mergers & acquisitions section 3c: securities regulation prof. amitai aviram [email protected]...

Mergers & acquisitionsSection 3c:

Securities regulationProf. Amitai [email protected]

University of Illinois College of LawCopyright © Amitai Aviram. All Rights Reserved

F15D

Securities regulationMethods of regulating

• Regulation of merit means a substantive assessment of the security’s risk (risky stock offers are prohibited)

• Regulation of disclosure means that issuers must provide certain information and will be punished if information was not provided or was misleading– How does disclosure regulate securities?

• Analogies– Bar exam vs. movie ratings– FDA drug approval vs. nutritional content disclosure

• Federal securities laws focus on disclosure

© Amitai Aviram. All rights reserved.2

Securities regulationSecurities Act of 1933

• Principally concerned with the primary market– Issuer: the company that is offering its securities– Primary market: transactions in which issuer purchases or sells its

securities• Two goals:

– Mandating disclosure of material information to investors– Prevention of fraud


Securities regulationSecurities Exchange Act of 1934

• Principally concerned with the secondary market• Regulates various activities, including:

– Proxy solicitation [§14(a-b)]– Share purchases & tender offers [§13(d), 14(d-e)]– Securities fraud (including insider trading) [§10(b) & Rule 10b-5]– Short swing-profits by firm insiders [§16(b)]

• Created the Securities & Exchange Commission (SEC)– Enforces securities laws– Promulgates rules & regulations to implement securities laws


Securities Act v. Exchange ActDisclosure requirements

Securities (’33) Act• Transactional

– Disclosure by issuers in connection with a primary market transaction

• File registration statement with SEC

• Provide prospectus to investors

Exchange (’34) Act• Periodic

– Form 10 (once per security class)– Form 10-K (annual)– Form 10-Q (quarterly)– Form 8-K (episodic, within four

business days)


Securities regulationOverview of Section 3c

1. What’s a security2. Offering securities3. Securities fraud4. Insider trading


What’s a security?Why does it matter?

• Securities regulation is the single most common source of legal malpractice claims among business lawyers– E.g., not recognizing that a transaction involves a security, and

therefore not following the registration process• Cause of action for securities fraud is easier to establish than

regular fraud– Easier to prove reliance on the misrepresentation of the other

party & transaction causation– Easier to prove materiality of representations


What’s a security?

• So what is a security?– Securities Act, §2(a)(1): “The term ‘security’ means any note,

stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, … investment contract, voting trust certificate, … any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities… or, in general, any interest or instrument commonly known as a “security”…”

• Wait! It gets worse!– First sentence of §2 states that the terms used in the act shall be

defined in accordance with the various provisions of §2, “unless the context otherwise requires.”


What’s a security?

• So the definition in §2(a)(1) of the Securities Act includes:– Specific instruments: note, stock, bond, etc.– Catch-all phases: investment contract, evidence of

indebtedness, any interest or instrument commonly known as a “security”, etc.

– Escape hatch: unless the context otherwise requires


What’s a security?Stock (Forman / Landreth)

• Forman: Instrument called ‘stock’ is considered stock if it has:– Right to receive dividends contingent upon an apportionment of profits– Negotiability– The ability to be pledged or hypothecated (pledged without delivery of possession)

– Voting rights in proportion to the number of shares owned– The ability to appreciate in value

• Landreth: If stock satisfies the Forman criteria, its sale is always governed by securities laws, and Howey test does not apply


What’s a security?Note (Reves)

“Family Resemblance Test”• Presumption that a note is a security• Presumption rebutted if note falls into one of these categories

– Note delivered in consumer financing– Note secured by a mortgage on a home– Short-term note secured by a lien on a small business or some of its assets– Note evidencing a ‘character’ loan to a bank customer– Short-term note secured by an assignment of accounts receivable– Note which simply formalizes an open-account debt incurred in the ordinary

course of business– Note evidencing loan by a commercial bank for current operations– Additional categories that a court finds not to be a security



• Criteria for evaluating whether a note is a security1. Motivations prompting reasonable seller/buyer to

enter into it• Security

– Seller's purpose is to raise money for the general use of a business enterprise or to finance substantial investments

– Buyer is interested primarily in the profit the note is expected to generate

• Not security– Facilitates purchase/sale of minor asset or consumer good– Corrects for the seller's cash-flow difficulties– Advances some other commercial or consumer purpose



• Criteria for evaluating whether a note is a security2. “Plan of distribution” of the instrument

• Security: If there is “common trading for speculation or investment”

3. Reasonable expectations of the investing public4. Factors that significantly reduce risk of the instrument,

rendering application of the Securities Acts unnecessary

• E.g., Existence of another regulatory scheme


What’s a security?Investment contract (Howey)

• Howey – An interest in an enterprise is an “investment contract” if it is:

1. An investment2. In a “common enterprise”3. With a reasonable expectation of profits4. Profits derived from the entrepreneurial or managerial

efforts of others


Investment contractsThe Howey test

1. An investment– Anything constituting legal consideration should satisfy the first

prong



2. “Common enterprise”• Horizontal commonality: Relationship between the investors.

Requires pooling of contributions and distribution of profits and losses on pro-rata basis among investors.

• Hypo: Five people pay $100 each to Jane, the founder of “Jane’s Inspiration Club”. Jane then gives inspirational talks around the country, and divides the admission fees (after deducting her expenses) among the investors in equal shares. Is there horizontal commonality here?



2. “Common enterprise”• Hypo 2 – the Pyramid scheme: Five people pay $100 each to Jane,

the founder of “Jane’s Inspiration Club”.• As club members, they give inspirational talks in which they

encourage listeners to join the club (which requires paying Jane $100).

• Each club member receives at the end of the year an ‘honorarium’ based on the number of people he recruited, the number of people they recruited, etc.

– Is there horizontal commonality?– To whose fortunes are club members’ fortunes tied?



2. “Common enterprise”• Vertical commonality: Relationship between investor and promoter

of the scheme. Requires that the “fortunes of the investors [be] linked with those of the promoters.”

– “Strict vert. comm.”: Investors’ fortunes linked to promoter’s fortunes– “Broad vert. comm.”: Investors’ fortunes linked to promoter’s efforts

• Split among circuits whether vertical commonality suffices to create a “common enterprise”

– 7th Cir. accepts only horizontal commonality– 5th, 8th, 9th & 10th Cir. accept both horizontal & vertical commonality



2. “Common enterprise”• Hypo 3: Alan creates an LLC, which has ten “member certificates”,

all of which he owns.– Owners of membership certificates manage the LLC (as if they were directors)

• Alan sells all ten member certificates to Betty• Betty later discovers that the LLC had certain liabilities that Alan did

not disclose.• She sues him for securities fraud. Are the membership certificates

securities?• Are the membership certificates an investment contract?• Might they belong to another class of securities?



3. Reasonable expectation of profits• In the past, courts (including the U.S. Supreme Court in Forman)

thought that “profits” under Howey are limited to variable returns (“capital appreciation” & “a participation in earnings).

– This excluded fixed return investments (e.g., bonds, notes) from being “investment contracts”.

• In SEC v. Edwards (2004), the Supreme Court clarified that profits include any “financial returns on… investments”

– So, both fixed & variable return investments qualify



4. Profits derived from efforts of others• Profits need to be solely derived from efforts of others; aimed to

protect passive investment– Courts sometimes consider investor’s knowledge of industry to assess whether

he/she is capable of exercising control • This prong becomes an issue with interests in unincorporated

entities (e.g., LLCs), where members maintain certain abilities to protect their investment (e.g., ability to remove the manager without cause, or to veto the taking of loans outside ordinary course of business)

– Why is this less of an issue with active SHs in a close corporation?



1. What’s a security2. Offering securities

– The registration process– Civil liabilities– Exemption from registration

3. Securities fraud4. Insider trading


The registration processPrior to filing a registration statement

• No offering of securities for sale through the mails or by use of interstate commerce


http://sunshinetree.org/images/nosoliciting-3.gif

The registration process From filing until statement becomes effective

• SEC review (adequacy of disclosure, not merits)• Offers permitted but no sales• Interim period is 20 days after filing unless SEC issues an

order halting the process– Price cannot be determined 20 days in advance, so:

• Issuer gets advance approval of incomplete statement (without the price)

• Issuer then adds price and asks to approve statement again, effective immediately


The registration process Once registration statement becomes effective

• Selling allowed• Prospectus must be delivered to people offered the

securities before the sale

Acme Shares


• Express private rights of action:– Securities Act §11 (misrepresentations in registration statement)

• No need to show reliance, causation or scienter– Securities Act §12(a)(1): strict liability for illegal offers / sales

• Main remedy: rescission– Securities Act §12(a)(2): misrepresentations in prospectus / oral

sales communication• Implied private rights of action:

– Exchange Act §10(b) & SEC rule 10b-5 [securities fraud]– Exchange Act §14(a) & related rules [proxy solicitation]


Civil liabilities

Civil liabilitiesMisrepresentations in registration statements

• Liability if at time registration became effective, it:– Contained an untrue statement of a material fact– Omitted a material fact

• required to be stated• or necessary to make the statements therein not misleading

• Exceptions:– No cause of action if plaintiff knew of untruth/omission– Doesn’t apply to transactions that are exempt from registration


• People liable:– Anyone who signed the registration statement

• Issuer, principal executive officers & majority of directors must sign– Every person named in reg. stat. as about to become a director– Every expert named in reg. stat. as having prepared or certified any part

of the statement, or as having prepared any report or valuation used in connection with the statement

– Every underwriter of the security• Standard of liability:

– The issuer is strictly liable– Due diligence defense available to the other defendants



Due diligence defense [§11(b)]• Misrepresentations in the “non-expertised part”

– Experts not liable [§11(a)(4)]– Non-experts have a defense if they show that, after reasonable

investigation, they had reasonable grounds to believe, and did believe that the statements were true [§11(b)(3)(A)]

• Test for reasonable investigation & reasonable belief – the level of care that a prudent person would exercise if his own money was at stake [§11(c)]



Due diligence defense [§11(b)]• Misrepresentations in the “expertised part”

– Expert has a defense if she shows that either• (i) she had, after reasonable investigation, reasonable ground

to believe and did believe, that the statements were not misleading

• (ii) the misleading part of the reg. stat. didn’t fairly represent her work [§11(b)(3)(B)]

– Non-experts have a defense if they had no reason to believe and did not believe that the statements were misleading or didn’t fairly represent expert’s opinion [§11(b)(3)(C)]



Civil liabilitiesViolating the registration process

• Securities Act §12(a)(1): Liability for offering or sellinga security in violation of the registration process mandated by the Securities Act

• Strict liability, unless security is exempt from registration• Securities Act causes issuers to provide more information to

prospective investors– Is there a reason to exempt any sale of securities from

registration?


Exemption from registrationSecurities Act §3-4

• Exempted securities [§3]– Specific exemptions [14 exemptions specified in §3(a)]– Exemptions under SEC rules/regulations, for offers up to $5M

[§3(b)]– Exempted securities are always exempted from registration

• Exempted transactions [§4], include:– “Transactions by any person other than an issuer, underwriter, or

dealer”– Private offerings: “Transactions by an issuer not involving any

public offering”– Exempted transactions may require registration before future

resale of securities


Exemption from registrationDoran v. Petroleum Management Corp.

• PMC organized an LP to drill for oil• Doran acquired an interest in the LP, and paid in part by

assuming one of PMC’s debts (and paying interest from his share of the profits the LP distributed)

• When LP starts losing money, Doran stops paying the debt; creditor sues & wins judgment vs. Doran & PMC

• Doran sues PMC for rescission of his acquisition of the LP interest & judgment declaring PMC liable for the assumed debt– Why does Doran think he can rescind the contract?– What’s PMC’s counter-argument?



• Doran claims violations of Securities Act & Exchange Act, including a violation of §12(a)(1): Offer/sale of securities without registration

• Is Doran’s LLC interest a security?– Trial court found that it is

• Is security exempt from registration?– PMC claims a §4(2) exemption, arguing that offer to Doran was a

private offering



Factors determining applicability of the §4(2) exemption:• Number of offerees & relationship of each to issuer

– Actual disclosure of info “a registration statement would have afforded”; or

– Access to same info• “Privileged position” (e.g., employment, family, bargaining

power) providing offerees with the ability to obtain the info• Offerees must have sufficient financial sophistication

• Number of units offered• Size of the offering (in dollars)• Manner of the offering

– Personal contact rather than public advertising or intermediaries (investment bankers/securities exchanges)


Exemption from registrationRegulation D

• To provide more certainty, Regulation D creates a safe harbor for private offerings

• In all of these cases:– Issuer can’t advertise publicly– Issuer must file a notice of the sale with the SEC shortly after it

issues the securities

Amount offered Max. # of offerees Rule

< $1M Unlimited 504

< $5M 35 505

> $5M 35 + sophistication test 506


Securities fraudWhy is there a special rule?

• Materiality: The number of factors that affect the value of a going business is usually larger than those affecting the value of an individual piece of property. It is more difficult for the outsider to know what info to ask for.– Therefore it is easier to mislead by omission

• Reliance/transaction causation: When buying on securities exchange, buyer doesn’t purchase directly from a seller (and doesn’t know who was the seller). How can she prove seller’s statements induced her to buy?

• Loss causation: Many factors affect shares’ market price. How can buyer prove that the price drop was due to the fraud?


Securities fraudExchange Act §10(b)

• “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.”

• §10(b) applies to both registered & unregistered securities• §10(b) is not self-executing; SEC rules fill 10(b) with content


Securities fraudRule 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,(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, or(c) 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.”


Securities fraudLiability for violating Rule 10b-5

• Rule 10b-5: “It shall be unlawful for any person…”• What are the consequences implied by “unlawful”?

– Criminal sanctions: Willful violation of provisions of the Exchange Act or rules promulgated under the act is a felony [EA §32(a)]

– Civil Action by SEC (for injunction or money penalty) [§21(d)]– Cause of action for private parties

• No express cause of action in §10(b) or Rule 10b-5• Superintendent of Insurance v. Bankers Life & Casualty Co (1971): Supreme

court implies private right of action• Today it is clear that such implied right of action exists


Rule 10b-5Elements

• Deception / manipulation• Jurisdictional nexus• Transactional nexus• Materiality• Scienter

• Reliance (transaction causation)• Loss causation

In private lawsuit (plaintiff is not SEC),

also…


Rule 10b-5Deception / manipulation

• Deception– A misstatement or an omission that misleads

• Manipulation– Artificially affecting market activity to mislead investors. E.g.,

• Wash sales: Manipulator enters purchase order & sale order at same time through same broker. Ownership of stock doesn’t change, price of deal doesn’t matter (manipulator is paying himself), but deal creates appearance that willing buyer & seller valued the stock at that price.

• Matched sales: Same, only using different brokers• Rigged prices: Collaborating manipulators buy & sell to/from each

other


Deception / manipulationDuty to disclose

• When 10b-5 liability is alleged for an omission (rather than making an untrue statement), liability arises only if defendant had a duty to disclose [Basic, FN 17]– Hypo: Acme is holding secret negotiations to merge with Ajax. A reporter asks

Acme’s CEO about rumors of the negotiations. What can the CEO do to keep the negotiations secret?

• Duty to correct– Statement that was correct at time it was made may require a correction if

circumstances change while a reasonable investor expects it to apply– Untrue statement made by an officer who didn’t know it was false requires

correction by another officer who knows statement is false– SHs & directors have no obligation to speak for the firm (unless they are also

officers), so they don’t need to correct wrong statements


Rule 10b-5Jurisdictional nexus

• 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…”

• Why is the jurisdictional nexus an element of securities fraud?


Rule 10b-5Transactional nexus

• Rule 10b-5: “…in connection with the purchase or saleof any security”

• “…in connection with…”: Fraud only needs to “touchand concern” a purchase or sale– E.g., defrauding party not necessarily party to the transaction

• “...purchase or sale…”: Both people who bought securities because of the misrepresentation & people who sold securities because of the misrepresentation– Doesn’t include people who decide not to buy due to a

misrepresentation [Blue Chip Stamps v. Manor Drug Stores (US 1975)]

• “…of any security” – must be a security, but doesn’t have to be a registered security


Rule 10b-5Materiality

• Rule 10b-5: “…(b) To make any untrue statement of amaterial 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…”


MaterialityBasic, Inc. v. Levinson [US 1988]

• Basic & Combustion secretly negotiated a merger for 2 years. Basic repeatedly denied rumors about these negotiations– Why did Basic & Combustion keep the negotiations secret?– Is this an insider trading case?

• Materiality standard: “substantial likelihood that a reasonable shareholder would consider the fact important in deciding how to [exercise her rights]” [TSC Industries, Inc. v. Northway, Inc. (US 1976)]– Basic court: Materiality depends on a balance between probability

& magnitude


Rule 10b-5Scienter

• State of mind of person making the misrepresentation– Intent to deceive, manipulate, or defraud [Ernst & Ernst v.

Hochfelder (US 1976)]– Later decisions held that reckless disregard of falsity of statement

is sufficient


Rule 10b-5Reliance (transaction causation)

• Transaction causation: But for the misrepresentation, plaintiff wouldn’t have purchased/sold the securities

• Plaintiff needs to show reliance on the misrepresentation in purchasing/selling the relevant securities– Omissions – reliance is presumed [Affiliated Ute Citizens of Utah v. U.S. (1972)]

• Basic v. Levinson – misrepresentation (reliance not presumed)– Basic is a class action, which can be certified only if it involves common

questions of fact or law– Unlikely that any evidence can prove reliance by all plaintiffs– Will this kill 10b-5 class actions?

• Basic court adopts the “fraud on the market” (FotM) theory – a rebutable presumption that all plaintiffs rely on the “integrity of the market price”


RelianceExplaining ‘fraud on the market’

• World with no fraud– Allison is a busy lawyer who has no time to compare prices when she buys

groceries at her local supermarket– Many other shoppers do compare prices and would shop elsewhere if the

supermarket raised its prices above those of rivals– If the supermarket can’t distinguish Allison from more price-sensitive

customers, will Allison’s pay more?• World with fraud

– Supermarket advertised tomatoes were 10% off, but instructed cashiers to charge original price (assuming price-sensitive customers will look at the advertised price but not check what they were charged)

– This fooled price-sensitive shoppers; Allison, of course, neither noticed the advertised price nor what she was charged

– Can Allison claim she relied on the advertised price?


RelianceFraud on the market

• FotM presumption can be rebutted if, e.g.,– Market was not deceived by the misrepresentation– Corrective statement issued prior to plaintiff’s purchase/sale– Plaintiff would have sold anyway

• E.g., plaintiff sold stock to raise money for a medical emergency. Since plaintiff had to sell, sale was not in reliance on integrity of market price

• FotM makes sense only if market is semi-strong form efficient– If less efficient, can’t rely on market price even if there are no

misrepresentations– If more efficient, misrepresentations won’t fool market


RelianceFraud on the market

• West v. Prudential Securities [CA7, 2002]: Hofman (a broker) told 11 customers that Jefferson Savings was about to be acquired at a premium, but this was a lie

• Plaintiffs bought Jefferson stock during time Hofman was persuading clients to buy that stock– Plaintiffs claim Hofman’s clients drove Jefferson’s price up, so

plaintiffs bought stock at artificially high prices• Court: Hofman’s misrepresentation was private (non-public)

information. FotM theory covers only fraud through publicly available information.


Rule 10b-5Loss Causation

• Loss causation: But for the misrepresentation, plaintiff wouldn’t have lost the amount sued for

• Change in price upon misrepresentation/correction isn’t enough• Market may not have believed the misrepresentation• Market price may have changed due to other reasons (e.g.,

info suggesting economy is entering recession)• West v. Prudential Securities: No loss causation when the alleged

misrepresentation was not public– If market is semi-strong efficient then an increase in the price of stock

without publicly-known information to justify it would result in the stock seeming too expensive, so some SHs would sell & bring price back down


Insider tradingIs insider trading bad?

• Ban on insider trading doesn’t prohibit trading by insiders; it prohibits trading on the basis of inside info– Narrower: doesn’t include trading by insiders wo/ inside info– Wider: may include trading by non-insiders on the basis of inside

info (e.g., insider tips friend who trades on this info)• Should insider trading be prohibited?


Is insider trading bad?Yes: Fairness

• Level the playing field between SHs– Insider SH profits more than outsider SH if allowed to use inside

info• But how is the outsider harmed?

– She made a buy/sale order voluntarily, and would have done so whether or not the insider participated in the trading

– Outsider gets a better price if insider increases demand when she is selling (or increases supply when she is buying)


Is insider trading bad?Yes: Incentives for bad management

• Insiders have influence on a firm’s performance. If they could insider trade, they may bet against their company (e.g., sell short its shares),and then sabotage the firm.– This argument applies only to bets

against insider’s company


Is insider trading bad?Yes: Disclosing secret information

• Confidential information leaked via insider trading– Insider trading may indirectly disclose info firm is trying to keep secret

(price changes caused by insider trading provide a hint to the market)– When the inside info is an acquisition, insider trading raises the price of

the shares, making it more expensive for A to buy T• Does government need to be involved?

– Expensive to monitor & detect use of inside information; significant economies of scale to monitoring

– Incarceration (which is unavailable as a private punishment) may be more effective than other sanctions in deterring insider trading


Is insider trading bad?No: Market efficiency

• If market is semi-strong form efficient, all public info is incorporated in the price, but private information isn’t

• Insider trading makes quicker & more gradual adjustments to the price, so price reflects private info– Results in more accurate prices (strong-form efficiency)


Is insider trading bad?No: Executive compensation

• Insider trading ties executive compensation to stock prices– Justifies only insider trading on good news– Also, profits depend on how much money insider trades more

than on the increase in share price• Unintended consequence: insider jobs become more attractive to rich

people• Firm that allows its executives to trade on inside info would be

able to pay them lower salaries– But insider trading is risky (may not be new inside info to trade on

every month), so executives would discount this source of income


Applying 10b-5 to insider trading

• Insider trading may be packaged as a 10b-5 violation: omission of a material fact (the nonpublic info) in connection with a purchase or sale of a security– ‘Disclose or abstain’: insider may either disclose the info & then trade

based on the now public info; or not disclose, but then has to abstain from trading based on the info

• Elements– Deception / manipulation– Jurisdictional nexus– Transactional nexus– Materiality– Scienter– Reliance (transaction causation)– Loss causation


Applying 10b-5 to insider tradingScienter

• In context of insider trading, scienter requires evidence that trading was on the basis of the material nonpublic info– Circuit split on whether possession of inside info while trading is sufficient, or

proof of use of the info is required• Rule 10b5-1(b) presumes scienter if insider traded while being aware

of material nonpublic info• Rule 10b5-1(c): affirmative defenses to rebut the presumption

– Before being aware of the info, insider entered a binding contract to buy/sell, instructed someone else to buy/sell, or adopted a written plan for trading (subject to additional conditions)

– Person other than natural person, where the natural person making the investment decision was not aware of the info

– Person other than natural person, that implemented a reasonable compliance program


Applying 10b-5 to insider tradingDeception / manipulation

• Liability for omission requires a duty to disclose– Duty to firm: Insider’s profit from trading is benefit arising from

fiduciary position & using firm’s property (info)• But firm often isn’t harmed from the insider trading• Firm may waive duty or ratify violation• Firm is unlikely to sue the insider

– Duty to SHs (traditional/classical theory): Implied FD of insider to firm’s SHs not to use nonpublic info that belongs to the firm to profit at their expense

– Duty to any principal (misappropriation theory): FD to one’s principal not to use for personal gain nonpublic info belonging to the principal

• Similar to duty to firm, but also applies to fiduciaries of principals other than the issuer


Applying 10b-5 to insider tradingTraditional theory

Who owes the duty?• Statutory insider [Defined in Exchange Act §16(a)]

– Directors, officers, 10%+ SHs• Temporary insider [Dirks v. SEC]

– Person obtained material nonpublic info from insider– With insider’s expectation that the outsider will keep the

disclosed info confidential– The relationship implies (or expressly requires) such a duty

• Derivative liability [Dirks v. SEC]– Person receiving tip from an insider (“tipee”) violates 10b-5 if:

• Insider breached FD by disclosing info to tipee– DoL, not DoC (insider must personally benefit from disclosure of info)

• Tipee knows or has reason to know of the breach of FD


Applying 10b-5 to insider tradingLimits of the traditional theory

• Chiarella v. United States [US 1980]: Chiarella worked at a financial printer retained by A in connection with a tender offer– A made effort to keep identity of T secret from printer’s employees, but

Chiarella figured it out & bought T shares– After the tender offer was announced, T’s shares rose in value & Chiarella sold

his shares at a profit– Chiarella’s was criminally prosecuted for a 10b-5 violation

• Court: Chiarella didn’t violate 10b-5, because he didn’t owe a duty to disclose the inside info– Cause of a 10b-5 violation is not the trading itself, but providing misleading info

in connection with trading (in insider trading – failing to disclose the inside info)– Chiarella didn’t owe fiduciary duties to T or its SHs, so no duty to disclose


Applying 10b-5 to insider tradingLimits of the traditional theory

• Dirks v. SEC [US 1983]: Secrist worked at Equity Funding (insurance company). To expose fraud he contacted Dirks (investment analyst). Dirks investigated, confirmed Secrist’s allegation & disclosed it to authorities, but also told his clients who sold their EF stock.

• SEC brought a 10b-5 action against Dirks for tipping the clients• Court: Dirks didn’t violate 10b-5

– Why was Dirks not in violation of Rule 10b-5?• Insider breached FD by disclosing info to tipee

– DoL, not DoC (insider must personally benefit from disclosure of info)• Tipee knows or has reason to know of the breach of FD

– What if Dirks paid Secrist for information about the fraud?


• U.S. v. O’Hagan [US 1997]: O’Hagan was a partner at a law firm hired by Grand Met to help in Pillsbury takeover. He wasn’t staffed on this matter, but learned of the deal & purchased Pillsbury securities. He was charged with a 10b-5 violation.– Did O’Hagan violate 10b-5 based on the traditional theory?

• Court upholds the misappropriation theory: A fiduciary’s use for personal gain of nonpublic info belonging to his principal, without disclosure of such use to the principal, constitutes fraud in connection with the purchase or sale of a security– If O’Hagen told his law firm & Grand Met that he was planning to trade on the

information of the takeover, would he have violated 10b-5?

Applying 10b-5 to insider trading Misappropriation theory


Applying 10b-5 to insider trading Misappropriation theory

• Rule 10b5-2: Non-exclusive list of three situations in which a person has a duty of trust or confidence for the purpose of the misappropriation theory:– Whenever a person agrees to maintain info in confidence– Whenever person communicating info and person to whom it is

communicated have a history, pattern or practice of sharing confidences, such that the recipient of the info knows or reasonably should know that person communicating the info expects recipient to maintain confidentiality

– Whenever the info is obtained from a spouse, parent, child or sibling, unless recipient shows that history, pattern or practice indicates no expectation of confidentiality


Insider trading & tender offersRule 14e-3

• Exchange Act, §14(e): “It shall be unlawful… to makeany untrue [statement or omission] or to engage in any fraudulent, deceptive or manipulative acts… in connection with any tender offer… The Commission shall [promulgate rules to fill prohibition with content].”

• Rule 14e-3(a): When a tender offer has commenced or is about to be commenced, it is a violation of §14(e) for a person other than A to trade in the relevant securities, if that person has material nonpublic information relating to the tender offer, which the person knows or has reason to know was acquired (directly or indirectly) from A, T or any officer, director, employee or other person acting on behalf of A or T


Insider trading & tender offersRule 14e-3

• Rule 14e-3(d): Corresponding prohibition on providing material nonpublic info if it is reasonably foreseeable that this communication will result in a violation of §14(e)

• Rule 14e-3 was upheld in U.S. v. O’Hagan


mergers & acquisitions section 3c: securities regulation prof. amitai aviram [email protected]...

Documents

index of securities

securities regulation

securities laws amitai

securities primary market

de securities fraud

disclosure amitai aviram

regulation of disclosure

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