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Securities regulation outline part one: raising capital I. Securities regulation overview


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PART TWO: LIABILITY




VIII. CIVIL LIABILITY UNDER THE 33 ACT



A. § 11 Liability Provisions: Fraud in the Registration Statement: The idea behind § 11 is that a material misstatement or omission in an effective registration statement already filed subjects the issuer to a prima facie case by anyone who bought the security – whether in the primary market or secondary market. “Free-writing” materials are not part of this, however. There are many possible defendants: the issuer, signatories of the registration statement, directors, partners, soon-to-become partners, expert parties, and underwriters. But not lawyers (lawyers they can be taken care of in malpractice, other means).
1) Immediate Defenses:
a) Statute of limitations: § 13: Strict one year statute of limitations after plaintiff discovers or should have made discovery and action cannot be brought more than three years after security offered to public.
b) Reliance: Though reliance is not required by the plaintiff during the first year, after 12 months of earning statements, the plaintiff must show reliance on the registration statement. Idea is that new info in annual reports has come out.
c) Resignation: If defendant has resigned with a letter and informed the SEC of the misstatement then they will be off the hook.

2) The Due Diligence Defenses: § 11 placed the burden on the defendants to show their nonculpability regarding portions of the registration statement. § 11 divides the portions into expertised and non-expertised. Goal is to get as many on hook as possible, force compliance.


a) Expertised Portions: Expertised portions of the registration statement are portions prepared or certified by an expert. This can be audited financial information or legal opinions.

The Expert: The Expert must show that they conducted a reasonable investigation and had reasonable grounds to believe and did believe that the expertised portions were true within their area of expertise. (same as Non-Expert for Non-Expertised). “I didn’t know is not sufficient.” Expert must literally kick the tires, ask the tough questions.

§ 11(b)(3)(B): (Sets forth).
The Non-Expert: The Non-Expert must show that they had no reason to believe and did not believe that the expertised portions were false.

§ 11(b)(3)(C): (Sets forth)

b) Non-Expertised Portions: Non-Expertised portions of the registration statement not prepared by an expert. These are unreasearched statements.



The Expert: No liability.
The Non-Expert: The Non-Expert must show that they conducted a reasonable investigation and had reasonable grounds to believe and did believe that the expertised portions were true. (same as Expert for Expertised). “I didn’t know is not sufficient.”

§ 11(b)(3)(A): (Sets forth)
c) Due Diligence Requirements (Generally):
Escott v. BarChris Constrution Corp. [USSD NY 1968]: Defendant BarChris company built bowling alleys, needed to raised capital, drafted registration statements to issue debentures. Reg. Statement seriously misstated company’s finances, overstated the number of bowling alleys BarChris had sold, did not disclose that BarChris would lose money on some notes, misstated backlogged orders, did not disclose that $ would go not to reconstruction but to debt financing, and that some insiders had not repaid loans. BarChris eventually filed for bankruptcy. Held: Everyone’s liable, should have investigated.

i) Outside Directors: Outside Directors due diligence can be related to their access and their position and their level of knowledge.


ii) Inside Directors and Offices: Inside Directors and offiecers are expected to make more complete investigations, because of familiarity. Presumed experts.
iii) Underwriters: Lead underwriter generally held to a higher standard than the syndicate underwriters.
iv) Experts: Only liable for information in their area of expertise.
3) Causation and Damages: The § 11 plaintiff does not need to prove causation, however, the defendant can advance causation as a defense to the plaintiff’s claim.
1) The Negative Causation Defense: Defendant can have a defense if they can show that other factors than the misinformation caused or contributed to making the price of the stock to fall. War, terrorism, loss of a CEO, etc. Defendant can write “event studies.”
Akerman v. Oryx Communications [2nd Cir. 1987]: Plaintiff challenged misinformation in IPO registration statement. Price went down between IPO and filing of suit. Price went up, however, between disclosure to public and the suit. Held: No causation.
2) Damages: Defendant will fight all of these with the negative causation defense, particularly the value issue.

Formula:


Cap: Damages cannot be any more than the aggregate offering price. Damages then depend on when plaintiff sold securities.

a) Securities Sold Before Suit:

Purchase Price

Sales Price
b) Securities Sold After Suit, Before Judgment:

Purchase Price



– Sales Price
c) Securities Held at Judgment:

Purchase Price



– Value at Time of Suit (not “Market Price”)

4) § 11 Plaintiffs: All purchaser of registered securities have standing to sue. Hertzberg v. Dignity Partners, Inc. [9th Cir. 1999]. Securities must be traced back to offering, though.


B. § 12 Liability Provisions:

1) Strict Liability for Offeror/Sellers: § 12(a)(1) imposes strict liability against sellers of unregistered securities when no exemption applies. ICC jurisdiction. Defendant can’t say “I didn’t know I was supposed to register.” Ultimate compliance required. Plaintiff must show:


a) Defendant Was an Offeror or Seller: Seller could have either transferred title, but could have participated in the solicitation. You can only go after your seller, not your seller’s seller.
Pinter v. Dahl [SCt. 1988]: Pinter had an oil and gas venture. Dahl purchased shares in the venture and then recommended to his friends that they buy shares. Venture failed, investors sued Pinter for recission. Pinter tries to get Dahl on the hook, too. Question was whether Dahl himself was an offeror or just gratuitous promoter. Blackmun Held: Anyone who solicits for their financial interest is a seller (broker etc). Giving gratuitous advice doesn’t make one a seller.
b) Defendant Failed to Comply With § 5 Req.s: Unregistered offer, no prospectus, etc.
c) Defendant’s Only Defense: Exemption: Defendant does have a defense if securities would have been exempt.
d) Remedy: If plaintiff still owns, gets back money and interest (no interest in § 11).

2) Misrepresentations in Public Offerings: § 12(a)(2) applies when there is a material misstatement of ommision in the prospectus in a public offering. Somewhat of an extension of § 11, applying to prospectuses.


a) Prospectus Must be In Registered Public Offering: Private offerings don’t qualify, nor do purchase price agreements. Those in a private placement can already “fend for themselves.”

Gustafson v. Alloyd Company, Inc. [SCt. 1995]: Closely held corporation sold all of its shares to an investment corporation. Investment company sued under § 12(a)(2) for rescission. Said there were material misstatement. Kennedy Held: Definition of prospectus only applies to public offerings.
b) Defendant Defenses: Defendant can show a) reasonable care and b) negative causation.

IX. CIVIL LIABILITY UNDER THE 34 ACT



A. Materiality: A misstatement of omission must be material. The same definition of materiality applies to both Rule 14a-9 and Rule 10b-5. What’s required under Reg. S-K is definitely material. In addition:
1) The General Standard: “Substantial Likelihood”: The TSC general standard often applies. There is no bright-line rule otherwise the flexibility of the SEC would be greatly reduced.
TSC Industries, Inc. v. Northway, Inc. [SCt 1976]: Marshall Held: A fact is material if “there is substantial likelihood a reasonable investor would consider it important” in making a securities related decision. This was a compromise between facts an investor “might” and “would” consider. This is a content-specific standard.
a) Quantitative & Qualitative Materiality: The “Total Mix” Test: Quantitative information is information that could effect the stock price (less than 5% is likely not material; between 5-10% could be material; more than 10% if material). Qualitative information is information about labor problems, illegal conduct, etc. This is always material if it refers to illegal activity or conflicts of interest. If client has bad news, disclose but don’t bury.
Ganino v. Citizens Util. Co. [2nd Cir. 2000]: Company stored 1995 income to use in 1996. Held: Even though misstatement only 1.7% revenue, was material.
2) Soft Information & Forward-Looking Statements: Soft information and forward-looking statements can also be material.
a) Puffery: Common law notion that puffery is not actionable. Regardless, Courts consider 1) how general the statement is; 2) whether the statement is one the company would utter regardless of the facts. Market will understand when company “puffs.”
b) The Probability-Magnitude Test: Another test for materiality is balancing of the probability and magnitude of the potential event. Say “no comment.” No need to voluntarily disclose. Materiality does not give rise to duty to speak. Business matters are not co-extensive with securities law obligations.
Basic v. Levinson [SCt 1988]: Combustion and Basic were going to merge. On three times Basic publically denied it was going to merge. Held: Materiality “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event.”
c) The Bespeaks Caution Doctrine (Judicial): Forward-looking statements inevitably can turn out wrong. The Bespeaks Caution Doctrine is a safe-harbor because it can immunize forward-looking statements if accompanied by cautionary documents. This entices companies to put the information out there.
d) Meaningful Cautionary Language: Rule 175 and 3b-6 (SEC): Benefits of safe-harbor are only for forward-looking statements. Codified in the PSLRA. Satisfying one of these by the defendant precludes action:

i) Defendant Did Not Have Actual Knowledge: If the defendant did not have actual knowledge that the misstatement was wrong, then not actionable.

ii) Immateriality: Material could be soft, Bespeaks Caution could also apply.

iii) Cautionary Statements: Cautionary statements cannot be just boilerplates but must “convey substantive information about factors that realistically could cause results to differ materially from those projected in the forward looking statements.”


3) Reasons, Opinions, and Beliefs: Reasons, opinions, and beliefs can be material.
Virginia Bankshares, Inc. v. Sandberg [SCt 1991]: Minority shareholders challenged the proxy disclosure in a squeeze-out merger. VBI statement had said that merger would incur a higher value for other shareholders. Minority shareholders contended that VBI didn’t really believe that, rather board just wanted to keep their jobs. Souter Held: Statement would be material misstatement or omission if it was a misstatement about its beliefs and the factual subject matter.
B. Rule 10b-5 & Non-Insider Trading Fraud: The Rule applies to fraud in connection with the purchase or sale of a security. There is an implied private right of action, so private plaintiffs, and SEC can bring suit.
1) Standing: The fraud or deception must be in connection with the purchase or sale of a security. Breaches of fiduciary duty, however, do not give rise to a Rule 10b-5 action. Santa Fe.
2) Materiality: The misstatement or omission must be material (see above).
3) Scienter: The mental state must “embrace intent to deceive, manipulate or defraud.” Negligence is not scienter. Recklessness (extreme departure from the standards of ordinary care) could be scienter.
Ernst & Ernst v. Hochfelder [1976]: Accounting firm negligently failed to audit a company’s accounting practices, firm did not become aware that company’s president was embezzling. Held: Negligence is not scienter.
4) Reliance & Causation: Reliance is an element, but standards generally relaxes requirements. Face-to-Face transactions not required. Affiliated Ute. Also there’s a difference between transaction causation and loss causation. Transaction: But for fraud, transaction would not have occurred. Loss causation: fraud produced the claimed fraud. Under PLSRA, plaintiffs must show loss causation in a Rule 10b-5 case (versus negative causation above).
a) Fraud on the Marketplace Rebuttable Presumption: Plaintiff does not need to show that they read misstatement, etc. This is the applicability of the ECMH. Market already reflects reliance. Must be impersonal, large national market. Face to face won’t do. Rebuttable by showing that market was inefficient, plaintiff would have traded anyway, that plaintiff was sophisticated, buyer would have bought or sold regardless.
C. Clause 2 of Rule 10b-5: The Duty to Update & the Duty to Correct: There is a duty to update issuer statements and to correct other statements that could be attributable to the issuer. Companies cannot speak in half-truths. This duty exists as long as the statement is “alive.” Rumors don’t give rise to the duty unless the issuer or whomever has endorsed those rumors. The issuer should know that people are relying on their statements. It is a misstatement or omission which gives rise to the duty, not the fact that information is material. This is an uncertain are of law, however.
In re Time Warner Securities Securities Litigation [2nd Cir. 1993]: Duty to update when company began to consider another major plan, alternative to the one announced. Alternative plan would have driven down earnings per share.
D. Rule 10b-5 & Insider Trading: The big focus of Rule 10b-5 is insider trading. Insider trading is unlawful trading by any person possessing “material nonpublic information.” Policy arguments for: include fairness, get info. on the market, egalitarian, pricing efficiency, way to compensate management. Arguments against: companies will hold onto information, there are other means. There’s “good” info and “bad” info.

1) Duty: (Only an element in omissions): Duty arises out of a fiduciary relationship when it comes to material nonpublic information. SEC v. Texas Gulf-Sulphur [2nd Cir. 1968]: Anyone with material nonpublic information must abstain from trading on the information or disclose it.


Chiarella [SCt. 1980]: Printer employed to print T.O. documents knew of impending T.O. No duty because EE did not have a duty to abstain or disclose information.
Held: No duty to target corporation; duty to ER reserved; misappropriation theory reserved. Awkward and unsatisfactory rule, though. Capital information hampered and egalitarian principle not effective.


Dirks [SCt 1983]: Tipper Secrist told tippee Dirks about big insurance fraud at Secrist’s old company.
Held: For Tipper Secrist to be liable: 1) tipper (Secrist) must have been violating fiduciary duty; 2) tippee (Dirks) must have known tipper was violating fiduciary duty; 3) there must be some benefit to the tipper (Secrist)]. Basically Quid Pro Quo. All this is hard to show. Analysts and whistle-blowers are immune. And tipper can be liable, if down the line sub-tipper trades even if Tipper doesn’t trade. If sub-tippees know or should know that info. came from fiduciary breach, they’re liable.

For Tippee to be liable: Tipper must be liable first.


Tipper/Tippee: (see above)
Constructive Insiders: FN14 [Dirks]: Accountants, lawyers, investment bankers as have same Rule 10b-5 duties as corporate insiders.
Strangers: Strangers with no Rule 10b-5 duty and thus no fiduciary relationship are not liable.



O’Hagan [SCt 1997]: Lawyer using inside information had a fiduciary duty to the corporation from where he got the source. Lawyer made $4.3M. Requirement of IT laws is to protect integrity of securities markets from outsiders. O’Hagan stands for outsiders (insiders already covered). And don’t forget mail and wire fraud provisions.


Misappropriation Theory: Misappropriation is the “use of a deceptive device” “in connection with securities trading.”

Rule 10b5-2: Requisite fiduciary duty for misappropiration theory liability: 1) agreement to keep information in confidence; 2) history of shared confidence between the parties; 3) info. to parents, spouses, etc. unless there was no expectation of confidence.
Rule 14e-3: Prohibits trading on basis of material nonpublic information regardless of breach of fiduciary duty in a tender offer.
E. Reg FD: To get around disclosure problems of companies not knowing bad trading from good. Rules encourage release of information, stops problem analysts getting a lot of info and currying favor. Enforceable only by SEC. Ends previous problems of selective disclosure. Problems though in mosaic theory in that analysts cane piece together info and conclude something material. An egregious violation would telling earnings per share to analysts but not to the public.
1) Prohibition On: Companies from selectively disclosing information to: a) broker-dealer; b) investment-adviser; c) investment company; d) holder of issuer’s stock.
2) Public Disclosure: If intentional it must be simultaneous. If unintentional, w/in 24 hours.
3) Public Disclosure Not Required If: a) to person with duty of trust and confidence; b) person who agrees to maintain info; 3) credit rating agency; 4) someone in connection with public offering under ’33 Act.

X. GENERAL CIVIL LIABILITY PROVISIONS



A. PSLRA: Today, if you can plead, do it in the 2nd Cir. because they have the easiest standards. If you’re the defendant, try to stay in the 9th Cir. because plaintiff will have to plead in great detail that which caused the recklessness, etc.

Generally:

1) In any private action the plaintiff must state exactly what was misleading and how it was misleading;

2) In any case involving scienter, the plaintiff must show that that the defendant acted with that state of mind.


B. Control Person Liability: Liability can be expanded to both deter and to compensate.

1) Primary Violator: Person who commits the violation.

2) Secondary Violator: Person who assists or supports the primary violator. Control persons are held liable to the same extent as the person they control. Decided by status, function.

Affirmative Defenses:



§ 15 of the 33 Act: No knowledge of the underlying facts.

§ 20A of the 34 Act: good faith, did not induce the acts leading to the violation, no exception for independent contractors.
Hollinger v. Titan Capital: Broker-dealers can be liable as control persons for their registered representatives. This induces better supervision.
C. Aiding and Abetting Liability: It’s harder to go after via aiding and abetting. Easier under control person.
Central Bank of Denver v. First Interstate Bank of Denver [SCt 1994]: Kennedy Held: A & A just simply isn’t in the law, regardless of what the lower courts may think.

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