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You Be The Judge: In re HP Secs. Litig.
Facts: Shortly after Léo Apotheker became CEO of HP, he decided to acquire Autonomy Corporation
at a cost of over $11 billion. His decision met with strong resistance from HP executives, including
CFO Catherine Lesjak. But he persisted. The day after HP announced the acquisition, its stock price
dropped 20 percent.
A week before the Autonomy deal was to close, the board of directors replaced Apotheker as CEO with
Meg Whitman. She sought to terminate the Autonomy acquisition but was told that the United
Kingdom's takeover rules made that impossible. Here is the timeline of events thereafter:
1. October: The Autonomy acquisition closed. Over the next few months, HP learned that
Autonomy's earnings and growth numbers were inaccurate.
2. February of the following year: In a conference call with investors, Lesjak attributed HP’s
weak revenue numbers to “acquisition-related integration costs and accounting adjustments.”
3. May 23:
a. Whitman learned that a senior executive at Autonomy (referred to as “Whistleblower
No. 4”), was warning of serious accounting improprieties. HP hired
PricewaterhouseCoopers to investigate.
b. Lesjak told analysts that HP's “second-quarter operating profit for software was
unfavorably impacted by acquisition-related integration costs.” She was not asked
about, nor did she choose to comment on, Autonomy's performance.
c. On the same call, Whitman said:
“When Autonomy turned in disappointing results, HP actually did a fairly deep dive to understand what
had happened here. And in my view, Autonomy is a terrific product. There is an enormous demand for
Autonomy.”
4. June 5: During a press interview, Whitman stated about Autonomy:
“In my view, this is the classic case of scaling a business from startup to grownup. Going through that
barrier of a billion dollars in sales is not easy because you can't run the organization at $1.5 billion the
same way you did at $500 million. You just can't. And for many entrepreneurs, processes and discipline
are dirty words, and you have to have those things, especially within the context of HP. I know exactly
how this world works. I have every confidence that Autonomy will be a very big and very profitable
business.”
5. August 22: On a conference call, Whitman said, “Autonomy still requires a great deal of
attention and we've been aggressively working on that business.”
6. September 10: HP's Form 10-Q reported that: “At the time of the Autonomy acquisition in
October 2011, the fair value of Autonomy approximated the carrying value.”
7. Fifteen months later, on November 20: The PriceWaterhouse investigation was complete. HP
announced that Autonomy had been a fraud. It wrote down the investment by $8.8 billion. HP's
stock dropped another 12 percent.
Shareholders filed suit alleging that the Whitman, Lesjak, and HP had committed fraud under §10(b).
The defendants filed a motion to dismiss, arguing that they did not have the requisite scienter.
You Be the Judge: Did the defendants have scienter?
Argument for the Shareholders: Even before the deal closed, executives at HP knew that it was a
mistake. Lesjak argued against it; Whitman tried to back out; yet still, it went forward. Then HP
discovered that Autonomy’s numbers were inaccurate. Later, Whistleblower No. 4 came forward. (It is
always a bad sign when there are so many whistleblowers, they have to take a number.)
Yet, for eight months, HP executives made filings with the SEC and statements to investors that gave
no hint of trouble. Whitman even made up a whole story about how Autonomy was just going through
growing pains. She stated that “Autonomy is a terrific product”—an odd description for a fraudulent
deal. She could have honestly answered any questions about Autonomy by saying she did not know
why it had underperformed but was actively investigating.
HP said in a filing that, at the time of the Autonomy acquisition in October, its fair value approximated
the carrying value. The senior executives could not possibly have believed that statement to be true. In
short, they deliberately duped and defrauded investors.
Argument for the Company and its Executives: Yes, there were rumors and allegations about
Autonomy, but not until November 20, when the PriceWaterhouse investigation finished, did the
defendants know for sure that the deal had been a fraud. As soon as the company knew, it made the
public announcement. Taking time to investigate a situation before making disclosures to the investing
public is not fraudulent, it is prudent and reasonable.
Moreover, many of defendants' statements were nothing more than puffery. Whitman said that
“Autonomy is a terrific product. There is an enormous demand for Autonomy.” This sort of optimistic
language does not create liability.
Even if some of their statements are untrue, HP executives are not liable if they acted carelessly, or
even recklessly. Under the scienter requirement, shareholders must show that the defendants acted with
intent or deliberate recklessness. Autonomy was a bad deal, but no one intentionally engaged in
wrongdoing. HP was the one who was duped.
Holding: All charges were dismissed, except for the ones against: (1) Whitman, for her statements on
May 23 and June 5 and (2) HP for its statements on September 10. The court ruled that Whitman’s
statement on August 22 was accurate enough not to have scienter.
Question: What is scienter?
Question: What is required for a defendant to be found liable under Rule 10b-5?
Case: Erica P. John Fund, Inc. v. Halliburton Co.
Facts: The events of this case occurred in the following order: (1) Halliburton Co. made a series of
statements about its potential liabilities and expected revenue; (2) the Erica P. John Fund, Inc. (EPJ)
purchased Halliburton stock on the open market; (3) the company corrected its prior disclosures; (4) its
stock price fell, causing EPJ to lose money; and (5) EPJ filed suit against Halliburton, alleging that the
company’s initial statements had violated §10(b) and Rule 10b-5.
Halliburton asked the court to overrule Basic v. Levinson and require EPJ to prove that it bought the
stock in reliance on Halliburton’s misstatements. Both the trial court and the appeals court denied
Halliburton’s request. The Supreme Court granted certiorari.
Issue: Can a court assume that a plaintiff who purchased a company’s stock in the open market relied
on its misstatements?
Excerpts from Chief Justice Robert’s Decision: The traditional (and most direct) way a plaintiff can
demonstrate reliance is by showing that he was aware of a company’s statement and engaged in a
relevant transaction—e.g., purchasing common stock—based on that specific misrepresentation. In
Basic, however, we recognized that requiring such direct proof of reliance would place an
unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an
impersonal market. That is because, even assuming an investor could prove that he was aware of the
misrepresentation, he would still have to show a speculative state of facts, i.e., how he would have
acted if the misrepresentation had not been made.
To address these concerns, Basic held that securities fraud plaintiffs can in certain circumstances
satisfy the reliance element of a Rule 10b-5 action by invoking a rebuttable presumption of reliance,
rather than proving direct reliance on a misrepresentation. The Court based that presumption on what is
known as the “fraud-on-the-market” theory, which holds that the market price of shares traded on
well-developed markets reflects all publicly available information, and, hence, any material
misrepresentations. The Court also noted that, rather than scrutinize every piece of public information
about a company for himself, the typical investor who buys or sells stock at the price set by the market
does so in reliance on the integrity of that price—the belief that it reflects all public, material
information.
At the same time, Basic emphasized that the presumption of reliance was rebuttable rather than
conclusive. Specifically, any showing that severs the link between the alleged misrepresentation and
either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be
sufficient to rebut the presumption of reliance. So for example, if a defendant could show that the
alleged misrepresentation did not, for whatever reason, actually affect the market price, or that a
plaintiff would have bought or sold the stock even had he been aware that the stock’s price was tainted
by fraud, then the presumption of reliance would not apply. In either of those cases, a plaintiff would
have to prove that he directly relied on the defendant’s misrepresentation in buying or selling the stock.
Halliburton [argues] that overwhelming empirical evidence’ now suggests that capital markets are not
fundamentally efficient. To support this contention, Halliburton cites studies purporting to show that
public information is often not incorporated immediately (much less rationally) into market prices. [But
e]ven the foremost critics of the efficient-capital-markets hypothesis acknowledge that public
information generally affects stock prices. That the price of a stock may be inaccurate does not detract
from the fact that false statements affect it, and cause loss, which is all that Basic requires.
Halliburton has not identified the kind of fundamental shift in economic theory that could justify
overruling a precedent on the ground that it misunderstood, or has since been overtaken by, economic
realities.
Question: What was the holding in Basic?
Answer: Basic held that securities fraud plaintiffs can in certain circumstances satisfy the reliance
Question: What was the rationale for the holding in Basic?
Answer: The court recognized that requiring such direct proof of reliance would place an
unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an
Question: What was the basis of Haliburton’s argument in this case?
Answer: Haliburton argued that overwhelming empirical evidence now suggests that capital markets
Case: Stoneridge Investment Partners, LLC v. Scientic-Atlanta, Inc.1
Facts: Charter Communications, a cable operator, engaged in a variety of fraudulent practices to pump
up its financial statements. When these efforts fell short, Charter approached two of its suppliers,
Scientific-Atlanta and Motorola, for help. These two companies supplied Charter with the digital cable
converter (set top) boxes that Charter furnished its customers. Charter arranged to overpay the
suppliers $20 for each box it purchased, with the understanding that they would return the
overpayment by purchasing advertising from Charter. These transactions had no economic purpose
other than inflating Charter’s revenue and operating cash flow numbers by $17 million.
The inflated numbers were included in financial statements filed with the SEC and reported to the
public. Purchasers of Charter stock sued the two suppliers alleging that they had violated §10(b) and
Rule 10b-5. The District Court granted Scientific-Atlanta’s motion to dismiss. The United States
Court of Appeals for the Eighth Circuit affirmed. The Supreme Court granted certiorari.
Issue: Is someone who aids and abets a violation of § 10(b) also liable under the statute?
Holding: No, judgment for Scientific-Atlanta affirmed. According to the court, reliance by Stoneridge
on Scientific-Atlanta’s deceptive acts is an essential element of the §10(b) cause of action. In this case,
no member of the investing public had knowledge, either actual or presumed, of Scientific-Atlanta’s
deceptive acts during the relevant times. Thus, Stoneridge cannot show reliance upon any of
Scientific-Atlanta’s actions except an indirect chain that the court finds too remote for liability.
It is true that a free economy presupposes a high degree of integrity in all of its parts. If investors
could sue a company like Scientific-Atlanta, there would be a risk that the federal power would be
used to encourage litigation in areas already governed by effective state laws.
Extensive discovery and prolonged litigation allow investors with weak claims to extort
settlements from innocent companies. Accepting Stoneridge’s approach would expose a new class of
defendants to these risks, contracting parties might find it necessary to protect itself from this exposure
by raising the cost of doing business, and overseas firms with no other exposure to our securities laws
could be deterred from doing business here. This in turn, may raise the cost of being a publicly traded
company and shift offerings away from domestic capital markets.
Here, Scientific-Atlanta was acting in concert with Charter in the ordinary course as a supplier.
The transactions took place in the marketplace for goods and services, not in the investment sphere.
Charter was free to do as it chose in preparing its books and conferring with its auditor. In these
circumstances, the investors cannot be said to have relied upon any of Scientific-Atlanta’s deceptive
acts in the decision to purchase or sell securities. Because they cannot show reliance,
Scientific-Atlanta has no liability to Stoneridge.
Question: Did Charter make false statements about the company’s financial strength?
Question: What role is this fraud did Scientific-Atlanta play?
Answer: Scientific-Atlanta, and Motorola, helped Charter inflate their financials by agreeing to
Question: In agreeing to this plan, didn’t all of the companies engage in fraud?
1 128 S. Ct. 761, 2008 U.S. LEXIS 1091, Supreme Court of the United States, 2008.
Question: if Scientific-Atlanta and Motorola helped Charter inflate its financials that it filed with
the SEC, why are they not liable for their involvement?
Answer: In order to be liable for fraud under §10(b), the investor (Stoneridge) must prove that they
relied on Scientific-Atlanta’s conduct in making their investment. Here, because Scientific-Atlanta
Question: Does that mean that Scientific-Atlanta, and Motorola get away with their involvement
in Charter’s scheme?
Answer: Not necessarily. The court pointed out that imposing liability using securities laws was
not appropriate because the transactions were not investment transactions, nor could Stoneridge
Insider Trading: §§16 and 10(b)
A fiduciary violates Rule 10b-5 (insider trading) if she trades stock of her company while in possession
of nonpublic material information, unless she has committed in advance to a plan to sell those
securities. Insider trading is a crime punishable by fines and imprisonment, but someone who trades on
inside information is liable only if he breaches a fiduciary duty.
Insiders who pass on nonpublic, material information are liable under Rule 10b-5, even if they do not
trade themselves, so long as (1) they know the information is confidential and (2) they expect some
personal gain.
Those who receive tips—tippees—are liable for trading on inside information, even if they do not have
a fiduciary relationship to the company, so long as (1) they know the information is confidential, (2)
they know that it came from an insider who was violating his fiduciary duty, and (3) the insider
expected some personal gain.
Additional Case: United States v. O’Hagan7
Facts: Grand Met hired the law firm of Dorsey & Whitney to represent it in a takeover of Pillsbury.
James O’Hagan was a partner in Dorsey & Whitney who did not work for Grand Met but who did
purchase significant amounts of Pillsbury stock during this period. After Grand Met publicly
announced its takeover attempt, O’Hagan sold his stock at a profit of more than $4.3 million. A jury
convicted O’Hagan of misappropriation in violation of §10(b) and the judge sentenced him to prison.
The appeals court reversed, ruling that misappropriation is not a violation of §10(b). The Supreme
Court granted certiorari.
Issue: Is misappropriation a violation of §10(b)?
Holding: Yes, misappropriation is a violation of §10(b). One of the important goals of the Exchange
Act is to ensure honest securities markets and thereby promote investor confidence. It makes no sense
to find a lawyer like O’Hagan guilty if he works for a law firm representing the target of a tender offer,
but not if he works for a law firm representing the bidder.
Question: What does §10(b) prohibit?
Question: What does that statute have to do with insider trading?
Question: What is wrong with insider trading?
Question: What did O’Hagan do wrong?
Question: How did he learn this?
Question: Was there anything wrong with buying Pillsbury stock?
Question: Would it have been clearly illegal to buy Pillsbury stock if O’Hagan’s firm had
represented Pillsbury?
Answer: Yes, that would clearly have been a violation of §10(b) because O’Hagan would have
Question: Why is it different for O’Hagan to purchase stock in Pillsbury when he works
(indirectly) for Grand Met?
Answer: As a lawyer for Grand Met, he had no fiduciary duty to Pillsbury, the company whose
Question: What did the Supreme Court hold this time?
Answer: It ruled that O’Hagan had misappropriated (i.e., stolen) this securities information from
Ask students to consider the following examples from a newspaper article on insider trading. 8 Do they
agree with the newspaper’s answers?
1. You are a taxi driver who overhears a well-dressed passenger, clearly a corporate bigwig,
ebulliently describe how his employer is about to receive approval for a new blockbuster cure for
cancer. You tell your broker to buy 1,000 shares of the stock.
2. You are the chauffeur for that same executive—he hired you with the understanding that
everything you overhear stays in the car—and he talks of the impending approval.
3. Your broker tells you to sell stock in a company because he just received a call from that
company’s chief executive, who instructed him to dump all his holdings. You sell the stock.
4. The same broker advises you to sell but does not say why. He says only that he has a strong belief
that you should do it.
5. A friend tells you that he is depressed because his wife has learned that she will probably be laid
off next week from her job as a top executive. Her company has discovered deep financial
problems, he says, and will disclose them soon. You reassure him, but when he leaves, you call
your broker and execute an order to sell short 5,000 shares of the company’s stock.
6. At your country club, you play golf with a new member who talks about a great new product his
company is about to introduce. He implies that the stock will rise sharply. The next day, you buy
some of the stock.
8 Stephen Labaton and David Leonhardt, “Whispers Inside. Thunder Outside,” The New York Times, June 30,
2002, §3; p.1.
7. You play golf with that same new member, who talks about the new product but gives no hint that
he is associated with the company or where he received the information. You buy.
8. At a party, you overhear an executive—whom you recognize but do not know—tell another guest
that his company’s outlook has taken a turn for the worse that has not been reported. You call your
broker and sell your interest in that company.
Blue Sky Laws
In 1911, Kansas became the first state to regulate the sale of securities through statutes. It was
concerned that some securities, “had no more substance than so many cubic feet of Kansas blue sky.”2
Multiple Choice Questions
1. CPA QUESTION When a common stock offering requires registration under the Securities Act
of 1933:
(a) the registration statement is automatically effective when filed with the SEC.
(b) the issuer would act unlawfully if it were to sell the common stock without providing the
investor with a prospectus
(c) the SEC will determine the investment value of the common stock before approving the
offering
(d) the issuer may make sales 10 days after filing the registration statement
2. CPA QUESTION Pace Corp. previously issued 300,000 shares of its common stock. The shares
are now actively traded on a national securities exchange. The original offering was exempt from
registration under the Securities Act of 1933. Pace has $2.5 million in assets and 425 shareholders.
With regard to the Securities Exchange Act of 1934, Pace is:
(a) required to file a registration statement because its assets exceed $2 million in value
(b) required to file a registration statement even though it has fewer than 500 unaccredited
shareholders
(c) not required to file a registration statement because the original offering of its stock was
exempt from registration
(d) not required to file a registration statement unless insiders own at least 5 percent of its
outstanding shares of stock
3. Lily would like to raise money for her video game start-up by selling shares. If she decided to raise
money through crowdfunding, she:
(a) can only sell to accredited investors
(b) can sell up to $5 million in stock during each 12-month period
(c) cannot sell on the Internet, but only through an approved intermediary
2 The Economist, “Suspiciously quiet,” Sept. 1, 2012.
(d) can advertise the items of the offering
4. If a publicly traded company wishes to issue more public stock, it will undertake a(n)_________.
If the underwriter buys the stock and resells it to the public, that is a ______________
underwriting. Before buying the stock, investors must receive a copy of the ____________.
(a) IPO, best efforts, registration statement.
(b) IPO, firm commitment, registration statement
(c) secondary offering, best efforts, prospectus
(d) secondary offering, firm commitment, prospectus
5. Three months ago, Noah bought stock under Rule 506 in TreesNFlowers, Inc. He has lost interest
in the company and would like to sell the stock. Which of the following statement is true?
(a) He can sell the stock now, so long as he sells it to an accredited investor.
(b) He can sell the stock now so long as the company grants permission.
(c) He must hold on to the stock for at least nine more months.
(d) He could sell the stock in three months, but only if the company goes public in the meantime.
Answer: (d).
Case Questions
1. Reflow Inc. failed to disclose in SEC filings that millions of dollars of its accounts receivables
were uncollectible. Two months after its IPO, the company went bankrupt. Shareholders filed suit
against the company’s law firm, alleging that it was liable under Section 10(b) for drafting Refco’s
SEC filings that contained these material omissions. Is the law firm liable? Should it be? Is it a
stronger or weaker case than Stoneridge?
2. Fluor, an engineering and construction company, was awarded a $1 billion project to build a coal
gasification plant in South Africa. Fluor signed an agreement with a South African client that
prohibited them both from announcing the agreement until March 10. Accordingly, Fluor denied all
rumors that a major transaction was pending. Between March 3 and March 6, the State Teachers
Retirement Board pension fund sold 288,257 shares of Fluor stock. After the contract was
announced, the stock price went up. Did Fluor violate Rule 10b-5?
Answer: Fluor was not in violation because the company lacked scienter. Fluor had no intent to
3. Do you love ice cream? Here is an opportunity for you! For only $800, you can buy a cow from
Berkshire Ice Cream. The company gets milk from the cow and you get to share in the profits from
the sale of ice cream. Just last month, Berkshire mailed $32,000 worth of checks to investors—who
are expecting a 20 percent annual rate of return. Are there any problems with this plan?
Answer: This ice cream company is selling a security and must comply with both state and federal
4. ETHICS Suppose that, while waiting in line at the grocery store, you overhear a stranger saying
that the FDA is going to approve a new drug tomorrow—one that will be a huge success for Alpha
Pharmaceuticals. Is it legal for you to buy stock in Alpha? Is it ethical? What would Kant and Mill
say?
5. Gary Griffiths was a vice president for a railroad. The CEO asked him to prepare an inventory of
all the rolling stock the company owned and to arrange trips among its rail yards for a group of
men in suits. Employees began asking Griffiths if the company would be sold and whether they
would lose their jobs. Indeed, the company was exploring sale options. Griffiths went to visit his
brother-in-law, Rex, who the next day purchased $400,000 in stock of the company. For a month,
Griffiths called regularly, and each time Rex bought more stock. In total, he spent $1.14 million on
company stock. After the company was sold, Rex made a substantial profit. .Did Gary and Rex
engage in illegal insider trading? Was the fact that men in suits were touring the rail yards material
nonpublic information?
Answer: The court found both men liable. Although there was no direct evidence that Gary passed
Discussion Questions
1. Federal security laws are based on the assumption that investors are knowledgeable enough to
assess the quality of a stock so long as the issuer provides adequate disclosure. Many states take a
different approach – they refuse to permit the sale of securities that they deem to be of poor quality.
Should securities laws protect investors in this way?
2. Securities laws are a balancing act between companies’ desire to raise money and investors’ need
for protection. Congress recently changed Rule 506 to permit advertising. Critics worry that this
change will permit fraudsters to attract more victims. It is true that Rule 506 limits public
solicitation to accredited investors. But just because accredited investors are financially secure,
does not mean they have investment savvy. (Think doctors and lawyers.) Should Congress have
made this change?
3. ETHICS David Sokol worked at Berkshire Hathaway for legendary investor Warren Buffett, who
is renowned not only for his investment skills but also his ethics. Bankers suggested to both Sokol
and the CEO of Lubrizol that the company might be a good buy for Berkshire. Sokol then found out
that the CEO of Lubrizol planned to approach Berkshire about a possible acquisition. Sokol
purchased $10 million worth of Lubrizol stock before recommending Lubrizol to Buffett. Sokol
mentioned to Buffett “in passing” that he owned shares of Lubrizol. Buffett did not ask any
questions about the timing or amount of Sokol’s purchases. Sokol made a $3 million profit when
Berkshire acquired Lubrizol. Did Sokol violate insider trading laws? Did he behave ethically? What
are Buffett’s ethical obligations?
Answer: Was the information Sokol had material? Buffett defended the purchase by saying that
Sokol had no way of knowing how Buffett would react to the purchase suggestion. Indeed, Buffett
4. The SEC believes that anyone in possession of material nonpublic information about a company
should be required to disclose it before trading on the stock of that enterprise. Instead, the courts
have developed a more complex set of rules. Do you agree with the SEC or the courts on this
issue?
?
5. What would you say to critics who argue that crowdfunding does not provide enough protection to
investors? That the business judgment rule will permit managers to spend the money as they will.
That few of these companies will ever go public, so investors will have limited opportunities to sell
their stock or realize any return on their investment.
