ABA Section of Business Law
ABA Section of Business Law
Business Law Today
March / April 2000
Legal-ease
Prospecting for investor truth
By Howard Darmstadter
In my preceding column, before I was so rudely interrupted, I was about to expound on the nature of Truth.
To reconstruct the scene, I’d been wondering why lawyers pack their sentences with so many exceptions and qualifications. Could it be, I wondered, that they believe that without the exceptions and qualifications, the sentence would be false?
"Ridiculous," I said. The unit of truth isn’t the sentence. There’s nothing wrong with providing the exceptions and qualifications in a different sentence. Consider: You can write the single sentence:
Payment will be made on the 25th of each month unless the 25th is not a business day, in which case payment will be made on the first business day following the 25th.
But you can also say it in two sentences:
Payment will be made on the 25th of each month. However, if the 25th is not a business day, payment will be made on the first business day following the 25th.
The statement "Payment will be made on the 25th day of each month" might appear to be false if considered alone, but who says you should consider it alone? Indeed, considered alone, how can you tell whether the sentence is true or false? "Payment" for what?
Each sentence in a prospectus is true or false only in the context provided by the entire prospectus, as well as the background knowledge and goals of the anticipated reader. This is fairly abstract, so before we drift away in speculation, let’s moor ourselves to a nonlegal example. After all, all knowledge does not have to be legal.
One of Newton’s laws is that force equals mass times acceleration, usually written F = ma. Most of us have little idea what that equation means, even if we know that it’s important. If we knew more physics, and could remember our college calculus, we could use it for all sorts of useful purposes. We could, for example, predict the tides and the motions of the planets, or keep the building from coming down around our ears.
F = ma is an important truth, but it depends for its importance and its truth on the rest of the Newtonian system — the other laws of motion and gravitation, and calculus. But even with the rest of the system, it’s only true in some contexts. For calculating the orbits of the planets, it’s super — unless you happen to be interested in precise predictions of the perihelion of Mercury. In that context, Newton’s laws are false, and something else — relativity theory — turns out to be true (for us, for now).
Wait a minute: You didn’t learn this stuff in law school? OK, here’s a brief history of modern physics: In the late 17th century, Isaac Newton came up with laws of motion and gravitation and a mathematical technique, calculus, that explained and predicted the motions of earthly bodies — falling apples, artillery shells, the tides — as well as the planets and their moons, as part of a single unified system. Early in the 20th century, Einstein showed that Newton’s laws aren’t quite right, and that the errors become larger as bodies move at higher speeds or in stronger gravitational fields.
For example, when Mercury makes its closest approach to the sun (its perihelion), the light rays from Mercury to us, passing close to the sun’s strong gravitational field (the sun is big!), get bent. (Actually, I’m told, it’s the space the rays pass through that gets bent — relativity is strange.)
So here’s how you write a textbook on mechanics for engineers (I’m not a physicist or an engineer, but I’m a lawyer, so I have the right to be an expert): You start with Newton’s laws — you can assume the students already know calculus — without the complexities that air resistance, friction and a whole range of other real-world considerations would raise. You give lots of examples and exercises until you feel that a diligent student will understand how to apply the Newtonian system. Then, one by one, you add air resistance, friction and other complexities. You never mention relativity theory. For an engineer, it’s irrelevant.
And now, back to our world.
A prospectus is a textbook: You’re trying to explain to someone — an investor — how something — a security — works. As in any textbook, the truth of what you say depends on your audience. Each sentence in a prospectus is true or false only as part of the structure of the prospectus and a set of loosely understood assumptions about what the prospectus reader needs to know. And, as in our engineering textbook, you can — you should — leave out exceptions that are not relevant to your investors’ needs.
An example: In writing a prospectus for certificates backed by credit card receivables, I had to explain how the receivables were allocated to the certificates. The allocation is done by allocating the total pool of receivables among the different series of certificates, then taking the amount allocated to each series and allocating it between the investors and the sponsor. Two-steps.
When I looked at the arithmetic however, the process was: First, each series is allocated a portion of the receivables equal to a/b, and, second, the investors in the series are allocated a portion of that amount equal to b/c. High school algebra tells you that the investors are therefore allocated a portion of the receivables equal to a/c — one-step.
When I drafted the allocations as a one-step process, however, the other lawyers were unhappy. They didn’t question my math, and they admitted that the reasons for the two-step process were of little interest to investors. But, they said, the allocations are in fact calculated by the two-step procedure. I couldn’t persuade them that my description of a one-step procedure was as true as it had to be. Eventually we compromised on presenting a one-step process in the body of the prospectus, with the two-step procedure in an appendix. (When I seize power, that appendix will be among the first to be shot.)
A nonlegal example we’re now familiar with: The brief history of physics I gave a few paragraphs back is ludicrously inadequate (and inaccurate) for most purposes. But for this column, it’s as true as it needs to be.
We’re so accustomed to the idea that you only have to say what you have to say that I shouldn’t have to give any more examples. It’s only when we stop thinking about what the audience needs to know, and start worrying about Truth, in either the philosophical or the 10b-5 sense, that philosophers and lawyers tend to lose their bearings.
One of the reasons I had trouble persuading the other lawyers involved with the prospectus was that we had different ideas of the audience for the prospectus. For those veterans, the audience was a group of sophisticated investors who, they said, would want to see the allocations described the way they had always been described. For me, however, there would be no need for the prospectus if you could assume that your audience already knew it all.
But who is the prospectus audience? Until we know, it’s difficult to say what disclosure is appropriate.
The SEC gives a bit of guidance. First, the investors are not lawyers. I know this because rule 421(b) says you should avoid "legal and highly technical business terminology" as well as "complex information copied directly from legal documents without any clear and concise explanation of the provision(s)." Presumably, we lawyers would understand what all that stuff means, but that’s not good enough for the SEC.
The SEC’s injunction to avoid "highly technical business terminology" may also mean that you can’t assume a highly sophisticated investor. Presumably, you can assume that the audience for a product that is sold primarily to institutional investors will be more sophisticated than the audience for a common-stock prospectus. But you can’t assume that the audience already fully understands the product.
If you’re writing a prospectus, you have to make decisions about what to say and how to say it, and these decisions can’t be made without some assumptions about your audience. But there’s not much to guide you, and there are lots of openings for second-guessing by the plaintiffs’ bar. All you can do is try to pitch your presentation to the "average investor" for the securities involved. If you happen to know that guy, I’d like to ask her a few questions.
Darmstadter is an assistant general counsel at Citigroup in New York City. You can e-mail him at darmstadte@citi.com.
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