sec reg

Reforms to stop nuisance suits

Mandatory court review of substantive justifications for settlement and attorneys' fees Institutional investor take control as lead P Fee shifting Ps may bring meritorious suits w/o + expected value bc --You can't let people get away with a little bit of fraud ----Establish good precedent for future cases --Certain conduct is deleterious societally and needs to be curbed. Activist plaintiffs can push their environmental or social goals even if there is not a positive expected value --Certain conduct might be unhealthy for the company in the long run, so while the short term costs of litigation have negative expected value, the case will pay itself off in the long run

Securities laws primarily rely on

Mandatory disclosure Anti-fraud liability Gun-jumping rules

Management Integrity

Mandatory disclosure items re: management's integrity and competence are req in registration statement, largeruly under Forms Reg S-K --Past biz experience --Management's past performance --Biz interests of insiders that may conflict with duty of loyalty to corp --Remuneration + other benefits paid / proposed to be paid to management --Material transactions b/w corp and officers, directors, holders of more than 10% of stock, and their associates

Elements of Cause of Action Rule 10b-5

Materiality (Basic) Deception (Santa Fe) Duty to Disclose (Stoneridge) Scienter (Ernest & Ernst) Pleading with Particularity of Scienter (Tellabs) Reliance (Affiliated Ute, Basic) Loss Causation (Dura)

Role of Materiality

Materiality is broad threshold req for many disclosure reqs All securities antifraud provisions refer to presence of material misstatement or omission, where add'l info is necessary, to make what has already been disclosure not materially misleading BUT, no general req that cos disclose ALL material info

Bottom Line Rationale for Materiality Distinction

Materiality standard exists to weed out frivolous lit The lower the materiality standard, the more frivolous lit Materiality standard matters most at mo to dis stage

Costs to applying securities laws

May need to send customer a prospectus and file annual reports w the SEC Anti Fraud liability also may apply to disclosures and affirmative, yet incomplete statements Result = Price may be far more expensive if not considered a security and may reduce social welfare

Difference between Reves and Howey

Motivation Focus --Reves: Focuses on motivation of lender (investor) + motivation of borrower (issuer of note) --Howey: ONLY asked if INVESTOR expected a profit, NOT whether issuer was selling securities to make a profit for itself Scope of Plan of Distribution --Reves: Focuses on plan of distribution, e.g. if instrument will generate "common trading" --Howey: Focuses on limited conception of common enterprise / horizontal commonality Expectations --Reves: Focuses on "reasonable expectations" of investing public, i.e. whether they expect note to be a security or not --Howey: Just asks whether the particular investors expected a profit. The the extent it's possible to expect a profit even from a non-security instrument, the two are not the same Multi-Factor vs. All Factors --Reves: Provides a multi-factor balancing test --Howey: Requires that ALL elements are met for a security to exist

Basis for Duty to Disclose Change of Control Potential

Need to disclose info under Rule 408 of Reg S-K to ensure earlier registration disclosure statements were not materially misleading Withdrawal of funds may also fall under Item 404 of Reg S-K's req of disclosure of transactions w related parties

Present Discount Valuation (PDV)

Need to reduce expected return from investment into present discounted value in today's dollars to make reasoned investment decision Need to Assess → -- Time value of money (dollar devaluation, impatience, opportunity cost of money of alt opportunities) -- Risk of non-payment

MATERIALITY OVERVIEW

No general duty to disclose --HOWEVER, affirmative, yet incomplete statement cannot be materially misleading (anti-fraud provisions) Basic v. Levinson → Materiality Test --Substantial likelihood that a reasonable investor would find the info significant given total mix of info ---- Probability (of information actually happening) x Magnitude (of disclosure on shareholders) Ganino → Caveat that rejects numeric bright-line rule for materiality -- May consider quantitative threshold but also factor in qualitative analysis (SAB Bulletin No. 99)

How Realistic is the Ct's Analyst Standard?

Not realistic bc average investor is less likely to actually "do the math" (analyze) as compared to financial institutions / investment bankers who are paid to do due diligence Realistic bc actual analysts have tools + should be covering everything and investors should be able to reasonably rely on their reports --Investors might believe that what is not covered by analysts is not material

Investor behavioral biases → rational vs. irrational investor:

Overconfidence and over-optimism Availability bias Endowment effects

Distinction between primary and secondary markets

Primary market transactions: Issuer sells own securities to raise capital for activities -- 1933 Securities Act: Lays out regulatory framework for issuance of securities to investors Secondary Transactions: Resale of security to another investor and no direct benefit to issuer (aside from enhanced liquidity/price transparency and resulting greater ease of raising new monies through issuance of add'l securities) -- 1934 Securities Exchange Act: Regulates secondary market transactions and market intermediaries (e.g. stock exchanges) SEC: Oversees both primary and secondary markets

More SEC and DoJ enforcement as an alternative to the Ps bar/private litigation

Pro --The government has certain advantages in securities litigation --Less incentive to bring frivolous lawsuits --More enforcement has more efficient targeted enforcement --Criminal suits are a greater deterrent Con --Limited resources might cause some fraud to go unpunished as a result of prioritization --Bureaucracy, lack of manpower to litigate every fraudulent activity --Costly to the public (individual harm vs. distribution of costs) --Politically hard to justify a massive expansion of the SEC and criminal law suits are expensive and uncertain --Criminal suits involve a higher burden of proof and have more uncertainty

Securities exchanges policing their own listed companies

Pros -Exchanges work closely with their listed companies Cons -Race to the bottom → if you're known as "hardo" exchange --People are less likely to work w your exchange OR you get reputational benefits -Exchanges won't want to bite the hand that feeds them Other Alternatives -Fixed bounties for plaintiffs' attorneys who pursue actions on their own, rather than on behalf of a class client Results in lots of bad whistleblower complaints from actors just looking for a big bounty Reliance on audit committees and auditors to detect fraud -Already exists in some form due to Sarbanes-Oxley

Making Securities Status Optional, Pros and Cons

Pros: --People/Organizations might opt in to take advantage of the reputational benefits of securities laws --Investors are capable of determining whether they want to invest in products that are registered securities or not --Current approach is just a "police at the elbow" approach that targets the least cost avoided Cons: --Allows issuers to choose most beneficial regime, which can be detrimental to purchasers due to lack of disclosure ----Fraud → the point of protecting individual investors evaporates --Lack of information can lead to investors making poor decisions

Puffery

Puffery is language that investors all realize is over-inflated and don't rely on / discount Puffery may simply be subset of more general definition of opinion Knowledge that certain lang is window-dressing and is systematically over-inflated is already broadly in the total mix of information --Therefore, puffer does not mislead given total mix of information -- Key to puffery is avoiding concrete numbers

Logic for Regulating Fraud

Rational investor problem → Rational Investor Assumption: Market participants are rational actors, who are self-interested utility maximizers who never make mistakes --Rational Investor Problem: Take filings to be true and assume the filings to be accurate Irrational Investor problem → Less sophisticated individual investors may be particularly vulnerable to fraud Means for Corporations to Distinguish Themselves as Truthful → --Reputational intermediaries → use Big 4 accounting firm to borrow legitimacy --Anti-fraud liability is a cost effective means of achieving this goal

Contexts for Mandatory Disclosure and how materiality qualifies disclosure obligation

Registration Statement: Securities issuers in public offering must file a registration statement w SEC containing info on: (Securities being offered, Use of proceeds, The Business, Managers & their comp, and Financial info) -- Definitions for info items are contained in Regulation S-K Periodic Reports: Publicly-held cos that trade on exchange OR meet certain shareholder # and asset value threshold MUST file periodic reports w SEC (Forms 10-K, 10-Q, 8-K) Regulation S-K: Info items sometimes req disclosure of only "material" info -- e.g. Item 101 of Regulation S-K (Description of Business) Reqs that affirmative statements are materially accurate and complete (Rule 408, Rule 12b-20) -- Rule 408: Deals w info in registration statement -- Rule 12b-20: Deals w info in mandatory "statement or report" under Exchange Act (like periodic disclosure reqs) Anti-Fraud Provisions: Once firms begin to disclose some info, they have duty imposed through anti fraud rules to not make a material omission necessary to avoid half-truths Insider Trader Restrictions: Insiders have duty to either "disclose or abstain from trading based on material, non-public corp info under Rule 10b-5

Common Stock

Residual and discretionary dividend Residual liquidation rights Voting rights for major corp decisions

Securities are intangible, provide value through →

Rights to cash flows Rights to assets in liquidation; AND Voting rights

Implied Private Cause of Action

Rule 10b-5 does not specifically mention WHO has standing to bring Rule 10b-5 action --^ Unlike § 11 (claim for fraud in registration statement), § 12(a)(1) (claim re: sale / offering of unregistered security), and § 12(a)(2) (claim for fraud in prospectus or oral comm re: sale / offering of security) --Limited implied private cause of action since Kardon v. National Gypsum ----But a series of SCOTUS cases and Private Securities Litigation Reform Act have imposed significant limits to scope of private cause of action ----Other antifraud provisions provide for a private cause of action such as § 11 and § 12(a)(2) in the Securities Act --Distinguishing feature of Rule 10b-5 is its broad scope

SEC's view on numerical rule of thumb → SAB Bulletin No. 99 (1999)

SEC has no objection to use of numerical rule of thumb to make prelim assumption that deviation blow amount for particular financial statement item is unlikely to be material -- HOWEVER, this is only beginning of materiality analysis and details non-exhaustive list of qualitative considerations that may make small misstatements material

Argument for Mandatory Disclosure

The more risky voluntary disclosure is, the stronger arg for mandatory disclosure Overcome collective action problem: creates + adapts disclosure rules to investors' info'l needs -- Standardized disclosures make comparisons across cos easier → lead to better investment decisions + more accurate securities pricing -- Overcomes coordination problems in creating and sustaining standardization Addresses agency cost issue in holding managers accountable for disclosures -- Eliminates corp's cost for manager's poor decisions by holding manager liable ----Bc managers' comp is tied to higher stock price, they have incentive to delay or conceal abad news ----Fear of replacement may make managers conceal bad news until they can turn things around, which may magnify underlying problems Positive externalities from mandatory disclosure -- Ensures that all firms must produce uniform system of info which benefits both investors and competitors ---- w/o this, each firm acting individually won't disclose to optimal extent, partly bc other firms can free ride on info generated re: industry, products, and financial Reduces duplicative research and resulting social waste -- First mover advantage for securities research reaps most of available products -- Disclosure eliminate temporary info'l advantages by conveying info swiftly

Why bring claims under both § 11 & Rule 10b-5?

The same act can be a plausible claim under both Longer statute of limitations Potentially broader set of defendants If one cause fails, can still possibly win on the other one

"In connection with the purchase or sale of a security"

To establish Rule 10b-5 action, P needs to show that the allegedly wrongful act occurred in connection with purchase of sale of securities --Difficult cases → outside the bounds of priority ----e.g. someone who did not purchase or sell a security (but claims they would have but for the fraud) attempts to bring suit ----e.g. purchaser or seller is not suing person on opposite side of securities transaction, but someone else "connected" with the transaction ----Factors to focus on while deciding difficult cases → Blue Chip Stamps: Actual purchaser or seller requirement Zandford: Boundaries of the "in connection with" requirement Cendant: Lead P requirement in a class action Central Bank of Denver: Status as a D is also tied to the "in connection with" requirement -----Ds = those who engage in material misstatement OR omission "in connection with purchase or sale" of sec

3 Types of Trading Forums →

Traditional Securities Exchanges: NYSE, ASE Physical trading floors (each security has specialist) + elec order systems NASDAQ: Nat'l Securities Exchange serves as most important elec market -- 3 tiers of markets w diff listing reqs ----Distinctive Feature: Dealers hold themselves out as being willing to continuously buy and sell at publicly quoted prices ----NASDAQ and NYSE: Self-regulatory orgs that set min capitalization and listing reqs for issuers that go above SEC mins ----FINRA: self-regulatory org that oversees broker-dealers who participate on trading forums Electronic Communications Networks: Bypass specialists and market makers by directly linking buyers and sellers

Intermediaries for Primary Market Transactions

Underwriters: Investment banks provide advice and financial expertise to issuers and market securities to public - 2 Roles → -- Firm commitment: commits to purchasing securities at discount AND guaranteeing sale of certain # of shares to investors -- Best efforts offering: commits to trying its best to sell shares,but makes no guarantees of share sales Attorneys: Oversee issuers and underwriters with regulatory reqs for IP + disclosure obligations once securities are issues Accounting Firms: Audited financial statements legitimize co's financials = key for investors --Reputational Leasing --Oversight Challenge Institutional Investors: Mutual funds and pension funds are main targets bc deep pockets to buy IPO chunks --Benefits ----Sophistication ----Deep pockets --Downsides ----Diverging incentives / conflicts of interest ----Potential passivity

No Personal Facts Exception

Whether personal facts must be disclosed turns solely on test of material y+ duty to disclose w/o special attention to whether such facts are "personal"

Must Investment be an Active Decision

Yes lol Part of employment (no choice) Magnitude matters → if it was hella big, then one can see that he could work for sake of investing, not work to get salary

Can Common Enterprise exist with Single Investor?

Yes → if 1 person buys all STOCK of a corp, this = securities transaction despite absence of collective action problem (Landreth) -- Part of logic → single purchase could 1 day put stock back into market HOWEVER, outside of clear stock context, collective action rationale behind sec reg disclosures may not weigh as strongly in favor of finding a common enterprise if there is just 1 investor SEC v. SG Ltd. - (1st Cir 2001)

How Rule 10b-5 could provide better protection than § 11

e.g. Company under-prices IPO and price goes from $10 at initial offering price to $30 w/in first day of trading, but falls back to $10 after a month of trading If you bring § 11 and Rule 10b-5 claim re: alleged material misrepresentation (or omission where there was duty to disclose) in IPO offering materials, you have 2 very different results → -- § 11: No damages → focus is on moment of initial public offering --Then price was $10 and now price is $10 because of alleged material misrepresentation in registration statement Rule 10b-5: Range of class participants of those who purchased $30 down to those who paid $10.01 in reliance on allegedly materially misleading registration statement --Damages sought = difference of purchase price and $10

Rule 10b-5 - Private Cause of Action

§ 10(b) of Exchange Act Authorizes SEC to adopt rules governing any manipulative or deceptive device in connection with the purchase / sale of any security Rule 10b-5, adopted pursuant to § 10(b), forms general anti-fraud provision of Exchange Act Rule 10b-5 prohibits → --Fraudulent devices and schemes, --Misstatement or omission of material facts, AND --Acts or practices that operate as a fraud or deceit, in connection with the purchase or sale of ANY security

3 Broad Components of Definition of Security under § 2(a)(1) of 1933 Act and § 3(a)(10) of 1934 Act

Broad exclusion from treatment as security if "the context otherwise requires" - i.e. discretion to SEC to exclude instruments from securities laws Laundry list of instruments many would commonly expect to be securities including stocks and bonds' AND More ill-defined terms such as "investment contract" - Vests degree of discretion in SEC in treating instruments as securities

Guiding Lights for Materiality

Case law Numerical rules of thumb

Main distinctions among Common Stocks, Preferred Stocks, and Debts

Cash flow rights Liquidation rights Voting rights

Note

Characteristics of notes → Fixed, periodic, and certain interest payment Fixed maturity date No voting rights Variations → contractual protections, interest rates, etc.

Securitization

Concept of pooling mortgages or other debt assets, then selling interest in pool to 3rd-Ps Benefits: Primary lending institutions like this bc it provides means for lender to get money back + keep liquid Allows diversification of risks + provides new investment vehicle for interested investors Debtors like this bc it allows lenders to charge lower interest rates Moral Hazard: allows banks to pass risk to 3rd-Ps as unclear to what extent reputational concerns will incentivize banks to screen mortgages carefully when they don't internalize default risk Dodd-Frank was 5% skin in the game req to securitization s to ensure that banks internalize more of the risks

"Investment of Money" can mean some other form of consideration

Consideration may vary based on how likely the consideration is something that otherwise would have been invested in the public capital markets Teamsters v. Daniel - (SCOTUS 1979) → Economic Realities

Cons of Requiring Disclosure of all info (including immaterial info)

Cost Chilling effect on info creation Info overload Concern re: disclosure to competitors

Standard for Dismissal for Lack of Materiality

Ct can't dismiss UNLESS omitted facts "are so obviously unimportant to a reasonable investor that reasonable minds could not differ on Q of their important"

Solely from the Efforts of the Promoter or a Third Party

Cts have not read the word "solely" literally in interpreting this Focus is on the degree of individual effort --The greater the degree of individual effort, the less of a need to find a security exists → ----The less likelihood of asymmetric info ----Need to be wary of expanding securities laws too far away from capital markets ----More involved you are, the more disclosure info and anti-fraud protection impose excessive transaction costs ----Degree of involvement may be viewed as proxy for sophistication and negotiation capability of investors → less need for protection Dividing line is likely issue of managerial control SEC v. Merchant Capital, LLC - (11th Cir 2007) → Solely does not mean solely

Should Cts focus on info analysts focus on rather than the gen pop of investors?

Cts should focus on the info analysts focus on, bc the paternalistic mission of securities law is to protect small investors, who invest through pensions, IRAs, and institutional investors (who rely on analysts) → essentially, small investors rely on institutional investors, so focusing on analysts does not undercut the small investors' interest Counter → Cts should not focus on analyst info, because gen pop hyper-specific tools to analyze information about M&A, IPOs, etc., which undercuts paternalistic mission of protecting small investors, and undercuts paternalistic mission

Rule 10b5, Defenses/Damages/Statute of Limitations

Defenses --Forward Looking statement Safe Harbor (Asher) Damages --Out-of-Pocket Damages (usually) --Proportionate Liability (21D(f) of '34 Act) Statute of Limitations --2 / 5 year - 28 USC § 1658(b) ---Earlier of two after discovery of facts underpinning Rule 10b-5 claim or 5 years after violation

Private Securities Litigation Reform Act of 1995

Designed to address shortcomings of Ps' bar class actions, key components → --Stay on discovery until after the motion to dismiss --Pleading with particularity req leading to strong inference of scienter --Lead P Provision: Rebuttable presumption that lead P in class action should be shareholder with largest financial interest in class action --Reasonable attorney fees --Proportionate liability for Ds not engaged in intentional fraud

Incentives for Settlement of Class Action Suits

Directors and officers liability insurance policies Incentives to settle depend on: -- Attorney's fees -- Distraction of management -- Case clouds over the biz bc its an outstanding problem -- Lower cost for yeeting "frivolous" litigation suit

Overview of Capital Markets, 3 Key Concepts

Distinction b/w primary and secondary markets Existence of several diff major secondary markets e.g. NASDAQ, NYSE, ECNS Liquidity and price transparency → vital for functioning of secondary markets

Forward-Looking Information

Equity investors focus on future prospects of issuer How does combo of past facts and future possible events affect "total mix" of info available to reasonable investor?

Informational Efficiency

Even if investors have behavioral biases and engage in irrational exuberance and other pricing errors, stock prices quickly reflect new info in efficient way Focus: on relative changes in stock prices in response to new public info, RATHER than if stocks reflect true underlying price of cos

Types of Frivolous Suits

Extortion / nuisance value Little evidence Expected cost of litigation > expected benefits

Virtues of the Plaintiff's Bar

Identify and investigate Expertise Coordinate Litigate Diversification

Significance of Alternative Regulatory Regime

If alt reg regime covers what securities law was meant to cover, then that instrument is not covered by securities law (Howey Test)

Why draw line at materiality, why not hold company liable for all misstatements?

Immaterial misstatements don't harm like material misstatements → you don't have standing

Summary of Distinctive Features of Securities and Securities Markets

Importance of capital markets and investments for economy Importance of investments relative to other decisions Investments often make people act irrationally Investment are intangible investments, thus, hard to value Collective action problems in situations where investors are dispersed Presence of alt regulatory regime (distinctive fed framework for securities + self-regulatory orgs)

Key factors to consider when determining whether securities law applies

Informational asymmetry Importance of capital markets Collective action problems High individual stakes Danger of opportunism Lack of another regulatory regime

Differences between stocks and goods →

Intangible Product: Securities provide value only through rights they provide investors Ownership of a share of common stock gives investor → - Pro rata rights to firm's cash flows (dividends) - Assets in liquidation - Right to vote to elect BoD (other significant decisions) Greater chance for fraud - Compare dollar value of IPO and tech boom in 90s to contemporaneous bubbles - Greater danger to capital markets - More stark collective action problem, as opposed to goods

Conflict between Shareholders and the Plaintiff's Bar

Interests of Ps' attorneys and shareholder class members may diverge, both over the size of attorney fee award + effort attorneys expend in litigation Ps' attorneys, unlike govt officials, are profit maximizers → file suit only when expect to profit --Attorneys won't file actions for clear-cut securities fraud if its small $ ----For smaller cos, private class action lit isn't important deterrent Ps' attorneys may settle too quickly to avoid expensive litigation bc they don't get full upside of trial award

How information disclosure matters

Intermediaries (brokers, mutual funds) filter info to investors Efficient Capital Markets hypothesis: info is rapidly incorporated into securities prices through the trading process. - 3 variants: weak, semi-strong, and strong

Howey does not apply to notes, BUT, if it did

Investment of money: Yes Expectation of profits (on investors part): Yes (at least to extend fixed interest payments are treated as profits) Common Enterprise: Yes Efforts of other: Yes

Mandate to Disclose Litigation or Criminal Activity

5th A privilege generally cannot form basis non-disclosure of past securities law violations Exception of Disclosure → Omission of fact that D has been informed by US Attorney that they were likely to be indicted for was not grounds for crim indictment for failure to disclose the potential indictment Mandatory Disclosures - Must disclose formal indictment - Must disclose office or director conviction of securities law violation, director or officer bankruptcy, or past role in cos that filed for bankruptcy - Must disclose crim cases and adjudications during previous 5 years and earlier crim cases if material for understanding of disclosed info - Must disclose self-dealing by officer or director even if unadjudicated - Unadjudicated civil cases against officers and directors and unadjudicated wrongdoing do not have to be disclosed, unless material bc substantially reflects on management integrity

Counterpoint to Mandatory Disclosures

Is more disclosure always better? Do we trust the SEC to do it better / be adaptable? - If not the SEC, who else? -- Private intermediaries Does mandatory disclosure significantly increase 3rd-P benefits? Risk of regulatory capture -- Higher change of regulatory mistakes w greater regulation?

"In a Common Enterprise"; purpose

Address collective action problems (sharpest in horizontal commonality) Even if 1 investor is at large informational disadvantage, investor can negotiation info as condition of investing / continuing to invest BUT, if there are many investors, no single investor may have incentive to seek out info bc benefit will accrue to all investors while investor seeking out info bears all costs = For this reason, common enterprises delineate terms of investor relationship, so that all investors know ex ante what rules are + don't negotiate individually

Affirmative Statements vs. Omissions

Affirmative Statements: Anti Fraud liability and SEC filing disclosure mandates (Rule 408 - Registration, Rule 12b-20 - Periodic Disclosures) req that affirmative statements are materially accurate and complete Omission: No general duty to disclose -- Paradox: Even if omission is material, omission by itself is NOT actionable under antifraud liability OR ANY OTHER violation of securities laws

3 possible ways to determine what "total mix" of information is

All SEC disclosure docs Anything financial advisors may reasonably look at, like SEC filings Anything that might possibly affect stock price

Should Cts focus on stock price movement OR lack thereof to determine materiality?

Arguments for considering → -- Under the efficient market hypothesis, the price reflects all material information, so if the information causes the price to move it is likely material -- Significant market response on day of disclosure may be evidence of materiality Arguments against considering → -- Disclosure statements could have positive and negative info → how do you know which is determinative of stock price changes? --Other info may arrive in marketplace from firm at same time that can generate noise in market price movement ----Initial disclosure may only contain limited info ----Market may be somewhat inefficient in processing new info --News of fraud may make negative reaction greater

Efficient Capital Markets Hypothesis

At any given time, prices reflect all available info about a particle stock or market - As prices respond only to info available in market, no one can out-profit others Strong Efficient Capital Markets Hypothesis → all info in market, whether public or private, is accounted for in stock price - Not even insider info could give investor advantage Semi-strong Efficient Capital Markets Hypothesis → all public info is calculated into stock's current share price - Neither fundamental nor tech analysis can be used to achieve superior gains Weak Efficient Capital Markets Hypothesis: Only past price info is incorporated into securities prices Policy Note → securities paternalism (govt monitoring) vs. private monitoring of info

Incentives to Settle Frivolous Litigation

Avoid litigation costs Avoid distraction litigation Avoid public embarrassment Avoid cloud of litigation's impact; and MOST IMPORTANT: Obtain directors and officer liability insurance coverage --D&O coverage excludes intentional fraud, but only if there is a finding of fraud at trial --Settling reduces risk that insurer will refuse to pay

Secondary Market Transactions and Players

Block Transaction vs. Brokered Trading for Masses Market Order →Broker seeks best available market price for customer Limit Order → Investor specifies price at which broker must buy or sell

In Re Merck & Co., Inc. - (3rd Cir 2005) → Analyst Standard

Facts: 01/02/22: Merck, D, announced IPO of its wholly owned subsidiary, Medco. Medco recognized customers' co-payments as revenue; Merck didn't initially disclose this revenue recognition on Form 10-K. 04/17/02: Merck disclosed revenue recognition, but not total amount of co-payments recognized → Merck's stock price rose from $55.02 to $55.05, and continued to rise for next 5 days. 21/06/02: WSJ published article reporting estimate of co-payments Medco recognized; right after publication, Merck's stock fell from $52.20 to $49.98. 05/07/02: Merck disclosed full amount of co-payment revenue recognized, and canceled IPO. Procedural History: Union, P, brought a securities fraud suit on behalf of Merck stockholders, claiming a violation of § 10(b) of the Securities Act of 1934; Merck filed a mo to dis on ground that Merck's disclosure or omission was not material; Dis Ct granted Merck's motion, Union app. Issue: D Holding: Omission/half truths re: revenue recognition were not material Rule: In efficient markets, information is material if it alters the price of the firm's stock at the moment the information becomes available. If info is important to reasonable investors, that importance will be reflected in stock price. The change in stock price need not be instantaneous; a change that occurs in the period immediately following the initial disclosure of the information is sufficient. Reasoning: Omission/half truths re: revenue recognition were not material Merck's disclosure of co-payment revenue recognition occurred on 04/17 → had no negative effect on Merck's stock price in period immediately following the disclosure. In fact, the stock actually went up $0.03 and continued to rise for the next five days. Accordingly, the disclosed information was not material. Even though S-1 filing did not disclose amount of co-payment recognized, which WSJ extrapolated to be $4.6 bil by calculating # of pharmacy prescriptions filed x assumed $10 co-payment, Ct held that arithmetic complexity req didn't undermine faith in an efficient market. Disposition: Aff

Basic v. Levinson - (SCOTUS 1988)

Facts: 1976: Combustion Engineering had discussions with BoD of Basic, Ds, about a possible merger b/w the corps. Over next 2 years, Ds made 3 public statements denying that it was engaged in any merger negotiations; in reliance on those statements, Levinson and other former Basic investors, Ps, sold their stock in Basic at artificially low prices. Ps brought a class-action suit vs. Basic BoD, alleging that the false public statements violated SEC Rule 10b-5. Procedural History: Dis Ct certified the class, but granted Summ J Ds, finding that statements about preliminary merger negotiations are not material statements of fact; 6th Cir aff class certification based on fraud-on-the-market theory of reliance, rev Summ J; SCOTUS granted cert. Issue: Can co statements about preliminary merger negotiations be material under Rule 10b-5? Based on a fraud-on-the-market theory, can individual class-action members be rebuttably presumed to have relied on false company statements? Holding: Affirmative false statement about material info triggered duty to disclose under antifraud provisions Yes Yes Rule: Co statements about preliminary merger negotiations can be material under Rule 10b-5 Based on a fraud-on-the-market theory, there is a rebuttable presumption that individual members of a P class of investors relied on false statements affecting price of co's shares Reasoning (Blackmun): Bc mergers can be the most important event in a co's existence, misstatements about merger negotiations can be material statements of fact. Whether they are or not depends on the facts of the case, and specifically, if there is a substantial likelihood that a reasonable investor would find the info significant given the total mix of info. An event may be contingent and probable, but still material → materiality is only intended to filter out unnecessary info Texas Gulf Sulphur Probability x Magnitude Test to determine materiality: Probability and Magnitude are fact-based inquiries → Probability: BoD resolutions, investment banker involvement, negotiations that may indicate increased probability of merger Magnitude: Merger premium, relative capitalizations of 2 cos determines magnitude of merger to a co's shareholders Req each individual P to prove actual reliance on misstatements would place an "unnecessarily unrealistic evidentiary burden on the rule 10b-5 P." Common sense that people who buy or sell stocks rely on the integrity of market, and this integrity is based on the available public info about cos → an investor's reliance on public misinfo about a co is therefore presumed under Rule 10b-5 Lower Cts' certification of Ps class aff, but presumption may be rebutted by D Disposition: Vacated, remanded.

Longman v. Food Lion - (4th Cir 1999)

Facts: ABC aired doc of Food Lion's disgusting practices and labor law violations; next day, Class A shares fell 11%, Class B shares fell 14%. Shareholders sued under Rule 10b-5, alleging Food Lion failed to disclose that its earning during a 2 ½ year period (05/1990 - 11/1992) were artificially inflated by fed labor law violations (forcing "off the clock" labor) + unsanitary food handling practices. Rule: Disclosure of information is not material under section 10(b) of the Securities Act of 1934 if the market already knew of the information at the time of disclosure. Reasoning: No material misstatements or omissions re: labor law violations Nature of off-the-clock claims and corresponding risk to earnings was already part of total mix of info before ABC broadcast Union's 07/1991 complaint Market had full opportunity to evaluate claims from that point in time Dept of labor settlement was small relative to earnings and experts viewed this as immaterial Stock price did not move at time of announcement of Dept of Labor settlement, which suggested immateriality of info No material misstatements or omissions re: unsanitary practices Statements were mere "puffery and generalizations that reasonable investors could not have relied upon when deciding whether to buy stock" Broadcast was mostly inadmissible hearsay and covered 3 of 1000s of stores → thus immaterial Food Lion had no policy supporting unsanitary practices Food Lion's stores scored at least as well as competitors' for sanitary St and Fed practices Disposition: Aff

Blue Chip Stamps, et al. v. Manor Drug Stores - (SCOTUS 1975) - § 10(b) Standing

Facts: Blue Chip Stamps, D, was req by US Dis Ct to make a tender offer for minority shares of corp in 1968. 2 years after tender offer, Manor Drug Stores, P, brought suit against D, alleging that D misrepresented its financial health in attempt to discourage minority shareholders from taking part in the tender offer, so that it could later purchase same shares at a lower market price. However, P didn't purchase or sell any Blue Chip Stamps during the time period in which misrepresentations were made. Procedural History: Dis Ct + Ct of App held that despite this fact, P had standing under § 10(b) of the Exchange Act to bring suit against D; SCOTUS granted cert. Issue: D Holding: Manor Drug Stores does not have standing to bring suit against Blue Chip Stamps in bc they didn't buy or sell Blue Chip Stamps stock when alleged misrepresentations were made. Rule: Only actual purchasers and sellers who acted in reliance on alleged materially misleading statements or omissions could bring suit under Rule 10b-5. No Exceptions. Reasoning: Second Circuit had earlier ruled that only purchasers and sellers who acted in reliance on alleged materially misleading statement or omission could bring suit under 10b-5. Alternative of including prospective purchasers was considered but not chosen by legislatures. Fear of vexatious litigation from allowing non-purchasers and non-sellers to have standing Key issue = lack of verifiability → whether P would have purchased something but for fraud is info solely in control of the P, and can't be disproved by the D Disposition: Reversed. Significance: Both prospective purchaser who never made purchase + shareholder, who thought about, but never made the sale of stock in reliance on material misstatement do not have standing under Rule 10b-5 Notes for Blue Chip Stamps SEC and Justice Department have standing to bring Rule 10b-5 action without showing an actual buyer or seller was defrauded Circuit courts are divided about whether a non-purchaser/non-seller can secure injunctive relief for Rule 10b-5 violations Shareholders who have neither bought nor sold can bring derivative action (on behalf of corporation) if the corporation has been engaged in buying or selling securities Rule 10b-5 standing for shareholders who have been fraudulently induced to give up their shares

Does Labor Count as Investment?

Labor can count as investment → if it is determinable consideration

Role of Risk Level in Determining Whether Its a Security

Level of risk presented by an investment affects whether it is a security, because securities laws are designed to reduce the risk created by investments -- If its low risk, but no other scheme mitigates that risk, SEC will find investment to be security Risks may take different forms: an investment with a low variability in returns = low risk bc returns are predictable but still entila's dangers

"With reasonable expectation of profits"

Look at the purchasers' motives Investors must be attracted solely by prospect of ROI → capital appreciation OR participation in earnings resulting from use of funds, not desire to consume United Housing Foundation v. Forman - (SCOTUS 1975)

Ganino v. Citizens United Co. - (2d Cir. 2000) - No bright-line numerical test for materiality

Facts: Citizens Co, D, was publicly traded corp that enjoyed 50 consecutive years of increases in earnings and revenue. 1995: 1 of D's large Ks fell through = D rushed to enter into another K with a telephone co providing services in HUN. Ds received a $$$ in transaction. However, instead of including this $$$ in its 1995 earnings statements, Ds spread this amount out over 1st two quarters of 1996 → resulted in apparent increase in revenue for 1st 2 quarters of 1996, which would not have occurred otherwise. When this was discovered by investors, Ganino, P, sued D. Procedural History: Dis Ct for D; P app to 2nd Cir. Issue: Is misstatement material if a reasonable investor would have considered misstatement significant enough to change their investment decisions? Holding: Yes Rule: Citizens' misstatement of its earnings was material because a reasonable investor would have considered it significant enough to change her investment decisions. Reasoning: Citizens' misstatement on its financial statements is material → misstatement is material if a reasonable investor would have considered misstatement significant enough to change their investment decisions. Citizens experienced increases in revenue + earnings for 50 years. Realizing D may not be able to continue growth, Ds manipulated its financial statements so that it would appear that these increases had continued for another year = a significant fact, which a reasonable investor would have considered in making an investment decision. Disposition: Reversed

Reves v. EY - (SCOTUS 1990)

Facts: Co-op, P, issued notes to both members and non-members at interest rate higher than that offered by local banks. P was audited by EY, D, who declared that P's assets were sound enough to issue said notes. 1984: P filed for bankruptcy → holders of the notes issued by P brought suit against EY, arg that EY violated the antifraud provisions of the 1934 Act. Procedural History: Dis Ct ruled in favor of P; EY app, 8th Cir reversed; SCOTUS granted cert. Holding: The notes were securities based on the "Family Resemblance Test' Rule: 4-factor balancing Family Resemblance Test for whether a note is a security → Presumption that if maturity is greater than 9 months, then it is a security Statutory exception → notes 9 months or less are not securities Then apply multi-factor balancing test Motives of lender and borrower Reasonable expectations of investors Plan of distribution resulting in common trading - or at least offered and sold to a broad segment of the public Presence of alternative regulatory regime Reasoning: Definition of a security balances competing concerns of stopping evasion of sec law and the need to limit applicability of securities antifraud liability "Stocks" are diff in that if an instrument bears out characteristics of a "stock" then it is "always an investment" (thus presumably a security) Notes are note like stocks, HOWEVER, not all notes are investments (or therefore securities) Notes are issued for consumption, commercial, or investment purposes, and ONLY those issued for investment purpose notes are securities Even if an instrument fails Howey test, it may still be a note → Howey test is not the sole test for a security Family Resemblance Test of Co-Op demand notes → Demand notes = securities bc → For general biz use Notes offered and sold to thousands Notes were sold as "investments" and public expected them to be securities AND There was no alt regulatory regime Ct rejected Co-Op defenses Demand notes posed risk, bc even tho they could demand repayment at any time, there was still bankruptcy risk Did not fall into statutory exception for notes w maturity of less than 9 months, bc demand notes could last for much longer

SEC v. Edwards - (SCOTUS 2004)

Facts: Edwards, D, operated a co that leased payphones; an individual would pay $7,000 up front and would receive a fixed return each month in exchange. D's co became insolvent → forced to declare bankruptcy. Upon declaring bankruptcy, SEC, P, filed suit against Edwards, alleging that his investment product was a security, and thus subject to federal securities laws. Holding: Sale-and-leaseback arrangements = investment contracts Rule: Investment promising a fixed rate of return can be an investment contract, and thus a security subject to federal securities laws. Reasoning: No reason to distinguish b/w fixed and variable returns → investments pitched as "low risk" are more attractive to most vulnerable group of investors (older and less sophisticated investors) Disposition: Reversed.

In the Matter of Franchard Corp - (SEC 1964)

Facts: Glickman was real estate developer who conducted biz through several corps, most successful of which was Venada Corp. When Venada encountered financial difficulties, Glickman started Franchard Corp, and purchased maj of its shares, elected himself to BoD → funds funneled from sale of shares of Franchard Corp to Venada, w/o knowledge of Franchard's shareholders or BoD, except for 1 board member who served on the board for both Franchard and Venada. SEC commenced these proceedings. Issue: Did Franchard properly disclosed Glickman's involvement in both Franchard and Venada? Holding: Registrant failed to disclose material info to Glickman's withdrawal of funds and pledge of shares No material omission in Registrant's failing to disclose that directors did not exercise req duty of care under St law Reasoning: Registrant failed to disclose material info re: Glickman's withdrawal of funds and pledge of shares Management quality is of cardinal importance to investors, particularly where shares are sold largely based on personal rep of co's controlling person Withdrawals were material transactions b/w Glickman and Registrant, even tho they accounted for less than 1.5% of gross book value of assets bc they account for higher % of equity or cash flow + involve controlling shareholder Pledges of shares posed possibility of a change in control → investors stood chance of losing Glickman Rejected arg that management should have privacy re: their personal affairs No material omission in Registrant's failing to disclose that directors did not exercise req duty of care under St law Obvious that Glickman would exercise dominant role as controlling shareholder BoD didn't completely abdicate responsibilities but instead met "regularly" and received info on Registrant from Glickman SEC is not empowered to determine regulatory standards of director behavior in conducting ord biz ops (matter for St law) Outright fraud or reckless indifference by directors may trigger disclosure reqs (since materially related to other info in registration statement) Disclosures may also be req where "affirmative reps" are made by which the performance of directors may be measured Disposition: Glickman must vacate BoD spot

SEC v. W.J. Howey Co. - (SCOTUS 1884)

Facts: Howey, D, is an FL corp that plants and sells orange groves. Howey-in-the-Hills Service, under common management with Howey, services orange groves in a large-scale farming operation. To raise money, D sold tracts of land to individuals. At time of the sale, buyers, who were typically not farmers or even residents of state, were offered Ks for maintenance of the groves by Service. 85% of the buyers signed service agreements. Service had near-total control of property + ops → purchasers would then share in the profits from sale of oranges. Procedural History: SEC, P, brought action against Howey for using interstate commerce to offer and sell unregistered securities in violation of § 5(a) of the Securities Act of 1933. Howey arg that it was not offering a security. Dis Ct and 5th Cir aff; SCOTUS granted cert. Issue: Are Ks involving investment of money in a common enterprise for a profit due to the acts of others securities under the Securities Act? Holding: Combo of offered land sales K and service K was an investment contract and therefore subject to securities regulation Rule: 4-part test for identifying an investment contract → An investment of money In a common enterprise With reasonable expectation of profits To be derived solely from the efforts of others Reasoning: Here, under "optional" service K, Howey affiliate exclusively oversees each citrus strip (w no access allowed by investors) and all proceeds are pooled and sold together in common enterprise w profits contingent on how all managed strips perform together Purchases primarily motivated in as investments and not generally "economically feasible: to develop land separately, making service K "essential" Even tho 15% of purchases did not buy the land-service combo, it was enough that Howey "offered" the combo Disposition: Reversed.

SEC v. Merchant Capital, LLC - (11th Cir 2007) → Solely does not mean solely

Facts: Merchant Capital, D, was in biz of buying and selling consumer debt, sold interests in several registered limited liability partnerships (RLLPs). Purchasers of RLLP interests were members of general public with no expertise in debt purchasing; became general partners. D served as managing general partner; no other options for managing general partner. Purchasers could only remove D as managing general partner for cause + partner unanimity. Purchasers were informed that they would participate in the partnerships + had power to participate in committees and call meetings, but their participation was in fact generally limited to checking boxes on ballots with very little info re: what they were approving. S pooled all of the purchasers' interests in accounts that were owned by D's servicer, New Vision, a wholesale debt purchaser + didn't register the RLLP interests with SEC. SEC brought an enforcement action, claiming that interests were investment Ks + D's failure to file a registration statement violated securities laws. Holding: The RLLPs met "solely through efforts of another" prong of Howey test Rule: An interest does not fall outside the definition of investment contract merely because the purchaser has some nominal involvement in the operation of the business. Reasoning: Solely is not literally interpreted, INSTEAD, focus is on dependency of investors on entrepreneurial or managerial skills of another Williamson presumption that general partnership interests are not securities are rebutted if → Partners have littler power in their hands Partners are inexperienced or knowledgeable in biz affairs; AND Partner can't replace the manager of the enterprise OR otherwise exercise meaningful partnership powers LLP is more likely a security compared with GP bc limited liability protects partner s→ leading them to be more passive Passive investors are more likely to need sec reg protection, altho, need to look at K to see if partners actually exercise control in venture Application of Williamson test to RLLPs Power distribution Experience and knowledge of partners General biz knowledge is not important Ability to replace merchant

SEC Mutual Benefits Corp. - (11th Cir 2005) - Pre-managerial efforts

Facts: Mutual Benefits Corp, D, was a viatical settlement provider; purchased life insurance policies from terminally ill individuals, continued to make premium payments, and sold interests in those policies to investors.For D + its investors to profit off a policy, policyholder had to die before their expected death date. D was supposed to estimate each policyholder's expected death date prior to signing settlement, but in practice often made life expectancy evals after closing settlements. D didn't register sales with SEC; SEC brought enforcement action, claiming that interests were investment contracts + D's failure to file a registration statement violated sec laws. Procedural History: Dis Ct found D's settlement contracts were investment Ks; D app, claiming that Ks weren't dependent on any post-purchase efforts by D so they could not be investment Ks + Ks only involved D's efforts prior to purchase, thereafter each K was dependent only on death date of policyholder. Holding: MBC's pre-purchase managerial activities satisfy the "efforts of another" prong → viatical settlements are investment contracts Rule: A purchase does not fall outside the definition of investment contract merely because the third-party efforts on which the investor relies occur before the purchase. Reasoning: Promoter D used expertise and negotiated price of the asset at issue (even tho ultimate value was determined based off of life-expectancy) Investors' expectations of profit relied heavily on pre and post-payment efforts of D to make viatical settlements profitable Howey and Edwards are "flexible tests → D's investment Ks = Efforts of another because → MBC identified patients Negotiated purchase prices Paid premiums Performed life expectancy analyses crucial to profitability Disposition: Affirmed

SEC v. SG Ltd. - (1st Cir 2001)

Facts: SG, D, started a website that operated a virtual stock exchange; virtual stock exchange was made up of virtual cos, stock of which website's users could buy or sell. Website stated that the users' funds were pooled into a single account from which users were paid when they sold virtual stock. D told users that the game was risk-free, guaranteeing at least a 10 % return + D would pay them on demand when they wished to sell. Website paid each user who referred a new client a bonus of 20% - 30% of the new client's buy-in. SEC, P, filed suit, alleging that website users' purchases of stock in virtual companies were investment Ks, thus req D + its website to comply with federal securities laws. Procedural History: Dis Ct dismissed the SEC's claim; SEC app. Holding: Virtual shares are securities Rule: The pooling of assets from multiple investors in such a way that all investors share in the profits and risks of the enterprise constitutes a common enterprise under the Howey Test. Reasoning: Characterization of a transaction as a "game" does not protect the transaction from securities laws → proper inquiry is whether the transaction satisfies the Howey Test. Here, investment of money and expectation of profits are met, so the the if game = a common enterprise. SG's game = a common enterprise of horizontal commonality because it (a) pools assets from multiple investors and (b) the investors share in the profits and risks of the game. The pooling element is met by literal terms of the game as described on the website, which states that users' assets are pooled. The sharing of the profits and risks element is met bc game operated in the form of a Ponzi scheme. Users' guaranteed returns were dependent on SG's bringing in new investors; w/o such new investments, SG may have been unable to pay investors upon demand as it promised. The funds of all users were inextricably intertwined + all users shared in reward of gaining and the risk of losing new investors. Disposition: Reversed Game vs. Investment If participants believe its a game, that = consumption, not participation

Landreth Timber Co. v. Landreth - (SCOTUS 1985) - Rejects Howey one test fits all → focus on particular categories of definition of security

Facts: Tax attorney (Dennis) with a few others negotiated and purchased all the stock of a lumber mill business. They had an audit done and an inspection as well. The old owner of the mill (Landreth) agreed to stay on as a consultant to help with daily operations of the mill. The mill did poorly, however, and Dennis and the other investors filed suit against Landreth seeking rescission of the stock purchase and damages, alleging violation of the securities laws in selling the stock without a registered public offering and securities fraud violations Issue: Was the "stock" an unregistered security? Holding: The stock in question = a security because it exhibits the characteristics of traditional stock, that is, the holding of an interest in a corp. Rule: Trad'l stock is the quintessential security as defined in the Securities Act of 1933, and thus further analysis is not required to determine its status as a security. Reasoning: Trad'l stock = clearest eg of a security as defined in the Securities Act of 1933, as it is explicitly mentioned in the statute. Ct distinguished Forman bc here Stock has stock-like characteristics, AND Key characteristics of stock that were identified in Forman The right to receive "dividends contingent upon an apportionment of profits" Transferability Voting rights in proportion to the number of shares owned Ability to appreciate in value Investors expect such instruments will fall under sec laws Sec law protections are designed for passive investors and active investors Tender offers, insider transactions, private placements, etc., are all w/in sec regime, so should view sec inclusively Furthermore, the general public has come to expect that traditional stock is considered to be a security. Since stock transferred here = traditional in that it involves the holding of shares of a corporation, it is a security as defined by the Securities Act of 1933, and thus must be registered. Disposition: Reversed.

Should it matter that all of the promoter's significant efforts were all contributed before the sale of the investment (rather than after the sale)?

MDC: Significant pre-purchase promoter efforts are enough for the promoter. --Life Partners Counterpoint: ongoing disclosure wouldn't benefit investors since all of Life Partners' pre-purchase efforts were reflected in the price paid by investors MDC: Value is from MDC's informational analysis and pricing --Life Partners Counterpoint: Because Life Partners' post-purchase efforts would not have a material impact on the outcome, Life Partners is not in an informationally superior position to the investor. MDC: MDC alone could gauge life expectancy and did not disclose --Life Partners Counterpoint: Key determinant of investment performance - life expectancy of the insured - is something available to everyone through life expectancy actuarial tables, etc. Landreth → Rejection of Howey test

Case for Voluntary Disclosures

Management positively influences securities prices Securities prices reflect prospects of issuer -- Non-disclosure increases uncertainty → adversely impacts price -- Incentive to reduce cost of capital → encourages issuer to make disclosure when selling securities AND make ongoing disclosure after public offering

Herman & Maclean v. Huddleston - (SCOTUS 1983) - Can bring § 11 and Rule 10b-5 suit

Facts: Texas International Speedway sold securities in a public offering to raise funds to build a speedway. The venture flopped and TIS went bankrupt. Plaintiffs are attempting to recover against TIS's auditor, Herman & MacLean because of allegedly fraudulent accounting statements Procedural History: S Issue: Are plaintiffs allowed to bring 10b-5 suits against auditors for allegedly fraudulent accounting statements? Holding: Cause of action under § 11 of Securities Act does not preclude bringing a suit under Rule 10b-5 of Exchange Act as conduct can be potentially actionable under both anti-fraud provisions § 11 narrow scope + low standard of liability + Rule 10b-5 broad scope + high standard for establishing liability (scienter) Reasoning: § 11 and Rule 10b-5 differ in their scope → § 11: Allows purchasers of a registered security to sue certain enumerated parties in a registered offering when false or misleading info is included in a registration statement IN CONTRAST, Rule 10b-5: Has much broader scope in allowing purchaser or seller defrauded in connection with purchase or sale of security to bring suit against "any person" who committed the fraud § 11 and Rule 10b-5 have different standards of liability → § 11: Issuers face virtually absolute liability for violations for material misstatement or omission Other § 11 Ds, like auditors, bear burden of demonstrating due diligence Rule 10b-5: Requires showing that D acted with scienter, i.e., with intent to deceive, manipulate, or defraud, which is a higher bar to claim § 11 was designed to provide heightened liability in public offering context It would run counter to this purpose to reduce liability by removing app of Rule 10b-5 liability if its requirements are met When Congress enacted changes to the securities laws courts had routinely allowed joint Rule 10b-5 and §11 claims → Congress did not change the law to close off this practice Ct states that "securities laws combating fraud should be construed 'not technically and restrictively, but flexibly to effectuate their remedial purposes" Significance: Rationale for Suit against auditors: Courts allow suit against auditors because they often are caught up in financial fraud of an issuer. PSLRA enacted a system of proportionate liability, corresponding to their responsibility in the fraud

United Housing Foundation v. Forman - (SCOTUS 1975)

Facts: United Housing, D, operated Co-op City, a housing project in NYC; to rent one of its units, potential tenants had to have an income below a certain level. Add'ly, tenants were req to purchase stock in the co-op. The stock would be repurchased by D upon the tenant vacating Co-op City, at same price that had been paid by said tenant. When D attempted to raise rents, the tenants/Forman, Ps, brought suit against D, alleging that P was misled in purchasing shares of the co-op, in violation of Securities Act of 1933. Procedural History: Dis Ct for D; Ct of App reversed; SCOTUS granted cert. Holding: Shares of stock allowing a person to use/consume item purchased, with no further opportunity for profit, are not securities subject to federal securities laws. Reasoning: Co-op stock did not fit stock category for definition of a security Primary purpose of sec reg is protection of capital markets Label of "stock" is not dispositive Need to look at → Economic realities (Howey test) Whether "stock" characteristics are there Co-op stock did not fit Howey test for investment contract Expectation of profits reqs that investors "be attracted solely" by prospect of ROI Capital appreciation OR participation in earnings resulting from use of funds, not desire to consume Altho "stock" could generate some income from leasing of comm'l areas and ops of washing machines, this was too speculative and insubstantial to make "stock" a security Purchase of co-op stock was primarily to obtain an apartment → = consumption Disposition: Reversed.

Hypothetical Ways to Make Voluntary Disclosure System Viable

Fed anti fraud liability → raises threat of legal liability under uniform standards K term commits issuer to disclose; non-disclosure = issuer liability Reputational backstop to accuracy of disclosures

Impact of Managerial Disclosures → Potential responses as shareholder to troubling ingo

File a derivative suit on behalf of shareholders claiming damages Mobilize shareholders to oust BoD Wage publicity campaign vs. management Sell shares

Debt

Fixed and certain interest payments - Conventional debt - Zero coupon bonds Highest liquidation rights - Liquation rights vary - Equity cushions No voting rights 2-way street → heightened returns vs. heightened risk

Preferred Stock

Fixed and discretionary dividend (priority over common stockholders) Medium liquidation rights (front of common shareholders = less risk, BUT, behind debt holders) Voting rights (generally contingent) - If defer dividends (2 / 3 quarters) may trigger voting rights Convertibility provisions allowing conversion of preferred stock to common stock Preferred stock K governs relationship w BoD - Fiduciary duties play gap-filling role

Various forms of commonalities

Horizontal Commonality → When returns to a group of investors are -- Pooled, AND -- Are correlated w one another (with pro rata distribution of returns) -- e.g. Howey and SG Ltd. Broad Vertical Commonality → -- The promoters' effort affect the individual investors collectively (even if no pooling of funds of pro rata profits) -- Different investors may receive diff returns (if there is more than one investors), AND -- Promoter does not necessarily have to share risk with the investors Narrow Vertical Common Enterprise → Same as broad vertical commonality except that the promoter takes on some risk of the investment going up or down with each individual investor (their returns are interwoven)

Why is horizontal commonality more worth SEC's time than vertical commonality

Horizontal Commonality: Need for sec reg is particularly strong when investors face collective action problem (all investors have same stake under horizontal commonality, none might negotiate for disclosures that would benefit all on their own accord) Vertical Commonality: Asymmetric returns based on individual efforts and/or promoter has something at stake = less need for uniform disclosure, as investors have greater incentive to push for info -- Turns on individual effort/performance

COUNTER ARGUMENT to MBC, SEC v. Life Partner (DC Cir 1996)

SEC v. Life Partners - (D.C. Cir 1996) Facts: Life Partners, D, operates a viatical settlement in which investors purchase an interest in life insurance policy of a person who is terminally ill. Settlement is paid out upon death of said terminally ill person. D puts settlements together, but is largely absent for remainder of investment. SEC brought suit against D, arg that viatical settlements are securities and must comply with securities regulations. Procedural History: Dis Ct for SEC; D app. Holding: D's viatical settlement is not a security bc it cannot be proven that the profits of the investment are the result of the efforts of D. Rule: Pre-purchase services are not sufficient to prove that the profits of an investment were the result of the efforts of others. Reasoning: The main factor that determines profit is the length of terminally ill person's life on which there is a life insurance policy → the longer the life, the less profit as the investors will be paying more of the terminally ill person's insurance premium. Only work conducted by D is pooling of funds from diff investors who are then matched up with life insurance policies. Since profits from viatical settlement are not primarily the result of the efforts of Life Partners ≠ a security under the Howey test. Disposition: Reversed.

How Investors Obtain and Use Info to Value Securities

Self-Help Limits: - Cost prohibitive for some types of info - Varied incentives to engage in info research

Logic of Class Action Suits: small v large number of shareholders

Small number of shareholders -- Efficient to spread costs of litigation as compared to potential settlement/damages Large number of shareholders -- Not one person has too big of a stake, but together, investors are more likely to participate/litigate and eventually win damages/settle

Duty to Disclose

Specific duties to disclose may flow from mandatory disclosure reqs contained in securities laws Affirmative, yet incomplete statement, may give rise to duty to disclose add'l info necessary to ensure that initial statement is not materially misleading

Federal Securities Law vs. State Corporate Law

St law primarily governs corp governance bc corps are legal entities created under St law - Diminutive DE's dominance of Corp Law Securities law is exclusively fed law class w limited role for St blue sky laws (combining disclosure reqs w limited merit review)