Gretchen Morgenson mangles the securities laws

Gretchen Morgenson writes about the securities laws today, specifically investor suits against UBS for participating in a sale of HealthSouth securities. Her problem is that UBS is trying to exploit a "nifty loophole to insulate them from investor lawsuits contending poor or improper due diligence." She later describes this "loophole" as a " get-out-of-jail-free card."

The "nifty loophole" Morgenson refers to is what securities lawyers call an "exemption." And therein lies a tale.

The exemption, Rule 144A, permits sale of securities to "qualified instititutional buyers" such as the Alabama pension fund that is the plaintiff in this case without being subject to the sweeping liabilities of the Securities Act of 1933. The plaintiff is trying to show that UBS doesn't get the 144A exemption because of an exception from the rule for "any transaction or series of transactions that, although in technical compliance with this section, is part of a plan or scheme to evade the registration provisions of the Act."

Without the exemption UBS may be held liable under the 1933 Act for lack of due diligence in connection with misstatements in the disclosure documents. The 1933 Act imposes significantly higher duties, particularly on collateral participants like underwriters, than under the general antifraud section (10(b)) of the 1934 act, which the Supreme Court has held does not reach aiding and abetting.

Morgenson quotes securities expert Lewis Lowenfels as pointing out "“The federal securities laws do not provide a safe harbor for fraud. If UBS knew that HealthSouth was issuing false and misleading financial statements, there is no exemption under these laws which UBS can rely upon in selling HealthSouth securities to the Alabama pension fund.” It is not clear whether Lowenfels is referring to the limitation on the exemption quoted above, or to potential liability under 10(b), which is not subject to the 144A exemption. 

Morgenson also refers to the SEC's position in the 2001 Safety-Kleen case that the exemption was available "against a plaintiff that made similar allegations to those of the Alabama retirement system in the HealthSouth case." The "similar allegations" apparently refer to the argument that the private placement should be integrated with a later public offering so that the Securities Act of 1933 applies to the transaction.

Morgenson concludes, that the case "raises these interesting questions: How much should due diligence in the public arena carry over to private transactions between sophisticated parties? What duty does one institution have to another? In this post-Enron world, the answers may not be as clear as they once were."

Although a reader certainly wouldn't get this just from reading her column, there are really several issues here:  (1) The 144A exemption; (2) whether there was a deliberate evasion of the 144A exemption which would make it inapplicable; and (3) whether UBS can be held liable under the 1934 Act for fraud.  In her conclusion, Morgenson seems to be suggesting that maybe the whole 144A "nifty loophole" should be cast aside, or at least that it should be sharply cut back when public transactions follow private ones.

Unfortunately, Morgenson does not tell us exactly what she's advocating. But by cleverly linking these issues and then obscuring the differences, her technique is to suggest that the 144A exemption is a "loophole" for fraud that ought to be abolished.

One thing should be made clear here: what Morgenson calls a "nifty loophole" is a carefully crafted exemption based on balancing the heavy costs of 1933 Act registration and liability against the slight benefits where the transactions involve institutions like pension funds that are able to fend for themselves and therefore do not need heavy 1933 Act protection. The exemption, as interpreted over the years, has given rise to a very significant market and structure of reliance. 

Morgenson is obviously trying to tear down that market through innuendos about "nifty loopholes" and "get-out-of-jail-free cards" that obscure important issues. Hopefully the SEC and the courts will resist.

And then we can turn to another issue: does Morgenson have her own duty, as a major financial columnist, to carefully and accurately state her arguments, rather than deliberately cloaking them in populist rhetoric and clever journalistic technique?  After all, while the disclosures for which UBS is being blamed were made to sophisticated investors, Morgenson's column goes out to millions of non-securities-lawyer readers who can't be expected to sort on their own through the nuances of the 1933 and 1934 Acts and the scope of exemptions.  Is Morgenson exploiting a "nifty loophole"  of her own?  What duty does a financial columnist have to her readers?  Should an editor at least insist on a reasonable standard of clarity?  These are questions at least this reader would like answered.

Comments

[Robert Schwartz]

Morgenson is red not expert, but so what.

144A allows participants in a subject transaction to claim and exemption from Section 5 (registration and prospectus delivery) under Section 4. Neither Section 4 nor 144A confer exemptions from Section 12(a)(2) or Section 17. So there are remedies under the '33 Act. It should be noted that Section 12 may be almost as onerous as Section 11.

Rule 144A stemed from an ambiguity in the SEC's interpretation of the '33Act. (There was an article about the problem in The Business Lawyer about 30 years ago, my father was one of the committee members). It is not the problem. The problem is that due dilligence is, as demonstrated by REFCO, not that good at uncovering true fraud.

[Larry E. Ribstein]

The Rule 144A exemption would mean that a 144A offering memorandum is not a "prospectus" for purposes of Section 12(a)(2) of the 1933 Act. See Gustafson v. Alloyd Co., Inc., 513 U.S. 561 (1995). Thus, the implications of Rule 144A go beyond those of the "Section 4(1)(1/2)" exemption on which it was based. I agree with the Refco point, which is only one of the arguments that might be brought to bear here -- assuming Morgenson wanted to discuss the issue straightforwardly.

[Robert Schwartz]

The offering memorandum used in a 144A transaction is very much like a public offering prospectus. I don't know what the lower courts have held in similar cases since Gustafson, but I do not think that it can be read so broadly as to exclude all private offering materials.

[Larry E. Ribstein]

The offering memorandum has been held not to be a 1933 Act prospectus. In fact, I don't think there's much of a question on that score. The only question I'm aware of concerns the A/B integration issue. The important point for my post is that one could get no clue of any of this from Morgenson's column.