The Law Comes Second

For a typical business, commercial litigation is like open-heart surgery. The fact that you have to do it is bad. If you can prevent it, you should. When you’re in it, you want it to end. After it’s over, even if you’re happy with the result, you hope you won’t have to do it again.

The expense and the distraction are reason enough to guard against litigation. But there is another reason as well: the uncertainty. Any lawyer who tells his client that he will surely win because the law is on his side is not a good lawyer. Obviously, if the law favors your case, then that is a tremendous advantage you have over your adversary. Use it. But never view it as a sure thing.

This is why commercial litigation is like personal injury litigation, civil rights litigation, and other kinds of disputes that get litigated. The most important thing in every case is not the law; it’s the human story. To be sure, the law matters. But the law always comes second, because even good courts can get the law wrong.

First the Story, Then the Law

Imagine that you’re in an adversarial proceeding in which you get to present your case first. Never lead with a statement of the law. You must begin with a compelling statement of what happened to bring you there – the facts rather than the law. Ideally you will tell the facts so well that by the end of it your audience – the judge, the arbitrators, or the jury – will necessarily think, “That’s terrible. Someone should fix this. I wish I could.” Then you can announce, “Once I’ve wrapped up, the other side will have their turn. And they will tell you that under the law your hands are tied, that there’s nothing you can do here. Really? Let’s look at what the law says.” In a perfect world, this is how you segue into the law.

To illustrate why you must never place all your hopes on the law, let’s look at two extreme examples in which a well-regarded, distinguished court got the law wrong, and not just tendentiously wrong, but so straightforwardly wrong that the reaction of every expert in the field was, in the language of modern Internet memes, “Wait wut?” Let’s start with the Ninth Circuit Court of Appeals’ reading of the Copyright Act. After that, we’ll elevate our attention to the Supreme Court’s reading of the Securities Act.

The Copyright Act Won’t Let You Terminate Your Deal – “Wait wut?”

When U.S. copyright law was rebooted by the Copyright Act of 1978, a provision was put into the new statute that was intended to protect the prototypical young artist who happily but naively makes a deal with Big Corporate Interests giving away ownership of the future catalog – and who then turns out to be a rock star. The new statute comes to the rescue of these rock stars by giving them an option for a complete do-over of their youthful deal with Big Corporate Interests – or simply to undo the deal entirely – after 35 years. In Congress, the bill that eventually became the Copyright Act of 1978 came with a report that clearly explained the point of this right to call a do-over after 35 years: “A provision of this sort is needed because of the unequal bargaining position of authors [such as future rock stars], resulting in part from the impossibility of determining a work’s value until it has been exploited.”[1]

The statute’s language providing for the do-over after 35 years is long and complicated but, if it is read with some patience, it seems perfectly clear. It comes down to this: By the satisfaction of certain conditions and the delivery of certain notices, the rock star’s youthful grant of her future catalog to Big Corporate Interests is “subject to termination” after 35 years no matter what she ever said to the contrary.[2] Key words: “subject to termination.” This statutory language seems plain. What could go wrong? 

Things went wrong in 1993, when the Ninth Circuit Court of Appeals decided a case called Rano v. Sipa Press, Inc. The court of appeals read these words – which say that the grant is “subject to termination” at 35 years – as preventing our proto-typical rock star from doing over the deal until after the passage of the 35 years. The Ninth Circuit interpreted this provision of the Copyright Act to say that “licensing agreements … are terminable at the will of the author only … at the end of thirty-five years from the date of execution of the license unless they explicitly specify an earlier termination date.”[3] But what starry-eyed youthful artist will have “explicitly specif[ied] an earlier termination date” when signing away the future catalog? Any rock star who is lucky enough to have said nothing about “early” termination should be able to take advantage of any opportunity that regular contract law might offer for terminating the bad deal at any time. In courts where the Ninth Circuit’s precedents govern, however, Congress’s goodhearted effort to help by saying that the rock star definitely, no matter what, can terminate at 35 years, also hurt the rock star by taking away other options that contract law might have offered the rock star to terminate before 35 years.

The Ninth Circuit’s reading of this language in the Copyright Act is not merely tendentious. Everyone agrees it is wrong. Every other court of appeals that has considered the statutory language has said so. The Seventh Circuit, looking at the Ninth Circuit’s conclusion in Rano, did not hold back. The Seventh Circuit wrote:

To put it mildly, [the Ninth Circuit’s construction of the statute] is deplored by commentators. If the Rano decision were a Broadway show, bad reviews would have forced it to close after opening night. [The widely-consulted expert David] Nimmer, for instance, finds Rano a “remarkable result,” a “wayward result,” “stunning, both for its utter absence of support in law and for the breadth of its error.” … Yet another commentator calls Rano a “ridiculously incorrect interpretation of the statute. It takes a provision meant to protect the author and turns it into a straitjacket.”[4]

Well, these things happen.

The Securities Act Doesn’t Say You Can Return the Security that the Seller Misrepresented – “Wait wut?”

Passing from copyright law to securities law, the Securities Act of 1933 is one of the New Deal enactments aimed at fixing the problems that gave us the Great Depression. The structure of the Act is fiercely complicated. More than two dozen sections interlock by referring not just backward but also forward. For example, Section 4 begins by saying, “The provisions of Section 5 shall not apply to ….” Within each section, the subsections, sub-subsections, and sub-sub-subsections likewise refer backward and forward. For example, sub-subsection 4(a)(7) refers to “transactions meeting the requirements of subsection (d).” 

This complicated structure of the 1933 Act and other federal securities laws necessitates a cadre of specialists. Outsiders may not always understand what these specialists are saying to one another. But among themselves, the specialists generally agree. They know when the ’33 Act, convoluted as it may be, is clear and precise and when it is vague and allows for multiple conflicting applications none of which is unreasonable.

In 1995, the Supreme Court shocked the specialists. The case is called Gustafson v. Alloyd Co., and in this case the Supreme Court cooked up a misreading of the ’33 Act so outlandish that, afterward, the specialists were generally united in their view that the Court had effectively ruled that 2 + 2 = 5. Here are some snippets from the gallery:

• “Gustafson displays a breathtaking disregard for the language and structure of the statute,” and “give[s] credence to the view that legal authorities have no meaning, that they are simply empty vessels into which those with the power to do so can pour whatever meaning they wish.”[5]

• In Gustafson, the Supreme Court “issued the most poorly-reasoned, blatantly results-driven securities opinion in recent memory.”[6]

• Gustafson is “by all accounts the worst securities law opinion ever written. … [T]he Supreme Court’s analysis cannot be defended ….”[7]

• In Gustafson, “some very bright Supreme Court justices, and their equally intelligent clerks, evidently attempted to figure out the Securities Act on their own—and they failed miserably.”[8]

Gustafson is about the meaning of a specific part of the ’33 Act: Section 12(2). To explain what Section 12(2) says and what happened in Gustafson, it helps to have a layout of the first seventeen sections of the Act. Here is an image that you can expand or zoom in on:

What is being regulated here is not really securities, it is information about securities. Sometimes the information is regulated very tightly, by a detailed repertory of the facts that must be disclosed to buyers. Other times, the information is regulated more loosely, by general declarations that material misrepresentations are not allowed and may have consequences.

The tight regulations are in the sections called out in blue in the above image – Sections 4-8 and 10-11. These closely intertwined sections pick out certain securities transactions – generally what are called “initial public offerings” – and they say that for an initial public offering of securities you must give a long, carefully defined repertory of disclosures both to the SEC (where it will be publicly available) and to anyone buying the security or entertaining an offer to buy it. The SEC gets this repertory of disclosures in a registration statement. The buyer gets (nearly) the same information in a prospectus.

The looser, broader regulations are found outside of Sections 4-8 and 10-11. These are not limited to initial offerings, and they lay down generally worded imperatives. Take, for example, Section 17. Look at how broad and indefinite the language of Section 17 is. It says that no one, “in the offer or sale of any securities,” may “obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”[9]

Another of the looser, more broadly worded sections is Section 12(2). This says you can return the security and get a refund from the man who sold it to you by means of a misrepresentation. And like Section 17, this section operates outside of the tight network of regulations that governs initial public offerings. By its terms, Section 12(2) operates more generally.

Then, in Gustafson, the Supreme Court said otherwise.

Even before Gustafson, there had been a movement in some lower courts to curtail the scope of Section 12(2). The sentiment was that securities litigation had become a scourge. The leading case that had curtailed Section 12(2) was a decision by the Third Circuit that said the section can’t possibly apply to anything other than “initial distributions”[10] of securities as opposed to “aftermarket trading.”[11] Why? Because, according to the Third Circuit, the point of the ’33 Act is to regulate “initial issuances,” and it’s another statute, the Securities Exchange Act of 1934, that regulates “aftermarket trading of securities.”[12] So this curtailed meaning simply must be how Section 12(2) is supposed to be understood.

But let’s look at what Section 12(2) says. It reads:

Any person who—

(1)  …

(2)  offers or sells a security (whether or not exempted by the provisions of section 3, other than paragraphs (2) and (14) of subsection (a) thereof), … by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,

shall be liable … to the person purchasing such security from him, who may sue … to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.[13]

However long this sentence may be, most of it should be clear enough – except perhaps for the word “prospectus” which appears in this part of it: “… offers or sells a security … by means of a prospectus or oral communication, which includes an untrue statement ….”

Luckily, the Act begins with a section devoted to definitions. It’s Section 2. Turning there, we find this definition of the word “prospectus”:

The term “prospectus” means any prospectus, notice, circular, advertisement, letter, or communication, written or by radio or television, which offers any security for sale or confirms the sale of any security ….[14]

Looking at that list, one wonders what sort of communication which offers a security for sale would not count as a prospectus. The only thing left out of this list, it seems, is an oral communication that isn’t made over the radio or television. And, looking back at Section 12(2), that’s the one thing that is mentioned in addition to prospectuses. Section 12(2) refers to “offers to sell a security … by means of a prospectus or oral communication, which includes an untrue statement ….” The literal meaning of Section 12(2), then, seems plain. In talking about prospectuses or oral communications, it is talking about any communication “by means of” which a security was offered or sold.

Nonetheless, the impulse to curtail Section 12(2) was real. For better or worse, the Third Circuit did it by insisting that everything is implicitly limited to the smaller world of “initial distributions.” When Section 12(2) came before the Supreme Court in Gustafson, however, the impulse to curtail the section found a different argumentative hook.

Looking for a way to limit the breadth of Section 12(2), the Supreme Court in Gustafson turned to the tightly interlocking, closely intertwined Sections 4-8 and 10-11 requiring that, for certain initial public offerings, the seller file with the SEC a registration statement. These sections also refer to prospectuses, because that’s how they address the information that, for these securities transactions, the seller must give to any buyers. These sections refer to “any prospectus relating to any security with respect to which a registration statement has been filed.”[15] And they say that the prospectus must “contain the information contained in the registration statement.”[16]

Finding an opportunity here, the Supreme Court concluded that the prospectuses “relating to any security with respect to which a registration statement has been filed” are just what Section 12(2) is talking about when Section 12(2) refers to a prospectus. Why? Because, according to the Supreme Court, the word must have just one meaning throughout the entirety of the Act. Section 12(2), therefore, is talking only about the kind of offer of securities that is regulated in Sections 4-8 and 10-11. That’s the kind of offer of securities for which a registration statement must be filed with the SEC, an initial public offering.

This reads Section 12(2) even more narrowly than the Third Circuit had read it. Whereas the Third Circuit curtailed Section 12(2) by limiting that section just to “initial offerings” based on the view that this is just the entire point of the ’33 Act, in contrast the Supreme Court’s logic in Gustafson goes farther and limits Section 12(2) to just those initial offerings that are public offerings. This is just those initial offerings in which the securities find their way into the hands of the wider public. Other initial offerings are private. The distinction matters because Sections 4-8 and 10-11 exempt private initial offerings from the requirement of filing a registration statement with the SEC and all that goes with that.

Well, if you sympathize with the view that securities litigation had become a scourge, then you might wonder, so what? Perhaps you applaud the Supreme Court for finding a way to confine the scourge.

The problem is that this particular argumentative hook makes undeniable nonsense out of the statute. According to the Supreme Court in Gustafson, the word “prospectus” anywhere in the Act necessarily refers to the kind of document that is required by Sections 4-8 and 10-11 to include all the important information that’s in a parallel registration statement. But the Act is sprinkled with provisions that provide for prospectuses in connection with other kinds of transactions and that don’t have to include all that information. For example:

• The definition of “prospectus” says nothing to suggest that private offerings cannot involve a prospectus. Private offerings, even when they are initial offerings, are exempted by Sections 4-8 and 10-11 from the requirement of filing a registration statement but still can involve a prospectus.

• There are many other categories of transactions that Section 3 says are generally outside the scope of the Act. And Section 12(2) explicitly says that it covers those Section 3 transactions. Therefore these transactions can involve prospectuses even though they do not require the filing of a registration statement.

• When Section 5, the heart of the tightly interlocking, closely intertwined Sections 4-8 and 10-11, says that in an initial public offering you cannot “transmit any prospectus … unless such prospectus” contains all the important information contained in the registration statement (technically, “meets the requirements of section 10”) – that plainly implies that there are other kinds of prospectuses, ones that are not used in an initial public offering and therefore do not have to include all that information.

Granted, it takes patience to untangle the Securities Act of 1933. But with a little patience, Gustafson’s illogic becomes plain. Even commentators who favored the outcome in Gustafson complained that “the route the Court took to get there” was “highly problematic.”[17]  

What Have We Learned?

The Ninth Circuit’s decision in Rano and the Supreme Court’s decision in Gustafson are extreme cases. They are not the norm. It remains true that the United States is a nation of law. Still, these extreme cases teach us something. The facts come first; the law comes second.

This lesson bears not just on how to present a case. For example, it also bears on whether to invoke a right to a jury trial. Some years ago, a very distinguished trial lawyer, widely acknowledged to be at the pinnacle of the field of defense-side complex commercial litigation, told me that in every case his instinct is to choose a jury over the bench. He explained that even in a complex case a bench trial is riskier than a jury trial because in a bench trial you find yourself in the hands of just one person whereas in a jury trial you have the safety of numbers. That preference for a jury goes against the common wisdom. Most lawyers reflexively believe that a complex commercial case is more likely to be correctly decided by a judge than by a jury. These lawyers think that jurors will not be able to understand convoluted laws like the Copyright Act or the Securities Act of 1933. But these lawyers may be underestimating the ability of a smart judge to rationalize an unusual take on the law.

In any event, whether your case is before a judge, a jury, or arbitrators, the audience should be primed by the facts before hearing the law.

[1] H.R. Rep. No. 94-1476, at 124 (1976).

[2] 17 U.S.C. § 203(a).

[3] Rano v. Sipa Press, Inc., 987 F.2d 580, 585 (9th Cir. 1993) (emphasis supplied).

[4] See Walthal v. Rusk, 172 F.3d 481, 483-484 (7th Cir. 1999) (quoting 2 Melville B. Nimmer & David Nimmer, NIMMER ON COPYRIGHT § 11.01 (1998), and Mark F. Radcliffe, Copyright Ownership Issues, 411 PLI/Pat at 243, 300 (Practicing Law Institute, PATENTS, COPYRIGHTS, TRADEMARKS, AND LITERARY PROPERTY COURSE HANDBOOK SERIES, 1995)).

[5] Edmund W. Kitch, Gustafson v. Alloyd Co.: An Opinion that Did Not Write, 1995 SUP. CT. REV. 99, 122 (1996).

[6] Stephen M. Bainbridge, Securities Act Section 12(2) After the Gustafson Debacle, 50 BUS. LAW. 1231, 1231-1232 (1995).

[7] Steve Thel, Free Writing, 22 J. CORP. L. 941, 943 (2007-2008).

[8] Larry D. Soderquest & Theresa A. Gabaldon, SECURITIES LAW 1 (3d ed. 2007).

[9] 15 U.S.C. § 77q(a).

[10] See Ballay v. Legg Mason Wood Walker, Inc., 925 F.2d 682, 688 (3d Cir. 1991).

[11] Id. at 689.

[12] Id. at 690.

[13] 15 U.S.C. § 77l(a). In 1995, Section 12 was amended by the addition of a subsection (b), and what had been known as Section 12(1) and Section 12(2) became 12(a)(1) and 12(a)(2).

[14] 15 U.S.C. § 77b)(a)(10).

[15] 15 U.S.C. § 77e(b).

[16] 15 U.S.C. § 77j(a)(1).

[17] Elliot J. Weiss, Securities Act Section 12(2) After Gustafson v. Alloyd Co.: What Questions Remain?, 50 BUS. LAW. 1209, 1210 (1995).