During respondent's federal criminal trial, which resulted in a conviction, defense counsel sought to impeach the credibility of key prosecution witnesses by testimony of a defense investigator regarding statements previously obtained from the witnesses by the investigator. When the investigator was called as a witness, the District Court stated that a copy of the investigator's report, inspected and edited by the court in camera so as to excise references to matters not relevant to such statements, would have to be submitted to the prosecution for inspection at the completion of the investigator's testimony. When defense counsel said he did not intend to produce the report, the court ruled that the investigator could not testify about his interviews with the witnesses. The Court of Appeals, considering such ruling to be reversible error, held that both the Fifth Amendment and Fed.Rule Crim.Proc. 16 prohibited the disclosure condition imposed.
1. In a proper case, the prosecution, as well as the defense, can invoke the federal judiciary's inherent power to require production of previously recorded witness statements that facilitate full disclosure of all the relevant facts. Here, the investigator's report might provide critical insight into the issues of credibility that the investigator's testimony would raise, and hence was highly relevant to such issues. Pp. 422 U. S. 230-232.
2. The Fifth Amendment privilege against compulsory self-incrimination, being personal to the defendant, does not extend to the testimony or statements of third parties called as witnesses at trial. In this instance, the fact that the statements of third parties were elicited by a defense investigator on respondent's behalf does not convert them into respondent's personal communications, and requiring their production would in no sense compel respondent to be a witness against himself or extort communications from him. Pp. 422 U. S. 233-234.
District Court's power to condition the impeachment testimony of respondent's witness on the production of the relevant portions of his report. The fact that the Rule incorporates the Jencks Act limitation shows no contrary intent, and does not convert the Rule into a general limitation on the trial court's broad discretion as to evidentiary questions at trial. Pp. 422 U. S. 234-236.
4. The qualified privilege derived from the attorney work product doctrine is not available to prevent disclosure of the investigative report, since respondent, by electing to present the investigator as a witness, waived the privilege with respect to matters covered in his testimony. Pp. 422 U. S. 236-240.
5. It was within the District Court's discretion to assure that the jury would hear the investigator's full testimony, rather than a truncated portion favorable to respondent, and the court's ruling, contrary to respondent's contention, did not deprive him of the Sixth Amendment rights to compulsory process and cross-examination. That Amendment does not confer the right to present testimony free from the legitimate demands of the adversarial system, and cannot be invoked as a justification for presenting what might have been a half-truth. Pp. 422 U. S. 240-241.
POWELL, J., delivered the opinion of the Court, in which BURGER, C.J., and BRENNAN, STEWART, MARSHALL, and BLACKMUN, JJ., joined, and in parts II, III, and V of which WHITE and REHNQUIST, JJ., joined. WHITE, J., filed a concurring opinion, in which REHNQUIST, J., joined, post, p. 422 U. S. 242. DOUGLAS, J., took no part in the consideration or decision of the case.
In a criminal trial, defense counsel sought to impeach the credibility of key prosecution witnesses by testimony of a defense investigator regarding statements previously obtained from the witnesses by the investigator. The question presented here is whether, in these circumstances, a federal trial court may compel the defense to reveal the relevant portions of the investigator's report for the prosecution's use in cross-examining him. The United States Court of Appeals for the Ninth Circuit concluded that it cannot. 501 F.2d 146. We granted certiorari, 419 U.S. 1120 (1975), and now reverse.
Respondent was tried and convicted on charges arising from an armed robbery of a federally insured bank. The only significant evidence linking him to the crime was the identification testimony of two witnesses, a bank teller and a salesman who was in the bank during the robbery. [Footnote 1] Respondent offered an alibi but, as the Court of Appeals recognized, 501 F.2d at 150, his strongest defense centered around attempts to discredit these eyewitnesses. Defense efforts to impeach them gave rise to the events that led to this decision.
teller whether he recalled having told the investigator that he had seen only the back of the man he identified as respondent. The witness replied that he did not remember making such a statement. He was allowed, despite defense counsel's initial objection, to refresh his recollection by referring to a portion of the investigator's report. The prosecutor also was allowed to see briefly the relevant portion of the report. [Footnote 2] The witness thereafter testified that, although the report indicated that he told the investigator he had seen only respondent's back, he, in fact, had seen more than that, and continued to insist that respondent was the bank robber.
court further advised that it would examine the investigator's report in camera, and would excise all reference to matters not relevant to the precise statements at issue.
error. Citing United States v. Wright, 160 U.S.App.D.C. 57, 68, 489 F.2d 1181, 1192 (1973), the court found that the Fifth Amendment prohibited the disclosure condition imposed in this case. The court further held that Fed.Rule Crim.Proc. 16, while framed exclusively in terms of pretrial discovery, precluded prosecutorial discovery at trial as well. 501 F.2d at 157; accord, United States v. Wright, supra at 66-67, 489 F.2d at 1190-1191. In each respect, we think the court erred.
The dual aim of our criminal justice system is "that guilt shall not escape or innocence suffer," Berger v. United States, 295 U. S. 78, 295 U. S. 88 (1935). To this end, we have placed our confidence in the adversary system, entrusting to it the primary responsibility for developing relevant facts on which a determination of guilt or innocence can be made. See United States v. Nixon, 418 U. S. 683, 418 U. S. 709 (1974); Williams v. Florida, 399 U. S. 78, 399 U. S. 82 (1970); Elkins v. United States, 364 U. S. 206, 364 U. S. 234 (1960) (Frankfurter, J., dissenting).
fundamental and comprehensive. The ends of criminal justice would be defeated if judgments were to be founded on a partial or speculative presentation of the facts. The very integrity of the judicial system and public confidence in the system depend on full disclosure of all the facts, within the framework of the rules of evidence. To ensure that justice is done, it is imperative to the function of courts that compulsory process be available for the production of evidence needed either by the prosecution or by the defense."
Decisions of this Court repeatedly have recognized the federal judiciary's inherent power to require the prosecution to produce the previously recorded statements of its witnesses so that the defense may get the full benefit of cross-examination and the truthfinding process may be enhanced. See, e.g., Jencks v. United States, 353 U. S. 657 (1957); [Footnote 5] Gordon v. United States, 34 U. S. 414 (1953); Goldman v. United States, 316 U. S. 129 (1942); Palermo v. United States, 360 U. S. 343, 360 U. S. 361 (1959) (BRENNAN, J., concurring in result). At issue here is whether, in a proper case, the prosecution can call upon that same power for production of witness statements that facilitate "full disclosure of all the [relevant] facts." United States v. Nixon, supra, at 418 U. S. 709.
It was therefore apparent to the trial judge that the investigator's report was highly relevant to the critical issue of credibility. In this context, production of the report might substantially enhance "the search for truth," Williams v. Florida, 399 U.S. at 399 U. S. 82. We must determine whether compelling its production was precluded by some privilege available to the defense in the circumstances of this case.
The Court of Appeals concluded that the Fifth Amendment renders criminal discovery "basically a one-way street." 501 F.2d at 154. Like many generalizations in constitutional law, this one is too broad. The relationship between the accused's Fifth Amendment rights and the prosecution's ability to discover materials at trial must be identified in a more discriminating manner.
allegedly made by third parties who were available as witnesses to both the prosecution and the defense. Respondent did not prepare the report, and there is no suggestion that the portions subject to the disclosure order reflected any information that he conveyed to the investigator. The fact that these statements of third parties were elicited by a defense investigator on respondent's behalf does not convert them into respondent's personal communications. Requiring their production from the investigator therefore would not in any sense compel respondent to be a witness against himself or extort communications from him.
We thus conclude that the Fifth Amendment privilege against compulsory self-incrimination, being personal to the defendant, does not extend to the testimony or statements of third parties called as witnesses at trial. The Court of Appeals' reliance on this constitutional guarantee as a bar to the disclosure here ordered was misplaced.
that its reference to the Jencks Act, 18 U.S.C. § 3500, signaled an intention that Rule 16 should control trial practice as well. We do not agree.
control over evidentiary questions arising at trial. 18 U.S.C.App. pp. 4493-4495.
The incorporation of the Jencks Act limitation on the pretrial right of discovery provided by Rule 16 does not express a contrary intent. It only restricts the defendant's right of pretrial discovery in a manner that reconciles that provision with the Jencks Act limitation on the trial court's discretion over evidentiary matters. It certainly does not convert Rule 16 into a general limitation on the trial court's broad discretion as to evidentiary questions at trial. Cf. Giles v. Maryland, 386 U. S. 66, 386 U. S. 101 (1967) (Fortas, J., concurring in judgment). [Footnote 10] We conclude, therefore, that Rule 16 imposes no constraint on the District Court's power to condition the impeachment testimony of respondent's witness on the production of the relevant portions of his investigative report. In extending the Rule into the trial context, the Court of Appeals erred.
Respondent contends further that the work product doctrine exempts the investigator's report from disclosure at trial. While we agree that this doctrine applies to criminal litigation as well as civil, we find its protection unavailable in this case.
"Historically, a lawyer is an officer of the court, and is bound to work for the advancement of justice while faithfully protecting the rightful interests of his clients. In performing his various duties, however, it is essential that a lawyer work with a certain degree of privacy, free from unnecessary intrusion by opposing parties and their counsel. Proper preparation of a client's case demands that he assemble information, sift what he considers to be the relevant from the irrelevant facts, prepare his legal theories, and plan his strategy without undue and needless interference. That is the historical and the necessary way in which lawyers act within the framework of our system of jurisprudence to promote justice and to protect their clients' interests. This work is reflected, of course, in interviews, statements, memoranda, correspondence, briefs, mental impressions, personal beliefs, and countless other tangible and intangible ways -- aptly though roughly termed by the Circuit Court of Appeals in this case as the 'work product of the lawyer.' Were such materials open to opposing counsel on mere demand, much of what is now put down in writing would remain unwritten. An attorney's thoughts, heretofore inviolate, would not be his own. Inefficiency, unfairness and sharp practices would inevitably develop in the giving of legal advice and in the preparation of cases for trial. The effect on the legal profession would be demoralizing. And the interests of the clients and the cause of justice would be poorly served."
certain materials prepared by an attorney "acting for his client in anticipation of litigation." Id. at 329 U. S. 508. [Footnote 11] See generally 4 J. Moore, Federal Practice ¦ 26.63 (2d ed.1974); E. Cleary, McCormick on Evidence 204-209 (2d ed.1972); Note, Developments in the Law -- Discovery, 74 Harv.L.Rev. 940, 1027-1046 (1961).
well as those prepared by the attorney himself. [Footnote 13] Moreover, the concerns reflected in the work product doctrine do not disappear once trial has begun. Disclosure of an attorney's efforts at trial, as surely as disclosure during pretrial discovery, could disrupt the orderly development and presentation of his case. We need not, however, undertake here to delineate the scope of the doctrine at trial, for, in this instance, it is clear that the defense waived such right as may have existed to invoke its protections.
opportunity to assist in avoiding unwarranted disclosure or to exercise an informed choice to call for the investigator's testimony, and thereby open his report to examination.
The only other evidence introduced against respondent was a statement made at the time of arrest in which he denied that he was Robert Nobles and subsequently stated that he knew that the FBI had been looking for him.
Counsel for the Government complained that the portion of the report produced at this time was illegible. The witness testimony indicates, however, that he had no difficulty reading it.
"[If the investigator] is allowed to testify, it would be necessary that those portions of [the] investigative report which contain the statements of the impeached witness will have to be turned over to the prosecution; nothing else in that report."
"If he testifies in any way about impeaching statements made by either of the two witnesses, then it is the Court's view that the government is entitled to look at his report and only those portions of that report which contain the alleged impeaching statements . . . of the witnesses."
Although the portion of the report containing the bank teller's alleged statement previously was revealed and marked for identification, it was not introduced into evidence. When the discussion of the investigator's testimony subsequently arose, counsel for the Government noted that he had only a limited opportunity to glance at the statement, and he then requested disclosure of that portion of the report as well as the statement purportedly made by the salesman.
As indicated above, the bank teller did not deny having made the statement recorded in the investigator's report. It is thus possible that the investigator's testimony on that point would not have constituted an impeachment of the statements of that witness within the contemplation of the court's order, and would not have given rise to a duty of disclosure. Counsel did not pursue this point, however, and did not seek further clarification of the issue. Respondent does not, and, in view of the failure to develop the issue at trial, could not, urge this as a ground for reversal. Nor does respondent maintain that the initial disclosure of the bank teller's statement sufficed to satisfy the court's order. We therefore consider each of the two alleged statements in the report to be impeaching statements that would have been subject to disclosure if the investigator had testified about them.
Rule 612 of the new Federal Rules of Evidence entitles an adverse party to inspect a writing relied on to refresh the recollection of a witness while testifying. The Rule also authorizes disclosure of writings relied on to refresh recollection before testifying if the court deems it necessary in the interests of justice. The party obtaining the writing thereafter can use it in cross-examining the witness, and can introduce into evidence those portions that relate to the witness' testimony. As the Federal Rules of Evidence were not in effect at the time of respondent's trial, we have no occasion to consider them or their applicability to the situation here presented.
"The purpose of the relevant part of the Fifth Amendment is to prevent compelled self-incrimination, not to protect private information. Testimony demanded of a witness may be very private indeed, but unless it is incriminating and protected by the Amendment, or unless protected by one of the evidentiary privileges, it must be disclosed."
Maness v. Meyers, 419 U. S. 449, 419 U. S. 473-474 (1975) (WHITE, J., concurring in result). Moreover, the constitutional guarantee protects only against forced individual disclosure of a "testimonial or communicative nature," Schmerber v. California, 384 U. S. 757, 384 U. S. 761 (1966); see also United States v. Wade, 388 U. S. 218, 388 U. S. 222 (1967); Gilbert v. California, 388 U. S. 263 (1967).
"reports, memoranda, or other internal defense documents made by the defendant, or his attorneys or agents in connection with the investigation or defense of the case, or of statements made by the defendant, or by government or defense witnesses, or by prospective government or defense witnesses, to the defendant, his agents or attorneys."
That Rule therefore would not authorize pretrial discovery of the investigator's report. The proposed amendments to the Federal Rules of Criminal Procedure leave this subsection substantially unchanged. See Proposed Rule 16 of Criminal Procedure, 62 F.R.D. 271, 305-306 (1974).
Rule 16(g) imposes a duty to notify opposing counsel or the court of the additional materials previously requested or inspected that are subject to discovery or inspection under the Rule, and it contemplates that this obligation will continue during trial. The obligation under Rule 16(g) depends, however, on a previous request for or order of discovery. The fact that this provision may have some effect on the parties' conduct during trial does not convert the Rule into a general limitation on the court's inherent power to control evidentiary matters.
We note also that the commentators who have considered Rule 16 have not suggested that it is directed to the court's control of evidentiary questions arising at trial. See, e.g., Nakell, Criminal Discovery for the Defense and the Prosecution -- the Developing Constitutional Considerations, 50 N.C.L.Rev. 437, 494-514 (1972); Rezneck, The New Federal Rules of Criminal Procedure, 54 Geo.L.J. 1276, 1279, 1282 n.19 (1966); Note, Prosecutorial Discovery Under Proposed Rule 16, 85 Harv.L.Rev. 994 (1972).
As the Court recognized in Hickman v. Taylor, 329 U.S. at 329 U. S. 508, the work product doctrine is distinct from and broader than the attorney-client privilege.
A number of state and federal decisions have recognized the role of the work product doctrine in the criminal law, and have applied its protections to the files of the prosecution and the accused alike. See, e.g., State v. Bowen, 104 Ariz. 138, 449 P.2d 603, cert. denied, 396 U.S. 912 (1969); State ex rel. Polley v. Superior Ct. of Santa Cruz County, 81 Ariz. 127, 302 P.2d 263 (1956); Peel v. State, 154 So.2d 910 (Fla.App. 1963); In re Grand Jury Proceedings (Duffy v. United States), 473 F.2d 840 (CA8 1973); In re Terkeltoub, 256 F.Supp. 683 (SDNY 1966).
The sole issue in Hickman related to materials prepared by an attorney, and courts thereafter disagreed over whether the doctrine applied as well to materials prepared on his behalf. See Proposed Amendments to the Federal Rules of Civil Procedure Relating to Discovery, 48 F.R.D. 487, 501 (1970); 4 J. Moore, Federal Practice ¦ 26.63  (2d ed.1974). Necessarily, it must. This view is reflected in the Federal Rules of Civil Procedure, see Rule 26(b)(3), and in Rule 16 of the Criminal Rules, as well, see Rules 16(b) and (c); cf. E. Cleary, McCormick on Evidence 208 (2d ed.1972).
What constitutes a waiver with respect to work product materials depends, of course, upon the circumstances. Counsel necessarily makes use throughout trial of the notes, documents, and other internal materials prepared to present adequately his client's case, and often relies on them in examining witnesses. When so used, there normally is no waiver. But where, as here, counsel attempts to make a testimonial use of these materials, the normal rules of evidence come into play with respect to cross-examination and production of documents.
We cannot accept respondent's contention that the disclosure order violated his Sixth Amendment right to effective assistance of counsel. This claim is predicated on the assumption that disclosure of a defense investigator's notes in this and similar cases will compromise counsel's ability to investigate and prepare the defense case thoroughly. Respondent maintains that even the limited disclosure required in this case will impair the relationship of trust and confidence between client and attorney and will inhibit other members of the "defense team" from gathering information essential to the effective preparation of the case. See American Bar Association Project on Standards for Criminal Justice, The Defense Function § 3.1(a) (App.Draft 1971). The short answer is that the disclosure order resulted from respondent's voluntary election to make testimonial use of his investigator's report. Moreover, apart from this waiver, we think that the concern voiced by respondent fails to recognize the limited and conditional nature of the court's order.
Respondent additionally argues that certain statements by the prosecution and the District Court's exclusion of purported expert testimony justify reversal of the verdict, and that the Court of Appeals' decision should be affirmed on those grounds. The Court of Appeals rejected respondent's challenge to the exclusion of the testimony of the proffered expert, 501 F.2d at 150 151. Respondent did not present this issue or the question involving the challenged prosecutorial statements to this Court in a cross-petition for certiorari. Without questioning our jurisdiction to consider these alternative grounds for affirmance of the decision below, cf. Langnes v. Green, 282 U. S. 531, 282 U. S. 538 (1931); Dandridge v. Williams, 397 U. S. 471, 397 U. S. 475 476, n. 6 (1970); see generally Stern, When to Cross-Appeal or Cross-Petition -- Certainty or Confusion?, 87 Harv.L.Rev. 763 (1974), we do not consider these contentions worthy of consideration. Each involves an issue that is committed to the trial court's discretion. In the absence of a strong suggestion of an abuse of that discretion or an indication that the issues are of sufficient general importance to justify the grant of certiorari, we decline to entertain them.
MR. JUSTICE WHITE, with whom MR. JUSTICE REHNQUIST joins, concurring.
doctrine of Hickman v. Taylor, 329 U. S. 495 (1947), can be extended wholesale from its historic role as a limitation on the nonevidentiary material which may be the subject of pretrial discovery to an unprecedented role as a limitation on the trial judge's power to compel production of evidentiary matter at trial, I add the following.
statements might be admissible in evidence under some circumstances, and might be usable to impeach or corroborate a witness. However, it concluded that, in the case before it, the plaintiff wanted the statements for preparation only, and had shown no reason why he could not obtain everything he sought by doing his own work, rather than utilizing that of his adversary.
"When Rule 26 and the other discovery rules were adopted, this Court and the members of the bar in general certainly did not believe or contemplate that all the files and mental processes of lawyers were thereby opened to the free scrutiny of their adversaries."
Similarly, the commentators have all treated the attorney work product rule solely as a limitation on pretrial discovery, e.g., 4 J. Moore, Federal Practice 26.626.64 (2d ed.1974); 8 C. Wright & A. Miller, Federal Practice and Procedure § 2026 (1970); 2A W. Barron & A. Holtzoff, Federal Practice and Procedure § 652 (Wright ed.1961), and some have expressly stated that it does not apply to evidentiary matter. F. James, Civil Procedure 211 n. 13 (1965); 4 J. Moore, Federal Practice ¦ 16.23[8.-4] (1963).
process is far greater where a rule keeps evidence from the factfinder than when it simply keeps advance disclosure of evidence from a party or keeps from him leads to evidence developed by his adversary and which he is just as well able to find by himself. In the main, where a party seeks to discover a statement made to an opposing party in order to prepare for trial, he can obtain the "substantial equivalent . . . by other means," Fed.Rule Civ.Proc. 26(b)(3), i.e., by interviewing the witness himself. A prior inconsistent statement in the possession of his adversary, however, when sought for evidentiary purposes -- i.e., to impeach the witness after he testifies -- is for that purpose unique. By the same token, the danger perceived in Hickman that each party to a case will decline to prepare in the hopes of eventually using his adversary's preparation is absent when disclosure will take place only at trial. Indeed, it is very difficult to articulate a reason why statements on the same subject matter as a witness' testimony should not be turned over to an adversary after the witness has testified. The statement will either be consistent with the witness' testimony, in which case it will be useless and disclosure will be harmless, or it will be inconsistent, and of unquestioned value to the jury. Any claim that disclosure of such a statement would lead the trial into collateral and confusing issues was rejected by this Court in Jencks v. United States, 353 U. S. 657 (1957), and by Congress in the legislation which followed.
argued, inter alia, that production would violate the "legitimate interest that each party -- including the Government -- has in safeguarding the privacy of its files.'" 353 U.S. at 353 U. S. 670. The Court held against the Government. The Court said that to deny disclosure of prior statements which might be used to impeach the witnesses was to "deny the accused evidence relevant and material to his defense," id. at 353 U. S. 667 (emphasis added). Also rejected as unrealistic was any rule which would require the defendant to demonstrate the impeachment value of the prior statements before disclosure, [Footnote 2/8] and the Court held that entitlement to disclosure for use in cross-examination is "established when the reports are shown to relate to the testimony of the witness." Id. at 353 U. S. 669. Thus, not only did the Court reject the notion that there was a "work product" limitation on the trial judge's discretion to order production of evidentiary matter at trial, but it was affirmatively held that, prior statements of a witness on the subject of his testimony are the kind of evidentiary matter to which an adversary is entitled.
facts remain hidden in an attorney's file and where production of those fact is essential to the preparation of one's case, discovery may properly be had. Such written statements and documents might, under certain circumstances, be admissible in evidence or give clues as to the existence or location of relevant facts. Or they might be useful for purposes of impeachment or corroboration."
may have written about the event. [Footnote 2/10] Since prior statements are inadmissible hearsay until the witness testifies, there is no occasion for ordering reports of such statements produced as evidence pretrial. However, some courts have ordered witness statements produced pretrial in the likelihood that they will become impeachment evidence. [Footnote 2/11] Moreover, where access to witnesses or to their information is unequal, discovery of their statements is often granted solely to help a party prepare for trial regardless of any eventual evidentiary value of the out-of-court statements. See Proposed Amendments to the Federal Rules of Civil Procedure Relating to Discovery, 48 F.R.D. at 501.
"Every lawyer dislikes to take the witness stand, and will do so only for grave reasons. This is partly because it is not his role; he is almost invariably a poor witness. But he steps out of professional character to do it. He regrets it; the profession discourages it. But the practice advocated here is one which would force him to be a witness not as to what he has seen or done, but as to other witnesses' stories, and not because he wants to do so, but in self-defense."
The remarks of the Court in Hickman v. Taylor, supra, while made in the context of a request for pretrial discovery, have application to the evidentiary use of lawyers' memoranda of witness interviews at trial. It is unnecessary, however, to decide in this case whether the policies against putting in issue the credibility of the lawyer who will sum up to the jury outweigh the jury's interest in obtaining all relevant information, and whether Jencks v. United States, supra, and 18 U.S.C.
§ 3500 are to be viewed as expressing a preference for disclosure of all facts. [Footnote 2/15] In this case, the creator of the memorandum was not the trial lawyer but an investigator, [Footnote 2/16] and he was, in any event, to be called as a witness by the defense. Accordingly, I would reverse the judgment below because, quite apart from waiver, the work product rule of Hickman v. Taylor, supra, has no application to the request at trial for evidentiary and impeachment material made in this case.
Under criminal discovery rules, the time factor is not as great as might otherwise appear. Federal Rule Crim.Proc. 16 permits discovery through the time of trial; and, under Fed.Rule Crim.Proc. 17(c), evidentiary matter may be obtained pursuant to subpoena in advance of trial in the discretion of the trial judge.
Prior to the Federal Rules, requests for witness statements were granted or denied on the basis of whether they were evidence and nonprivileged. In the main, production was denied, either because witness statements were not evidence (they are inadmissible hearsay until and unless the witness testifies); because a party is not entitled to advance knowledge of his adversary's case; or because the Statements were made by the client or his agent to his attorney, and thus covered by the attorney-client privilege. 4 J. Moore, Federal Practice ¦ 26.63  (2d ed.1974), and cases cited therein. The cases did not hold that witness statements were generally privileged if they were evidentiary, and had no cause to decide whether a work product notion should protect them from discovery, since they were nondiscoverable anyway under applicable discovery rules. But see Walker v. Struthers, 273 Ill. 387, 112 N.E. 961 (1916).
Mr. Justice Jackson's concurrence is even more express on this point. It states: "[T]he question is simply whether such a demand is authorized by the rules relating to various aspects of discovery.'" 329 U.S. at 329 U. S. 514.
Mr. Justice Jackson also emphasized that the witness statements involved in Hickman v. Taylor were neither evidence nor privileged. Id. at 329 U. S. 516. Indeed, most of the material described by the Court as falling under the work product umbrella does not qualify as evidence. A lawyer's mental impressions are almost never evidence, and out-of-court statements of witnesses are generally inadmissible hearsay. Such statements become evidence only when the witness testifies at trial, and are then usually impeachment evidence only. This case, of course, involves a situation in which the relevant witness was to testify and thus presents the question -- not involved in Hickman v. Taylor -- whether prior statements should be disclosed under the trial judge's power over evidentiary matters at trial.
In 422 U. S. 13 of its opinion, the Court cites Fed.Rule Crim.Proc. 16(c), as containing the work product rule. In n 10, the Court correctly notes that Rule 16(c) is not "directed to the court's control of evidentiary questions arising at trial." It seems to me that this supplies a better ground for the Court's decision than "waiver."
The majority does cite one case, In re Terkeltoub, 256 F.Supp. 683 (SDNY 1966), in which the court referred to the work product doctrine in preventing the Government from inquiring of a lawyer before the grand jury whether he had participated in suborning perjury of a prospective witness while preparing a criminal case for trial. In any event, a grand jury investigation is, in some respects, similar to pretrial discovery. Compare In re Grand Jury Proceedings (Duffy v. United States), 473 F.2d 840 (CA8 1973), with Schwimmer v. United States, 232 F.2d 855 (CA8), cert. denied, 352 U.S. 833 (1956). The proper scope of inquiry is as broad, and it can be used as a way of preparing for the later criminal trial. There is, for example, a split of authority on whether the work product rule applies to IRS tax investigations. Compare United States v. McKay, 372 F.2d 174 (CA5 1967), with United States v. Brown, 478 F.2d 1038 (CA7 1973).
Shaw v. Wuttke, 28 Wis.2d 448, 454-456, 137 N.W.2d 649, 652-653 (1965); State ex rel. State Highway Comm'n v. Steinkraus, 76 N.M. 617, 620-621, 417 P.2d 431, 432-433 (1966); E. I. duPont de Nemours & Co. v. Phillips Petroleum Co., 24 F.R.D. 416 (Del.1959); United States v. Matles, 154 F.Supp. 574 (EDNY 1957); United States v. Sun Oil Co., 16 F.R.D. 533 (ED Pa.1954); United States v. Gates, 35 F.R.D. 524 (Colo.1964).
"'Now, if a paper be in possession of the opposite party, what statement of its contents or applicability can be expected from the person who claims its production, he not precisely knowing its contents?'"
353 U.S. at 353 U. S. 668 n. 12.
Cummings v. Bell Telephone Co. of Pennsylvania, 47 F.R.D. 373 (ED Pa.1968); Marks v. Gas Service Co., 168 F.Supp. 487 (WD MO.1958); Maginnis v. Westinghouse Electric Corp., 207 F.Supp. 739 (ED La.1962); Julius Hyman & Co. v. American Motorists Ins. Co., 17 F.R.D. 386 (Colo.1955); Parrett v. Ford Motor Co., 47 F.R.D. 22 (WD Mo.1968); Scuderi v. Boston Ins. Co., 34 F.R.D. 463, 468 (Del.1964) (each involving a situation in which a member of a litigation team witnessed an event or scene in the course of preparing a case for trial and the court ordered disclosure of his report of the event); Bourget v. Government Employees Ins. Co., 48 F.R.D. 29 (Conn.1969); McCullough Tool Co. v. Pan Geo Atlas Corp., 40 F.R.D. 490 (SD Tex.1966); O'Boyle v. Life Ins. Co. of North America, 299 F.Supp. 704 (WD MO.1969). Cf. LaRocca v. State Farm Mutual Automobile Ins. Co., 47 F.R.D. 278 (WD Pa.1969), and Kennedy v. Senyo, 52 F.R.D. 34 (WD Pa.1971) (in each of which the preparation for trial was the subject of the suit); see also Natta v. Hogan, 392 F.2d 686, 693 (CA10 1968); F. James, Civil Procedure 211 (1965).
The holding in Jencks v. United States, 353 U. S. 657 (1957), would put to rest any claim that such prior statement would be disclosable only if the adversary established its evidentiary value ahead of time by specific proof that it was inconsistent.
Vetter v. Lovett, 44 F.R.D. 465 (WD Tex.1968); McDonald v. Prowdley, 38 F.R.D. 1 (WD Mich.1965); Tannenbaum v. Walker, 16 F.R.D. 570 (ED Pa.1954); Fulton v. Swift, 43 F.R.D. 166 (Mont.1967); Republic Gear Co. v. Borg-Warner Corp., 381 F.2d 551, 557-558 (CA2 1967) (in camera inspection). Cf. Goosman v. A. Duie Pyle, Inc., 320 F.2d 45 (CA4 1963). For cases contra, see 4 J. Moore, Federal Practice 26.64 n. 14 (2d ed.1974).
"Moreover, the concerns reflected in the work product doctrine do not disappear once trial has begun. Disclosure of an attorney's efforts at trial, as surely as disclosure during pretrial discovery, could disrupt the orderly development and presentation of his case. We need not, however, undertake here to delineate the scope of the doctrine at trial, for, in this instance, it is clear that the defense waived such right as may have existed to invoke its protections."
Ante at 422 U. S. 239.
As noted above, the important question is not when the document in issue is created, or even when it is to be produced. The important question is whether the document is sought for evidentiary or impeachment purposes, or whether it is sought for preparation purposes only. Of course, a party should not be able to discover his opponent's legal memoranda or statements of witnesses not called, whether his request is at trial or before trial. Insofar as such a request is made under the applicable discovery rules, it is within the rule of Hickman v. Taylor even though made at trial. Insofar as the request seeks to invoke the trial judge's discretion over evidentiary matters at trial, the rule of Hickman v. Taylor is unnecessary, since no one could ever suggest that legal memoranda or hearsay statements are evidence. If this is all the majority means by the above-quoted language, I agree.
If the witness does not acknowledge making an inconsistent statement to the lawyer -- even though the lawyer recorded it -- the cross-examiner may not offer the document in evidence without at least calling the lawyer as a witness to authenticate the document and otherwise testify to the prior statement.
United States v. Porter, 139 U.S.App.D.C.19, 429 F.2d 203 (1970); United States v. Fiorillo, 376 F.2d 180 (CA2 1967); Gajewski v. United States, 321 F.2d 261 (CA8 1963), cert. den., 375 U.S. 968 (1964); United States v. Newman, 476 F.2d 733 (CA3 1973); Travelers Ins. Co. v Dykes, 395 F.2d 747 (CA5 1968); United States v. Alu, 246 F.2d 29 (CA2 1957); United States v. Chiarella, 184 F.2d 903, modified on rehearing, 187 F.2d 12 (CA2 1950), vacated as to one petitioner, 341 U.S. 946, cert. denied as to other petitioner sub nom. Stancin v. United States, 341 U.S. 956 (1951); United States v. Clancy, 276 F.2d 617 (CA7 1960), rev'd on other grounds, 365 U. S. 312 (1961).
The cases have held records of witness statements made by prosecutors to be disclosable under 18 U.S.C. § 3500, United States v. Hilbrich, 341 F.2d 555 (CA7), cert. den., 381 U.S. 941, reh. den., 382 U.S. 874 (1965), and 384 U.S. 1028 (196); United States v. Aviles, 315 F.2d 186 (CA2 1963); Saunders v. United States, 114 U.S.App.D.C. 345, 316 F.2d 346 (1963); United States v. Smaldone, 484 F.2d 311 (CA10 1973), cert. den., 415 U.S. 915 (1974). Cf. Canaday v. United States, 354 F.2d 849 (CA8 1966). In State v. Bowen, 104 Ariz. 138, 449 P.2d 603 (1969), the court reached a contrary result under state law.
A conflict arose among lower federal courts over the question whether the work product of members of a litigation team other than the lawyer was protected from discovery by the rule of Hickman v. Taylor, supra. Ghent, Development, Since Hickman v. Taylor, of Attorney's "Work Product" Doctrine, 35 A.L.R.3d 438-440 (§§ 7 [a] and [b]) and 453-455 (§§ 15[a] and [b]) (1971); Proposed Amendments to the Federal Rules of Civil Procedure Relating to Discovery, 48 F.R.D. 487, 501-502 (1970). With respect to discovery in civil cases under Fed.Rule Civ.Proc. 26, the conflict was resolved in the 1970 amendments by affording protection to documents by a party's "representative," whether a lawyer or not. Where the purpose of the rule protecting the work product is to remove the incentive a party might otherwise have to rely solely on his opponent's preparation, it is sensible to treat preparation by an attorney and an investigator alike. However, the policy against lawyers testifying applies only to the lawyer who tries the case.


This is “Securities Regulation”, chapter 26 from the book The Legal Environment and Foundations of Business Law (v. 1.0). For details on it (including licensing), click here.
In , we examined state law governing a corporation’s issuance and transfer of stock. In , we covered the liability of directors and officers. This chapter extends and ties together the themes raised in and by examining government regulation of securities and insider trading. Both the registration and the trading of securities are highly regulated by the Securities and Exchange Commission (SEC). A violation of a securities law can lead to severe criminal and civil penalties. But first we examine the question, Why is there a need for securities regulation?
Recognize that the definition of security encompasses a broad range of interests.
Understand the functions of the Securities and Exchange Commission and the penalties for violations of the securities laws.
Understand which companies the Securities Exchange Act of 1934 covers.
Explore the purpose of state Blue Sky Laws.
Know the basic provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
What we commonly refer to as “securities” are essentially worthless pieces of paper. Their inherent value lies in the interest in property or an ongoing enterprise that they represent. This disparity between the tangible property—the stock certificate, for example—and the intangible interest it represents gives rise to several reasons for regulation. First, there is need for a mechanism to inform the buyer accurately what it is he is buying. Second, laws are necessary to prevent and provide remedies for deceptive and manipulative acts designed to defraud buyers and sellers. Third, the evolution of stock trading on a massive scale has led to the development of numerous types of specialists and professionals, in dealings with whom the public can be at a severe disadvantage, and so the law undertakes to ensure that they do not take unfair advantage of their customers.
The Securities Act of 1933 and the Securities Exchange Act of 1934 are two federal statutes that are vitally important, having virtually refashioned the law governing corporations during the past half century. In fact, it is not too much to say that although they deal with securities, they have become the general federal law of corporations. This body of federal law has assumed special importance in recent years as the states have engaged in a race to the bottom in attempting to compete with Delaware’s permissive corporation law (see Chapter 23 "Corporation: General Characteristics and Formation").
Securities law questions are technical and complex and usually require professional counsel. For the nonlawyer, the critical question on which all else turns is whether the particular investment or document is a securityAny note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a security.. If it is, anyone attempting any transaction beyond the routine purchase or sale through a broker should consult legal counsel to avoid the various civil and criminal minefields that the law has strewn about.
Under this definition, an investment may not be a security even though it is so labeled, and it may actually be a security even though it is called something else. For example, does a service contract that obligates someone who has sold individual rows in an orange orchard to cultivate, harvest, and market an orange crop involve a security subject to regulation under federal law? Yes, said the Supreme Court in Securities & Exchange Commission v. W. J. Howey Co.Securities & Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). The Court said the test is whether “the person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Under this test, courts have liberally interpreted “investment contractA commitment of money or capital to purchase financial instruments as a means to gain profitable returns in the form of income, interest, or the appreciation of the value of the instrument itself. It can be interpreted by the courts to be a security for purposes of the federal securities laws.” and “certificate of interest or participation in any profit-sharing agreement” to be securities interests in such property as real estate condominiums and cooperatives, commodity option contracts, and farm animals.
The Supreme Court ruled that notes that are not “investment contracts” under the Howey test can still be considered securities if certain factors are present, as discussed in Reves v. Ernst & Young, (see Section 26.3.1 "What Is a Security?"). These factors include (1) the motivations prompting a reasonable seller and buyer to enter into the transaction, (2) the plan of distribution and whether the instruments are commonly traded for speculation or investment, (3) the reasonable expectations of the investing public, and (4) the presence of other factors that significantly reduce risk so as to render the application of the Securities Act unnecessary.
The Securities and Exchange CommissionAn independent federal regulatory agency whose primary task is to investigate complaints or other possible violations of the law in securities transactions and to bring enforcement proceedings when it believes that violations have occurred. (SEC) is over half a century old, having been created by Congress in the Securities Exchange Act of 1934. It is an independent regulatory agency, subject to the rules of the Administrative Procedure Act (see Chapter 5 "Administrative Law"). The commission is composed of five members, who have staggered five-year terms. Every June 5, the term of one of the commissioners expires. Although the president cannot remove commissioners during their terms of office, he does have the power to designate the chairman from among the sitting members. The SEC is bipartisan: not more than three commissioners may be from the same political party.
The SEC’s primary task is to investigate complaints or other possible violations of the law in securities transactions and to bring enforcement proceedings when it believes that violations have occurred. It is empowered to conduct information inquiries, interview witnesses, examine brokerage records, and review trading data. If its requests are refused, it can issue subpoenas and seek compliance in federal court. Its usual leads come from complaints of investors and the general public, but it has authority to conduct surprise inspections of the books and records of brokers and dealers. Another source of leads is price fluctuations that seem to have been caused by manipulation rather than regular market forces.
Among the violations the commission searches out are these: (1) unregistered sale of securities subject to the registration requirement of the Securities Act of 1933, (2) fraudulent acts and practices, (3) manipulation of market prices, (4) carrying out of a securities business while insolvent, (5) misappropriation of customers’ funds by brokers and dealers, and (4) other unfair dealings by brokers and dealers.
When the commission believes that a violation has occurred, it can take one of three courses. First, it can refer the case to the Justice Department with a recommendation for criminal prosecutionThe process of bringing a legal action against a defendant for criminal behavior. in cases of fraud or other willful violation of law.
Second, the SEC can seek a civil injunctionA judicial process or order requiring a person or entity to do a particular act or to refrain from doing a particular act. in federal court against further violations. As a result of amendments to the securities laws in 1990 (the Securities Enforcement Remedies and Penny Stock Reform Act), the commission can also ask the court to impose civil penaltiesA term used to describe when a state entity, government agency, or private party seeks monetary relief, fines, and/or restitution for wrongdoing by another.. The maximum penalty is $100,000 for each violation by a natural person and $500,000 for each violation by an entity other than a natural person. Alternatively, the defendant is liable for the gain that resulted from violating securities law if the gain exceeds the statutory penalty. The court is also authorized to bar an individual who has committed securities fraud from serving as an officer or a director of a company registered under the securities law.
Third, the SEC can proceed administratively—that is, hold its own hearing, with the usual due process rights, before an administrative law judgeThe presiding officer of an administrative hearing.. If the commissioners by majority vote accept the findings of the administrative law judge after reading briefs and hearing oral argument, they can impose a variety of sanctions: suspend or expel members of exchanges; deny, suspend, or revoke the registrations of broker-dealers; censure individuals for misconduct; and bar censured individuals (temporarily or permanently) from employment with a registered firm. The 1990 securities law amendments allow the SEC to impose civil fines similar to the court-imposed fines described. The amendments also authorize the SEC to order individuals to cease and desist from violating securities law.
The SEC’s fundamental mission is to ensure adequate disclosure in order to facilitate informed investment decisions by the public. However, whether a particular security offering is worthwhile or worthless is a decision for the public, not for the SEC, which has no legal authority to pass on the merits of an offering or to bar the sale of securities if proper disclosures are made.
One example of SEC’s regulatory mandate with respect to disclosures involved the 1981 sale of $274 million in limited partnership interests in a company called Petrogene Oil & Gas Associates, New York. The Petrogene offering was designed as a tax shelter. The company’s filing with the SEC stated that the offering involved “a high degree of risk” and that only those “who can afford the complete loss of their investment” should contemplate investing. Other disclosures included one member of the controlling group having spent four months in prison for conspiracy to commit securities fraud; that he and another principal were the subject of a New Mexico cease and desist order involving allegedly unregistered tax-sheltered securities; that the general partner, brother-in-law of one of the principals, had no experience in the company’s proposed oil and gas operations (Petrogene planned to extract oil from plants by using radio frequencies); that one of the oils to be produced was potentially carcinogenic; and that the principals “stand to benefit substantially” whether or not the company fails and whether or not purchasers of shares recovered any of their investment. The prospectus went on to list specific risks. Despite this daunting compilation of troublesome details, the SEC permitted the offering because all disclosures were made (Wall Street Journal, December 29, 1981). It is the business of the marketplace, not the SEC, to determine whether the risk is worth taking.
The SEC enforces securities laws through two primary federal acts: The Securities Act of 1933 and The Securities Exchange Act of 1934.
The primary means for realizing these goals is the requirement of registration. Before securities subject to the act can be offered to the public, the issuer must file a registration statementA set of documents that a company must file with the SEC before it proceeds with an initial public offering. and prospectusA document that provides details about an investment offering for sale to the public—the facts an investor needs to make an informed decision. with the SEC, laying out in detail relevant and material information about the offering as set forth in various schedules to the act. If the SEC approves the registration statement, the issuer must then provide any prospective purchaser with the prospectus. Since the SEC does not pass on the fairness of price or other terms of the offering, it is unlawful to state or imply in the prospectus that the commission has the power to disapprove securities for lack of merit, thereby suggesting that the offering is meritorious.
The SEC has prepared special forms for registering different types of issuing companies. All call for a description of the registrant’s business and properties and of the significant provisions of the security to be offered, facts about how the issuing company is managed, and detailed financial statements certified by independent public accountants.
Once filed, the registration and prospectus become public and are open for public inspection. Ordinarily, the effective date of the registration statement is twenty days after filing. Until then, the offering may not be made to the public. Section 2(10) of the act defines prospectus as any “notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security.” (An exception: brief notes advising the public of the availability of the formal prospectus.) The import of this definition is that any communication to the public about the offering of a security is unlawful unless it contains the requisite information.
The SEC staff examines the registration statement and prospectus, and if they appear to be materially incomplete or inaccurate, the commission may suspend or refuse the effectiveness of the registration statement until the deficiencies are corrected. Even after the securities have gone on sale, the agency has the power to issue a stop order that halts trading in the stock.
Section 5(c) of the act bars any person from making any sale of any security unless it is first registered. Nevertheless, there are certain classes of exemptions from the registration requirement. Perhaps the most important of these is Section 4(3), which exempts “transactions by any person other than an issuer, underwriter or dealer.” Section 4(3) also exempts most transactions of dealers. So the net is that trading in outstanding securities (the secondary market) is exempt from registration under the Securities Act of 1933: you need not file a registration statement with the SEC every time you buy or sell securities through a broker or dealer, for example. Other exemptions include the following: (1) private offerings to a limited number of persons or institutions who have access to the kind of information registration would disclose and who do not propose to redistribute the securities; (2) offerings restricted to the residents of the state in which the issuing company is organized and doing business; (3) securities of municipal, state, federal and other government instrumentalities, of charitable institutions, of banks, and of carriers subject to the Interstate Commerce Act; (4) offerings not in excess of certain specified amounts made in compliance with regulations of the Commission…: and (5) offerings of “small business investment companies” made in accordance with rules and regulations of the Commission.
Sections 11 and 12 provide that anyone injured by false declarations in registration statements, prospectuses, or oral communications concerning the sale of the security—as well as anyone injured by the unlawful failure of an issuer to register—may file a civil suit to recover the net consideration paid for the security or for damages if the security has been sold.
Although these civil penalty provisions apply only to false statements in connection with the registration statement, prospectus, or oral communication, the Supreme Court held, in Case v. Borak,Case v. Borak, 377 U.S. 426 (1964). that there is an “implied private right of actionA ruling by the Supreme Court that allows individuals who have been defrauded to seek damages resulting from a violation of SEC rules.” for damages resulting from a violation of SEC rules under the act. The Court’s ruling in Borak opened the courthouse doors to many who had been defrauded but were previously without a practical remedy.
The Securities Act of 1933 is limited, as we have just seen, to new securities issues—that is the primary marketThe market in which the money or capital for the security is received by the issuer of the security directly from investors (such as in an initial public offering transaction).. The trading that takes place in the secondary marketThe market in which securities are bought and sold subsequent to original issuance and are typically held by one investor selling them to another investor. is far more significant, however. In a normal year, trading in outstanding stock totals some twenty times the value of new stock issues.
To regulate the secondary market, Congress enacted the Securities Exchange Act of 1934A law that was enacted to provide governance of securities transactions on the secondary market and to regulate the exchanges and broker-dealers in order to protect the investing public. This act also established the SEC.. This law, which created the SEC, extended the disclosure rationale to securities listed and registered for public trading on the national securities exchanges. Amendments to the act have brought within its ambit every corporation whose equity securities are traded over the counter if the company has at least $10 million in assets and five hundred or more shareholders.
Any company seeking listing and registration of its stock for public trading on a national exchange—or over the counter, if the company meets the size test—must first submit a registration application to both the exchange and the SEC. The registration statement is akin to that filed by companies under the Securities Act of 1933, although the Securities Exchange Act of 1934 calls for somewhat fewer disclosures. Thereafter, companies must file annual and certain other periodic reports to update information in the original filing.
The Securities Exchange Act of 1934 also covers proxy solicitationAn attempt by a group or delegation to obtain the authorization from other individuals to vote on their behalf.. Whenever management, or a dissident minority, seeks votes of holders of registered securities for any corporate purpose, disclosures must be made to the stockholders to permit them to vote yes or no intelligently.
The logic of the Borak case (discussed in Section 26.1.3 "Securities Act of 1933") also applies to this act, so that private investors may bring suit in federal court for violations of the statute that led to financial injury. Violations of any provision and the making of false statements in any of the required disclosures subject the defendant to a maximum fine of $5 million and a maximum twenty-year prison sentence, but a defendant who can show that he had no knowledge of the particular rule he was convicted of violating may not be imprisoned. The maximum fine for a violation of the act by a person other than a natural person is $25 million. Any issuer omitting to file requisite documents and reports is liable to pay a fine of $100 for each day the failure continues.
Long before congressional enactment of the securities laws in the 1930s, the states had legislated securities regulations. Today, every state has enacted a blue sky lawA state law that regulates the offering and sale of securities to protect the public from fraud., so called because its purpose is to prevent “speculative schemes which have no more basis than so many feet of ‘blue sky.’”Hall v. Geiger-Jones Co., 242 U.S. 539 (1917). The federal Securities Act of 1933, discussed in Section 26.1.3 "Securities Act of 1933", specifically preserves the jurisdiction of states over securities.
Blue sky laws are divided into three basic types of regulation. The simplest is that which prohibits fraud in the sale of securities. Thus at a minimum, issuers cannot mislead investors about the purpose of the investment. All blue sky laws have antifraud provisions; some have no other provisions. The second type calls for registration of broker-dealers, and the third type for registration of securities. Some state laws parallel the federal laws in intent and form of proceeding, so that they overlap; other blue sky laws empower state officials (unlike the SEC) to judge the merits of the offerings, often referred to as merit review lawsLaws that regulate the disclosure and the substantive merits and fairness of the securities offerings to investors.. As part of a movement toward deregulation, several states have recently modified or eliminated merit provisions.
Many of the blue sky laws are inconsistent with each other, making national uniformity difficult. In 1956, the National Conference of Commissioners on Uniform State Laws approved the Uniform Securities Act. It has not been designed to reconcile the conflicting philosophies of state regulation but to take them into account and to make the various forms of regulation as consistent as possible. States adopt various portions of the law, depending on their regulatory philosophies. The Uniform Securities Act has antifraud, broker-dealer registration, and securities registration provisions. More recent acts have further increased uniformity. These include the National Securities Markets Improvement Act of 1996, which preempted differing state philosophies with regard to registration of securities and regulation of brokers and advisors, and the Securities Litigation Uniform Standards Act of 1998, which preempted state law securities fraud claims from being raised in class action lawsuits by investors.
In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection ActA federal law aimed at financial reform and designed to promote financial stability, it was established to enhance the power of regulatory agencies and add additional enforcement agencies., which is the largest amendment to financial regulation in the United States since the Great Depression. This amendment was enacted in response to the economic recession of the late 2000s for the following purposes: (1) to promote the financial stability of the United States by improving accountability and transparency in the financial system, (2) to end “too big to fail” institutions, (3) to protect the American taxpayer by ending bailouts, and (4) to protect consumers from abusive financial services practices. The institutions most affected by the regulatory changes include those involved in monitoring the financial system, such as the Federal Deposit Insurance Corporation (FDIC) and the SEC. Importantly, the amendment ended the exemption for investment advisors who previously were not required to register with the SEC because they had fewer than fifteen clients during the previous twelve months and did not hold out to the public as investment advisors. This means that in practice, numerous investment advisors, as well as hedge funds and private equity firms, are now subject to registration requirements.For more information on the Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub.L. 111-203, H.R. 4173), see Thomas, “Major Actions,” Bill Summary & Status 111th Congress (2009–2010) H.R.4173, http://thomas.loc.gov/cgi-bin/bdquery/z?d111:HR04173:@@@L&summ2=m&#major%20actions.
The SEC administers securities laws to prevent the fraudulent practices in the sales of securities. The definition of security is intentionally broad to protect the public from fraudulent investments that otherwise would escape regulation. The Securities Act of 1933 focuses on the issuance of securities, and the Securities Exchange Act of 1934 deals predominantly with trading in issued securities. Numerous federal and state securities laws are continuously created to combat securities fraud, with penalties becoming increasingly severe.
What differentiates an ordinary investment from a security? List all the factors.
What is the main objective of the SEC?
What are the three courses of action that the SEC may take against one who violates a securities law?
What is the difference between the Securities Act of 1933 and the Securities Exchange Act of 1934?
What do blue sky laws seek to protect?
Understand how the Foreign Corrupt Practices Act prevents American companies from using bribes to enter into contracts or gain licenses from foreign governments.
Understand the liability for insider trading for corporate insiders, “tippees,” and secondary actors under Sections 16(b) and 10(b) of the 1934 Securities Exchange Act.
Recognize how the Sarbanes-Oxley Act has amended the 1934 act to increase corporate regulation, transparency, and penalties.
Corporations may be found liable if they engage in certain unlawful practices, several of which we explore in this section.
Investigations by the Securities and Exchange Commission (SEC) and the Watergate Special Prosecutor in the early 1970s turned up evidence that hundreds of companies had misused corporate funds, mainly by bribing foreign officials to induce them to enter into contracts with or grant licenses to US companies. Because revealing the bribes would normally be self-defeating and, in any event, could be expected to stir up immense criticism, companies paying bribes routinely hid the payments in various accounts. As a result, one of many statutes enacted in the aftermath of Watergate, the Foreign Corrupt Practices Act (FCPA)A US law, enacted 1977, that in part prohibits US firms from bribing foreign officials to obtain or retain business. of 1977, was incorporated into the 1934 Securities Exchange Act. The SEC’s legal interest in the matter is not premised on the morality of bribery but rather on the falsity of the financial statements that are being filed.
Congress’s response to abuses of financial reporting, the FCPA, was much broader than necessary to treat the violations that were uncovered. The FCPA prohibits an issuer (i.e., any US business enterprise), a stockholder acting on behalf of an issuer, and “any officer, director, employee, or agent” of an issuer from using either the mails or interstate commerce corruptly to offer, pay, or promise to pay anything of value to foreign officials, foreign political parties, or candidates if the purpose is to gain business by inducing the foreign official to influence an act of the government to render a decision favorable to the US corporation.
But not all payments are illegal. Under 1988 amendments to the FCPA, payments may be made to expedite routine governmental actions, such as obtaining a visa. And payments are allowed if they are lawful under the written law of a foreign country. More important than the foreign-bribe provisions, the act includes accounting provisions, which broaden considerably the authority of the SEC. These provisions are discussed in SEC v. World-Wide Coin Investments, Ltd.,SEC v. World-Wide Coin Investments, Ltd., 567 F.Supp. 724 (N.D. Ga. 1983). the first accounting provisions case brought to trial.
Corporate insidersA corporate director, officer, or shareholder with more than 10 percent of a registered security who through influence of position obtains knowledge that may be used to gain an unfair advantage to the detriment of others. The definition has been broadened to include relatives and others.—directors, officers, or important shareholders—can have a substantial trading advantage if they are privy to important confidential information. Learning bad news (such as financial loss or cancellation of key contracts) in advance of all other stockholders will permit the privileged few to sell shares before the price falls. Conversely, discovering good news (a major oil find or unexpected profits) in advance gives the insider a decided incentive to purchase shares before the price rises.
Because of the unfairness to those who are ignorant of inside information, federal law prohibits insider tradingBuying or selling securities of a publicly held company by those who have privileged access to information concerning a company’s financial condition or plans.. Two provisions of the 1934 Securities Exchange Act are paramount: Section 16(b)16(b)	A section of the 1934 Securities Exchange Act that allows shareholders to sue corporate officers, directors, or owners of more than 10% of the company’s shares for any profits made by insider trading. 16(b) is not enforced by the SEC,but by private parties, and covers profits made within a “short swing” (six month) period. and 10(b).
The Securities Exchange Act assumes that any director, officer, or shareholder owning 10 percent or more of the stock in a corporation is using inside information if he or any family member makes a profit from trading activities, either buying and selling or selling and buying, during a six-month period. Section 16(b) penalizes any such person by permitting the corporation or a shareholder suing on its behalf to recover the short-swing profitsAny profits made from the purchase and sale of company stock if both transactions occur within a six-month period; insiders are required to return any profits made from the purchase and sale of company stock if both transactions occur within a six-month period.. The law applies to any company with more than $10 million in assets and at least five hundred or more shareholders of any class of stock.
Suppose that on January 1, Bob (a company officer) purchases one hundred shares of stock in BCT Bookstore, Inc., for $60 a share. On September 1, he sells them for $100 a share. What is the result? Bob is in the clear, because his $4,000 profit was not realized during a six-month period. Now suppose that the price falls, and one month later, on October 1, he repurchases one hundred shares at $30 a share and holds them for two years. What is the result? He will be forced to pay back $7,000 in profits even if he had no inside information. Why? In August, Bob held one hundred shares of stock, and he did again on October 1—within a six-month period. His net gain on these transactions was $7,000 ($10,000 realized on the sale less the $3,000 cost of the purchase).
As a consequence of Section 16(b) and certain other provisions, trading in securities by directors, officers, and large stockholders presents numerous complexities. For instance, the law requires people in this position to make periodic reports to the SEC about their trades. As a practical matter, directors, officers, and large shareholders should not trade in their own company stock in the short run without legal advice.
(3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Rule 10b-5 applies to any person who purchases or sells any security. It is not limited to securities registered under the 1934 Securities Exchange Act. It is not limited to publicly held companies. It applies to any security issued by any company, including the smallest closely held company. In substance, it is an antifraud rule, enforcement of which seems, on its face, to be limited to action by the SEC. But over the years, the courts have permitted people injured by those who violate the statute to file private damage suits. This sweeping rule has at times been referred to as the “federal law of corporations” or the “catch everybody” rule.
Insider trading ran headlong into Rule 10b-5 beginning in 1964 in a series of cases involving Texas Gulf Sulphur Company (TGS). On November 12, 1963, the company discovered a rich deposit of copper and zinc while drilling for oil near Timmins, Ontario. Keeping the discovery quiet, it proceeded to acquire mineral rights in adjacent lands. By April 1964, word began to circulate about TGS’s find.
Newspapers printed rumors, and the Toronto Stock Exchange experienced a wild speculative spree. On April 12, an executive vice president of TGS issued a press release downplaying the discovery, asserting that the rumors greatly exaggerated the find and stating that more drilling would be necessary before coming to any conclusions. Four days later, on April 16, TGS publicly announced that it had uncovered a strike of 25 million tons of ore. In the months following this announcement, TGS stock doubled in value.
The SEC charged several TGS officers and directors with having purchased or told their friends, so-called tippeesSomeone who receives and acts on insider information., to purchase TGS stock from November 12, 1963, through April 16, 1964, on the basis of material inside information. The SEC also alleged that the April 12, 1964, press release was deceptive. The US Court of Appeals, in SEC v. Texas Gulf Sulphur Co.,SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968). decided that the defendants who purchased the stock before the public announcement had violated Rule 10b-5. According to the court, “anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.” On remand, the district court ordered certain defendants to pay $148,000 into an escrow account to be used to compensate parties injured by the insider trading.
The court of appeals also concluded that the press release violated Rule 10b-5 if “misleading to the reasonable investor.” On remand, the district court held that TGS failed to exercise “due diligence” in issuing the release. Sixty-nine private damage actions were subsequently filed against TGS by shareholders who claimed they sold their stock in reliance on the release. The company settled most of these suits in late 1971 for $2.7 million.
Following the TGS episode, the Supreme Court refined Rule 10b-5 on several fronts. First, in Ernst & Ernst v. Hochfelder,Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). the Court decided that proof of scienterA legal term that refers to having intent or knowledge of wrongdoing.—defined as “mental state embracing intent to deceive, manipulate, or defraud”—is required in private damage actions under Rule 10b-5. In other words, negligence alone will not result in Rule 10b-5 liability. The Court also held that scienter, which is an intentional act, must be established in SEC injunctive actions.Aaron v. SEC, 446 U.S. 680 (1980).
The Supreme Court has placed limitations on the liability of tippees under Rule 10b-5. In 1980, the Court reversed the conviction of an employee of a company that printed tender offer and merger prospectuses. Using information obtained at work, the employee had purchased stock in target companies and later sold it for a profit when takeover attempts were publicly announced. In Chiarella v. United States, the Court held that the employee was not an insider or a fiduciary and that “a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.”Chiarella v. United States, 445 U.S. 222 (1980). Following Chiarella, the Court ruled in Dirks v. Securities and Exchange Commission (see Section 26.3.2 "Tippee Liability"), that tippees are liable if they had reason to believe that the tipper breached a fiduciary duty in disclosing confidential information and the tipper received a personal benefit from the disclosure.
The Supreme Court has also refined Rule 10b-5 as it relates to the duty of a company to disclose material informationInformation that would be likely to affect a stock’s price once it became known to the public., as discussed in Basic, Inc. v. Levinson (see Section 26.3.3 "Duty to Disclose Material Information"). This case is also important in its discussion of the degree of reliance investors must prove to support a Rule 10b-5 action.
In 2000, the SEC enacted Rule 10b5-1A provision that defines when a purchase or sale constitutes trading “on the basis of” material nonpublic information as any time a person trades while aware of material nonpublic information., which defines trading “on the basis of” inside information as any time a person trades while aware of material nonpublic information. Therefore, a defendant is not saved by arguing that the trade was made independent of knowledge of the nonpublic information. However, the rule also creates an affirmative defense for trades that were planned prior to the person’s receiving inside information.
In addition to its decisions relating to intent (Ernst & Ernst), tippees (Dirks), materiality (Basic), and awareness of nonpublic information (10b5-1), the Supreme Court has considered the misappropriation theoryA theory based on the act of stealing, or misappropriating, confidential information and then trading securities based on the misappropriated insider knowledge., under which a person who misappropriates information from an employer faces insider trading liability. In a leading misappropriation theory case, the Second Circuit Court of Appeals reinstated an indictment against employees who traded on the basis of inside information obtained through their work at investment banking firms. The court concluded that the employees’ violation of their fiduciary duty to the firms violated securities law.United States v. Newman, 664 F.2d 12 (2d Cir. 1981). The US Supreme Court upheld the misappropriation theory in United States v. O’Hagan,United States v. O’Hagan, 521 U.S. 642 (1997). and the SEC adopted the theory as new Rule 10b5-2A provision that includes a nonexclusive definition of circumstances and that establishes a duty of trust or confidence for purposes of the misappropriation theory of insider trading.. Under this new rule, the duty of trust or confidence exists when (1) a person agrees to maintain information in confidence; (2) the recipient knows or should have known through history, pattern, or practice of sharing confidences that the person communicating the information expects confidentiality; and (3) a person received material nonpublic information from his or her spouse, parent, child, or sibling.
In 1987, in Carpenter v. United States,Carpenter v. United States, 484 U.S. 19 (1987). the Supreme Court affirmed the conviction of a Wall Street Journal reporter who leaked advanced information about the contents of his “Heard on the Street” column. The reporter, who was sentenced to eighteen months in prison, had been convicted on both mail and wire fraud and securities law charges for misappropriating information. The Court upheld the mail and wire fraud conviction by an 8–0 vote and the securities law conviction by a 4–4 vote. (In effect, the tie vote affirmed the conviction.)Carpenter v. United States, 484 U.S. 19 (1987).
Beyond these judge-made theories of liability, Congress had been concerned about insider trading, and in 1984 and 1988, it substantially increased the penalties. A person convicted of insider trading now faces a maximum criminal fine of $1 million and a possible ten-year prison term. A civil penalty of up to three times the profit made (or loss avoided) by insider trading can also be imposed. This penalty is in addition to liability for profits made through insider trading. For example, financier Ivan Boesky, who was sentenced in 1987 to a three-year prison term for insider trading, was required to disgorge $50 million of profits and was liable for another $50 million as a civil penalty. In 2003, Martha Stewart was indicted on charges of insider trading but was convicted for obstruction of justice, serving only five months. More recently, in 2009, billionaire founder of the Galleon Group, Raj Rajaratnam, was arrested for insider trading; he was convicted in May 2011 of all 14 counts of insider trading. For the SEC release on the Martha Stewart case, see http://www.sec.gov/news/press/2003-69.htm.
Companies that knowingly and recklessly fail to prevent insider trading by their employees are subject to a civil penalty of up to three times the profit gained or loss avoided by insider trading or $1 million, whichever is greater. Corporations are also subject to a criminal fine of up to $2.5 million.
In Stoneridge Investment Partners v. Scientific-Atlanta,Stoneridge Investment Partners v. Scientific-Atlanta, 552 U.S. 148 (2008). the US Supreme Court held that “aiders and abettors” of fraud cannot be held secondarily liable under 10(b) for a private cause of action. This means that secondary actorsA ruling by the Supreme Court stating that “aiders and abettors” of fraud cannot be held secondarily liable under 10(b) for a private cause of action., such as lawyers and accountants, cannot be held liable unless their conduct satisfies all the elements for 10(b) liability.
For an overview of insider trading, go to http://www.sec.gov/answers/insider.htm.
Congress enacted the Sarbanes-Oxley Act in 2002 in response to major corporate and accounting scandals, most notably those involving Enron, Tyco International, Adelphia, and WorldCom. The act created the Public Company Accounting Oversight BoardA body created by Sarbanes-Oxley that oversees, inspects, and regulates accounting firms in their capacity as auditors of public companies., which oversees, inspects, and regulates accounting firms in their capacity as auditors of public companies. As a result of the act, the SEC may include civil penalties to a disgorgement fund for the benefit of victims of the violations of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Corrupt practices, misuse of corporate funds, and insider trading unfairly benefit the minority and cost the public billions. Numerous federal laws have been enacted to create liability for these bad actors in order to prevent fraudulent trading activities. Both civil and criminal penalties are available to punish those actors who bribe officials or use inside information unlawfully.
Why is the SEC so concerned with bribery? What does the SEC really aim to prevent through the FCPA?
To whom does Section 16(b) apply?
Explain how Rule 10b-5 has been amended “on the basis of” insider information.
Can a secondary actor (attorney, accountant) be liable for insider trading? What factors must be present?
This case presents the question whether certain demand notes issued by the Farmer’s Cooperative of Arkansas and Oklahoma are “securities” within the meaning of § 3(a)(10) of the Securities and Exchange Act of 1934. We conclude that they are.
The Co-Op is an agricultural cooperative that, at the same time relevant here, had approximately 23,000 members. In order to raise money to support its general business operations, the Co-Op sold promissory notes payable on demand by the holder. Although the notes were uncollateralized and uninsured, they paid a variable rate of interest that was adjusted monthly to keep it higher than the rate paid by local financial institutions. The Co-Op offered the notes to both members and nonmembers, marketing the scheme as an “Investment Program.” Advertisements for the notes, which appeared in each Co-Op newsletter, read in part: “YOUR CO-OP has more than $11,000,000 in assets to stand behind your investments. The Investment is not Federal [sic] insured but it is…Safe…Secure…and available when you need it.” App. 5 (ellipses in original). Despite these assurances, the Co-Op filed for bankruptcy in 1984. At the time of the filing, over 1,600 people held notes worth a total of $10 million.
Petitioners prevailed at trial on both their federal and state claims, receiving a $6.1 million judgment. Arthur Young appealed, claiming that the demand notes were not “securities” under either the 1934 Act or Arkansas law, and that the statutes’ antifraud provisions therefore did not apply. A panel of the Eighth Circuit, agreeing with Arthur Young on both the state and federal issues, reversed. Arthur Young & Co. v. Reves, 856 F.2d 52 (1988). We granted certiorari to address the federal issue, 490 U.S. 1105, 109 S.Ct. 3154, 104 L.Ed.2d 1018 (1989), and now reverse the judgment of the Court of Appeals.
The fundamental purpose undergirding the Securities Acts is “to eliminate serious abuses in a largely unregulated securities market.” United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 849, 95 S.Ct. 2051, 2059, 44 L.Ed.2d 621 (1975). In defining the scope of the market that it wished to regulate, Congress painted with a broad brush. It recognized the virtually limitless scope of human ingenuity, especially in the creation of “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits,” SEC v. W.J. Howey Co., 328 U.S. 293, 299, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946), and determined that the best way to achieve its goal of protecting investors was “to define ‘the term “security” in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.’” Forman, supra, 421 U.S., at 847-848, 95 S.Ct., at 2058-2059 (quoting H.R.Rep. No. 85, 73d Cong., 1st Sess., 11 (1933)). Congress therefore did not attempt precisely to cabin the scope of the Securities Acts. Rather, it enacted a definition of “security” sufficiently broad to encompass virtually any instrument that might be sold as an investment.
[In deciding whether this transaction involves a “security,” four factors are important.] First, we examine the transaction to assess the motivations that would prompt a reasonable seller and buyer to enter into it. If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a “security.” If the note is exchanged to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, on the other hand, the note is less sensibly described as a “security.” Second, we examine the “plan of distribution” of the instrument to determine whether it is an instrument in which there is “common trading for speculation or investment.” Third, we examine the reasonable expectations of the investing public: The Court will consider instruments to be “securities” on the basis of such public expectations, even where an economic analysis of the circumstances of the particular transaction might suggest that the instruments are not “securities” as used in that transaction. Finally, we examine whether some factor such as the existence of another regulatory scheme significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.
What are the four factors the court uses to determine whether or not the transaction involves a security?
How does the definition of security in this case differ from the definition in Securities & Exchange Commission v. W. J. Howey?
[A] tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.
Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure. This standard was identified by the SEC itself in Cady, Roberts: a purpose of the securities laws was to eliminate “use of inside information for personal advantage.” Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.
Under the inside-trading and tipping rules set forth above, we find that there was no actionable violation by Dirks. It is undisputed that Dirks himself was a stranger to Equity Funding, with no preexisting fiduciary duty to its shareholders. He took no action, directly, or indirectly, that induced the shareholders or officers of Equity Funding to repose trust or confidence in him. There was no expectation by Dirk’s sources that he would keep their information in confidence. Nor did Dirks misappropriate or illegally obtain the information about Equity Funding. Unless the insiders breached their Cady, Roberts duty to shareholders in disclosing the nonpublic information to Dirks, he breached no duty when he passed it on to investors as well as to the Wall Street Journal.
It is clear that neither Secrist nor the other Equity Funding employees violated their Cady, Roberts duty to the corporation’s shareholders by providing information to Dirks. The tippers received no monetary or personal benefit for revealing Equity Funding’s secrets, nor was their purpose to make a gift of valuable information to Dirks. As the facts of this case clearly indicate, the tippers were motivated by a desire to expose the fraud. In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by Dirks. Dirks therefore could not have been “a participant after the fact in [an] insider’s breach of a fiduciary duty.” Chiarella, 445 U.S., at 230, n. 12.
We conclude that Dirks, in the circumstances of this case, had no duty to abstain from the use of the inside information that he obtained. The judgment of the Court of Appeals therefore is reversed.
When does a tippee assume a fiduciary duty to shareholders of a corporation?
Did Dirks violate any insider trading laws? Why or why not?
How does this case refine Rule 10b-5?
We granted certiorari to resolve the split among the Courts of Appeals as to the standard of materiality applicable to preliminary merger discussions, and to determine whether the courts below properly applied a presumption of reliance in certifying the class, rather than requiring each class member to show direct reliance on Basic’s statements.
The Court previously has addressed various positive and common-law requirements for a violation of § 10(b) or of Rule 10b-5. The Court also explicitly has defined a standard of materiality under the securities laws, see TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976), concluding in the proxy-solicitation context that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.”…We now expressly adopt the TSC Industries standard of materiality for the 5 10(b) and Rule 10b-5 context.
The application of this materiality standard to preliminary merger discussions is not self-evident. Where the impact of the corporate development on the target’s fortune is certain and clear, the TSC Industries materiality definition admits straight-forward application. Where, on the other hand, the event is contingent or speculative in nature, it is difficult to ascertain whether the “reasonable investor” would have considered the omitted information significant at the time. Merger negotiations, because of the ever-present possibility that the contemplated transaction will not be effectuated, fall into the latter category.
Even before this Court’s decision in TSC Industries, the Second Circuit had explained the role of the materiality requirement of Rule 10b-5, with respect to contingent or speculative information or events, in a manner that gave that term meaning that is independent of the other provisions of the Rule. Under such circumstances, 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.” SEC v. Texas Gulf Sulphur Co., 401 F.2d, at 849.
Whether merger discussions in any particular case are material therefore depends on the facts. Generally, in order to assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transactions at the highest corporate levels. Without attempting to catalog all such possible factors, we note 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. To assess the magnitude of the transaction to the issuer of the securities allegedly manipulated, a factfinder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value. No particular event or factor short of closing the transaction need to be either necessary or sufficient by itself to render merger discussions material.
As we clarify today, materiality depends on the significance the reasonable investor would place on the withheld or misrepresented information. The fact-specific inquiry we endorse here is consistent with the approach a number of courts have taken in assessing the materiality of merger negotiations. Because the standard of materiality we have adopted differs from that used by both courts below, we remand the case for reconsideration of the question whether a grant of summary judgment is appropriate on this record.
The fraud on the market theory is based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available information regarding the company and its business.…Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.…The causal connection between the defendants’ fraud and the plaintiff’s purchase of stock in such a case is no less significant than in a case of direct reliance on misrepresentations. Peil v. Speiser, 806 F.2d 1154, 1160-1161 (CA3 1986).
We agree that reliance is an element of a Rule 10b-5 cause of action. Reliance provides the requisite causal connection between a defendant’s misrepresentation and a plaintiff’s misrepresentation and a plaintiff’s injury. There is, however, more than one way to demonstrate the causal connection.
Presumptions typically serve to assist courts in managing circumstances in which direct proof, for one reason or another, is rendered difficult. The courts below accepted a presumption, created by the fraud-on-the-market theory and subject to rebuttal by petitioners, that persons who had traded Basic shares had done so in reliance on the integrity of the price set by the market, but because of petitioners’ material misrepresentations that price had been fraudulently depressed. Requiring a plaintiff to show a speculative state of facts, i.e., how he would have acted if omitted material information had been disclosed, or if the misrepresentation had not been made, would place an unnecessarily unrealistic evidentiary burden on the Rule 10b-5 plaintiff who has traded on an impersonal market.
The presumption is also supported by common sense and probability. Recent empirical studies have tended to confirm Congress’ premise that the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations. It has been noted that “it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?” Schlanger v. Four-Phase Systems, Inc., 555 F.Supp. 535, 538 (SDNY 1982).…An investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price. Because most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.
The judgment of the Court of Appeals is vacated and the case is remanded to that court for further proceedings consistent with this opinion.
How does the court determine what is or is not material information? How does this differ from its previous rulings?
What is the fraud-on-the-market theory?