CHAPTER 25

1. CHAPTER 25 Securities Fraud and Insider Trading

2. INTRODUCTION This chapter focuses on Section 10(b) and Rule 10b–5. It sets forth the seven elements necessary in a Rule 10b–5 securities fraud case and the fraud-on-the-market theory of liability. The safe-harbor for certain forward-looking statements is discussed. Section 17(a) of the 1933 Act, under which the U.S. government can bring fraud claims, is briefly discussed. The chapter defines insider trading and discusses in detail the legal elements of an insider-trading case. Short-swing trading is then defined, and the rules for calculating the recoverable profits are discussed, as well as the requirements for reporting by insiders.

3. SECTION 10(B) OF THE 1934 ACT • Section 10(b) gives the SEC power to prohibit individuals or companies from engaging in securities fraud by authorizing the SEC to prescribe specific rules for the protection of investors. • Rule 10b–5. More suits brought under 10b-5 than any other security law provision: 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, (1) to employ any device, scheme, or artifice to defraud, (2) 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, or (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

4. RULE 10B–5 • Individual investors have a private cause of action. • Controlling Persons. Every person who, directly or indirectly, controls any person is jointly and severally liable, unless the controlling person acted in good faith and did not directly or indirectly induce the acts. • Aiding and Abetting. Private plaintiff may not maintain an aiding and abetting suit; however SEC may bring suit.

5. RULE 10B–5 • Conspiracy. No private implied cause of action for conspiracy under Section 10(b). • Primary Liability for Secondary Actors.  Secondary actors (such as an accountant, lawyer, or bank) can be liable in private suits if their conduct satisfies the requirements for primary liability. • Statute of Limitations--suits must be brought within one year of the date the plaintiff discovered or should have discovered the fraud or within three years of the date of the violation, whichever is shorter.

6. PRIMARY LIABILITY FOR SECONDARY ACTORS  Case 25.1 Synopsis. McGann v. Ernst & Young. Ernst & Young was the auditor for Community Psychiatric Centers (CPC). Plaintiffs alleged that Ernst & Young failed to disclose that CPC had major accounts receivable problems, thereby issuing a false and misleading auditing opinion. Plaintiffs also alleged Ernst & Young knew that CPC would include this audit report in its Form 10-K. The district dismissed the case and Plaintiffs appealed. ISSUE: Is an accounting firm subject to primary liability under Section 10(b) of the 1934 Act when it prepares a fraudulent audit report that it knows its client will include in a Form 10–K? HELD: YES--REVERSED. an accounting firm can have primary liability under Section 10(b) when it prepares a fraudulent audit report it knows will be used in a Form 10-K. The case was remanded for further proceedings on this issue.

7. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Summary. Plaintiff must show each of the following elements, described in more detail below: • The defendant used either an instrumentality of interstate commerce or the mails or a facility of a national securities exchange. • The defendant made a statement that either misrepresented or omitted a fact. • The fact was of material importance. • The misrepresentation or omission was made with scienter (culpable state of mind).

8. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Summary. Plaintiff must show each of the following elements, described in more detail below: • The statement or mission was made in connection with the purchase or sale of securities. • The plaintiff acted in reliance either on the defendant’s misrepresentation or on the assumption that the market price of the stock accurately reflected its value. • The defendant’s misrepresentation or omission caused the plaintiff to suffer losses. • Interstate Commerce - defendant must have used interstate commerce, the mails, or a national securities exchange.

9. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Misstatement or Omission - misrepresentation of a fact, or a fact that is left out of a statement, such that the statement becomes misleading. • Misstatements. A prediction about the future can be a misstatement, but only if the person making the prediction does not believe it at the time. Generally, silence or a “no comment” statement in response to rumors will not lead to liability if the company has not previously spoken on the subject and insiders are not trading or tipping.

10. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Omissions - can occur when a company makes a statement that is true at the time but that becomes misleading in light of later events. However, if investors are reasonably relying on the previous statements, the company can be held liable for failing to disclose the new information. • Statements by Third Parties and Entanglement - a company may have a duty to disclose all facts regarding a particular issue, even if the company itself did not publish the misleading projection or make the statement.

11. OMISSIONS Case 25.3--Weiner v. Quaker Oats Co. Quaker was acquiring Snapple for $1.7 billion in cash. The market did not approve of the acquisition and showed it by dropping Quaker’s stock price by ten percent. Quaker borrowed the money to acquire Snapple, thus increasing its total debt-to-total capitalization ratio to approximately 80 percent. In the current Quaker Annual Report, Quaker states that its guideline for this ratio is in the “upper 60-percent range.” Quaker also said it was committed by seven-percent, real earning growth over time. The plaintiff alleged that Quaker had a duty to update these statements because they were misleading. The court dismissed the growth statements because it is “over time”. ISSUE: Under what circumstances do a corporation and its officers have a duty to update, or at least not to repeat, particular projections regarding the corporation’s financial condition (for example, total debt-to-total capitalization ratio or earnings growth projections)? HELD: The appeals court remanded the case for further findings to decide if a reasonable investor would find Quaker’s statements misleading based on the Annual Reports.

12. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Material Fact - to recover, a plaintiff must prove a material fact, i.e., what a reasonable investor would consider important in deciding how to act. Material facts affect the market value of the company’s stock. A manager can be liable even if she did not know the omitted or misrepresented fact came within the legal definition of a material fact. Examples of material facts: • Any statements about the earnings, distributions, or assets of a company. • Significant facts about a parent or a subsidiary. These include the discovery of embezzlement or falsification of financial statements, an impending tender offer, or the loss of a manufacturer’s major customer. • Perhaps the inability to obtain supplies, increased costs of supplies, a decision to close a plant, or potential liability in a lawsuit. • Vague statements of corporate optimism and mere puffing are NOT material.

13. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Bespeaks Caution Doctrine - precise cautionary language that adequately discloses the risks involved about projections, estimates, and other forward-looking statements that renders immaterial any misrepresentation or omission.

14. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Scienter - no liability for innocent misstatements or omissions, only misstatements or omissions made with the intent to deceive. The U.S. Supreme Court has made clear that scienter is more than mere negligence or lack of care

15. SCIENTER Case 25.4 Synopsis. Kasaks v. Novak. Plaintiffs sued AnnTaylor Stores Corporation — which, through its wholly-owned subsidiary, defendant AnnTaylor, Inc., is a specialty retailer of women’s clothing, shoes, and accessories — and several of its top officers (including Novak) for violation of Section 10(b) and Rule 10b-5. They alleged that the defendants knowingly and intentionally issued financial statements that overstated AnnTaylor’s financial condition by accounting for inventory that they knew to be obsolete and nearly worthless at inflated values and by deliberately failing to adhere to the Company’s publicly stated markdown policy. The district court dismissed the complaint for failure to plead scienter and fraud with sufficient particularity. Plaintiffs appealed. issue: Are allegations of motive and opportunity sufficient to meet the PSLRA’s heightened pleading standards for scienter? Can fraud be pleaded with sufficient particularity if the plaintiff relies on unnamed confidential sources? HELD: REVERSED and REMANDED to the trial court with instructions that the plaintiffs be permitted to re-plead their claims in light of the Second Circuit’s opinion.

16. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Recklessness - majority of courts regard recklessness as sufficient for scienter. To avoid liability, managers should make no statement unless, after thorough investigation, they in good faith believe it to be true. • In Connection with the Purchase or Sale of Any Security - only persons who actually purchase or sell securities can sue under Rule 10b–5. Parties that make or are responsible for misstatements and omissions in a manner reasonably calculated to influence the investing public or if they were of the sort upon which the investing public might reasonably rely may be liable. A company must be careful to monitor its public statements, such as those made in periodic reports, press releases, proxy solicitations, and annual reports.

17. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Reliance - to hold defendant liable, an investor must show that she relied either directly or indirectly on the misrepresentation or omission. • Direct Reliance - plaintiff actually read the document. In the case of an omission, plaintiff will be presumed to have relied on the omission, if it was material. • Fraud on the Market - rare because transactions are usually not conducted on a face-to-face basis. The market is interposed between the parties, providing important information to the parties in the form of the market price. • Truth on the Market - In the following case, an appellate court found that the market was aware of one set of facts undisclosed by the defendants, but was not aware of another set of undisclosed facts.

18. PRIMA FACIE ELEMENTS FOR RULE 10B-5 CAUSE OF ACTION • Causation - plaintiff must prove that the defendant’s misstatement or omission caused him or her to suffer losses. Increasingly, this is an economic question, e.g., what factors influence the price of a stock in the securities market?

19. DIRECT RELIANCE Case 25.5 Synopsis. Rissman v. Rissman. Randall Rissman owned 2/3 of the stock of Tiger Electronics, a toy and game company founded by his father. His brother Arnold owned the balance. Randall managed the business while Arnold worked as a salesperson. Arnold did not elect himself to the board of directors of Tiger, although he could have done so because Tiger permitted cumulative voting. After the brothers had a falling out, Arnold sold his shares to Randall for $17 million. Thirteen months later, Tiger sold its assets to Hasbro for $335 million. Arnold sued Randall, claiming that Randall had deceived him into thinking that he would never take Tiger public or sell it to a third party. CONTINUED

20. DIRECT RELIANCE Case 25.5 Synopsis. (Cont’d) Based on representations made to Arnold who believed his stock would remain illiquid and not pay dividends, he sold his shares for whatever Randall was willing to pay. Arnold then sought the extra $95 million he would have received had he retained his stock until the sale to Hasbro. Arnold sued. The trial court granted Randall’s motion to dismiss the federal securities law claims, and Arnold appealed. For purposes of the appeal, the appeals court assumed the accuracy of Arnold’s allegations that Randall had told Arnold that he was determined to keep Tiger a family firm and that Randall secretly had planned to sell Tiger after acquiring Arnold’s shares. ISSUE: Does a non-reliance clause in a written stock-sale agreement preclude a seller of stock from recovering damages under the federal securities laws for prior oral statements? HELD: AFFIRMED.

21. FRAUD ON THE MARKET Case 25.6 Synopsis. In Re Apple Computer Securities Litigation. Apple was highly touting its new computer, the Lisa. The market was discounting the news. When the failure of Lisa occurred, Apple stock dropped by 75 percent. The plaintiffs sued under Section 10(b) claiming fraud on the market. ISSUE: Is there fraud on the market when a manufacturer made optimistic predictions about a new product, even though analysts and others following the company discounted the predictions and publicized the true state of affairs? HELD: NO. Since the market was aware of the situation, the suit was dismissed as a matter of law.

22. REFORM ACT SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS Forward-looking statements were designed to promote market efficiency by encouraging companies to disclose projections and other information about the company’s future prospects.

23. REFORM ACT SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS • Safe Harbor - forward-looking statements provide a safe harbor for certain statements made by a company regarding its securities. These include: • Statements concerning projection of revenues, income, earnings per share, capital expenditures, dividends, capital structure, or other financial items; • Statements concerning the plans and objectives of management for future operations, including plans relating to the issuer’s products and services; • Statements of future economic performance, including any such statement in the management’s discussion and analysis of financial condition; and • Any statement of the assumptions underlying or relating to any such statement.

24. REFORM ACT SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS • Scope of Safe Harbor - the forward-looking statement safe harbor does not apply to: • An initial public offering (IPO); • An offering of securities by a blank check company; • A rollup or going-private transaction; • A tender offer; or • An offering by a partnership, limited liability company, or direct participation investment program.

25. REFORM ACT SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS • Two Prongs. Safe harbors limit liability as long as the forward-looking statement is identified as forward-looking, and the statement is accompanied by meaningful cautionary statements. • Other factors. The safe harbor applies when the company: • Identifies the statement as a forward-looking statement, • States that results may differ materially from those projected in the statement, and • Identifies a readily available written document that contains factors that could cause results to differ materially.

26. AUDITOR DISCLOSURE OF CORPORATE FRAUD The Reform Act promotes disclosures by independent public accountants of illegal acts committed by their publicly traded audit clients. The accounting firm must notify the company’s management of the illegal act(s) and notify the SEC in the event the company does not correct the errors in a timely manner.

27. REMEDIES FOR VIOLATION OF RULE 10B-5 • Damages. Generally, an investor’s damages are out-of-pocket losses, i.e., that is, the difference between what the investor paid (or received) and the fair value of the stock on the date of the transaction. • Rescission. An investor can also elect to rescind the transaction and receive the investment plus, in some cases, interest. Punitive damages are not available.

28. INSIDER TRADING • Definition. Generally, insider trading is stock-trading by “insiders” (such as officers and directors) based on material nonpublic information. Insider trading focuses on the duty to disclose by insiders. In other words, an insider must either disclose the information or not trade. The U.S. Supreme Court has held that a trade based on material nonpublic information is illegal only if there is a breach of duty by the person trading; or if the person trading is the recipient of a tip - a piece of inside information - there must be a breach of duty by the person who gave the tip. The person giving the tip is known as the tipper; the person receiving it is known as the tippee.

29. INSIDER TRADING • 10b-5 Presumption - persons who trade while in possession of material, nonpublic information trade on the basis of that information are presume insider traders unless the trade is pursuant to a pre-existing plan.

30. CLASSICAL THEORY OF INSIDER-TRADING • Insiders include not only traditional insiders - such as officers and directors - but also temporary insiders, such as outside counsel and financial consultants. • Traditional Insiders - Traditionally, only persons closely allied with the corporation itself were considered insiders. • Officers and Directors - owe fiduciary duties to the shareholders. • Controlling Shareholders - can control corporate activities and owe fidicuary duty to minority shareholders. • Employees - may not personally profit from confidential information. • The Corporation - must not trade while in possession of material nonpublic information, e.g., buy-back shares. • Temporary Insiders - contractors who are attorneys, accountants, consultants, and investment bankers.

31. TIPPEES OF INSIDERS • Scope. Tippees, persons who receive information from a traditional or temporary insider, may also be subject to liability under Rule 10b–5. However, in most cases a tippee has no independent legal duty to the shareholders of the corporation. • Liability of Tippers and Tippees - to be liable, the tipper must desire to benefit herself and breach a fiduciary duty to the corporation by disclosing non-public, confidential information to the tippee. The tippee is liable only if she knew or should have known that the tipper’s disclosure of the confidential information constituted a fiduciary breach. • Remote Tippees (tippees of tippees) - are not liable unless they knew or should have known that the first-tier tipper was breaching a fiduciary duty in passing on the nonpublic information.

32. TIPPEES OF INSIDERS Case 25.7--Dirks v. SEC. Dirks was an investment analyst of insurance company securities to institutional investors. Secrist, a former employee of Equity Funding of America and someone wanting to expose fraudulent activities there, contacted Dirks and told Dirks of overvaluation of assets of Equity Funding. After checking out Secrist’s story, Dirks advised clients to sell their Equity Funding shares. When the fraud was later revealed at Equity Funding, the stock priced dropped. ISSUE: Is the tippee liable absent a violation of fiduciary duty by the tipper? HELD: No. The U.S. Supreme Court held that since Secrist, the tipper, had no fiduciary duty, Dirks was not liable as a tippee.

33. MISAPPROPRIATION THEORY OF INSIDER TRADING • Scope. If a person misappropriates non-public information, he has breached a fiduciary duty to the source of nonpublic information and is therefore liable under Rule 10b-5 because he converted the confidential information to his own use. • Duties of Trust or Confidence - are assumed in the following situations: • Agreement - when a person agrees to keep the information confidential. • Prior Dealings - when two people have a history, pattern, or practice of sharing confidences. • Family Connection - when a person receives or obtains material nonpublic information from a spouse, parent, child, or sibling.

34. MISAPPROPRIATION THEORY OF INSIDER TRADING Case 25.8-- United States v. O’Hagan. O’Hagan was a partner in a law firm that represented Grand Met in its acquisition of Pillsbury. O’Hagan traded on this non-public information and made over $4 million in profits. He was convicted on 57 counts of securities violations. ISSUE: Is a person who trades in securities for personal profit, using confidential information misappropriated in breach of fiduciary duty to the source of the information, guilty of violating Section 10(b) and Rule 10b–5? HELD: YES. The Supreme Court upheld the convictions under Section 10(b) and Rule 10b-5 because O’Hagan misappropriated information in violation of his duty to his partners and client.

35. RICO Securities fraud cannot be the basis for a RICO (see Chapter 17) case unless the defendant has been criminally convicted in connection with the fraud. Similarly, a criminal conviction under the Wire and Mail Fraud Acts for misappropriation of an employer’s confidential information could, assuming other requirements are met, be the basis for a civil RICO case.

36. ENFORCEMENT OF INSIDER-TRADING PROHIBITIONS • Elements. In both government and private actions, the complaining party must demonstrate: • A misstatement or omission of a material fact, • Scienter, • Reliance by the injured party, • Causation, and • Loss.

37. ENFORCEMENT OF INSIDER-TRADING PROHIBITIONS • Private Actions - plaintiff must have standing, i.e., plaintiff is the actual purchaser or seller of securities, and the plaintiff’s loss must have been proximately caused by the acts of the defendant. Plaintiffs costs are limited to her actual out-of-pocket damages. • SEC Civil Enforcement - defendant may be liable for treble damages and enjoined from future trading. • Criminal Prosecutions - brought by the Department of Justice/U.S. Attorney’s Office. If convicted, defendant faces up to $1 million fine and/or imprisonment for up to ten years.

38. THE SECURITIES FRAUD ENFORCEMENT ACT OF 1988 • Increased Penalties - now up to 10 years in prison and up to $1 million in fines. Violators and their firms may be liable for civil penalties of triple the profit gained or loss avoided as a result of the wrongful trading. • Bounty Payments - of up to 10% of the revenues recovered may be paid to individuals whose tips result in insider-trading prosecutions. • Private Right of Action - for contemporaneous traders (persons who purchased or sold securities of the same class at the same time the insider was trading)

39. SHORT-SWING TRADING • Scope. Short-swing trading is the purchase and sale, or the sale and purchase, by officers, directors, and greater-than-10% shareholders of equity securities of a public company within a six-month period. Liability is imposed regardless of the defendant’s state of mind.

40. SHORT-SWING TRADING • Equity Security—any stock, any security or bond that is convertible or carries a warrant and any other security the SEC deems an equity security. • Matching—the shares that are sold need not be the same shares that were purchased, as long as the sales occurred within six months. • Profit Calculation—recoverable profits are calculated by comparing the sale price with the purchase price of the transaction(s). • Six Months—the clock starts ticking on the day the first purchase or sale occurred and ends at midnight two days before the corresponding date in the sixth succeeding month.

41. DEFINITIONS • Officer or Director—at the time of either the purchase or sale. • Greater-than-10% Shareholder—a shareholder, even though not an officer or director, who owns more than 10% of the stock at the time or the sale or purchase may be liable. • Beneficial Ownership of Shares—officers, directors, and greater-than-10% shareholders can be liable for short-swing trades of shares owned by a spouse, minor children, or any other relative living in her household, as long as she can vest title in herself or derive an economic benefit from the ownership of the shares.

42. SHORT-SWING TRADING • Unorthodox Transactions - a director, officer or 10% shareholder will not be liable if he did not receive cash and the sale/purchase of shares was involuntary, generally in the context of mergers and corporate reorganizations. However, if the trader received cash, then liability would attach. • Prohibition on Selling Short - officers or directors cannot sell a security they do not own. If the trader does not deliver the security within twenty days of the sale, she will be liable unless she acted in good faith and was unable to make the delivery or deposit within the specified time, or satisfying the time requirements would have caused undue inconvenience or expense

43. THE RESPONSIBLE MANAGER Preventing Securities Fraud and Insider Trading • Companies and managers have an obligation: • Not to mislead investors in company public announcements, periodic reports, or speeches. • To make disclosure if it knows its insiders, such as officers or directors, are trading in the company’s securities. • Comply with forward-looking factors and cautionary language. • To not trade while in possession of material nonpublic information. • To carefully guard confidential information and establish rigid procedures to enforce confidentiality. • Establish comprehensive policies on insider trading policies and punishment. • To disclose any short swing purchases or sales within a six month period and pay all profits to the corporation. • Report their security holdings and their trades in a timely manner.

44. REVIEW 1. What is an S-1 review, and why should an accountant do one? • Why is materiality judged at the time of the misstatement or omission? • When do courts consider a market efficient?