SEC Action—The SEC may seek remedial actions against an issuer in violation of the law (i.e.,
it may compel the issuer to correct misleading information) or it may ask the Department of
Justice to pursue criminal actions against the alleged violator.
Add. Info: The Supreme Court held, in Musick, Peeler & Garrett v. Employers Insurance of
Wausau (1993), that when securities fraud occurs and damages are assessed, the defendants
have the right to seek contribution form others, such as accountants, lawyers, and other parties
who may have shared responsibility for the violation. Since these suits are normally in the
millions, there is a strong incentive to drag in all parties related to the transaction.
Add. Case: Harden v. Raffensperger (7th Cir., 1995)–Firstmark, a financial services company
and a member of NASD, issued $20 million in bonds. NASD rules prohibit companies from
issuing their own securities without hiring a “qualified independent underwriter” to perform
due diligence on the registration statement and recommend a minimum yield. Firstmark hired
Raffensperger as its underwriter. Firstmark was in shaky financial shape, which the registration
statement noted. Raffensperger did not buy, sell, distribute or solicit orders for the Firstmark
bonds (the company did that itself); its duty was to prepare the registration statement and
recommend a yield. After the bonds were sold, the company went bankrupt. Bond buyers sued
Raffensperger, claiming that the registration statement contained material falsehoods and
omitted material facts. Raffensperger moved for summary judgement on the grounds that it was
not an underwriter because it did not offer the bonds for sale. Court said no. Raffensperger
appealed.
Decision: Affirmed. The Securities Act states that an underwriter includes any person who
participates or has “direct or indirect participation in” the purchase, offer, or sale of securities
in connection with their distribution. The Supreme Court has broadly interpreted who
Liability for Misstatements—A charge of securities fraud may be brought under the 1934 Act
for misstatements or omissions (material misinformation) about the financial status of a business
that has publicly traded securities. Liability may be imposed upon corporate officers or those
persons who aided in the preparation of materials containing the offending information. The
fraud may be based on any relevant business documents, not just the disclosure materials.
Add. Case: Basic Inc. v. Levinson (S. Ct., 1988)–Basic began negotiations with Combustion
Inc. about the possibility of merging the companies. Several times in 1977 and 1978, Basic
denied that it was in negotiations. In December of 1978, Basic’s Board of Directors accepted a
tender offer by Combustion. Shareholders of Basic, who purchased after the first denial and sold
before the merger, sued Basic and its directors. The shareholders alleged securities fraud under
Sect. 10(b) because Basic made false and misleading public comments. The shareholders were
harmed because they sold their shares before the tender offer and received a lower price per
share than they would have had they sold to Combustion.
Decision: The SCt announced here that it will impose a “standard of materiality” in securities
fraud cases. The standard is fact-specific and requires that statements be misleading as to a
material fact. That is, a piece of information will be considered material if there is “a substantial
likelihood that the disclosure of the omitted fact would have been viewed by the reasonable
Add. Case: Mercury Air Group v. Mansour (5th Cir., 2001)–Mercury, a company that sells
fuel to airlines, was uninterested in investing in Sun Jet, a new airline. Mercury was sent a
Private Placement Memo, which included financial projections as of May 30, and a statement
that the projections would not be updated. Mercury invested $500,000 on August 15. It was not
sent the new financials from Sun Jet that indicated a significant decline in prospects as of June
30. Mercury received that information on September 17. On October 1, Mercury gave Sun Jet $1
million in credit to buy fuel. Sun Jet was soon bankrupt. Mercury sued Sun Jet’s major officers
for Rule 10b-5 violations. The court dismissed the suit and imposed sanctions on Mercury.
Mercury appealed.
Decision: Affirmed. Sun Jet’s failure to update its income projections did not violate Rule 10b-5
since its materials specifically warned about the accuracy of projections and stated that they
would not be updated. Furthermore, Mercury decided to lend Sun Jet $1 million after it received
Add. Case: In Re Software Toolworks (9th Cir., 1994)–Software Toolworks (ST) produced
software for PCs and Nintendo games. ST issued public stock at $18.50 a share. The price fell in
a few months to $2.375. Investors filed a class action, claiming that ST, the auditor, and the
underwriters had issued a false and misleading prospectus and registration statement in
violation of the securities law and had defrauded investors in violation of Rule 10b-5. They
claimed the numbers in audited financial statements were falsified and that the information
about the size of orders on hand were false. ST and its officers settled for $26.5 million. Auditors
and underwriters were granted summary judgment by court, which found that they had used due
diligence in their duties and had made no material misrepresentations or omissions. Plaintiffs
appealed.
Decision: Reversed. It is for the jury to decide if the underwriters and auditors used due
Add. Case: Virginia Bankshares v. Sandberg (S. Ct., 1991)–First American Bank wanted to
merge with Virginia Bankshares. The bank board approved a tender offer of $42 per share for
the minority stockholders. The bank solicited proxies from the shareholders for a vote on the
merger. In material sent with the proxy, the bank urged shareholders to approve the merger,
stating that they would receive a “high” value for their stock. Sandberg did not give her proxy
and brought suit alleging that the bank solicited her proxy with materially false and/or
misleading statements.
Decision: The Court had to determine if the statements of opinion made by the board were
material. Shareholders attach great value to the opinions of directors of company. The question
for the Court became whether or not the statements made were actionable under §14(a) (SEC
Add. Case: Stransky v. Cummins Engine (7th Cir., 1995)–“The predicate for this case is a
familiar one: a company makes optimistic predictions about future performance, the predictions
turn out to be less than prophetic, and shareholders cry foul, or more specifically, fraud.”
District court dismissed the complaint. Class action shareholders appealed.
Decision: Reversed in part and remanded. Projections can lead to 10b-5 liability only if it was
not made in good faith or was made without a reasonable basis. The engine manufacturer’s
failure to update or correct optimistic projections concerning engine shipments and earnings per
share based on its alleged knowledge of rising warranty costs for engines could not form the
basis of a Rule 10b-5 fraud action. However, claims that Cummins had a duty to correct or
Add. Info: Securities fraud suits are common; many are settled; most are not successful if tried:
In re HealthCare Compare Corp. (7th Cir.)—HealthCare projected its earning that year would be
about $1.20 per share. Two months later the CEO said that those earnings estimates were too
high and that earnings would probably be under $1.10 per share. The stock price fell 30% in one
day and a shareholder suit was filed in less than 24 hours claiming securities fraud for the
earlier estimate. Appeals court upheld dismissal of the claim, agreeing that there was no
evidence that the statements were made without a reasonable basis.
Klein v. Software Spectrum (5th Cir.)—Stockholders sued Software when the company’s stock
price fell sharply when its disappointing financial results were released. Appeals court upheld
dismissal of the suit because plaintiffs failed to give any evidence of fraud, other than to assert
that the stock should not have fallen and that expectations of poor earnings should have been
revealed earlier.
Lasker v. New York State Electric & Gas (2nd Cir.)—NYSEG formed a computer software
company, Enersoft, to produce and sell software for natural gas utilities. High development costs
resulted in lower earnings than would have occurred if funds had not been diverted to Enersoft,
causing the stock to fall when a financial report was issued. Shareholders sued. Appeals court
upheld dismissal of the suit; there was no materially misleading information about Enersoft. “A
reasonable investor would not believe that, by merely making the broad, general statements cited
in this complaint, NYSEG has insured against the risks inherent in diversification.”
Safe Harbor—The Private Securities Litigation Reform Act (PSLRA) of 1995 provides a safe
harbor that gives immunity from suit for corporate forecasts that turn out not to have been
accurate, so long as the forecast was given with adequate disclaimers that warn of uncertainty.
The intent of the law is to reduce the number of securities fraud suits.
Federal Exclusivity—The 1995 Act did not do much to reduce litigation, so Congress passed the
Securities Litigation Uniform Standards Act of 1998. Which requires securities suits involving
nationally-traded securities to be heard in federal court (to eliminate big companies being drug
into courts in bizarre places such as small towns in rural Texas where the sophistication and
integrity of the system has been questioned). The Act also limited the basis for suit to try to
prevent innocuous “misstatements” from being the basis for suit.
CASE: City of Livonis Employees Retirement System v. Boeing (7th Cir., 2013)—Class action
was filed on behalf of all buyers of Boeing stock in a certain time period contending that Boeing
was overly optimistic about the ability to get the new 787 Dreamliner into service. When
problems became known, the stock price dropped. Claim was that executives made false
statements about the prospects for the plane, which was securities fraud. District court dismissed;
plaintiffs appealed.
Decision: The PSLRA says that a plaintiff must show actual knowledge of the falsity of a
forward- looking statement by company officials. The statement must have been made in a
Questions: 1. Would the result be different if plaintiffs could show that company leaders knew
for sure the plane was not as far along as was claimed?
Yes, that could be evidence of intentional misrepresentation; but that could not be shown here;
2. If a report is filled with cautionary statements about the future, does that provide strong
protection to a company and its executives against such claims?
Yes, the PSRLA was designed to give safe harbor to many corporate statements. Filling a report
Add. Case: Slayton v. American Express (2nd Cir., 2010)—Investors who bought AE stock
between 1999 and 2001 sued AE and its executives for securities fraud for misleading
statements. They claimed AW invested in too much high-yield debt (junk bonds) and lost large
sums but in an SEC filing in 2001 overstated the quality of future results. After the filing, AE
announced a huge loss in a write-down of the junk bonds. Investors claimed the SEC filing was
misleading, giving false confidence to investors. Suit dismissed. Appealed.
Decision: Defendants are not liable if the allegedly false or misleading information is identified
as forward looking and accompanied by cautionary statements. The SEC filing was accompanied
Add. Case: Ray v. Citigroup Global Markets (7th Cir., 2007)—SmartServ Online was hot stuff
during the dot-com bubble. It shares rose fast to a peak of $170 in early 2000. Citigroup brokers
recommended the stock and some customers bought it. It collapsed to under $1 per share.
Investors sued Citigroup, claiming misrepresentation. The district court noted that suit must be
under federal law in federal court and held there was no misrepresentation. Investors appealed.
Decision: Affirmed. There is no securities fraud. There is no causation between the opinion of
the brokers and what happened to the company. The fall in value was not due to any action by
Add. Case: Tellabs, Inc. v. Makor Issues & Rights (Sup. Ct., 2007)– Shareholders of Tellabs,
who purchased stock during a particular time period, accused the company and its CEO of a
scheme to deceive the investing public about the true value of the company’s stock. Plaintiffs
contend that the CEO falsely assured investors that Tellabs was going to enjoy strong growth,
when he knew the opposite to be true. During the time period in question, as negative news
became available, the stock price dropped from a high of $67 to $16. The class action suit claims
securities fraud. The district court agreed that, under the Private Securities Litigation Reform
Act (PSLRA), plaintiffs must plead their case with the particularity required by the law, not make
general assertions. The filing was amended, but the court rejected this as failing to show that the
CEO acted with scienter. The appeals court reversed, holding that plaintiffs had sufficiently
alleged that the CEO acted with the requisite state of mind. Tellabs appealed.
Decision: Vacated and remanded. In determining whether a securities fraud complaint gives rise to a “strong
inference” of scienter, within the meaning of the PSLRA, the court must consider alternative inferences that may be
Add. Case: Green v. Ameritrade (8th Cir., 2002)–Green subscribed to Ameritrade’s “real time”
stock price quote service. He sued Ameritrade because, he alleged, their price quotes were not
real time but often lagged hours behind actual sales. He sued for breach of contract under
Nebraska law. Ameritrade removed the suit from Nebraska state court to federal court and
moved to dismiss the suit as preempted by the Securities Litigation Uniform Standards Act of
1998 (SLUSA). The trial court held that SLUSA did not apply, so the suit should be heard in state
court under state law. Ameritrade appealed.
Decision: Affirmed. SLUSA was designed to curb abuse in securities suits that were filed under
state law to evade federal pleading requirements set by the Private Securities Litigation Reform
Act. The goal of SLUSA was to curb shareholder derivative suits in which the goal was a
windfall of attorney’s fees, with no real desire to assist the corporation on whose behalf the suit
Sarbanes-Oxley Act Requirements—Requires that the CEO and CFO of large companies with
publicly traded stock personally certify financial reports made to the SEC. This has forced a
significant increase in accounting and forced many companies to change their procedures, not
just for accounting, but for reporting on many aspects of operations. Knowing misstatements
have serious consequences. Protection is provided for corporate whistleblowers and creates a
cause of action for them if they suffer retaliation.
Add. Case: SEC v. Gemstar-TV Guide Intl (9th Cir., 2005)–In 2002, Gemstar revised its 2001
earnings statements downward; its stock then dropped sharply. Right before that filing, its CEO,
Yuen, sold 7 million shares of stock for $59 million. As soon as the accounting mess became
public, Yuen and CFO Leung resigned their positions. The board granted them about $37 million
worth of cash and stock. As permitted under the Sarbanes-Oxley Act, the SEC intervened, asking
the court to order the $37 million be placed in escrow pending the results of the investigation of
the accounting problems at the company. The district court granted the request, holding that
Sarbanes-Oxley allows “extraordinary” payments to be forced into escrow pending
investigations. The company appealed.
Decision: Affirmed. The payments made by the publicly traded company to its officers were “extraordinary,” for
purpose of the escrow order provision of Sarbanes-Oxley, since the nature, purpose, and circumstances of the
payments had nothing to do with the company’s ordinary business. The officers were resigning under fire. They were
INSIDER TRADING—Insider trading occurs when someone with information that has not
been made public, that affects the value of a stock, buys or sells the stock. Rule 10b-5 has been
used to prohibit this behavior, although the 1934 Act does not specifically mention insider
trading. The SEC originally used a 1961 administrative ruling (Cady, Roberts) to outlaw the
practice. The Texas Gulf Sulphur case of 1968 was the first federal court of appeals case to
uphold insider trading actions. Prosecutions for insider trading have become more common over
the past decade and generally involve persons other than corporate executives.
SEC Prosecution—The SEC may prosecute persons with insider information if they trade to
their personal benefit on the information before it is made public. The exact boundaries of the
law are not set, but the key tends to be when the information was stolen or when a fiduciary duty
has been breached.
Supreme Court Interpretation—The Supreme Court has helped to define who is an “insider”
for purposes of the federal securities laws. In Chiarella v. U.S., the Court held that a printer, who
in the course of his printing work obtained unreleased information about a stock and traded in the
stock to his profit, was not an insider. Chiarella owed no fiduciary duty to the shareholders of the
company in which he traded. He was simply a lucky outsider who happened to pick up a
valuable bit of information. Similarly, in Dirks the court found that the accused had not violated
a fiduciary obligation.
Add. Case: Dirks v. SEC (S. Ct., 1983)–Dirks worked for a broker-dealer firm. He was given
information that officers of Equity Funding were engaged in fraud, so company stock was
grossly overvalued. Dirks investigated and determined the tips were true. He informed his
clients, the Wall Street Journal, and regulators of his information. A sell-off of the company’s
stock began and prices dropped. The SEC charged Dirks with insider trading because he used
information not made public to trade in securities (for his clients). The SEC alleged Dirks should
have divulged his information to the public before informing his clients.
Decision: Reversed. For insider trading to fall under Rule 10b-5, the trader must have
personally benefited from the disclosure of non-public information. That is, he must have
garnered “secret profits.” Because Dirks owed no fiduciary duties to the company in question,
CASE: SEC v. Ginsburg 11th Cir., 2004)—Ginsburg was CEO of a company who was
discussing the possibility of merging with another company. He told his brother and father to buy
stock in the other company. When the merger was announced, they made a large profit. SEC
sued Ginsburg for insider trading. The jury ordered him to pay $1 million in penalties. Trial
judge set the verdict aside. SEC appealed.
Decision: Reversed; penalty is reinstated. The SEC did not have to prove that Ginsburg forced
Questions: 1. The Ginsburgs denied that the phone conversations were about a likely merger
between Evergreen and EZ, and there is no recording of the conversations, so how could
Ginsburg be found liable for insider trading for passing on private information?
They could not prove the content of the calls. It was for the jury to determine if the
circumstances were sufficient to prove the case. The calls were made and the purchases followed.
2. Why was this a civil case and not a criminal case?
The SEC probably thought that they would win a civil case but maybe not a criminal case, which
Add. Case: SEC v. Adler (11th Cir., 1998)–The SEC sued executives of a computer firm and
some of their business associates for insider trading based on material nonpublic information
about the firm concerning a forthcoming large order that would greatly affect the firm’s stock
price.
Decision: Mere knowing possession of material nonpublic information while trading is not a per
se violation of insider trading laws. There was a material issue of fact to be determined by a jury
Add. Case: Clay v. Riverwood International (11th Cir., 1998)–Riverwood granted to its senior
executives stock appreciation rights (SARs). They “would receive payment from the company
equal to the difference between the SARs grant value and the fair market value of Riverwood’s
stock at the time they exercised them.” Later, Manville Corp., majority owner of Riverwood,
decided to sell it. Deals with prospective buyers were negotiated. During that time, the
executives exercised their SARs for $7 million. Clay, a shareholder, sued, claiming insider
trading and securities fraud. District court dismissed the suit; Clay appealed.
Decision: Affirmed. The SARs were not securities. They were cash-only instruments, not stock
options, with no stock rights. Nor are SARs “privileges with respect to” securities, as may be
Insider Trading Sanctions Act—ITSA was passed by Congress in 1984 and gives the SEC a
specific statute under which to prosecute insider traders. Persons found guilty of insider trading
under this Act and their “controlling persons” may be subject to payment of treble damages
based on their illegal profits or losses avoided. Violators may also have to pay persons who
suffered losses as a result of their actions, with their illegal profits. Criminal penalties are
available. The 1984 Act was reinforced in 1988 by the Insider Trading and Securities Fraud
Enforcement Act, which increases the amount of fines that may be levied against private and
corporate insider traders. The 1988 Act also requires investment firms to police themselves in an
effort to keep employees from misusing material, non-public information. Recent cases have
extended insider trading liability from the individual responsible for the fraud to the “controlling
person” or corporation charged with protecting against such abuse.
Issue Spotter: Can You Exploit the Gossip?
You have no fiduciary duty to either firm, as you have no professional relationship to either one.
The elevator occupants should not be talking about the matter in public, but that is their problem.
Unless you think it unethical to trade on the information, you can do it. There is no insider
trading violation in that case. There is no reason to think it unethical either. Stock is being sold at
the current price–someone will get it–you or another buyer. That buyer is no more “deserving” of
the profit than you are.
International Perspective: European Approaches to Insider Trading
The U.S. has long had the toughest rules against insider trading, but other countries are moving
in that direction. The U.K. is now similar to the U.S. France and Germany have enacted tough
laws but enforcement, as in Italy and Japan, is not regarded as serious.
THE INVESTMENT COMPANY ACT—Passed in 1940, it mandates that investment
companies register with the SEC and gives it control of the structure of the companies. The Act
allows the SEC to regulate investment company activities and makes companies liable for
violations of these regulations.
Investment Companies—Investment companies invest or trade in securities. Three types of
investment companies exist: face-amount certificate companies, unit investment trusts, and
management companies (the most important). Investment companies that do not sell to the
public, but simply invest internally, are not subject to the public-related provisions of the Act.
Mutual Funds—Also known as an open-end or management company, a mutual fund is
composed of shares held by investors. The money from the sale of shares in a mutual fund are
invested in a portfolio of securities. The cost of a share in a mutual fund is thus determined by
the current value of the fund’s portfolio. Mutual funds may be: a) load (sold to the public through
a securities dealer who charges a sales commission), and b) no-load (sold directly to the public
through the mails, no commission).
Regulation of Investment Companies—Investment companies must register with the SEC, file
annual reports, and provide financial information on an on-going basis. Capital requirements for
these firms are determined by the SEC. Investors must receive, as dividends, at least 90% of the
taxable ordinary income of these types of firms.
Registration and Disclosure—The shares that investment companies sell must be registered with
the SEC like other securities. These companies must adhere to the registration and disclosure
requirements of the 1933 and 1934 Acts. Investment companies may only charge investors a
price per share equal to its current net asset value plus a maximum load of 8.5%.