Collateral Estoppel Implications of SEC Adjudications
Edmund H. Kerr and Robert J. Stillman, 42(2): 441–86 (Feb. 1987)
The Supreme Court held in Parklane Hosiery Co. v. Shore , 439 U.S. 322 (1979), that issues decided in an SEC district court enforcement action could be used offensively and be given preclusive (collateral estoppel) effect against the defendant in a later private action for damages under the securities laws. In University of Tennessee v. Elliot , 478 U.S. 788 (1986), the Court recently gave a ringing endorsement to the issue preclusive effect of administrative adjudications. These decisions suggest that findings made by the SEC in an administrative proceeding will bind the respondent when the respondent is later sued for damages for securities fraud. This Article analyzes that possibility, and it adduces federal case law and theory that might confound the case for preclusion.
An Insider's View of the Insider Trading and Securities Fraud Enforcement Act of 1988
Stuart J. Kaswell, 45(1): 145–80 (Nov. 1989)
This Article outlines the provisions of the recently enacted Insider Trading and Securities Fraud Enforcement Act of 1988. The Article discusses how the legislation alters the federal securities laws and imposes specific new statutory responsibilities on broker-dealers and investment advisers. It discusses changes to the law that permit the SEC to seek a civil penalty against a controlling person with respect to illegal insider trading committed by a controlled person. The Article also discusses aspects of the legislative process that produced this act.
How Accurate are Estimates of Aggregate Damages in Securities Fraud Cases?
Kenneth R. Cone and James E. Laurence, 49(2): 505–26 (Feb. 1994)
The parties in rule 10b-5 securities class actions frequently use computer simulations of stock trading to estimate aggregate damages. Despite the fact that these models often generate damage estimates amounting to hundreds of millions of dollars, they have never been publicly tested against actual class claims. This Article tests the models against claims data from two securities cases and concludes that the models substantially overestimate actual claims.
Estimating the Number of Damaged Shares in Securities Fraud Litigation: An Introduction to Stock Trading Models
Dean Furbush and Jeffrey W. Smith, 49(2): 527–43 (Feb. 1994)
Calculating damages in class action securities fraud litigation requires estimating the number of affected shares. The authors describe a trading model that has been used extensively for such purposes. They analyze its properties and highlight its weaknesses, showing that it is unbiased only under the assumption that all shares are equally likely to trade on any given day. Under more realistic assumptions, the model overestimates the number of damaged shares and, thus, overestimates damages. An alternative model is suggested.
The Role of Financial Economics in Securities Fraud Cases: Applications at the Securities and Exchange Commission
Mark L. Mitchell and Jeffry M. Netter, 49(2): 545–90 (Feb. 1994)
This Article illustrates how financial economics has been and can be applied in securities fraud litigation. Specifically, it describes an empirical technique (event study) developed by academic financial economists, relates this event study methodology to the relevant areas of securities fraud law, and shows its application in SEC enforcement actions to establish materiality and calculate disgorgement.
Using Finance Theory to Measure Damages in Cases Involving Fraudulent Trade Allocation Schemes
Jeffry L. Davis, William C. Dale, and James A. Overdahl, 49(2): 591–615 (Feb. 1994)
Federal laws governing both the securities markets and the commodities markets prohibit brokers, advisors, and other market professionals, except in specific instances, from allocating orders among accounts after trades have been executed. This prohibition is aimed at preventing these persons from engaging in fraudulent trade allocation schemes, the object of which is to divert profitable trades to favored accounts, including the broker's own, and allocating losing trades to less favored accounts. In this Article the authors use finance theory to develop a systematic and quantifiable measure of damages in cases of fraudulent trade allocation. This Article treats the trader's discretion to allocate orders after trade execution as an option that can be valued, like any other option, using the theory of rational option pricing. The authors apply their measure to two actual trade allocation cases. It is their contention that this method is generally applicable to all trade allocation cases.
Mirkin v. Wasserman: The Supreme Court of California Rejects the Fraud-on-the-Market Theory in State Law Deceit Actions
Christopher Boffey, 49(2): 715–39 (Feb. 1994)
In Mirkin v. Wasserman, 858 P.2d 568 (Cal. 1993), the California Supreme Court rejected a call to incorporate the fraud-on-the-market theory into the law of deceit in that state. The theory allows plaintiffs in actions under rule 10b-5 to establish the required element of reliance by showing they relied on the integrity of the market price for securities they purchased. The author reviews the case and argues that the fraud-on-the-market theory is equivalent to the indirect reliance theory, which is already available to California tort plaintiffs.
The Implications of Central Bank
Joel Seligman, 49(4): 1429–49 (Aug. 1994)
This Article addresses seriatim: (i) the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994); (ii) the implications of that decision; and (iii) what should be the appropriate liability standard in derivative claims.
Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A .–The Beginning of an End, Or Will Less Lead to More?
Lisa Klein Wager and John E. Failla, 49(4): 1451–66 (Aug. 1994)
This Article explores the implications of Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994), from a practitioner's vantage point. In particular, it identifies the most likely areas of future litigation related to alternative theories of liability that may be asserted against parties who traditionally have been charged with aiding and abetting securities fraud. The authors question whether the demise of aiding and abetting liability will, as a practical matter, lessen the likelihood that professionals and other "outsiders" will be sued.
Central Bank of Denver v. SEC
Simon M. Lorne, 49(4): 1467–78 (Aug. 1994)
The author, General Counsel of the SEC, presents a hypothetical future opinion of the Supreme Court. The opinion demonstrates that the Court's recent decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994), cannot properly be read as precluding the possibility that the SEC may still bring enforcement actions seeking injunctive or other civil relief against those who aid or abet violations of section 10(b) and rule 10b-5.
The Future of Aiding and Abetting and Rule 10b-5 After Central Bank of Denver
David S. Ruder, 49(4): 1479–87 (Aug. 1994)
This Article urges Congress to amend section 10(b) of the Exchange Act–which is highly unlikely to happen–to provide aider and abettor liability and suggests that Congress may be faced with the need to deal with a Supreme Court majority that will limit the law of securities fraud under rule 10b-5.
SEC v. Central Bank: A Draft Opinion for the Court's Conference
Edward C. Brewer, III and John L. Latham, 50(1): 19–46 (Nov. 1994)
In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994), the Supreme Court held that section 10(b) of the Exchange Act does not create aiding and abetting liability. That decision involved private parties suing under the section 10(b) implied right of action. After Central Bank, the SEC has dismissed most of its aiding and abetting claims and requested that Congress amend section 10(b) but is pursuing a small number of test cases in which it maintains that the decision does not apply to its enforcement actions under the existing statute. Simon M. Lorne, General Counsel of the SEC, presented a hypothetical opinion to that effect in Central Bank of Denver v. SEC, 49 BUS. LAW. 1467 (1994), and three other symposium Articles commented on the questions and problems raised by the Central Bank decision. The authors, who are counsel of record to an individual aiding and abetting defendant in a test case in the Eleventh Circuit and the Northern District of Georgia, present a contrary hypothetical opinion explaining why, after Central Bank, the SEC may not pursue aiding and abetting claims under the existing section 10(b).
Secondary Liability Under Rule 10b-5: Still Alive and Well After Central Bank?
Gareth T. Evans and Daniel S. Floyd, 52(1): 13–34 (Nov. 1996)
Although in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A ., 511 U.S. 164 (1994), the Supreme Court held that there is no aiding and abetting liability in a private action under rule 10b-5, the Court recognized that secondary actors are still subject to liability for primary violations. Since Central Bank, numerous lower courts have struggled with the issue of when the conduct of secondary actors (such as accountants, underwriters, and lawyers) gives rise to primary as opposed to aiding and abetting liability. Some courts have imposed primary liability on secondary actors for assisting in the preparation of statements that are alleged to contain misrepresentations or omissions. Other courts have held that the same conduct is merely aiding and abetting. This Article analyzes the approaches courts have taken to the scope of primary liability following Central Bank and discusses whether they are consistent with the Supreme Court's reasoning.
Is Mens Rea Required for a Criminal Violation of the Federal Securities Laws?
Norwood P. Beveridge, 52(1): 35–64 (Nov. 1996)
Although it has been six decades since the enactment of the Securities Act and the Exchange Act, the question of whether criminal intent must be proved for a criminal violation of either statute has remained in doubt due to equivocation in the decided cases and commentary. The author argues that, in light of the legislative history and the usual presumption that criminal conviction requires proof of criminal intent absent a clear congressional mandate to the contrary, proof of a general criminal intent, or mens rea , must always be shown for conviction of a securities law offense.
Controlling Person Liability Under Section 20(a) of the Securities Exchange Act and Section 15 of the Securities Act
Lewis D. Lowenfels and Alan R. Bromberg, 53(1): 1–33 (Nov. 1997)
The Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), eliminated federal private securities actions against secondary parties based upon aiding and abetting and possibly on conspiracy, respondeat superior , and common law agency as well. It is then reasonable to expect that more private actions against secondary parties will be based upon control person liability, which has explicit statutory authority in federal and state law. This Article examines secondary liability in private actions against controlling persons under section 15 of the Securities Act and section 20 of the Exchange Act in cases not involving broker-dealers (for whom a separate jurisprudence has developed). It addresses the specific statutory language, the legislative history, and the relevant judicial decisions to establish a prima facie action against controlling persons under section 15 and section 20 as well as the elements of defenses that must be established to avoid liability. The Article concludes that the law, with respect to controlling person liability and sections 15 and 20, is unpredictable and confusing, in short subject to the same uncertainties that motivated the Supreme Court to abolish aider and abetter and, perhaps, other theories of secondary liability in Central Bank.
The Analyst-Added Premium as a Defense in Open Market Securities Fraud Cases
William O. Fisher, 53(1): 35–64 (Nov. 1997)
Analysts predict earnings but are often wrong. When their predictions are too high, those overly optimistic forecasts may inflate the price of a company's stock. A considerable body of caselaw defines when an issuer is liable for forecasts an analyst makes. This Article argues that, when the company is not liable under that caselaw for an analyst prediction, any damages awarded against the company should exclude the price inflation caused by the analyst's too rosy forecast.
U.S. Securities Fraud Across the Border: Unpredictable Jurisdiction
Lewis D. Lowenfels and Alan R. Bromberg, 55(3): 975–1021 (May 2000)
We live in an increasingly global financial community. In recent years, transactions involving securities often extend across national borders. Under these circumstances, parties who view themselves as defrauded in connection with securities transactions that are predominantly extraterritorial in nature, but have some connection to the United States, often attempt to seek redress in U.S. courts under the broad antifraud provisions of section 10(b) of the Exchange Act and rule 10b-5 promulgated thereunder. Parties seeking such redress must first establish subject matter jurisdiction under the Exchange Act. This Article addresses the essential question, which is to what extent and under what factual circumstances the federal securities laws and particularly the antifraud provisions of section 10(b) and rule 10b-5 will be applied to securities transactions that are predominantly extraterritorial in nature but have some connection to the United States. Unfortunately, Congress has not provided clear, specific guidelines with respect to these issues. Therefore, it has been left to the federal courts to attempt to develop some parameters in this area. This Article explores both the meager statutory guidelines and the much more extensive case law that delineate these parameters.
The Neglected Relationship of Materiality and Recklessness in Actions Under Rule 10b-5
Allan Horwich, 55(3): 1023–38 (May 2000)
The concept of "materiality" under the federal securities laws has received much attention from the courts and the SEC, yet it has become increasingly murky. Judgments about what is and what is not material for purposes of the disclosure requirements under SEC rules and the antifraud provisions of the federal securities laws are often very difficult. At the same time, errors in making those judgments can result in civil liability. Litigants seldom contend that, and courts seldom address whether, a defendant's judgment about whether a fact was material is germane in assessing liability, particularly under rule 10b- 5. This Article suggests that the determination of liability under rule 10b-5, particularly where the defendant is alleged to have acted recklessly (rather than with a specific intent to defraud), should take into account whether the defendant was reckless in failing to appreciate the materiality of the fact that was omitted or misrepresented. In other words, a determination of whether a defendant acted with scienter encompasses an evaluation of whether the defendant was reckless in not recognizing that the omitted or misrepresented fact was material.
The Boundaries of the "In Connection With" Requirement of Rule 10b-5: Should Advertising Be Actionable as Securities Fraud?
Francesca Muratori, 56(3): 1057 (May 2001)
The content of advertising has traditionally been the domain of consumers and the companies enticing them to make purchases, often stretching the truth in the process. Consumers, long familiar with those techniques, understand that ads are not the province of hard facts. Those relationships may be poised to undergo change in the wake of the Second Circuit's holding in In re Carter-Wallace Securities Litigation . Issuer liability to stockholders who claim a trading decision was based on allegedly misleading advertising expands the boundaries of the "in connection with" element of Rule 10b-5 and imposes uncertainty on the conduct of business.
The Fiduciary Duties of Institutional Investors in Securities Litigation
Craig C. Martin & Matthew H. Metcalf, 56(4): 1381 (Aug. 2001)
The Private Securities Litigation Reform Act of 1995 was enacted to expand the role of institutional investors in securities litigation in the hopes that such involvement would serve to moderate what were widely perceived as abusive litigation practices in this area. However, these institutional investors must also observe their significant fiduciary obligations under the Employee Retirement Income Security Act. The Article discusses the redefined role of institutional investors in securities litigation in light of both of these pieces of legislation and examines some potential benefits and unique concerns that institutional investors must now consider when a securities fraud claim arises.
Rule 10b-5's "In Connection With": A Nexus for Securities Fraud
Lewis D. Lowenfels and Alan R. Bromberg, 57(1): 1 (Nov. 2001)
The precise meaning of the crucial words "fraud in connection with the purchase or sale of any security" as used in section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder has never been completely clear. Courts have not pinned down with any specificity the meaning of the requirement that fraud occur in connection with the purchase or sale of a security. In this article the authors analyze this requirement from a number of different vantage points in a number of different factual settings. There is a clear dichotomy in the case law. On one side is a broad judicial interpretation of the "in connection with" phrase, and this broad view is clearly the predominant line of authority. On the other side is a narrower, more circumscribed, judicial interpretation of this phrase which, although by no measure predominant, does manage to retain a certain stubborn vigor and vitality. The ultimate test is a nexus: how close must the fraud be to the purchase or sale of a security to invoke the coverage of Rule 10b-5?
Financial Statement Fraud: The Boundaries of Liability Under the Federal Securities Laws
Richard C. Sauer, 57(3): 955 (May 2002)
Accurate information about public companies is fundamental to the operation of our capital markets. The recent spate of major accounting scandals, however, reminds us that the reported performance of public companies can be highly vulnerable to manipulation. The result is the squandering of billions in investor funds and the erosion of faith in the securities markets. This Article describes common approaches employed to misrepresent the operating results of public companies. Taking examples from recent SEC enforcement actions, it discusses a range of earnings management techniques and analyzes their status under present standards of legal liability, with particular emphasis on those areas of financial reporting in which standards are unclear or evolving.
Section 11 of the Securities Act: The Cornerstone Needs some Tuckpointing
Allan Horwich, 58(1): 1–44 (Nov. 2002)
Section 11 of the Securities Act provides for civil liability for the sale of securities pursuant to a materially false or misleading registration statement. Developments since enactment necessitate revision of section 11, particularly as the focus of litigation involving initial public offerings shifts to section 11 in reaction to the burdens imposed by Congress under Rule 10b-5 of the Securities Exchange Act. The 1995 amendment of section 11 that modified joint and several liability by providing for proportionate liability only for outside directors created inconsistencies in the statutory scheme that should be cured. The special protection afforded outside directors vis-à-vis other categories of defendants should be re-examined in view of recent corporate scandals. Moreover, sound policy supports extending proportionate liability to all nonexpert individuals who are subject to suit under section 11 who do not act with actual knowledge of the misrepresentation or omission. The statutory safe harbor for forward-looking statements that was enacted in 1995 does not apply to an initial public offering. That safe harbor should protect statements made in that context; there is no convincing rationale for the exclusion, and the other protections for forward-looking statements are not adequate for this purpose. Further, in the rare case where the issuer of securities did not know and could not have known of the material deficiency in disclosure, issuer strict liability should be relaxed. Concurrent state and federal jurisdiction of section 11 claims should be re-examined. These and other suggested reforms would harmonize section 11 with other provisions of the federal securities laws.
Enron at the Margin
William H. Widen, 58(3): 961–1002 (May 2003)
This Article explains how Enron's officers, directors, and lawyers orchestrated violations of the margin regulations when they structured and implemented the now infamous Raptor transactions. Thus, the oft-repeated mantra Enron technically complied with existing law in structuring these transactions is exposed as false. This Article analyzes the Raptor transactions against the standard of conduct required by the Securities Exchange Act of 1934 and the margin regulations promulgated by the Federal Reserve Board under that Act. Significantly, a violation of the margin regulations does not require proof of scienter. Existing law and regulations are reviewed to outline possible criminal liability for the identified margin violations that do not rely on proof of scienter. The identified violations are linked to the harm that contributed to Enron's downfall. Although the Raptor transaction structures were, in detail and purpose, novel, they failed for traditional and foreseeable credit quality reasons. The over-leverage and resulting unstable credit of the Raptor structure, supplemented by a general purpose to deceive, emerge as the real culprits. Enron violated disclosure laws by falsely claiming high credit standing for its derivatives transactions (although the details of determining liability for disclosure violations are left to others). The Article concludes by suggesting that a decision to prosecute Enron and its enablers for technical criminal violations of law would signal a return to traditional notions of criminal liability. Such a return to basic principles of criminal law might be very effective medicine for what ails existing corporate and legal culture. By insisting that ignorance of law is no defense, even to technical violations of law, society directs that the business and legal communities should seek ethical standards for their communities elsewhere rather than in technical compliance with law.
A New Player in the Boardroom: The Emergence of the Independent Directors' Counsel
Geoffrey C. Hazard, Jr. and Edward B. Rock, 59(4): 1389–1412 (Aug. 2004)
When should a secondary actor to a securities fraud—like an accountant or a lawyer—be liable to the same degree as the primary culprit? Ever since the Supreme Court abolished aider and abettor liability for violations of section 10(b) of the Securities Exchange Act of 1934, courts have struggled to answer that question, and the struggle has led to competing standards. In the case of misrepresentations in connection with the purchase or sale of securities, the Courts of Appeal have split between those imposing liability on secondary actors who ''substantially participate'' in making a misrepresentation, and those who also require, as a ''bright line'' test, that the misrepresentation be publicly attributed to the secondary actor before the plaintiff makes his or her investment decision. The court hearing the cases arising from the Enron debacle adopted yet a third alternative, the so-called ''creation'' test, imposing liability on a secondary actor who, alone or with others, ''creates'' a misrepresentation. This Article explores the problem of misrepresentations by secondary actors in securities frauds, analyzes the competing standards of liability, traces the roots of the creation test, and argues ultimately that the creation test and the substantial participation test share deficiencies that the bright line test avoids.
Securities Fraud, Stock Price Valuation, and Loss Causation: Toward a Corporate Finance–Based Theory of Loss Causation
Jay W. Eisenhofer, Geoffrey C. Jarvis, and James R. Banko, 59(4): 1419–45 (Aug. 2004)
Some recent decisions in securities cases and articles addressing the concept of "loss causation" have deviated from basic principles of corporate finance. In particular, certain courts and commentators have concluded that a stock drop following the disclosure of fraudulent activity is essential to establish loss causation and, hence, is a sine qua non for a plaintiff to prevail on the merits and ultimately recover damages. This article takes the position that those decisions and commentators are either incorrect or over-broad in their statements and should not be followed. Under sound principles of corporate finance, where expectations of future cash flow have been artificially inflated because of fraud, then the resulting stock price also is artificially inflated by fraud. Under such circumstances, if the plaintiff can demonstrate that he or she overpaid for the stock as a result of the fraud, and the price of the stock declined as a result of an explicit (or implicit) disclosure of diminished future cash flow expectations, such a showing should be sufficient to meet the loss causation requirement, even if the share price decline was prior to any explicit disclosure of the fraud.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Civil Liability for Aiding and Abetting
Richard C. Mason, 61(3):1135—1182 (May 2006)
Civil liability for aiding and abetting provides a cause of action that has been asserted with increasing frequency in cases of commercial fraud, state securities actions, hostile takeovers, and, most recently, in cases of businesses alleged to be supportive of terrorist activities. The U.S. Supreme Court, in its 1994 decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver , ended decades of aiding and abetting liability in connection with federal securities actions. However, the doctrine since has flourished in suits arising from prominent commercial fraud cases, such as those concerning Enron Corporation and Parmalat, and even in federal securities cases some courts continue to impose relatively broad liability upon secondary actors. This article reviews Central Bank and its limitations, before turning to an analysis of the elements of civil liability for aiding and abetting fraud. The article then similarly identifies and analyzes the elements of liability for aiding and abetting breach of fiduciary duty, which predominantly concerns professionals, such as accountants and attorneys, that are alleged to have assisted wrongdoing by their principal. The analysis then examines aiding and abetting liability in the context of particular, frequently–occurring, factual matrices, including banking transactions, directors and officers, state securities actions, and terrorism. The article concludes by summarizing emerging principles evident from judicial decisions applying this very flexible and potent source of civil liability.
Independent Directors as Securities Monitors
Hillary A. Sale, 61(4):1375-1412 (August 2006)
This paper considers the role of independent directors of public companies as securities monitors. Rather than engaging in the debate about whether independent directors are good or bad, important or unimportant, the paper takes their existence and basic governance role as a given, focusing instead on what recent statements from Securities and Exchange Commission officials indicating an increased focus on independent directors and their role in preventing securities fraud. The paper notes that the SEC believes that independent directors are on the board to act, at least in part, as securities monitors. This securities monitor role is another aspect of the information-forcing-substance disclosure model that the SEC has used to achieve improved corporate governance. Although directors face heightened risk when they draft or sign disclosure documents, they also have an ongoing responsibility to be informed of developments within the company, ensure good processes for accurate disclosures, and make reasonable efforts to assure that disclosures are adequate. Independent directors with expertise should be involved in reviewing and, sometimes, drafting statements. All directors, however, should be fully aware of the company's press releases, public statements, and communications with security holders and sufficiently engaged and active to question and correct inadequate disclosures. In addition to defining the role of independent directors as securities monitors, the article reviews the liability independent directors might face under private causes of action and contrasts it with the SEC's enforcement powers and remedies. The article describes some of the SEC's prior statements that emphasize the role of independent directors as securities monitors and the importance of their providing both guidance and check and balance.
Internal Investigations and the Defense of Corporations in the Sarbanes-Oxley Era
Robert S. Bennett, Alan Kriegel, Carl S. Rauh, and Charles F. Walker, 62(1): 55–88 (Nov. 2006)
Internal investigations long have been an integral part of the successful defense of corporations against charges of misconduct, as well as an important board and management tool for assessing questionable practices. With the heightened standards of conduct and increased exposure created by Sarbanes-Oxley, this essential instrument for safeguarding corporate interests has become even more crucial in identifying and managing risk in the enforcement arena. This article examines from a practitioner's standpoint when and how internal investigations should be conducted in order to protect the corporation in criminal, civil and administrative proceedings. Particular attention is paid to the issues created by a concurrent government investigation and in dealing with employees and former employees in the course of an investigation. The article also addresses the role of the Audit Committee under Sarbanes-Oxley, and the important issue of reporting the findings of the investigation to appropriate corporate officials. The subject of self-reporting by the Company to enforcement authorities is considered as well. In this context, the article explores the SEC's position on crediting self-reporting and cooperation as set forth in the Seaboard report; Department of Justice policy as embodied in the Thompson Memorandum; and the impact of the Federal Sentencing Guidelines for Organizations.
Should the SEC Be a Collection Agency for Defrauded Investors?
Barbara Black, 63(2): 317–346 (February 2008)
One of the important functions of the U.S. Securities and Exchange Commission ("the SEC") is enforcing the securities laws and punishing violators. Collecting damages for defrauded investors was not, historically, an important part of the agency's mission; rather, that was the function of private securities fraud class actions. Section 308 (the "Fair Fund provision") of the Sarbanes–Oxley Act of 2002 gives the SEC a more prominent role in compensating investors and allows the agency, in some circumstances, to distribute civil penalties to defrauded investors. The SEC has established Fair Funds in a number of high–profile cases and has taken pride in the large amounts of money it has obtained for investors. Meanwhile, section 308 has become an instrument in the business community's campaign against private securities fraud class actions.
This Article reviews the background of the SEC's disgorgement and penalty powers, the history and language of section 308, and SEC enforcement actions against corporations in financial fraud cases and then looks at the business community's reaction to section 308 and recent SEC enforcement actions. The Article concludes that the SEC's increased emphasis on section 308 could lead to a weakening of its effectiveness as an enforcement agency and further erode support for private securities litigation—an unfortunate outcome for investors.
Disgorgement: Punitive Demands and Remedial Offers
Elaine Buckberg and Frederick C. Dunbar, 63(2): 347–382 (February 2008)
U.S. Securities and Exchange Commission ("SEC") enforcement actions against corporate executives accused of securities fraud have become more visible since the Sarbanes–Oxley of 2002 set new standards to ensure that executives are held individually responsible for corporate fraud. Although long available to the SEC, the disgorgement remedy gained greater prominence because of the Sarbanes–Oxley Act requirement that the chief executive officer and chief financial officer of any company restating its financials due to material non–compliance disgorge incentive or equity–based compensation and profits from sales of stock following the false reporting. The SEC may also seek disgorgement from other executives and of other benefits, including any increment to pension or other retirement plans. Traditionally, class actions were the primary means by which shareholders sued officers and directors for securities claims. But the deterrent value of such lawsuits is arguably compromised because these cases almost always settle—and the employer and its directors' and officers' liability carrier usually fund the full settlement.
Computing accurately the benefits to the executive from the fraud requires an analysis of causation similar to that performed by the U.S. Supreme Court in Dura Pharmaceuticals, Inc. v. Broudo. In the case of an executive benefiting from inflated shares, the approach to measuring the inflation per share at the time of the purchase and sale is the same one as would be used in a shareholder class action. If the wrongdoing included fraudulent accounting leading to higher executive pay, then a similar causation standard applies—namely, how did the defendant's compensation change as a direct result of the fraudulent financials. For some types of accounting violations, such as recognition of revenue in the wrong year, the gains in executive compensation in the year the revenue was recognized are offset, at least to some extent, by the loss in compensation in the year the revenue should have been recognized. The principles of proximate cause and offsetting in disgorgement are grounded in both economics and securities fraud case law.
The Clawback Provision of Sarbanes-Oxley: An Underutilized Incentive to Keep the Corporate House Clean
Rachael E. Schwartz, 64(1): 1-36 (November 2008)
The Sarbanes-Oxley Act of 2002, passed in the wake of corporate scandals involving misstated financial reports, included a provision for certain compensation and profits from the sale of company stock to be "clawed back" from chief executive officers and chief financial officers of companies that are required to restate their financials, due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct. Courts have determined that only the Securities and Exchange Commission may sue to enforce this clawback provision. In the six years following passage of the law, there have been Sarbanes-Oxley clawbacks in only a small number of cases, each one an options backdating case involving allegations that the officer affected personally committed fraud. This Article takes the position that the clawback provision has no scienter requirement and its application should not be limited to officers who have personally engaged in misconduct. Rather, the wording of Sarbanes-Oxley, its legislative history, and the policies it serves call for the clawback to be applied to the chief executive officers and chief financial officers of companies that are required to restate their financials due to material non-compliance with any financial reporting requirement of the securities laws as a result of misconduct, regardless of whether those officers actively participated in the wrongdoing, knew of and failed to correct the wrongdoing, or were oblivious to wrongdoing by employees subject to their control. This general rule can be made subject to an exemption for circumstances involving certain misconduct by non-management employees.
Applying Stoneridge to Restrict Secondary Actor Liability Under Rule 10b-5
Todd G. Cosenza, 64(1): 59-78 (November 2008)
Although the U.S. Supreme Court's decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., was widely viewed as a sweeping rebuke of the application of "scheme" liability to secondary actors, the Court's decision also raised some questions regarding the precise scope of secondary actor liability under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. There is an obvious tension between the Court's holding that the secondary actors in Stoneridge could not be held liable because their "deceptive acts, which were not disclosed to the investing public, [were] too remote to satisfy the element of reliance" and its pronouncement that "[c]onduct itself can be deceptive" and could therefore satisfy a Rule 10b-5 claim. In particular, the question of what type of conduct satisfies the element of reliance in a claim against a secondary actor who assists in the drafting of a company's public disclosures remains open to interpretation.
This Article first discusses the general standards of section 10(b) liability and the Supreme Court's decision in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. The next part of the Article compares the judicial standards of secondary actor liability under Rule 10b-5(b)—the bright line, substantial participation, and creator standards—that emerged in the post- Central Bank era. It then discusses Stoneridge and the Court's recent rejection of secondary actor "scheme" liability under Rule 10b-5(a) and (c). Finally, it reviews recent applications of Stoneridge and analyzes the implications of these decisions going forward.
Disclosure Obligations Under the Federal Securities Laws in Government Investigations
David M. Stuart and David A. Wilson, 64(4): 973-998 (August 2009)
With the prevalence of government investigations into corporate conduct, public companies frequently face decisions about whether, when, how, and where to disclose to investors the existence of such investigations and the facts learned in the course of, or as a result of, those investigations. While the federal securities laws (and the rules and regulations promulgated thereunder) require disclosure of specific events that may arise during an investigation, neither those laws nor the courts that have interpreted them provide clear guidance for many of the disclosure decisions that must be made over the course of an investigation. As a result, counsel must carefully analyze numerous facts and circumstances, understand the company's previous disclosures, make "materiality" assessments, and determine whether to make disclosure in a current report or wait until the next periodic filing. This Article seeks to present, through an analysis of precedent disclosures, caselaw, rules, and practical ramifications, the considerations counsel must take into account in evaluating disclosure decisions in the context of an investigation. These considerations can help counsel avoid having a disclosure decision worsen the already difficult circumstances posed by the investigation itself.
Reforming the Regulation of Broker-Dealers and Investment Advisers
Arthur B. Laby, 65(2): 395–440 (February 2010)
A key component of financial regulatory reform is harmonizing the law governing broker-dealers and investment advisers. Historically, brokers charged commissions and were regulated under the Securities Exchange Act of 1934. Advisers charged asset-based fees and were subject to the Investment Advisers Act of 1940, which contains a special exclusion for brokers. In recent years, brokers have changed their compensation structure and many now market themselves as advisers, raising questions about whether they should be treated as such. The Obama Administration's 2009 white paper on regulatory reform and draft legislation call for a fiduciary duty to be imposed on brokers that provide advice. This Article explores the debate over regulating brokers and advisers, and makes four key claims. First, changes in brokers' compensation and marketing methods vitiate application of the broker-dealer exclusion and should subject brokers to the Advisers Act. Second, changes in the nature of brokerage, spurred by changes in technology, make the broker-dealer exclusion unsustainable and Congress should repeal it. The third claim is that imposing fiduciary duties on brokers is incompatible with their historical roles as dealers and underwriters. To resolve this tension, this Article suggests a compromise that enhances brokers' duties but does not hobble their ability to perform their traditional functions. Finally, regulating brokers as advisers would overburden the U.S. Securities and Exchange Commission. This Article offers alternatives to alleviate the strain.
The SEC and the Financial Industry: Evidence from Enforcement Against Broker-Dealers
Stavros Gadinis, 67(3): 679 - 728 (May 2012)
The Securities and Exchange Commission plays a central part in the U.S. regulatory framework for the supervision of the financial industry. How has the SEC carried out this mission? Despite recurrent crises, systematic studies of SEC performance data are surprisingly scarce. As the SEC reforms itself to address the shortcomings revealed in 2007–2008, a systematic examination of the agency’s past record can help identify priorities and evaluate the agency’s renewed efforts. This study takes a first step in studying empirically SEC enforcement against investment banks and brokerage houses, examining the agency’s record in the period right before the 2007–2008 crisis. This data suggests that defendants associated with big firms fared better in SEC enforcement actions as compared to defendants associated with smaller firms in three important dimensions. First, SEC actions against big firms were more likely to involve corporate liability exclusively, with no individuals subject to any regulatory action. Second, big-firm defendants were more likely to end up in administrative rather than court proceedings, controlling for types of violation and levels of harm to investors. Third, within administrative proceedings, big-firm employees were likely to receive lower sanctions, notably temporary or permanent bars from the industry. These patterns have important implications for major debates concerning corporate liability, regulatory capture, and the public and private enforcement of securities laws.
Closing Time: You Don’t Have to Go Home, But You Can’t Stay Here
Richard D. Bernstein, James C. Dugan, and Lindsay M. Addison, 67(4): 957 - 976 (August 2012)
In a significant trend, U.S. courts are increasingly rejecting cases involving foreign plaintiffs or foreign conduct. This trend was accelerated by the U.S. Supreme Court’s decision in Morrison v. National Australia Bank Ltd., which established that U.S. securities laws cannot be applied extraterritorially. Lower courts have extended the presumption against extraterritoriality to other federal and state statutes.
SEC Enforcement Actions and Issuer Litigation in the Context of a "Short Attack"
Charles F. Walker and Colin D. Forbes; 68(3): 687-738 (July 2013)
Issuers faced with a short attack—short selling of the issuer’s stock combined with the spread of negative rumors—may contemplate defensive strategies such as litigation and contacting government regulators, in addition to the investor and public relations efforts that are typically utilized in the wake of negative media coverage. Precedent calls for caution in these circumstances, as the record shows that the results of such strategies are mixed, with the SEC often turning its investigative focus to the issuer, and with costly litigation frequently resulting in compromise. This article begins with a discussion of the recent history of regulatory and legislative efforts to address concerns around short attacks and “naked” short selling. It then turns to a discussion of the SEC enforcement cases and private litigation relating to short attacks, and concludes that the SEC has appropriately brought enforcement cases only in clear-cut instances of fraud, while policing the margins through enforcement of the technical requirements of Regulation SHO. The article shows that the SEC enforcement record in this area, and the proof issues generally attendant to these cases, present important considerations for issuers who perceive themselves under siege in a short attack.
Equity Receivers and the In Pari Delicto Defense
Hon. Steven Rhodes and Kathy Bazoian Phelps; 69(3): 699-716 (May 2014)
Federal equity receivers are creations of equity. The in pari delicto doctrine is similarly a defense based in equity. When equity receivers are called upon to administer the assets of a receivership entity for the benefit of defrauded victims, courts sitting in equity must balance the needs of the victims with the rights of the defendants to assert the in pari delicto defense to litigation claims brought by the receiver against them. The competing equities reveal the great discretion that courts can exercise in permitting litigation claims to proceed in the face of the assertion of the in pari delicto defense. Courts, however, must also be mindful of a variety of issues and obstacles in deciding whether to allow the in pari delicto defense.
Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency
Henry T. C. Hu; 70(2): 347-406 (Spring 2015)
Financial innovation has fundamental implications for the key substantive and information-based mechanisms of corporate governance. “Decoupling” undermines classic understandings of the allocation of voting rights among shareholders (via, e.g., “empty voting”), the control rights of debtholders (via, e.g., “empty crediting” and “hidden interests”/ “hidden non-interests”), and of takeover practices (via, e.g., “morphable ownership” to avoid section 13(d) disclosure and to avoid triggering certain poison pills). Stock-based compensation, the monitoring of managerial performance, the market for corporate control, and other governance mechanisms dependent on a robust informational predicate and market efficiency are undermined by the transparency challenges posed by financial innovation. The basic approach to information that the SEC has always used—the “descriptive mode,” which relies on “intermediary depictions” of objective reality—is manifestly insufficient to capture highly complex objective realities, such as the realities of major banks heavily involved with derivatives. Ironically, the primary governmental response to such transparency challenges—a new system for public disclosure that became effective in 2013, the first since the establishment of the SEC—also creates difficulties. This new parallel public disclosure system, developed by bank regulators and applicable to major financial institutions, is not directed primarily at the familiar transparency ends of investor protection and market efficiency.
As starting points, this Article offers brief overviews of: (1) the analytical framework developed in 2006−2008 for “decoupling” and its calls for reform; and (2) the analytical framework developed in 2012−2014 reconceptualizing “information” in terms of three “modes” and addressing the two parallel disclosure universes.
As to decoupling, the Article proceeds to analyze some key post- 2008 developments (including the status of efforts at reform) and the road ahead. A detailed analysis is offered as to the landmark December 2012 TELUS opinion in the Supreme Court of British Columbia, involving perhaps the most complicated public example of decoupling to date. The Article discusses recent actions on the part of the Delaware judiciary and legislature, the European Union, and bankruptcy courts—and the pressing need for more action by the SEC. At the time the debt decoupling research was introduced, available evidence as to the phenomenon’s significance was limited. This Article helps address that gap.
As to information, the Article begins by outlining the calls for reform associated with the 2012−2014 analytical framework. With revolutionary advances in computer- and web-related technologies, regulators need no longer rely almost exclusively on the descriptive mode rooted in intermediary depictions. Regulators must also begin to systematically deploy the “transfer mode” rooted in “pure information” and the “hybrid mode” rooted in “moderately pure information.” The Article then shows some of the key ways that the new analytical framework can contribute to the SEC’s comprehensive and long-needed new initiative to address “disclosure effectiveness,” including in “depiction-difficult” contexts completely unrelated to financial innovation (e.g., pension disclosures and high technology companies). The Article concludes with a concise version of the analytical framework’s thesis that the new morphology of public information—consisting of two parallel regulatory universes with divergent ends and means—is unsustainable in the long run and involve certain matters that need statutory resolution. However, certain steps involving coordination among the SEC, the Federal Reserve, and others can be taken in the interim.
The Legality of Opportunistically Timing Public Company Disclosures in the Context of SEC Rule 10b5-1
Allan Horwich, 71(4): 1113-1150 (Fall 2016)
Commentators have discovered that executives who engage in securities transactions purportedly under the shield of a Rule 10b5-1 Plan, so that their trades do not constitute unlawful insider trading, achieve abnormal returns. There is speculation that these returns may be achieved by influencing the timing of corporate disclosures, so that, for example, bad news is withheld at the corporate level until after a Plan sale occurs.
This Article concludes that so long as this delay in disclosure does not violate an SEC mandated disclosure requirement, Rule 10b-5 is not violated, and the SEC could not expand Rule 10b-5 to reach disclosure timing of this type. The Article also addresses the application of the common law to disclosure timing. The use of corporate information to time corporate disclosure for a personal benefit, to achieve a more favorable outcome in personal securities trading pursuant to a Plan, may be a breach of duty under the corporate common law of some states, including Delaware, applying established principles of the common law of insider trading. It is unlikely, if not impossible, however, that state regulatory authorities could or would pursue such conduct.
If remedial action is needed to discourage, and effectively preclude, disclosure timing, it should be in the nature of SEC mandated disclosures of information regarding Rule 10b5-1 Plans, something the SEC proposed more than ten years ago and then abandoned without explanation, and the exclusion of those who engage in disclosure timing from the benefits of Rule 10b5-1 by amending that rule itself.
The Post Dodd-Frank Act Evolution of the Private Fund Industry: Comparative Evidence from 2012 and 2015
Wulf A. Kaal, 71(4): 1151-1206 (Fall 2016)
This comparative survey study examines the private fund industry’s reactions and adjustments to a rapidly evolving regulatory framework, three years after the first application of mandatory registration and disclosure rules for private fund advisers under the Dodd-Frank Act. Using two datasets (2012: N = 94; 2015: N = 69) for a population of 1267 registered investment advisers to add an historical time series perspective, the author analyzes and compares survey respondents’ short- and long-term estimations of industry effects. The data suggest that immediate and short-term concerns have given way to adaptation to the changes.
The Promise of Unfavorable Research: Ramifications of Regulations Separating Research and Investment Banking for IPO Issuers and Investors
Benjamin J. Catalano; 72(1): 31-60 (Winter 2016/2017)
The trend in Securities and Exchange Commission and Financial Industry Regulatory Authority rulemaking and enforcement to insulate research from investment banking influence has led to the removal of research analysts from the underwriting process with adverse consequences for new issuers and their investors. The approach conflicts with the congressional objective under the Jumpstart Our Business Startups (JOBS) Act to incorporate research fully in public offerings for emerging growth companies, which now comprise the vast majority of IPO issuers. Faced with these competing objectives, broker-dealers should have written policies and procedures that are carefully crafted to service their underwriting and investor clients appropriately and to take advantage of the JOBS Act privileges with respect to research.
A Call for the SEC to Adopt More Safe Harbors that Limit the Reach of Rule 10b-5
Allan Horwich; 74(1) 53-90 (Winter 2018/2019)
The SEC has often adopted regulations that describe conduct that is deemed not to violate the law or that effectively exclude specified conduct from the scope of particular provisions of the securities laws, such as the prohibition on deception imposed by SEC Rule 10b-5. This article examines the nature of and rationales for the provisions that have narrowed the reach of that rule, and proposes that this approach be applied more broadly, further reducing the exposure of issuers of securities and other persons to claims under Rule 10b-5 without impairing the SEC’s enforcement of the securities laws. This will reduce uncertainty regarding the scope of Rule 10b-5, including in the arena of private damage claims, directing the focus to misrepresentations and half-truths. Several specific proposals are made here. The intention is to focus attention on the utility of the safe harbor approach in today’s litigation landscape and generate discussion that might lead to broader application of this concept.
The Myth of Morrison: Securities Fraud Litigation Against Foreign Issuers
Robert Bartlett, Matthew D. Cain, Jill E. Fisch, and Steven Davidoff Solomon; 74(4) 967-1014 (Fall 2019)
Using a sample of 388 securities fraud lawsuits filed between 2002 and 2017 against foreign issuers, we examine the effect of the Supreme Court’s decision in Morrison v. National Australia Bank Ltd. We find that the description of Morrison as a steamroller, substantially ending litigation against foreign issuers, is a myth. Instead, we find that Morrison did not significantly change the type of litigation brought against foreign issuers, which, both before and after this case, focused on foreign issuers with a U.S. listing and substantial U.S. trading volume. Although dismissal rates rose post- Morrison, we find no evidence that this was related to the decision. Settlement amounts and attorneys’ fees remained unchanged post-Morrison. We use these findings to theorize that Morrison was primarily a preemptive decision about standing that firmly delineated the exposure of foreign issuers to U.S. liability in response to the Vivendi case, which sought to expand the scope of liability for foreign issuers whose shares traded primarily in non-U.S. venues. When Morrison is placed in its true context, it is justified as a decision in line with administrative and court actions that have historically aligned firms’ U.S. liability to be proportional to their U.S. presence. Although Morrison had this defining effect, it did not change the litigation environment for foreign issuers, which was the oft-cited import of the decision. More generally, our analysis of Morrison also underscores how the decision has been mistakenly characterized as a case primarily about extraterritoriality rather than standing.
State Section 11 Litigation in the Post-Cyan Environment (Despite Sciabacucchi)
Michael Klausner, Jason Hegland, Carin LeVine, and Jessica Shin; 75(2): 1769-1790 (Spring 2020)
In Cyan, Inc. v. Beaver County Employees Retirement Fund, the U.S. Supreme Court held that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) preserved state courts’ jurisdiction to adjudicate cases brought under the Securities Act of 1933, with defendants having no right to remove a case to federal court. The result of this decision has been a dramatic increase in section 11 cases litigated in state court, often with a parallel case brought in federal court against the same defendants based on the same alleged misstatements.
The Evolution and 2020 Status of Cooperation in SEC Enforcement Investigations
Dixie L. Johnson, Carmen J. Lawrence, and Jamie Stinson 75(4): 2427-2466 (Fall 2020)
When facing potential enforcement action from the Securities and Exchange Commission (“SEC”), companies often seek to mitigate the consequences by cooperating with the SEC in one or more of the following ways: self-policing, self-reporting, remediation, and cooperation. While a 2001 SEC report of investigation known as the Seaboard Report provides a roadmap for what steps to take in order to earn cooperation credit and describes generally the potential benefits to be received, no such report or guidance exists that details exactly what tangible benefits a company will receive in return for the earned credit and how it will be determined. In addition, outside of narrow exceptions where the SEC engages in self-reporting initiatives, companies looking for publicly available guidance on how best to cooperate face a lack of consistency in the SEC’s settlement documentation describing cooperation factors and what benefits may be earned.