The Ralston-Landreth-Gustafson Harmony: A Security!

Author:Nicholas L. Georgakopoulos
Position:Harold R. Woodard Professor of Law, Indiana University Robert H. McKinney School of Law
Pages:553-602
 
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THE RALSTON-LANDRETH-GUSTAFSON HARMONY:
A SECURITY!
NICHOLAS L. GEORGAKOPOULOS*
I. INTRODUCTION ............................................................................................. 554
II. THE CASE LAW OF INVESTMENT CONTRACT ................................................ 555
III. THE FUNCTION OF INVESTMENT CONTRACT ................................................. 559
A. Evaluation Difficulty at the Time of the Offer .................................. 562
B. Lack of Future Control ...................................................................... 563
IV. PRICING MECHANISMS .................................................................................. 564
A. Supply-Demand ................................................................................. 565
B. The Capital Asset Pricing Model ....................................................... 567
1. Risk ......................................................................................... 568
2. Diversification ........................................................................ 570
3. Limitatio n of Diversification in Stocks .................................... 572
4. Measuring Undiversifiable Risk .............................................. 573
5. Pricing Undiversifiable Risk ................................................... 576
C. Goods Subject to Each Pricing Mechanism....................................... 581
V. FROM THE SALE-OF-BUSINESS DOCTRINE TO GUSTAFSON ............................ 583
A. Registration Process Primer .............................................................. 585
B. Gustafson, the Earthquake ................................................................. 591
C. No Rubble After Gustafson ................................................................ 593
1. Private Placement Memoranda Continue, Rescission
Ends ........................................................................................ 594
2. Cannot Attribute the Subprime Mortgage Crisis to
Gustafson ................................................................................ 594
VI. GUSTAFSON WORKS! ..................................................................................... 595
A. Repealing Rescission Was Correct .................................................... 598
B. Fraud Protection Is Not Excessive .................................................... 600
VII. CONCLUSION ................................................................................................. 601
APPENDIX A: PRICES OF STOCK AND S&P 500 INDEX .......................................... 602
Copyright © 2013, Nicholas L. Georgakopoulos.
* Harold R. Woodard Professor of Law, Indiana University Robert H. McKinney School
of Law. I wish to thank Jennifer Drobac, Rob Katz, Emily Michiko Morris, and Antony
Page for their helpful comments, and Miriam Murphy and Susan deMaine for their expert
librarian assistance. I urge you to send your comments to me at ngeorgak@iu.edu.
554 CAPITAL UNIVERSITY LAW REVIEW [41:553
I. INTRODUCTION
A security is anything “commonly known as a ‘security.’”1 Of all the
weak foundations on which to build a statutory scheme of regulation, this
may be the weakest from the perspective of logic yet one of the most
durable in terms of functionality.
While many regulatory schemes determine their application by a
definition, the securities laws’ definition is unusual. The statutory text of
the definition could serve as an illustration of circular logic, defining a
security with a long list of specific transactions and closing with “any
interest or instrument commonly known as a ‘security.’”2 The courts,
grasping for a definition, have latched on to the words “investment
contract” that appear within this laundry list.3 This supposed definition is
unclear and unprincipled. Unsurprisingly, the courts have sharply
disagreed on its interpretation.4 Closer scrutiny reveals that the definition
is incomplete because it turns on imputed motive from unspecified facts.
The passage of time, however, has produced a uniquely powerful ally
to this definition: the development of finance theory. This Article takes the
lessons of finance and offers a principled approach to the definition of a
security. The juxtaposition of the analysis to the case law reveals a
paradox. While securities law proceeded with the wisdom of placing
substance over form until the mid-1980s, the Supreme Court deviated and
placed form over substance in 1985 when it rejected the sale of business
doctrine.5 Although the Court restored the consequences of the sale of
business doctrine in 1995,6 it did so without expressly restoring the
supremacy of substance over form.
Part II of this Article discusses the case law concerning the definition
of a security. Part III analyzes the case law to find the definition’s
functional role. Part IV presents finance theory and finds its analysis
harmonious with that of the legal analysis. Part V explores the history of
the sale of business doctrine, its reversal, and its implicit reinstatement by
1 Securities Act of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1) (Supp. V 2012).
2 Id.
3 Id. See also Douglas M. Branson & Karl Shumpei Okamoto, The Supreme Court’s
Literalism and the Definition of “Security” in the State Courts, 50 WASH. & LEE L. REV.
1043, 104849 (1993).
4 Id. at 104950.
5 See Landreth Timber Co. v. Landreth, 471 U.S. 681, 694 (1985); Gould v. Ruefenacht,
471 U.S. 701, 706 (1985).
6 See Gustafson v. Alloyd Co., 513 U.S. 561, 576 (1995).
2013] THE RALSTON-LANDRETH-GUSTAFSON HARMONY 555
Gustafson. Part VI argues that the resulting regime works, and Part VII
concludes.
II. THE CASE LAW OF INVESTMENT CONTRACT
Whether something is a security is of enormous importance. Under
securities law, the buyer has the right to rescind the purchase if the seller
has failed to disclose all the material attributes of the security,7 sellers and
those facilitating the sale are subject to expansive liability for false
statements,8 and issuers of securities are subject to obligations to disclose,9
restraints on trading,10 and face heightened anti-fraud liability.11 Ordinary
contract law, by contrast, follows the principle of “buyer beware.”12
Barring special regulation such as lemon laws,13 neither sellers nor
intermediaries have obligations to speak.14 Buyers obtain the right to
7 Securities Act of 1933 § 12, 15 U.S.C. § 77l(a) (2006) (“Any person who—(1) offers
or sells a security in violation of section 5, or (2) offers or sells a security . . . by means of a
prospectus or oral communication, which . . . omits to state a material fact . . . shall be
liable . . . .”).
8 Securities Act of 1933 § 11(a), 15 U.S.C. § 77k(a) (2006) (“In case any part of the
registration statement . . . omitted to state a material fact . . . any person acquiring such
security . . . may . . . sue—(1) every person who signed the registration stat ement; (2) every
person who was a director of . . . the issuer . . . ; (4) every accountant, engineer, or
appraiser . . . who has . . . prepared or certified any part of the registration statemen t,
or . . . any report or valuation which is used in . . . the registration statement, . . . ; (5) every
underwriter . . . .”).
9 Securities Exchange Act of 1934 § 13(a), 15 U.S.C. § 78m(a) (2006) (“Every
issuer . . . shall file with the [SEC], . . . —(1) such information and documents . . . as the
[SEC] shall require . . . . (2) such annual reports . . . as the [SEC] may prescribe.”).
10 Securities Exchange Act of 1934 § 16(a), 15 U.S.C. § 78m(d)(1) (2006 & Supp. V
2012); 17 C.F.R. § 240.13d-1 (2011) (requiring any person who acquires “directly or
indirectly the beneficial ownership of any equity security” of particular classes to file
certain information with the SEC).
11 See, e.g., 17 C.F.R. § 240.10b-5 (2012); id. § 240.14e-3.
12 See, e.g., 7 JOSEPH M. PERILLO, CORBIN ON CONTRACTS § 28.35, at 181 (rev. ed.
2002).
13 See, e.g., Magnuson-Moss Warranty—Federal Tr ade Commission Improvement Act,
15 U.S.C. §§ 2301–2312 (2006).
14 See RESTATEMENT (SECOND) OF CONTRACTS § 161, cmt. a (1981). Comment a to
section 161 states:
Non-disclosure without concealment is equivalent to a
misrepresentation only in special situations. A party making a contract
is not expected to tell all that he knows to the other party, even if he
(continued)

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