plaintiffs could get a
profit from their shares is if the profit from the commercial leasing and
laundry facilities was so great that it wiped each tenant’s rent obligations.
Only then would tenants get money in their pocket.
The court
rejects the “risk capital approach,” that when there is a risk of loss
involved, even a non-security should be treated as a security (e.g., as
in a person who buys a share in a country club. The reason he is buying is to
have membership and enjoy the amenities. If the country club is already built,
then the share purchase should not be covered by securities law. But if the
country club is unbuilt and the purchase of shares will go toward its
development, then it should be so covered). Here, there was no risk of loss
involved because the tenants could trade in their shares for the exact purchase
price.
·
Substance over
form (again); the transaction is termed as a sale of securities, yet it is not.
Form over substance
Landreth Timber Co. v. Landreth
·
Defendant
sought to sell his timber company;
·
Pursuant to an
agreement with plaintiff, defendant sold ALL of the stock to plaintiff;
·
However,
defendant stayed on staff to help get plaintiff off the ground;
·
When the
project failed, plaintiff sued defendant seeking rescission of the transaction,
that defendant sold unregistered securities in violation of SA.
·
Defendant
countered, that the “Sale of Business Doctrine” removed the transaction from SA
coverage, that shares are not securities in the sale of all of a company’s
shares to one individual because the buyer is taking over the business for
himself and, thus, is not relying on the efforts of others to obtain a profit.
·
Held:
There are two kinds of stock purchasers in general:
|
Types of stock purchasers
|
|
|
Strategic
buyers
|
Financial
buyers
|
|
Usually businesses who acquire either working control or full
ownership for the purpose of expanding the business, alleviating a problem,
or creating a synergy with the existing business.
|
Usually individuals who are hoping that the business does well
and that, thus, they will receive dividends or an appreciation in the value of
their shareholding.
|
Here,
plaintiff is a financial buyer. He did not own any existing business, so none
of the strategic buyer purposes come into play. Plaintiff had no knowledge
whatsoever about timber milling, so defendant stayed on staff and helped with
managing the project; thus, plaintiff was more like a passive investor, having
no control over the success of the mill and hoping that all goes well.
·
Form over
substance; the transaction is termed as a sale of securities, but it does not
appear to fit within the Howey substantive definition of investment
contract.
Changes
Limiting private rights of action
Refusal of SCT to recognize private rights of action
SIPC v. Barbour
·
The Securities
Investor Protection Corp. (SIPC) is a government entity that has the discretion
to pay customers of failed brokerage firms for their losses.
·
A receiver of a
failed broker-dealer sought to compel the SIPC to pay him on behalf of the
customers, alleging a private right of action.
·
Held:
The SIPC is a creature of Congress, it has discretion whether or not to assist
and it does not have to act at the whim of private parties.
TAMA v. Lewis
·
The Investment Advisers
Act provides for the SEC to bring suit for punitive damages and also declares
that certain fraudulent contracts shall be void.
·
Plaintiff
brought suit for rescission of the contract and for punitive damages, alleging
a private right of action.
·
Held:
The provision declaring that the fraudulent contracts are void creates a
limited private right of action for rescission of contracts, but this does not
mean that the punitive damages are available to private parties also.
Touche Ross Co. v. Redington
·
Section 17(a)
of the 1934 Act which broadly requires individuals to maintain records does not
create a private right of action for clients who were damaged by a broker’s
failure to comply with the requirement
by maintaining such records.
Aiding and abetting liability
Central Bank of Denver v. First Interstate Bank of Denver
·
Central Bank
was the indenture trustee of a bond issue secured by real estate.
·
The issuer
provided Central Bank with an appraisal of the land that was 16 months old and
did not reflect changes in property values.
·
Central Bank
was aware of the issuer’s fraudulent appraisal, but didn’t do anything about
it.
·
Purchasers sued
Central Bank for aiding and abetting the issuer’s violation of Sect. 10(b).
·
Held:
There is no aiding and abetting liability under 10(b)(5); to hold otherwise
would be to allow liability without the requirement of proving reliance, as
required in direct 10(b)(5) cases.
·
Dissent:
The Courts of Appeal recognize aiding and abetting liability based on a tort
standard. A civil claim for aiding and abetting would have helped to avoid the
2008 crisis because third parties would be more careful.
State class actions
Epstein v. MCA, Inc.
·
Plaintiffs
alleged a due process violation in their securities law claims, that counsel had
a conflict of interest.
·
The suit was
based on state law because federal securities law claims may not be litigated
in state courts. But the only way counsel could get money on the federal claims
was to settle with the defendant.
·
Counsel’s
interests were more in line with defendant’s than with plaintiffs’ on the
claims; settlement on the state law claims would also settle the federal claims
through issue preclusion.
Registration
The registration process
1933 Act, Section 5
a.
Until an
effective registration statement, there shall be no:
1.
Sales of
securities; or
2.
Delivery of
securities for sale.
b.
After filing a
registration statement, you shall not:
1.
Transmit a
non-§10 prospectus; or
2.
Deliver a
security for sale with a §10(a) (post-effective) prospectus.
c.
Prior to filing
a registration statement, you shall not offer a security for sale.
|
Section 5 of
the 1933 Act
|
|||
|
c. Prior to filing a registration statement, there shall be no
offers to sell a security.
|
“Offer” means ANY attempt to sell, solicit a
counteroffer for, or otherwise dispose of a security, except for negotiations
with underwriters.
|
||
|
b. After filing a registration statement, you shall not:
|
|||
|
|
1. Transmit a non-§10 prospectus, or
|
Before effectiveness, enter the “roadshow” period.
§2(a)(10) defines a prospectus as “any
communication which offers or confirms the sale of a security
§2(a)(10)(b) excludes from the meaning
advertisements stating only:
·
The security;
·
The price;
·
The
underwriter(s) (defined as any purchaser with an eye toward distribution);
and/or
·
From whom a
prospectus can be obtained.
Rule 134 provides further exclusions and
requires a legend along with any pre-effective, post-filing roadshow
communications.
Rule 430 provides that the incomplete
registration statement is a permissible communication during the roadshow.
|
|
|
2. Deliver a security for sale without a §10(a) (post-effective) prospectus.
|
After effectiveness of the registration, enter the “free writing”
period.
This provision requires that the issuer deliver a prospectus
containing the finalized registration information along with the security,
which logically means that it doesn’t apply until after effectiveness.
|
||
|
a. Until the registration statement is effective, there shall be
no:
1. Sale of securities,
or
2. Delivery of
securities for sale.
|
|||
Exemptions from registration
SEC v. Ralston Purina
·
∆ offered
unregistered stock options to its “key employees,” those in both labor and
management who have influence in the organization in some way.
·
SEC sued for
injunction; ∆ countered, that it was not a “public offering” and, thus, no
registration required.
·
Held: The
purpose of the Act is investor protection. Thus, only an offering to those who
are able to fend for themselves is considered a private placement and all
others are “public offerings.” Here, laborers are probably not savvy enough to
fend for themselves and require the protections of the Act.
Rule 506 exemptions from registration
·
Offerings to no
more than 35 non-accredited investors and that comply with Rules 501 and 502
are exempt.
·
Rule 501
o
Provides a long
list of accredited investors.
·
Rule 502(b)
o
The private
purchase memoranda (the functional equivalent of a registration statement,
contains the same information) must be provided to the 35 or less
non-accredited investors PRIOR to the sale.
The prospectus
Gustafson v. Alloyd Co.
·
The 1933 Act
provides for rescission where a seller made material misrepresentations or
omissions in the prospectus.
·
π purchased the
business by purchasing all of ∆’s shares.
·
The contract
contained misrepresentations.
·
π sought
rescission, that the contract is included within the meaning of prospectus.
·
Held:
Prospectus should be defined to give consistencey to the Act, which provides in
part that a prospectus “shall contain information in the registration
statement.” There is no statutory provision that requires a share purchase
agreement to contain information that would be included in a registration
statement; thus, it would be inconsistent to define a share purchase agreement
as a prospectus. Further, a prospectus is generally a document held out to the
public for an issuance or sale of securities by the issuer or a controlling
shareholder, not a private contract for the sale of a closely held business. Thus,
π cannot rescind under the Act.
·
Note that if
the SCT had not overturned the Sale of Business Doctrine in Landreth,
then this case would be moot because shares in the total sale of a business
would not be defined as a “security” and would thus not come under the Act’s
extensive regulations and/or exceptions.
|
Rescission
under the Act
|
||
|
Forman
|
Landreth
|
Gustafson
|
|
The “shares” for apartments are not securities, so buyers cannot
rescind under the Act
|
The shares in the sale of a business are securities and buyers
can rescind.
|
Same, but buyers cannot rescind.
|
Disclosure theory
Teoh and Hwang: silence can be used by firms to signal information
that they could not otherwise disclose.
Insider trading
Chiarella v. U.S.
·
∆ worked for a
printer contracted to print advertisements for an impending takeover bid.
·
The names of
the parties were not revealed until just before printing, even so, ∆ was able
to deduce the information.
·
∆ bought shares
of the seller for cheap, then sold at the elevated value after the takeover was
announced.
·
∆ was sued by
the SEC for defrauding.
·
The 2d Circuit
held ∆ liable under a common law deceit theory, that ∆ was required to disclose
the material information regarding the impending takeover bid before he sold
the shares, that the Act requires “equal access to information.”
·
Held:
This is not a case of common law deceit. ∆ had no fiduciary link to the buyer
that would give him a duty to disclose material information.
·
The SEC
responded by promulgating Rule 14e-3(a), which states that trading with
undisclosed information about an impending bid is a deceptive practice.
Dirks v. SEC
·
Disgruntled
insiders informed ∆ of fraud within the corporation.
·
∆ informed his
clients of the fraud, who then sold their stock in the corp. and gave
commissions to ∆
·
When the price
plummeted, the SEC investigated and found fraud in the corp. as well as the
fact that ∆ received the tip.
·
The SEC sued ∆
for insider trading.
·
Held: If
the tipper was breaching a fiduciary duty to the corporation in giving the tip
to the tippee AND IF the tippee gave valuable consideration in exchange for the
tip, then the tippee would definitely inherit the tipper’s fiduciary duties to
the corp. and be liable for insider trading. But EVEN IF, the tippee gave no
consideration and the information was received as a gift, then the tippee would
still probably be guilty of insider trading. Here, everything was done with an
altruistic purpose – the tipper who was upset with the corporate fraud and the
tippee who first tried to get the WSJ to publish the story – so no insider
trading.
U.S. v. O’Hagan
·
The attorney
for the acquirer knew that a tender offer (a public offer to pay shareholders a
premium for their shares) was about to be made to the target.
·
The attorney
purchased shares in the target and sold after the tender offer came out in
violation of Rule 14e-3(a); the SEC sued.
·
Held: The
SCT laid out the Misappropriation Theory, which looks to the dishonest nature
of the conduct with an eye toward fiduciary duties. Here, the attorney is an
agent of the acquirer and his purchase of the target’s shares before the tender
offer was not in the best interests of the client.
Haddock & Macey
Prohibition of
insider trading simply transfers money to informed traders
NLG’s retort:
prohibition is good
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