240 TENDER OFFER AND TAKEOVER REGULATION Ch. 11 "-§ _79__ --'ISSUER PURCHASES OF ITS OWN STOCK 241 position with respect to bidder's offer. The Rule 14e-2 statement must also include all reasons for the position taken, or the stance of Two-tiered tender offers permitted. Sometimes a tender neutrality, as well as any explanation of the inability, to take a offer decides to make a tender offer for control of a company and position. In setting forth its reasons, the target com~any s ma~a~e­ ~hen follows .t~e tender offer by .a merger of the target company ment is of course subject to all of the rules concermng matenah_ty mto the acqmrmg company at a price below that which was paid in as well' as the p~tential civil and criminal liabilities for matenal the tender offer. This is commonly referred to as a two-tiered front­ misstatements. end loaded offer. There is not~ing under federal law to prohibit such offers so long as the first step adequately discloses any plans Insider trading prohibited. 1934 Act Rule 14e-3 p~o~i?its for a second step merger. In contrast, a number of states have insider trading during a tender offer. The Rule 14e-3 proh1b1t10ns adopted fair price statutes that place insurmountable barriers on expressly apply not only to insiders of the target c~mpanJ:' bu~ als_o these front-end loaded offers. to anyone else. The rule goes on to state that there 1s n? ~wlatwn 1f the transaction was an independent investment declSlOn rather Target's defensive tactics not prohibited. As discussed in than based on knowledge of material non-public information. Rule § 81 below, frequently managell1ent will want to oppose a third­ 14e-3 supplements the insider trading prohibitions that are found party tender offer and will do so by engaging in defensive tactics. in 1934 Act Rule 10b-5. See § 96 below. State law may place significant restrictions on the target company's Prohibition of contemporary purchases during tender management's ability to fend off a hostile offer. For a while there offer. 1934 Act Rule 14e-5 prohibits tender offerors. ~rom p~rchas­ :-vas som~_question as to whether federal law would have an impact ing shares subject to a tender offer and related secunties durmg the m curta1lmg these defensive tactics. It is now clear that this is term of a tender offer. As discussed earlier, the tender offer entirely within the purview of state law. The Schreiber decision commences once the Schedule TO is filed with the SEC. Rule 14e-5 now makes it clear that defensive tactics cannot violate 1934 Act prohibits not only purchases of the securities subjec_t to _a tender § 14(e), even if manipulative, unless there has been a material offer but also of any securities immediately convertible mto such misrepresentation or omission. secu;ity. In contrast, the purchase of an _option or sec~rity_ futures product is allowed, since it is not i~m~dmtelJ:' convertible u~to ~he § 78. Arrangements Affecting Director Turnover in underlying security. See In re Comm1sswn Gmdance on ~-pphcatwn Connection With a Tender Offer-1934 Act of Certain Provisions of Securities Act of 1933, Secunties Act of § 14(f) i ~. ~--, .... . , ~ 1934 Rules Thereunder to Trading in Security Futures Products, .... ! ·" Sec. Act Rel. No. 33-8107, Sec. Exch. Act Rel. No. 34-46101, 2002 As is the case with any transfer of corporate control tender WL 1357820 (SEC June 21, 2002). However, if the futures contract offers :nill fr~q~ently result in a shift in corporate man;gement. expires before the termination of the tender offer then the purchase Accordmgly, 1t 1s not uncommon to find tender offers containing of a security futures product will be precluded under Rule 14e-5. agreements relating to management turnover and the election of new directors. These control transfers can raise problems under Short tendering and hedged tendering prohibited. Short state law relating to invalid control premiums and other breaches tendering of securities during a tender offer is the practice of of fiduciary duty. Under 1934 Act § 14(f), when a tender offer for tendering or guaranteeing securities not owned by the pe~s?n eq_uity securities subject to the Act's reporting requirements con­ making the tender or guarantee. 1934 Act Rule 14e-:4 proh1?1ts tams agreements concerning the designation of new directors other­ short tendering and "hedged tendering." Hedged tendermg cons1sts wise than through a formal vote at a meeting of securities holders of tendering shares that are encumbered by a call option or some ~here :nust be full disclosure. Contemplated management turnover: other obligation to sell the shares to someone ot~er than the tender mcl~dmg any arrangement regarding the make-up of the majority offeror. Rule 14e-4 is designed to prevent tendermg shar~s that are of d1rectors, also must be disclosed. not actually owned. The prohibition against short tendermg means that during a tender offer, it is illegal to tender s~ares that you _do not own. Thus, it is necessary that anyone tendermg shares durmg § 79. Issuer Purchases of Its Own Stock-1934 Act a tender offer either actually be the owner or be a bo?"~ _fide § 13(e) and the Going Private Rule; Issuer beneficial owner of the shares being tendered. The proh1b1twns Self-Tender Offers against short tendering and hedged tendering a:e de~igned to Issuer's Share Repurchases eliminate related manipulative practices in connectwn w1th a ten­ der offer. 1934 Act Rule 13e-1 applies to an issuer's purchases of its own stock after a third party has filed a tender offer for its securities.

--~1!!1'1!!~-"'!''~"''q. .,.,..,.-,. i-=cause of action § 80. Private Remedies Under the Williams Act­ for the defendant's delay. Following the opening that was left by Remedies for Violations of 1934 Act this Supreme Court decision, many subsequent cases have held that §§ 13(d), 13(e), 14(d), 14(e) a target company has standing to .seek injunctive relief to bar additional purchases until the Schedule !3D has been filed. Howev­ Most of the litigation concerning the question of the existence er, there have also been some decisions to the contrary, holding of implied private rights of action under the Williams Act has that no private remedy exists even for injunctive relief. While the arisen in the context of 1934 Act § 14(e)'s general a~tifraud p~o­ shareholders of the target company may be able to bring suit, the scriptions. The courts seem to be consistent in favon.ng the exis­ shareholders of the acquiring company may not base a claim under tence of at least a limited implied remedy under sectwn 14(e), ~t section 13(d). A number of courts have held that not only does a least when the suit is brought by a target company shareholder m section 13(d) remedy extend to failure to file, but also to filings that furtherance of the interests of target company shareholders gener- contain material misstatements and/or omissions. ally. Since time is of the essence in takeover battles, frequently the Since 1934 Act §§ 13(d), 13(e), and 14(d) all apply to issuers relief sought in an action under 1934 Act §§ 13(d), 13(e), 14(d), or subject to the 1934 Act's registration and reporting requirements, 14(e) will be one for preliminary injunctive relief. Plaintiffs in such and involve mandatory filings with the SEC, there are a num?er of actions bear an especially high burden in light of the dual require­ other remedies for material misstatements. For example, any mves­ ment that they prove both a substantial likelihood of success on the tor who is injured by reliance upon material misstatements in the merits and irreparable injury if the preliminary injunction is not Schedule 13D Schedule 13E-3, Schedule TO, or Schedule 14D-9, issued. Failure to meet either a substantial likelihood of success or may sue for damages under the express remedy provide~ in 1934 irreparable injury will result in a denial of preliminary relief. Act § 18(a). It is to be noted, however, that th~ sectw.n 18(a) However, serious violations will warrant preliminary relief, since remedy is an extremely limited one insofar as It reqmr.es the waiting until a full trial on the merits will usually mean that the investor to have actually relied upon the documents filed with the challenged transaction will take place years before the case is SEC. See § 97 below. In addition to the express liability provisions resolved. As one court has put it, "[e]ffectively the only relief of section 18(a), any material misstatements or omissions that give available to an issuer, under the prevailing view, is an order rise to an injury in connection with the purchase or sale of a requiring the five percent owner to file a corrected Schedule 13D security will state a cause of action under 1934 Act Rule 10b-5. The and perhaps enjoining further acquisitions pending the correc­ cases are in conflict, but there have been a number of decisio~s that tions." Hubco, Inc. v. Rappaport, 628 F.Supp. 345, 354 (D.N.J. have held that the relevant provisions of sections 13 and 14 m and 1985). of themselves provide a basis for at least limited privat~ relief: One On appropriate facts, some courts have recognized the poten­ pattern that has emerged is the availability of injunctive reltef as tial for an implied remedy for damages for violations· of section opposed to damages. However, some cour~s have recognized the 14(d). Thus, for example, shareholders denied a tender offer premi­ availability of an action for damages. E.g., Field v. Trump, 850 F.2d um because of the tender offeror's wrongful interference with their 938 (2d Cir.1988). Subsequently, the Second Circuit ruled that proration rights could recover in an action under section 14(d)(6). there is no private damage remedy to be implied under section Pryor v. USX Corp., 1991 WL 346368, [1991-1992 Transfer Binder] 13(d). Hallwood Realty Partners, L.P. v. Gotham Partners, L ..P., Fed.Sec.L.Rep. (CCH) ~ 96,630 (S.D.N.Y.1991) The courts have 286 F.3d 613 (2d Cir.2002). At the same time that the court deme~ recognized an implied right of action under Rule 14a-10's all the existence of a damage remedy, the court stressed that tt holders requirement. See, e.g., In re Digital Island Securities Litiga- §82 246 TENDER OFFER AND TAKEOVER REGULATION Ch. 11 STATE REGULATION OF TENDER OFFERS 247

tion, 357 F.3d 322 (3d Cir. 2004); Polaroid Corp. v. Disney, 862 ~~e control contest reflects a battle of policies rather than personal­ F.2d 987 (3d Cir.1988). Additionally, the Sixth Circuit recognized a Ities. For example, management may buy out a corporate raider private remedy for violation of section 13(e)'s going private provi­ with corporate funds at a premium without breaching a duty to the sions which allegedly resulted in the loss of plaintiffs state law shareholders where the raider has threatened liquidation. See Cheff appraisal remedy due to material misstatements or omissions. v. Mathes, 41 Del.Ch. 494, 199 A.2d 548 (1964). There have been a Rowing Co. v. Nationwide Corp., 972 F.2d 700 (6th Cir.1992), cert. number of cases in Delaware and·' elsewhere that indicate the states denied 507 U.S. 1004 (1993). are taking a firmer role in regulating tender offer practices of Most courts that have considered the issue have recognized an target company directors. As a starting point, the protection of the implied remedy under 1934 Act § 14(e) in the hands of the target business judgment rule has been severely limited For example, in company or a target company shareholder. For example, it has been Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 held that a nontendering target shareholder has standing to sue (Del.1985), the Delaware court ruled that in agreeing to a lock-up both the target and acquiring corporations. See Plaine v. McCabe, arrangement with a white knight, the target company's directors 797 F.2d 713 (9th Cir.1986). breached their fiduciary duty to their shar~holders. However, in another case, the Delaware Supreme Court permitted the use of a In Piper v. Chris-Craft Industries, Inc., 430 U.S. 1 (1977), the discriminatory issuer self-tender since it was a proportional re­ .~~---"' Supreme Court held that a competing offeror cannot maintain a '}·~-~... ~ sponse to a reasonably perceived threat to corporate policies. Uno­ '' .. ~~- ~.- .. private right of action under section 14(e)'s general antifraud ..: ~;.. ~ -~· cal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del.1985). The SEC proscriptions. In so deciding, the Court did not rule out any private has since adopted rules prohibiting exclusionary tender offers both remedy; in fact, the opinion held out much hope for the recognition by issuers and third parties. 1934 Act Rules 13e-4(D(8)(i), 14d- of a section 14(e) private right of action in the hands of the target 10(a)(1). The Delaware court has severely limited management company or its shareholders. There are a number of federal circuit entrenchment tactics by identifying target management's primary court decisions recognizing a target shareholder's right to sue for duty once a company is for sale, as "maximization of the company's violation of section 14(e), at least where the injury is not premised value at a sale for the stockholders' benefit." Revlon, Inc. v. on the loss of an opportunity to control the target company. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 182 (Del.1985) Additionally, a target company's management may seek private Subsequent decisions have somewhat clouded the issue of when this injunctive relief for violations of section 14(e). The Supreme Court's duty to maximize value is triggered. These cases and their progeny ruling in Schreiber v. Burlington Northern, Inc., 472 U.S. 1 (1985), are explored more fully in courses on corporate law and corporate emphasizes that disclosure is not only the primary but probably the acquisitions. ~ . ! ' )t. sole focus of section 14(e). The Supreme Court's narrow reading of The illustrative corporate law cases discussed above focus on section 14(e) in Schreiber strongly favors a scienter requirement. concepts of self-dealing and the fiduciary duties of corporate officers and directors. Some of the same concepts may come into play under § 81. Responses to Tender Offers: Anti-Takeover the federal securities acts. The Supreme Court's ruling in Schreiber Moves and Defensive Tactics v. Burlington Northern, Inc., 472 U.S. 1 (1985) that section 14(e) When faced with an uninvited or hostile takeover attempt, does not prohibit manipulative conduct unless there has been a management of the target company will frequently decide to oppose material misstatement or omission is a major impediment to the the offer. Defensive tactics can raise questions under both state and federal control of defensive tactics under the current statutory federal law. When a target's management decides to fight off a framework. contender for control, there is always the possibility of being charged with wasting of corporate assets or other forms of misman­ § 82. State Regulation of Tender Offers agement. In some instances, as a matter of state law, manage­ Prior to the adoption of the Williams Act in 1968 there was ment's defensive tactics will be upheld under the business judg­ virtually no specialized regulation of tender offers at' either the ment rule, although there are limits in the context of defensive federal or state level. In less than twenty years, the states went maneuvers. In the first instance, courts recognize that in fending through three generations of takeover statutes. Investor protection off challengers, incumbent management represents existing corpo­ has not been the motivating factor behind these statutes. In most rate policies, and management is entitled to use reasonable expen­ instances, state tender offer acts have been passed at least in part ditures of corporate funds in order to defend its policies, so long as to protect incumbent management and other employees of local 248 TENDER OFFER AND TAKEOVER REGULATION Ch. 11 § 82 STATE REGULATION OF TENDER OFFERS 249

companies that were potential takeover targets. As a result, rather of shares owned by the acquiring person, with each control zone than merely supplementing the federal legislation, most state stat­ triggering the act's substantive requirements. Acquiring persons utes impose more impediments to the takeover, thus inhibiting or must deliver to the target company a disclosure statement describ­ at least slowing down any transaction. In tender offer jargon, the~e ing the proposed acquisition. The target company's board then has acts are often referred to as "shark repellent" because of their 10 days to call a special shareholders' meeting which must take deterrent effect. place within fifty days. At tha( ,meeting, the transaction requires The federal legislation embodied in the Williams Act attempts approval of a majority· of the disinterested shares not owned or to strike a balance between the need for disclosure and investor controlled by the acquiring person or any affiliate. The Supreme protection on the one hand, and, on the other, the fear of eliminat­ Court decision upholding the Indiana Control Share Act, CTS Corp. ing too many potential tender offerors from the market place .. Much v. Dynamics Corp. of America, 481 U.S. 69 (1987). The Indiana of the state legislation to date has probably gone too far m the control share statute, unlike the Illinois statute which was struck direction of deterring bidders from participating in the tender offer down in !'1ITE, ~as. not balance4 in fa von of incumbent manage­ market. The Supreme Court has held that when the state law ment. It ts thus Significant that state takeover statutes maintain a limitations on tender offers prove too restrictive and conflict with position of neutrality, rather than favoring target management. the basic policy of the Williams Act, these laws are invalid because Another second generation statute is known as a "best price" or ;~""""--·~ they impose an unconstitutional burden on interstate commerce. "fair price" statute and is designed to limit two-tiered front end '}·~ ..~·> .. ~~-~· .. ~_.- ··;, ... ~- See Edgar v. MITE, 457 U.S. 624 (1982). Other federal courts have loaded offers. By requiring a supermajority vote for a merger unless used the preemption doctrine to invalidate state tender offer stat­ the land statute requires any takeover be approved by at least utes under appropriate circumstances. eighty percent of the shares and two-thirds of the disinterested First generation statutes. Major variations among the state shares unless the target shareholders receive the "best price" paid tender offer statutes are found in the qualification requirements. by the acquiring person within specified (e.g., a two-year) period. Following the pattern of the state blue sky laws, many of the state Although the CTS decision does not address the issue, there is a tender offer statutes go beyond the disclosure philosophy of the strong argument that best price statutes will withstand constitu­ Williams Act by giving the state administrator the power to review tional scrutiny. the merits of the tender offer or the adequacy of the disclosure. The Third generation takeover statutes. Once one of the second state administrator is often empowered to hold hearings which may generation state takeover statutes-the Indiana Control Share be initiated by the administrator, the target company, or a certain Act-had passed constitutional scrutiny in the Supreme Court the

;: percentage of the target company's shareholders. Even state re~la­ third generation of tender offer statutes began to appear. One form tion that is limited to full disclosure, as opposed to a ment or that such statutes took was to apply the law of the host state to substantive review of the terms of the offer, may impose burdens corporations incorporated elsewhere. Such statutes, in regulating beyond those created by the federal legislation. The ~~st proi?i­ what has been called pseudo-foreign corporations, raise additional nent example is the commonly found state-imposed waiting ~erw.d constitutional and policy questions. See TLX Acquisition Corp. v. between the filing of the tender offer and the date on whtch tt Telex Corp., 679 F.Supp. 1022 (W.D.Okl.1987). Another variety of becomes effective. third generation takeover statute is modeled on the New York Second generation state takeover statutes. Following the "freeze" statute, also known as a business combination statute. Supreme Court's ruling in Edgar v. MITE Corp., 457 U.S. 624 The idea behind such statutes is to delay any transaction that (1982) a number of states enacted "second generation" takeove.r would complete the second step of a two-step acquisition, in those statutes that were designed to overcome the constitutional infirmi­ instances in which the first step was not agreed to by target ties of the Illinois statute that was struck down in MITE. The basic company's management. Thus, for example, the New York statute thrust of these statutes is to regulate tender offers through state prohibits a merger or other business acquisition within five years of law rules relating to corporate governance rather than through the control acquisition date unless the transaction was approved by state securities laws and administrative regulations. The basic the target company's directors prior to the control acquisition date. approach of such statutes is substantive regulatio~ of ten~er ~ffer.s. Other states have followed the New York lead, including Delaware, Ohio was the first state to adopt second generatiOn legtslatwn m which has adopted a three-year-freeze statute. Freeze statutes have the form of what has become known as control share legislation. A withstood constitutional attacks. Based on earlier Supreme Court control share act classifies takeover transactions by the percentage doctrine, there would appear to be considerable question whether 250 TENDER OFFER AND TAKEOVER REGULATION Ch. 11

such statutes can withstand constitutional scrutiny. Neve~th~less, the Delaware statute has withstood challenges at the pre~1mmary injunction stage because of the failure to show a hkehhood of success on the merits of the constitutional challenge, ?ut .the court Chapter 12 noted that although the statute was probably constltutwn~l,. ~he constitutionality issue is not an easy one. Amanda. Acqms1twn I Corp. v. Universal Foods Corp., 877 F.2d 496 (7th Clr.1989); RP MANIPULATION AND FRAUD- Acquisition Corp. v. Staley Continental, Inc., 686 F.Supp. 476 CIVIL LIABILITY; IMPLIED (D.Del.1988). PRIVATE REMEDIES; SEC RULE IOb-5; FRAUD IN CONNECTION WitH THE PURCHASE OR SALE OF ;f,::::;"' SECURITIES; IMPROPER r.•: ~7~-.r:~ TRADING ON NONPUBLIC ·. r: MATERIAL INFORMATION -- "·.:f" Table of Sections Sec. 83. Market Manipulation and Deceptive Practices-1934 Act §§ 9, 10, 14(e), 15(c). 84. Implied Remedies in the Federal Courts. 85. Section 10(b) and the Evolution of the Implied Remedy Under 1934 Act Rule 10b-5. 86. Rule 10b-5 Overview; Summary of the Principal Ele­ ments. : ~ . L.Jt. : ,.;~:.~ 87. "In Connection With" the Purchase or Sale of Any Security. 88. "Purchase or Sale"-Identifying Purchases and Sales. 89. Standing to Sue. 90. The Scienter Requirement; 1933 Act § 17(a) and 1934 Act Rule 14a-9 Compared. 91. Materiality. 92. Reliance; Fraud on the Market. 93. Causation. 94. The Measure of Damages. 95. Securities Class Actions; Litigation Reform. 96. Insider Trading. 97. Liability for Material Misstatements and Omissions of Fact in Documents Filed With the SEC-1934 Act § 18(a). 98. Corporate Mfirmative Disclosure Obligations and Ac­ countability.

251 252 MANIPULATION AND FRAUD Ch. 12 § 83 MARKET MANIPULATION 253 Sec. 99. Corporate Mismanagement, Rule lOb-5, and the Decep­ order to prevail in a suit charging manipulation, it must be proven tion Requirement. that the defendant's primary intent in entering the transaction was 100. The Effect of Plaintiffs Conduct on Implied Civil Liabili­ p_rice manipulation. It is not sufficient that the challenged conduct ty; Due Diligence; In Pari Delicto. simply had the effect of artificially affecting the price of the 101. Waiver of Claims; Voiding of Contracts in Violation of security. The Supreme Court has repeatedly stated that manipu­ the Securities Laws. lation is "a term of art" limited to certain types of transactions 102. Multiple Defendants: Controlling Person Liability; Aiding specifically designed to artificially affect the price of a security. See and Abetting; Joint Liability. Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 4 76 (1977); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199 (1976). Therefore, the fact that the conduct in question affects the price of a security will not by itself mean that it was an illegal manipulative act. Once the § 83. Market Manipulation and Deceptive Prac­ manipulative intent is present, hpwever, conduct that affects the tices-1934 Act§§ 9, 10, 14(e), 15(c) price is manipulative. • The overwhelming majority of the securities laws' liability Common examples of manipulation include wash sales and provisions (both civil and criminal) focus on disclosure and registra­ matched orders. A wash sale is a fictitious sale where there is no tion requirements. In addition, there is a group of provisions geared change in beneficial ownership and thus no true economic conse­ to preventing artificial market activity and practices desi~~d to quence. A matched order occurs when orders are entered simulta­ have the effect of setting manipulated-and hence, artificial­ security prices. These provisions are those directed specifically to neou~ly t_o buy and sell the same security. Another manipulative address market manipulation. The purpose of the various statutes practice Is known as "parking," which consists of transferring and rules prohibiting market manipulation is to prevent activities record own~rship of securities in order to hide the true identity of that rig the market and thereby to permit the operation of the the beneficial owner. A planned series of purchases of securities "natural law" of supply and demand. In this way the market price that is specifically designed to artificially restrict the supply and thereby raise prices is a manipulation. of securities will reflect as much as is possible a fair and just price for each security. Although it can take many forms, manipulation Manipulation can take many forms. Manipulations often have a consists of any intentional interference with supply and demand. number of"com~on characteristics. For example, the following factors are classic elements" of a market manipulation: (i) restric­ What Constitutes Manipulative Conduct? tion of the "float" or floating supply of the securities in the public 1934 Act § 9 outlaws manipulative practices in connection with market; (ii) _price leadership by the manipulator; (iii) dominating the trading of exchange-listed securities and also provides a private and controllmg the market for the security; and (iv) a collapse of remedy for investors injured by the prohibited manipulative con­ the market for the security after the manipulative activity has duct. In 2000, section 9(a)'s anti-manipulation provisions (but not ceased. The foregoing factors are indicia of market manipulation section 9(e)'s private right of action) were extended to securities­ but are not necessarily present in every manipulation case. ' based swap agreements even though those agreements are not . Subjective intent combined with deceptive conduct can estab­ securities under the SEA. lish manipulation. Manipulative conduct is not limited to conduct Section 9's prohibitions are supplemented by 1934 Act§ 10(b), that actually causes a rise (or fall) in the stock price. It includes which empowers the SEC to promulgate rules barring manipulative conduct that retards a decline in price that would otherwise result as well as deceptive conduct, and also by 1934 Act § 15(c), which from supply and demand forces. prohibits fraudulent and manipulative conduct by broker-dealers. In interpreting the 1934 Act provisions, the courts have recognized Overview ofAnti-Manipulation Provisions the concept of manipulation as a narrow one. In the first instance, Broker-dealers and their employees are, of course, subject to there is a specific intent requirement. Manipulation, as that term is !934 Act Rule 10b-5's general anti-fraud proscriptions that prohib­ used in the securities laws, does not extend to many acts and It any person from engaging in deceptive conduct in connection practices that have the effect of manipulating the price of a security with a purchase or sale of a security. 1934 Act Rule 15c1-2 is a rule but are not so specifically intended. Presumably, manipulation has specifically tailored to broker-dealers and generally prohibits fraud­ the same meaning under each of the Exchange Act provisions. In ulent, manipulative and deceptive practices in connection with Ch. 12 §83 MARKET MANIPULATION 255 254 MANIPULATION AND FRAUD

securities brokerage transactions. The types of specific conduct ~hat Former Rule lOb-4 addressed short tendering in connection are addressed in other broker-dealer rules include market mampu­ with tender offers and was replaced by 1934 Act Rule 14e-4. lation high pressure sales tactics, deceptive recommendations, gen­ 1934 Act Rule 10b-5 is the broadest of the § lO(b) rules. Rule eratio~ of excessive commissions, unauthorized trading, improper 10b-5 prohibits material misstatements and omissions as well as order executions, improper extension of credit for securities trans­ fraudulent acts in connection witl). purchases and sales of securities; actions, and misuse of customer funds or securities. it supports a broad implied private right of action. Rule lOb-5 is Manipulation can arise in many respects in connecti?n with a considered throughout this chapter. public offering of securities. For example, SEC Re.~latwn M .s~­ Former Rule lOb-6, which is now part of Regulation M, prohib­ verely regulates purchases of publicly offered secunhes by partici­ ited purchases during a distribution of securities by persons inter­ pants in a public offering. See § 49 above. ested in the distribution, except for stabilizing bids in compliance Beyond the above-mentioned specific manipulative br~ker-deal­ with former Rule 10b-7 which is now RulEj 104 of Regulation M. er activities and the general anti-manipulation and deceptwn rules, Former Rule lOb-S, which is now A part of Regulation M, prohibit­ the SEC makes it clear that violation of its rules is not limited to ed manipulative and deceptive devices in con~ection with a securi­ violation of any specified SEC rules, but rather covers all conduct ties distribution through rights held by security holders. that operates as a deceptive or manipulative device. 1934 Act Rule 1934 Act Rule 10b-9 prohibits "all or none" offerings of l:r:~-=' 15c1-2(c). In addition to the applicable statutes and SEC rules, the securities unless all such securities are "sold at a specified price ~.. : ~·t~~.":~· rules of the various self-regulatory organizations (the stock ex­ within a specified time, and * * * the total amount due to the seller changes and FINRA) impose standards of conduct on ~raker dea~­ is received by him by a specified date." ers. Finally, these requirements may be supplemented m appropn­ 1934 Act Rule lOb-10 requires that brokers confirm all trans­ ate cases by fiduciary duty principles. Because they result from actions in writing. Among other things, the confirmation must artificial activity, manipulated prices are in and of themselves disclose the broker's commission and whether he or she is acting as unfair. principal or as an agent for someone other than the customer. 1934 Act § 10(a) prohibits "short sales" and "stop loss" orders Former Rule 10b-13 which prohibited a tender offeror from in violation of SEC rules. 1934 Act§ 10(b), which is much broader, purchasing securities targeted by the tender offer once the tender provides that it is unlawful "to use or emplo_Y [utilizin~ any .means 1.•• offer has commenced was carried forward in 1934 Act Rule 14e-5, or instrumentality of interstate commerce], m connectwn w1th the purchase or sale of any security * * * any manipulative or decep­ which is now a part of Regulation 14E governing manipulative and deceptive tender offer practices. • 1,. ~- ),!' tive device or contrivance in contravention of such rules and ~ .;~~-:v regulations as the Commission may prescribe as. neces~ary or a~~ 1934 Act Rule lOb-16 requires disclosure of credit terms in propriate in the public interest or for the protecb?n of mv.estors. connection with margin transactions. 1934 Act Rule 10b-17 prohib­ The SEC, following the legislative mandate, has mvoked 1ts rul~­ its untimely announcements of dividends, stock splits, reverse stock making authority to prohibit a wide variety of con~uct that ~s splits, and rights or subscription offerings. 1934 Act Rule 10b-18 outlined here and discussed more fully in other sectwns of th1s sets out a safe harbor rule for issuer purchases of its own shares. book. Manipulation and Short Sales The Section lO(b) Rules Short sellers have long been viewed with suspicion and distrust 1934 Act Rule lOb-1 applies the prohibitions against market in the stock markets. The SEC had for years restricted short sales manipulation contained in 1934 Act § 9(a) to securities not covered under its so-called "up tick" rule (or "tick test"), that allowed a by 1934 Act § 12's registration requirements. short sale only where the previous trade caused an increase in 1934 Act Rule 10b-3 prohibits broker-dealers from engaging in price, thereby theoretically preventing short-sellers from placing manipulative or deceptive acts and practices with regard to s~c~ri­ additional pressure on a falling market. There was much criticism ties not traded on a national exchange and with regard to mumc1pal of this rule because it discriminated against short-sellers that securities. Rule 10b-3 thus closes a large part of the gap left by provide important price discovery information. In response to that 1934 Act § 9, which applies only to transactions effected through a criticism, the SEC eliminated its uptick test rule for short sales in July 2007. The greater flexibility allowed by that rule change was national exchange. 256 MANIPULATION AND FRAUD Ch. 12 §83 MARKET MANIPULATION 257

thought to have encouraged short sales and added volatility in the and dealers from implying that the SEC has reviewed their finan­ stock market during the crisis that occurred in 2007 and 2008. cial standing and/or business practices. Under 1934 Act Rule 15c1- Short sellers were even blamed for bringing down Bear Stearns and 5, broker-dealers including municipal securities dealers who control Lehman Brothers. On July 15, 2008, the SEC issued an emergency or are controlled by the issuer of a security, cannot enter a order prohibiting naked short selling in the stocks of 19 major customer's transaction wit~wut ~isclosing the control relationship. financial companies, including Fannie Mae and Freddie M~c. _Th~t ~934 Act R~le 15~1-6 reqmres brokers and dealers participating or restriction was later expanded to cover hundreds of financial msti­ ~nterested m a distribution to fully disclose such participation or tutions. One economic study indicated that declines in the stocks of I~terest. ~ule 15cl-7 prohibits churning or the charging of exces­ the financial firms covered by the SEC's emergency order could not SIVe fees _m connection with discretionary accounts, and requires be attributed to short selling. The study further found that the SEC prompt disclosure of all transactions made on behalf of discretion­ short selling restriction had resulted in a decline in the quality of ary accounts. Rule 15c1-8 prohibits sales "at the market" unless the market for those stocks. Nevertheless, the SEC continues to the broker or dealer has a reason!lble belief that a market exists. take the view that short sales need to be regulated to prevent Rule 15c1-9 _prohibits brokers and dealers from disseminating pro undue volatility and manipulation. For example, in 2008, the SEC forma financml statements with regard to issuers and their securi­ also adopted Rule 10b-21 that prohibits naked short selling by ties .u~less _the assumptions underlying the pro forma figures are .~..... -~-; entering a short sale with the intent not to provide sufficient shares exphcitly disclosed and explained. Rule 15c2-1 prohibits brokers 1:::~--~" to effect delivery for the short sale. This supplements SEC Regula­ and dealers from hypothecating customers' securities and certain ~ .· .:. ' ' . tion SHO that governs the mechanics of short sales generally. In commingling of securities held by the broker-dealer for the custom­ addition as noted previously, Rule 105 of SEC's Regulation M er. Rule 15c2-4 requires prompt transmission by brokers and prohibit~ short sales by a company's insiders and affiliates during a dealers of all funds or other consideration received in connection distribution of the company's securities. As this book went to press, with underwriting activities. Rule 15c2-5 requires disclosures of the the SEC solicited comments on additional short sale regulation. See terms of and risks associated with securities transactions on credit· Sec. Exch. Act Rel. No. 34-59748 (SEC April10, 2009). compliance with Regulation T's margin procedures will satisfy th~ In the spring of 2009, the SEC proposed two alternative rule. In 1992, the Commission adopted more comprehensive penny approaches to regulating short sales. The SEC presented two pro­ stock regulation in 1934 Act Rules 15g-1 through 15g-6; these rules replaced the former Rule 15c2-6. posals, each with an alternative version. The first propos~ was to implement a "short sale price test" or "short sale pnce test 1934 Act Rule 15c2-7 generally requires all market quotations restriction" that would take the place of the former uptick rule. to be properly identified, including the identity of the broker or The second proposal was to implement a circuit breaker rule that dealer placing the quotation. The rule thus prohibits "fictitious" would be triggered by a significant price decline in a particular q_uotations without disclosure to the applicable inter-dealer quota­ security and would either halt short selling in that security or, tion system that any such quotation is properly being entered on under the alternative proposal would trigger a short sale price test. behalf of another broker-dealer or is entered pursuant to an ar­ rangement with other broker-dealers. Manipulation Rules Under Section 15 of the Exchange Act 1934 ~ct Rule 15c2-8 establishes what constitutes proper con­ 1934 Act § 15(c) prohibits brokers and dealers from participat­ duct relatmg to brokers' and dealers' prospectus delivery obli­ ing in manipulative, deceptive or fraudulent acts and practices in gations under the 1933 Act. 1934 Act Rule 15c2-11 prohibits connection with sales, or attempts to induce purchases or sales, of b_rokers or dealers from entering or resuming quotations in securi­ securities. This prohibition extends to dealings in municipal securi­ ties unless there is adequate available current public information ties and transactions in connection with the procedures set up to concerning the security and issuer. There is a safe harbor for facilitate a national market system. As is the case with 1934 Act determining whether the public information is reasonably current. § 10(b), the rules promulgated under section 15(c) span a wide variety of conduct. Manipulation: Private Remedies 1934 Act Rule 15c1-2 prohibits fraud and misrepresentation by . 1934 Act_ §_ ~(e) gives a private remedy in damages to any securities brokers and dealers and also prohibits conduct that mvestor who IS ll1Jured by conduct in violation of section 9 which is operates as a fraud and material misstatements and omissions limited to securities on a national exchange (which noV.: includes within § 15(c)'s purview. 1934 Act Rule 15cl-3 prohibits brokers the NASDAQ stock market). 1934 Act § 9 requires that the plain- 258 MANIPULATION AND FRAUD Ch. 12 §85 EVOLUTION OF THE IMPLIED REMEDY 259

tiffs mJury arise out of the purchase or sale of a manipulated however, even they have been significantly narrowed since the mid security; it is not sufficient that the plaintiff retained the security 1970s. that was the subject of the alleged manipulation. In addition to The restrictive trend of the implication cases generally has not costs and reasonable attorneys' fees, the plaintiff is entitled to bypassed the securities laws. The Supreme Court has reaffirmed its damages based on the difference between the actual value and the past recognition of implied private rights of action for violations of price as affected by the manipulative conduct. Liability under 1934 Act Rule 10b-5 and 1934 Ac£,§ 10(b) and the proxy disclosure section 9(e) is expressly limited to persons "willfully" participating requirements of 1934 Act § 14(a). In Central Bank of Denver v. in the manipulative conduct; willfulness would seem to be an even First Interstate Bank of Denver, 511 U.S. 164 (1994), the Supreme stricter requirement than scienter, which is required generally in Court ruled that there is no implied right of action against aiders suits under 1934 Act Rule 10b-5. It must be remembered that, in and abettors of securities law violations. Accord Stoneridge Invest­ addition to the defendant's willful participation, the substantive ment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008). violation requires proof of manipulative intent. In addition, in order See§ 102 below. to recover for manipulative conduct, the plaintiff must show that his or her injury was a direct, rather than remote, consequence of § 85. Section lO(b) and the Evoluti~n of the Implied the prohibited activity. All of the foregoing factors combine to make Remedy Under 1934 Act Rule lOb-5 ·f::-:::: the section 9(e) remedy a very limited one. ,,,,.A·.rc, The Statutory Context .~: ~ ~··· ' . The Fifth Circuit initially held that manipulative activity that comes within the scope of section 9 cannot give rise to a Rule 10b-5 The primary private remedy for fraud available under the

·.~.?' action independently; plaintiff had to establish that all of section Securities Exchange Act has been the one implied 1934 Act Rule 9's elements had been met. Chemetron Corp. v. Business Funds, 10b-5, which prohibits fraudulent conduct in connection with a Inc., 682 F.2d 1149 (5th Cir.1982), vacated and remanded, 460 U.S. purchase or sale of securities. Although several Supreme Court 1007 (1983) Quite properly, however, that decision was vacated and cases have limited the scope of the Rule 10b-5 private right of remanded for further consideration in light of Herman & MacLean action, it continues to be a significant weapon against securities v. Huddleston, 459 U.S. 375 (1983), which held that the remedies fraud. To put the Rule 10b-5 remedy in its proper perspective, it under 1934 Act Rule 10b-5 and 1933 Act § 11 are cumulative. In must be viewed in conjunction with the other modes of private light of that Supreme Court ruling, it seems implausible that the relief provided by the securities laws. Some of the concurrent section 9 and Rule 10b-5 remedies are mutually exclusive. In other antifraud provisions are found in the 1933 Act.

,,r··r;_'.·,i~• words, a plaintiff injured by the defendant's manipulative conduct The 1933 Act contains two sections providing for express . •·. may sue under either or both. Accordingly, it is clear that manipu­ -.-~,.!:! private damage remedies for misrepresentation in connection with lation can form the basis of a 1934 Act Rule 10b-5 claim, provided the sale of a security. See 1933 Act §§ 11, 12(a)(2); §§ 53, 54 above. that all of the elements of a 10b-5 claim can be established. Those These supplement the 1933 Act's general antifraud provision em­ principal elements include showing that the defendant acted with bodied in 1933 Act § 17(a). Section 17(a) does not create an express scienter, that the plaintiff was deceived by relying on the deceptive right of action and, although there is considerable authority to the conduct, and that the injury was caused by the defendant's conduct. contrary, it has been held by a few courts to support an implied private remedy. In contrast to these provisions in the 1933 Act, the § 84. Implied Remedies in the Federal Courts express remedies available under the 1934 Act are much more Although the securities laws provide a wide variety of express limited in scope. 1934 Act § 9(e) confers a private right of action statutory remedies for injured investors, powerful private enforce­ upon an injured investor against one who has willfully engaged in ment weapons have arisen out of implied rights of action. However, market manipulation of securities subject to the 1934 Act's regis­ Since 1975, the Supreme Court has been narrowing the number of tration and reporting requirements by virtue of being listed on a implied remedies available under federal statutes. This narrowing national exchange. 1934 Act § 18(a) sets out a private right of trend has resulted in limiting the remedies that have been recog­ action for an investor who has been injured due to reliance on nized. Since it is clear that private remedies will not lightly be read materially misleading statements or omissions of material facts in into the statutes, it is questionable whether additional new reme­ documents required to be filed with the SEC. 1934 Act § 16(b)'s dies will be recognized. On the other hand, there are some firmly disgorgement of insider short-swing profits is the third express entrenched implied rights of action for securities law violations; private remedy contained in the 1934 Act. A fourth private remedy 260 MANIPULATION AND FRAUD Ch. 12 §85 EVOLUTION OF THE IMPLIED REMEDY 261 was created by The Insider Trading and Securities Fraud Enforce­ the rule, although the courts frequently refer to the legislative ment Act of 1988 and is codified in 1934 Act § 20A. history behind the statute. The express remedies under the 1933 Act apply only to fraud in connection with the sale of securities, thus providing protection The Development of the Implied Rule lOb-5 Remedy only to injured purchasers and not to injured sellers. The 1934 In 1946, a federal district, court held that, notwithstanding the Act's express remedies do not distinguish between purchasers and absence of an express private. right of action, Rule 10b-5 gives rise sellers. The 1934 Act's express remedies are restricted, however, to to a private remedy in the hands of injured investors. Kardon v. securities subject to the 1934 Act registration and reporting re­ National Gypsum Co., 69 F.Supp. 512 (E.D.Pa.1946). The implied quirements. These express remedies are also subject to a number of remedy started to grow and flourish in the district and circuit other limiting factors that are discussed in earlier sections of this courts but did not receive formal Supreme Court approval until book. 1934 Act§ 10(b) and 1934 Act Rule 10b-5 do not have many twenty-four years later. See Superintendent of Insurance v. Bank­ of these limiting factors. Although arguments have been made to ers Life & Casualty Co., 404 U.S. 6 (1971). Over the years there the contrary, the overwhelming majority of decisions agree that the seems to have been a general demise of 'implied remedies in the Rule lOb-5 remedy is cumulative with the express remedies noted federal courts. Nevertheless, the Rule 10b-5 remedy remains firmly above. See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375 entrenched. The Rule 10b-5 action has, however, been cut down in (1983). scope in many respects.

1934 Act Rule lOb-5 In the 1970s and 1980s, a series of Supreme Court cases limited the scope of the private right of action under Rule 10b-5; A proper perspective on 1934 Act Rule 10b-5 also requires an this trend carried through the end of the century. First, the Court examination of the rule's history and development. The general ruled that, in order to maintain an action, the plaintiff must be antifraud provision of the 1934 Act is contained in § 10(b), which either a purchaser or seller of the securities in question. Blue Chip \ provides that it is unlawful "to use or employ [utilizing any means Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). Second, a or instrumentality of interstate commerce], in connection with the showing of negligent conduct will not suffice; the defendant must '. purchase or sale of any security * * * any manipulative or decep­ ' have acted with scienter. Ernst & Ernst v. Hochfelder, 425 U.S. 185 tive device or contrivance in contravention of such rules and (1976). Third, the conduct complained of must be "deceptive." regulations as the Commission may prescribe as necessary or ap­ •, ·' Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977). propriate in the public interest or for the protection of investors." It is quite easy to establish federal jurisdiction to support a !1: In 1934 Act Rule 10b-5 the SEC fashioned its most encompassing antifraud prohibition. Rule 10b-5 claim. All that is required is for some aspect of the securities transaction under attack to have been carried out Promulgated in 1942, 1934 Act Rule lOb-5 was patterned through the use of an instrumentality of interstate commerce. For directly upon 1933 Act § 17(a), except that Rule 10b-5 further example, even an intrastate telephone call has been held sufficient extends to misstatements and omissions occurring in connection to satisfy the jurisdictional requirements of Rule 10b-5. While a with either a purchase or sale of securities, while 1933 Act § 17(a) face-to-face conversation itself will not satisfy the jurisdictional is limited to fraudulent sales and offers to sell. Rule 10b-5 prohib­ requirements, there may be Rule 10b-5 jurisdiction if the conversa­ its: (1) fraudulent devices and schemes, (2) misstatements and tions are part of a transaction that utilizes an instrumentality of omissions of material facts, and (3) acts and practices which operate interstate commerce. Also, although it might be argued that the as a fraud or deceit. When it adopted 1934 Act Rule 10b-5, the language of 1934 Act § 10(b) and Rule lOb-5 require otherwise, it Commission, without even realizing its eventual reach, created a seems to be the majority rule that it is not necessary that the powerful antifraud weapon. According to one account, the decision misrepresentation be communicated through an instrumentality of to adopt the rule and model it on 1933 Act § 1 7(a) was arrived at interstate commerce, so long as there is a connection between the without any deliberation, with the only official discussion consisting use of the jurisdictional means and the fraud. of one SEC Commissioner reportedly observing, "we are against Additionally, through the doctrine of supplemental or pendent fraud, aren't we?" See Conference on Codification of the Federal jurisdiction, a plaintiff with a Rule lOb-5 claim may bring related Securities Laws, 22 Bus.Law. 793, 922 (1967) Given this back­ state statutory or common law claims into the federal court. The ground, it is clear that not much can be gleaned from the history of significance of pendent jurisdiction has diminished because of the 262 MANIPULATION AND FRAUD Ch. 12 §86 SUMMARY OF THE PRINCIPAL ELEMENTS 263

Securities Litigation Uniform Standards Act of 1998 (SLUSA), plaint. There is no parallel requirement for defendants in Rule 10b- which preempted state law with regard to class actions of fifty 5 actions. The courts generally have assumed that it is not neces­ persons or more involving securities fraud. Individual actions, class sary for the defendant to have been a purchaser or seller of actions on behalf of fewer than fifty persons, and derivative actions securities in order to be held to have violated Rule 10b-5. Any may still have parallel state law claims. statement reasonably calculated to affect the investment decision of The Rule 10b-5 remedy may be used in a wide variety of a reasonable investor will satisfy.' the "in connection with" require­ factual contexts. The 10b-5 action has been used to address the ment even if the defendant was not a purchaser or seller. Although problems of material corporate misstatements or nondisclosures, aiders and abettors can be held liable in criminal and SEC enforce­ insider trading, and corporate mismanagement problems that arise ment actions, aiders and abettors are not subject to liability in in the context of transactions in shares or other securities. Further­ private damage actions. Thus, in private suits, only primary viola­ more, a parallel antifraud remedy has been implied under 1934 Act tors and their controlling persons can be held liable. proxy Rule 14a-9. There will frequently be cumulative Rule lOb-5 and 14a-9 remedies available in the case of mergers and corporate Of Any Security reorganizations, which involve both a shareholder vote and securi­ Rule lOb-5 applies to any purchase or sale by any person of ties transactions. Similarly, 1934 Act Rule 10b-5 has a role to play any security. The fact that a security is exempt from 1933 Act or in the tender offer context, which necessarily involves the sale of 1934 Act registration does not affect the applicability of Rule lOb­ '¥f7 •· target company stock. In addition, the fact that securities may be S's proscriptions. The rule applies regardless of whether the securi­ exempt from registration under the 1933 Act will not preclude an ty is registered under the 1934 Act, and regardless of whether the action under Rule 10b-5. company is publicly-held or closely-held. Rule 10b-5 applies even to government and municipal securities, and in fact, to any kind of § 86. Rule lOb-5 Overview; Summary of the Princi­ entity that issues something which can be called a "security." pal Elements Because of this broad scope, the rule may be invoked in many situations. As a result of the Commodity Futures Modernization There are five principal elements for stating a claim under ' Act of 2000, 1934 Act, § 10(b) (and hence Rule 10b-5) now applies '· Rule 10b-5. The plaintiff must show: (1) fraud or deceit (2) by any L to security-based swap agreements even though those instruments ';·- person (3) in connection with (4) the purchase or sale (5) of any are not securities. security. Furthermore, since Rule lOb-5, like its parent section, requires deceit or fraud, the elements of common law fraud­ Scienter materiality, reliance, causation, and damages-thus must be part of any Rule 10b-5 claim. One of the essential elements of a fraud claim is demonstrating that the defendant acted with scienter. In its strictest sense, Purchase or Sale scienter means an intent to deceive, but there is substantial author­ ity under common law that making statements in reckless disre­ An important corollary to the "purchase or sale" requirement gard of the truth will suffice to establish scienter. In 1976, the is that, in order to have standing to sue, a 10b-5 plaintiff in a Supreme Court held that a valid claim for damages under Rule private damages action must have been either a purchaser or seller lOb-5 must establish that the defendant acted with scienter. Ernst of the securities that form the basis of the material omission, & Ernst v. Hochfelder, 425 U.S. 185 0976) The Court, however, did misstatement, or deceptive conduct. Most courts allow a remedy for not decide whether a showing of reckless conduct would satisfy the a corporation (or in a shareholder derivative suit) for certain scienter requirement. Nevertheless, the majority of lower court transactions in its own shares, including corporate repurchases of decisions has found that recklessness is sufficient to state a claim its own shares at an inflated price, or an additional issuance of under Rule 10b-5. corporate shares on an unfavorable basis. Materiality By Any Person In order for a misstatement or omission to be actionable under As pointed out directly above and as discussed below, a plaintiff Rule lOb-5, it must be a material one. The Supreme Court has in a private damage action under Rule 10b-5 must have been a defined materiality in terms of the type of information that a purchaser or seller of the security forming the basis of the com- reasonable investor would consider significant in making an invest- §87 PURCHASE OR SALE OF ANY SECURITY 265 264 MANIPULATION AND FRAUD Ch. 12

ment decision. The materiality of a particular item is based on a § 87. "In Connection With" the Purchase or Sale of highly factual inquiry and is to be determined within the total mix Any Security of information that is publicly available. The courts have generally assumed it is not necessary that the defendant have been a purchaser or seller of securities in order to Reliance be held to have violated 1934 Act Rule 10b-5. It is sufficient that Following the basic requirements for proving common law the material misstatement, omis!iion, or fraudulent act, in the fraud reliance is an element of any private Rule 10b-5 claim. In a words of both the statute and the rule, be "in connection with the sharply divided decision, the Supreme Court has recognized the purchase or sale of any security * * * ." This means that there fraud-on-the-market presumption of reliance under which a show­ must be some connection between the misstatements or conduct in ing that a material misstatement or omission adversely affected the question and a transaction in securities. The courts have interpret­ market price creates a presumption of reliance. Basic Inc. v. Levin­ ed this language broadly. However broadly this may be interpreted, son, 485 U.S. 224 (1988). Defendant may rebut the presumption of there are limits and, as discussed belQw, there must be a significant reliance or show that reliance was unreasonable. connection between the fraud and a purchase or sale of securities. Any statement that is reasonably calculated to affect the in­ Causation vestment decision of a reasonable investor will satisfy the "in .·~.... _ _,,, ~·f·-····> Again, as is the case with common law fraud, in addition to connection with" requirement. As a general proposition, dissemina­ ' .. _.. _. ~· . scienter, materiality, and reliance, causation is an element of a Rule tion to the public through a medium of communication upon which 10b-5 action. Many courts have divided causation into two sub­ the reasonable investor would rely will satisfy the "in connection parts: transaction causation and loss causation. Transaction causa­ with" requirement. Even a technical advertisement in a specialized tion requires a showing that, but-for the violations in question, the journal could be said to be in connection with a purchase or sale of transaction would not have occurred (at least in the form that it a security if it is likely to affect the readers' investment decisions took). Loss causation requires a showing of a causal nexus between about the company's securities. See, e.g., In re Carter-Wallace, Inc. the transaction and the plaintiffs loss. Securities Litigation, 150 F.3d 153 (2d Cir.1998) (refusing to dis­ miss claim). Thus, advertisements in a medical journal concerning a L'' Damages new drug could form the basis of a securities fraud claim. This result is not without controversy. . '.i,. Also, as is the case with any fraud claim, the plaintiff must be ,1-",· able to establish damages. In most Rule 10b-5 litigation, the Public announcements and other dissemination of information appropriate measure of damages is the out-of-pocket loss proxi­ can be in connection with the purchase or sale even if the speaker mately caused by the material misstatement or omission. Depend­ or disseminator is not a purchaser or seller. Although the existence ing on the facts, other measures, such as benefit of the bargain may of a public market at the time of any news release is not by itself be appropriate. sufficient to satisfy the "in connection with" requirement, if the news release relates to matters likely to affect the price of the stock Statute of Limitations significantly, the requirement is satisfied. Similarly, information As part of the Sarbanes-Oxley Act Congress enacted a statute contained in periodic SEC filings such as the annual or quarterly of limitations (two years from discovery but not more than five report will be considered to have been in connection with the years after the violation) for "a claim of fraud, deceit, manipu­ purchase or sale of a security where the material disclosed relates lation, or contrivance in contravention of a regulatory requirement to the types of information that an investor would use in deciding to purchase or sell a security. Press releases and other statements concerning the securities laws." 28 U.S.C.A. § 1658(b). directed to issues that investors deem important in making invest­ Cumulative Remedies ment decisions are likely to be considered to have been made in connection with the purchase or sale of a security. In Herman & MacLean v. Huddleston, 459 U.S. 375 (1983), the Supreme Court held that the remedies under 1933 Act § 11, for In United States v. O'Hagan, 521 U.S. 642 (1997), the Supreme misstatements in 1933 Act registration materials, and Rule lOb-5 Court held that a Rule 10b-5 violation does not require that the are cumulative. Rule 10b-5 remedies are cumulative with other fraud be linked to identifiable purchasers or sellers of securities. A breach of duty to the source of confidential information will support express remedies as well. 266 MANIPULATION AND FRAUD Ch. 12 §89 STANDING TO SUE 267

a Rule 10b-5 violation so long as the confidential information is F.Supp. 978, 986-87 (D. Utah 1997), relying in part on Rathborne v. misused in connection with securities trading. It thus is not neces­ Rathborne, 683 F.2d 914, 920 (5th Cir.1982). 1934 Act § 3(a)(14) sary that the source of the information to whom the duty was owed provides: "[t]he terms 'sale' and 'sell' each include any contract to have been a purchaser, seller or issuer of the securities in question. sell or otherwise dispose of." It is noteworthy that the definition The broad interpretation of the "in connection with" require­ "includes" contracts to sell but does not purport to be exclusive ment in O'Hagan was reaffirmed by the Supreme Court in SEC v. and thus limited by the express e~amples of what is a sale that are Zandford, 535 U.S. 813 (2002). In Zandford, the SEC sued a stock given in the statute. 1934 Act § 3(a)(13) contains a parallel defini­ broker who emptied his client's account and converted the pro­ tion of "purchase." The definition of purchase or sale includes a ceeds. The defendant contended that since there was no fraud in "contract of sale" even though the sale does not take place and no connection with specific securities transactions, Rule 10b-5 could securities are transferred. See, e.g., Falkowski v. Imation Corp., 320 not be used to challenge the broker's actions. The Supreme Court F.3d 905 (9th Cir. 2003). Furthermore, the "in connection with" rejected this argument, reasoning that the purpose of the federal requirement does not require identification of the specific security, securities laws was to assure the existence of honest securities or a demonstration that money was actually invested in securities markets and to promote investor confidence. The court explained to qualify plaintiff as a purchaser of the securities within th~ that there was the requisite deception insofar as the broker failed meaning of Rule 10b-5. See Grippo v. Perazzo, 357 F.3d 1218 (11th to disclosed the challenged embezzlement out of a securities ac­ Cir. 2004). count to his customer and that this was sufficient connection to Concepts of purchase and sale are to be construed flexibly in establish securities fraud. The Zandford decision is significant in order to accomplish the purpose of the securities laws. The courts . ·.,-. that it establishes a broad test for the reach of the securities laws . will consider the economic reality of the transaction and whether it Rather than simply focus on a specific transaction, if the fraud lends itself to fraud in the making of an investment decision. As involves securities in any meaningful way, then the securities laws ?ne ?ourt explained, "several factors have so far emerged in this are implicated. It is also noteworthy that the Justices who are mqmry: (1) whether a transfer of ownership or control of the generally divided in securities decisions were unanimous in the security occurred; (2) whether consideration or value was given· (3) ,,' Zandford holding. whether, in appropriate contexts, there was a change in the fu~da­ L,,, mental nature of the security; and (4) whether the transaction had I~::.:.:.~ § 88. "Purchase or Sale"-Identifying Purchases and a direct effect on the conduct of the securities market." Seolas v. Sales Bilzerian, 951 F.Supp. 978, 987 (D.Utah 1997). :.. ~~- ..v ~..:;j;~ Rule lOb-5 applies to fraud and misstatements or omissions in Whether or not a contract of sale is binding will ordinarily connection with the purchase or sale of any security. The defini­ dep.end on state !a~. Thus an oral contract of sale, including an oral tions of purchase and sale go far beyond garden-variety cash for optiOn contract, 1s a sale of a security subject to the federal stock transactions. However, not every transfer of securities will securities laws. The Wharf (Holdings) Ltd. v. United International constitute a sale. Holdings, 532 U.S. 588 (2001). The securities laws contain various formulations of the defini­ tions for purchase and sale but each is designed to identify a § 89. Standing to Sue transaction in which the securities are acquired or disposed of for Rule 10b-5's applicability is premised upon a transaction that value. Thus, for example, 1933 Act § 2(a)(3) defines "sale" as is "in connection with" a "purchase or sale" of a security. Six years including "every contract of sale or disposition of a security or after the initial recognition of an implied private 10b-5 remedy, the interest in a security, for value." In most situations, this definition Second Circuit in Birnbaum v. Newport Steel Corp., 193 F.2d 461 will encompass transactions such as exercise of options, mergers, (2d Cir.1952), cert. denied, 343 U.S. 956 (1952), held that a Rule exercise of conversion rights, pledges, and the like. On its face, the 10b-5 plaintiff in a private damages action must have been either a SEA definition may be even broader, as there is no explicit require­ purchaser or seller of the securities that form the basis of the ment that the security be disposed of for value. Thus, for example, material omission, misstatement, or deceptive conduct. The Birn­ it is not necessary to show that there is consideration in the baum decision, was adopted by the Supreme Court nearly twenty traditional sense. As one court explained, "[t]he fact that no 'value' years later, in Blue Chip Stamps v. Manor Drug Stores 421 U.S. was paid is not necessarily dispositive." Seolas v. Bilzerian, 951 723 (1975). ' 268 MANIPULATION AND FRAUD Ch. 12 §90 THE SCIENTER REQUIREMENT 269

After the purchaser/seller standing rule was developed, it soon § 90. The Scienter Requirement; 1933 Act § 17(a) became clear that a plaintiff shareholder satisfies the purchas­ and 1934 Act Rule 14a-9 Compared er/seller standing requirement in a shareholder derivative suit brought on behalf of a corporation defrauded in connection with its Rule lOb-5 describes the type of conduct proscribed but it does purchase or sale of securities. While a shareholder can bring a not set out the appropriate standard of culpability. The question has thus arisen as to whethev the securities laws reach negligent derivative suit in a representative capacity for the corporation, misconduct or are limited to intentional misstatements and omis­ other members of the corporate community cannot. Thus, for sions. After twenty years of conflicting cases, in 1976 the Supreme example, a corporate director cannot bring a claim based on a Court held in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976), transaction by the corporation. Similarly, Rule 10b-5 standing does that, in order to establish a valid claim for damages under Rule not extend to non-shareholder officers. Even being a shareholder 10b-5, it must be proven that the defendant acted with scienter. will not assure standing to sue. In order to state a 10b-5 claim The Supreme Court subsequently held in Aaron v. SEC, 446 U.S. based on the corporation's purchase or sale of a security, the 680 (1980) that the scienter standard a'pplies under Rule 10b-5 shareholder must be suing in a derivative rather than individual regardless of whether the action is one for damages or an enforce­ capacity. ment action brought by the Commission. In the context of a Share exchanges or cash-out transactions pursuant to a corpo­ criminal case, in addition to scienter, the prosecution must estab­ rate merger or other business combination will ordinarily consti­ lish that the defendant acted willfully, which means that he or she tute purchases and sales for Rule 10b-5 purposes. Where a corpora­ acted with a realization that the acts were wrongful. See, e.g., ·:.. United States v. Stewart, 305 F.Supp.2d 368 (S.D.N.Y. 2004) ··-~. tion ceases to exist due to a merger or other form of corporate reorganization, it has been held that the successor corporation, The Supreme Court in Aaron u. SEC also held that scienter is although not itself a purchaser or seller of the securities in ques­ not an element of an SEC claim for injunctive relief under 1933 Act \ ., tion, may maintain a Rule 10b-5 action for securities sold or §§ 17(a)(2) and (a)(3). The Court reasoned that, although the purchased by the disappearing corporation. In contrast, an ex­ language of 1934 Act Rule 10b-5 is identical in all relevant parts to '. change of shares or merger with a shell company that is undertak­ that of 1933 Act § 17(a), 1934 Act § 10(b)'s overall scope is '· en merely for "corporate restructuring" has been held not to statutorily limited to manipulative or deceptive conduct. "Manipu­ constitute a purchase or sale under Rule 10b-5. lation" is a term of art that is limited to certain specific types of trading practices and thus is not applicable in most antifraud cases. There is authority to the effect that a person need be neither a The statutory deception requirement has been held to mandate a purchaser nor a seller of the securities in order to maintain an showing of scienter in order to state a 10b-5 claim because decep­ action for injunctive relief under Rule 10b-5. There is also some tion connotes common law fraud and common law fraud requires authority to the contrary. scienter. As discussed more fully below, one corollary of Rule 10b- Fraudulently inducing shareholders not to part with their 5's deception and scienter requirements is that, as is the case with shares will not by itself support a Rule 10b-5 damage action. Even fraud generally, the complaint must be pleaded with sufficient particularity. with additional compelling factors, it is clear that the "aborted seller" doctrine survives the Supreme Court decision in Blue Chip 1934 Act § 14(a) and Rule 14a-9 give rise to an implied Stamps u. Manor Drug Stores above. In Merrill Lynch, Pierce, antifraud remedy in connection with a proxy solicitation. Section Fenner & Smith v. Dab it, 54 7 U.S. 71 (2006), the Supreme Court 14(a) does not expressly impose the limitation that SEC rules held that SLUSA preempts state law claims that could be brought address conduct that is manipulative or deceptive. A number of by someone who held rather than sold securities. The Court noted courts have held that the absence of a similar deception require­ that the absence of a Rule 10b-5 remedy reinforced the application ment in the language of section 14(a) results in a finding that n of SLUSA's preemptive effect. negligence is sufficient to state a claim under the proxy rule's antifraud provisions. The reasoning of the Supreme Court in Aaron When a shareholder is frozen out of a corporation or otherwise seems to compel a finding that scienter is not required in an action put in the position of a "forced seller," Rule 10b-5 standing under the proxy rules. Accordingly, it is appropriate that a majority ordinarily will exist even though there was no voluntary investment of the decisions conclude that negligence is sufficient to establish a decision. violation of section 14(a) and Rule 14a-9's prohibitions on material 270 MANIPULATION AND FRAUD Ch. 12 § 91 MATERIALITY 271

misrepresentations and omissions in connection with proxy solicita­ Rights, Ltd., 551 U.S. 308 (2007) (the court should consider all tions. inferences and weigh them together in determining whether the defendant acted with scienter). ·As is the case with the other Recklessness as Scienter elements of fraud, scienter is subject to FRCP Rule 9(b)'s require­ It is clear that the scienter requirement is satisfied by a ment that fraud be pleaded wit~ particularity. showing of intentional misrepresentation made with the intent to deceive. But what about conduct that falls short of willful misrepre­ § 91. Materiality· sentation? In reaching its decisions in Hochfelder and Aaron the The test of materiality depends not upon the literal truth of Court did not decide whether a showing of reckless conduct would statements, but upon the ability of reasonable investors to become satisfy the scienter requirement. It has long been the rule at accurately informed. Courts do not focus on a particular sentence common law that, at least under certain circumstances, the show­ that is part of a larger statement or disclosure without considering ing of reckless disregard of the truth or the maki~g of a sta~ement with no belief in its truth constitutes scienter m an actwn for the entirety the statements in quesJion. Accordingly, when there is deceit. While the recklessness question remains unsettled at the adequate cautionary language warning investors as to certain risks, optimistic statements are not materially misleading. As discussed Supreme Court level, the vast majority of t~e circu~t and district .~...... --, court decisions have found that recklessness 1s sufficient to state a more fully below, a finding of materiality is based on the total mix :r·~c,•> of information available. However, the mere fact that information -~~ ~~~: ~ ._.- ~r claim under 10b-5. may be publicly available does not mean that it is necessarily Some courts have spoken in terms of a "barely reckless" incorporated into every statement made. Thus, for example, it was standard whereas most decisions impose a "highly reckless" stan­ held that even though information in a company's Form lOK filing dard. The stringent recklessness standard adopted by the Ninth and annual report to shareholders might have clarified alleged Circuit has been phrased in terms of deliberate or conscious reck­ misstatements in a proxy solicitation, the alleged misstatements in \ .; lessness. See, e.g., Employers Teamsters Local Nos. 175 and 505 the company's proxy statement might nevertheless be actionable. ' Pension Trust Fund v. Clorox Co., 353 F.3d 1125, 1134 (9th Cir. See United Paperworkers International Union v. International Pa­ 2004) As other courts have put it: "[a]n egregious refusal to see the per Co., 985 F.2d 1190 (2d Cir.1993). obvious, or to investigate the doubtful, may in some cases give rise It has repeatedly been held that the concept of materiality ·- .~· ' to an inference of ... recklessness." MBI Acquisition Partners v. cannot be distilled into a bright-line test. Thus, summary judgment ... ~ . Chronical Publishing Co., 301 F.Supp.2d 873 (W.D. Wis. 2002), •· , ..:·· quoting Rehm v. Eagle Fin. Corp., 954 F.Supp. 1246, 1255 (N.D.Ill. based on a finding of no materiality ordinarily will not be appropri­ '1:::~~~ ::_., 1997) and Goldman v. McMahan, Brafman, Morgan & Co., 706 ate. Determinations of materiality relating to accounting matters ,._.,,.~<· F.Supp. 256, 259 (S.D.N.Y.1989). are not determined on a mathematical basis alone; misstatements may otherwise be important to shareholders. Pleading and Proving Scienter Materiality depends on whether the plaintiff can establish "a Scienter is based on the defendant's state of mind and, as is the substantial likelihood that a reasonable shareholder would consider case in many cases, may be difficult to prove with direct evidence. it important." TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, On appropriate facts, a court may be willing to permit an inference 449 (1976) (emphasis added). Accord Basic Inc. v. Levinson, 485 that the defendant acted with the requisite scienter. However, such U.S. 224 (1988). The test of materiality is whether a reasonable an inference should not be made lightly. In making the determina­ investor would have considered the matter significant; it is not tion of culpability, the court should consider all inferences and necessary to show that the investor would have acted differently. It weigh them together in determining whether the defendant acted is not sufficient to show that a shareholder might have found the with scienter. Thus, the presence of some facts that could lead to an information to be of interest. inference of scienter may be negated by other inferences. Scienter Not every miniscule inaccuracy will be actionable. Thus, for should be inferred only when the fact pattern indicates that the example, the mere fact that a company's disclosures are not consis­ defendants must have been acting with the requisite state of mind. tent with generally accepted accounting practices does not mean In order to withstand the scrutiny imposed by the Private Securi­ that they are actionable under the securities laws. However, reck­ ties Litigation Reform Act of 1995, the inference of scienter must less departures from accepted accounting practices can be action­ be both reasonable and strong. See Tellabs, Inc. v. Makor Issues & able under Rule 10b-5. 272 MANIPULATION AND FRAUD Ch. 12 § 91 MATERIALITY 273

Immateriality of Vague Statements; Sales Talk and "Puff­ silence will not suffice and it must be decided whether preliminary ing"; Statements of Opinion and Intent negotiations need be disclosed. Similarly, once an issuer, rather Summary judgment or dismissal of the complaint is appropri­ than maintaining silence, voluntarily makes a statement-such as ate when the statements are too vague to be actionable. Similarly, in response to an inquiry from the press or securities analysts-all nondisclosure of extremely contingent or speculative possibilities statements must be totally dev9id of material misstatements. As will be immaterial as a matter of law. Additionally if there are the Supreme Court has pointed out, arguments based on the adequate cautionary warnings, claims based on projections and premature nature of the disclosure are not pertinent in determin­ other forward looking statements may be subject to dismissal or ing the materiality of a particular misstatement; "[t]he secrecy summary judgment. rationale is merely inapposite to the definition of materiality." As a general proposition, statements of opinion are not action­ Basic Inc. v. Levinson, 485 U.S. 224, 235 (1988). able unless they relate to management's assessment of the company S?~e courts were of the view that preliminary acquisition or to other material facts. Thus, for example, general statements of negotratwns need not be disclosed until there has been an agree­ optimism are not actionable. Borrowing from the common law of ment in principle as to the transaction's' price and structure. misrepresentation in certain cases the courts have tolerated some However, the SEC and many courts took a contrary position degree of "puffing" or "sales talk." However, given the importance reasoning the "price and structure" threshold frequently would of full candor, courts should be reluctant to permit misrepresenta­ provide too late a materiality date, especially when the issue is a tion under the guise of puffing. Misrepresentation by implying the denial of such negotiations when in fact they are taking place. In existence of certain facts cannot be disguised as mere puffing. Basic Inc. u. Levinson, supra, the Supreme Court accepted the Similarly, use of percentages may imply a factual basis and if so, SEC's view in holding that whether preliminary merger negotia­ cannot be protected as mere puffing. A reading of the cases yields tions have crossed the materiality threshold is a question of fact. the following general rule: while a good faith opinion (or even Whether a fact is material depends upon whether a reasonable "puffing") is not material, a statement of opinion made with no investor would consider it significant in making his or her invest­ belief in its truth is actionable. ment decision . ,, ... - .. Materiality of Contingent Events Predictions, Projections, and Other "Soft" Information; Disclosures relating to contingent events may be actionable. In Management Discussion and Analysis such cases, materiality is judged in light of the magnitude of the Another issue relating to materiality that is getting increased event in question and the probability of its occurrence. See Basic attention is with regard to predictions and other "soft informa­ Inc. v. Levinson, 485 U.S. 224 (1988). The greater the magnitude tion." There are two questions that frequently arise regarding and the greater the probability of the event, the more likely it is disclosure of soft information. One question is the extent to which that it will be material. Thus, for example, relatively uncertain contingencies that would have a great impact on the company may there is an obligation to make a prediction or other disclosures of be material. Conversely, a virtually certain event with substantially soft information. A second issue that arises is whether an incorrect opinion, projection, or prediction is actionable. less significance may also be material. However, too much uncer­ tainty will result in a finding of immateriality. Following the traditional common law rule, vague opinions and predictions are not actionable. However, the mere fact that a Materiality of Merger Negotiations statement is couched in the form of soft information, such as a Especially difficult questions of materiality relate to the ques­ prediction or projection, does not preclude a finding of materiality. tion of whether preliminary merger negotiations or other control­ Additionally, management's opinion as to the fairness of a transac­ related transactions must be disclosed. It is the general view that tion, although opinion, can be material. See Virginia Bankshares, Rule lOb-5 does not impose an affirmative duty of disclosure, and Inc. v. Sandberg, 501 U.S. 1083 (1991). thus silence cannot be actionable. Thus, absent some independent There have been significant changes in the Commission's atti­ basis for the duty, the existence of preliminary negotiations will not tude towards projections. There currently are many line-item dis­ have to be disclosed. However, when a material development is closure requirements that call for certain types of soft information. covered by a line-item disclosure requirement in a document that For example, under Item 303 of Regulation S-K, in the course of its needs to be filed with the SEC or otherwise publicly disseminated, Management Discussion and Analysis (MD&A) of financial condi- I 274 MANIPULATION AND FRAUD Ch. 12 § 91 MATERIALITY 275

tion and report of operations, management is directed to analyze language in both 1933 Act and 1934 Act filings. However, most operations. This analysis must include disclosure of trends and such statements were couched in such general terms as to render uncertainties likely to have a material effect on the company. The them ineffective. As noted above, it .is not sufficient to simply use a MD&A also should contain discussion of any positive trends that caution to the effect that projections and the like may not reflect management foresees. The SEC has taken a vigorous enforcement actual performance. Similarly, trying to cover all disclosures with a stance on these disclosures. The MD&A disclosure mandate can general cautionary statement is unlikely to be effective. In order to result in material misstatements or omissions that will give rise to be effective, the cautionary language should not only alert the liability. Although the MD&A disclosures contained in Item 303 or reader to the risk factors, but should briefly summarize each of the Regulation S-K require disclosure of "known trends or uncertain­ risk factors. Cautionary language about one risk will not be effec­ ties," MD&A does not alter the basic rule that projections are not tive with regard to other risks. Companies seeking to rely on the required. bespeaks caution doctrine must thus be careful to couch the cau­ tionary language in terms of the specific risks and uncertainties As pointed out above, once a prediction, projection, or valuation involved. The cautionary language- must 'directly relate to the is made, it must withstand materiality scrutiny if there are any alleged misstatements in question. ' inaccuracies. The mere fact that a projection turns out to be wrong is not sufficient to state a Rule 10b-5 claim. Analysts' Opinions and Estimates Safe Harbor for Forward-Looking Statements Ordinarily, a company's management will not be held responsi­ ble for opinions, projections, and estimates of security analysts even As part of the Private Securities Litigation Reform Act of 1995 though management may have supplied the analysts with some of (PSLRA), Congress enacted 1934 Act § 21E which provides a safe the information they used to formulate their estimates. A company harbor for forward-looking statements. 1934 Act § 21E is modeled will be held responsible if it passes on misinformation to analysts on 1933 Act Rule 175, 1934 Act Rule 3b-6, and the "bespeaks caution" doctrine created by the federal courts. The section 21E with the intention that the analysts communicate the misinforma­ tion to the market. In the absence of such an intent to defraud the I ~· safe harbor allows corporate management to disclose forward-look­ (" ~ .. ing information and projections to investors, while retaining protec­ market, a company will not be held accountable for analysts' ',. opinions unless the company has "adopted or endorsed" the ana­ ''-.: tion under the safe harbor. 1934 Act § 21E applies to 1934 Act reporting companies, persons acting on behalf of such companies, lysts' reports or unless the company or its management influenced outside reviewers retained by such companies, and underwriters or controlled the analysts' projections. :[~l·k deriving or obtaining forward-looking information from such com­ In a related development, the SEC adopted Regulation FD to ',. ·--···~ ~·., . panies. The safe harbor applies to forward looking statements but prohibit selective disclosure. Companies who make disclosures to I• ~J!}I not to statements of fact. 1933 Act § 27 A contains a safe harbor analysts now have to make prompt public announcements so that that parallels the one set forth in 1934 Act § 21E. all investors can have access to the same information. Regulation FD applies only to "communications by the company's senior The "Bespeaks Caution" Doctrine and Materiality management, its investor relations professionals, and others who A number of courts have adopted what is referred to as the regularly communicate with market professionals and security "bespeaks caution" doctrine. As noted above, Congress codified the holders." Regulation FD further applies only to a company's "com­ bespeaks caution doctrine as part of PSLRA. The doctrine holds munications with market professionals, and holders of the issuer's that sufficient cautionary language may preclude misstatements securities under circumstances in which it is reasonably foreseeable from being actionable. PSLRA makes it clear that the bespeaks that the security holders will trade on the basis of the informa­ caution doctrine expressly applies the doctrine to both oral and tion." Accordingly, Regulation FD does not apply when the compa­ written "forward-looking statements," but should not be extended ny is communicating with the press, rating agencies, and during to material misstatements or omissions of fact. The bespeaks cau­ ordinary business communications with customers and suppliers. tion doctrine cannot be applied to protect statements that were known to have been inaccurate when made. Also, the statutory safe Duty to Correct or Update harbor applies only to "meaningful" cautionary language. Once a statement of fact (as opposed to a projection) has been A review of disclosure documents both before and after the made, the person making the statement is then under a duty to 1995 PSLRA legislation revealed widespread use of cautionary correct any misstatements that person also perhaps has a duty to § 92 276 MANIPULATION AND FRAUD Ch. 12 RELIANCE; FRAUD ON THE MARKET 277 update the public as to any material changes. The courts have quirements. First, the information in question must have been drawn a distinction between the duty to correct misinformation and material. Second, the market must have been sufficiently active to the absence of a duty to update information that was accurate be deemed to be efficient. Third, the misinformation must have when disseminated. been disseminated publicly. It would appear that the absence of an efficient market should § 92. Reliance; Fraud on the Market be sufficient to rebut any presu~ption of reliance based solely on The reliance requirement is a corollary of mate~iali.ty. As i.s market impact. However, the Eleventh Circuit has held that even true under common law, the reliance requirement apphes ~n secun­ undeveloped markets can provide a basis for the "fraud-on-the­ ties fraud cases. Reliance is an element of a private claim under market" presumption of reliance, at least where the defendants Rule 10b-5, but not in enforcement actions brought by the govern­ knew that there would be no market but for their scheme to ment. defraud. See Shores v. Sklar, 844 F.2d 1485 (11th Cir.1988). This Following the same pattern as cases involving materiality, type of case does not really invo!ve a fraud on the market but rather a fraudulent scheme depicting the existence of a market questions of reliance are highly fac~ual an~ t~us court~ are properl?' reluctant to dismiss on the pleadmgs. Similarly, claims that. reh­ which in fact would not exist upon full and accurate disclosure. Some courts have referred to this as a fraud-created-the-market ;.r::~::: ance was unreasonable will often be highly factual and thus map­ propriate for dismissal before trial. theory of recovery. Some courts have rejected the fraud-created-the­ ~: ~~:~~-r-~· market theory of recovery. The Supreme Court in Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-154 (1972) held that in a face-to­ A number of courts have referred to a "truth on the market" face transaction between seller and purchaser where the defendant defense to a fraud-on-the-market theory of liability. In Basic, the Court noted that even in the face of materially misleading state­ purchaser failed to state material facts, th~ p~aintifrs reliance can ments, if accurate information "credibly entered the market and be presumed from the materiality of t~e ~mis.sw~s. The Court there dissipated the effects of the misstatements," then the misstate­ held that upon a finding of matenahty It . IS then ~p to the ments would not be actionable. Although sounding more like a defendant to prove that the plaintiff had not m fact rehed on the ', question of causation or materiality, many courts have labeled the material omissions. I,. availability of adequate accurate public information as a truth-on­ Public markets are generally efficient markets. In an efficient the-market defense. market securities prices are determined by the total mix of avail­ Any reliance by the plaintiff must be reasonable. Thus, for able information. The integrity of the securities markets is pre~­ example, once accurate information has been disclosed publicly, it is ised on the dissemination of accurate information about compames not reasonable for an investor to rely on representations to the and their securities. When misleading information is injected into contrary. An investor who is aware of the wrongful conduct cannot the market it can move securities prices in an artificial manner. succeed in a Rule 10b-5 claim. Investors i~ publicly traded securities rely on securities pric~s. as the reflection of accurate pricing mechanisms. When the pncmg Issuing warnings as to the reliability of information may pre­ mechanisms are rendered inaccurate because of material misinfor­ clude a showing of reasonable reliance on the information. It has mation, something that is tantamount to a fraud h~s taken .place. been held, for example, that a plaintiff claiming reliance on alleged Fraud on the market recognizes the impact of false mformatwn by material misstatements will be charged with knowledge of warnings providing a presumption of reliance for investors who are .able to in the private placement memorandum concerning the investment establish the other elements of securities fraud. In applymg the risks, thus making reliance unreasonable. In contrast, oral state­ presumption of reliance and economic theor~, the ~ourts fashione.d ments minimizing the significance of the written materi(J.ls will still a fraud-on-the-market presumption for provmg rehance. See Basic be actionable. Although general blanket disclaimers of reliance will Inc. v. Levinson, 485 U.S. 224 (1988). Simply put, the courts find not be effective, a specific disclaimer will preclude a fraud action. that the reliance requirement in a securities fraud action can be As noted earlier, many courts have referred to the effect of satisfied by a showing that the market price was affected by the warnings as the "bespeaks caution" doctrine which, on appropriate misstatement or omission and the plaintifrs injury is due to a facts, will preclude a finding of reasonable reliance. It must be purchase or sale at the then fraudulently induced market pric~. The remembered, however, blanket warnings and disclaimers in offering fraud-on-the-market presumption of reliance has three basic re- materials cannot preclude reliance on otherwise materially mislead- 278 MANIPULATION AND FRAUD Ch. 12 §94 THE MEASURE OF DAMAGES 279 ing statements. The cautionary language must be sufficient to Rule 10b-5. In Virginia Bankshares, Inc. v. Sandberg, 501 U.S. adequately negate any reasonable implication to the contrary from 1083 (1991) the Supreme Court held that alleged misstatements the projection or prediction. that were made in connection with a shareholder vote that was not § 93. Causation required to effectuate the transaction in question could not form the basis of a private damage action. The Court therefore held that As in other areas of the law, causation embodies two distin?t material misstatements or omis$ions which affect the transaction concepts: (1) cause in fact and (2) legal cause. Legal ca~se 1s only in a collateral sense fail to establish the type of direct causal frequently dealt with in terms of proximate ca':se. Cause-m-fact connection that is required to state a claim under the proxy rules. questions are frequently stated in terms of the sme qua non rule: but for the act or acts complained of, the injury woul~ not ~a:e Loss causation. The plaintiff must be able to prove "loss occurred. Legal cause represents the law's doctrinal bas1s for hml.t­ causation:" namely that the plaintiffs injury (generally the diminu­ ing liability even though cause in fact may b~ proven. Courts m tion in the value of his or her investment) is directly attributable both tort and contract cases frequently speak m terms of foresee­ both to the wrongful conduct and the for~ and manner in which ability in order to determine the extent of proximate ~r legal caus.e. the challenged transaction occurred. Loss causation provides the Causation in securities law involves the same analys1s of cause m necessary connection between the challenged conduct and the fact and legal cause that was developed under the .common law. plaintiffs pecuniary loss. Loss causation does not require that the However notwithstanding the similarity of analys1s, the courts material misstatement or omission be the exclusive cause of the have de;eloped their own rubric for causation in securities cases. loss; it is sufficient to show that it was a significant contributing Courts have broken down the causation analysis in securities factor to the loss. The concept of loss causation was expressly cases into two categories: "transaction causation" and "loss causa­ codified by the Private Securities Litigation Reform Act in 1934 Act tion." As is true with any causation analysis, these concepts ~rebut § 21D(b)(4) provides that loss causation is an element of a private suit for securities fraud. Loss causation issues can be highly factual, ,; a means to an end. Transaction causation and loss causatwn are \ .,. difficult concepts, and careless use of these terms is likely to hinder thus frequently precluding judgment on the pleadings. However, rather than facilitate understanding. because of the enhanced pleading requirements for securities fraud, I -~ ' failure to specifically allege facts showing loss causation will result '-·' Transaction causation. To begin with, the plaintiff must in dismissal. In Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 prove "transaction causation," which means that, but for the (2005), the Supreme Court held that change in the stock price wrongful conduct, the transaction would not have gone through,. at H following the allegedly misleading disclosures may not be sufficient least in the form that it eventually took. The concept of transactwn ~~·l· :;; to show the loss causation necessary to establish a private remedy. causation has been properly characterized as "nothing more than {:..!::~ The Court thus held that a plaintiff cannot establish loss causation 'but for' causation," and more questionably as "mere~y another merely by alleging that security price was inflated because of way of describing reliance." Castellano v. ~oung & R':b1cam, Inc., misrepresentation. See also, e.g., Oscar Private Equity Investments 257 F.3d 171, 186 (2d Cir.2001). Transactwn causatwn does n~t v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007). represent the strictest form of "but for" . causation beca':se. 1t requires only that the terms of the transactwn ha~e ~een Sl.gmfi­ cantly affected by the material misstatement or om1sswn. It 1s not § 94. The Measure of Damages necessary to prove that the transaction would not have occurred The assessment of damages in Rule 10b-5 cases, like any but for the alleged Rule 10b-5 violation. It must be shown, howev­ quantification of economic loss, has been a challenging task for the er that there was a direct causal nexus between the alleged courts. Evaluating the current state of the law is also difficult and the resulting transaction. Furthermore, as is the case vi~lation because most 10b-5 litigation does not proceed to final judgment on with proximate cause generally, in applying the transaction causa­ the merits. As a result, there is a relative paucity of decisions tion analysis, intervening causes can preclude a Rule 10b-5 recov­ dealing with the question of damages. A few generalizations can be ery; however, not all intervening causes will prev~nt recove.ry. made. First, the cases agree that punitive damages are not available Many courts are willing to infer or pre~u~e transact.wn caus.atwn in Rule 10b-5 suits. However, punitive damages may be available in once it has been established that an om1ss1on of fact 1s matenal. A 10b-5 litigation, when common law fraud claims are brought into 1991 Supreme Court decision involving causati~n under the proxy the case under the doctrine of pendent, or supplemental, jurisdic­ rules undoubtedly has implications for fraud actiOns brought under tion. Even in the absence of a state law permitting punitive 280 MANIPULATION AND FRAUD Ch. 12 §95 SECURITIES CLASS ACTIONS 281

damages, punitive damages may be awarded in an arbitration inducement, while a claim for fraud generally leads to out-of-pocket proceeding. recovery. The plaintiffs measure of recovery under federal securities law There are additional instances in which a measure of damages is limited to damages actually and proximately caused by the other than out-of-pocket loss may be available. Disgorgement of ill­ violations in question. Limiting recovery to actual damages is gotten gain may be appropriate when the remedy is based in terms required by the terms of 1934 Act § 28(a). The fact that damages of restitution, and unjust enrichm~t rather than any compensable are limited to actual damages means, for example, that a plaintiff loss to the plaintiff. Thus,· for example, a suit against someone who will not be able to participate in a double recovery. has traded on inside information in breach of a duty to the plaintiff There is no universally recognized unitary theory of damages is often said to be in the nature of restitution, and thus disgorge­ in actions brought under 1934 Act Rule 10b-5. As one court put it, ment of profits is the proper measure. "Anyone researching the issue of Rule 10b-5 damages would be . The. Private Securities Litigation Reform Act included a provi­ immediately confronted with the repeated observation that this is a SIOn des1gned to assure that damages l!fe limited to losses caused by confused area of the law where courts, forced to rely on their own the material misstatement or omission. 193!1 Act § 21D(e) sets wits, have crafted a myriad of approaches." Koch v. Koch Indus­ forth the method for calculating damages in civil actions, which is ,,..,._ .. tries, Inc., 6 F.Supp.2d 1192, 1204-1205 (D.Kan.1998). The proper based on the mean trading price of the security at issue. The mean ;J!:.. ~~ . ,_.-~- . ..- .. measure of damages at common law is an equally elusive concept . trading price includes the original value of the security on the date !}<-~ ,•_. ~ . -.;- ...::··. In Rule 10b-5, cases most courts have rejected a benefit-of-the­ the plaintiff purchased or sold the security and the value of the \X, J '!: . bargain measure of damages in lieu of an out-of-pocket measure, in security during the 90-day period after corrective information has large part because in most instances proof of benefit-of-the-bargain been disseminated. If during the 90-day period the plaintiff sells or damages is speculative. However, in appropriate cases some courts repurchases the security, damages are determined according to the have looked to the benefit-of-the-bargain. There have been still price of that transaction and the value of the security immediately other approaches to Rule 10b-5 damages. Some other courts in following the dissemination of the corrective information. federal securities cases have adopted a rescission measure while In assessing the plaintiffs actual loss, the courts have not still others in insider trading cases require the disgorgement of ill­ always limited recovery to the out-of-pocket loss resulting directly gotten gains. from the transaction in shares. For example, it has been held that It may fairly be said that benefit-of-the-bargain should be the promised, but unrealized, tax losses are properly considered in exception rather than the rule, because it is in essence a contract assessing the measure of damages. Sharp v. Coopers & Lybrand, remedy that is based on a breach of promise rather than the 649 F.2d 175 (3d Cir.1981), cert. denied, 455 U.S. 938 (1982). traditional out-of-pocket tort remedy. In breach of promise cases, However, the Second Circuit has taken a contrary view in ruling benefit-of-the-bargain is applicable when that measure can be es­ that Rule 10b-5 is limited to actual damages and that awarding tablished with reasonable certainty. damages for hoped-for but unrealized tax savings would be an impermissible grant of expectation damages. Freschi v. Grand Coal The measure of damages adopted in any particular case is Venture, 767 F.2d 1041 (2d Cir.1985), vacated and remanded for dependent to a large extent upon the theory of recovery. When the further consideration, 478 U.S. 1015 (1986), on remand, 800 F.2d essence of the plaintiffs claim is fraud in the inducement-namely, 305 (2d Cir.1986). It seems that the court there took an unreason­ that he or she would not have entered into the transaction but for ably restrictive reading of 1934 Act § 28(a)'s limitation to actual the defendant's fraud, rescission is arguably the proper measure of damages. There is a Supreme Court ruling that comes to bear on damages. In such a case, rescission would restore the status quo. the effects of tax consequences in securities damage actions. In Rescission would not be appropriate, however, when the defendant Randall v. Loftsgaarden, 478 U.S. 647 (1986), the Court held that is not on the other side of the transaction (either as a broker or intangible tax benefits are to be treated differently from tangible principal). When the essence of the claim is not that the defendant property and thus are not income which needs to be deducted in induced the transaction, but rather, that the plaintiffs injury is the calculation of rescissory damages under 1933 Act § 12. attributable to the defendant's fraudulent inflation or deflation of the security's price, then the appropriate remedy would seem to be § 95. Securities Class Actions; Litigation Reform the out-of-pocket measure. In other words, rescission rests on a Congress enacted the litigation reform legislation in response claim that the transaction should be undone due to fraud in the to perceived abuses involving securities class actions. First, the 282 MANIPULATION AND FRAUD Ch. 12 §95 SECURITIES CLASS ACTIONS 283

Private Securities Litigation Reform Act of 1995 (PSLRA) ad­ rep:esent the class." This means that the court's approval is dressed many areas of private securities litigation including proce­ s~bJect t? the court's discretion in determining "that lead plain­ dural reforms, enhanced pleading standards, and increased protec­ tiffs chmce of representative best suits the needs of the class." See tion for disclosures involving soft information and projections. In re Cendant Corp. Litigation, 182 F.R.D. 144, 149 (D.N.J.1998). Second, Congress enacted the Securities Litigation Uniform Stan­ In exercising this discretion, the courts should consider both the dards Act of 1998 (SLUSA) which prevents most class actions based quality and the cost of the legal.r,epresentation. In addition to the on securities fraud from being brought in state court. cost of rep:esentation, courts will consider a firm's experience, size, and financial resources available for the action. Private Securities Litigation Reform Act of 1995 (PSLRA) Attorneys' fees. PSLRA also addressed the issue of attorneys' A number of observers had become increasingly concerned with fees in securities class actions. 1934 Act § 21D(a)(6) states that abuses of class actions in securities litigation. Among other things, attorneys' fees in class action cases are limited to a reasonable there was concern over the use of then-existing class action proce­ amount, but discretion in determining what' is reasonable is left to dures to bring strike suits in order to exact "extortionate settle­ the courts. Attorneys' fees may be- calculated according to the ments." No doubt there were instances of litigation abuses, but it lodestar approach-multiplying an attorney's hours by a reasonable was highly questionable whether those abuses were sufficient to fee and increasing the amount due to relevant factors. Class action warrant broad-based legislation with the potential for reducing the settlements are subject to court approval, as is the allocation of efficacy of legitimate efforts to recoup losses resulting from securi­ attorneys' fees out of the settlement fund. PSLRA does not man­ ties fraud. In any event, Congress responded with legislation de­ date a particular method of calculating the attorneys' fees. signed to limit the suspected abuses. PSLRA added 1934 Act§ 21D which purports to discourage frivolous lawsuits by establishing Pretrial motions and pretrial discovery. The Reform Act special procedures for instituting private class actions under the a_ttempts to limit the use of pretrial discovery as a fishing expedi­ \ ... securities laws. 1934 Act § 21D of the Exchange Act covers a wide tw~. 1934 Act § 21D(b)(3) provides that all discovery be stayed 'i''' ,.. range of topics, including restrictions on the class representative, durmg the pendency of a motion to dismiss or a motion for i' ·.' limits on attorneys' fees, pleading requirements, pretrial discovery, summary judgment, in order to alleviate discovery expenses on and the burden of proof on some issues. There are parallel provi­ defendants. The stay is mandatory. However, the stay will be lifted sions for claims made under the 1933 Act. if necessary to avoid "undue prejudice." Qualifications of lead plaintiff The traditional approach in Enhanced pleading requirements regarding defendants' class actions is to determine the lead plaintiff by looking to the first state of mind. In suits involving money damages predicated on :<" claim that is filed. The lead plaintiff and lead counsel provisions are proof that a defendant acted with a certain state of mind, plaintiffs part and parcel of PSLRA's intent to prevent the "race to the must plead with particularity that the defendant acted with such courthouse" phenomenon sometimes associated with the first-to­ state of mind with respect to each act or omission. 1934 Act file rule. PSLRA creates a presumption in favor of the shareholder § 21D(b)(2). Plaintiffs further must provide facts that indicate a with the largest financial interest as lead plaintiff; this is designed "strong inference" that a defendant acted with a particular state of to encourage the appointment of institutional investors as lead mind. A "reasonable inference" of scienter is not sufficient. In plaintiffs. Accordingly, courts often will favor lead plaintiff applica­ order to withstand the scrutiny imposed by the PSLRA, the infer­ tions by institutional investors. However, the statutorily mandated ence of scienter must be both reasonable and strong. See Tellabs, preference for institutional investors does not mean that institu­ Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). tional investors will always prevail in their applications to serve as Review of proceedings for possible sanctions. In order to lead plaintiff. dissuade abusive litigation, courts are directed to perform a manda­ Selection of lead counsel. Frequently, the same transaction tory review at the final adjudication of the action to determine will give rise to multiple class action filings in various federal whether any party or attorney violated FRCP Rule ll(b). In the district courts. This results not only in several candidates for lead event that the mandatory review reveals any violation by an plaintiff, but also in several candidates for lead counsel. The pre­ attorney or party, the Act directs the court to impose sanctions on sumptive lead plaintiffs choice of lead counsel is not automatic. the attorney or party pursuant to Rule 11 unless the violator can PSLRA provides that: "[t]he most adequate lead plaintiff shall, establish a proper basis for not imposing the sanctions. Once an subject to the approval of the court, select and retain counsel to FRCP Rule 11 violation is established, the attorney or party is 284 MANIPULATION AND FRAUD Ch. 12 §96 INSIDER TRADING 285 given an opportunity for a hearing. Prior to the imr:osition of overcome the federal discovery stay or because of a migration of the sanctions, the court must give the attorney or party notice and an weaker cases to state court. Although the 1997 SEC study indicated opportunity to respond. a drop in securities litigation, more recent evidence is that this Security deposit. In private suits involving class action decrease has not continued. In recent years, there has been an claims the court may require an undertaking from the attorneys upswing in securities litigation. This increase in litigation, which is for th~ plaintiff or defendant, the parties the:nselves, or both. T_he attributable to the weak marl{~t in the beginning of the new court may use equitable principles to ascertam whet~er to reqmre millennium, shows that· the Reform Act has not unduly restricted an undertaking and to determine the relevant proportwns. litigation. · Notice of class action settlements. Notice of final ?r pro­ Securities Litigation Uniform Standards Act of 1998 (SLU­ posed settlement agreements in class actions must be provided to SA) class members. A summary of the agreement must appear on the cover page of the notice. The notice must also include the ave~age PSLRA's procedural reform~. apply '()nly to class actions amount of damages per share that will be recovered; explanatwns brought in federal court. Private acttons under 1933 Act §§ 11 and of attorneys' fees and costs; the name, address, and telephone 12 can be brought in either federal or state court. Jurisdiction over number of the lead counsel; and a statement outlining the reasons SEA claims is exclusively federal; however, state securities law and for settlement. As in the case with class actions generally, courts common law fraud could provide alternative forums for class action will review settlements in order to determine fairness to class plaintiffs trying to avoid PSLRA. Congress largely eliminated these members. alternatives in SLUSA which mandates that most class actions involving publicly traded securities be brought in federal court. Projections and forward looking statements. 1933 Act § 27A and 1934 Act § 21E provide a safe harbor for forward­ SLUSA preempts class actions involving state securities law and class actions based on common law fraud. Covered securities 1 • ..• looking statements and the "bespeaks caution" doctrine created by '!j'' are defined in such a way as to include most publicly traded the federal courts. The safe harbor allows corporate manag~ment to securities. SLUSA is not complete in its elimination of state court disclose forward-looking information and projections to. mvestors class actions since the SLUSA preempts only those actions involv­ ... with a presumption that there was a .reasona~le basis for ~he '" ing publicly traded securities. SLUSA also applies only to fraud and projections. The bespeaks caution doctnne pr?vld.es that spe~1fic misrepresentation claims that are based on conduct "in connection cautionary language can render inaccurate proJectwns not actwn­ with the purchase or sale" of a covered security. Even though 1933 able. See§ 91 above. Act §§ 11 and 12(a)(2) do not require scienter, they appear to be Calculation of damages. As noted in § 94 above, PSLRA subject to SLUSA's preemption. In contrast, 1933 Act § 12(a)(1) is addresses the calculation of damages in certain situations. based on a violation of the 1933 Act registration provisions and Impact of PSLRA. In 1997, the SEC delivered to the Presi­ should remain removable to state court since they are not subject to the language of the SLUSA's preemption. dent a report on the effects of the 1995 Litigation R:eform Act. ~he Commission noted a drop in the number of cases bemg filed durmg It is important to note further that the SLUSA applies only to the twelve month period following the Act's adoption. It was noted class actions and thus not to individual or derivative suits. There that most of the cases filed contained detailed allegations. There also is an exclusion for actions brought in the state of incorporation seems to have been a slowing of the "race to the courthouse," as involving certain corporate transactions (known as the Delaware most cases were filed at least several weeks following the release of "carve out" exception which was designed to leave corporate law negative news forming the basis of the law suit. ~~LRA's height­ litigation in the state courts). The preemption only applies to fraud ened pleading standards and discovery stay proviswns app~ar to related claims and thus does not preclude state law claims on other have been successful in making it more difficult for plamtiffs to theories such as conversion, breach of contract, or breach of fiducia­ ry duty. bring securities law claims. Class action complaints contain many fewer secondary defendants, including accountants and lawyers. § 96. Insider Trading The study further indicated that institutional investo~s have ~ot played a significant role in class action litigation notw1thstandmg Overview PSLRA's provisions encouraging such involveme~t. The SEC also Over the past forty years, there have been many celebrated noted an increase in state court filings, perhaps m an attempt to cases involving trading in securities based on nonpublic confidential r-r--·

286 MANIPULATION AND FRAUD Ch. 12 § 96 INSIDER TRADING 287 or proprietary information. There have been some highly publicized deal only with remedies for insider trading rather than add · insider trading cases. Defendants in insider trading cases have not th b t t• · ressmg e su s an Ive questwn of what types of conduct compr· · been limited to corporate insiders and have included a wide range t d. . . 1se Improp- er ra I~g on nonpubhc Information. In 1984, Congress enhanced of people, including celebrities, psychiatrists, football coaches, for­ ~he. SEC s e~forcement capabilities and bolstered the penalties for mer athletes, newspaper columnists, printers, leading arbitrageurs, Insider 1934 Act § In .1988, Congress supplemented and most unfortunately, lawyers. tradn~g. 2~A_· Rule 10b-5 With an express pnvate nght of action. 1934 Act § 20A In analyzing the law of what traditionally has been called Nevert~eles~, the. fact r:mains that there is no statutory definitio~ insider trading, many cases do not involve corporate insiders but to prec~sely Identify whrch types of insider trading are permissible rather deal with outsiders. Outsider trading involves what has for a and which are not. long time been referred to as trading on market information. This occurs when someone who is not an insider of the company whose Th~ primary basi.s of the prohibitions on trading while in shares are traded finds out information that will affect the market possesswn of nonpubhc material information has been 1934 Act price of the shares. This occurs, for example when someone has Rule .10b-5 .. Rule lOb-5, which ·dqes not' expressly address the advance knowledge of a pending tender offer or an impending news ques.twn of ~ns!der trading, has frequently been used to regulate article that is likely to affect the company's stock. It is in such tradmg. by m~Iders who possess confidential inside information concernmg their company's stock. instances of outsider trading that the courts have come to rely on the misappropriation theory for imposing liability under 1934 Act As disc~~sed more fully below, the prohibition of Rule 10b-5(c) Rule 10b-5. ~as been ~tlhzed to cra~t a rule of law that subjects certain persons m possesswn of matenal nonpublic information to a "dr· 1 The SEC has repeatedly declared that the eradication of trad­ b t · " 1 Th . sc ose or a s am ru e. e disclose or abstain rule means that whe t ing on inside information is one of its top priority enforcement t .al · · n po en- targets. Trading on inside information destroys the integrity of the I secuntles traders have obtained the matena · 1 In1ormatwn· " · In· such a way as to subject them to Rule 10b-5's reach th t market place by giving an informational advantage to a select group ·th b t · f . , ey mus r . of corporate insiders and others having an informational advantage. er :r a s am r~m tradmg or disclose the information prior to .. ' The practice of insider trading is especially pernicious in light of tradmg. In most Ir:stances, disclosure is not a reasonable option· •:... the federal securities laws' thrust of full disclosure, which is de­ ~herefor~, the practical ~andate is to abstain from trading until th~ signed to create and maintain an informed market and a level mformatwn has been disclosed. Since insider trading prohibitions playing field in securities transactions. Some commentators have are based on a rule that does not even mention insider trading the argued that insider trading does not have, significant adverse courts ~or years have been plagu~d :nith the difficulties of tryi~g to market impact, but fortunately, the courts, Congress, and the SEC ascertam th: proper scope of msider trading prohibitions. One have, not joined in that position. On the other hand, it is generally cofolse~uence I~ that the law continues to change as the courts' view recognized that there is a positive value in encouraging corporate of msider tradmg evolves. officers, directors, and other employees to invest in the shares of . . Using ~ gefoleral antifraud proscription as the catchall for their company. Accordingly, there are a number of instances in msider tradmg IS prob.lematic. There are many insider trading which trading by insiders is permissible. Unfortunately, the law abuses that d~ n.ot fit m~o a traditional fraud analysis. Applying regarding the use of nonpublic material information when trading Rule. 10b-5 to msider tradmg IS much like tryr·ng to fit a square peg in shares has not developed systematically. Nor has it evolved in mto a round hole. T.he resulting confusion will continue unless such a way as to produce bright-line tests of when it is permissible ~ongress adopts a ratwnal definition of impermissible insider trad­ to trade. mg. It is ironic that, as important as regulating trading on the basis of inside information may be under the securities laws, there is no The Development of Rule lOb-5 in Insider Trading. Cases express statutory prohibition. Most insider trading cases are based In the seminal decision of Cady, Roberts & Co., 40 S.E.C. 907 on 1934 Act Rule 10b-5's general antifraud provisions, which do (S~C 1961). The SEC imposed disciplinary sanctions against a not specifically mention insider trading. 1934 Act § 16(b)'s prohibi­ re~stered . brok~r-dealer who directed his customers to liquidate tion against short-swing profits by designated statutory insiders their holdmgs m Curtiss-Wright stock because he had ad (see chapter 13 below) is the one of three sections in the SEA that ~n~wledge of a divide~d cut. The broker, tipped by a corp~~~~= expressly deal with insider trading. The remaining two sections msider, was merely a tippee who in turn tipped his customers. The 288 MANIPULATION AND FRAUD Ch. 12 §96 INSIDER TRADING 289

SEC found that this conduct "violated [10b-5(c)] as a practice Causation in Insider Trading Cases-"Use" Versus "Posses­ which operated as * * * fraud or deceit upon the purchasers." The sion" Commission's opinion explained that "analytically, the obligation Another question that has arisen is to what extent it must be [to disclose or abstain from trading] rests on two principal ele" shown that the inside information in fact caused the transactions in ments; first, the existence of a relationship giving access, directly or question. This issue has arisen, for example, in the context of the indirectly, to information intended to be available only for a corpo" argument that it must be shown ,that the trader in fact used the rate purpose and not for the personal benefit of anyone, and in(ormation in question;· namely, that he or she would not have second the inherent unfairness involved where a party takes ad­ traded but-for the confidential information. This debate arose in vantag~ of such information knowing it is unavailable to those with the course of Congressional deliberation over whether to define whom he is dealing." in~ider trading. In another case the issue was raised by a defendant Following the SEC's Cady, Roberts decision, the Second Circuit bemg prosecuted for improper trading on confidential information. in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir.1968), cert. Two circuit courts held that it is not. sufficient to establish that the denied, 394 U.S. 976 (1969). held that corporate insiders who defendant possessed inside information when the trades in question purchased stock on the open market with knowledge of a valuable were made. Instead, it must be shown that the use of the informa­ mineral find that had not yet been publicly announced had violated tion actually caused the trades. United States v. Smith, 155 F.3d Rule lOb-5 because the information not disclosed at the time of the 1051 (9th Cir.1998); SEC v. Adler, 137 F.3d 1325 (11th Cir.l998). ;~·-·-".>~"' ...... ~·-.--~ transactions would have been "material" to a reasonable person's But both courts pointed out that proof of trades while in possession ~"(.· .· )~ :f: investment decision. The fact that the insiders began purchasing of the information creates a very strong inference that the defen­ :::. ·. ,'"; stock and options raised a strong inference that they considered the dant in fact used the information. The burden would then shift to information material. One lesson that can be learned from the the defendant to show that he or she did not use the information court's reasoning is that when purchasing the shares of their own when making the trades. \ .··· company, corporate insiders should adopt a regular and peri?dic 1934 Act Rule 10b5-1 requires that the defendant have used plan of purchases. Otherwise, it is likely that the fact finder m1ght the information in making the challenged securities transactions. infer that the information available to the insider was in fact The rule thus rejects liability based merely on showing that the material, and thus induced illegal insider trading. defendant and subject to a disclose or abstain obligation merely Following the lead of Texas Gulf Sulphur, it has been held that possessed material non public information. In addition to adopting a tip of inside information will give rise to liability for fraud on the the "use" test for liability, Rule 10b5-1 presumes that someone (' •••••1 market. One court has even held that non-insider tippees who sell who trades while in possession of material nonpublic information ~ ..[:: ,JJ: If.~ in reliance on confidential inside information will be liable and held ~as in fact used the information in making the trade. The presump­ '~!)'J accountable by disgorging their profits. See Financial Industrial twn of use that follows from trading while in possession may be Fund, Inc. v. McDonnell Douglas Corp., 474 F.2d 514 (lOth Cir. r~bu~ted by a showing that the defendant (1) had a preexisting 1973), cert. denied, 414 U.S. 874 (1973). Subsequent Supreme bmdmg contract to enter into the transaction in question, (2) Court decisions narrowed the scope of tippee liability. Dirks v. SEC, executed a prior instruction to a third party to execute the transac­ 463 U.S. 646 (1983); Chiarella v. United States, 445 U.S. 222 tion. i~ question, or (3) had previously adopted a written plan (1980). spec1fymg the transactions in question. Perhaps an even more formidable impediment to implied pri­ Rule 10b5-l(c) establishes two affirmative defenses that rebut vate actions under Rule lOb-5 by open market purchasers or sellers the presumption that the insider has in fact used the material against persons trading on inside information is the Supreme nonpublic information in making the trades in question. The first Court's ruling that the mere possession of inside information does defense is set forth in Rule 10b5-l(c)(l). Rule 10b5-l(c) protects not create a duty to market participants. Chiarella v. United States, individuals or entities, and applies in situations where material 445 U.S. 222 (1980). In 1988, Congress supplemented any remedy nonpublic information was not a factor in a trading decision be­ that may exist under Rule lOb-5 with an express private right of ?ause a .trade was carried out pursuant to a pre-existing contract, action by contemporaneous traders against persons making improp­ mstructwn, or plan. Rule 10b5-l(c)(l) provides that a purchase or er use of material, nonpublic information. 1934 Act § 20A. Under sale of securities is not deemed to be made on the basis of material this express remedy, contemporaneous traders are permitted to sue nonpublic information if the individual or entity making the pur­ for a disgorgement of the improper profits (or loss avoided). chase or sale can show that, prior to becoming aware of the 290 MANIPULATION AND FRAUD Ch. 12 §96 INSIDER TRADING 291 material nonpublic information, the individual or entity had en­ tered into a binding contract for the purchase or sale of t.he in an effort to maintain confidentiality. Chiarella, however, identi­ security, or instructed a third party to purchase or se.ll the sec~~Ity fied the target company by reading the other information in the for its account or adopted a written plan for tradmg secunties. tender offer material. Armed with·this knowledge, he purchased the Furthermore, the trading plan must specify the "amount" of se?u­ target company's stock and sold it at a profit after the tender offer rities to be purchased or sold and the "price" and "date" on which was publicly announced. Chiarella's indictment was framed in the securities were to be purchased or sold, or include a written terms of Rule 10b-5's require~nt that insiders possessing confi­ dential material information must either disclose the information formula for determining the amount, price and ~ate of the t~ansac­ tion, or does not permit the individual or entity to exercise any or abstain from trading. The Court reversed the defendant's convic­ subsequent influence over how, when and whether to conduct the tion on the grounds that he had no legal duty to speak and thus purchases or sales, and delegated. t~ose deci~ions to a person who was not subject to the disclose or abstain obligation. The Court, in did not possess material nonpubhc mformatwn. The second. af~r­ Chwrella, first distinguished the SEC's ruling in Cady, Roberts on mative defense to the Rule 10b5-1 presumption of u~e ~f. mside the grounds that, in the later. decision' the SEC had imposed information is available only to entities and thus not to mdividuals. ~anction~ against a broker-dealer -who had wrongfully obtained Rule 10b5-l(c)(2) permits an entity to demonstrate that a trade mformatwn from corporate insiders. The Supreme Court reasoned was not on the basis of material nonpublic information by de~?n­ that the SEC's opinion in Cady, Roberts "recognized a relationship strating (1) that the individual who made the. investm~nt decisiOn of trust and confidence between the shareholder of a corporation on behalf of the entity was not aware of the mformatwn, and (~) and those insiders who have obtained confidential information by the entity had implemented reasonable policies and procedures, m reason of their position with that corporation." The Court also light of the nature of the entity's business, to ensure t~at those explained that the Texas Gulf Sulphur "disclose or abstain" rule making investment decisions on its behalf would not vwlate the was limited to persons-both insiders and others-who are subject to a duty to disclose apart from the mere possession of confidential insider trading laws. inside information. Even beyond the presumptions an~ def~n~es ~st~blished .by Rule 10b5-1, the SEC or a private plaintiff clmmmg msider tradm.g The Supreme Court in Chiarella held that the absence of a can establish an inference that improper trading has taken place If wrongful conversion or misappropriation of the information meant the insider has engaged in unusual trading patterns. In such a case, that no violation of Rule lOb-5 had occurred because there was no the plaintiff has the burden of showing the existence o.f an u~usual le~al duty to disclose such information prior to trading. The Court trading pattern. Some courts have indicated that thi~ reqm~es a pomted out, however, that the only issue before it was whether a showing that the insiders' transactions were "d.ramatlcally di~fer­ duty to disclose under 10b-5 was created vis-a-vis the target compa­ ent" from their prior trading patterns. As explmned by the Nmth ny by the mere possession of nonpublic information that would Circuit, "[a]mong the relevant factors to consider are:. (1.) the affect the price of its stock. The Supreme Court in Chiarella did not amount and percentage of shares sold by insiders; (2) the timmg of ~ecide whether the printer's relationship to the acquiring corpora­ the sales; and (3) whether the sales were consistent with th.e tion created a duty to abstain from trading. Justice Stevens, in his insider's prior trading history." In re Silicon Graphics Inc. Secun­ co~currenc.e, emphasized that this latter theory was not decided, ties Litigation, 183 F.3d 970, 986 (9th Cir.1999), relying on Provenz whlle Justice Brennan's concurrence and the dissent would have v. Miller, 102 F.3d 1478, 1491 (9th Cir.1996). uph~ld the conviction had the conversion theory been presented to the jury. It thus appears that at least four of the Justices would The Duty Requirement have affirmed the conviction had these alternative theories been presented to the jury. As noted above, in Chiarella v. United States, 445 U.S. 222 (1980), the Court held that, in a market tra~sactio~, t~er~ was no The Misappropriation Theory duty to disclose based solely on the possess,~on of m~Ide mfo~m~; tion, at least when that information was market. mfor~atwn. D~fficult que.stions can arise in determining which relationships rather than fundamental information related to the ISS~er .s condi­ estabhsh a fiduciary duty of confidentiality. 1934 Act Rule 10b5-2 tion. The defendant, Chiarella, was an employee of a prmtmg firm provides some guidance as to when the disclose or abstain obli­ hired to produce documents for various tender offers. The t~rget gation will apply. Of course, not every relationship is a fiduciary company's identity was concealed in the galleys sent to the pnnter one creating such a position of trust and confidence. For example in one leading case, it was held that the relationship of a customer to 292 MANIPULATION AND FRAUD Ch. 12 § 96 INSIDER TRADING 293 his stock broker did not create a duty of confidentiality. In another belonging to Dow Jones, and that the reporter had a duty t case the court explained that a fiduciary relationship requires 0 safeguard that information. The breach of that duty according! measure of superiority, dominance, or control." United "so~e to a of Dow Jones' property right in contr: States v. Kim, 173 F.Supp.2d 1035 (N.D.Cal.2001), amended by, amo~mted de~rivation of the Mrul Fraud Act. In reaching its decision under the 184 F.Supp.2d 1006 (N.D.Cal.2002). The court then went on to hold ve~twn M_a1l Fraud Act, the Supreme Court embraced the rationale under­ that co-members of an entrepreneurs' society did not create such a lymg the New York decision iJ;l,Diamond v. Oreamuno, 24 N.Y.2d relationship. In so ruling, the court indicated that not every ~o~fi­ 494, 301 N.Y.S.2d 78, 248 N.E:2d 910 (1969), allowing a corporation dentiality agreement will trigger the obligation. For example, msid­ to r~cover the profits of insiders who traded on confidential infor­ er trading liability will not arise out of a confidentiality agreement matiOn. that is not taken as legally binding but rather as a statement of ethical and moral obligation. Th_e long w~t fo_r the Supreme Court's resolution of the issue ended m 1997 With decision in United States v. O'Hagan, 521 A theft of information has been held insufficient to trigger Rule 1~s ?-S. (1997), wh1ch upheld. misappropriation as a basis for 10b-5's disclose or abstain rule. See SEC v. Dorozhko, 606 ~42 F.Supp.2d 321 (S.D.N.Y. 2008) (computer hacker who traded on m~posmg Rule 10b-5 liability for trading on'nonpublic information. 0 Hagan arose out of the prosecution of a partner in a law firm stolen information did not violate Rule lOb-5). On appeal, the Second Circuit reversed the district court's dismissal. SEC v. Doro­ tha~ was retained by a would-be tender offeror. The attorney, after zhko, 2009 WL 2169201 (2d Cir. 2009). Although the Second Circuit havmg _lean:ed of the firm's client's planned takeover, purchased ,-.:::· call optwns m the target company prior to the announcement of the ~1! ' ,, ·. '' agreed that the hacker was not under a fiduciary or other duty that ·::-. 'J.; tender offer. The indictment charged that the attorney had violated would trigger the disclose or abstain rule, he could nevertheless be held accountable for the trades to the extent he acquired the Rule lOb-5 and 1934 Act Rule 14e-3, which prohibits trading in nonpublic information through a misrepresentation. Id. The Second ad~ance of a tender offer; he was also charged with violating the Circuit remanded the case to the district court for determination of ma1l fraud statute. The Eighth Circuit overturned a conviction on whether the hacker obtained the information in a deceptive manner all_three counts. The court of appeals's rejection of the Rule 10b-5 through a misrepresentation, which would include a misrepresenta­ claim was ?ased on_ two ground~. First, the court stated that Rule tion of his identity. Id. I?b-5 re~mres a misrepresentatiOn or nondisclosure. Secondly, the ~1ghth C_Ircuit held that a duty owed to the source of the nonpublic Rule 10b5-2 indicates that a contractual or other relational mformatwn was not sufficient to satisfY 1934 Act§ 10(b)'s require­ basis for an expectation of confidentiality may be sufficient to ment th~t the fraud be "in connection with the purchase or sale" of trigger Rule 10b-5. Although the SEC maintained that a contractu­ ~ sec~~Ity. T~e _Supreme Court rejected both objections to the al confidentiality obligation is sufficient, this has been challenged as Im_po~Itlon of hab1lity. _The Court responded to the first objection by too broad a view. Critics of the SEC view contend that the obli­ P_omtmg ~ut that tradmg on nonpublic information involves decep­ gation must be fiduciary in nature. The SEC prevailed on this issue tl~e ~ond1sc~osure. ~he ~eception that results from the misappro­ in SEC v. Cuban, 2009 WL 2096166 (N.D. Tex. 2009) to the extent pnatwn of mf?rmatwn 1s based on a "feigning fidelity" to the that breach of an express or implied agreement not to use the source of the mformation and the fiduciary's failure to disclose information can support an insider trading claim. The court in the plans_ to trade on the information. Second, in addition to being Cuban case also held, however, that there is a distinction between a pr_em1sed o~ ~he necessary deceptive conduct, liability based on non-use agreement and a confidentiality agreement which will not m1sapp~opna~wn satisfies the requirement that the violation be "in by itself support the disclose or abstain obligation. It has also been connectiOn With the purchase or sale of any security" because it is questioned whether the marital relationship can trigger the Rule not necessary to make a further link to "identifiable purchasers or 10b-5 obligation since it is not ordinarily considered to be one that sellers of securiti~s." The O'Hagan decision accordingly clarified is fiduciary in nature. that the duty whiCh forms the basis of the Rule 10b-5 violation Although the Supreme Court was equally divided on the 10b-5 need . not be owed to a purchaser or seller of securities. It is claim in Carpenter v. United States, 484 U.S. 19 (1987), the Court suffi_cient that the breach of duty is carried out through securities was unanimous in finding that the misappropriation of information tradmg. Th~ use of a_ securities transaction to effectuate the breach constituted a violation of federal Mail Fraud Act. In affirming the of the duty Is a sufficient connection. mail fraud conviction, the Court reasoned that the information Under 1934 Act Rule 10b5-2, there are "three non-exclusive concerning the Heard on the Street column was clearly property bases for determining that a duty of trust or confidence was owed ~···-

Ch. 12 §96 INSIDER TRADING 295 294 MANIPULATION AND FRAUD Insider Trading: Private Remedies Under Rule 1 Ob-5; En­ by a person receiving information: (1) when the person agreed to hanced SEC Sanctions keep information confidential; (2) when the persons involved in the communication had a history, pattern, or practice of sharing confi­ Following on the heels of the Supreme Court's ruling in Dirks Second Circuit in Moss v. Morgan Stanley Inc., 719 F.2d 5 (2d dences that resulted in a reasonable expectation of confidentiality; t~e Cir.1983), cert. denied, 465 U.S. 1025 (1984) held that someone who and (3) when the person who provided the information was a sells a target company's stock ,ip. the open-market prior to the spouse, parent, child, or sibling of the person who received the tend~r ~ffer's. announcement does not have a lOb-5 claim against a information, unless it were shown affirmatively, based on the facts ~on-msi~er tippe_e who purchased shares using nonpublic material and circumstances of that family relationship, that there was no mformatw.n obtained from the tender offeror's investment advisor. reasonable expectation of confidentiality." Selective Disclosure and I~ so holdmg, the court rejected the idea of a non-insider's duty to Insider Trading, Sec. Exch. Act Rel. No. 34-42259 (SEC Dec. 20, disclose to an open market seller based on a misappropriation 1999). Family relationships thus can provide the basis for a confi­ the?~ or on th~ fact that the defendant owed a special duty to the dential relationship sufficient to trigger insider trading liability. plamtiff due to Its status as a broker-dealer. . See, e.g., SEC v. Yun, 327 F.3d 1263 (11th Cir. 2003) (whether The existence of a meaningful private remedy under Rule 10b- communications between spouses were confidential was a jury question). As noted above, there have been some indications that 5 to redress insider trading violations was at best questionable . ~ongress was concerned with the apparently increasing number of Rule 10b5-2 goes beyond the scope of the statute in recognizing a mstance~ in wh~ch .individu~ls were taking undue advantage of ..•.~r·-·~'>-"' ,_..-..·.r.·. disclose or abstain duty outside of a fiduciary relationship or non­ e.r.~~·--.'. ;· n~npubhc. matenal mformahon. Accordingly, Congress responded use agreement. See SEC v. Cuban, supra; SEC v. Kim supra. with two Important pieces of legislation. The Insider Trading Sanc­ tions A~t ?f 1984 .(ITSA) enhanced the government's ability to Tippee Liability pursue msider tradmg. The Insider Trading and Securities Fraud The Supreme Court in Dirks v. SEC, 463 U.S. 646 (1983) held Enforcement Act of 1988 (TSFEA) continued this trend and also \' that "a tippee assumes a fiduciary duty to the shareholders of a added an express private remedy. These important remedial provi­ ,. corporation * * * only when the insider has breached his fiduciary sions are discussed below. duty to the shareholders * * * and the tippee knows or should Enhanced remedies and penalties-The Insider Trading know that there has been a breach." Corporate insiders do not Sanctions Act of 1984 (ITSA). One backlash of the Chiarella and breach a fiduciary duty unless the purpose of their passing on the Dzrks decisions has been a push for congressional enactment of i ": {-~-~-- information was to obtain, directly or indirectly, some personal or st~onge~ insider trading penalties. ITSA permits the SEC to bring !' ·~ ~·ci economic benefit. In order for a tippee to be held liable, there must smt ag~mst anyon~ violat~ng ~he 1934 Act or rules "by purchasing ~:.!!)~ have been some benefit to the tipper in making the tip. The benefit ?r sellm~ a,secunty while m possession of material nonpublic does not have to be a tangible one, and thus a gift of the informa­ mformatwn. 1934 Act § 21A. The enhanced sanctions apply not tion to a friend or relative for purpose of making the trades is o?ly to the person who violates the Act by trading on the informa­ sufficient. It is possible to establish liability based on a tip on the ~wn, but. also to someone who violates the Act by passing on the basis of circumstantial evidence. ~nformat~on to someone else to facilitate his or her trading on the mformatwn. The enhanced set of remedies for illegal insider trad­ The application of tippee liability is not limited to cases of true ~ng fu~t.her provide for both the disgorgement of any profit and the insiders. Tippee and tipper liability also applies in the misappropri­ ImpositiOn of a civil penalty. The civil penalty in such a suit which ation context. This is true even if the tippee is remote from the can be in to disgorgement of the gain, tipper so long as there is a direct tainted chain of information. gra~ted add~tion ill-gotte~ can be as h1gh as treblmg the profits gained or loss avoided by the Thus, a tip from a magazine employee about an upcoming article ~o defen?ant. In addition, the 1984 amendments to the Exchange Act a printer and then to three intermediaries nevertheless resulted m al~o mcreased the .crimina.! penalties for insider trading. ITSA a Rule 10b-5 violation under the misappropriation theory. United r~Ises a number of mterestmg questions. For example: do succes­ States v. Falcone, 97 F.Supp.2d 297 (E.D.N.Y.2000). In order to s~ve actions for civil penalties under ITSA and for criminal viola­ establish tippee liability, contact between a tipper and the tippee tions based on the same transactions violate the constitutional must be established. If a tippee knows or has reason to know of the p~ohi?ition against double jeopardy? Since the treble damage provi­ taint from the tipper, there is no additional need to show that the siOn IS a penalty (although denominated as civil in nature), there tippee owed a fiduciary duty to the tipper. 296 MANIPULATION AND FRAUD Ch. 12 § 98 DISCLOSURE OBLIGATIONS & ACCOUNTABILITY 297 would appear to be an argument that it should be treated as criminal so that double jeopardy would apply. On the other hand, a having. read the faulty document filed, actually relies upon state­ ments m the document and is therefore injured. The courts have Supreme Court decision subsequently ?eld tha~ the~e is a strong presumption to be given to a con.gresswnal destgnatwn of a sanc­ held that section 18(a) requires .an "eyeball" test· that is the tion as civil. See Hudson v. Umted States, 522 U.S. 93 (1997). plaint~ff must h~ve actual knowledge of and relia~ce upo~ the Under the current approach, it is doubtful that even a treble mate~tals filed wtth the Commission, or a copy thereof; it is not penalty for insider trading violations .would be considered criminal. suffictent that the plaintiff sa';\', similar information contained in In any event, it is clear that double Jeopard~ would not apply to a other documents prepared by the issuer. Ross v. A.H. Robins Co., criminal action followed by an SEC suit for dtsgorge.m:nt of pro~ts. 607 ~.2d 545, 552 (2d Cir:1979); Heit v. Weitzen, 402 F.2d 909, 916 This is the case because it is recognized that a cnmmal fine ts a (2d Ctr.1968), cert. denied, 395 U.S. 903 (1969). Reliance based on a different matter from the remedial considerations underlying a "fraud on the market" theory may be the foundation for a remedy disgorgement action. under Rule 10b-5, but will not satisfy section 18(a)'s requirements. Private remedies-Insider Trading and Securities Fraud Section 18(a) does not apply,, however: to annual reports that Enforcement Act of 1988(/TSFEA). Congress bolstered the reme­ must be sent to shareholders and uled with the SEC unless the dies provided by ITSA when it enacted ITSFEA. Per~aps the most re~o~t i.s incorpo:ated i1_1to the proxy statement or ~ther proxy significant aspect of ITSFEA is its applicabilitY_ to ?rtvate enforce­ sohcttatwn matenals whtch are considered "filed" documents un­ ment. There is an express private right of actwn m the hands of der section 18(a). Not all required disclosures are contained in filed contemporaneous traders. 1934 Act § 20A of the Exc~ange ~ct documents. Thus, for example, a company's annual report to share­ provides that anyone violating the. A~t or SE? rules whtle .tradmg holders is not a filed document and thus cannot form the basis for in possession of material, nonpubhc mformatwn. shall be h~bl~ to section 18 liability unless the reader gathers the information in contemporaneous traders trading on the other stde of the mstder question from reading the 10K annual report that is filed with the ..,.._ \ ~.: . trader's transactions. Thus, if the violator is selling, all con~empo­ SEC. Even. with. respect to disclosures contained in SEC filings, the raneous purchasers can sue, while if the violator is purchasmg, all SEC has tdenttfied certain disclosures as not constituting filed <"_•• ··, contemporaneous sellers can sue. Damages ~n .an action under the documents. Thus, fo~ example, financial information required by express insider trading private remedy are hmtted to the .Pr?~ts or Part I of Form 10-Q ts deemed not to be in a "filed" document for losses avoided by the illegal transactions and are to be dtmmtshed the purpose of section 18(a) liability. by any disgorgement (as opposed to penalty) ordered i~ a~. SEC enforcement action. ITSFEA also specifically addresses habthty of § 98. Corporate Affirmative Disclosure Obligations employers and controlling persons. Under ITSF~A, ~ co~rt can and Accountability impose the treble damage penalties for insider ~radmg vwlatwns on .As noted, companies subject to 1934 Act § 12's regis­ a controlling person only if: (1) the controllmg person knew or alre~dy tratwn reqmrements must file periodic reports with the SEC pursu­ acted in reckless disregard of the fact that the controlled per~on was likely to engage in illegal insider trading and (2) the control.hl_lg ~t to 1934 Act § 13. 1934 Act § 16(a) further requires officers, and ten percent beneficial owners of registered reporting person failed to take adequate precautions to prevent th: prohtbtt­ dtrector~, compames to file reports of all transactions in the issuer's shares. ed conduct from taking place. 1934 Act § 21A(b) It ts further See chapter 13 belo~ ..In addition, 1934 Act § 13(d) requires filings provided that general principles of respondeat superior and ~934 Act § 20(a) controlling person liability do not apply to acttons by .any ~erson acqmrmg 5% of an equity security subject to the and reporting requirements, and 1934 Act § 14(d) brought for illegal insider trading activities. ~egtstratwn tmposes filing requirements in connection with tender offers. See chapter 11 above. § 97. Liability for Material Misstatements and Omis­ sions of Fact in Documents Filed With the In the absence of a filing requirement there is no affirmative SEC-1934 Act§ 18(a) obligat~on to disclose material information 'until the next quarterly report ts due, except for the limited number of items that must be 1934 Act § 18(a) upon anyone responsible for material mis­ in interim reports on Form 8-K. The mandatory disclo­ statement or omission of fact in connection with any document disclo~ed sure. ttems in these interim reports has expanded. SOX § 409 required to be filed with the Commission und~r the terms of the provtdes that the SEC should promulgate rules, as it deems "neces­ 1934 Act. Section 18(a) is available to any mvestor who, after sary or useful for the protection of investors and in the public Ch. 12 § 98 DISCLOSURE OBLIGATIONS & ACCOUNTABILITY 299 298 MANIPULATION AND FRAUD t~ disclose the. inf?rmation. This absence of an affirmative company interest " to provide for "real-time" disclosure of "information disclosure obhgatwn under Rule lOb-5 is further strengthened by concerning material changes in the financial condition or opera­ the Supreme Court's ruling that the mere possession of confidential tions of the issuer in plain English, which may include trend and insid~ information is not sufficient t~ trigger the duty to disclose or qualitative inform~tion and graphi<: ~resentations." .Even before abstam from trading. Chiarella v. United States, 445 U.S. 222 this legislative impetus, the Commisswn .movmg .more to­ beg~n (~980) As one court has aptly explained, "[a]bsent a specific duty to wards a system of continuous rather than penodi? reportmg when di~close, even the most .material 'information imaginable may be it proposed expanding the items that have to be disclosed promptly Withheld from the public." Polak v. Continental Hosts, Ltd., 613 on Form 8-K. Until the adoption of section 13(a)(1), the .1934 Act F.Supp. 153, 156 (S.D.N.Y.1985). did not contain an express requirement for prom~t disclos~re. Section 13(a)(l) authorizes SEC rulemaking to reqmre real time Once a company chooses to make a statement Rule 10b-5 disclosure of material changes in financial condition, but is not an comes into play. Thus, for example, once a statem~nt has been across-the-board-requirement that a corporation r~po:t mate~ial mad: b~ the issuer or one of its represent?-tives, there may be a information that is not otherwise required by the perwdic reportmg contmumg duty to update and/or correct the information that was and shareholder information requirements. Thus, there is no affi~­ previously disseminated. Furthermore, when' the initial disclosure mative duty to disclose many types of material developments until has been made in an SEC filing pursuant to a line-item disclosure the next quarterly report. In contrast, the rules of ~he maj.or stock requirement, the curative disclosure must be made in the appropri­ exchanges expressly require corporations to make timely disc~osure a~e manner, which frequently will require the filing of an amended of all information that would be material to the reasonable mves­ disclosure form. The duty to correct erroneous information does not tor. However, the violation of the exchange listing requirements mean that once some disclosures have been made all facts that can lead only to sanctions by the exchange which have rarely been might be. of interest to investors must be disclosed. The duty of further disclosure applies only when failure to do so would make imposed for this type of violation alone. The SEC does not. h~ve the statement previously made materially misleading in light of enforcement power to pursue violations of the exchange hstmg subsequent developments. ~·'. requirements. ,,:··· Responding to market rumors. It seems clear that issuers The above-mentioned interim prompt disclosure requirements have no independent obligation to correct rumors that cannot be are not supplemented by additional requirement to be implied from traced back to the issuer or its representatives. However the Rule 10b-5. Whether Rule lOb-5 alone is sufficient to trigger a situation is different when the issuer elects to speak. O~ce a similar affirmative duty of disclosure is, at most, highly doubtful. statement has been made, the duty to correct may arise. When Rule 10b-5(a) and (c) deal with acts and practices that constitute presented with a question about market rumors, companies have fraud or deceit. Rule 10b-5(b) prohibits materially misleading state­ two alternatives. The company can, of course, respond with full ments and materially misleading omissions from statements made. disclosure, which in the case of preliminary negotiations or other Rule 10b-5 does not by itself impose affirmative disclosure require­ sen~itive business developments, might be counterproductive. Alter­ ments absent some independent duty to disclose, such as one natively, the company can issue a "no comment" response. It has imposed by a line-item disclosure requirement of ~n applicable SEC been observed that while the "no comment" response may be required filing. Mere nondisclosure, absent an mdependen.t ~uty necessary for business reasons, as issuers develop increasing "no such as a line-item disclosure mandate, contemporaneous msi~er comment" policies, less information will be filtered into the market. trading, or some other collateral activity, is insufficient to establish On the other hand, the absence of information clearly is preferable a violation of Rule 10b-5. In relevant part, Rule 10b-5(b) provid~s to the presence of misleading information. that it is unlawful "to omit to state a material fact necessary m order to make the statements made, in light of the circumstances Adoption of and entanglement with statements by third under which they were made, not misleading." These words cle~rly parties. Just as issuers have no duty to respond to rumors, they do seem to contemplate that in order to create liability for omisswn ~ot have a du~y to respond to analysts' statements so long as the there must be some statement in which the material facts do not Issuer had no mvolvement with the analyst making the statement. In order to be held accountable as a primary violator the issuer or appear. Thus, even though some observers may have taken a m~re its representative must have either created the or expansive view of the rule and have indicated that an affirmati~e mi~statement h~ve had the misstatement publicly attributed to it. E.g., Cooper v. disclosure duty should be found to exist, the company may av01d Pickett, 137 F.3d 616, 624 (9th Cir.1997). Thus, for example, there liability for keeping silent absent an independent basis for the duty 300 MANIPULATION AND FRAUD Ch. 12 §99 CORPORATE MISMANAGEMENT 301 · duty with regard to an analyst's projection unless the issuer hasIS no adopted the projection or has otherwise· " entang1 e d" I't se lf :V~'th the extent to which links on a company sponsored web site to third the analyst's opinions. See, e.g., In re Navarre Corp. Securities party sites will constitute an adoption of the statements contained LI·t· Iga t' wn, 299 F ·3d 735 (8th Cir.2002) ' However, once the companyr b T t on those sites. At the very least, management should be careful to or a representative responds to the analyst's statements, Ia II Y disclaim responsibility for statements that may appear in third can follow if there is sufficient involvement by the comp~my. On ~he party web sites that are linked to the company web site. In 2000 ther hand the mere fact that a third party obtained mformatwn the SEC issued an interp.retati,v,e release that among other things: ~rom comp~ny insiders is not by itself sufficient ~o create ,entangl~­ addressed company web sites. See Use of Electronic Media, Sec. Act ment so as to hold the company liable for the third party s materi­ Rei. No. 33-7856, 2000 WL 502290 (SEC April 28, 2000). The SEC ally misleading statements ..Entar:glement is establis?ed, howev~r, explained that it considers a number of factors in determining "when company officials 'mtentwnally foster a mistaken beh~f whether a hyperlink on a company sponsored web site that links to concerning a material fact.' " In re Cabletron Systems, Inc. Securi­ a third party's web site will operate as the company's adoption of ties Litigation, 311 F.3d 11, 38 (1st Cir. 2002). ~' sta~ement by ~ the information contained on the,third party web site. The context Pany official that he or she is "comfortable with analysts of the hyperlink must be considered. Specifically, does the corpora­ com · · s h estimates can form the basis of liability for over-opt~mis~.. uc a tion expressly adopt or endorse the statements that may be con­ statement can operate as an adoption of the analyst s opn~wn. On tained on the third party web site that is hyperlinked to the ~J·--.--·>--"'.. ~:.:~r~-.c :~· th other hand merely stating that it was comfortable with ana­ company web site? If there is such an endorsement, then the ly~s' estimates' does not make the company liable simply because corporation may be held accountable by statements made on the the estimate turns out to be wrong. third party web site. The SEC further takes the position that if the Regulation FD-prohibition on selective disclosure. S~C hyperlink exists within a portion of the web site that constitutes a Regulation FD was adopted in 2000 in order to level the playmg document that satisfies delivery requirements under the federal field concerning access to information about a company that comes securities laws, the company will be deemed to have adopted the from the company. Under Reg. FD, selective disclosur: by a compa­ statements contained on the hyperlinked third party web site. ny to analysts or other third parties is no longer permitted. Reg. FD Additionally, if the company is embarking on an offering of securi­ f ~.' "-·-' requires companies who make disclosures to analysts to make ties and is "in registration" under the 1933 Act, then there is a prompt public announcements so that all investors can ?av~ access strong presumption that the company has adopted statements that to the same information. Reg. FD, although controversial, IS not a are contained in web sites that are hyperlinked to the company's novel idea. For example, the New York Stock Exchange has for a web site. Another factor in determining whether information con­ ~ .. long time had a policy against selective disclosure to anal~sts. R~g. tained in a third-party web site will be attributed to the company is FD applies only to "communications by the company s semor the likelihood of confusion. For example, if the hyperlink from the management, its investor relations profession~ls, and others w_ho company-sponsored web site presents a separate screen announcing regularly communicate with market professwnals ,a~~ secunt! that the viewer is leaving the company's web site, there is less holders." Further, Reg. FD applies only to a company s coY?mun,I­ likelihood that the company will be deemed to have adopted the cations with market professionals, and holders of the Issuer s statements on the third party's web site. Company disclaimers of securities under circumstances in which it is reas_onably fo~eseeable liability for statements contained in hyperlinked third-party web that the security holders will trade on the bas1s of the mform~­ sites will not in and of themselves insulate the company from tion." Accordingly, Reg. FD does not apply when the. company IS liability if there are other indications that the company has some­ how endorsed the statements. communicating with the press, rating agencies, and .ordmary-course business communications with customers and suppliers. § 99. Corporate Mismanagement, Rule lOb.,-5 and the Company web sites. An issue related to entanglement is the Deception Requirement accountability of corporate management for materi.al t?at appe.ars on the Internet. It is clear that companies that mam~am web SI~es Although directed at securities fraud, over its history Rule lOb- must be careful to monitor the co~tent o~}he s1tes .. Mat~n~~ 5 has had a role to play in preventing corporate mismanagement misstatements and omissions will satisfy the m connectwn w1th that results in deception in connection with a purchase or sale of requirement. There thus can be serious securities law conse~uenc~s securities. While the high-water mark for Rule lOb-5 in misman­ for the content on company sponsored web sites. Another 1ssue IS agement cases seems to be well in the past, the rule still may have some impact in regulating corporate management practices. In Ch. 12 §99 302 MANIPULATION Al'IJJ FRAUD CORPORATE MISMANAGEMENT 303

2002 Congress enacted the SOX which instated various reforms in provide a cause of action for breaches of fiduciary duty in connec­ resp~nse to corporate scandals such as those involving Enron Corp. tion with freeze-out transactions, and thus to rule otherwise in the and Worldcom. Some of the Sarbanes-Oxley amendments may be case at hand would be to federalize the corporate law of directors' relevant in setting a new tone for the role of Rule 10b-5 in dealing obligation; it further refused to impose a higher standard than the with governance issues. In relevant part, SOX addressed corpora~e applicable state law. governance, including the role of independent directors and audit In the wake of the Santa decision, commentators were quick committees as well as the establishment of corporate codes of Fe to. predict a demise of Rule 10b-5's role in the area of corporate ethics. Thi~ may signal a new Congressional policy? opening the mismanagement. However, there were five post-Santa Fe court of door once again for the use of Rule 10b-5 to momto.r corporate appeals decisions that took an expansive reading of Rule 10b-5 and governance. As discussed below, the cases to .date make It c~e.ar that a correspondingly narrow reading of the Supreme Court's decision. a breach of fiduciary duty, without more, IS not a secuntles. law Healey v. Catalyst Recovery of Pennsylvania, 616 F.2d 641 (3d violation. It remains to be seen whether the pendulum will begm to Cir.1980); Kidwell v. Meikle, 5.97_ F.2d 1273 (9th Cir.1979); Ala­ swing to the other direction. bama Farm Bureau Mutual Casualty Co. v. American Fidelity Life Although under current law, corporate mismanagement alone Insurance Co., 606 F.2d 602 (5th Cir.1979); Wright v. Heizer Corp., will not state a Rule 10b-5 claim, the courts must look to the 560 F.2d 236 (7th Cir.1977), cert. denied, 434 U.S. 1066 (1978); substance rather than form of the claims. Thus, for example, a Goldberg v. Meridor, 567 F.2d 209 (2d Cir.1977), cert. denied, 434 defendant's characterization of the plaintiff's claim as one based on U.S. 1069 (1978). Under these and other decisions, it is clear that w: .. corporate mismanagement will not defeat an otherwise valid securi­ the fact that mismanagement is involved does not preclude a Rule ~-- !-~ ties fraud claim. 10b-5 claim for material misrepresentations. However, it is also As pointed out earlier in this chapter, 1934 Act § 10(b) prohib­ clear that, standing alone, a breach of fiduciary duty is not a its "manipulative or deceptive" practices as defined ?Y SEC rules. securities law violation. Similarly, a lapse in a board of directors' In 1971 in Superintendent of Insurance v. Bankers Life & Casualty business judgment alone cannot form the basis of a securities law Co., 404 U.S. 6 (1971), the Supreme Court announced that Rule violation. 10b-5 is violated when there is deception touching the purchase or I ~' In Goldberg v. Meridor, 567 F.2d 209 (2d Cir.1977), cert. .. '-· ~. sale of a security even if the acts complained of amount to no more denied, 434 U.S. 1069 (1978), the defendant parent corporation than corporate mismanagement. The defendants, management of caused a controlled subsidiary to issue common stock and convert­ an insurance company, caused the company to part with its assets ible debentures. The offering raised seven million dollars in cash that consisted of marketable securities. The Court upheld the 10b-5 that was in turn loaned to its direct parent corporation. The public claim since the corporation was forced to part with its securities offering was followed by an exchange of assets whereby the control­ and thus the "seller was duped into believing that it . . . would ling parent sold its assets to the subsidiary in return for stock in receive the proceeds." As a result of the Court's ruli~g, Rule 10b-5 the subsidiary. After the transactions were completed, the direct became a potential remedy to redress corporate mismanagement. parent's sole asset was the stock of the subsidiary, in which the The 10b-5 mismanagement remedy continued to garner great sup­ plaintiff was a minority shareholder, and the subsidiary had ac­ port until the Supreme Court's ruling in Santa Fe Industries, Inc. quired all of the parent's assets and liabilities (including the seven v. Green, 430 U.S. 462 (1977). million dollar debt running to the subsidiary). The plaintiff brought The Santa Fe case involved a claim by a shareholder who was suit under Rule 10b-5, claiming that the defendant caused its frozen out by the majority pursuant to a short-form merger. The subsidiary to issue stock in the public offering for the benefit of the parent corporation complied with the requirements set out by the controlling parents, and that the subsequent exchange of assets was applicable Delaware short-form merger. sta~ute and disclosed all of inadequate consideration and thus operated as a fraud against the the required information to both the mmonty shar~holders and the subsidiary in the issuance of its own shares. The Second Circuit independent appraiser. The plaintiff claimed that smce the c~sh-out applied the "controlling influence" doctrine. Under the controlling price was low, the transaction operated as a fraud or deceit upon influence doctrine, for a transaction in which the decision-makers him within the meaning of Rule 10b-5(c). The Supreme Court are controlled directors, the standard of disclosure is measured by responded that, in order to state a 10b-5 clai_m t?e plaintiff n:ust what would have been material to a disinterested director dealing show an element of "deception" that was lackmg m the allegatwns at arms length. Although disclosure to the shareholders would not in Santa Fe. The Court pointed out that a number of states did not have directly affected the corporate decision in question, the court 304 MANIPULATION AND FRAUD Ch. 12 § 102 MULTIPLE DEFENDANTS 305 reasoned that, armed with material facts of the transactions, share­ prohibition against waivers does not preclude releases of liability holders would have been able to avail themselves of a remedy at issued for consideration in connection with settlements of litigation state law. Accordingly, the Second Circuit in Goldberg held that or incipient suits. However, to be valid, such a release must be for disclosure of the unfair exchange would have been the basis of an consideration and the parties must have had knowledge of the injunction under New York law, and thus the .plai.ntiff~ were claim. deceived into not seeking that relief. As a second JUShficatwn for the requisite deception and causation elements, the court pointed Voiding of Contracts Waiving Compliance with the Securi­ out that public disclosure of all relevant facts might hav~ sha~ed ties Laws the subsidiary's directors into voting against the transac~wns w1~h its parents rather than hanging its dirty linen out m pubhc. 1934 Act § 29(b) goes beyond the anti-waiver prohibitions discussed above. While the anti-waiver provisions merely preclude § 100. The Effect of Plaintiff's Conduct on Implied certain defenses to conduct that violates the securities acts, section Civil Liability; Due Diligence; In Pari De­ 29(b) can be viewed as providing ~n affirmative remedy for parties licto who have entered into contracts with provisions contrary to the securities laws. See Mills v. Electric Auto-Lite Co., 396 U.S. 375, In order to recover in an action for common law fraud, plain­ 385-388 (1970). 1934 Act § 29(b) provides that contracts involving tiffs are required to prove that their reliance was reasonable. As a performance that would be in violation of the Act are void. In the corollary to the reliance element, the federal cour~s developed a first instance, this means that since a contract in violation of the requirement that the plaintiff in a Rule lOb-.5 a~t10n ha:e acted act is void, a party to that contract will have a successful defense to with due diligence with regard to the transactwn m questwn. Th.e an action to enforce the contract. In addition to being used defen­ plaintiffs due diligence requirement develo~ed initially alon~ negli­ sively, 1934 Act § 29(b) can be used affirmatively by a party gence lines. However, in Rule 10b-5 cases, 1t see~s ~nque.s~wnable 'I :~: ;; challenging a contract in violation of the Act. The Supreme Court ' ~~.. _· ' that this has been changed by the Supreme Court s 1mpos1bon of a has held that a similar provision contained in the IAA supports a ::. scienter requirement upon defendant's conduct, which impliedly 1!_,,:·).•·' private right of action for rescission. Transamerica Mortgage Advis­ t....-,.-· should carry over to the plaintiffs standard of conduct. It .would I.O.,o!-, ors, Inc. v. Lewis, 444 U.S. 11 (1979). The same result must follow make little sense to say that an investor's negligence is sufficient to with respect to section 29(b) for contracts in violation of the 1934 negate the defendant's more culpable intentional conduct. Act or applicable SEC rules. The Supreme Court in Bateman Eichler, Hill Richards, Inc. v. Berner, 4 72 U.S. 299 (1985), held that the in pari delicto defense § 102. Multiple Defendants: Controlling Person Lia­ cannot be invoked in a Rule 10b-5 action unless it can be said that the plaintiff was indeed truly as culpable as the defendant. Al­ bility; Aiding and Abetting; Joint Liability though it has been suggested that this ruling abolishes the due Controlling Person Liability diligence defense, the courts have not agreed. In a related develop­ ment, in Pinter v. Dahl, 486 U.S. 622 (1988) the Supreme Court 1934 Act § 20(a) states that "[e]very person who, directly or extended the Bateman Eichler rationale in defining equal fault indirectly, controls any person liable under any provision of this under the 1933 Act. chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled § 101. Waiver of Claims; Voiding of Contracts in Vio­ person .... " Thus, for a controlling person to be liable, the person lation of the Securities Laws over who control was exercised must have committed a primary violation of the securities laws. Section 20(a) of the .Exchange Act Waiver of Claims closely parallels 1933 Act § 15 for liability under 1933 Act § 11 or Under common law and equitable principles, a party who § 12. voluntarily relinquishes a known right can be found to have waived For a plaintiff to have a prima facie case that the defendant his or her claim for relief. 1933 Act § 14 provides that contracts was a controlling person within the meaning of 1934 Act § 20(a) and stipulations purporting to waive compliance with any provision the plaintiff must show that (I) the defendant had actual power o; of the Act or SEC rules promulgated thereunder are void. The 1934 influence over the controlled person, and (2) the defendant induced Act's counterpart is found in 1934 Act § 29(a). It is clear that the or participated in the alleged illegal activity. Several circuits hold 306 MANIPULATION AND FRAUD Ch. 12 § 102 MULTIPLE DEFENDANTS 307 that under the second prong of the test, the defenda_n~ must have been a "culpable participant" in the alleged illegal act1v1ty. Defenses. Under the statute, a defendant has two affirmative defenses to a controlling person liability claim. First, the defendant What constitutes control? Although the term "control" is can try to establish that he or 'she acted in "good faith." The no t d e fi1ne d 1·11 1934 Act § 20(a), the SEC has defined. , " thet termll d defendant will have the burden of proving his or her own good "control" generally (including the terms "controlmg1 , con ro. e faith, which "requires not only the establishment of a proper b " nd "under common control with") to mean "the possesswn, system of supervision, but also.'its diligent enforcement." Harrison t• f directY 'a or indirect, of the power to direct or cause t h e d.1rec wn o v. Dean Witter Reynolds, Inc., 79 F.3d 609 (7th Cir.1996). Secondly, the management and policies of a person whether. t~~ough the the defendant can also try to establish that he or she did not induce ownership of voting securities, by con~ract, _or ?ther~1se. 1933 A~t the alleged violation, or in other words, that he or she did not Rule 405. The most common relatwnsh1p m wh1ch control. 1s participate in the violation. presumed is that of the employer-employee. However, controllmg Other liability compared. As a gimeral proposition, control­ person liability is limited to transactions taking place on be~alf of ling person liability is distinct· ftom other forms of secondary the employer. Thus, for example, when .the investor deals w~th an liability. It has different elements, and in some respects it is employee other than in his or her capac1ty as an employee w~thout broader, while in others it is narrower. Much debate has occurred relying on any affiliation with the employer, the employer w1ll not over whether section 20(a) is an exclusive remedy, so that common ~.t·-=-:>-"'""~'" '~~ ..-~·~L·- be held accountable as a controlling person. ~n the . other hand, law claims based on agency theories such as respondeat superior ~~~~><. :~· when an employee is acting under the employer s ausp1ces, control­ cannot be brought by plaintiffs. A number of circuit courts have ling person liability and control depends upon control ov~r t~e held that section 20(a) is not an exclusive remedy. The Ninth and employee; control with regard to the particular transactwn m Third Circuits decided differently, and have held that section 20(a) question need not be shown. Controlling shareholders can be found is an exclusive remedy. The Ninth Circuit, however, has since to be control persons. Corporate officers ar~ usually ~resumed to changed its position and is now aligned with a majority of cases possess the requisite power to control the actwns of the1r employees permitting the common law claim to proceed. Hollinger v. Titan and are often held accountable as controlling persons. Corporate Capital Corp., 914 F.2d 1564 (9th Cir.1990), cert. denied, 499 U.S. 976 (1991). directors are not automatically liable as controllin~ _Per~ons .. Thus, "[t]here must be some showing of actual partlc1patwn m the Aiding and Abetting Liability corporation's operation or some influence before the consequences of control may be imposed." Burgess v. Premier Corp., 727 F.2d Decline of Aiding and Abetting Liability. In cases involv­ 826 832 (9th Cir.1984) (quoting Herm v. Staffor~, 663 F.2~ 669, ing violations of the securities laws, plaintiffs often brought suit 684, (6th Cir.1981)). The Eleventh Circuit adopted 1ts own art.Icula­ against not only the person who was the primary violator of the tion of the test for controlling person liability where the pnmary specific statute, but also any persons who may have assisted in the violator is an entity. Brown v. Enstar Group, Inc., 84 F.3d 393 wrongful act. Aiding and abetting is an outgrowth of criminal law. (11th Cir.1996). The court, adopting the approach that had been Until 1994, private suits against aiders and abettors were most often brought to assure a solvent defendant. Aiders and abettors taken by the district court, focused on thr~e factor.s. The court formerly were generally held to be jointly and severally liable to explained that controlling person liability exists: (1) If t~e alleged plaintiffs for violations and were often viewed as better sources control person had the power to control the gene~al ~ffa~rs of the from which to seek monetary awards. The Supreme Court eliminat­ entity at the time of the alleged securities law vwlatwns, (2) ~he ed private aiding and abetting claims. Central Bank of Denver, N.A. alleged control person possessed the power t? c?~trol the specific v. First Interstate Bank of Denver, 511 U.S. 164 (1994). Aiding and company policy that resulted in primary ha~Ihty~ and <.3) the abetting remains an important issue in criminal and SEC enforce­ controlled entity committed a securities law vwlatwn. T~Is test, ment actions. In the private litigation arena, there is an increasing which would be applicable to corporate officers and directors, tendency of plaintiffs to try to characterize participants in a securi­ among others, seems to be a fair restateme~t of the ~en~:al ties fraud as primary violators. principles of controlling person liability. Controllmg person hab1hty does not depend upon the actual exercise of the power .to control. Distinction between primary and secondary violations. Thus all that is necessary is to establish the possesswn of the To the extent that an accountant or an attorney actually prepares powe~ of control over the primary violator. documents containing materially misleading statements, then pri­ mary liability may well be appropriate. See, e.g., Ziemba v. Cascade 308 MANIPULATION AND FRAUD Ch. 12 § 102 MULTIPLE DEFENDANTS 309

International, Inc., 256 F.3d 1194 (11th Cir.2001). Thus, for exam­ defendant's violation(s) was knowing. Non-knowing defendants ple, when a law firm makes public materially misleading statements n:ay still ~e held jointly and severally liable under certain provi­ that investors might rely upon, the law firm may be held accounta­ siOns relatmg to the uncollectible shares of other defendants. If a ble as a primary violator. An attorney's drafting of disclosure can plaintiff establishes: (1) that the recoverable damages under the lead to primary liability if the disclosure is found to have violated judgment are more than ten percent of the net worth of the the securities laws and the person drafting the disclosure created plaintiff; and (2) that the net ~orth of the plaintiff is less than the fraud. See, e.g., In re Enron Corp. Securities, Derivative & $200,000, a non-knowing defendant will be held jointly and several­ ERISA Litigation, 235 F.Supp.2d 549 (S.D.Tex. 2002). However, ly liable for any uncollectible shares. Additionally, non-knowing primary liability for violation of Rule 10b-5 necessarily depends defendants may be held jointly and severally liable for up to 50% of upon knowledge or willful ignorance regarding the falsity of the another defendant's share who is unable to pay due to insolvency. statement. Primary liability is not always dependent on the defen­ However, defendants paying additional amounts due to uncollect­ dant having actually participated in the drafting of the materially ible shares may, within six months of the•date of payment seek misleading statement. For example, a chief executive officer and a contribution. All defendants held liable in' an action rna; seek chief operating officer could be classified as primary violators for contribution within six months of the final judgment from parties having allowed the inaccurate filings to be filed. Some courts ha;e not nam~d in the suit. Additionally, any defendant who settles prior required that the defendant have actually made the statement m to final Judgment may not seek a right of contribution and the order to be held liable as a primary violator. Other courts, however, court is required to reduce the final judgment by the amount the found that other types of substantial assistance can be sufficient to settling defendant paid to the plaintiff. In addition to the foregoing establish primary liability under the securities laws. Those deci­ rules on liability, PSLRA requires bar orders with regard to partial

R':.' sions held that primary liability could be found if the defendant settlement of securities law claims. knowingly participated in the fraudulent scheme even though he or ...... ,. ·-·.··t she was not responsible for the statements at issue. The Supreme Contribution and Indemnity Court's decision in Stoneridge Investment Partners, LLC v. Scienti­ Subject to proportionate liability described above, defendants "".-.,/;.,. fic-Atlanta, Inc., 552 U.S. 148 (2008) likely •.!..'!;;;,· put an end to this so­ found liable for violations of securities laws are often jointly and ...... ~ - ' called scheme liability, at least in private suits. Among other things, severally liable to plaintiffs for their fraudulent acts under Rule ft.~~~., ~ t" .... the Court held that the defendant's involvement in the misstate­ 10b-5, and consequently, the entire damage award can be collected G;::::. ments in questions must have been apparent to the plaintiff so as from one or more defendants, assuming joint liability is found. c:::r to satisfy the reliance requirement. ~Ji.H. ~~ ;; . Under the tort principle of contribution, the court may distribute ! C:.!!;:i the loss among the joint tortfeasors by requiring each defendant to Joint and Several and Proportional Liability pay his or her portion of the damages. A person seeking contribu­ 1934 Act § 21D(g), which was enacted as part of PSLRA tion may do so either by the use of third party practice (impleader) :I changed the prior rule of joint and several liability for defendants or by bringing a separate action. The Supreme Court held that a in 1934 Act suits. The statute institutes a system of proportionate right of contribution was an appropriate part of the implied right of liability for defendants who do not knowingly commit violations of action that has long existed under Rule 10b-5. Musick, Peeler & the Act. Proportionate liability is also applicable to outside directors Garrett v. Employers Insurance of Wausau, Musick, Peeler & in actions under 1933 Act§ 11. Defendants engaging in "knowing" Garrett v. Employers Insurance of Wausau, 508 U.S. 286 (1993). In violations of the securities laws are subject to joint and several so ruling, the Court distinguished cases decided under other federal liability. Knowing violations include material misrepresentations or statutes containing an express right of action but no right of omissions made with actual knowledge of false information, and do contribution. Although a number of decisions caution against the not include reckless conduct. Defendants not meeting the standard implication of additional federal remedies, once the courts have of knowledge are responsible only for their proportionate share of a recognized an implied right of action, then it is appropriate to flesh judgment. Courts in private actions are required to instruct jur~es it out so as to render it a reasonable remedy. 1934 Act §§ 9(e) and to answer special interrogatories or make findings in non-jury smts 18(a) both contain an express right of action and further provide with respect to each defendant. The court or jury must determine for a right of contribution. The Court reasoned that the similarities (1) whether each defendant violated any securities law; (2) the between 1934 Act §§ 9(e), 18(a), and 10(b) support the recognition percentage of each defendant's responsibility; and (3) whether each of an implied right of contribution under Rule lOb-5. 1933 Act § 11 310 MANIPULATION AND FRAUD Ch. 12

contains a right of contribution. In contrast, _1933 _Act § ~2 does not. Although contribution is generally recog_n~zed, I~demmty gen­ erally has not been permitted in federal secunhes clmms. Chapter 13 Class Action Settlements The PSLRA codifies what had become the emerging rule re­ garding partial settlements of cases involving multiple defendants INSIDER REPORTING AND and or potential defendants. 1934 Act § 21D(f)(7) sets forth. the SHORT-SWING TRADING- settlement bar rule for pretrial settlements. If_ a ~efendant m a 1934 ACT§ 16 Rule 10b-5 action settles prior to trial, the court IS directed t? en:er a bar order which will preclude all future claims for. contnbutwn Tahle of Sections against the settling defendant arising out of the a~twn_. The ?ar Sec. ' order is bilateral in that it prohibits not only contnbutwn claims 103. Reporting Requirements for Insiders and Their Transac­ against the settling defendant, but also any c?ntribut~on claims the tions in Shares-1934 Act§ 16(a). settling defendant might have, except clmms agmnst someone 104. Disgorgement of Insider Short-Swing Profits-1934 Act whose liability was extinguished by the settleme~t. PSL~ further § 16(b). provides that any judgment subsequently obtamed agamst non­ 105. Who Is Subject to 1934 Act §§ 16(a) and (b)? When Does settling defendants shall be reduced by the greater of (1) an a~?~nt Insider Status Attach? 106. corresponding to the settling defendant's per~entage responsibility, The Definition of "Purchase" and "Sale" and the Prag­ or (2) the dollar amount paid by the settlmg defendant to the matic Approach Under 1934 Act§ 16(b). 107. Prohibitions Against Short Sales by Insiders-1934 Act plaintiff. 1934 Act § 21D(g)(7). § 16(c).

,, ...•

§ 103. Reporting Requirements for Insiders and Their Transactions in Shares-1934 Act § 16(a) Overview of 1934 Act§ 16 Filing Requirements By virtue of 1934 Act § 16(a), all officers, directors, and benefi­ cial owners of more than ten percent of any class of equity security registered under 1934 Act § 12 must file appropriate notice with the Commission on Form 3 within ten days of becoming an officer, director, or beneficial owner. The section 16(a) filing must include disclosure of all ownership interest in any of the issuer's equity securities. Further, when there has been a change in an officer's, director's, or beneficial owner's share holdings, notice must also be filed with the Commission, generally on Form 4. The Sarbanes­ Oxley Act mandated more rapid reporting of insider transact~on than formerly was the case under section 16(a). Section 16(a) requires Form 4 reports of changes in beneficial ownership to be \ ' filed with the SEC by the end of the second business day after the day of execution of the transaction. The SEC may set another

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