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Exam # ______

Securities Regulation FINAL EXAMINATION

Professor Palmiter University of Michigan Law School Winter 1998

INSTRUCTIONS

[see updated online instructions]

SHORT ESSAYS

The following questions call for a series of short answers, mostly arising under the Securities Act of 1933 (the "Securities Act"). In your answers, cite to the relevant statutory or regulatory provisions, as well as any significant cases, and briefly explain yourself. The information in each question is cumulative; you should use information in earlier questions to answer later questions. If you need additional facts to answer, state them and explain their relevance.

Pete and Catherine purchased a timber mill and incorporate it as Twin Peaks Lumber, Inc. (TPL), a Washington State corporation. Catherine manages the firm, which operates in Twin Peaks, Washington. The business thrives, and they want to expand the mill's operations. They need capital.

Question (1) Catherine mails letters to two friends about buying TPL shares. Benjamin, who runs the local hotel, is loaded with cash and savvy; he says he will invest $800,000. Leo, who is a suspiciously well-to-do truck driver and has a cabin in Idaho, is long on brawn but short on investment experience; he says he can invest $400,000. As they are writing their checks, Catherine calls Leeland, her lawyer. She says, “This is a private placement, right?” What should Leeland advise?

Question (2) Headstrong and decisive, Catherine sells only to Benjamin. She then contacts a handful of local banks for them to lend to TPL. She would give the banks an unsecured note with a term of 6 months, renewable for up to 10 additional six-month periods, and returning 5.5

Sec Reg - Final Exam Page 1 Winter 1998 Exam # ______points above prime. The proceeds would help finance TPL's expansion plans. She asserts the instrument should be seen as a "local junk bond." (Generally, "junk bonds" are unsecured, subordinated, long-term, high-interest instruments syndicated nationally and internationally through investment banks to numerous investors. Junk bonds often trade in institutional markets, such as those envisioned by Rule 144A.) Outline an argument that these instruments are not securities.

Question (3) Catherine asks her lawyer Leeland to contact local banks about her “local junk note” proposal. Leeland is often a closing attorney in commercial lending transactions and knows many local lending officers. He calls twelve and sets up appointments for Catherine, who conducts all negotiations. Behind the scenes, Leeland advises Catherine on what documents to assemble for the banks; he drafts a memorandum for TPL describing the company and the “local junk note” offering; he negotiates an indenture with the banks. The banks lend TPL money. Leeland worries the disclosure Catherine gave the banks was not complete. Assuming the “local junk notes” were securities, is Leeland liable under Rule 10b-5?

Question (4) Catherine's planned expansion works like a charm, and the banks are thrilled. Catherine wants a public stock offering to finance another larger, high-tech mill. Her lawyer Leeland calls some Seattle investment banks about participating in a public offering. For his services, Catherine promises Leeland $150,000 worth of stock to be issued in the offering. Leeland accepts. Does any of this violate the Securities Act?

Question (5) The TPL registration statement becomes effective. The TPL prospectus says "TPL management believes that TPL will experience strong growth in the coming years. The capital expansion funded by this offering will enable TPL to increase its linear foot capacity by at least 250%." Although the new mill increased capacity by 220%, TPL's actual lumber production increased only 90%, as demand for U.S. timber stayed flat. TPL’s stock price falls and investors in the offering consider suing. What impediments are there for investors in the offering who want to sue under § 11 for the false “strong growth” prognostication?

Question (6) Norma, who runs a successful cafe in Twin Peaks, notices a number of international visitors in town. She suspects TPL may be a takeover target and wants to invest her life's savings in TPL stock. But she does not want to buy on the market, where trading is thin. Norma learns that Benjamin, the savvy innkeeper who bought a large block of stock before TPL went public, might sell. In December, 10 months after Benjamin bought his stock, Norma buys from him at the currently prevailing market price. The international visitors happened to be mountain climbing, and Norma wants to rescind her purchase. Advise her.

Sec Reg - Final Exam Page 2 Fall 1999 Exam # ______LONG ESSAY

You represent Silicon Graphics, Inc. (“SGI”) which has been sued for securities fraud in the Northern District of California. See the attached condensed and excerpted complaint, which for present purposes you should treat as complete.

You have been asked to prepare a memo for your client that identifies and discusses the 10b-5 “culpability” defenses that SGI may be able to make in a motion to dismiss the complaint. Remember that a motion to dismiss “tests the legal sufficiency of the complaint.” See North Star Int'l v. Arizona Corp. Comm'n, 720 F.2d 578, 581 (9th Cir.1983). In reviewing a motion to dismiss, the court “must assume all [the plaintiff’s] factual allegations to be true and must construe them in the light most favorable to the [plaintiff].” See North Star, 720 F.2d at 580. Legal conclusions, however, need not be taken as true merely because they are cast in the form of factual allegations. Western Mining Council v. Watt, 643 F.2d 618, 624 (9th Cir.1981).

Make sure you identify particular passages in the complaint (with paragraph number references) that contain pleading or substantive deficiencies with respect to allegations of culpability. Assume that the Private Securities Litigation Reform Act of 1995 is fully applicable in this case and that there are no issues of retroactive application.

UNITED STATES DISTRICT COURT NORTHERN DISTRICT OF CALIFORNIA

In re SILICON GRAPHICS, INC. ) Lead Case No. C-96-0393-FMS SECURITIES LITIGATION ) CLASS ACTION

FIRST AMENDED CONSOLIDATED COMPLAINT ------

SUMMARY OF ACTION

1. This is a class action for purchasers of Silicon Graphics, Inc. ("SGI" or the "Company") stock between Sept. 13, 1995 and Dec. 29, 1995 (the "Class Period"), brought by investors who purchased SGI stock during the Class Period. This action alleges that defendants made false and misleading statements about SGI's business [and] its most important new product ...

2. SGI sells desktop graphics workstations. In recent years, its stock traded at a price earnings multiple reserved for premier growth companies with track records of meeting the investment community's expectations for high profit growth. This stock performance enabled SGI's corporate executives to exercise stock options and sell stock at large profits and enabled SGI to grow by using its stock to make acquisitions of other companies. ...

3. After reaching an all-time high of $44-7/8 on Aug. 21, 1995, SGI stock declined sharply as investors became concerned over SGI's ability to maintain its historic 40%+ growth rate due to increased competition. This decline, at a time when the market overall and the stock of SGI's main competitors (Sun Microsystems and Hewlett Packard) was increasing, was viewed with concern by SGI's executives. ...

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4. In June 1995, one of SGI's major competitors, Hewlett Packard, introduced a new, powerful 3-D graphics workstation that posed a substantial competitive threat to SGI's existing 3-D graphics workstation. ... In reaction, on July 10, 1995, SGI announced its own line of enhanced 3-D graphics workstations -- known as the Indigo2 Workstation -- via a press event, an analysts' meeting and a one-hour long interview on the Dow Jones Investor Network at 1:00 p.m. by Defendant Edward R. McCracken ("McCracken") CEO and Chairman of the Board of SGI. According to SGI and McCracken, the new Indigo2 Workstation line would generate "more than $1 billion in sales during the current fiscal year ended June 30, 1996" -- a 50% increase over Indigo2's current sales! ... Beginning in Aug. 1995, SGI stock declined due to investors' concerns over SGI's ability to continue to achieve 40%+ growth. This large decline in SGI's stock in just eight weeks, during which the market overall and the stock of similar companies -- especially SGI's competitors, Sun Microsystems and Hewlett Packard -- increased in price, was viewed with concern by SGI's insiders, for the reasons pleaded elsewhere.

5. Then, around September 13, 1995, near the end of SGI's first quarter of FY96, as SGI attempted volume shipments of Indigo2 Workstations, SGI discovered the ASIC chips [supplied by Toshiba] were defective and that it could not assemble anywhere near enough Indigo2 workstations that worked to meet demand. ... On Sept. 13, 1995, after SGI stock had begun to decline sharply from its all-time high and rumors circulated that SGI was encountering problems manufacturing its Indigo2 Workstations, McCracken told a Morgan Stanley analyst, with respect to SGI's new Indigo2 Workstation product line, that "[t]here were no supply constraints."

6. ... SGI knew it would get much less than $1 billion in revenue from its Indigo2 Workstation product line in FY96 and would not be able to achieve 40% growth. ... SGI's executives knew that publicly disclosing that SGI had serious production problems with its most important new product and that shipments of ... the product would be delayed would send SGI stock tumbling even lower and severely hurt sales of Indigo2 Workstations as potential customers would purchase competitive products ..... SGI's executives agreed to pursue a "conspiracy of silence" to conceal these problems from the public and to tell customers that the reason they were not receiving all the Indigo2 Workstations they ordered was due to extraordinary heavy demand that SGI simply could not meet. Thus, when rumors of production problems with the Indigo2 Workstation product line surfaced in mid-Sept. and early Oct. 1995, SGI executives falsely told securities analysts that SGI had successfully introduced the Indigo2 Workstation, that the product was enjoying strong demand and "there were no supply constraints" .... This was not true. In fact there were severe shipping constraints due to the problems SGI was having with the ASIC chips. ...

8. On Oct. 19, 1995, SGI announced its first quarter FY96 results [through Sep. 30, 1995], reporting revenues of $595 million, well below expectations of $650 million, and earnings per share of $.33, at the low end of expectations. [On Nov. 12, 1995, SGI filed its Report on Form 10-Q for the quarter ended Sept. 30, 1995.] These results -- [which reflected] 33% revenue growth -- were viewed as disappointing by the investment community given SGI's prior representations of 40%-45% growth. SGI publicly said nothing about the problems it was encountering with its Indigo2 Workstations and blamed these disappointing results on reduced productivity of its North American direct sales force due to a recent reorganization of that sales force, ... In a conference call with securities analysts and investors and an interview with Reuters [on that date], McCracken was extraordinarily bullish about SGI's business, indicating that the primary cause of the disappointing first quarter -- the reduced productivity of SGI's direct North American Field Organization -- “was a temporary problem which had been corrected”; ...

9. Thus, while reporting worse than expected first quarter FY96 results, SGI

Sec Reg - Final Exam Page 4 Fall 1999 Exam # ______assured analysts and investors that it would get back close to its targeted 40% growth rate in the second quarter of FY96 and would reach or exceed that growth rate for FY96 as a whole. ... As a result of these positive representations ... SGI stock declined by only $2 per share after the announcement of its disappointing first quarter FY96 results.

14. In mid-Dec. 1995, SGI stock fell when rumors circulated that SGI's second quarter FY96 results might be worse than anticipated. However, on Dec. 15, 1995, McCracken communicated with securities analysts to assure them (and through them the securities markets) that SGI had had a good month in November, that the reorganization of its North American direct sales force had been successful and that productivity there was growing, that demand for SGI's Indigo2 Workstation remained strong ... As a result, SGI was supposedly on track to achieve strong second quarter FY96 results. Notwithstanding these reassurances, during the last week of Dec. 1995, SGI stock declined to $26-7/8 per share, as information leaked into the market that weakness in U.S. business ... might prevent SGI from achieving its 40% growth target in its second quarter of FY96.

15. Each of the positive statements about SGI's business during the Class Period was materially false and misleading when issued, and failed to disclose, inter alia, the following adverse information which was then known only to defendants due to their access to internal SGI data:

(a) That SGI was not receiving a sufficient quantity of ASIC chips from Toshiba for use in manufacturing its Indigo2 Workstation to enable it to ship the product in necessary volume to meet demand for those products or achieve its stated revenue growth target, which would adversely impact SGI's revenue and earnings per share at least through the third quarter of FY96; ...

(d) That SGI was suffering severe supply constraints of the critical ASIC chips for its Indigo2 Workstation and because of the defects in and yield problems with these chips SGI had issued a "Stop Ship" report on that product, which had an adverse impact on SGI's revenue because the product could not be shipped in the scheduled volumes; ...

(l) That, as a result of the foregoing, SGI's forecasts that it would return to and achieve close to 40% growth during the second quarter of FY96 and above 40% growth for the balance of FY96 were false when made, as such growth was impossible to achieve in light of these undisclosed problems; ...

16. Notwithstanding defendants' repeated assurances ... that sales of its Indigo2 Workstations were meeting expectations and not constrained by component part shortages, on Jan. 2, 1996, SGI revealed [truthfully] that it had suffered another quarter of decelerating revenue and earnings growth and was going to report a much worse FY96 second quarter than earlier forecast, belatedly acknowledging that its results for the rest of FY96 would be much worse than earlier forecast and well below the 40% growth target. As a result of these revelations, SGI stock collapsed, falling on Jan. 2, 1996 from $27-1/4 to a low of $22, on extraordinary volume of 11 million shares, and falling again on Jan. 3, 1996 to a low of $21-1/8 per share on huge volume of 6.5 million shares. In mid-Jan. 1996 SGI reported [in a press release] revenues of just $675 million (compared to forecasts of $760 million) and earnings per share of $.30 (compared to forecasts of $.46-$.49), shortfalls of about 15% and 30% from analysts' expectations, and a growth rate of only 22%, compared to the 40% forecast by SGI.

JURISDICTION AND VENUE

22. Jurisdiction exists pursuant to §27 of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. §78aa, and 28 U.S.C. §1331. The claims asserted arise under §§ 10(b), 20(a) and 20A of the Exchange Act, 15 U.S.C. §§78j(b) and 78t(a), 78t- 1 and Rule 10b-5.

23. Venue is proper in this District pursuant to §27 of the Exchange Act and 28 U.S.C. §1391(b). Many of the acts giving rise to the violations complained of occurred in this District.

24. In connection with the wrongs complained of, defendants used the instrumentalities of interstate commerce including the U.S. mails and the facilities of the national securities markets.

THE PARTIES

25. Plaintiffs [twelve are listed] purchased [between 100 and 500] shares of SGI stock on [dates between September 13, and December 20, 1995] at [market prices above $22 per share] and were damaged thereby. ....

26. Defendant SGI is headquartered at Mountain View, California and sells desktop graphics workstations, multi-processor servers, advanced computing platforms and application software. SGI stock trades in an efficient market on the New York Stock Exchange.

27. [Complaint names six Individual Defendants.]

(a) Defendant Edward R. McCracken ("McCracken") is Chairman of the Board and CEO of the Company, and as such was primarily responsible for SGI's communications with securities analysts and was intimately involved in the development of the Indigo2 Workstations. [McCracken was defined as one of the Individual Defendants.] Because of defendant McCracken's position with the Company, he knew the adverse non-public information about its business, finances, products, markets and present and future business prospects via access to internal corporate documents (including the Company's operating plans, budgets and forecasts and reports of actual operations compared thereto), conversations and connections with other corporate officers and employees, attendance at management and Board of Directors' meetings and committees thereof and via reports and other information provided to him in connection therewith. ...

MOTIVE AND OPPORTUNITY

30. Each defendant had the opportunity to commit and participate in the fraud. The Individual Defendants were the top officers of SGI and they controlled its press releases, corporate reports, SEC filings and its communications with analysts. Thus, they controlled the public dissemination of, and could falsify, the information about SGI's business, products and future prospects that reached the public and impacted the price of its stock.

31. Each of the Individual Defendants also had the motive to commit and participate in the fraud. In recent years, SGI's stock traded at a price earnings multiple reserved for premier growth companies with track records of meeting the investment community's expectations for high profit growth. This stock performance enabled SGI's corporate executives to exercise stock options and sell stock at large profits and enabled SGI to grow by using its stock to make acquisitions of other

Sec Reg - Final Exam Page 6 Fall 1999 Exam # ______companies. ... Defendants also wanted to cover up the problems with and deterioration in SGI's business (and their own mistakes and acts of mismanagement) to make it appear that SGI's business was succeeding and achieving the 40% growth they had forecasted, ... Also, the defendants were motivated to misrepresent the status of SGI's Indigo2 Workstation project and shipments of those machines to conceal the serious product problems SGI was having with those machines in an attempt to maintain SGI's competitive position ... [which] would have been even more seriously damaged if SGI admitted it was having serious problems with its most important new product.

SGI'S AND ITS INSIDERS' ACTUAL KNOWLEDGE OR RECKLESS DISREGARD OF THE UNDISCLOSED ADVERSE CONDITIONS IMPACTING SGI'S BUSINESS

32. As part of SGI's corporate planning and management process, SGI prepares a corporate business plan and budget for each fiscal year. This is known as the "Fiscal Year Corporate Plan/Budget." The Fiscal Year Corporate Plan/Budget ("Plan/Budget") for a given fiscal year is prepared and revised during the last half of the preceding fiscal year and is completed by top management for Board review and approval near the end of the prior fiscal year. ... In addition, SGI's FY96 Plan/Budget also included forecasted revenues by product line, including the Indigo2 Workstation, ...

35. ... SGI's finance department generated monthly financial reports providing detailed data with respect to overall corporate revenue, net income and earnings per share, as well as sales by specific product lines and by geographic region -- all presented so as to compare performance for that month, that quarter and the year-to- date compared to the FY96 Plan/Budget. These monthly financial reports include a so- called "Flash" report prepared immediately after the monthly close and distributed to top management within 48-72 hours, which provides summary product shipment, sales and income data.

36. As a result of the problems with the ASIC chips for use in the Indigo2 Workstation, as well as weak sales in North America due to problems with SGI's North American direct sales force, ... SGI's results for the month and quarter ended Sept. 30, 1995 were significantly below forecasted or budgeted levels. Each of the individual defendants received this information by way of the Sept. "Flash" report on or about Oct. 3-4, 1995, and/or the Sept. Monthly Financial Statement/Package on or about Oct. 10, 1995. ...

40. Internally at SGI, the problems with Indigo2 Workstation production due to ASIC chip yield problems continued to be encountered throughout Nov. 1995. ... As a result, SGI had suffered a very poor November, with revenues, net income and earnings per share well below forecasted and budgeted levels. This information was provided to each of the defendants in the Nov. 1995 "Flash" financial report ... distributed to them no later than Dec. 4 or 5 and 10, 1995, respectively.

DEFENDANTS' FRAUDULENT SCHEME AND COURSE OF BUSINESS

43. Each of the defendants is liable as a participant in a fraudulent scheme and course of business that operated as a fraud or deceit on purchasers of SGI stock, including false and misleading statements and/or concealed material, adverse facts. The scheme: (i) deceived the investing public regarding SGI's business; (ii) artificially inflated the price of SGI stock; (iii) [and] caused plaintiffs and other members of the Class to purchase SGI stock at inflated prices; ...

[Paragraphs 44-49 essentially recount the allegations of paragraphs 3-4 above]

FALSE AND MISLEADING STATEMENTS

DURING THE CLASS PERIOD

[Paragraphs 50-66 essentially recount the allegations of paragraphs 5-17 above]

CLAIM FOR RELIEF I Section 10(b) Of The Exchange Act And Rule 10b-5 Against All Defendants

79. Plaintiffs incorporate by reference ¶¶1-78.

80. Each of the defendants: (a) knew or had access to the material adverse non- public information about SGI's financial results and then existing business conditions, which was not disclosed; and (b) participated in drafting, reviewing and/or approving the misleading statements, releases, reports and other public representations of and about SGI.

81. During the Class Period, defendants, with knowledge of or reckless disregard for the truth, disseminated or approved the false statements specified above, which were misleading in that they contained misrepresentations and failed to disclose material facts necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.

82. Defendants have violated §10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder in that they: (a) employed devices, schemes and artifices to defraud; (b) made untrue statements of material facts or omitted to state material facts necessary in order to make statements made, in light of the circumstances under which they were made, not misleading; or (c) engaged in acts, practices and a course of business that operated as a fraud or deceit upon the purchasers of SGI stock during the Class Period.

83. Plaintiffs and the Class have suffered damage in that, in reliance on the integrity of the market, they paid artificially inflated prices for SGI stock. Plaintiffs and the Class would not have purchased SGI stock at the prices they paid, or at all, if they had been aware that the market prices had been artificially and falsely inflated by defendants' false and misleading statements. ...

CLASS ALLEGATIONS

90. Plaintiffs bring this action as a class action pursuant to Federal Rules of Civil Procedure 23(a) and 23(b)(3) on behalf of all persons who purchased the stock of SGI during the Class Period (the "Class"), except defendants, members of their immediate families and any entity in which a defendant has a controlling interest. ...

BASIS OF ALLEGATIONS

96. Plaintiffs have alleged the foregoing based upon the investigation of their counsel, which included a review of SGI's SEC filings, securities analysts reports and advisories about the Company, press releases issued by the Company, media reports about the Company and discussions with consultants, and believe that substantial evidentiary support will exist for the allegations set forth in ¶¶ 4-15, 19, 27-43, 46, 49-50, 53, 56, 58-70, 72-82, 84 and 87 after a reasonable opportunity for discovery.

PRAYER FOR RELIEF

WHEREFORE, plaintiffs pray for judgment as follows:

1. Declaring this action to be a proper class action pursuant to Rules 23(a)

Sec Reg - Final Exam Page 8 Fall 1999 Exam # ______and 23(b)(3) of the Federal Rules of Civil Procedure on behalf of the Class defined herein;

2. Awarding plaintiffs and the members of the Class compensatory damages;

3. Awarding plaintiffs and the members of the Class pre-judgment and post- judgment interest, as well as reasonable attorneys' fees, expert witness fees and other costs;

4. Awarding extraordinary, equitable and/or injunctive relief as permitted by law, equity and the federal statutory provisions sued hereunder, pursuant to Rules 64, 65 and any appropriate state law remedies; and

5. Awarding such other relief as this Court may deem just and proper.

JURY DEMAND

Plaintiffs demand a trial by jury.

DATED: October 17, 1996 MILBERG WEISS BERSHAD HYNES & LERACH WILLIAM S. LERACH PATRICK J. COUGHLIN SUSAN S. GONICK TRAVIS E. DOWNS, III

/s/ ______WILLIAM S. LERACH

600 West Broadway, Suite 1800 San Diego, CA 92101 Telephone: 619/231-1058

Sec Reg - Final Exam Page 9 Winter 1998