Hicks, J. William

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Indiana University Bloomington Maurer School of Law

Maurer School of Law: Indiana UniversityDigital Repository @ Maurer LawArticles by Maurer Faculty Faculty Scholarship1994Misrepresentation in the Sale of Stock: WhichBuyers Are Protected?J. William HicksIndiana University Maurer School of Law, hicks@indiana.eduFollow this and additional works at: https://www.repository.law.indiana.edu/facpubPart of the Securities Law CommonsThis Article is brought to you for free and open access by the FacultyScholarship at Digital Repository @ Maurer Law. It has been accepted forinclusion in Articles by Maurer Faculty by an authorized administrator ofDigital Repository @ Maurer Law. For more information, please contactwattn@indiana.edu.Recommended CitationHicks, J. William, "Misrepresentation in the Sale of Stock: Which Buyers Are Protected?" (1994). Articles by Maurer Faculty. 2700.https://www.repository.law.indiana.edu/facpub/2700S E C U R I T I E SMisrepresentation in theSale of Stock:Which Buyers are Protected?by J. William HicksCaseat aISSUEDoes Section 12(2) of the SecuritiesAct of 1933 extend to a privatelynegotiated sale of stock?FACTSArthur Gustafson, Daniel McLean,and Francis Butler (collectively the"Gustafson Group"), were the soleshareholders of Alloyd Company,Inc. ("Alloyd"), a manufacturerof clear plastic blister packagingand automatic heat seal packagingequipment. In May 1989, theGustafson Group decided to sellAlloyd and engaged KPMG PeatMarwick ("Peat Marwick"), a nation-al accounting firm, to locate a buyerPeat Marwick prepared a detailedprofile of Alloyd in order to solicitprospective buyers.Wind Point Partners II ("WindPoint"), an experienced and sophis-ticated investment partnership,received a copy of the profile. InAugust 1989, after conducting exten-sive due diligence regarding Alloyd,visiting Alloyd's facility, and inter-viewing key Alloyd executives, WindPoint submitted a written proposalto purchase Alloyd by buying thestock held by the Gustafson Group.The Gustafson Group agreed to sellAlloyd to Alloyd Holdings, Inc.("Holdings"), a corporation formedby Wind Point to effectuate thepurchase.Two members of the GustafsonGroup, McLean and Butler, investedin Holdings and, together with threeother individuals and Wind Point,became its shareholders. McLeanand Butler also became officers anddirectors of the new company.Prior to signing the Stock PurchaseAgreement at the closing of thetransaction on December 20, 1989,Wind Point attempted to learn asmuch as it could about Alloyd's busi-ness and financial condition. Itretained Peat Marwick to help in this(Continued on page 97)ARTHUR L. GUSTAFSON et al. V.ALLOYD Co., INC. AND WINDPOINT PARTNERS II, L.P.DOCKET No. 93-404ARGUMENT DATE:NOVEMBER 2, 1994FROM: THE SEVENTH CIRCUITGlanceJ. William Hicks is theC. Ben Dutton Professorof Law at Indiana UniversitySchool of Law, Third Street andIndiana Avenue, Bloomington,IN 47405; (812) 855-3844,and the author of thetwo-volume treatise "CivilLiabilities and EnforcementUnder the 1933 Act" (ClarkBoardman Callaghan SecuritiesLaw Series, rev'd ed. 1994).This case concerns thecivil liability of personswho misrepresent materi-al facts in a privatelynegotiated sale of securi-ties. The Supreme Courtwill decide whetherSection 12(2) of theSecurities Act of 1933provides a buyer ofsecurities with a rightto rescind the purchaseboth in public andprivate offerings.L A Wendeavor. Peat Marwick providedWind Point with information aboutAlloyd's inventory but, becauseAlloyd took inventory only at theend of each year, the inventoryinformation was based on estimatesof the cost of goods sold and of grossprofits. The parties discussed theappropriateness of taking a physicalinventory but, ultimately, closedtheir agreement without havingtaken a physical audit.At the closing of the transaction,Holdings acquired all of Alloyd'sstock for approximately $18.7 mil-lion plus $2.1 million to reflect anestimate of Alloyd's increase in networth from December 31, 1988,through the closing. A provision inthe Stock Purchase Agreementrequired that after the year-endaudit of Alloyd's financial state-ments, sellers or buyers would remitan appropriate amount to cover anyvariance between the estimatedchange in Alloyd's net worth for1989 and the actual change.By February 8, 1990, McLean, whoby then had become president ofHoldings, learned that Alloyd's actu-al earnings and net book value for1989 were significantly lower thanthe estimates relied upon by WindPoint in making its offer to buyAlloyd. This variance was attributedto the fact that Alloyd's year-endinventory was significantly lowerthan the estimates provided by theGustafson Group to Wind Point.After confirming the discrepancy,McLean informed Wind Point of theinventory shortfall. Later, theGustafson Group paid $815,000 plusinterest to Holdings pursuant to theadjustment provision in the StockPurchase Agreement.On February 11, 1991, Wind Pointand Holdings sued the GustafsonGroup in the United States DistrictCourt for the Northern District ofIllinois. They asserted two claims: 1)violation of Section 12(2) of theSecurities Act of 1933, 15 U.S.C. §771(2)("Section 12(2)") and 2)breach of the representations andwarranties made in the StockPurchase Agreement.Both sides conducted extensive dis-covery and filed cross-motions forsummary judgment. (See Glossaryfor the definition of summary judg-ment.) On May 29, 1992, the districtcourt entered an unpublished ordergranting the Gustafson Group'smotion for summary judgment. Inruling for the Gustafson Group, thedistrict court relied heavily on thereasoning of the Third Circuit inBallay v. Legg Mason Wood Walker,925 F.2d 682 (3d Cir. 1991), whichheld that Section 12(2) applies onlyto initial offerings by a company andnot to subsequent trading bysecurity holders.Wind Point and Holdings appealedto the Seventh Circuit Court ofAppeals. In an unpublished order,the Seventh Circuit vacated the dis-trict court's order and sent the caseback to the district court for furtherproceedings in light of the SeventhCircuit's recent decision in PacificDunlop Holdings, Inc. v. Allen &Co., 993 F.2d 578 (7th Cir. 1993),which concluded that Section 12(2)was not limited to initial offerings.The Gustafson Group responded tothis setback by filing a petition forcertiorari with the Supreme Courtseeking review of the SeventhCircuit's action, which the Courtgranted.CASE ANALYSISSection 12(2) of the Securities Act of1933 (the "1933 Act" or the "Act")creates an expansive civil remedyfor misrepresentations made by sell-ers of securities. It provides that anyperson who sells, or offers to sell, asecurity "by means of a writtenprospectus or oral communication"that contains materially misleadingstatements is liable to the purchaserof the security.Until the late 1980s, most attorneysand courts did not question thatSection 12(2) applied to all fraudu-lent sales of securities - those salesby a company when the securitieswere originally distributed to thepublic as well as to those sales bysecurity holders when the securitieswere traded privately or throughbroker-dealers in public markets.Recently, however, several federaldistrict courts and two federal appel-late courts have invoked a restrictivereading of Section 12(2) to deny pro-tection to buyers of securities in pri-vate resale transactions and to cus-tomers of broker-dealer firms seek-ing relief against allegedly fraudulentconduct of individual brokers. SeeBallay, 925 F.2d 682, and FirstUnion Discount Brokerage Serv. v.Milos, 997 F.2d 835 (11th Cir. 1993)(both courts reading Section 12(2)as applying only to the original pub-lic offering of a security). The onlyother federal appellate court toaddress the issue squarely, theSeventh Circuit, determined, asnoted above, that Section 12(2) doesapply to resales of securities. PacificDunlop, 993 F.2d at 582.In this case, the Supreme Court willresolve this conflict and, in doing so,will decide the scope of protectionafforded to buyers of securitiesunder Section 12(2). The issue rais-es questions regarding the languageand structure of the 1933 Act, thepurpose of the statute, legislativehistory, and public policy.Both sides agree that the startingpoint in every case involving statuto-ry construction is the statutory lan-guage. However, as sellers in a pri-vate resale transaction, theGustafson Group argues that the lan-guage of Section 12(2), especiallythe term prospectus, indicates thatIssue No. 2Congress intended the remedy toapply to public, not private, sales ofstock. The term is defined broadly inSection 2(10) of the 1933 Act, 15U.S.C. Section 77b(10) ("Section2(10)"), but this definition is explic-itly withdrawn where "the contextotherwise requires." Not surprising-ly, the Gustafson Group contendsthat the context for this term inSection 12(2) is public distributionsof newly created securities bycorporate issuers.The Supreme Court has recognizedthat the 1933 Act was "primarilyconcerned with the regulation ofnew offerings." United States v.Naftalin, 441 U.S. 768 (1979). Giventhis legislative objective as demon-strated in the legislative history, theGustafson Group contends thatCongress used the term prospectusin Section 12(2) in its usual and cus-tomary sense, i.e., as a reference to adocument that solicits public inves-tors to purchase securities. Further-more, they see this construction asentirely consistent with the 1933Act's liability scheme which, in theiropinion, is limited to public offerings.In contrast, Wind Point and Holdingsargue that the terms prospectus andoral communication in Section 12(2)are unambiguous and that, underrules of statutory constructionemployed by the Court, the plainmeaning of the provision controlswithout any need to examine the leg-islative history. King v. St. Vincent'sHosp., 112 S. Ct. 570, 575 n. 14(1991), quoting Rubin v. UnitedStates, 449 U.S. 424, 430 (1981).Wind Point and Holdings stress thebroad definition of the term prospec-tus in Section 2(10), noting that it isnot limited to primary offerings.Although the statutory definition ofthe term prospectus is qualified bythe phrase "unless the context oth-erwise requires," Wind Point andHoldings assert that there is nothingunusual about resales, public orprivate, that warrants a restrictiveapplication of Section 2(10) in thecontext of the liability for misrepre-sentations established by Section12(2). Moreover, argue Wind Pointand Holdings, the language ofSection 12(2) does not limit itsapplication to fraud in connectionwith initial distributions of securi-ties. According to Wind Point andHoldings, the absence of ambiguityin the definition of prospectusmeans that the profile and theStock Purchase Agreement eachconstituted a prospectus within themeaning of Section 12(2). Thisresult, they urge, is consistent with amajor goal of the 1933 Act - theprotection of all purchasers againstmisrepresentation in public andprivate transactions.Legislative history is frequentlyhelpful in determining the meaningof statutory terms and provisions.In this case, both sides rely on it,despite the fact that the legislativehistory of Section 12 is sparse atbest. Pinter v. Dahl, 486 U.S.622 (1988).The Gustafson Group invokes thelegislative history of the 1933 Actto demonstrate that the primaryconcern of Congress was the regula-tion of public securities offerings andinfers from that history that Section12(2) should have a consistent pur-pose. Wind Point and Holdings, onthe other hand, argue that thesilence of the legislative history asto Section 12(2) justifies a literalinterpretation of the provision, aconstruction that protects all buyersregardless of the nature of thetransaction.It is appropriate for the Court toaddress public policy considerationsinvolved in the construction ofSection 12(2). Pinter, 486 U.S. at653. On this point, the GustafsonGroup offers several arguments insupport of its narrow reading ofSection 12(2). First, the GustafsonGroup observes that Congress in1933 imposed stringent duties onlyon sellers engaging in public offer-ings, interfering as little as possiblewith private business transactions.Thus, the Gustafson Group arguesthat Section 12(2) should not reachthe type of transaction involved inthis case - a privately negotiatedsale of stock to experienced,sophisticated buyers. Second, theGustafson Group contends that abroad construction of Section 12(2)is unnecessary in view of the evenmore expansive protection thatbuyers enjoy under Rule 10b-5 andSection 10(b) of the SecuritiesExchange Act of 1934. 15 U.S.C. §78j(b). Finally, the GustafsonGroup maintains that extending theremedy of Section 12(2) to private-ly negotiated transactions wouldinterfere with the ability of privatepersons to place limits on their bar-gains, would add to the cost of pri-vate transactions, and wouldincrease litigation in federal courts.Wind Point and Holdings counterby arguing that none of these policyarguments demonstrates thatapplying Section 12(2) to privatetransactions is beyond the scope ofwhat a rational Congress could pos-sibly have intended. They arguethat congressional sensitivitytoward private business transac-tions was reflected in the registra-tion and prospectus deliveryrequirements of the 1933 Act, butnot in the Act's civil liability provi-sions. As to the possibility of ren-dering superfluous Rule 10b-5 byexpanding protection under Section12(2) to all buyers, Wind Point andHoldings observe that theGustafson Group's argumentignores the important substantivedifferences between the two reme-dies, and also overlooks the obviousfact that "it is hardly a novel propo-sition that the Securities Exchange(Continued on page 99)American Bar AssociationAct and the Securities Act 'prohibitsome of the same conduct."'Herman & MacLean v. Huddleston,459 U.S. 375 (1983). And, inresponse to the contention that anarrow construction of Section12(2) will reduce transaction costsand litigation, Wind Point andHoldings assert that a policy requir-ing a party to tell the truth is notantiefficient or antibusiness. Finally,Wind Point and Holdings argue thataffirming the Seventh Circuit in thiscase would merely maintain the sta-tus quo of case law that for 50 yearshas permitted any sophisticatedparty represented by competentcounsel to use Section 12(2) torescind, i.e., to cancel, a privatelynegotiated securities transactionbecause of a seller's material omis-sion or misrepresentation.SIGNIFICANCESection 12(2) offers importantbenefits to defrauded buyers in pri-vate securities transactions that areunavailable under the all-purposeantifraud remedy found in Rule10b-5. Under Section 12(2), a buyercan recover for negligent misstate-ments or omissions, while the sellermust prove that he or she acted withdue care. Under Rule 10b-5, howev-er, a buyer must establish that theseller actually knew that the com-munication was inaccurate. In addi-tion, a buyer under Section 12(2)need not prove that he or she reliedupon a misstatement or omission inmaking a purchase. Finally, unlikebuyers proceeding under Rule 10b-5who must bring suit in federal court,Section 12(2) buyers may sue eitherin state or federal court.The Supreme Court's decision inGustafson will determine whetherall securities buyers will enjoy theseadvantages. The outcome takes oneven greater meaning for investorsin view of decisions by the Courtduring the past 20 years that havesignificantly weakened both Section12, Pinter, 486 U.S. at 647, and Rule10b-5, Central Bank of Denver, N A.v. First Interstate Bank of Denver,N.A., 114 S.Ct. 1439 (1994); Lampf,Pleva, Lipkind, Prupis & Petigrowv. Gilbertson, 501 U.S. 350 (1991);Ernst & Ernst v. Hochfelder, 425U.S. 185 (1976); Blue Chip Stampsv. Manor Drug Stores, 421 U.S.723 (1975).ARGUMENTSFor Arthur L. Gustafson (Counselof Record: Donald W. Jenkins;Vedder, Price, Kaufman &Kammholz; 222 North LaSalleStreet, Chicago, IL 60601; (312)609-7500) and for Daniel R. McLeanand Francis I. Butler (Counsel ofRecord: Harold C. Wheeler; Seyfarth,Shaw, Fairweather & Geraldson;55 East Monroe Street, Chicago, IL60603; (312) 346-8000):1. The language and structure of the1933 Act demonstrate that Section12(2) applies to public, not private,sales of securities.2. The 1933 Act was intended tointerfere as little as possible withprivate business. Section 12(2) is anunusually powerful remedy that hasno proper place in a privately negoti-ated transaction.For Alloyd Company, Inc. and WindPoint Partners II, L.P. (Counsel ofRecord: Robert J. Kopecky; Kirkland& Ellis; 200 East Randolph Drive,Chicago, IL 60601; (312) 861-2000):1. The language and structure of the1933 Act demonstrate that Section12(2) applies to both public and pri-vate sales of securities.2. Application of Section 12(2) toprivate transactions is consistentwith the broad remedial purpose ofthe 1933 Act. The interests of thepurchaser in having truthful infor-mation about the securities is thesame in either a private or publictransaction.AMICUS BRIEFSIn support of Arthur L. Gustafson,Daniel R. McLean, and FrancisI. ButlerSecurities Industry Association,Inc. (Counsel of Record: Robert L.Schnell; Faegre & Benson; 2200Norwest Center, 90 South 7thStreet, Minneapolis, MN 55402;(612) 336-3000).In support of Alloyd Company, Inc.and Wind Point Partners II, L.P.The National Association ofSecurities and Commercial LawAttorneys (Counsel of Record:Patrick E. Cafferty; Miller FaucherChertow Cafferty and Wexler; 30North LaSalle Street, Suite 3200,Chicago, IL 60602; (312) 782-4880);North American SecuritiesAdministrators Association, Inc.(Counsel of Record: Karen M.O'Brien, General Counsel; NorthAmerican Securities AdministratorsAssociation, Inc.; One MassachusettsAvenue, NW, Washington, DC 20001;(202) 737-0900);Securities and ExchangeCommission (Drew S. Days, III,Solicitor General; Department ofJustice, Washington, DC 20530;(202) 514-2217).Issue No. 2

Misrepresentation in the Sale of Stock: Which Buyers Are Protected?

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Misrepresentation in the Sale of Stock: Which Buyers Are Protected?

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