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

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, 1048–49 (1993).

4 Id. at 1049–50.

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 statement ,

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

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