I think HBO’s John Oliver is a funny guy. He recently did a piece on over-the-top televangelists who extract vast sums of money from unsuspecting viewers, which you can watch by clicking here. Although the piece is hilarious, Oliver points out that it’s also tragic; people with serious problems (like cancer) are essentially defrauded by charlatans offering “healing” in exchange for compensation. Making things worse, this particular form of fraud is government-sanctioned, because these “religious organizations” act as 501(c)(3) nonprofits, and the “pastors” often claim tax exemptions for their multimillion dollar homes on the grounds that the homes qualify as “parsonages” under the Internal Revenue Code.
Sadly, fraud comes in many forms, from shady televangelists to Nigerian banker schemes to issuances of worthless stock. But the word “fraud” often gets thrown around without people understanding what it really means. For those of our lawyer-readers, let’s return to the BAR/BRI review course for a moment (and for normal people, here’s a workable definition of fraud): “Fraud” is generally defined as (1) an intentional misrepresentation of a “material fact”; (2) made by one person to another with knowledge of its falsity; (3) for the purpose of inducing the other person to act; and (4) upon which the other person reasonably relies with resulting injury or damage. (Careful, though: statutes such as securities laws and consumer protection laws often contain their own specialized definitions of “fraud.”)
In this post, I want to talk about just how detailed a disclosure of “material fact” needs to be in order to negate claims of fraud. Suppose you disclose that a risk exists; how much detail needs to be provided before the other person is at least on inquiry notice?
To illustrate the point, let’s briefly look at a recent decision from a federal court in Massachusetts, Tutor Perini Corp. v. Banc of America Securities. Tutor Perini is a major construction conglomerate. Tutor opened a nondiscretionary investment brokerage account with BOA in 2004. (A “nondiscretionary account” means that any investments require the client’s approval.) Under the account, Tutor’s Treasurer made daily investment decisions under the oversight of the company’s President and its Chief Executive Officer. In 2007, Tutor invested in student loan auction rate securities (“SLARS”). (“Auction rate securities” were somewhat complicated investment instruments – essentially, long-maturity floating rate securities. Their coupon payments were determined through “Dutch auctions,” in which prospective purchasers submitted bids through their broker-dealer to an auction agent.)
You probably can guess where this discussion is going. The market for SLARS collapsed, and Tutor lost a lot of money. This being America, Tutor sued BOA for securities fraud, essentially arguing while BOA had made certain disclosures about how SLARS worked, it hadn’t disclosed quite enough - such as about how and when BOA invested in SLARS. There was no question, though, that BOA had disclosed that ARS auctions could fail; that BOA was under no obligation to prevent auctions from failing; and that the SLARS in which Tutor had invested had maturities of between 30 and 40 years. Additional disclosures were available in publicly available documents and on BOA’s website.
Tutor’s first problem was that no one wants to hear the Yankees, the Cowboys or Microsoft whine about how unfair life is. Put another way, the bigger your company is, the harder it is to prove that someone took advantage of you. The Court picked up on this theme, writing: “[Tutor] is a sophisticated Qualified Institutional Buyer that received numerous written disclosures about the risks of auction failure.”
More importantly, the Court held that BOA was only responsible for disclosing that a risk existed; it was not obligated to disclose in minute detail the magnitude of the risk. The Court wrote: “Because [the] risk was disclosed accurately, there is no duty to disclose all facts reflecting the degree of risk.” The Court cited Hill v. Gozani, 638 F.3d 40, 60 (1st Cir. 2011): “To the extent that the plaintiff’s complaint is that the precise degree of risk was not stated, that failure is not sufficient to have rendered the statements misleading.” The Court also cited Mississippi Pub. Employees’ Ret. Sys. v. Boston Scientific Corp., 649 F.3d 5,29 (1st Cir. 2011), noting that once a risk a disclosed, the “disclosure is [not] misleading merely because it did not state that the risk was serious.”
Here are the takeaways on this: If you have a disclosure obligation, you don’t have to go into every intricate detail, but you do have to give people enough information so that they understand there is a risk. If you receive a disclosure, on the other hand, keep in mind that you may not be able to argue that it was insufficiently detailed -- a court or jury may determine that you were placed on inquiry notice.
The topic of inquiry notice becomes especially important in deals that management really wants to happen. In the excellent book “Done Deal,” about negotiation, Michael Benoliel discusses Ted Turner’s purchase of MGM/UA in 1985. Turner knew that the broadcasting industry was on the verge of consolidating, and he knew that his company was vulnerable because it didn’t control enough of certain types of programming, such as movies. Turner made a bid to buy CBS, and failed, which infuriated him. Businessman Kirk Kerkorian, sensing Turner’s vulnerability, told Turner that he, Kerkorian, was going to put MGM/UA up for auction, but would give Turner right of first refusal. Turner could have the company for $1.5 billion, if he closed the deal within two weeks.
Benoliel writes about what happened next:
“On August 6, 1985 – two days before the deadline and without any negotiation whatsoever over the price – Turner signed a purchase agreement to buy MGM/UA. In his rush to close the deal, Turner paid $200 million to $300 million more than industry analysts thought the company was worth, and he failed to notice that MGM was in a bit of a financial freefall at the time, producing a slew of unpopular, money-losing new films. In addition, Turner’s attorneys had failed to ask what recent legal commitments MGM had made, and thus did not uncover the fact that on August 4, MGM/UA had signed a contract Rainbow Services locking up all cable rights, and that HBO had already contracted to buy several MGM movies at a very advantageous rate.”
In short: Always do your homework. As NBA great Earl Monroe once said: “Just be patient. Let the game come to you. Don’t rush. Be quick, but don’t hurry.”