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Chapter 45 - Securities Regulation
45-11
d. Escott v. BarChris Construction Corp. (p. 1202). This is the most important case in
the history of Section 11. This case deserves careful treatment in class. We spend
almost an entire class period on it.
Points for Discussion: Ask your students why they think the court found the
misstated and omitted facts to be material to a purchaser of the BarChris debentures.
Current assets were overstated by a great amount, 15.6%. Current assets are
important to a debenture holder, because they indicate liquidity--the ability of
BarChris to pay its debts as they come due. Contingent liabilities were understated
liability to factors affected future liquidity and profitability. BarChris’s operation of
bowling alleys affected its business risk and indicated liquidity problems due to
customer defaults.
Review each defendant’s ability to meet his due diligence defense. First consider
Trilling. Trilling knew of some errors in the registration statement. Other errors he
should have known about because of his position (controller) within BarChris, which
Auslander must be pitied, for only unfortunate timing imposed liability on him. He
was an outside director, so he did not have access to the information to which
portions, the analysis is different. Here he had a duty to investigate. He could not
merely rely upon Peat, Marwick. Why was his checking with Dun & Bradstreet, the
person.
Note that Auslander, as a director, is liable even if he did not sign the amendment.
Trilling as an officer, had to sign to become liable; however, as a controller, Trilling
was required to sign. [See Securities Act Section 6.]
Additional Points for Discussion: Note that Peat, Marwick is liable for the audited
Chapter 45 - Securities Regulation
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expert. Therefore, it must make a reasonable investigation. PM made two
BarChris was operating the alley through a subsidiary.] The court held that he
should have discovered the dual names. Why? He had read minutes of a board of
directors meeting that BarChris’s chairman recommended that BarChris operate
Capitol Lanes. He also knew that Capitol Lanes was paying rentals to Talcott and
existed and was being operated by BarChris. Insurance is not usually maintained on
vacant land, because there is nothing to insure. Also one job cost ledger card and
two accounts receivable cards showed names of both Capitol and Heavenly on them.
Berardi’s said he didn’t look at these cards. Although GAAS doesn’t require an
that BarChris had to return the temporary cash deposit to Talcott, the court found
that it was not reasonable to expect Berardi to read all of BarChris’s correspondence,
absent a red flag. [Note that the underwriters, who are not considered in our excerpt
of the opinion, were required to read BarChris’s correspondence-with-Talcott file,
matters with Trilling instead of investigating independently, read only selected
meeting minutes--the ones given to him--ignoring executive committee minutes that
would have alerted him to the worsened receivables delinquency problem, and did
person has superior abilities (as a person’s level of intelligence, experience, and
education increases, a person is better able to detect red flags and to form a belief
Chapter 45 - Securities Regulation
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better opportunity to discover red flags concerning accounting data), and the
Although at one time there was some doubt about whether the courts would hold
auditors to a higher standard than GAAS, it is fairly clear now that GAAS is the
appropriate standard for Section 11 liability. See the professionals’ liability chapter,
Chapter 46, for an extended discussion of this issue.
anticipation of businesses seeking capital from investors in the new market economies.
American law has tended to be the model for those establishing laws in these emerging
economies, but each nation has its eccentricities. One constant, however, is that a country’s
laws apply to all issuers, both foreign and domestic.
G. 1934 Act Reporting Requirements
file may be suspended.
2. Briefly describe the documents that must be filed by reporting issuers. Note that these
documents are rarely seen by investors.
a. The 10-K report includes, in addition to information listed in the textbook at page
1207 information on material legal proceedings involving the issuer, descriptions of
law: four days after the occurrence of the event.
c. Log On (p. 1207): Students can check the SEC’s EDGAR database.
3. Short-Swing Insider Trading. Cover the disclosure obligation of insiders and their
liability for buying and selling or selling and buying their issuer’s equity securities in a
insider would not be buying and selling in such a short period of time unless he were
Chapter 45 - Securities Regulation
45-14
affect a court’s determination whether a person is an officer for purposes of section
16(b).
Example: Problem Cases ##8 and 9.
purchase merely made him a 10% holder.
Directors and officers need merely be a director or officer either when they buy or
when they sell.
H. Proxy Solicitation Regulation
1. State the function of regulating proxy solicitations: to allow shareholders to exercise
misstatements and omissions in proxy statements.
2. Shareholder proposals
a. The SEC proxy rules were adopted in 1983 and been amended slightly since then.
Critics charge that the rules have drastically reduced the level of shareholder
participation, harming the best interests of shareholders. Probably the better view of
in Chapter 43.
b. Review the SEC rules regarding excludable proposals. There are several other
grounds for excluding proposals that are not in the text, including:
1) the proposal is contrary to SEC rules or regulations.
2) the proposal relates to an election to a political office.
3) the proposal is moot.
4) the proposal is beyond the corporation’s power to effectuate.
c. Use the following examples of shareholder proposals to illustrate the exclusion rules:
1) A proposal to bar the Cracker Barrel restaurant from discriminating against gay
business operation.
2) A proposal to require cumulative voting for directors. Usually this would not be
excludable, but in one no-action letter, the SEC held the proposal excludable,
because under Wisconsin corporation law, cumulative voting was not permitted.
3) A proposal to require directors to retain impartial real estate appraisers to update
which require valuation of real estate at lower of cost or market.
Chapter 45 - Securities Regulation
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4) A proposal to require a supermarket chain to compile information on non-union
lettuce purchases and distribute such information. Not excludable, because it
does not relate to ordinary business and is mere compliance work.
5) A proposal to require Manville Corp. to disclose its contracts with university
business.
6) A proposal to require Firestone to take steps to initiate liquidation of the
misleading: what is a fair return?
7) A proposal that Humana Corp. make more charitable contributions because
false, but that it was misleading.
8) A proposal to require disclosure of corporate action taken to contain radioactive
material at a dam break. Not excludable. Not ordinary and not moot, because
the proposal wants more disclosed than has been previously disclosed.
9) Additional Example: Problem Case # 11.
d. You should follow shareholder proposals as shareholders react to the credit crunch
and falling market prices of 2008 and 2009. Several shareholders have proposed that
I. Ethics in Action: Sarbanes-Oxley Act of 2002 (p. 1209)
1. This is a good time to hit the changes imposed on public companies by the Sarbanes-
Oxley Act of 2002. If you want to cover all of Sarbox at once, you’ll want to assign
additional materials in Chapters 4, 43, and 46.
2. Cover the section on SOX 404, the most controversial part of the Act. You will want to
issuers?
J. 1934 Act Liability Provisions
1. Section 18. Note the similarities and differences between Securities Act Section 11 and
Chapter 45 - Securities Regulation
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
a. Review the elements of a Rule 10b-5 violation. Note especially that it is designed to
stop fraud. In an omission case, the fraud requirement dictates that there be a duty to
disclose, usually because of a fiduciary duty owed to the plaintiff.
If there is no fraud--that is, no misstatement or omission--there is no Section 10(b)
liability. Thus, mere corporate mismanagement or other breach of a fiduciary duty
that corporate managers owe to shareholders does not create Section 10(b) liability.
There must be a misstatement or omission of material fact.
Example: Problem Case # 13.
plaintiff.
Example: Problem Case # 15.
Additional Example: Introductory Chapter Problem (p. 1182).
Give special attention to materiality as it affects a corporation’s obligation to provide
continuous information about itself. This has been an important issue for over 20
years.
Example: Problem Case #12.
b. SRM Global Fund L.P. v. Countrywide Financial Corp. (p. 1212). This is one of
several cases that were brought against companies and their officers in the wake of
the financial meltdown of 2007 and 2008. Other cases include Problem Cases ## 15
and 16 at the end of this chapter. These cases are particular relevant to students.
common law.
Points for Discussion: What were the misstatements or omissions of material fact
that the plaintiffs alleged caused the plaintiff’s losses and the defendants to have
liability under Rule 10b-5? They are summarized in the first two pages and include
representations by the defendants that Countrywide had adequate reserves and
increase as loans mature, and warning that market interest rate increases would
reduce borrowers’ ability to meet the increased monthly payments on their ARMs.
These and other warnings were made in filings with the SEC and meetings with the
media. Note also how the court turned SRM’s fraud-on-the-market argument against
Chapter 45 - Securities Regulation
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Countrywide’s financial Armageddon existed only in hindsight. It is not appropriate
to judge someone’s action with the 20-20 vision of hindsight.
Additional Points for Discussion: The most telling argument, although it could be
used only with regard to the state common law of fraud claim, was that SRM must
have been taking stupid pills. OK, the court did not use that term, but it was clear
that the court found that SRM, being a large hedge fund and a very sophisticated
investor, should have done more to protect itself by investigating information
available to it and not to be misled by positive information. As we know from media
reports, SRM was not the only investor who failed to see the warning signs and lost
significant amounts of money in the financial meltdown.
important issues. The acceptance of the fraud-on-the-market theory was expected.
The adoption of a case-by-case basis for determining the materiality of merger
negotiations eliminated the division of the courts of appeals on the issue. Note also
that the court refused to accept the argument that administrative convenience
Example: Problem Case # 16.
e. Rule 10b-5 and trading on inside information
which summarizes the Chiarella and Dirks cases.
3) Insider liability. Chiarella and Dirks can be read to impose liability on insiders
when:
traded, and
b) there is a breach of the fiduciary duty either
* by using confidential corporate information in a transaction in the
corporation’s securities or
corporation’s shares.
4) Tippee liability. Chiarella and Dirks can be read to impose liability upon
tippees when:
a) there is an insider’s breach of his fiduciary duty by receiving a personal
benefit by disclosing confidential corporate information to the tippee,
Chapter 45 - Securities Regulation
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b) the tippee knew or should have known of the insider’s breach of his
fiduciary duty, and
c) the tippee uses the information in a transaction in the corporation’s shares.
d) Dirks v. SEC (p. 1217). Review the facts of this case, especially noting that
the SEC and state insurance departments failed to act on allegations of fraud
Points for Discussion: Why did the court rule that the insider, Secrist, had
not breached a fiduciary duty by making disclosure of the fraud to Dirks?
section 10(b)? Is this situation different from Secrist’s situation in Dirks?
Yes, because the director--unlike Secrist--is not solely motivated to get out
the fraud.
In footnote 14 (not included in the excerpt but summarized in the text on
which they may receive confidential information.
Additional Example: Problem Cases ## 17 and 18.
e) In December 2014, the Second Circuit of Appeals in U.S. v. Newman, 2014
U.S. App. LEXIS 23190 (2d Cir. 2014) held that tippees have liability only
if four requirements are met:
individual for personal benefit.
In the Newman case, the tippees were remote from the insiders, and they
knew next to nothing about the insiders and nothing about whether the
insiders received a personal benefit. Therefore, the court concluded that the
Chapter 45 - Securities Regulation
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The court stated that
and represents at least a potential gain of a pecuniary or similarly
valuable nature. In other words . . . , this requires evidence of "a
relationship between the insider and the recipient that suggests a quid
pro quo from the latter, or an intention to benefit the [latter]."
examination in order to become a financial analyst to editing the insider's
résumé and sending it to a Wall Street recruiter. Some of that assistance
began before the insider began to provide tips about Dell's earnings to the
tippee. The evidence also established that the other insider and the other
qualify.”
We will have to watch whether the Supreme Court will review this case and
state that the Dirks court defined personal benefit more expansively than did
the Second Circuit. Moreover, the Supreme Court may take issue with the
Second Circuit’s language that the tippee must “know” of the insider’s
5) Misappropriation Theory. Note that the Supreme Court has held that Rule 10b-5
information.
6) Note that trading on inside information is rampant due to the difficulty of
purely by monetary reasons. Ask your students what they think should be done
gained or loss avoided.
7) Several critics of the securities laws point out that prohibiting insider trading
results in market inefficiency. Permitting insider trading would make the market
more efficient because the market price of a security would reflect all available
Chapter 45 - Securities Regulation
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
information about the security. As a result, allowing insider trading would
benefit all investors by allowing them to buy and to sell at the efficient market
price.
securities markets, because it is perceived as being unfair. Allowing insider
trading would increase the likelihood that investors would not view investing in
cherish.
f. Aiding and Abetting Liability. Note that the Supreme Court in the Central Bank
case, noted in Chapter 46 at page 1249 and 1251, eliminated aiding and abetting
liability under Rule 10b-5. However, Congress modified the 1934 Act to permit the
SEC only to prosecute aiders and abettors. The Supreme Court explained aiding and
defendants’ own deceptive conduct.
Points for Discussion: Ask students whether they believe Scientific-Atlanta and
Motorola acted ethically by participating in Charter’s scheme to misrepresent its
financial position. It is clearly unethical. They knowingly enabled Charter to engage
in fraud, because they knew that Charter was going to account for the wash
bad behavior. They just don’t have to pay damages to the investors who relied on
Charter’s financial statements. Why? It is because those statements were Charter’s,
not Scientific-Atlanta’s or Motorola’s. Both defendants properly accounted for the
wash transaction. Charter did not. In other words, the aiders and abettors made none
the whole marketplace in which the Charter or other issuing companies do business.
That would expose a new class of persons to liability, increase the cost of being a
public company, and shift securities offerings away from U.S. markets. Scheme
liability would place liability even on a person’s who acts were a remote cause of the
g. Regulation FD
