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Securities Regulation
Southern Illinois University School of Law
Lee, Mark N.

I. Introduction
A. How Stock Markets Work
· Controlling shareholders and managers who act in the best interest of the shareholders will want to disclose accounting based and other information up to the point where the marginal benefits to the shareholders exceed or equal the marginal cost of producing and disseminating the information.
· Capital is moved from those who value it less to those who value it more.
· Benefits of Disclosure:
1. Prospective shareholders and creditors demand information on which to base their investment decisions.
a. More cost to the potential investor in obtaining information, the less they are willing to offer for a share or the higher the interest rate necessary to satisfy them.
i. Producing the information will cost the company less than the aggregate cost to potential and present investors.
b. Cheaper to communicate through financial statements and publicity releases than to answer questions one by one.
2. Owners and managers reduce the appearance that they are diverting funds when they disclose.
a. Establish a monitoring system to inhibit, if not prevent, those in control and other employees from misusing corporate resources.
i. CPA’s.
3. Corporations avoid the discount that investors are likely to apply to investments in the corporation when the corporation publishes information. Corporations have to offer a higher payout if they do not disclose more information.
a. Externality- the first corporation to disclose a particular type of information may not receive the full benefit of this disclosure unless some other corporation also discloses.
· Disclosure does not solve all potential problems:
1. The best accounting reports can only provide a subset of the data that investors might find useful. The data that is disclosed, ex post, may actually appear to have been chosen to mislead unwary readers.
2. Financial statements provide a very inefficient vehicle for dishonest corporate owners and managers to cheat investors. Investors want to know about the future, but accounting data only addresses the past.
· The law of fraud cuts down on transaction costs, but there are limits on the measures we will go to prevent fraud:
§ If there is too much information, investors would have to spend too much time trying to understand it all.
§ At a certain point, the threat of liability could make the corporation stop disclosing information.
B. Issues in the 1933 Act
· What are private companies allowed to disclose?
· How are companies allowed to raise capital?
· How do you file a registration statement?
· What are the exemptions from registration?
· The liability provisions.
C. Issues in the 1934 Exchange Act
· What are the reporting requirements?
· Section 10b-5 (fraud and insider trading)
· Market manipulation.
· Proxy solicitations.
· Responsibilities of securities attorneys.
D. The Efficient Market Hypothesis:
o Weak- current price is an unbiased minimum variance estimate of the future price. Securities only provide a “random walk”- future stock prices will not correspond to any pattern that traders can discern by studying historical price data, etc.
o Semi-strong- Stock market price reflects all relevant publicly available information. Investors cannot earn profits by learning publicly disclosed data. If everyone knows the information, the market will reflect it. Block trades- hundreds of thousands of shares are exchanged at once by institutional investors. If only some people know the information, they will trade, others will mimic their trades.
o The Supreme Court endorses this semi-strong version.
o Strong-form- no one can consistently earn positive abnormal returns from access to information (although people may occasionally profit from inside information).
· Lawyers can prove causation, reliance, and materiality simply by believing in the EMH- simply show that the client knew the price.
· Policy Implications from EMH:
o Given securities markets that are “fundamental-value” efficient allocate capital to its best uses, regulation that promotes efficiency may be desirable and regulation that interferes with market allocation of resources may be suspect.
o EMH tells us that a return on a security turns only on its beta (market risk) and therefore investors should not attempt to pick good deals based on a determination that a stock is “underpriced.”
o If there is a profit opportunity in a hostile takeover, this is a sign that the managers should be replaced. (this is significant in determining the appropriate scope of manager’s power to defend against takeovers).
E. Regulation FD- Prohibition on Selective Disclosure
· Regulation FD was adopted in 2000 in order to provide equal access to information about a company that comes from the company. Selective disclosure by a company to analysts or other third party parties is no longer permitted.
o FD requires that companies who make disclosures to analysts to make prompt public announcements so that all investors can have access to the same information.
o FD applies only to a company’s communications with market professionals, and holders of the issuer’s securities under circumstances in which it is reasonably foreseeable that the security holders will trade on the basis of the information.

II. Liability for Material Misstatements or Omissions by Sellers of Securities
A. 12(a)(2)
· 12(a)(2) of the 1933 Act creates an express private remedy for material misstatements or omissions in connection with the sale or offer for sale of a security.
o Applies to both written and oral communications; it would be inappropriate to give undue weight to the prospectus and thereby give short shrift to the impact of oral communications.
§ Accurate disclosure in the prospectus likely control over any alleged misstatements made orally or otherwise outside of the prospectus.
· 12(a)(2) renders the seller liable if he or she “shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission.”
o “Reasonable Care” requirement imparts a negligence standard and it is therefore not necessary for the purchaser to show any type of scienter on the seller’s part.
§ Although there is not a per se affirmative investigation requirement, it has been held that the 12(a)(2) standard of reasonable care may impose a duty to investigate depending on the circumstances.
· Sanders v. John Nuveen & Co.- underwriters presence in the offering can act as an implied representation that the underwriter has investigated the issue. D’s presence bolstered the value of the commercial paper.
o Efficient Market Hypothesis- even though the plaintiffs did not read the prospectus, they knew how much the price was and the price reflected D’s ability to influence the market. 1933 Act imposes liability without regard to whether buyer relied on misrepresentation or omission.
o Even though this case involves the sale of commercial paper, the prospectus still affects the price. A prospectus that reported on the true financial condition of WH would have caused a total collapse of the market for the notes.

A. Materiality- Tests for determining materiality of factual statements.
· Defendant liable when:
(i) The defendant affirmatively misrepresented a material fact, or
(ii) The defendant omitted a material fact that made his statement misleading, or
(iii) The defendant remained silent in the face of a fiduciary duty to disclose a material fact.
o When is there a fiduciary duty to disclose a material fact?
(a). When a corporate insider trades on confidential information.
(b). When a corporation has made inaccurate, incomplete, or misleading prior disclosures
(c). Statute or regulation requires disclosure.

o Reasonable Investor test- TSC Industries v. Northway- There must be a substantial likelihood that the disclosure of an omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.
§ If the information that would otherwise be material, but doesn’t add to the total-mix of information (like when someone already knows the information), then it does not have to be disclosed.
§ TSC Industries set the reasonable shareholder standard for proxies, but tried to balance this against an overabundance of trivial information. Court applies the standard to purchases.
o Probability/Magnitude test- materiality depends on a balance between probability and magnitude.
· Probability- indicia of interest by board- e.g., board resolutions, instructions to investment bankers, and actual negotiations.
· Magnitude- size of entities, potential premiums over market value.
§ Basic Incorporated v. Levinson- D made three statements that denied merger negotiations, even though D was engaged in merger negotiations. Court found P sold at a depressed amount in reliance on the price.
· The bidder did not have a duty to issue its own press release correcting D’s statements.
o In order to prevail on a Rule 10b-5 claim, plaintiff must show that statements made by the corporation were misleading as to material facts, not simply that the statement is false or incomplete, if misrepresented fact is otherwise insignificant.
§ No liability for false or misleading statements regarding insignificant facts.
o Silence, absent a duty to disclose, is not misleading.
§ “No comment” statements are the functional equivalent of silence. However, there is the risk that a “no comment” will constitute an admission if the issuer adopts a policy of denying merger rumors

disclose tentative internal estimates, even though they conflict with published estimates, unless the internal estimates are so certain that they reveal the published figures as materially misleading.
§ Firms need not estimate how accurate they believe their estimate to be.
§ Firms produce many projections and they may reveal the projection they think best while withholding others, so long as the one revealed has a “reasonable basis.”
· Rule 175 (’33 Act)- Safe harbor for forward looking statements (but not statements of fact).
§ SEC and Congress wanted to create an incentive for corporation to put out forward looking statements. Part of a policy seeking greater disclosure.
o PSLRA provides a safe harbor for forward looking statements that prove false if the statement is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ.
o PSLRA also introduced a heightened pleading standard- complaint seeking recovery for securities fraud must allege specific facts that raise a “strong inference” of “the required state of mind.” Thus, P must prove the facts show a strong inference that D had “actual knowledge” that the statement was false or misleading.
§ Court doesn’t need to look at scienter because if a statement is accompanied by meaningful cautionary language, the Ds’ state of mind is irrelevant.
· What is “Meaningful Cautionary Language?” Compare courts different interpretations:
o When an investor has been warned of risks of a significance similar to that actually realized, she is sufficiently on notice of the danger of the investment to make an intelligent decision about it according to her own preferences for risk and reward.
o PSLRA does not require the warning to mention all factors, only important factors that could cause the actual results to differ materially from those in the forward-looking statement.
§ Harris v. Ivax Corporation- Defendant manufactured generic drugs and issued press release that acknowledged business problems, but also showed signs of optimism. Statement in press release that reorders were expected to improve as customer inventories were depleted qualified as “forward-looking statement,” as required to come within safe harbor.
o Whether a forward-looking statement bears cautionary language is a factual question, which is not resolvable at the pleading stage.
§ Asher v. Baxter International Inc.- Defendant manufactured drugs. Second quarter financial results were below projections. Court determined that discovery would be necessary to determine if the Bespeaks Caution doctrine applied.
o Cautionary statements listed numerous possible risks but failed to mention others that executives were allegedly aware of. Court will allow D to prove what their risks were ex ante.
E. Duty to Correct
· 10b-5 prohibits omissions of a material fact only if the fact was necessary to make the statements made not materially misleading.
o Once a statement of fact (as opposed to a projection) has been made, the person making the statement is then under a duty to correct any misstatements. That person also perhaps has a duty to update the public as to any material changes.
· Applies when a company makes a statement that, at the time made, the company believed to be true, but as revealed by subsequently discovered information, actually was not true. The company must then correct the prior statement within a reasonable time.
· Company has no duty to correct incorrect rumors that it did not start.
F. Duty to Update
· Sometimes statements that were accurate when made become inaccurate or misleading because of subsequent events.
The duty to update lasts only as long as the prior incorrect information continues to affect prices in the market. For example, a statement that said no negotiations were ongoing would not have to