Issuers Raising Capital Directly From Investors: What Disclosure Does Rule 10b-5 Require?

Thursday, September 4, 2003

Prof. Harry Gerla, University of Dayton School of Law Journal of Corporation Law - Vol. 28, No. 1, Pgs. 111-141, http://

Better Business Management & Planning Practices

Abstracted from: Issuers Raising Capital Directly From Investors: What Disclosure Does Rule 10b-5 Require?

By: Prof. Harry Gerla University of Dayton School of LawJournal of
Corporation Law - Vol. 28, No. 1, Pgs. 111-141

Overview: Describes the disclosure required by Rule 10b-5 when an issuer sells securities directly to investors. Focuses on offerings not covered by 1933 Act disclosure requirements. Recommends a level of disclosure that would provide investors with adequate information without imposing excessive costs on small issuers.

Shedding light on the law of nondisclosure.
Based on the issuer’s size or the offering’s size or nature, issuers can sometimes make a securities offering without the guidance of particular disclosures mandated by the 1933 Act. Prof. Harry Gerla explains that in these circumstances, only Rule 10b-5 sets the parameters for disclosure and governs whether the omission of material information is permissible. Investors cannot rely on 1933 Act Section 17(a) to compel the issuer to reveal material information because no private right of action lies under that section. Nor is Section 12(2) sufficient, because it does not require disclosure of a material fact unless that fact is necessary to render whatever is disclosed "not misleading." Although no case law on point addresses an issuer’s disclosure obligation under Rule 10b-5 to those investors who directly purchase securities, insider-trading cases shed some light. Insiders who wish to trade in the company’s stock must disclose what material nonpublic
information they know if they owe the purchaser a duty of disclosure. While issuers generally owe a duty of disclosure to stockholders, whether they owe the same duty to debtholders or to purchasers of investment contracts remains unclear.

Conflict of goals.
One goal of the securities laws is to assist investors in making intelligent investment decisions; another is to help companies raise capital. If issuers are not required to disclose any material facts, the author cautions, investors cannot make informed investment choices. Small issuers often sell securities to friends and family who do not ask for the material information required to decide whether to invest. These investors will not be protected by a standard that requires an issuer to provide only the material information necessary to make prior disclosures not misleading. Nevertheless, reading Rule 10b-5 to require the issuer to disclose all material facts would undermine the goal of facilitating capital formation.

Seeking a standard elsewhere.
Searching for another approach, the author notes an intermediate standard from Restatement of Torts Section 551: one party must disclose to the other "facts basic to the transaction." This
standard is too narrow for a securities transaction, however, because it require disclosure of information only about discrepancies between the stock price and the actual market value. The Federal Trade Commission Act requires disclosure of information if the failure to disclose would be deceptive or unfair. The standard may be read to requires disclosure of facts required to make other facts that were disclosed not misleading, disclosure of material facts that are inconsistent with the investors’ reasonable expectations, and disclosure of material facts critical to an
informed business decision. This would call for explanations of what
returns are likely and how the business will produce them, how investors’ money will be used, how the business is managed, what the important risks are, and how the investor may obtain a return of capital.

Abstracted from Journal of Corporation Law,
published by University of
Iowa, College of Law, Iowa City, IA 52242

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