[4](1): Common Law Fraud

1. [4](1): Common Law Fraud • Knowing (scienter) • Economic loss (contracts): Intentional or reckless disregard for the truth • Personal injury or property loss in some states: Negligent disregard for the truth • Misrepresentation • Untrue statement • But can be an omission from a statement which makes the statement misleading • When the person making the statement has a fiduciary duty • of a Material Fact • Fact is important to a reasonable person considering the transaction • which induces Reasonable Reliance • reliance might be unreasonable if there is easy access to the truth • and causes Damages • actual damages such as economic losses, and possibly punitive damages

2. [4](2): Non-Disclosure in Securities Markets • Fiduciary Duty • Board of Directors and Management to shareholders and market participants • Breach of Duty • Failure to disclose material information • Important for a reasonable person in making decisions to buy or sell shares • Plaintiff would not have traded and experienced a loss from trade • Standard: Intentional and Gross Negligence • Liability for intentional deception: actual knowledge that statement is untrue • Liability for reckless disregard of material facts and the duty to disclose • Some states find liability for negligent disregard of material facts • Damages: rescission or actual damages (out of pocket loss) • punitive damages for intentional deception

3. [4](3): Securities Exchange Act (1934) • Section 10(b) and Rule 10b-5 • Section 10(b) provides the SEC with power to regulate securities markets • Rule 10b-5 makes it unlawful to make an untrue statement of a material fact or to make an omission of a material fact which makes a statement misleading • Section 14(a) and Rule 14a-9 • Section 14(a) provides the SEC with power to regulate proxy solicitations • Rule 14a-9 prohibits false or misleading statements of a material fact in a proxy solicitation, or an omission of a material fact that would make a current or past proxy solicitation false or misleading • Section 14(e) • Section 14(e) provides the SEC with power to regulate tender offers • Section 14(e) makes it unlawful to make an untrue statement of a material fact in the context of a tender offer, or an omission of a material fact which makes a statement misleading

4. [4](4): SEC Rule 10b-5 • Rule 10b-5: Employment of Manipulative and Deceptive Practices • It shall be unlawful • (1) To employ any device, scheme, or artifice to defraud • (2) To make any untrue statement of an material fact, or to omit to state a material fact which makes a statement misleading • (3) To engage in any fraudulent act, practice, or course of business • History of Rule 10b-5 (1942) • Originally designed to fill a gap in the SEC Act (1934) to cover misleading statements by a purchaser, rather than a seller, of securities • Adopted in response to the case of a corporate president telling shareholders that the company was doing badly in order to purchase their stock at low prices • Now a catch-all rule against fraud and fraudulent practices that affect participants in securities markets

5. [4](5): Violations of Rule 10b-5 • Creates Duty for Board of Directors and Management to the participants in securities markets, not just shareholders • Criminal Liability: SEC and Department of Justice • Civil liability: Damages for market participants who incurred an economic loss • Criminal Liability for “willful” violations: 15 USCS 78ff • Intentional violation: actual knowledge that statements are untrue or misleading • Civil Liability: 15 USCS 78r • What is the minimum standard of care for breach of duty? • Civil liability for intentional (willful) misleading statements • Circuit Courts agree on civil liability for reckless misleading statements • Supreme Court has ruled NO civil liability for negligent misleading statements

6. [4](6): Standing to Sue Under Rule 10b-5(2) • Who can sue for damages (standing)? • Purchasers or sellers of a security • But NOT people who were mislead into not purchasing or not selling • New Legislation on Class Action Shareholder Lawsuits • Private Securities Litigation Reform Act (1995): Section 21D • Rules for class formation and selection of attorneys to represent the class • Pro rata division of recoveries and settlements • Court approval of attorneys fees • Securities Litigation Uniform Standards Act (1998): Section 27 • Class action lawsuits based on securities fraud must be filed in Federal Courts • Preempts lawsuits in state courts

7. [4](7): Penalties and Remedies Under Rule 10b-5(2) • SEC Penalties for violations • Injunctions against future violations • Criminal penalties for willful violations (enforced by Dept of Justice) • Corporations: criminal fines up to $25 million • Individuals: criminal fines up to $5 million and prison up to 20 years • Civil Penalties for willful violations (enforced by SEC) • Corporations: civil fines up to $600,000 • Individuals: civil fines up to $120,000 • Civil Remedies for shareholders • Damages for purchaser = (purchase price - stock value at time of fraud) x shares • Reform Act (1995) limits damages for fraud • Stock value at time of fraud cannot be lower than the average stock price during the 90 day period after misleading statement is corrected • No punitive damages (unlike common law fraud)

8. [4](11): Levinson v. Basic: Supreme Court • What is the Supreme Court’s interpretation of materiality? • Adopts the factual test from TSC Industries v. Northway (1976) • TSC involved a proxy solicitation • Material fact is a fact for which there is a “substantial likelihood” that a “reasonable investor” would consider it “significant” or “important” in deciding whether to purchase or sell a security • Facts are more likely to be material when • (1) Higher probability of occurrence: • How serious are the negotiations? • (2) Greater magnitude of the event: • What is the potential impact on market value of the corporation?

9. [4](14): Levinson v. Basic: Reliance • The Supreme Court also addressed the issue of “reasonable reliance” • What is the “Fraud-on-the-Market” Theory? • All investors who traded during the period from the time the false or misleading statement was made to the time is was corrected, are presumed to have relied on the misleading statement • Reason: market is reflecting the public information or misinformation • No need for each plaintiff in the class to prove individual reliance • But this theory of reliance is a “rebuttable presumption” • Defendant can prove that individual plaintiffs did not rely • Plaintiffs knew the true material facts or traded for some other reason • Defendant can prove that the market price was not affected by the false or misleading statements • Enough participants knew the true facts so that the market price was not affected

10. [4](15): Liability for Corporate Advisors Under Rule 10b-5(2) • Can corporate advisors violate Rule 10b-5? • YES, if they intentionally (or recklessly) make false or misleading statements that they know the corporation will then use to defraud purchasers or sellers of securities • Accountants can be liable for statements in audits • Attorneys can be liable for statements in opinion letters • YES, for aiding and abetting the violations of the corporation if they knowingly provide substantial assistance to the corporation in making false or misleading statements (Reform Act (1995) - 15 USCS 78t(e)) • Remedies and Penalties • Damages for shareholders in suits against corporate advisors • Reform Act (1995) allows the SEC to bring criminal actions against persons who aid and abet violations of the securities laws

11. [4](16): SEC Rule 14a-9 • Creates Duty of Board of Directors and Management to Shareholders • For false and misleading statements in proxy solicitations • Supreme Court allows private shareholder lawsuits • Standard of Care • Circuit Courts agree on civil liability for intentional and reckless misleading statements or omissions • Some Circuits (2nd NY and 3rd PA) allow civil liability for negligence • Opinions and Projections • Not misleading if adequately and prominently qualified • Can be misleading if not believed by corporation • Can be misleading if lacks a reasonable basis in fact • Merger example of false and misleading statements • Price and method of payment (bonds or stock) is “fair”

12. [4](17): Section 12 of Securities Act • Civil Liability for false and misleading statements in prospectuses • Liability if know (intentional) or should have known (reckless) • What is a forward-looking statement? • Projections of revenues, income, earnings, capital expenditures, dividends, etc. • Plans and objectives, or future economic performance • Safe Harbor for forward-looking statements: Reform Act (1995) • No civil liability for a forward-looking statement IF • (1) identified as a forward-looking statement • (2) accompanied by meaningful cautionary statements • OR if plaintiff fails to prove actual knowledge by the officer that the statement was false or misleading

13. [4](18): Trump Securities Litigation • Trump issues $675 million in first mortgage bonds (1988) • Purchase Taj Mahal Casino and complete construction • Interest rate on bonds = 14% (high grade corporate bonds = 9%) • False or Misleading Statement? • “The Partnership believes that funds generated from the operation of the Taj Mahal will be sufficient to cover all of its debt service.” • Disclaimers and Cautionary Statements: “Special Considerations” • Success of Taj Mahal will depend upon financial, business, competitive, regulatory, and other factors, as well as prevailing economic conditions • Taj Mahal has no operating experience and is twice as large as any existing casino in Atlantic City • Casino win in Atlantic City will decline after Taj Mahal opens • Risks from delays in construction or obtaining operating licenses

14. [4](19): Trump Securities Litigation • Bondholders sue under Section 12 and Rule 10b-5 when they discover that Trump Partnership plans to declare bankruptcy • Argue that Trump has no reasonable basis for his prediction that Taj Mahal can cover its debt service • Argue that the cautionary statements and disclaimers were inadequate • 3rd Circuit Court (1993) rejects civil liability • Trump prediction is not a material misleading statement • Because Trump made clear and substantive cautionary statements • cautionary statements were more than vague or blanket disclaimers • Reasonable investors should view these bonds as risky • High interest rate clearly reflects the risks • “Bespeaks Caution Doctrine”: potentially misleading predictions are not material if they are adequately qualified

15. [4](20): Forward Looking Statements • When does a failure to update forward-looking statements violate Rule 10b-5? • SEC interpretation: Duty to correct prior statements • When the corporation knows or should know that persons continue to rely on the prior statements • (1) that have become false and misleading by subsequent events • (2) that are later discovered to have been false and misleading • Example: updated earnings projections • Can a corporation insulate itself from liability by characterizing all statements about its business in terms of the “near future”? • And surrounding them with cautionary statements • How detailed must the cautionary statements be?