Presentation on theme: "Securities Regulation"— Presentation transcript:
1Securities Regulation MaterialityWhat matters to investors?(last updated 17 Jan 13)
2Securities Fraud Action PartiesPlaintiff (purchasers or sellers)Defendant (primary violator / including company)ElementsMaterialMisrepresentation or omissionScienterRelianceCausationDamagesRequired nexusJurisdictional nexus (federal court)Transactional nexus (“in connection with purchase or sale of securities”)
3Materiality “test” TSC Industries v. Northway (US 1976): A fact is material if "there is a substantial likelihood a reasonable investor would consider it important" in deciding how to vote [whether to buy or sell stock.]Put another way, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available.
4Forward-looking information Materiality contextsForward-looking informationObjective testsTotal mixManagement integrity
5Forward-looking information Basic Inc. v. Levinson (US 1987):What kind of lawsuit?What did plaintiffs allege?What were company’s arguments?Overwhelm investorsNeed secrecyKnowabilityWhat does 6th Circuit say?What does Supreme Court hold?
6Forward-looking information Basic Inc. v. Levinson (US 1987):... with respect to contingent or speculative information or events .... materiality "will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity"Justice Harry Blackmun
7Hypothetical #1The CEOs of Six Feet and Dearly Departed (two mortuary companies – Six Feet is publicly-traded; Dearly Departed is privately-held) have discussed a merger. Price? Ratio? Survivor? Antitrust scrutiny?A reporter from Eulogy Magazine interviews David and asks, “Does Six Feet have any acquisitions in the pipeline?”David turns to you, his lawyer. What do you whisper to him?
8Basic Inc. v. Levinson (US 1987): ... a factfinder will need to look to indicia of interest in the transaction at the highest corporate levels. Without attempting to catalog all such possible factors, we not by way of example that board resolutions, instructions to investment bankers, and actual negotiations between principals or their intermediaries may serve as indicia of interest.fn 17. To be actionable, of course, a statement must also be misleading. Silence, absent a duty to disclose, is not misleading under Rule 10b-5. "No comment" statements are generally the functional equivalent of silence.Justice Harry Blackmun
9Find Primary Material (1) Statute: ’34 Act §12(b) [PDF] (2) Form: 10-K, Item 7 [description / form)(3) Reg S-K: Item 303 (MD&A) Full Fiscal Years. ... [Reg S-K / Item 303](a)(1) Identify any known trends or any known ... events ... that will result in or that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way.(4) Rule: 12b-20 [‘34 Act Rules / 12b-20]In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the requirement statements, in the light of the circumstances under which they are made not misleading.DescriptionLinks
10Hypothetical #2The Six Feet and Dearly Departed merger plans continue apace, but still no final deal on price and structure.Six Feet is about to file its annual report with the SEC. Six Feet projects cash flow from DD of about $25,000,000 next year growing at 10% for 5 years, with cash flows afterward of $40,000,000 – all discounted 20%.CEO David turns to you again. Must Six Feet mention the possibility of a merger? (By the way, Six Feet’s capitalization is about $350,000,000.)
12Forward-looking information Materiality contextsForward-looking informationObjective testsTotal mixManagement integrity
13Litwin v. Blackstone Group LP (2d Cir 2011) What kind of lawsuit?What does complaint allege?Basis for dismissal?Omission from IPO prospectus?MD&A: known trends reasonably likely to cause financial info misleadingFGIC; credit default swaps (insurance) on CDOs / RMBSs downward trend in real estate mktNot material – below SEC 5% test$331 million = 0.4% of assets under mgt$122 million decline = 4% annual revenueQualitative: No significant mkt reaction / no analyst surpriseMaterial - qualitativeCorp PE significant segmentMask change in earnings / affect mgt payCorporate Private EquityReal EstateMarketable Alternative Asset MgtFinancial Advisory
14SEC Staff Accounting Bulletin “qualitative factors may cause misstatements of quantitatively small amounts to be material”hides unlawful transactionsRelates to significant segmentSignificant market react to disclosureHide failure to meet analyst expectationsChanged incomeAffect compliance with loan covenants
16In re Merck & Co. Sec Litig (3d Cir 2005) What was Medco’s “revenue recognition” policy?Why recognize revenues that are later netted out in computing net profits?Why is Merck’s stock price affected by sub’s “net zero” revenue recognition?What was the Medco IPO? And why was it scuttled?What is Merck’s argument that Medco’s revenue recognition was not material?Wasn’t 4/17 disclosure opaque?Only when WSJ did the math?What does the court conclude about Merck’s “delayed, piecemeal” disclosure?
17An efficient market? 7/5 – 4th S-1 Filing 4/17 – 1st S-1 filing 6/21 – WSJ story7/9 – end of class periodAn efficient market?
18Mattrixx Initiatives v. Siracusano (US 2011) Plaintiff’s allegations?Reports: consumers who use Zicam report loss of smellJafek study: 10 patients lose smell after using Zicam / studies linking zinc sulfateCompany gives rosy picture and predicts revenue/earnings riseFDA investigation reported: stock price falls 11.7%GMA story: highlights Jafek study, stock falls againDefendant’s argument?Adverse event reports that not statistically significant not materialAdverse events not establish causation/ just random eventOtherwise bury investors with “trivial information”Court decision?Medical researchers use not only stat sig / rare events, ethicsFDA acts on suspicion of causation, as do consumers, thus investors
196/17/09: FDA warns consumers to stop using Zircam: may cause loss of smell 12/14/10: Matrixx sold to private investors for $75.2 million
20Forward-looking information Materiality contextsForward-looking informationObjective testsTotal mixManagement integrity
21Longman v. Food Lion, Inc (4th Cir 1999) 8/90 – UFCW labor union alleges widespread labor violations / FL denies employee mistreatment11/91 – UFCW brings DOL complaint and issues press release / company says has clear policy against “off the clock”11/92 – PrimeTimeLive trashes Food Lion’s labor practices and sanitationEmployees forced to work off the clock / big $$$ back pay liabilityMeat pulled out of dumpster and bleached / Ees re-date packagesStock falls 11%
22Longman v. Food Lion, Inc (4th Cir 1999) Fourth Circuit:… nature of the off-the-clock claims and the claims’ risk to earnings were in fact well known to the market before the PTL broadcast [no price drop after DOL settlement]… statements [about cleanliness] are a kind of puffery … most of broadcast was inadmissible hearsay … isolated instances of workplace errorsSec Reg Record?
23Would you invest in this man? Management Discussion & Analysis:“The partnership [to build an Atlantic City mega-casino] believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service ...Elsewhere in the prospectus: “… no history of earnings … its operations will be subject to all of the risk inherent in the establishment of a new business enterprise” “… [timing of payments] could adversely affect its ability to pay interest"“… no assurance can be given that Taj Mahal will generate cash flow sufficient to pay debt service"The “Donald”
24Materiality in context Historical factsSpeculative(3) ContextualTestTSC v. Northway(“reasonable investor”)Basic v. Levinson(“prob + magnitude”“Truth on market” / “bespeaks caution”
25Materiality in context Historical factsSpeculative(3) ContextualTestTSC v. Northway(“reasonable investor”)Basic v. Levinson(“prob + magnitude”)“Truth on market” / “bespeaks caution”
26Materiality in context Historical factsSpeculative(3) ContextualTestTSC v. Northway(“reasonable investor”)Basic v. Levinson(“prob + magnitude”“Truth on market” / “bespeaks caution”
27Forward-looking information Materiality contextsForward-looking informationObjective testsTotal mixManagement integrity
28Philosophy“Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.”Louis BrandeisOther People’s Money (1913)
29Corporate federalism“Thus social standards newly defined [by the Securities Act of 1933] gradually establish themselves as new business habits.”Felix Frankfurter”creator of ’33 Act”
30In Matter Franchard Corp (SEC 1964) InvestorsGlickmanVenada Corp.Class A sharesClass B sharesGlickman --withdraws $2.4 MM from companypledges stock on $4.2 MM loans (24% interest)departs after being caught in more liesFranchard Corp.
31In Matter Franchard Corp (SEC 1964) Disclosure of self-dealing“Of cardinal importance in any business is the quality of management”Withdrawals = 1.5% book valueDiversion to Venada = Glicksman dominatedPledges of stock = personal loansDefault terms on loans = change of control possibleIs all self-dealing “material”?
32Beyond SEC line items? Rule 12b-20 [See also Rule 408] In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the requirement statements, in the light of the circumstances under which they are made not misleading.
33Corporate federalism“To generally require information … as to whether directors have performed their duties in accordance with the standards of responsibility required of them under State law would stretch disclosure beyond the limitations contemplated by the statutory scheme …William CaryChair, SEC ( )
35SEC v. Fehn (9th Cir 1996) Would you have invested – “blind pool” public offering?Earlier securities law violations?Not disclose CEO Wheeler?Manipulate price in aftermarket?Should lawyer be responsible?What is “aiding and abetting”?What if CEO identity not required by line-item form?Must incriminate / disclose possible illegality?
37Intersection of securities law and other regulatory regimes HypotheticalIntersection of securities law and other regulatory regimes
38Self incriminationDrug kingpin Pablo Escobar hires your client Key Airways, Inc to bring “cargos” into the United States. The contract It represents 1.5% of total revenues.Must Key Airways, a public company, disclose this contract in its upcoming quarterly report? Including possible criminality?
39Self incrimination“The mere possibility of incrimination is insufficient to defeat the strong policies in favor of disclosure.”California v. Byers (US 1971)* * *“… the distinction between “mere” bribes to foreign officials] and bribes coupled with kickbacks to the directors … is fundamental to a meaningful concept of materiality …. And the preservation of state corporate law.”Gaines v. Houghton (9th Cir. 1981)
41Oran v. Stafford (3d Cir 2000) Timeline: 2/94 – Belgian cardiologist notices link to heart valve leaks11/95 – AHP knows of 31 European cases / FDA panel approves drug3/97 – AHP learns from Mayo Clinic of heart-valve abnormalities in 17 fen-phen users7/97 – Mayo data disclosed to public / AHP says “investigating”9/97 – FDA says survey shows 1/3 fen-phen users have heart troublesAHP withdraws drug / stock price falls 5%WSJ reports possible lawsuits / price drops another 6%Investors who bought while AHP knew more than public sue. What theory?3/97 annual report (new drugs big hit, no mention of European, Mayo data)4/97 press release (responds to news reports that drugs “safe & effective”7/97 press release (discusses Mayo data, but no mention knew 3 mos ago)Should have disclosed:Mayo and European dataMisled FDAKnew data earlier than said
42Oran v. Stafford (3d Cir 2000)Third Circuit (Materiality of omissions):AHP stock price went up after 7/97 press release on Mayo dataEuropean data was not statistically significant / “inconclusive”AHP description of FDA approval process was factually correctMayo and European data was “purely speculative” until FDA notified AHP of link
43Oran v. Stafford (3d Cir 2000)Third Circuit (Failure to satisfy SEC rules):Even if obligated to disclose in periodic reports (item 303, Reg S-K), no private cause of actionSEC standard of materiality “signficantly beyond” price +magnitude test of BasicViolation of SEC line-item rules not necessarily violation of 10b-5
44’34 Act S12(b) [find this]Form 10-K, Item 7 [find this: 1 2 3 4)Regulation S-K, Item 303 (MD&A) Full Fiscal Years. ... [find this](a)(1) Identify any known trends or any known ... events ... that will result in or that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way.Rule 12b-20 [find this]In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the requirement statements, in the light of the circumstances under which they are made not misleading.’34 Act Release 26,831 [find this]… the MD&A need not contain a discussion of the impact of [merger] negotiations where, in the registrant's view, inclusion of such information would jeopardize completion of the transaction.
45Ganino v. Citizens Utilities Co (2d Cir 2000) Why are steadily increasing earnings so important?Why did Citizens recognize 1995 fees in 1996? “store income”?What happened when company comes clean? 4/97 – rumors, 8/97 10QWhy should investors be concerned if fees from Hungarian company constituted only 1.7% of total revenues?What did the court decide?
46Va Bankshares v. Sandberg (US 1991) Proxy statement:The Plan of Merger has been approved by the Board of Directors because it provides an opportunity for the Bank’s public shareholders to achieve high value for their shares.The price to be paid is about 30% higher than the [last trade price before announcement of the proposal]. The $42 per share to be paid public holders represents a premium of approximately 26% over book value.
47Va Bankshares v. Sandberg (US 1991) Supreme Court (actionability of statements of opinion)… Shareholders know that directors usually have knowledge and expertness far exceeding the normal investor’s resources …… statements of belief are factual in two senses: directors hold the belief stated … statement about belief expressed.… disbelief, standing alone, is insufficient to satisfy element of factJustice David Souter