Securities Issuer Liability for Third Party Misstatements: Refining the Entanglement Standard
Meister, D. Joseph, Vanderbilt Law Review
Smith, president of E.com, Inc., believes his firm's securities are undervalued.1 Believing that expanded coverage in the financial press will cause E.com's securities to trade at higher prices, Smith begins a public relations program designed to help investment analysts more accurately forecast his firm's future performance. Jones, financial analyst, takes information from the public relations program, drafts an optimistic forecast for E.com, and then asks its executives for their review and comment. Smith and his executives make extensive factual and descriptive edits to the report but refuse to comment on financial earnings projections, citing a longstanding company policy against such. Instead, Smith gives Jones repeated assurances that E.com is "well on its way to a great quarter," and that he was "incredibly bullish" on his firm's future earnings potential. Catching the innuendo, Jones drafts a favorable report on E.com's prospects, causing the financial markets to bid up the company's stock price in reliance on the new information.
In reality, Smith and his executives realize that E.com's internal earnings projections are far below those predicted in Jones's market report, but they take no measures to correct their company's inflated stock price. In the meantime, Baker, individual investor, purchases a large stake in E.com, relying on the company's market price as an indication of its fair value. Soon thereafter E.com discloses its low earnings in its mandatory quarterly financial report, its stock price plummets, and Baker loses his life savings. Baker brings a private securities fraud action under federal securities law alleging that E.com intentionally misled analysts-and therefore the market-to inflate its stock price. Is E.com liable to Baker (and other harmed investors) for the analyst's misstatements? Under what circumstances should it be?
The prevailing standard for determining issuer liability under the federal securities laws for third party misstatements asks whether the issuer "sufficiently entangled" itself with the analyst's report to such a degree that the analyst's misstatements can fairly be attributed to the issuer.2 If the entanglement threshold is met, a company has a duty to correct material misstatements affecting the market when it subsequently realizes their inaccuracy,3 else the company becomes liable for civil and regulatory sanctions under the federal securities fraud laws.4 Not surprisingly, courts applying the standard have had to grapple with what "entanglement" means in applications.5 Although the doctrine is developing with greater clarity,6 the standard for liability remains too muddled for corporate managers to avoid running afoul of the law with predictive certainty.7
This Note cuts a bright-line path through the entanglement thicket. Part II discusses the forecasting methods of investment analysts and the information they use to construct their corporate valuations. Part III describes the federal regulatory framework governing corporate disclosure and Rule 10b-5 liability for wrongdoing. Part IV describes the contours of the prevailing entanglement standard and its related theories. Part V refines the problem in light of the analytical framework governing corporate liability for third party misstatements. Part VI discusses the policy interests of the key stakeholders involved, including securities issuers, investors, and society at large. Finally, Part VII recommends that courts adopt a practical bright-line standard for pre-publication entanglement liability premised on explicit corporate agreement with an analyst report's final contents, marshaling current doctrine, policy interests, and the realities of modern financial analysis for support. Part VIII resolves the hypothetical posed above.
II. INVESTMENT ANALYSTS AND THE MECHANICS OF SECURITY VALUATION
Developing a practical standard for securities issuer liability under the federal securities laws is a complicated task because the financial markets rely on investment professionals and other third party intermediaries to collect and disseminate information on corporate value. …