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Rule 10b-5 Antifraud Liability

Rule 10b-5 Antifraud Liability. Private Rights of Action. Rule 10b-5 Antifraud Liability. Elements of the Cause of Action. material. JURISDICTIONAL NEXUS “instrumentality of interstate commerce”. misrepresentation or omission. scienter. TRANSACTIONAL NEXUS

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Rule 10b-5 Antifraud Liability

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  1. Rule 10b-5Antifraud Liability

  2. Private Rights of Action

  3. Rule 10b-5 Antifraud Liability • Elements of the Cause of Action material JURISDICTIONALNEXUS “instrumentality ofinterstate commerce” misrepresentationor omission scienter TRANSACTIONALNEXUS “in connection withthe purchase or sale” reliance causation damages

  4. Rule 10b-5 Private Cause of Action • Origins Section 10 It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange— (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

  5. Rule 10b-5 Private Cause of Action • Origins Rule 10b-5 It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange--

  6. Rule 10b-5 Private Cause of Action • Origins Rule 10b-5 (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person . . .

  7. Rule 10b-5 Private Cause of Action • Origins Rule 10b-5 … in connection with the purchase or sale of any security

  8. Rule 10b-5 Private Cause of Action • Herman & Maclean v. Huddleston et al. Herman & MacLean TexasInternationalSpeedway Investors IPO

  9. Rule 10b-5 Private Cause of Action • Herman & Maclean v. Huddleston et al. DISTINGUISHING § 11 and RULE 10b-5 • RULE 10b-5 • - higher burden, but broad scope • SECTION 11 • - minimal burden, but narrow scope • - covers the field • - scienter requirement is principal obstacle • - misrepresentation in the registration statement • - investor must “trace” security to offering

  10. Economics of Securities Fraud • Private Securities Litigation Reform Act of 1995 • (Sections 21D and 21E of the Exchange Act) Pleading with Particularity Stay on Discovery until after Motion to Dismiss Early Class Notice Lead Plaintiff Presumption Court Review for Reasonable Attorney’s Fees Forward Looking Information Safe Harbor Proportionate Liability

  11. Who can sueunder Rule 10b-5?

  12. Who Can Sue Under Rule 10b-5 • “In connection with” material JURISDICTIONALNEXUS “instrumentality ofinterstate commerce” misrepresentationor omission scienter TRANSACTIONALNEXUS “in connection withthe purchase or sale” reliance causation damages

  13. Who Can Sue Under Rule 10b-5? DOJInvestigation PUBLICOFFERING CUSTOMERS • Blue Chip Stamps v. Manor Drug Stores BLUE CHIPSTAMPS

  14. Who Can Sue Under Rule 10b-5? • Blue Chip Stamps v. Manor Drug Stores 1. What are the categories of investors who are harmed from fraud without engaging in a securities transaction?

  15. Who Can Sue Under Rule 10b-5? • Blue Chip Stamps v. Manor Drug Stores a. investors who choose not to purchase due to the fraud b. actual shareholders who choose not to sell shares c. shareholders, creditors, and others who are harmed by insider activities in connection with the purchase or sale of securities

  16. Who Can Sue Under Rule 10b-5? • Blue Chip Stamps v. Manor Drug Stores 2. The Court emphasize that without theBirnbaum rule “[p]laintiff’s entire testimony could be dependent upon uncorroborated oral evidence of many of the crucial elements of his claim, and still be sufficient to go the jury”. Why does it follow that vexatious litigation will follow?

  17. Who Can Sue Under Rule 10b-5? • Blue Chip Stamps v. Manor Drug Stores 3. Does eliminating non-purchasers and sellers from Rule 10b-5 actions solve the vexatious litigation problem? - no

  18. Who Can Sue Under Rule 10b-5? • Blue Chip Stamps v. Manor Drug Stores 4. According to the Court, “[t]he Birnbaum rule undoubtedly excludes plaintiffs who have in fact been damaged by violations of Rule 10b-5, and to that extent it is undesirable”. Why is it undesirable?

  19. Who Can Sue Under Rule 10b-5? • Summary • Plaintiffs in a Rule 10b-5 action can be a seller or a purchaser • - compare with §§ 11, 12(a)(1), 12(a)(2) where only the purchaser can sue • 2. Defendants include any person whose fraudulent activity is in connection with the purchase or sale of a security by plaintiff. • - defendant does not have to be a buyer or seller of securities

  20. The Lead Plaintiff

  21. Who Can Sue Under Rule 10b-5? • Lead Plaintiff in a Class Action • (Exchange Act Provisions added by the PSLRA) § 21D(a)(3)(A) – Early notice to the class § 21D(a)(3)(B)(iii)(I) – Rebuttable presumption of lead plaintiff for “person or group of persons” § 21D(a)(3)(B)(iii)(II) – Evidence required to rebut the presumption § 21D(a)(3)(B)(iv) – Limited discovery on issue of adequate plaintiff § 21D(a)(3)(B)(v) – Lead plaintiff selects lead counsel (subject to court approval) § 21D(a)(3)(B)(vi) – Restriction on professional plaintiffs § 21D(a)(6) – Court review for “reasonable” attorney fees

  22. Who Can Sue Under Rule 10b-5? • Lead Plaintiff in a Class Action • § 21D(a)(3)(B) of the 1934 Act Subject to subclause (II), for purposes of clause (i), the court shall adopt a presumption that the most adequate plaintiff in any private action arising under this chapter is the person or group of persons that— (aa) has either filed the complaint or made a motion in response to a notice under subparagraph (A)(i); (bb) in the determination of the court, has the largest financial interest in the relief sought by the class; and (cc) otherwise satisfies the requirements of Rule 23 of the FederalRules of Civil Procedure.

  23. Who Can Sue Under Rule 10b-5? • In re Cendant Corp. Litigation 1. Prior to the PSLRA, it was not uncommon for investors with a relatively small stake to serve as the private securities fraud class actions’ lead plaintiff. Often, such lead plaintiffs had repeat relationships with one of the major private plaintiff attorney law firms. What problem can arise from such a relationship?

  24. Elements of theCause of Action

  25. Rule 10b-5 Antifraud Liability • Elements of the Cause of Action material JURISDICTIONALNEXUS “instrumentality ofinterstate commerce” misrepresentationor omission scienter TRANSACTIONALNEXUS “in connection withthe purchase or sale” reliance causation damages

  26. Misstatement of Material Fact • Materiality (Basic v. Levinson) • Misstatement of Fact (Virginia Bankshares) We now cover the additional topics: • Deception (Santa Fe) • Omissions – Duties to Disclose • Forward-looking Statement Safe Harbors

  27. Misstatement of Material Fact K IRBY • Santa Fe Industries, Inc. v. Green minorityshareholders $150 / share Santa Fe 60% 95% 100% DGCL § 253 short-form merger Assets:$640 / share Stock:$125 / share no voting rights notice and appraisal

  28. Misstatement of Material Fact • Santa Fe Industries, Inc. v. Green • What is the essence of the claim? • breach of fiduciary duty because the transaction was unfair • no claim that there was an omission or misstatement in merger documentation • What is the Court’s response? • breach of fiduciary duty, absent fraud, does not violate Rule 10b-5 • Rule 10b-5 is violated by manipulative or deceptive conduct

  29. Misstatement of Material Fact • Santa Fe Industries, Inc. v. Green full and fair disclosure fairness of transaction Santa Fe STATE Shareholder liability Corporate governance Director/officer fiduciary duties Shareholder rights/duties FEDERAL Transactional disclosure Periodic disclosureby public companies Fraud in connection with securities transactions

  30. Misstatement of Material Fact • Santa Fe Industries, Inc. v. Green • Is the Court’s discussion of the intersection of state corporate law and federal securities law essential to its holding? • - mostly dicta, but reveals judicial attitude that is likely to be suspicious of attempts to expand the federal securities law

  31. Misstatement of Material Fact • Santa Fe Industries, Inc. v. Green 2. Does the Court’s holding in Santa Fe mean that no breach of fiduciary duty can ever be a violation of Rule 10b-5? - breaches of a fiduciary duty of disclosure are still actionable - breaches of a fiduciary duty of loyalty are still relevant

  32. Misstatement of Material Fact • Santa Fe Industries, Inc. v. Green 3. Can there be deception even if there is no misstatement or omission? Does manipulation require a misstatement or omission?

  33. Misstatement of Material Fact • Summary • duty to disclose if trading in securities • duty to update, in some circuits, if prior disclosure has become materially misleading so long as “alive” or has forward intent and connection upon which parties may be expected to rely • duty to correct in all circuits if statements were misleading at time they were made • duty to avoid “half-truths” • periodic disclosure requirements impose additional disclosures for specified categories

  34. Forward-Looking StatementSafe Harbor

  35. Misstatement of Material Fact • Forward Looking Safe Harbor -- § 21E

  36. Misstatement of Material Fact • Forward Looking Safe Harbor • Exchange Act §21E(c)(1) • a person shall not be liable with respect to any forward-looking statement, whether written or oral, if . . . (A)(i) identified as a forward-looking statement, and is accompanied bymeaningful cautionary statementsidentifying important factors that could cause actual results to differ materially . . .; or . . .

  37. Misstatement of Material Fact • Forward Looking Safe Harbor • Exchange Act §21E(c)(1) • a person shall not be liable with respect to any forward-looking statement, whether written or oral, if . . . (B) the plaintiff fails to prove that the forward-looking statement . . . (i) was made withactual knowledgeby that person that the statement was false of misleading . . .

  38. Rule 10b-5 Antifraud Liability • Elements of the Cause of Action material JURISDICTIONALNEXUS “instrumentality ofinterstate commerce” misrepresentationor omission scienter TRANSACTIONALNEXUS “in connection withthe purchase or sale” reliance causation damages

  39. Scienter • State of Mind ACTUAL MOTIVE - intent to defraud KNOWLEDGE - knowledge facts and appreciation of how the market will be mislead RECKLESSNESS - “so highly unreasonably and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent … obvious that the defendant must have been aware of it”

  40. Scienter ERNST & ERNST auditor NAY mailrule president 92% stockholder First Securities • Ernst & Ernst v. Hochfelder “high-yield” ESCROWACCOUNTS “high-yield” ESCROWACCOUNTS investors

  41. Scienter ERNST & ERNST auditor NAY mailrule president 92% stockholder First Securities • Ernst & Ernst v. Hochfelder “high-yield” ESCROWACCOUNTS “high-yield” ESCROWACCOUNTS investors

  42. Scienter • Ernst & Ernst v. Hochfelder 1. Why does Justice Powell say that the logic of the SEC’s approach “would impose liability for wholly faultless conduct where such conduct results in harm to investors, a result the Commission would be unlikely to support?

  43. Scienter • Ernst & Ernst v. Hochfelder • Does recklessness count as “intent to deceive, manipulate, or defraud”? • If the defendant truly had no motive to deceive – why should recklessness count as scienter? • Could we justify eliminating recklessness as a means of reducing “vexatious” litigation?

  44. Scienter • Ernst & Ernst v. Hochfelder 3. Why does negligence on the part of Ernst & Ernst trigger § 11 liability but not Rule 10b-5 liability (for which the plaintiff must show at recklessness)?

  45. Pleading Requirements

  46. Scienter • Pleading Requirements • Exchange Act §21D(b)(1) • In any private [anti-fraud] action arising under th[e 1934 Act] . . . the complaint shall specify each statement alleged to have been misleading, thereasonor reasonswhythe statement is misleading. . . .

  47. Scienter • Florida State Bd. Of Admin. v. Green Tree Fin. Corp. • Exchange Act §21D(b)(1) • In any private [anti-fraud] action arising under th[e 1934 Act] . . . the complaint shall specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularityall facts on which that belief is formed.

  48. Scienter Forward-Looking: knowledge Historical: recklessness • Pleading Requirements • Exchange Act §21D(b)(2) • In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

  49. Scienter • Florida State Bd. Of Admin. v. Green Tree Fin. Corp. discount rate default rate prepayment rate Green TreeFinancial Corp subprime loans high interest rates debt securities low interest rates

  50. Securitization discount rate default rate prepayment rate Green Tree 11% Interest 7% Interest

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