Management Chapter 22 The Alleged Facts Instead Suggest That American

Chapter Twenty-Two

Securities Fraud and Insider Trading

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE

When May an Accountant Look the Other Way?

Issue Presented: When will an accountant be held liable for material omissions in an offering

memorandum for which the accountant offered no opinion but compiled financial

projections?

The U.S. Court of Appeals for the Second Circuit affirmed the dismissal of the complaint

in Shapiro v. Cantor, 123 F.3d 717 (2d Cir. 1997). The U.S. Supreme Court rejected secondary

There was no allegation that the projections misrepresented any financial fact. Rather,

the plaintiff argued that they were fraudulent because there was no mention of Greenberg’s

felony conviction or of the role of his twelve-year-old son. The court held that Touche Ross

cannot be liable for failure to disclose material information under Section 10(b) unless it was

Although Touche Ross had no legal obligation to disclose the conviction, it was

unethical for it to continue to work with the promoter once it discovered the fraud. The

engagement partner should have urged his client to make full disclosure and to appoint an

QUESTIONS AND CASE PROBLEMS

Question 1

Issue Presented: Is it illegal insider trading for a psychiatrist to trade on information that a

patient reveals during therapy? Is his broker liable? Is their conduct ethical?

Under the misappropriation theory, the SEC must show that (1) the defendant converted

material, nonpublic information, (2) in breach of a fiduciary duty, (3) in connection with the

purchase or sale of securities, and (4) the defendant acted with scienter. If the defendant is a

tippee, the SEC must further prove that the tippee traded on the misappropriated information

when he knew or should have known it was misappropriated.

Sloate also contended that the SEC’s complaint should have been dismissed because Dr.

Willis’s misconduct did not defraud the investing public or Joan Weill as an investor. Again, the

court disagreed: Rule 10b-5 is broadly worded to require only that the plaintiff show that the

defendant acted in a manner that constituted a fraud or deceit upon any person. The court

found it sufficient that the fraud was committed upon Weill in her capacity as a patient of

Willis.

Consequently, both defendants were held liable for Rule 10b-5 violations under the

misappropriation theory, later embraced by the U.S. Supreme Court in United States v. O’Hagan,

521 U.S. 642 (1997). In addition to the illegal (and necessarily unethical) behavior involved in

the trades, Willis’s behavior in revealing information told in confidence by a patient is highly

unethical and usually can be disciplined by professional associations.

Question 2

Issue Presented: (a) Is an auditor liable under Section 10(b) or Rule 10b-5 for overstated

earnings resulting from option backdating? (b) Does it matter whether the employess who

did the audit in a subsequent year were not aware of the earlier alleged backdating?

(a) The U.S. Court of Appeals for the Ninth Circuit held that the plaintiffs had alleged

sufficient facts to show scienter and refused to dismiss the case. New Mexico State Investment

Council v. Ernst & Young, 641 F.3d 1089 (9th Cir. 2011). The court began by noting:

A backdated option is not in and of itself improper under the law or accounting

principles. However, when a company chooses to issue such fiin the money”

A complaint will survive a motion to dismiss fionly if a reasonable person would deem

the inference of scienter cogent and at least as compelling as any opposing inference one could

draw from the facts alleged.” Thus, the ficourt must compare the malicious and innocent

inferences cognizable from the facts pled in the complaint, and only allow the complaint to

survive a motion to dismiss if the malicious inference is at least as compelling as any opposing

innocent inference.” Scienter requires more than a misapplication of accounting principles.

The plaintiffs alleged scienter fibased on three specific points when EY was faced with

circumstances that would compel a reasonable auditor to further investigate and disclose

Broadcom’s backdating of options: (1) a large grant of options on May 26, 2000 for which EY

was given no documentation; (2) options granted in 2001 during a period when Broadcom’s

Question 3

Issues Presented: (a) Are insiders automatically liable for a violation of Rule 10b-5 if they sell

company shares before material non-public information is released to the public, but after it

has come to the attention of the company? (b) Is a company’s outside counsel liable for a

violation of Rule 10b-5 if she trades on material non-public information? (c) Do the bans on

insider trading extend to all employees of a company? (d) Is an employee’s broker

potentially liable as a tipper of inside information? (e) When do tippees of inside

information become liable for a violation of Rule 10b-5? (f) What are the differences among

private class actions, SEC enforcement provisions, and criminal prosecution by the U.S.

Attorney’s Office? What damages are recoverable in the various proceedings?

(a) Gallop’s vice president of marketing and its directors are traditional insiders, who

are prohibited from trading in their employer’s stock based on material non-public information.

There is no question in the present case that the filing of a large product liability claim is

(b) Courts have held that an insider is a person who, because of his position or intimate

association with a corporation, has greater knowledge of the financial affairs of the corporation.

(c) In the leading case of SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), the

court held that the insider concept extends for purposes of Rule 10b-5 to any employees who

(d) Collin’s broker presents a slightly more difficult case. To find the broker liable as a

tippee (and subsequently a tipper) of confidential information, the plaintiffs will need to show

(e) As the above discussion should make clear, a tippee is only liable for a violation of

Rule 10b-5 if he or she stood in a position of constructive trust with respect to the tipper, or had

(f) (1) Private Actions. The most important limitation on private actions is that the

plaintiffs must have actually been injured by the insider trading. All purchasers of company

(2) SEC Enforcement Actions. The SEC could obtain disgorgement of all wrongfully

obtained profits on the shares sold, in addition to the broker’s fees on these transactions. Under

(3) Criminal Prosecution. Under the Insider Trading and Securities Fraud Enforcement

Question 4

Issue Presented: Can a settlement agreement foreclose claims for violations of Rule 10b–5

based on statements made during mediation subject to a confidentiality agreement?

In Facebook, Inc. v. Pacific Northwest Software, Inc., 640 F.3d 1034 (9th Cir. 2011), the court

dismissed the suit by the Winklevosses. The court assumed, without deciding, fithat a party

Even putting aside the release, the court held that Winklevosses did not have a valid

Rule 10b-5 claim. The confidentiality agreement, which the parties signed before mediating the

dispute, provided: fiAll statements made during the course of the mediation or in mediator

follow-up thereafter at any time prior to complete settlement of this matter are privileged

settlement discussions . . . and are nondiscoverable and inadmissible for any purpose including

in any legal proceeding.” As a result, the Winklevosses could not introduce any evidence of

what Facebook said, or did not say, during the mediation in support of their securities claims.

Because the Winklevosses could not show that Facebook misled them about the value of its

shares or that disclosure of the tax valuation would have significantly altered the mix of

information available to them during settlement negotiations, their securities claims must fail.

The court held that even if it were to construe the confidentiality agreement as a waiver

of the Winklevosses’ Rule 10b–5 claims, it still would not violate Section 29(a) because the

agreement was entered into fiin the adversarial setting that is characteristic of litigation.” In

such cases, the parties are finot so concerned with protecting their rights as investors as they

[are] with establishing a general peace.”

Question 5

Issue Presented: What factors determine when forward-looking statements accompanied by

cautionary statements are protected by the safe harbor in the Private Securities Litigation

Reform Act from securities fraud under Sections 10(b) and 20(a)?

The court ruled in Slayton v. American Express Co., 604 F.3d 758 (2d Cir. 2010), that

American Express was not entitled to safe harbor protection based on its cautionary language

The court concluded, however, that the allegedly misleading statement was protected by

the actual knowledge prong of the safe harbor because the plaintiffs did not plead facts

Question 6

Issue Presented: Is there a Rule 10b-5 violation when insiders include misstatements in a

prospectus, but also include significant high-risk warning statements that refer to the subject

of these misstatements?

The TIS prospectus was misleading with respect to the cost of construction anticipated

on the basis of known events, the working capital position, and the urgency of TIS’s need to

Question 7

Issue Presented: Is a top executive’s lie about having a college degree a material

misrepresentation within the meaning of the 1933 and 1934 Acts? Would false claims about

having experience with an initial public offering or experience leading a company through

human clinical trials be a material misrepresentation?

The issue for the court in Greenhouse v. MCG Capital Corp., 392 F.3d 650 (4th Cir. 2004),

was whether Bryan J. Mitchell’s claim that he had a college degree from Syracuse University

was a fimaterial fact” within the meaning of the securities laws. The MCG shareholders claimed

The MCG shareholders argued that this one misrepresentation affected MCG’s securities

by making investors question the integrity of the company and its executives:

While MCG did not deny Mitchell’s misstatement, its defense was that his misstatement

was immaterial within the context of the securities laws.

The U.S. Court of Appeals for the Fourth Circuit noted that the use of the term fimaterial

misrepresentation” in the securities fraud context is not quite accurate:

Here, an investment in close textual reading pays dividends. The plain language

of Rule 10b-5 and Section 11(a) requires any successful securities-fraud suit to

Thus immaterial lies are not a basis for suing under the securities laws.

The case thus centered on what constitutes a material fact. In Basic, Inc. v. Levinson, 485

U.S. 224 (1988), the U.S. Supreme Court adopted the following standard for materiality: fia

plaintiff must show that the statements were misleading as to a material fact. It is not enough

The appeals court then considered whether a reasonable jury could find it fisubstantially

likely” that a reasonable investor would believe that the disclosure of the untrue fact altered the

fitotal mix” of information. The court noted: fiIt is important to note that a ‘reasonable investor’

is neither an ostrich, hiding its head in the sand from relevant information, nor a child, unable

to understand the facts and risks of investing.”

The court listed facts that a reasonable investor might find material: fiFor example, a

reasonable investor would likely value information found in MCG’s publicly filed statements

and elsewhere including: Mitchell’s years of management in financial institutions; the other

board members’ and key managers’ similar track record; the years of MCG’s earnings

statements as a private company; the firm’s debt/equity ratio; the general costs of capital and

macroeconomic trends; the strength of MCG’s potential competitors; etc.”

The court pointed out, however: fiWhile we do not hold as a matter of law that a key

manager’s education could never be material, we do find that Mitchell’s education is immaterial

here.” Mitchell’s misrepresentation did not alter the total mix of information relevant to the

reasonable investor.

The problem in this case arose because media and pundits speculated that more

misstatements would inevitably follow this immaterial one: fiIn short, the unavoidable

conclusion one reaches is that, in an age of heightened sensitivity to corporate scandal some

investors found, for a very short period of time, MCG’s stock to be damaged goods because the

The directors of MCG should consider whether to keep Mitchell on as CEO. Mitchell’s

integrity was brought into question by the revelation that he lied. In order to ensure that no

other misrepresentations were made, board members should review the veracity of Mitchell’s

The Supreme Court offered additional guidance on the significance in a securities fraud

case of trading prices after the truth is revealed in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S.

336 (2005). In this case, the U.S. Court of Appeals for the Ninth Circuit had ruled that a plaintiff

could establish economic loss and loss causation merely by establishing that the price of the

Although the Supreme Court did not expressly state that a plaintiff must allege that the

share price fell significantly after the truth became known, it suggested that this was highly

relevant to the issue of economic loss causation. The Court pointed out that the securities laws

made private securities fraud actions available to maintain public confidence in the marketplace

by deterring fraud, finot to provide investors with broad insurance against market losses.”

Failure to require the plaintiff fito provide a defendant with some indication of the loss and the

Question 8

Issue Presented: (a) Is an investment adviser or its parent liable under Rule 10b-5 for false

statements included in mutual fund prospectuses? (b) Is either firm liable under Section

20(a) or Section 20(b)?

(a) In a five-four decision, the U.S. Supreme Court ruled in Janus Capital Group, Inc. v.

First Derivative Traders, 131 S. Ct. 2296 (2011), that neither the investment adviser nor its parent

was liable under Rule 10b-5 for misrepresentations in the mutual fund prospectuses because

they were fimade” by the mutual funds not the adviser or its parent. Because the Janus Fund’s

board of trustees has fiultimate authority” over the content of the statements in a Fund

prospectus, only Janus Fund, not Janus Management, could have fima[d]e” those statements.

The Court reasoned that a person fi ‘makes’ a statement by stating it.” Accordingly:

The fimaker of a statement is the entity with authority over the content of the statement

and whether and how to communicate it. Without such authority, it is not ‘necessary or

inevitable’ that any falsehood will be contained in the statement.”

In a dissent by Justice Breyer, in which Justices Ginsburg, Kagan, and Sotomayor joined,

he stated:

Neither common English nor this Court’s earlier cases limit the scope of that

word [fimake”] to those with fiultimate authority” over a statement’s content. To

. . .

Neither can the majority find support in any relevant precedent. The majority

says that its rule fifollows from Central Bank of Denver, N.A. v. First Interstate Bank

. . .

Central Bank is a case about secondary liability, liability attaching, not to an

individual making a false statement, but to an individual helping someone else

do so. . . .

the Act.

. . .

Thus, as far as Central Bank is concerned, depending upon the circumstances,

board members, senior firm officials, officials tasked to develop a marketing

document, large investors, or others (taken together or separately) all might

fimake” materially false statements subjecting themselves to primary liability.

(b) If the directors of the mutual funds were not aware of the misrepresentations, then

the funds would not be liable under Rule 10b-5 due to the lack of scienter. As a result, JCM