1. Securities Fraud
Rule 10b-5
Last updated 20 Feb 12

2. Securities Fraud Action
William Rehnquist:
When we deal with private actions under Rule 10b-5, we deal with a judicial oak which has grown from little more than a legislative acorn.
Blue Chip Stamps v. Manor Drug Stores (US 1975)

3. Securities Exchange Act of 1934
Section Manipulative and Deceptive Devices
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.

4. Securities Fraud Action
Rule 10b-5
Transactional nexus
Plaintiff
Defendant
Elements
Procedure
Transactional nexus
By means of interstate commerce or mails
“in connection with purchase or sale”

5. Securities Fraud Action
Rule 10b-5
Transactional nexus
Plaintiff
Defendant
Elements
Procedure
Plaintiff
Purchaser or seller
Except in SEC action

6. Securities Fraud Action
Rule 10b-5
Transactional nexus
Plaintiff
Defendant
Elements
Procedure
Defendant
Primary violator (makes statements on which reliance)
Includes company statements
No aiding & abetting (accts / advisors)

7. Securities Fraud Action
Rule 10b-5
Transactional nexus
Plaintiff
Defendant
Elements
Procedure
Elements
Material misrepresent / omission
Scienter – not negligence / knowledge, reckless
Reliance – “fraud on market”
Causation – must be proved
Damages – out-of-pocket

8. Securities Fraud Action
Rule 10b-5
Transactional nexus
Plaintiff
Defendant
Elements
Procedure
Procedure
Statute of limitations (2 yrs + 5 yrs)
Special rules for class actions
Venue (where company has headquarters)
Worldwide service of process
Federal discovery rules

9. Compare to other private actions
Exchange Act
Securities Act
Rule 10b-5
§ 18(a)
§ 9(c)
§11
§12(a)(1)
§12(a)(2)
Fraud icw purchase or sale of security
Materially false statement in SEC filing
Specified manipu-lative practice
(pools, etc)
False statement in registration statement
Offer or sale of unregistered, non-exempt securities
Offer or sale by means of materially false prospectus

10. Securities Fraud Class Action
“when talk is not cheap”

11. Stanford Class Action Clearinghouse

12. Stanford Class Action Clearinghouse
                                                                                                                                
Federal Securities Fraud Class Action Litigation
(lawsuits filed)
Pre-Reform Post-Reform
Stanford Class Action Clearinghouse

14. “King of Pain” Curriculum Vitae 1946: born in working-class Pittsburgh
                                                                                                                                
“King of Pain”
Curriculum Vitae
1946: born in working-class Pittsburgh
1970: U Pittsburgh law grad
1976: joins Milberg Weiss (San Diego)
2004: moves to Lerach Coughlin Stoia Geller Rudman & Robbins (San Diego)
2005: $7.2 billion recovery in Enron litigation ($45 over career)
2007: pleads guilty to obstruction of justice (later Milberg Weiss)
2009: disbarred by California State Bar
2010: released from prison / “Circle of Greed” published
“Loathed because he's so mean, feared because he's so powerful, Bill Lerach is the lawyer everyone in Silicon Valley hates.”
Fortune Magazine, Sep. 2000
“"In 10 or 15 years you will be holding another hearing about a debacle in the securities market that will make you remember the S&L mess with fondness."
Bill Lerach,
congressional testimony (1995)

15. Investigate corporate disclosures …
                                                                                                                                
Investigate corporate disclosures …

17. Who can be sued … Press Release:
The company is today announcing its year-end financial results, which continue to look favorable.
* * *
Auditor
no mention that financials are not audited
no mention of auditor, which had advised that financials actually “NOT favorable”
Lawyer
no mention of lawyer who helped draft the press release
no “noisy withdrawal” by lawyer

18. Identify corporate “fiction” …
                                                                                                                                
Identify corporate “fiction” …

19. 2d and 3d Circuits -
Motive and opportunity
Concrete personal benefit
Insider trading

20. 1st, 5th, 6th, 10th, 11th Circuits
Strong inference of scienter
M&O is external marker
Unusual insider trading

21. 9th Circuit
“Deliberate recklessness”
Intentional misconduct

22. Tellabs, Inc. v. Makor Issues & Rights, Ltd. (US 2007)
… PSLRA strong inference of state of mind (scienter) means … “a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference.”
… allegations must also be considered “holistically” [isolated insider sales not enough, must have unusual, broad sales]
“omissions and ambiguities [in the plaintiffs’ allegations] count against inferring scienter” [discount confidential witnesses]
Ruth Bader Ginsburg
(civil rights lawyer)

23. … followed by “surprise”
                                                                                                                                
… followed by “surprise”

24. … resulting in “price drop”
                                                                                                                                
… resulting in “price drop”

25. Basic Inc v. Levinson (US 1988)
Timeline
The lies
10/21/77: news interview that “no reason for stock activity and no negotiations”
9/25/78: response to NYSE inquiry that “management unaware of development”
11/6/78: Quarterly report that “unaware of any developments”
The truth
12/18/78: announce tender offer by Combustion

26. Efficient Capital Market Hypothesis

27. Basic Inc v. Levinson (US 1988)
“… in open and developed securities market .. Misleading statement defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.”
“… reliance is an element of a Rule 10b-5 cause of action.
“Presumptions typically serve to assist courts in managing circumstances in which direct proof for one reason or another is rendered difficult.”
How can presumption be overcome?
Justice Harry Blackmun
[MN lawyer]

28. Basic Inc v. Levinson (US 1988)
“… I fear that the Court’s decision may have many adverse, unintended effects as it is applied and interpreted in the years to come.”
“… Court assumes buyers and sellers rely on the “integrity of the market price … which most mystifies me.”
Justice Byron White
[former football player]

29. Big vs small companies Small companies Big companies Less publicized
Fewer analysts
No SEC interest
Smaller total damages
Big companies
Public disclosure
Many analysts
SEC investigation
Large damages

30. Identify “scienter” – such as …
                                                                                                                                
Identify “scienter” – such as …

31. Plead “scienter” … PSLRA [Exchange Act 21D(b)(1)]
                                                                                                                                
Plead “scienter” …
PSLRA [Exchange Act 21D(b)(1)]
In any private action arising under this chapter in which the plaintiff may recover money damages only on proof that the defendant acted with a particular state of mind, the complaint shall, with respect to each act or omission alleged to violate this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

32.                                                                                                                                 
File a complaint
(e.g. Bay Networks, Inc)

33. Complaint must tell “fraud” story …
                                                                                                                                
Complaint must tell “fraud” story …

34. … to withstand “motion to dismiss”
                                                                                                                                
… to withstand “motion to dismiss”

35. If so, start settlement negotiations …
                                                                                                                                
If so, start settlement negotiations …

36. Settlement with “corporation”
                                                                                                                                
Settlement with “corporation”
Buying shareholders
(plaintiffs)
Payment
Corporation
Usually nominal
payments
Insider
trading
Corporate execs
(D&O insurance)

37. Settlement with “corporation”
                                                                                                                                
Settlement with “corporation”
Buying shareholders
(plaintiffs)
Holding shareholders
(losers!)
Payment
Subsidy
Corporation
Usually nominal
payments
Insider
trading
Corporate execs
(D&O insurance)

38. Settlement with “corporation”
                                                                                                                                
Settlement with “corporation”
Selling shareholders
(windfall winners!)
Buying shareholders
(plaintiffs)
Holding shareholders
(losers!)
Payment
Subsidy
Corporation
Usually nominal
payments
Insider
trading
Corporate execs
(D&O insurance)

39. "Index Funds and Securities Fraud Litigation" (Booth)
SFCA doesn’t make sense
Most investors are diversified
SFCA settlement : holders effectively pay buyers
Because of circularity: stock price declines on SFCA filing
Consider index fund
almost always loses more than it gains when SFCA
index funds should oppose SFCA
Capturing deterrent effect
w/o SFCA might be more securities fraud
Solution: corporation itself claim – against the individual wrongdoers
subject of a derivative action for the benefit of the corporation – and thus all of the stockholders
constitute a significant deterrent to fraud
Procedure
rules of civil procedure: derivative claim must be resolved before SFCA
No SFCA unless certified no other equally good way to litigate
Caveat: attorney fees are likely to be higher in class actions than in derivative actions

40. Sup Ct 10(b) jurisprudence
1970s / 1980s
2000s Gr
Transactional
No privity
Zandford A
Plaintiff
Blue Chip Stamps
Lead plaintiff* B
Defendant
Central Bank
Stoneridge C
Elements
(1) Materiality
Basic
Bespeaks caution*
(2) Misrep
Va Bankshares
(3) Scienter
Ernst & Ernst
Tellabs / reckless*
(4) Reliance
Affiliated Ute / Basic
Rebut presumption*
(5) Causation/$
---
Dura / circularity*
Procedural
(1) S/L
Gilbertson / Huddleston
SOX / Reynolds
(2) Federal/state
Santa Fe
Dabit
(3) Arbitration
Shearson/Am Express
FINRA / D-F*
* open questions

41. Mechanics of Class Action Class Counsel Functions
                                                                                                                                
Mechanics of Class Action Class Counsel Functions
Get started
identify material corporate misrepresentations
find appropriate shareholders to act as class representatives
file a complaint in a court of class counsel’s choosing
Take care of legalities
defend the complaint against motion to dismiss (on legal grounds)
urge the judge to grant class action status to the litigation
send notice to class members, giving them an option to withdraw from the lawsuit
undertake discovery of information from the company and other sources
Close the deal
enter into settlement negotiations with company officials
champion any settlement before the judge
administer settlement funds
appeal any adverse decisions by the trial court judge

42. Mechanics of Class Action Class Counsel Functions
                                                                                                                                
Mechanics of Class Action Class Counsel Functions
Get started
identify material corporate misrepresentations
find appropriate shareholders to act as class representatives
file a complaint in a court of class counsel’s choosing
Take care of legalities
defend the complaint against motion to dismiss (on legal grounds)
urge the judge to grant class action status to the litigation
send notice to class members, giving them an option to withdraw from the lawsuit
undertake discovery of information from the company and other sources
Close the deal
enter into settlement negotiations with company officials
champion any settlement before the judge
administer settlement funds
appeal any adverse decisions by the trial court judge

43. Mechanics of Class Action Class Counsel Functions
                                                                                                                                
Mechanics of Class Action Class Counsel Functions
Get started
identify material corporate misrepresentations
find appropriate shareholders to act as class representatives
file a complaint in a court of class counsel’s choosing
Take care of legalities
defend the complaint against motion to dismiss (on legal grounds)
urge the judge to grant class action status to the litigation
send notice to class members, giving them an option to withdraw from the lawsuit
undertake discovery of information from the company and other sources
Close the deal
enter into settlement negotiations with company officials
champion any settlement before the judge
administer settlement funds
appeal any adverse decisions by the trial court judge