978-1285770178 Lecture Note BL ComLaw 1e IM-Ch07 Part 2

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 11

whole or in part.

Blackstone raised more than $4.5 billion through the IPO. Blackstone officers received nearly all

of the net proceeds. If the company had disclosed the omitted information in its registration

statement, how might these results have been different? Informed investors would probably not have

been willing to pay the same price for shares of Blackstone’s stock as they paid without the omitted

information. Thus, most likely, the amount of capital raised through the IPO would have been less, and the

Litwin alleged that Blackstone had negligently omitted material information from the registration

statement. What will he and the others have to show to prove their case? To succeed in a negligence

action, the plaintiffs must prove that (1) the defendants owed a duty of care to the plaintiffs, (2) the defendants

breached that duty, (3) the defendants’ breach caused injury to the plaintiffs, and (4) the plaintiffs suffered a

ANSWER TO “THE ECONOMIC DIMENSION”

QUESTION IN CASE 7.1

Blackstone raised more than $4.5 billion through the IPO. Blackstone officers received nearly all

of the net proceeds. If the company had disclosed the omitted information in its registration

statement, how might these results have been different? Informed investors would probably not have

information. Thus, most likely, the amount of capital raised through the IPO would have been less, and the

III. The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 concerns primarily the resale of securities, requiring continuous,

periodic disclosure, under Section 12, by all corporations with securities on the exchanges and those

companies that have assets in excess of $10 million and five hundred or more shareholders.

whole or in part.

Section 10(b) and Rule 10b-5 prohibit fraud in connection with the purchase or sale of a security. Rule

10b-5 applies to virtually all securities transactions. The elements of a securities fraud action are—

ENHANCING YOUR LECTURE—

 CORPORATE BLOGS AND TWEETS MUST COMPLY

WITH THE SECURITIES AND EXCHANGE ACT 

regulations. The SEC treats statements by employees on online media, such as blogs and Twitter, the same

as any other company statements for purposes of federal securities laws.

BEWARE OF TWEETS CONTAINING FINANCIAL INFORMATION

problems with the SEC. Many of his former audience were disappointed by the company’s oversight, which

put an end to his spontaneous, personal, and informal style. Brewer-Hay is now much more reserved in his

tweets on financial matters and often simply repeats eBay executives’ statements verbatim.a

A 2008 SEC RELEASE PROVIDES GUIDANCE

The release also addressed company–sponsored blogs, electronic shareholders’ forums, and other

“interactive Web site features.” The SEC acknowledged that blogs and other interactive Web features are a

useful means of ongoing communications among companies, their clients, investors, shareholders, and

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 13

whole or in part.

subject to the antifraud provisions of federal securities laws. “While blogs or forums can be informal and

conversational in nature, statements made there . . . will not be treated differently from other company

statements.” In addition, the release stated that companies cannot require investors to waive protections

under federal securities laws as condition of participating in a blog or forum. (The release also cautioned

companies that they can, in some situations, be liable for providing hyperlinks to third party information or

a. Cari Tuna, “Corporate Blogs and ‘Tweets’ Must Keep SEC in Mind,”, online.wsj.com, April 27, 2009. Web.

b. SEC Release Nos. 34–58288, IC–28351, File No. S7–23–08. Commission Guidance on the Use of Company Web Sites.

A key to liability is whether inside information is material. Facts to be disclosed include—

• Fraudulent trading in the company’s stock.

• A dividend change (up or down).

• A contract for the sale of corporate assets.

Case 7.2: SEC v. Texas Gulf Sulphur Co.

The Texas Gulf Sulphur Co. (TGS) drilled a hole in 1963 that appeared to yield a core with an ex–

ceedingly high mineral content. Keeping this secret, TGS officers, directors, and employees made substantial

The U.S. Court of Appeals for the Second Circuit reversed and remanded. The test of “materiality” is

whether the information would affect the judgment of reasonable investors. An important factor in determining

whether the discovery of ore is a material fact is the importance attached to it by those who know of it. Stock

14 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

whole or in part.

by the information.

………………….………….…………………..……..………………………………..……………………………….…..

Notes and Questions

industry should be barred from purchasing stocks simply because they have developed an expertise about

that industry that enables them to make profitable investments. Should higher-level company officers as

well as directors be prohibited from holding company stock altogether to eliminate much of the

incentive to engage in insider trading? Because most officers and directors do not engage in insider

trading, such a proposal would probably not be helpful.

shortly thereafter.

to TGS, instead of playing down the drilling results, would the defendants have avoided liability?

Explain. Probably not. While revealing such news might have been “fairer” to the public, TGS officers,

directors, and employees still had material information the would affect the judgment of reasonable investors.

That information was not released in a timely manner.

stock without concern for liability if he or she—after the decision was made to buy or sell the stock—comes

into the possession of inside information relating to that stock.

is most probably yes, because the defendants’ trading was based on their possession of inside information of

a material fact without its public disclosure, which is a violation of SEC Rule 10b-5. Depending on subsequent

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 15

ADDITIONAL BACKGROUND—

officers with inside information could trade with impunity without disclosing the information (as long as they

avoided outright fraud). Although this rule is sometimes stated to be the majority rule, it has been applied in

few cases over the last ninety years. Instead, the courts have developed a number of “exceptions.” Some

state courts have developed an agency law theory. According to agency law, an agent may not profit from

using the property of his or her principal. It is reasoned by analogy that a director or officer may not profit from

way, there should be no conclusion of wrongdoing. Do your students agree with this contention? Does

insider trading in the stock of a corporation do no harm to the corporation? In Diamond v. Oreamuno,

24 N.Y.2d 494, 248 N.E.2d 910, 301 N.Y.S.2d 78 (1969), the court pointed out that, “despite the lack of any

specific allegation of damage, it may well be inferred that the defendants’ actions might have caused some

harm to the enterprise. Although the corporation may have little concern with the day–to-day transactions in its

stockholders.’”

3. Outsiders and SEC Rule 10b-5

Section 10(b) and Rule 10b-5 covers certain “outsiders” (those who trade on inside information ac-

16 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 17

ADDITIONAL BACKGROUND—

Misappropriation Theory—United States v. Carpenter

then buy or sell stock based on the probable impact of the column on the market and share the resulting

profits. David Carpenter, a news clerk at the Journal, also participated in the scheme, acting primarily as a

messenger between the conspirators. Over a four-month period, the net profits resulting from this trading

activity were about $690,000. Correlations between the “Heard on the Street” articles and trading in the Clark

account were noted at Kidder Peabody, and inquiries began. Later, the SEC began an investigation.

In United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), the U.S. Court of Appeals for the Second

Circuit upheld the convictions of the defendants, ruling that the defendants had violated insider-trading laws

by trading to their profit on the basis of information obtained by Winans in violation of his duty to his employer

to keep the information confidential. The court brushed aside the defendant’s argument that the

4. Insider Reporting and Trading—Section 16(b)

Section 16(b) provides for the recapture by a corporation of all profits realized by officers, directors,

and certain large stockholders of Section 12 corporations on any purchase and sale or sale and

purchase of the corporation’s stock within any six–month period. It is irrelevant whether the insider

18 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

whole or in part.

B. REGULATION OF PROXY STATEMENTS

Section 14(a) of the 1934 act regulates management’s solicitation of proxies from shareholders of

Section 12 companies. There must be full and accurate disclosure. SEC Rule 14a-9 is similar to the

antifraud provisions of Rule 10b-5. Remedies for violation range from enjoining a shareholder vote to

1. Scienter Requirement

Section 10(b) and Rule 10b-5 require proof of an intent to defraud or knowledge of the

misconduct—false statements, a wrongful failure to disclose material facts, or recklessness as to

the truth or falsity of statements.

Between May 4 and June 22, 2009, Boeing Co. made announcements that implied its Dreamliner, which

had not yet flown, was on track for its “First Flight” (a significant milestone in the development of new aircraft)

scheduled for June 30. Meanwhile, however, the plane failed important stress tests—before and after

redesign—and on June 23, Boeing canceled the scheduled flight. This presaged a delay in the delivery of the

Dreamliner to the airlines. Boeing’s stock price dropped more than 10 percent. On behalf of all persons who

………………….………….………………………………..………….………………………….……..…………………

Notes and Questions

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 19

whole or in part.

Initial pleadings are comprised of a complaint, a summons, and an answer. The pleading at the center of the

dispute in the City of Livonia case was the plaintiffs’ complaint.

The plaintiffs in this case consisted of persons who bought stock in the Boeing Co. between the tests of

its new 787–8 Dreamliner and the announcements of the cancellation and of the delay in delivery and who

the plaintiff must state facts giving rise to a strong inference of scienter at least as likely as any plausible

opposing inference.

The complaint in the City of Livonia case alleged violations of Section 10(b) and Rule 10b-5. The plaintiffs

claimed that Boeing Co. and its officers, James McNerney and Scott Carson, knew about the likely

Livonia case, the court concluded that the plaintiff’s complaint did not meet the requirement that a complaint

alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, the plaintiff

must state facts giving rise to a strong inference of scienter at least as likely as any plausible opposing

inference.

On the plaintiffs’ appeal, the U.S. Court of Appeals for the Seventh Circuit affirmed the dismissal. The

appellate court explained that “allegations * * * merely implying unnamed confidential sources of damaging

information require a heavy discount. The sources may be ill–informed, may be acting from spite rather than

knowledge, may be misrepresented, may even be nonexistent.” The court reasoned that the defendants had

20 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

whole or in part.

In the City of Livonia case, the plaintiffs alleged in their complaint that Boeing Co. and its officers, James

McNerney and Scott Carson, knew about the likely postponement of the First Flight of the company’s new

Dreamliner aircraft, even when those officers made public statements to the contrary. The plaintiffs asserted

that their allegations were confirmed by “internal e–mails” at Boeing, implying that someone inside the

confidential sources, which the court suggested the lawyers might have made to prevent the dismissal of their

case or to have prompted further discovery and thereby encourage the defendants to settle. The court

suggested that those sanctions should consist of a fine, but deferred to the lower court for the amount. That

court “may have additional insights into the accused lawyers’ conduct, by virtue of having spent more time on

the litigation than the appellate court.”

• Halperin v. EBanker USA.com, Inc., 295 F.3d 352 (2d Cir. 2002) (in investors’ action against three

corporations and several officers and directors, alleging that the defendants fraudulently misrepresented the

future registration of certain securities, the securities’ offerings did not contain material omissions—”[a]n

offeror is not liable for securities fraud simply because the investment did not turn out as the investor hoped”).

public forecasts that were materially false and misleading).

• In re Enron Corp. Securities, Derivative & ERISA Litigation, 235 F.Supp.2d 549 (S.D.Tex. 2002)

(investors stated claims, or failed to state claims, in securities fraud actions against Enron Corp., as well as

individual executives, attorneys, accountants, banks, and others, alleging elaborate and large-scale Ponzi