Michaels

2007 OUTSIDE DIRECTOR LIABILITY FOR SHELF OFFERINGS 345
NO FRAUD? NO PROBLEM: OUTSIDE DIRECTOR

LIABILITY FOR SHELF OFFERINGS UNDER SECTION 11
OF THE SECURITIES ACT OF 1933
DAVID I. MICHAELS *
The central purpose of the securities laws in the United States is to ensure
that quality information about the companies who sell their securities to the
public is being disclosed to investors. This objective is achieved through
the imposition of liability for failure to comply with the laws disclosure
obligations. In particular, Section 11 of the Securities Act of 1933 imposes
liability on parties who fail to conduct reasonable due diligence in
accordance with the first-time offering of securities.
Historically, courts construed the due diligence obligation under Section 11
such that parties intimately involved in a public offeringe.g., inside
directors and underwriterswere required to perform thorough due
diligence while outside directors, by virtue of their limited involvement,
were not. This makes sense because Section 11 liability was created in
order to deter negligent due diligence, without interfering with honest
business practices. Imposing varying levels of due diligence on parties
based on their respective involvement adheres to this principle.
Shelf offeringsa relatively new means of selling securities to the public
complicate things. Unlike a traditional offering, in a shelf offering there is
virtually no time to conduct due diligence. Thus, scholars and industry
professionals have argued that there should be a Section 11 safe harbor for
underwriters when a company conducts a shelf offering. They expressed no
similar concern for outside directors because it was assumed that outside
directors were subject to minimal liability under Section 11. In re
WorldCom, Inc. Securitie s Litigation, changed this assumption and
demonstrated the need for regulatory action. In re WorldCom imposed an
unrealistic standard of due diligence for outside directors that does not
serve any of Section 11s objectives. This article proposes that a safe
harbor for outside directors, modeled on the state law business judgment
rule, would provide an efficient solution to this problem.
*
J.D., UCLA School of Law (expected 2008). Articles Editor, UCLA Law Review.
Special thanks to Lynn Stout, Paul Hastings Professor of Corporate and Securities
Law at UCLA School of Law, for her guidance and mentoring; her approach to legal
scholarship was an inspiration throughout writing this article. I also thank Joe
Zujkowski and the editors of the Annual Review of Banking and Financial Law.
This article is dedicated to my familymy parents, Karen and Alvin, my brothers,
Sam and Fred, and my sister, Mimi.
I. Introduction................................................................... 346
II. Background on the Securities Act of 1933 and the Securities

and Exchange Act of 1934............................ 350
III. Shelf Offerings and the Integrated Disclosure System... 352

A. The Integrated Disclosure System........................ 352
B. Shelf Registration and Offerings.......................... 353
IV. Principal Civil Liability Provisions of the Securities

Acts................................................................................ ...... 359
A. Rule 10b-5 of the Securities and Exchange Act of
1934............................................................................ 360
B. Section 11 of the Securities Act of 1933............... 362
1. Section 11s Due Diligence
Defenses......................................................... 364
2. What Constitutes Reasonable Due
Diligence? ..................................................... 366
V. The Problem with Section 11 Liability for Outside Directors in

the Context of Expedited Shelf Offerings.. ............................ 371
A. Digression: Who is an Outside Director?............ 372
B. No Deterrence, Substantial Interference.............. 374
C. Proposed Solution: Section 11 Safe Harbor........ 379
1. The Business Judgment Rule and a
Section 11 Safe Harbor...................... 379
2. Possible Criticism......................... 383
D. No Fraud? No Problem: Perverse Incentives
Without a Safe Harbor............................................... 384
VI. Conclusion.................................................................. 385
The strictest law often causes the most serious wrong.

- Marcus Tullius Cicero, 106 BC 48 BC
I. INTRODUCTION
The Securities Act of 1933 (1933 Act) and the Securities

and Exchange Act of 1934 (1934 Act) are pieces of New Deal
legislation enacted in the wake of the Great Depression. Both acts
primary concern is adequate disclosure to investorsthe public
needs as much detail about a company as possible in order to make
informed investment decisions. 1 The 1933 Act governs the initial
offering of securities, while the 1934 Act governs securities that are
already trading on the market. An essential element to the extensive
regulatory scheme envisioned under both acts is the imposition of
liability for failing to comply with the acts disclosure requirements.
Most notably, Section 11 of the 1933 Act imposes liability for false
or misleading information disclosed to investors when a company
sells its securities for the first time, 2 and Rule 10b-5 of the 1934 Act
imposes liability for fraudulent or deceptive practices in connection
with the purchase and sale of securities trading in secondary
markets. 3
Section 11 liability applies to parties involved in the
preparation of a misleading registration statement of securities.
However, for parties who conducted thorough due diligence, Section
11 provides an affirmative defense called the due diligence
defense. 4 Historically, courts construed this defense as mandating
various levels of due diligence based on the particular defendants
involvement in the offering. 5 For parties intimately involved in the
offeringsuch as inside directors and underwritersthe standard of
due diligence was stringent, while the standard for outside directors
was not. This makes sense (and is consistent with Congresss and
the Securities and Exchange Commissions (SEC) interpretation of
what constitutes adequate due diligence) 6 because the more involved
a party is in a given offering, the more thorough we want them to be
and, thus, the more liability we want to impose in order to deter them
1
See infra notes 29, 39-41 and accompanying text.
2
15 U.S.C. 77k (2000).
3
17 C.F.R. 240.10b-5 (2006).
4
15 U.S.C. 77k (b)(3).
5
See Escott v. BarChris Const. Corp., 283 F. Supp. 643, 682-701 (S.D.N.Y. 1968);
Feit v. Leasco Data Processing Equipment Corp., 332 F. Supp. 544, 577-78
(E.D.N.Y. 1971); Weinberger v. Jackson, No. C-89- 2301-CAL, 1990 WL 260676
(N.D. Cal. Oct. 11, 1990); Laven v. Flanagan, 695 F. Supp. 800, 811-12 (D.N.J.
1988).
6
See infra notes 226-29.
from neglecting their duties. However, when it enacted the 1933

Act, Congress cautioned that liability for deterrence purposes should
not extend so far that it would interfere with honest business
practices. 7
Enter the problem of shelf offerings. Shelf offerings are a
relatively new 8 means of selling securities to the public. A shelf
offering is a method by which large public companies can sell
securities on the market without having to jump through many of the
1933 Act hoops typically associated with an initial public offering. 9
As a consequence, shelf offerings happen much faster and require
significantly less disclosure than traditional offerings. Thus, there is
less time to conduct due diligence and less information that needs to
be reviewed as a part of the due diligence process. The benefit for
issuers, of course, is that it gives them the ability to raise capital
quickly and at opportune pricing. However, this benefit is not
without a corresponding burden; the de minimis due diligence in a
shelf offering runs the risk of frustrating the 1933 and 1934 acts aim
at ensuring disclosure of quality information to investors.
Because of this risk, the SEC has maintained that shelf
offering due diligence is to be equally thorough to that of a
traditional offering. 10 It therefore repeatedly rejected requests by
scholars and industry professionals that it adopt a Section 11 safe
harbor for underwriters when a company conducts a shelf offering. 11
Perhaps this rejection was reasonable in light of the fact that
underwriters can invest in developing sophisticated techniques to
adjust their due diligence for the shelf offering market. 12 Moreover,
underwriters can self-insure Section 11 risk by raising their fees. 13
Outside directors, however, cannot self-insure, and, yet, few
scholars have made a case for an outside director Section 11 safe
harbor for shelf offerings. This is not surprising considering that
most scholars assumed outside directors were subject to very little (if
any) liability under Section 11. 14 In re WorldCom, Inc. Securities
7
See infra Part V.
8
The SEC formally began permitting shelf offerings in the early 1980s. See infra
text accompanying notes 73-77.
9
See infra Part III.B.
10
See infra note 251 and accompanying text.
11
Id.
12
See infra Part V C 2.
13
See id.
14
See, e.g., Donald C. Langevoort, Deconstructing Section 11: Public Offering
Liability in a Continuous Disclosure Environment, 63 LAW & CONTEMP. PROBS. 45,
Litigation, 15 the most recent caseand probably most important in

the last 3 or 4 decadesconstruing the due diligence defense,
challenges this assumption. In re WorldCom held, in essence, that all
parties involved in the preparation of a registration statement are
subject to the same stringent standard of due diligence. 16 As
discussed above, this is inappropriate because the due diligence
inquiry must take into account the defendants level of involvement
in the offering (i.e., insiders, who are intimately involved in an
offering, should be subject to a higher standard of due diligence than
an outsider who was not involved to a similar degree).
This creates a perfect-storm environment for outside
directors. First, by holding them to the same standard as insiders,
outside directors are now subject to an unrealistic standard of due
diligence because they lack the time and resources that insiders
have. 17 Second, while Section 11 has minimal pleading
requirements, 18 the court in In re WorldCom has, at the same time,
made it virtually impossible for an outside director to successfully
assert Section 11s due diligence defense. 19 Plaintiffs asserting a
Rule 10b-5 fraud-on-the-market claim, on the other hand, will be
subject to an elevated standard of pleading that will be difficult to
overcome. 20 And for reasons that will be elaborated below, Rule
10b-5, although a 1934 Act provision, applies to shelf offerings
under the 1933 Act. 21 Moreover, when a plaintiff seeks to assert a
claim based on a materially misleading registration statement, a
cause of action under both Rule 10b-5 and Section 11 typically exists
because both rest on the same set of facts (the same misstatements or
56 (2000) (Outside directors may be harder to reach under . . . [the 1933 and 1934
acts], but that is probably appropriate given the limited involvement such directors
usually have.); id. at 65 ([O]ne would expect that few judges or juries would
assign much of the [Section 11] liability load to non-complicit outside directors. In
this light, should they have any liability exposure at all, absent knowledge of the
fraud or perhaps reckless disregard? My sense is that little justification exists for
doing so.) (emphasis added).
15
2005 WL 638268 (S.D.N.Y. 2005).
16
See infra text accompanying notes 185-87.
17
See infra Parts IV.B.2., V.B.
18
See infra note 127 and accompanying text (noting that Section 11 places a
relatively minimal burden on a plaintiff because all she must show is a material
misstatement or omission to establish [her] prima facie case. (quoting Herman &
MacLean v. Huddleston, 459 U.S. 375, 382 (1983))).
19
See infra text accompanying note 190.
20
See infra Part IV.A.
21
Because shelf registration statements incorporate by reference 1934 Act filings,
they are within Rule 10b-5s reach. See infra Parts III.A., B., IV.A.
omissions in a registration statement). Thus, Section 11 claims will

run rampant because plaintiffs will elect to assert Section 11 claims
(that will now almost certainly get past summary judgment), as
opposed to Rule 10b-5 fraud claims (because of the heightened
pleading requirements).
Because of In re WorldCom and the significant problem of
outside director Section 11 liability for shelf offerings, I argue in this
article that the SEC should adopt a safe harbor for outside directors.
Currently, a safe harbor for directors substantive decisions exists
under state law: the business judgment rule. It awards directors with
a shield from liability provided they follow certain procedures in
informing themselves of all material information about a given
matter. 22 The procedural requirements of the business judgment rule
mirror what has historically been considered the due diligence
requirements for outside directors under Section 11. Previous
scholars have defended the business judgment rule on behavioral and
economic grounds. 23 Because of the congruity of the business
judgment rule and Section 11 liability, I draw on this previous
scholarship and argue that a Section 11 safe harbor for outside
directors is justifiable based on a similar rationale.
The article proceeds as follows. Part II provides an overview
of the 1933 and 1934 acts. Part III discusses the mechanics of shelf
offerings and the integrated disclosure system between the 1933 and
1934 acts. Part IV discusses the principal liability provisions of the
acts; it focuses on Rule 10b-5 of the 1934 Act and Section 11 of the
1933 Act. Part V outlines the problems with holding outside
directors to the same standard of liability of an insider. It then
proposes a solution: a business judgment rule-like safe harbor for
outside directors who follow procedural requirements in informing
themselves of all material information surrounding an offering.
Finally, it describes the perverse incentives the SEC will be
endorsing if it does not create such a safe harbor. A brief conclusion
follows.
22
See Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985); See also infra text
accompanying notes 234-35.
23
See e.g., Lynn A. Stout, In Praise of Procedure: An Economic and Behavioral
Defense of Smith v. Van Gorkom and the Business Judgment Rule, 96 NW. U. L.
REV. 675 (2002).
II. BACKGROUND ON THE SECURITIES ACT OF 1933 AND THE

SECURITIES AND EXCHANGE ACT OF 1934
Prior to the stock market crash of 1929 and the Great

Depression 24 that followed, Congress had been reluctant to regulate
publicly traded securities. 25 However, President Roosevelt, who
recognized that corporate law reform was necessary in order to
restore investor confidence in the capital markets, urged Congress to
take legislative action. 26 As a result, the Senate Committee on
Banking and Currency conducted a series of investigations into stock
market practices that were thought to have caused the 1929 crash. 27
These investigations uncovered scores of irresponsible and
unscrupulous practices pervasive in the stock markets that required
remediation. In response, Congress enacted, among other things, the
1933 Act and the 1934 Act. 28
The New Deal legislation, including the 1933 Act, was
designed to provide investors with full disclosure of material
information concerning public offerings of securities in commerce, to
protect investors against fraud and, through the imposition of
specified civil liabilities, to promote ethical standards of honesty and
fair dealing. 29 Although the 1934 Act has similar objectives to
promote full disclosure, prevent fraud, and impose civil
liabilities 30 it governs the purchase and sale of securities already
24
During the great depression (between 1929 and 1932) the stock market lost over
83 percent of its value. See LOUIS LOSS AND JOEL SELIGMAN, SECURITIES
REGULATION ch. 1-F (3d. ed. 1989).
25
See id.
26
See id. (citing H.R. REP. NO. 73-85 at 1-2 (1933)). See also James M. Landis, The
Legislative History of the Securities Act of 1933, 28 GEO. WASH. L. REV. 29, 30
(1959) (discussing President Roosevelts message to Congress).
27
See S. REP. NO. 73-1455, at 1-4 (1934).
28
See LOSS AND SELIGMAN, supra note 24, at ch. 1-F. For an in depth discussion of
the legislative history of the Securities Act of 1933, see Landis, surpa note 26, at 29-
49.
29
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976). See also, SEC v. Capital
Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963) (A fundamental purpose . . .
was to substitute a philosophy of full disclosure for the philosophy of caveat emptor
and thus to achieve a high standard of business ethics in securities industry.); Feit v.
Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 563 (E.D.N.Y. 1971) (The
keystone of the Securities Act of 1933, and of the entire legislative scheme of the
securities laws, is disclosure.).
30
See Ernst & Ernst, 425 U.S. at 195.
trading on an open exchange, while the 1933 Act deals primarily

with the securities initial distribution. 31
Section 5 32 of the 1933 Act sets forth the Acts general
disclosure requirements in the negative by prohibiting the public sale
of securities unless a registration statement is filed with the SEC 33
and furnished a prospectus along with the registration statement. 34
To illustrate, the registration process is separated into three
statutorily prescribed parts: the pre-filing period, 35 the waiting
period, 36 and the post-effective period. 37 The company must furnish
a prospectus when the registration statement becomes effective and
must meet the requirements of Section 10 38 of the 1933 Act. Section
10(a) requires that the prospectus contain the information contained
in the registration statement; 39 including all the relevant details
about the issuer 40 an investor needs to make a fully informed
investment decision. 41 Section 5s prohibition thus imposes the 1933
Acts disclosure obligations on issuers because they cannot sell their
securities without making a registration statement and prospectus
available to investors.
Investor need for full disclosure of material information
about an issuer is no less present in the context of the purchase and
sale of securities already trading on an open exchange than it is in the
securities initial distribution. Thus, the 1934 Acts disclosure
31
See LOSS AND SELIGMAN, supra note 24, at ch. 1-H-2.
32
Codified at 15 U.S.C. 77e (2000).
33
15 U.S.C. 77e(a) (2000).
34
Id. 77e(b)(1).
35
Id. 77e(a)(1), (a)(2), (c); see THOMAS LEE HAZEN, TREATISE ON THE LAW OF
SECURITIES REGULATION ch. 2.3 (5th ed. 2002 & Supp. 2006).
36
15 U.S.C. 77e(a)(1), (a)(2), (b)(1), 77h(a); see HAZEN, supra note 35, at ch. 2.4
(stating that the waiting period begins with the filing of the registration statement.
37
15 U.S.C. 77e (b)(1), (b)(2); see HAZEN, supra note 35, at ch. 2.3 - 2.5
(discussing the numerous requirements and restrictions governing each of the three
periods).
38
15 U.S.C. 77j.
39
Id. 77j(a)(1) (referencing schedule A of the 1933 Act which sets out a list of
information to be provided in the registration statement); see id. 77aa.
40
A company that has or will issue (sell) its securities on an exchange is referred to
as an issuer. See id. 77(a)(4).
41
Id. 77aa; see also HAZEN, supra note 35, ch. 2.2[1] (discussing Section 5s
general purpose of full disclosure to investors). The SEC recently enacted Rule
421(d), the new plain English rule, for the purposes of enhanc[ing] the readability
of the prospectus. 17 C.F.R. 230.421(d) (2006). Rule 421(d) requires issuers to
use plain English principles in the preparation of certain portions of the
prospectus. Id.; see also HAROLD S. BLOOMENTHAL, SECURITIES LAW HANDBOOK,
6:9-6:17 (2006 ed.) (discussing the plain English rule).
requirements pick up where the 1933 Acts disclosure requirements

leave off, 42 requiring issuers to make periodic disclosure. Periodic
disclosure under the 1934 Act is comprised of filing with the SEC an
annual report on Form 10-K, 43 a quarterly report on Form 10-Q, 44
and a report of any significant company development on Form 8-K. 45
III. SHELF OFFERINGS AND THE INTEGRATED DISCLOSURE

SYSTEM
This article focuses on outside director liability under the

1933 and 1934 Acts in the context of shelf offerings. This Part
provides a necessary overview of the mechanics of shelf registration
and offering. A discussion of shelf offerings, however, would be
deficient without some background on the integrated disclosure
system. Thus, Section A provides a brief summary of integrated
disclosure between the 1933 and 1934 Acts. Section B follows with
an in-depth look at shelf offerings.
A. The Integrated Disclosure System
Under the old system, issuers were required to comply with

all 1933 Act and 1934 Act disclosure rules even though both Acts
separately mandated disclosure of essentially the same information. 46
As a result, issuers incurred substantial and unnecessary costs. 47
Moreover, because the 1933 and 1934 Acts had divergent disclosure
procedures, the information was being disseminated in two different
formats 48 which resulted in investors receiving duplicative and, thus,
confusing information. 49 In a landmark article, Milton Cohen
42
15 U.S.C. 78m (2000).
43
17 C.F.R. 249.310 (2006).
44
Id. 249.308a.
45
Id. 249.308.
46
See Michael McDonough, Comment, Death in One Act: The Case for Company
Registration, 24 PEPP. L. REV. 563, 584-87 (1997); BLOOMENTHAL, supra note 41,
3:2.
47
See generally BLOOMENTHAL, supra note 41, 3:2; McDonough, supra note 46, at
587-88
48
See Milton H. Cohen, Truth in Securities Revisited, 79 HARV. L. REV. 1340,
1350-53 (1966) (discussing the method of 1933 Act disclosure under the old
system); id. at 1359-61 (discussing the method of 1934 Act disclosure under the old
system).
49
See id.; McDonough, supra note 46, at 587-88. The problem of duplicative
information was especially problematic because the whole purpose of the federal
pointed out that the majority of information companies were required

to disclose under the 1934 Act 50 was the same information included
in a 1933 Act registration statement. 51 He therefore argued that the
SEC should emphasize 1934 Act periodic reporting as opposed to the
initial 1933 Act registration statement, which is a mere one-time
event unlikely to be useful on an ongoing basis. 52
In 1982, the SEC realized Cohens vision by adopting an
integrated disclosure system. 53 The new systems most significant
innovation permitted issuers to incorporate by reference 1934 Act
filings into a 1933 Act registration statement. 54 Some examples of
filings that may be incorporated by reference are: summary
information, risk factors, use of proceeds, plan of distribution,
descriptions of the companys business, property and legal
proceedings, financial statements, selected financial data and ratios
of earnings to fixed charges, and managements discussion and
analysis (MD&A). 55
Of course, the integrated disclosure system did not
significantly alter the amount of disclosure a company must make
when it sells its shares for the first time on an open exchange (known
as an initial public offering (IPO)), since they have never made
disclosures under the 1934 Act. 56 However, for companies that have
made periodic disclosure under the 1934 Act, incorporating by
reference substantially decreased the amount of information to be
disclosed in a 1933 Act registration statement. 57
B. Shelf Registration and Offerings
In theory, when offering their shares to the public, issuers

register a specific number of securities with the SEC for the purpose
of selling the entire allotment when the registration statement
securities laws is to protect investors by imposing disclosure obligations on issuers.

See supra Part II. Duplicative information thus frustrates this purpose because it can
confuse investors.
50
15 U.S.C. 78m (describing periodic reporting under the 1934 Act).
51
Cohen, supra note 48, at 1368.
52
Id. at 1341-42, 1367.
53
See 17 C.F.R. 229.10-229.915 (2006).
54
See LOSS AND SELIGMAN, supra note 24, ch. 2-D-1.
55
HAZEN, supra note 35, ch. 3.4[4][A].
56
See supra Part II. (noting that the 1934 Act governs the purchase and sale of
securities already trading on an open exchange); see LOSS AND SELIGMAN, supra
note 24, ch. 1-H-3 (providing an overview of the 1934 Act).
57
See HAZEN, supra note 35, chs. 3.4[4][A], [C].
becomes effective. However, in reality issuers often offer only a

portion of the allotted shares, upon the registration statement
becoming effective, and delay sale of the remaining shares for a
future, unspecified date (known as a delayed offering). Pre-
registration of securities that are not presently sold is known as shelf
registration the securities are figuratively placed on the shelf
instead of being sold when the registration statement becomes
effective. 58 An issuer may then take the securities off the shelf at a
later date and sell them to the public; this is referred to as a shelf
take-down or shelf offering. A shelf offering is a particularly
attractive strategy because, by pre-filing with the SEC, the issuer is
not bound by the myriad due diligence obligations associated with an
IPO. The issuer can therefore time the market sell securities
rapidly at a time that best suits its capital needs or when the market
would provide the most favorable pricing. 59 This strategy is
especially advantageous in a sale of debt securities because a shelf
offerings speed enables the issuer to take advantage of fluctuating
interest rates, which particularly affect the debt markets. 60
Although shelf registration provides a clear benefit to
issuers, 61 the 1933 Act contains a substantial obstacle to its use:
Section 6(a) of the 1933 Act states in relevant part that [a]
registration statement shall be deemed effective only as to the
securities specified therein as proposed to be offered. 62 For a long
time the SEC interpreted this sentence to mean that a registration
statement is only effective as to securities presently offered for sale
because including more securities in a registration statement would
be misleading in that it would give[the] securities offered at some
remote future date at least the appearance of a registered status. 63
Thus, up until the mid 1950s, the SECs strict reading of Section 6(a)
58
See Scott Hodes, Shelf Registration: The Dilemma of the Securities and Exchange
Commission, 49 VA. L. REV. 1106, 1107 (1963).
59
See HAZEN, supra note 35, ch. 3.11.
60
See id.; see generally Christopher B. Barry et al., Interest Rates and the Timing of
Public Issues of Corporate Debt (Nov. 12, 2003) (unpublished report, on file with
Texas Christian University), available at http://groups.haas.berkeley.edu/wfw/
papers/5.pdf.
61
See generally Barbara Ann Banoff, Regulatory Subsidies, Efficient Markets, and
Shelf Registration: An Analysis of Rule 415, 70 VA L. REV. 135, 145-54 (1984)
(discussing the benefits of Rule 415 to issuers).
62
15 U.S.C. 77f(a) (2000).
63
Hodes, supra note 58, at 1106 (quoting Shawnee Chiles Syndicate, 10 SEC 109,
113 (1941).
effectively prohibited shelf registration by proscribing the

registration of securities that were not presently offered for sale. 64
To be sure, as a part of the 1954 Securities Acts amendment
program, the Senate Committee on Banking and Currency clarified
that [S]ection 6(a) of the [1933] Act . . . does not permit
registration for the shelf. 65
The SECs reluctance to permit shelf registration was well
founded. As discussed, shelf offerings are offerings of securities that
have been pre-filed with the SEC. By definition, then, the securities
have been sitting on the shelf for a period of time. 66 Thus, the
information contained in a shelf registration statement may include
obsolete or outdated information at the time of sale, 67 potentially
frustrating the 1933 Acts aim to disclose accurate information to
investors. 68 Moreover, due to the short time frame of a shelf
offering, the issuers and its underwriters ability to conduct due
diligence is limited 69 potentially frustrating the 1933 Acts aim of
prohibiting the dissemination of false or misleading information to
investors. 70
The concern regarding investors receiving up-to-date
information was remedied in part by post-effective amendments.
A post-effective amendment requires an issuer to update the shelf
registration statement periodically if there has been a fundamental
64
See LOSS AND SELIGMAN, supra note 24, ch. 2-A-5.
65
S. REP. NO. 83-1036, at 10 (1954); see also Hodes, supra note 58, at 1113-15
(discussing the 1954 amendment program and the Senate Committee report).
66
See supra text accompanying note 58.
67
LOSS AND SELIGMAN, supra note 24, ch. 2A-5 (observing that Commission
expressed concerns about disclosure and due diligence in limiting reach of Rule
415).
68
See, e.g., Hodes, supra note 58, at 1107 (If securities are registered for future
distribution, however, prospective investors who rely on the information in the
registration statement may receive information that is no longer current . . . .
Allowing registration long in advance . . . clearly frustrates the objective of the
[1933] act.) (emphasis in original); see also supra text accompanying notes 29, 39-
41 (observing that 1933 Acts purpose is to provide full disclosure to potential
investors).
69
John C. Coffee, Jr., Re-Engineering Corporate Disclosure: The Coming Debate
Over Company Registration, WASH. & LEE L. REV. 1143, 1148 (1995) ([T]here is
clearly insufficient time in a shelf registration for traditional due diligence
procedures to be conducted before each individual offering.).
70
See 15 U.S.C. 77k (2000) (imposing civil liability for misstatements or
omissions of material fact in the registration statement).
change to the information contained in it. 71 Consequently, a shelf

registration statement combined with a post-effective amendment
provides investors with current information. As a result of this
innovation, over time, the SEC began permitting shelf registration,
but it did so only in a limited set of circumstances. 72
In 1982 right around the time the SEC overhauled the
Securities Acts disclosure system by integrating disclosure under the
1934 Act with the 1933 Act 73 the SEC yielded to market forces
calling for wide availability of shelf registration and enacted Rule
415, 74 which permitted shelf registration, on an experimental basis. 75
Experimental Rule 415 proved to be a success in the eighteen months
following enactment. 76 As a result, in 1983, the SEC adopted Rule
415 permanently. 77 However, based on the concerns noted above
adequacy of disclosure and limited due diligencethe SEC limited
the availability of shelf registration to those offerings where the
benefits of shelf registration are most significant and where the
disclosure and due diligence concerns are mitigated by other
factors. 78 A principal mitigating factor persuading the SEC to
permit certain kinds of issuers to register securities for the shelf was
the extent to which a given issuer was followed by the investment
community. 79 The theory was that the larger the company, the more
widely it was followed by Wall Street, which tends to increase the
71
17 C.F.R. 229.512(a)(1) (2006) (requiring issuer [T]o reflect in the prospectus
any facts or events arising after the effective date of the registration statement (or the
most recent post-effective amendment thereof) which, individually or in the
aggregate, represent a fundamental change in the information set forth in the
registration statement).
72
See LOSS AND SELIGMAN, supra note 24, ch. 2A-5 (stating that [i]n 1968, the SEC
published Guide 4, summarizing the exceptional circumstances in which shelf
registration would be permitted under the [1933] Act (emphasis added)); John Paul
Ketels, SEC Rule 415The New Experimental Procedures for Shelf Registration, 10
SEC. REG. L.J. 318, 321 (1983).
73
John Ketels observed that temporary Rule 415, 17 C.F.R. 230.415 (1982), was a
logical extension of the integrated disclosure system. Ketels, supra note 72, at
320.
74
17 C.F.R. 230.415 (1982).
75
See LOSS AND SELIGMAN, supra note 24, ch. 2-A-5.
76
See Shelf Registration, Securities Act Release No. 6499, Exchange Act Release
No. 20384, [1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) 83,449, at 86,335,
86,339 (Nov. 17, 1983) (In the eighteen months since its adoption on a temporary
basis, Rule 415 has operated efficiently and has provided registrants with important
benefits in their financings, most notably cost savings.) (footnote omitted).
77
17 C.F.R. 230.415 (1983).
78
Shelf Registration, supra note 76, at 2.
79
See LOSS AND SELIGMAN, supra note 24, ch. 2A-5.
quality of information disseminated to investors. 80 Hence, the SEC

imposed a capitalization threshold: only companies with either a
market float 81 of $150 million or $100 million combined with an
annual trading volume of at least three million shares were eligible. 82
Moreover, because the integrated disclosure system permitted
companies to incorporate by reference 1934 Act filings into 1933 Act
registration statements, new due diligence methods were being
developed in order to utilize 1934 Act due diligence when
conducting 1933 Act due diligence. 83 Accordingly, shelf offerings
were permitted for widely followed issuers. 84
In 1992, the SEC expanded the types of permissible shelf
registrations to include unallocated shelf registration. 85 This was a
substantial expansion of shelf registration because, under the 1983
rules, an issuer had to allocate from the gross dollar value of the
registration statement to the specific type of security being sold (i.e.,
debt or equity). 86 In an unallocated shelf registration, however, an
80
See Shelf Registration, supra note 76 ([F]or companies in the top tier, there is a
steady stream of high quality corporate information continually furnished to the
market and broadly digested, synthesized and disseminated.).
81
Investopedia.com, Float, http://www.investopedia.com/terms/f/float.asp (last
visited Nov. 13, 2006) (noting that float is [t]he total number of shares publicly
owned and available for trading. The float is calculated by subtracting restricted
shares from outstanding shares.
82
17 C.F.R. 239.13 (1982).
83
See Shelf Registration, supra note 76, at 83,449 ([P]rocedures for conducting
due diligence investigations of [top tier] registrants, including continuous due
diligence by means such as designated underwriters counsel, are being adapted to the
intergrated [sic] disclosure system and shelf registration.).
84
17 C.F.R. 230.415 (1983). The standard used to determine which issuers
qualify for shelf registration is simple: if the issuer is eligible to utilize a Form S-3 or
F-3 registration statement, it is permitted to register securities for the shelf. 17
C.F.R. 230.415(a)(1)(x) (1983). Form S-3, the short-form registration form for
widely followed public companies, permits an issuer to incorporate by reference
virtually all of its 1934 Act filings, requiring only a brief description of the
transaction in the prospectus. See HAZEN, supra note 35, 3.4[4][C]. In order to be
eligible to utilize Form S-3 registration under the 1983 version of Rule 415, the
issuer must have had either $150 million float, or a $100 million float and an annual
trading volume of at least three million shares. 17 C.F.R. 239.13 (1982).
85
Simplification of Registration Procedures for Primary Securities Offerings, Sec.
Act Rel. No. 6964, [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) 83,385, at
83,385 (Oct. 22, 1992).
86
See LOSS AND SELIGMAN, supra note 24, ch. 2A-5 ([T]he Commission addressed
the market overhang problem of equity securities by amending Form S-3 to
authorize unallocated or universal shelf registration by allowing companies to
register debt, equity, or other securities without a specific allocation of offering
amounts.).
issuer may pre-register debt, equity and other classes of securities

on a single shelf registration statement without a specific allocation
of offering amounts among the classes of securities being
registered. 87 In addition, as a part of the 1992 expansion of shelf
registration, the SEC lowered the eligibility threshold. Previously,
only companies with either a market float of $150 million, or $100
million combined with an annual trading volume of at least three
million shares, were eligible. 88 However, the SEC lowered the
threshold to $75 million, regardless of trading volume. 89
In 2005 the SEC extended the shelf registration rules even
90
further. Of particular relevance to this article was the change in
rules for what are known as well-known seasoned issuers
(WKSIs). 91 Rule 405 92 sets forth the requirements that must be
met in order for an issuer to be deemed a WKSI. Generally
speaking, a WKSI is a company that either has a market float of at
least $700 million 93 or has issued in the last three years at least $1
billion in debt securities. 94 The difference, as it relates to shelf
registration, between WKSIs and issuers that otherwise meet the
requirements for short-form registration 95 (meaning that they are
eligible for shelf registration) is that WKSIs are eligible for
automatic shelf registration. 96 In an automatic shelf registration
the securities become effective as soon as the registration statement
is filed. 97 Thus, WKSIs are able to file a registration statement and
87
Simplification of Registration Procedures for Primary Securities Offerings, supra
note 85.
88
17 C.F.R. 239.13 (1982).
89
17 C.F.R. 239.13 (1992).
90
See Securities Offering Reform, Securities Act Release No. 8591, Exchange Act
Release No. 52,056, 70 Fed. Reg. 44,722 (Aug. 3, 2005).
91
See 17 C.F.R. 230.405, 239.13, 230.415 (2006).
92
17 C.F.R. 230.405.
93
17 C.F.R. 230.405(1)(i)(A).
94
17 C.F.R. 230.405(1)(i)(B)(1) (A well-known seasoned issuer is an issuer that
. . . has a worldwide market value of its outstanding voting and non-voting common
equity held by non-affiliates of $ 700 million or more; or . . . has issued in the last
three years at least $ 1 billion aggregate principal amount of non-convertible
securities, other than common equity, in primary offerings for cash, not exchange,
registered under the Act).
95
See supra note 84 and accompanying text (noting that Form S-3 is the short-form
registration statement for widely followed issuers).
96
HAZEN, supra note 35, at 3.11.
97
See id. For WKSIs, Rule 415 goes even further than automatic shelf registration.
For example, WKSIs do not have to specify the amount of securities being offered
from the shelf, they do not need to provide as much detail in their registration
sell securities in an immediate takedown on the same day. 98 What

this means is that those associated with a WKSI shelf offering have
no time to conduct due diligence. 99 The rationale for providing
greater flexibility to WKSIs was essentially the same as the rationale
for adopting an expansive system of shelf registration in the first
place: the more widely followed an issuer is, the greater the chance
that quality information about the issuer has been disseminated, 100
and WKSIs are the most widely followed issuers in the marketplace.
101
IV. PRINCIPAL CIVIL LIABILITY PROVISIONS OF THE

SECURITIES ACTS
This section of the article discusses the most significant civil

liability provisions of the 1933 and 1934 acts. Section A provides an
overview of liability under Rule 10b-5 of the 1934 Act. Because a
more detailed discussion of Section 11 is needed, Section B discusses
liability under Section 11, Section 11s due diligence defenses, and
case law interpreting those defenses.
statements as do other Form S-3 registrants, and they can add additional classes of
securities after the effective date of the registration statement. See id.
98
John C. Coffee, Jr., A Section 11 Safe Harbor, 234 N.Y. L. J. 5 (Sept. 15, 2005)
(discussing Securities Act Release No. 33-8591).
99
See id.
100
See supra text accompanying notes 76-79 (explaining that the rationale
behind the deferential treatment for WKSIs is the fact that the market
widely follows and understands them).
101
In granting WKSIs greater shelf registration flexibility, the SEC noted:
Overall, the issuers that will meet our thresholds for [WKSIs]
are the most active issuers in the U.S. public capital markets. In
2004, those issuers, which represented approximately 30% of
listed issuers, accounted for about 95% of U.S. equity market
capitalization. They have accounted for more than 96% of the
total debt raised in registered offerings over the past eight years
by issuers listed on a major exchange or equity market. These
issuers, accordingly, represent the most significant amount of
capital raised and traded in the United States. As a result of the
active participation of these issuers in the markets and, among
other things, the wide following of these issuers by market
participants, the media, and institutional investors, we believe
that it is appropriate to provide communications and registration
flexibilities to these [WKSIs] beyond that provided to other
issuers, including other seasoned issuers.
Securities Offering Reform, supra note 89, at 19.
A. Rule 10b-5 of the Securities and Exchange Act of

1934
As mentioned above, 102 the 1934 Acts central focus is

fundamentally the same as the 1933 Acts to protect investors
from corrupt practices in connection with the purchase and sale of
securities by imposing thorough disclosure obligations on issuers. 103
However, the 1934 Act regulates securities that are already trading
on an open exchange. 104 The 1934 Act, and rules promulgated
thereunder, does this by imposing periodic reporting requirements 105
and liability for failure to comply with those requirements. 106 Of all
the investor protections contained in the 1934 Act, however, none is
more encompassing than Section 10(b) 107 and Rule 10b-5 108
promulgated thereunder. 109 Section 10(b), the 1934 Acts general
antifraud provision, makes it unlawful [t]o use or employ, in
connection with the purchase or sale of any security . . . any
manipulative or deceptive device or contrivance in contravention of
such rules and regulations as the [SEC] may prescribe as necessary
or appropriate in the public interest or for the protection of
investors. 110 Rule 10b-5 prohibits: (1) fraudulent devices and
schemes, (2) misstatements and omissions of material fact, and (3)
acts and practices which operate as a fraud or deceit. 111 Rule 10b-
5s coverage is broad: any person who makes an untrue statement or
omission of a material fact in connection with the purchase or sale of
a security can be made a defendant in a Rule 10b-5 action (also
102
See supra Part II.
103
See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 195 (1976).
104
See id.
105
15 U.S.C. 78m (2000).
106
E.g., 17 C.F.R. 240.10b-5 (2005).
107
15 U.S.C. 78j(b) (2000).
108
17 C.F.R. 240.10b-5 (2005).
109
See Chiarella v. United States, 445 U.S. 222, 226, 234-35 (1980) (noting that
Section 10(b) and Rule 10b-5 are the Securities Acts catch-all antifraud devices);
see also Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir.
1984) (The purpose of 10(b) and Rule 10b-5 is to protect persons who are
deceived in securities transactionsto make sure that buyers of securities get what
they think they are getting and that sellers of securities are not tricked into parting
with something for a price known to the buyer to be inadequate or for a
consideration known to the buyer not to be what it purports to be.).
110
15 U.S.C. 78j(b).
111
HAZEN, supra note 35, ch. 12.3[2] (citing 17 C.F.R. 240.10b-5).
referred to as a fraud-on-the-market action); 112 and any oral or

written communication, or manipulative or deceptive practice, in
connection with the purchase or sale of a security whether or not the
offering is registered under the [1933] Act is within Rule 10b-5s
reach. 113
As broad as Rule 10b-5s coverage is in terms of permissible
defendants and conduct, it does have its limitations, one of particular
significance. Because a Rule 10b-5 action is premised on fraudulent
or deceptive practices, the Supreme Court has held that in order to
violate Rule 10b-5 a person must have acted with scienter 114 a
mental state embracing intent to deceive, manipulate, or defraud.115
By holding that scienter is an element of a Rule 10b-5 action, the
Supreme Court placed a formidable procedural hurdle in a plaintiffs
path: Rule 9(b) of the Federal Rules of Civil Procedure requires that
averments of fraud must be pleaded with particularity. 116 Although
Rule 9(b) does not require a plaintiff to plead with particularity a
defendants state of mind 117 which would seem to suggest that
scienter, a state of mind, may be pleaded generallyin 1995, in an
attempt to curtail frivolous shareholder suits, Congress enacted the
Private Securities Litigation Reform Act 118 (PSLRA) which
imposed an even higher standard than Rule 9(b) particularity for
pleading scienter under Rule 10b-5: plaintiffs are required to state
with particularity facts giving rise to a strong inference that the
defendant acted with the required state of mind. 119
112
See John J. Clarke, Jr., How to Prepare an Initial Public Offering 2006:
Potential Liabilities in Initial Public Offerings, 1568 PLI/CORP. 165, 193 (2006).
113
Id.
114
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976); see also Aaron v. SEC,
446 U.S. 680, 691, 695 (1980) (noting that scienter is an element of a Rule 10b-5
action).
115
Ernst & Ernst, 425 U.S. at 193 n.12.
116
FED. R. CIV. P. 9(b). Compare FED. R. CIV. P. 8 (the more liberal notice pleading
requirements do not require pleading with particularity).
117
FED. R. CIV. P. 9(b).
118
Private Securities Litigation Reform Act of 1995, PUB L. NO. 104-67, 109 Stat.
737 (1995).
119
15 U.S.C. 78u-4(b)(2) (2000) (emphasis added) (Arguably, the PSLRA did not
heighten the standard for pleading scienter but merely adopted existing Second
Circuit precedent. Prior to the enactment of the PSLRA, the Second Circuit imposed
the higher standard: plaintiffs were required to plead the factual basis which gives
rise to a strong inference of fraudulent intent. OBrien v. Natl Prop. Analysts
Partners, 936 F.2d 674, 676 (2d Cir. 1991) (internal quotation marks omitted).
Conversely, the Ninth Circuit permitted scienter to be averred generallyconsistent
with the plain language of Rule 9(b). See In re GlenFed, Inc. Sec. Litig., 42 F.3d
B. Section 11 of the Securities Act of 1933
Section 11 120 of the 1933 Act was designed to assure

compliance with the disclosure provisions of the Act by imposing a
stringent standard of liability on the parties who play a direct role in
a registered offering. 121 Unlike Rule 10b-5 (which, as noted,
applies to any person who makes an untrue statement or omission of
a material fact), Section 11 imposes liability for a limited class of
persons; 122 it applies to parties involved in the preparation of a
registration statement and to directors, regardless of whether they
1541, 1546-47 (9th Cir. 1994) (en banc). Finally, other circuits simply applied Rule
9(b)s standard particularity requirement to averments of scienter. E.g., Serabian v.
Amoskeag Bank Shares, Inc., 24 F.3d 357, 361 (1st Cir. 1994). Thus, at least for
some circuits, it is not clear whether the PSLRA did in fact heighten the pleading
standards. What is clear is that Congress intended to elevate the standards for
pleading scienter in order to curb frivolous lawsuits. See, e.g., In re Silicon
Graphics, Inc. Sec. Litig., 183 F.3d 970, 973 (9th Cir. 1999) (Congress enacted the
PSLRA to deter opportunistic private plaintiffs from filing abusive securities fraud
claims, in part, by raising the pleading standards for private securities fraud
plaintiffs. (citing H.R. REP. CONF. NO. 104-369, at 32-41 (1995))). For a detailed
discussion on the standards for pleading scienter under Rule 10b-5, see HAZEN,
supra note 35, ch. 12.8[4].)
120
15 U.S.C. 77k.
121
Herman & MacLean v. Huddleston, 459 U.S. 375, 381-82 (1983) (citing H.R.
REP. NO. 85, 73d Cong., 1st Sess. 9 (1933)).
122
Section 11(a) states in relevant part that the following types of parties are
permissible Section 11 defendants:
(1) every person who signed the registration statement;
(2) every person who was a director of (or person performing
similar functions) or partner in the issuer at the time of the filing
of the part of the registration statement with respect to which his
liability is asserted;
(3) every person who, with his consent, is named in the
registration statement as being or about to become a director,
person performing similar functions, or partner;
(4) every accountant, engineer, or appraiser, or any person
whose profession gives authority to a statement made by him,
who has with his consent been named as having prepared or
certified any part of the registration statement, or as having
prepared or certified any report or valuation which is used in
connection with the registration statement, with respect to the
statement in such registration statement, report, or valuation,
which purports to have been prepared or certified by him;
(5) every underwriter with respect to such security.
15 U.S.C. 77k(a).
were involved in the preparation. 123 In addition to being more

limited than Rule 10b-5 with regard to covered persons, Section 11 is
also more limited with regard to covered conductinstead of
applying to any oral or written communication, it imposes liability
only for untrue statements of material fact in the registration
statement (or omitting material facts from it). 124
Any purchaser of a security at the time it was offered can
assert a claim under Section 11. 125 Purchasers who acquire their
shares in the open market can also assert Section 11 claims as long as
they can trace their securities to those covered by the registration
statement that contained the alleged misleading information. 126
Tracing is another area in which Rule 10b-5s coverage is broader
than Section 11s: Rule 10b-5 has no tracing requirement. 127
Section 11 places a relatively minimal burden on a
plaintiff because all she must show is a material misstatement or
omission to establish [her] prima facie case. 128 This marks another
significant distinction between Rule 10b-5 and Section 11, but here it
is Section 11 that is more plaintiff friendly. Recall that plaintiffs
asserting a Rule 10b-5 claim are subject to the rules burdensome
pleading standard the scienter requirement. 129 Plaintiffs asserting
a Section 11 claim, on the other hand, are not required to plead
scienter because it appears only in Section 11s affirmative due
diligence defenses (discussed below). Thus, Section 11 shifts the
burden of (dis)proving scienter to the defendants.
Although Section 11 is negligence based, federal circuit and
district courts are split on exactly what its pleading requirements
123
Id.
124
Id. The Supreme Court in TSC Industries, Inc. v. Northway, Inc., set forth the
standard for materiality under Section 14 of the 1934 Act. TSC Industries, Inc. v.
Northway, Inc., 426 U.S. 438, 449 (1976). An omitted fact is material if there is a
substantial likelihood that a reasonable shareholder would consider it important in
deciding how to vote. Id.; see also Basic Inc. v. Levinson, 485 U.S. 224, 231-32
(adopting the TSC materiality standard for Rule 10b-5 claims). The same test for
materiality applies to Section 11 claims. See, e.g., In re Merck & Co. Sec. Litig.,
432 F.3d 261, 273 (3d Cir. 2005); see also Feit v. Leasco Data Processing Equip.
Corp., 332 F. Supp. 544, 569-75 (E.D.N.Y. 1971) (applying the materiality test to
Section 11).
125
15 U.S.C. 77k(a).
126
Id.; see In re Sterling Foster & Co., Inc., Sec. Litig., 222 F. Supp. 2d 216, 247
(E.D.N.Y. 2002).
127
See, e.g., Hillary A. Sale, Disappearing Without a Trace: Section 11 and
12(a)(2) of the 1933 Securities Act, 75 WASH. L. REV. 429, 469 (2000).
128
Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983)
129
See supra text accompanying notes 113-18.
are. 130 Fraud is not an element of a Section 11 action, 131 yet some
courts have held that when an action sounds in fraud, the
heightened pleading standards of Rule 9(b) of the Federal Rules of
Civil Procedure 132 apply. 133 Other courts have held that because
Section 11 claims do not require proof of fraud, they are subject to
Rule 8(a) of the Federal Rules of Civil Procedure 134 standard
notice pleading. 135
1. Section 11s Due Diligence Defenses
The issuer of securities is strictly liable under Section 11 for

material misstatements or omissions in the registration statement. 136
Section 11 does, however, provide affirmative defenses to the other
enumerated defendants, 137 including officers who sign the
registration statement, inside and outside directors, underwriters, and
accountants. 138 These defendants can escape liability by establishing
130
See generally, BLOOMENTHAL, supra note 41, 29:58-29:60 (discussing the
pleading requirements for a Section 11 claim and the various approaches taken by
federal district and circuit courts).
131
See 15 U.S.C. 77k(a).
132
FED. R. CIV. P. 9(b).
133
See In re Daou Sys., Inc., Sec. Litig., 411 F.3d 1006, 1027 (9th Cir. 2005), as
amended (Although section 11 does not contain an element of fraud, a plaintiff
may nonetheless be subject to Rule 9(b)s particularity mandate if his complaint
sounds in fraud.); Rombach v. Chang, 355 F.3d 164, 170 (2d Cir. 2004) ([T]he
heightened pleading standard of Rule 9(b) applies to Section 11 . . . claims insofar
as the claims are premised on allegations of fraud.); Cal. Pub. Employees Ret. Sys.
v. Chubb Corp., 394 F.3d 126, 161 (3d Cir. 2004) ([S]ection 11 1933 Act claims
that are grounded in allegations of fraud are subject to Fed.R.Civ.P. 9(b).); Melder
v. Morris, 27 F.3d 1097, 1100 n.6 (5th Cir. 1994) (When 1933 Securities Act
claims are grounded in fraud rather than negligence . . . Rule 9(b) applies.); Sears v.
Likens, 912 F.2d 889, 893 (7th Cir. 1990) (applying Rule 9(b) to a plaintiffs Section
11 claim). Rule 9(b) states that [i]n all averments of fraud . . . , the circumstances
constituting fraud . . . shall be stated with particularity. FED. R. CIV. P. 9(b).
134
FED. R. CIV. P. 8(a).
135
See Romine v. Acxiom Corp., 296 F.3d 701, 704 (8th Cir. 2002) ([Section] 11
claims do not require proof of fraud and therefore the notice pleading requirements
of Rule 8(a) apply.); In re Sirrom Capital Corp. Secs. Litig., 84 F. Supp. 2d 933,
937 (M.D.Tenn. 1999) (To establish a prima facie case under Section 11, a plaintiff
need only show that he bought the security and that there was a material
misstatement or omission in the registration statement.).
136
See 15 U.S.C. 77k(b) (2000) (providing affirmative defenses to Section 11
defendants other than the issuer).
137
See id.
138
See id. 77k(a)(1)-(5).
either the whistle-blower defense 139 or the due diligence

defense. 140 Two defenses collectively make up the due diligence
defense: the reasonable investigation defense and the reasonable
reliance defense. 141 Thus, in order for a defendant to successfully
assert the due diligence defense, she must either show that she
conducted a reasonable investigation into the information contained
in the registration statement 142 or, with regard to misstatements or
omissions in expertized portions of the registration statement, that
she reasonably relied on an experts opinion or work product. 143
Under the reasonable investigation defense, a non-expert
defendant can escape liability with regard to any part of the
registration statement not purporting to be made on the authority of
an expert 144 if the defendant had, after reasonable investigation,
reasonable ground to believe and did believe, at the time such part of
the registration statement became effective, that the statements
therein were true and that there was no omission to state a material
fact. 145 The same standard for reasonable investigations applies to
expert defendants. 146 However, Section 11 provides an expert
defendant with an additional defense she can escape liability if the
misstatements or omissions in the registration statement did not
fairly represent [her] statement as an expert or was not a fair copy of
or extract from [her] report or valuation as an expert. 147
139
Id. 77k(b)(1), (2); see also HAZEN, supra note 35, ch. 7.4[1].
140
Id. 77k(b)(3). The due diligence defense is the most commonly used Section
11 defense.
141
Although both defenses collectively make up the due diligence defense, it is
common to refer to the reasonable investigation defenses as the due diligence
defense. This is because where a party is investigating, it is actually conducting
due diligence (i.e., it is affirmatively taking action) as opposed to relying on the
opinion of another. However, for the purposes of this article, I will refer to both
collectively as the due diligence defense and, where necessary, refer to the two
defenses separately as the reasonable investigation defense and the reasonable
reliance defense.
142
Id. 77k(b)(3)(A), (B) (treasonable investigation defenses for experts and non-
experts).
143
Id. 77k(b)(3)(C) (reasonable reliance on an expert defense).
144
Id. 77k(b)(3)(A). An example of an expert and its corresponding expertized
portion of a registration statement is the accountant and the audited financial
statements. See John Nuveen & Co., Inc. v. Sanders, 450 U.S. 1005, 1010 (noting
that the reasonable reliance provision in Section 11 exists because, almost by
definition, it is reasonable to rely on financial statements certified by public
accountants.) (Powell, J., dissenting).
145
15 U.S.C. 77k(b)(3)(A).
146
Id. 77k(b)(3)(B)(i).
147
Id. 77k(b)(3)(B)(ii).
The reasonable reliance defense applies to expertized

portions of the registration statement. 148 Under this defense, a
defendant can escape liabilityprovided that she was not an expert
involved in the preparation of the portion of the registration
statement at issueif she demonstrates that she had no reasonable
ground to believe and did not believe, at the time such part of the
registration statement became effective, that the statements therein
were untrue or that there was an omission to state a material fact. 149
2. What Constitutes Reasonable Due

Diligence?
As discussed above, determining what the plaintiff must

prove to establish her prima facie case is simple given Section 11s
strict language. 150 However, determining what the defendant must
prove in order to establish a due diligence defense is far less clear.
Specifically, what constitutes a reasonable investigation or
reasonable reliance? The statute provides a first step in answering
this question: the standard for reasonableness is that required of a
prudent man in the management of his own property. 151 However,
this is hardly a clear standard. As Richard Sauer noted, it is the
familiar standard of care imposed on a trustee under the common
law, and notoriously subjective. 152
In response to this problem the SEC enacted Rule 176,
Circumstances affecting the determination of what constitutes
reasonable investigation and reasonable grounds for belief under
section 11 of the Securities Act. 153 The rule sets forth a list of
factors a court may consider when making a reasonableness
determination. Pursuant to Rule 176, a court may consider, among
other things, [t]he type of issuer; 154 [t]he type of security; 155
[t]he type of person; 156 [t]he office held when the person is an
148
Id. 77k(b)(3)(C).
149
Id.
150
All the plaintiff must show is a material misstatement or omission to establish
[her] prima facie case. Herman & MacLean v. Huddleston, 459 U.S. 375, 382
(1983); see supra text accompanying note 127.
151
15 U.S.C. 77k(c) (2000).
152
Richard C. Sauer, The Changing Dimensions of Director Liability Under the
Federal Securities Laws, 37 SEC. REG. & L. REP. 413, 414 (2005) (emphasis added).
153
17 C.F.R. 230.176 (2006).
154
Id. 230.176(a).
155
Id. 230.176(b).
156
Id. 230.176(c).
officer; 157 [t]he presence or absence of another relationship to the

issuer when the person is a director . . .; 158 and [r]easonable
reliance on officers [and] employees . . . . 159 However, Rule 176
has failed to provide directors with clear guidance. First, it can be
considered or disregarded, and there is no requirement to give certain
factors greater weight than others. Moreover, the SEC did not intend
for the list to be exclusive, adding further uncertainty into the mix. 160
Second, many of the factors are notably vague. 161 For example, what
does it mean to consider the type of issuer, the type of security,
or the type of person?
What is more troubling is the lack of case law dealing with
the due diligence defenses. For roughly 35 years subsequent to the
enactment of the 1933 Act, not a single Section 11 due diligence case
was decided. 162 Escott v. BarChris Construction Corporation 163 was
the first; it commenced Section 11 jurisprudence with a stringent
standard of liability for directors. At the same time, however, the
BarChris court recognized that a case-by-case approach was
necessary when making a due diligence inquiry because not all
directors will be equally involved in a given offering. 164 The court
therefore adopted a flexible approach: what constitutes reasonable
due diligence depends largely on the degree of the defendants
involvement in the preparation of the defective registration
statement. 165
157
Id. 230.176(d).
158
Id. 230.176(e).
159
Id. 230.176(f).
160
Circumstances Affecting the Determination of What Constitutes Reasonable
Investigation and Reasonable Belief Under Section 11 of the Securities Act,
Securities Act Release No. 6335, Exchange Act Release No. 18,011, Investment
Company Act Release No. 11,889, 46 Fed. Reg. 42,015, at 42,021 (Aug. 18, 1981)
[hereinafter Reasonable Investigation and Reasonable Belief] (The explanation of
the specific circumstances in . . . [Rule 176] is not intended to be exhaustive . . . .);
Sauer, supra note 151, at 414 (The [SECs] implementing release makes clear that
th[e] list of relevant factors [in Rule 176] is not exclusive.).
161
See Sauer, supra note 152, at 414 (noting that [m]ost [of the factors] are
generic.).
162
See Escott v. BarChris Const. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968); Sauer,
supra note 152, at 414.
163
Id.
164
Id. at 684-701 (applying a case-by-case approach to the due diligence defense
asserted by each of the defendants).
165
Id. at 697 (It is impossible to lay down a rigid rule suitable for every case
defining the extent . . . [of a defendants due diligence]. It is a question of degree, a
matter of judgment in each case.).
For inside directorsthat is, directors with intimate

knowledge of corporate affairs and of the particular
transactions 166 this standard was intensified three years later by
Feit v. Leasco Data Processing Equipment Corporation. 167 The
court in Feit held that inside director liability approaches that of the
issuer as guarantor of the accuracy of the prospectus. 168 Pursuant to
the courts holding, inside directors are virtually strictly liable under
Section 11. 169 The court did note, however, that the due diligence
standard for outside directorsthat is, directors who do not have
intimate knowledge of corporate affairs and of the particular
transaction 170 was probably something less, though it did not state
what it was. 171
Following BarChris and Feit, courts began to put some meat
on the bones of the due diligence standard for outside directors. 172
For example, in Weinberger v. Jackson the court held that an outside
director is not obliged to conduct an independent investigation into
the accuracy of all the statements contained in the registration
statement . . . [and can] rely upon the reasonable representations of
management, if his own conduct and level of inquiry were reasonable
under the circumstances. 173 The types of conduct the court found to
be reasonable under the circumstances were: regular attendance at
board meetings and reasonable familiarity with the companys
business, operations, and financials. 174 In Laven v. Flanagan the
court similarly held that outside directors are under a lesser
obligation to conduct a painstaking investigation than an inside
director and, thus, may rely solely on representations of the
companys management, external auditors, or underwriters in order
to satisfy their due diligence defenses. 175 Taken together, Feit,
Weinberger, and Laven stand for the principle that outside directors,
166
Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 578 (E.D.N.Y.
1971).
167
See id. at 577.
168
Id. at 578.
169
170
See Feit, 332 F. Supp. at 578; see infra Part V.A. (discussing the actual
definition of outside director).
171
Id. at 577-78.
172
See, e.g., Weinberger v. Jackson, No. C-89- 2301-CAL, 1990 WL 26067 *4
(N.D. Cal. Oct. 11, 1990); Laven v. Flanagan, 695 F. Supp. 800, XXX (D.N.J.
1988).
173
Weinberger, 1990 WL 260676, at *4.
174
Id.
175
Laven, 695 F. Supp. at 812.
by virtue of their more limited role in the company, can satisfy their
due diligence defenses by doing what outside directors typically
doattend board meetings, review and understand company
financials, and rely on the representations by the various parties who
are intimately involved in company affairs.
The most recent pronouncement from the judiciary regarding
Section 11 due diligence comes from two decisions in the WorldCom
litigation. 176 In 2002, WorldCom announced a massive restatement
of its financials based on accounting irregularities. 177 A subsequent
investigation uncovered a fraudulent scheme implemented by a small
group of WorldComs senior executives for the purposes of
artificially inflating WorldComs stock price. 178 The scheme was
aimed at reducing WorldComs largest single operating expense: its
line costs. 179 Line costs represent the fees telecommunications
carrierssuch as WorldCompay to local third party providers for
the right to access the third parties networks. 180 Pursuant to
generally accepted accounting principles (GAAP), these line costs
are to be recorded as expenses. Instead of following GAAP,
however, WorldCom directed a sizeable portion of its line costs to its
capital accounts. 181 The net result of this practice was a reduction in
WorldComs line cost expense-to-revenue (E/R) ratioa financial
ratio used by Wall Street to measure telecommunication companies
operating performance, and one that appeared in the financial
statements incorporated by reference into WorldComs debt
securities shelf registration statementswhich made WorldCom
appear to be in a better financial condition than it was. 182
WorldComs financial woes eventually led to its demise and
a great deal of litigation thereafter. 183 Of relevance is the opinion by
176
See In re WorldCom, Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y.
2004); see In re WorldCom, Inc. Securities Litigation, 2005 WL 638268 (S.D.N.Y.
2005).
177
See generally In re WorldCom, 346 F. Supp. 2d at 635-55.
178
REPORT OF INVESTIGATION BY THE SPECIAL INVESTIGATION COMMITTEE OF THE
BOARD OF DIRECTORS OF WORLDCOM, INC. 9-12 (Mar. 31, 2003),
http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/worldcom/bdspcomm60903rpt.
pdf.
179
See In re WorldCom, Inc., 346 F. Supp. 2d at 640.
180
See Corrected First Amended Class Action Complaint at 34, In re WorldCom,
346 F. Supp. 2d 628 (No. 02-Civ-3288).
181
Id. at 35.
182
See In re WorldCom, 346 F. Supp. 2d at 640.
183
See, e.g., In re WorldCom, 2005 WL 638268 at *1 (The facts underlying
WorldComs [financial restatement] spurred numerous lawsuits).
Judge Denise Cote of the Southern District of New York in In re

WorldCom Securities Litigation, regarding Bert Robertss
(Roberts, the former chairman of WorldComs board) motion for
summary judgment based on Section 11s due diligence defenses. 184
In that case, the plaintiffs Section 11 claim stemmed from
WorldComs financial statements incorporated by reference into two
sizeable shelf offerings of WorldCom debt securities. 185
In denying Robertss motion for summary judgment, the
court held, as a matter of law, that WorldComs low E/R ratio
constituted a red flag. 186 This placed Roberts on inquiry notice
thereby foreclosing summary judgment based on the due diligence
defenses. 187 Thus, pursuant to the courts holding, the existence of a
red flag means that a directors due diligencethat is, the
directors reliance on an expert or investigation into the material
contained in unexpertized portions of the registration statementis
per se unreasonable at the summary judgment stage. This holding
represents a significant departure from the line of due diligence cases
previously discussed 188 for two reasons.
First, while those cases may differ on what constitutes
reasonable due diligence, they all share a common framework for the
reasonableness inquiry: a reasonableness determination involves a
fact intensive inquiry that must take into account the defendants
relationship to the issuer. According to the court in In re WorldCom,
however, the defendants relationship to the issuer is irrelevant
because the court declined to decide whether Roberts was either an
inside or outside director, but assumed for the purposes of its
analysis that he was an outside director. 189 The problem with this
holding, which will be elaborated below in Part V.A, is that inside
directors are virtually strictly liable under Section 11. 190
Second, the due diligence inquiry in all of the prior Section
11 cases was made at the summary judgment stage of the litigation.
Although the court in In re WorldCom, on a motion for summary
184
See In re WorldCom, 2005 WL 638268.
185
Id. at *1, 2.
186
Id. at *17.
187
See William K. Sjostrom, Jr., The Due Diligence Defense Under Section 11 of
the Securities Act of 1933, 44 BRANDEIS L.J. 549, 608-09 (2006) (suggesting a
smoking gun alternative to the red flag approach).
188
189
In re WorldCom, 2005 WL 638268, at *12; see infra Part V.A. (discussing why
this holding is problematic).
190
judgment, held that WorldComs low E/R ratio was a red flag, it also
held that the true red flag determination is inappropriate at the
summary judgment stage because it involves a fact intensive
inquiry. 191 The effect of this holding is that going forward the due
diligence defenses can be outflanked to the extent that a plaintiff
[can] credibly allege that a red flag existed that required the
defendants to make further inquiry. 192
V. THE PROBLEM WITH SECTION 11 LIABILITY FOR OUTSIDE

DIRECTORS IN THE CONTEXT OF EXPEDITED SHELF OFFERINGS
Holding an outside director to the same standard of due

diligence for an expedited shelf offering as an inside director imposes
an undue burden on industry and does not achieve any of the 1933
Acts objectives. Based on the previous discussion of Section 11
liability 193 and the purpose of the 1933 Act in general, 194 it might
seem that Section 11 was designed to provide an investor with a
remedy; that is not the case. Civil liability under [S]ection 11 . . .
was designed not so much to compensate the defrauded purchaser as
to promote enforcement of the Act and to deter negligence by
providing a penalty for those who fail in their duties. . . . [T]he
[1933] Act is more concerned with prevention than with cure. 195
Moreover, a principal aim of the 1933 Act was to deter directors
from spreading themselves too thin by taking multiple board
positionsdisabling them from providing meaningful service to any
or all of the companies on whose boards they sat. 196 As the Congress
noted in 1933:
The picture of persons, assumed to be responsible

for the direction of industrial enterprises, occupying
50 or more directorships of corporations is the best
proof that some change is demanded. Directors
191
In re WorldCom, 2005 WL 638268, at *11.
192
John C. Coffee, Jr., Due Diligence After WorldCom, N.Y. L. J., 5 (Jan. 20, 2005)
(discussing In re WorldCom, Inc. Securities Litigation, 346 F. Supp. 2d 628
(S.D.N.Y. 2004), the case in the WorldCom litigation dealing with the underwriters
motion for summary judgment based on the due diligence defenses).
193
See supra Part IV.B.
194
See supra Part II.
195
Globus v. Law Research Service, Inc., 418 F.2d 1276, 1288-89 (2d Cir. 1969).
196
See Allan Horwich, Section 11 of the Securities Act: The Cornerstone Needs
Some Tuckpointing, 58 BUS. LAW. 1, 10-11 (2002).
should assume the responsibility of directing and if

their manifold activities make real directing
impossible, they should be held responsible to the
unsuspecting public for their neglect. 197
However, Congress continued with a caveat:
But to require [directors] to guarantee the absolute

accuracy of every statement that they are called upon
to make, would be to gain nothing in the way of an
effective remedy and to fall afoul of the Presidents
injunction that the protection of the public should be
achieved with the least possible interference to
honest business. 198
Taken together, these two paragraphs evince Congresss intent to

impose civil liability on directors in order to deter them from
neglecting their duties to the corporations whose boards they sit on,
and also its intent to achieve this goal with the least possible
interference to honest business. 199 Imposing a stringent standard of
due diligence on an outside director in the context of a shelf offering
is contrary to this principle.
A. Digression: Who is an Outside Director?
As an initial matter, the question who is an outside

director? needs to be answered. 200 It might seem odd that this
question is being posed here; odd because the Section 11 cases
previously discussedBarChris, Feit, Weinberger, and Laven
distinguished between inside and outside directors in order to
determine whether the defendants have satisfied their due diligence
defenses. Thus, logic would suggest that courts must first defined
outside director before applying the law. However, this is not the
case. In both Weinberger and Laven, the courts simply stated that
197
H.R. REP. NO. 73-85, at 5 (1933).
198
Id.
199
Id.
200
See supra text accompanying note 169 (providing a cursory definition of outside
director, however, it was provided solely for the purposes of having a necessary
working definition in the previous discussion. A more searching discussion of
outside director for present purposes is necessary.).
the defendants were outside directors without discussing the issue

further. 201
Perhaps there is an explanation for this, albeit a semantic
one. It is likely that the courts in Weinberger and Laven were using
the term outside director synonymously with disinterested or
non-executive directorfamiliar corporate law terms used to
describe directors who are not also executives (or employees) of, or
have a financial interest in the company. Although the courts could
properly define outside director as above since the due diligence
inquiry necessarily takes into account the defendants relationship to
the issuer, a problem still remains because outside director is a
term of art under the securities code. (For example, defendants who
are found to have violated Section 11 are held jointly and severally
liable. 202 Outside directors, on the other hand, can only be held
severally liable for violations of Section 11 203 ). Therefore, a court
applying Section 11s due diligence defenses first needs to determine
whether a director defendant fits within the statutory term of outside
director. Of course, the problem is there is no statutory definition of
outside director. Congress has explicitly instructed the SEC to
adopt a definition but the SEC has failed to do so. 204 As the court in
In re WorldCom recognized:
The lack of a uniform understanding of who is an

outside director within the case law is exacerbated
by the SECs failure to promulgate its own definition
of inside and outside directors for the purposes of
Section 11, despite Congresss explicit instruction
201
Weinberger v. Jackson, No. C-89- 2301-CAL, 1990 WL 260676, at *4 (N.D. Cal.
Oct. 11, 1990) (noting that [d]efendant Valentine was an outside director, without
providing any further discussion); Laven v. Flanagan, 695 F. Supp. 800, 812 (D.N.J.
1988) (treating three director defendants [a]s outside directors, without explaining
why).
202
15 U.S.C. 77k(f)(1) (2000).
203
15 U.S.C. 77k(f)(2)(A) (2000) (cross-referencing 15 U.S.C.A. 78u-4(f),
proportionate liability under the PSLRA).
204
15 U.S.C.A. 78u-4(f)(10)(D) (the term outside director shall have the
meaning given such term by rule or regulation of the [SEC].). This does not mean
that Weinberger and Laven were wrong to not reference the lack of a statutory
definition. The distinction between outside and inside director for Section 11
purposes was established when PSLRA was enacted in 1995. Weinberger and Laven
were decided prior to that.
within the PSLRA that it define the term outside

director. 205
In sum, while it may be possible to identify an outside

director as synonymous with disinterested or non-executive
director, there is currently no statutory definition for who is an
outside director for Section 11 purposes? This is a significant
problem. As noted above, an inside director is virtually held strictly
liable under Section 11. 206 An outside director, on the other hand,
may successfully assert a due diligence defense to win a motion for
summary judgment. 207 However, if a court cannot determine
whether a director is an inside director or an outside one, defendant
will not be able to obtain a summary judgment, and the case will
likely settle; 208 a case-in-point is In re WorldCom. 209 Therefore it is
crucial for the SEC to take action and define outside director.
B. No Deterrence, Substantial Interference
An important concept to keep in mind is that Section 11 does

not aim to punish, but rather to ensure, with minimal interference,
that parties do not neglect their due diligence duties when issuing
securities. 210 Therefore, it is necessary to closely examine exactly
what outside directors do (i.e., what their duties are) or, perhaps more
precisely, what they do not do, before determining whether a
stringent standard of liability for outside directors is appropriate.
The role of outside director under Section 11 has been
widely viewed as that of a gatekeeper. 211 Although scholars
disagree as to the precise definition of gatekeeper, 212 a gatekeeper
205
In re WorldCom, supra note 175 at *10 [ In re WorldCom, Inc. Securities
Litigation, 2005 WL 638268 (S.D.N.Y. 2005) ] (citing 15 U.S.C. 78u-4(f)(10)(D)).
206
207
15 U.S.C. 77k(b)(3) (2000).
208
This is due in part to the tendency of securities class actions to settle. See Sauer
supra note 151, at 414.
209
See supra text accompanying note 187 (noting that the court declined to decide
whether Roberts was an inside or outside director).
210
211
See, e.g., John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of
Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 308 (2004).
212
See generally Lawrence A. Cunningham, Choosing Gatekeepers: The Financial
Statement Insurance Alternative to Auditor Liability, 52 UCLA L. REV. 413, 417
n.6 (2004) (discussing the various approaches scholars have taken in defining the
term gatekeeper).
is generally understood as one who looks over company

managements shoulder. 213 Different types of gatekeepers serve
different due diligence functions and at varying levels. For example,
accountants and underwriters are what I call institutional
gatekeepers by virtue of their strong reputational stake to certify or
bond the accuracy of an issuers disclosure. 214 These
institutional gatekeepers must vigorously play the role of skeptic
refusing to take managements representations about the true state of
affairs on face value. 215 Institutional gatekeepers are well situated
to perform this duty because they are well-trained professionals 216
who derive sizeable income from performing gatekeeping functions.
On the other hand, outside directors role as a gatekeeper is
considerably more passive; it is best understood as a corollary of the
duty of inquire and to monitor 217 under state law, collectively. 218
Pursuant to these duties, outside directors are required to oversee
the conduct of the corporations business, take reasonable steps to
keep abreast of the information that flows to the board as a result of
the oversight, and follow up reasonably on information that has
been acquired and should raise cause for concern. 219
However, outside directors ability to monitor is constrained
by several factors. As a number of leading corporate law professors
have noted, outside directors typically rely on otherssuch as
underwriters, inside directors, officers, and accountantsfor
information. Thus, by the time an outside director gets her hands on
information that is to be disclosed in a registration statement, and
213
Langevoort, supra note 14, at 58 (citing Escott v. BarChris Const. Corp., 283 F.
Supp. 643 (S.D.N.Y. 1968)). For an in depth discussion on the definition of
gatekeeper see John C. Coffee, Jr., Gatekeeper Failure and Reform: The
Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 308-311 (2004).
214
Langevoort, supra note 14, at 58.
215
Id.
216
Donald C. Langevoort, Seeking Sunlight In Santa Fes Shadow: The SECs
Pursuit Of Managerial Accountability, 79 WASH. U. L. Q. 449, 485 (2001).
217
In fact, it has been argued that the role of the outside director of a public
company can best be described as that of a securities monitor. Hillary A. Sale,
Independent Directors as Securities Monitors, 61 BUS. LAW. 1375 (2006).
218
Professor Melvin Eisenberg has described the duty of corporate directors as a
moral obligation to exercise care in the performance of ones role . . . . This moral
obligation is an aggregate comprised of four relatively distinct duties: (1) the duty . .
. to monitor . . . ; (2) the duty of inquiry . . . ; (3) the duty to employ reasonable
decision making processes; and (4) the duty to make reasonable decisions. Melvin
A. Eisenberg, The Duty of Care of Corporate Directors and Officers, 51 U. PITT. L.
REV. 945, 948 (1990).
219
Id.
assuming this information is materially misleading, the negligence,

recklessness, or fraud involved would have already occurred. This
puts the outside director in a worse position to discover the flaw than
if she were an insider. Therefore, an outside director is in a worse
position to discover the flaw than an insider. 220 As cogently
expressed by Professor Laura Lin,
[i]n light of managements control over information,

. . . outside directors merely receive selective
information that would support managements
desired position on [a] matter. As a result, instead of
acting as a check against potential managerial
indiscretion, outside directors may see major issues
confronting the corporation through managements
eyes. 221
In additional to their deficient access to information, outside

directors lack the time to do more than review . . . business
decisions. 222 According to one industry survey, most companies
conduct just six board meetings per year, with each meeting lasting
only three to five hours. 223 Further, Professor Stephen Bainbridge
has observed that most outside directors have full-time employment
elsewhere, which commands a bulk of their attention . . . . 224
Given all these constraints, it should be clear that outside
directors play a very small role . . . in a public offering vis--vis the
other participants. 225 How does the imposition of a stringent due
220
See Stephen M. Bainbridge, A Critique of the NYSEs Director Independence
Listing Standards, 30 SEC. REG. L.J. 370, 389 (2002) (noting that outside directors
dependence on management for information is a factor that impede[s] an
independent director from monitoring management); Larry E. Ribstein, Market vs.
Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of
2002, 28 J. CORP. L. 1, 26 (2002) ([Outside directors] must depend on insiders for
critical information.); Laura Lin, The Effectiveness of Outside Directors as a
Corporate Governance Mechanism: Theories and Evidence, 90 NW. U. L. REV. 898,
914 (1996).
221
Lin, supra note 217, at 914.
222
Ribstein, supra note 217, at 26.
223
THE CONFERENCE BOARD, DIRECTORS COMPENSATION AND BOARD PRACTICES IN
2006 22 (2006) (emphasis added).
224
Bainbridge, supra note 217, at 388
225
Donald C. Langevoort, The Reform of Joint and Several Liability under the
Private Securities Litigation Reform Act of 1995: Proportionate Liability,
Contribution Rights and Settlement Effects, 51 BUS. LAW. 1157, 1164 (1996); see
diligence standard under Section 11 deter outside directors from

negligently performing such a limited function? I argue that it does
not; and I emphatically argue that it specifically does not in the
context of a shelf offering. To illustrate, let us now revisit shelf
offerings while thinking about outside directors limited role in such
an offering.
As noted in Part III.B, the time-frame of a shelf offering as
compared to that of an IPO has been substantially condensed. A
typical IPO involves a considerable amount of due diligence by all
parties involved, including inside and outside directors, underwriters,
accountants, and lawyers. 226 The entire process generally takes
between three and six months to complete. 227 During this time,
outside directors will certainly be aware of the IPO and are likely to
be involvedif not intimately involvedin the offerings due
diligence. Thus, Section 11 liability in this context might deter
outside directors from neglecting their due diligence obligations.
Shelf offerings (or shelf takedowns), on the other hand, are truly
high velocity transactions. Assuming that no post-effective
amendment [is] needed, the issuer [can] decide that the time [is] ripe
for [a] takedown, obtain bids from underwriters and sell the
securities, all within a day or two. 228 It is unlikely that an outside
director will have any time to conduct due diligence in this
condensed time-frame; however, it is likely that an outside director
will not even be aware that the company is conducting a shelf
offering. Consequently, outside directors may not responsible for
conducting any due diligence in an expedited shelf offering. This is
necessarily the case when the issuer is a WKSI because there is no
time to conduct due diligence in a WKSI shelf offering. 229
Therefore, Section 11 liability for outside directors in this context
also Langevoort, supra note 14, at 56 (noting the limited involvement outside
directors have in public offerings).
226
See RICHARD W. JENNINGS & HAROLD MARSH, JR., SECURITIES REGULATION:
CASES AND MATERIALS 129-33 (6th ed. 1987) (discussing the preparation of a
registration statement for an IPO); CHARLES J. JOHNSON, JR. & JOSEPH MCLAUGHLIN,
CORPORATE FINANCE AND THE SECURITIES LAWS 331-74 (3d ed. 2004) (providing an
in-depth look at the due diligence procedures in an IPO).
227
Stacy J. Kanter, Deciding Whether to go Public: Certain Basic Considerations,
1328 PLI/CORP. 9, 12 (2002).
228
JAMES D. COX ET AL., SECURITIES REGULATION: CASES AND MATERIALS 198 (5th
ed. 2006) (emphasis added) (discussing market windows for shelf offerings).
229
See Coffee, supra note 97 (Prior to the adoption of the rule for WKSIs, directors
had very little time between the filing and the offering to conduct due diligence;
after it, those associated with . . . [WKSIs] have none. (emphasis added)).
serves no deterrent value because the shortened time frame renders it

impossible for outside directors to conduct any due diligence, let
along do it negligently.
Thus, while it may be reasonable to impose elevated due
diligence requirements on outside directors in the context of an IPO,
it is untenable to presume that an outside director will likewise be in
a position to conduct meaningful due diligencethat is, in order to
win on a motion for summary judgment based on a Section 11 due
diligence defensein the condensed time-frame of a shelf offering.
This conclusion is consistent with the SECs interpretation of what
constitutes a reasonable investigation or reasonable reliance. When it
proposed Rule 176, 230 the SEC noted, Congress intended that there
would be a variation in the thoroughness of the investigation
performed by the different persons subject to Section 11 liability
based on the importance of their place in the scheme of
distribution. 231 Further, the SEC included subsection (e) 232 in Rule
176 to clarify that a director who has another relationship with the
issuer involving expertise, knowledge or responsibility with respect
to any matter giving rise to the omission or misstatement will be held
to a higher standard of investigation and belief than an outside
director with no special knowledge or additional responsibility. 233
In addition to not serving any deterrent value, requiring an
outside director to perform due diligence at the level of an insider
constitutes a considerable interference with business practice,
running afoul of the 1933 Act. 234 In re WorldCom serves as a good
illustration of this notion. As discussed, the court denied Robertss
motion for summary judgment for failing to make further inquiry
into WorldComs declining E/R ratio. 235 If outside directors were
required during an expedited shelf offering to scrutinize carefully
every financial ratio in order to avoid Section 11 liability, this due
diligence would impede the offering process. The whole purpose of
230
17 C.F.R. 230.176 (2006).
231
Reasonable Investigation and Reasonable Belief, supra note 159, at 408 (internal
quotation marks omitted).
232
Rule 176(e) states that a relevant circumstance a reviewing court should take into
consideration when making a reasonableness determination is [t]he presence or
absence of another relationship to the issuer when the person is a director or
proposed director. 17 C.F.R. 230.176(e).
233
Reasonable Investigation and Reasonable Belief, supra note 159, at 408
(emphasis added).
234
235
In re WorldCom, supra note 175 at *11-12.
the expedited shelf offering process is to take advantage of the

expedited process. 236
C. Proposed Solution: Section 11 Safe Harbor
1. The Business Judgment Rule and a Section 11

Safe Harbor
The previous section outlined the problems with holding an

outside director to the same standard of liability as an insider. This
section proposes a solution to this problem by applying Professor
Lynn Stouts 237 economic and behavioral defense of the business
judgment rule, a state law doctrine, to the Section 11 due diligence
process. The business judgment rule is a presumption that in
making a business decision, the directors of a corporation acted on an
informed basis, in good faith and with the honest belief that the
action taken was in the best interests of the company 238 In essence,
this rule presumes that the directors acted with due care. This
presumption prohibits judges from reviewing director decisions if,
when making those decisions, the directors followed certain
procedures in informing themselves of all material information
surrounding the given matter. 239 The rule is recognition that judges
are ill-equipped to second guess, after the fact, the reasonableness of
a boards decision.given the extraordinarily complex business
world. 240
In this section, I argue that a standard of review similar to the
business judgment rule should apply to the outside director under a
Section 11 due diligence scheme. Outside directors should be
shielded from liability if they follow certain procedures in informing
themselves of material information when conducting due diligence.
236
237
Stout, supra note 23, at XXX
238
Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985) (emphasis added) (internal
quotation marks omitted).
239
See id.
240
Stout, supra note 23, at 681; See Daniel R. Fischel, The Business Judgment Rule
and the Trans Union Case, 40 BUS. LAW. 1437, 1441 (1985) (Allowing
shareholders to challenge business decisions on the basis that they were not
informed has the effect of substituting the business judgment of . . . [judges] on the
issue of how much information should be acquired for the business judgment of
those entrusted, by virtue of their superior expertise and incentives, with managing
the firm's affairs.)
As will be developed below, such a process of due care solves the

deterrence and interference problems described above.
In her article, In Praise of Procedure: An Economic and
Behavioral Defense of Smith v. Van Gorkom and the Business
Judgment Rule, 241 Professor Stout argues that the efficacy of the
business judgment rule lies in its process due care requirements. She
begins her analysis by presenting the two most common critiques of
the business judgment rule. The first critique is that by shielding
directors from liability for failing to follow process due care, the
business judgment rule does not discourage director carelessness.
This is because so long as directors followed the requisite procedures
in making a business decision, the director is protected regardless of
how foolish the decision was. The second critique is that the
business judgment rule only encourages directors to adopt elaborate
and costly decision-making routines. 242
Professor Stout challenges these critiques and defends the
business judgment rules process due care requirement by applying
behavioral and economic theory in the context of the corporate
boardroom.. She premises her argument on two basic assumptions:
(1) a behavioral assumption that corporate directors try to do the
right thing to serve the best interests of the firm and its
shareholders, 243 and (2) an economic assumption that this desire to
do the right thing decreases as the amount of personal sacrifice
involved increases. 244 The business judgment rules process due care
requirements (which would shield from liability directors who
inform themselves of all material information before they make a
decision) operate to reduce the marginal personal sacrifice associated
with doing the right thing. 245
In particular, the business judgment rule can reduce

an altruistic directors cost of comprehension (that
is, the cost of finding out what is going on at the
firm and what available courses of action and
likely consequences might be) and also can reduce
a directors cost of confrontation (that is, the cost
241
Stout, supra note 23, at 676.
242
Id. at 676.
243
Id. at 683.
244
Id. at 686. ([W]hen plotted as a function of personal cost, the supply of
altruistic behavior is downward sloping. The higher the price of behaving
altruistically, the less altruism supplied.).
245
Id. at 678.
of demanding more information from management

or challenging a management-recommended course
of action). 246
Thus, as these costs are reduced, directors become more likely to do

the right thing which, in turn, provides a benefit to the shareholders.
To illustrate, it is necessary to conduct a closer examination
of these two types of coststhe cost of comprehension and
confrontation. First, the business judgment rule reduces a directors
marginal cost of comprehension by rewarding her with a shield from
liability provided that she follow certain procedures in becoming
informed of material information, including reading reports, listening
to presentations, asking questions, and hearing answers. 247 Outside
of this, the only extra effort the director must make is to think. 248
Thus, because the directors marginal personal sacrifice associated
with thinking is low, she is likelybecause she is motivated to do
the right thingto be altruistic and think. Second, the business
judgment rule reduces a directors marginal cost of confronting
company management.
The rule does this by giving a director an

independent reason for asking questions and
demanding further informationin other words, a
reason other than pure distrust. In effect, it allows a
director to say to the CEO: Its not that I doubt
your judgment. Its just that to protect myself, I
must know all the facts. 249
If we accept Professor Stouts argument, a solution to the

problem of Section 11 liability for outside directors in the context of
shelf offerings begins to emerge. Put simply, is not the business
judgment rules procedural requirement that outside directors inform
themselves before making a decision just a different way of saying,
outside directors must conduct due diligence? Recall that outside
director due diligence consists of attending board meetings,
reviewing and understanding company financials, and relying on the
representations by the various parties who are intimately involved in
246
Id.
247
Id. at 689.
248
Id.
249
Id. at 690.
company affairs. 250 This is precisely what the business judgment

rule requires. In fact, the SEC itself has stated that outside directors,
in order to adequately provide protection to shareholders, must
become reasonably well informed. 251 Moreover, both Section
11 252 and the duty of care (and the business judgment rules
corresponding shield from liability for breaches of it) 253 attempt to
impose liability in order to deter director carelessness, without
causing undue interference with honest business practices. Thus,
because process due care is essentially the same as Section 11 due
diligence, and because Section 11 liability and the duty of care are
both aimed at preventing the same type of harm (i.e., director
carelessness), Professor Stouts analysis fits comfortably within the
Section 11 due diligence scheme.
The solution to the problem outlined in Part V.B thus
becomes clear: in the context of an expedited shelf offering, instead
of requiring an outside director to carefully scrutinize every financial
ratio to avoid liability (as was the case in In re WorldCom), the SEC
should adopt a business judgment rule-like safe harbor for outside
directors who follow the requisite procedures in informing
themselves. This strikes the most efficient balance between the need
to impose liability for issuing materially misleading information, and
the desire to do so with the least possible interference with honest
business practices. As opposed to imposing a draconian standard of
liability that accomplishes little in deterrence, the reward of a
business judgment rule-like safe harbor for outside directors would
250
251
Sale, supra note 214, at 1382 (quoting Report of Investigation in the Matter of
Stirling Homex Corporation Relating to Activities of the Board of Directors of
Stirling Homex Corporation, Exchange Act Release No. 34-11516, 7 SEC Docket
298, 300 (July 2, 1975)); see also id. (Outside directors are required to accept the
responsibility affirmatively to keep themselves informed of developments within the
company . . . . (emphasis added) (quoting Report of Investigation in the Matter of
National Telephone Co., Inc., Relating to Activities of the Independent Directors of
National Telephone Co., Inc., Exchange Act Release No. 34-14380, 13 SEC Docket
1393 (Jan. 16, 1978)).
252
A primary purpose of Section 11 was to deter director carelessness with the least
possible interference with honest business. See supra text accompanying notes 193-
97.
253
The business judgment rule recognizes that judges are ill-equipped to second
guess director decisions. However, courts will impose liability where a director was
grossly negligent in failing to inform herself of all material information. See supra
text accompanying notes 235-37.
enable them to conduct meaningful due diligence by reducing the

marginal personal sacrifice associated with it. 254
2. Possible Criticism
Critics of providing a safe harbor for outside directors would

perhaps point to the SECs repeated refusal to adopt a similar safe
harbor for underwriters. 255 In declining to grant a safe harbor for
underwriters in shelf offerings, the SEC stated, In view of the
compressed preparation time and the volatile nature of the capital
markets, underwriters may elect to apply somewhat different, but
equally thorough, investigatory practices and procedures to
integrated registration statements. 256 However, there is a marked
difference between underwriters due diligence and outside directors
due diligence. Underwriters, as institutional gatekeepers, can self-
insure the risk associated with Section 11 liability by raising their
fees across-the-board. 257 The premium clients pay for underwriters
services, which then operates as a pool of insurance money that can
be used for funding Section 11 losses. Moreover, underwriters have
the resources to invest in sophisticated systems in order to adjust
their due diligence for the rapid nature of shelf offerings.
Outside directors, on the other hand, cannot avail themselves
of these protective methods. First, outside directors can not self-
insure Section 11 risk. In order to self-insure, outside directors
would have to obtain multiple board positions, and at increased
salaries. This is hardly possible and certainly undesirable. Indeed, as
noted, one of the primary purposes of the 1933 Act was to deter
directors from assuming multiple board positions. 258 Second,
although it may be possible for outside directors to put 1933 and
254
Recommending what procedural requirements should appear in a Section 11 safe
harbor is outside the scope of this article. One prominent securities scholar has put
forth some possible requirements of a safe harbor for outside directors. See Coffee,
supra note 97.
255
See Adoption of Integrated Disclosure System, Securities Act Release No. 6383,
[Transfer Binder] Fed. Sec. L. Rep. (CCH) 72,328, at 11,399 n.98 (Mar. 3, 1982)
(noting that the SEC refused to adopt a safe harbor for underwriters in lieu of Rule
176).
256
Reasonable Investigation and Reasonable Belief, supra note 159, at 406
(emphasis added).
257
See Coffee, supra note 97 (noting that underwriters, unlike outside directors, can
self insure the risk of Section 11 liability).
258
1934 Act compliance programs in place 259 in order to review the

1934 Act reports that get incorporated by reference into shelf
registration statements, outside directors access to information is
still defective based on their role in the scheme of distribution. 260
Admittedly, if there existed a compliance program sophisticated
enough to detect red flags then perhaps outside directors, like
underwriters, could perform shelf offering due diligence that is
different from, but still equally thorough as IPO due diligence.
D. No Fraud? No Problem: Perverse Incentives

Without a Safe Harbor
It is widely assumed that outside directors have relatively

little to fear on the merits of a Rule 10b-5 fraud-on-the-market
action. 261 This is due in large part to the considerable procedural
hurdles of a 10b-5 action. The highest, of course, is the scienter
standard for pleading fraud. 262 Because outside directors are less
likely than their inside director counterparts to have the requisite
knowledge of the misstatement or omission required to meet the
pleading standard, 263 they are rarely sued in securities fraud class
actions. 264
259
Indeed, pursuant to the duty to monitor discussed above, one of the functions of
outside directors is to oversee the conduct of the corporations business, and take
reasonable steps to keep abreast of the information that flows to the board as a result
of the oversight. Supra note 216 and accompanying text. Putting a compliance
program in place has been recognized by the Delaware Supreme Court as part of
the duty to monitor. See In re Caremark Intl, Inc. Derivative Litigation, 698 A.2d
959, 970 (Del Ch. 1996) ([I]t would . . . be a mistake to conclude that . . . corporate
boards may satisfy their . . . duty to monitor, without assuring themselves that
information and reporting systems exist in the organization that are reasonably
designed to provide . . . to the board timely, accurate information sufficient to allow .
. . the board . . . to reach informed judgments concerning the corporations
compliance with law . . . .).
260
See supra text accompanying notes 214-21 (discussing the inability of outside
directors to fill a gatekeeping role to the same degree of thoroughness and
effectiveness as an institutional gatekeeper).
261
Donald C. Langevoort, The Human Nature of Corporate Boards: Law, Norms,
and the Unintended Consequences of Independence and Accountability, 89 GEO. L.J.
797, 822 (2001).
262
263
Sale, supra note 214, at 1389.
264
John C. Coffee, Jr., Reforming the Securities Class Action: An Essay on
Deterrence and Its Implementation, 106 COLUM. L. REV. 1534, 1549 (2006).
Section 11s pleading requirements, unlike Rule 10b-5

requirements, place a relatively minimal burden on a plaintiff. With
In re WorldCom in place as the most current Section 11 case, outside
directors have virtually no due diligence defense. As discussed, the
due diligence defenses can be outflanked to the extent that a
plaintiff [can] credibly allege[] that a red flag existed that required
the defendants to make further inquiry. 265 Given the scarcity of
published Section 11 due diligence opinions, 266 this holding is likely
to have wide influence and long lasting force. Thus, going forward,
plaintiffs will likely pursue Section 11 claims to take advantage of its
lenient pleading requirements. 267 This scenario should be troubling
mostly because of its likelihood: shelf registration statementsvis-
-vis the incorporation by reference featurecontain the same
information a plaintiff would use to assert a Rule 10b-5 claim. In
other words, both causes of action rest on the same set of facts.
VI. CONCLUSION
It has been long assumed that outside directors had little (if
any) liability under Section 11. Because of this, previous scholarship
on Section 11 due diligence focused on softening the standard for
underwriters as opposed to outside directors. However, In re
WorldCom has significantly altered the Section 11 landscape and
calls into question the assumption that outside directors are subject to
minimal liability. This article reflects the debate that will ensue
concerning outsider directors in the aftermath of WorldCom. The
article began by discussing the problem with holding outside
directors to the same standard of due diligence as insiders, given that
the stringent standard applied for insiders arguably does not serve
any deterrent value when applied to outsiders. Such stringent
standards may actually operate as an undue interference with normal
business practice. This article proposes a reasonable solution to this
265
Coffee, supra note 190.
266
See supra Part IV.B.2.
267
Of course, some jurisdictions require the plaintiff to meet Federal Rules of Civil
Procedure Rule 9(b)s particularity requirements for claims that sound in fraud.
See supra text accompanying footnotes 130-32. However, this does not mean a
plaintiff will not sill be incentivized to bring a Section 11 claim. First, not all
jurisdictions follow the sounds in fraud rule. See supra text accompanying notes
133-34. Second, a Rule 10b-5 claim requires the plaintiff to plead scienter which, as
discussed, carries a more burdensome standard than regular fraud pleading under
Rule 9(b). See text accompanying notes 115-18.
problem: construction of a Section 11 safe harbor modeled off of the

business judgment rule. The reward of this rule is that it will shield
from liability outside directors who inform themselves of all material
information surrounding an offering. This proposed rule incentivizes
outside directors to conduct meaningful due diligence by reducing
the marginal personal sacrifice associated with conducting such due
diligence.

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2007 OUTSIDE DIRECTOR LIABILITY FOR SHELF OFFERINGS 345

NO FRAUD? NO PROBLEM: OUTSIDE DIRECTOR

II. Background on the Securities Act of 1933 and the Securities

III. Shelf Offerings and the Integrated Disclosure System... 352

IV. Principal Civil Liability Provisions of the Securities

V. The Problem with Section 11 Liability for Outside Directors in

VI. Conclusion.................................................................. 385

The strictest law often causes the most serious wrong.

The Securities Act of 1933 (1933 Act) and the Securities

from neglecting their duties. However, when it enacted the 1933

Litigation, 15 the most recent caseand probably most important in

omissions in a registration statement). Thus, Section 11 claims will

II. BACKGROUND ON THE SECURITIES ACT OF 1933 AND THE

Prior to the stock market crash of 1929 and the Great

trading on an open exchange, while the 1933 Act deals primarily

requirements pick up where the 1933 Acts disclosure requirements

III. SHELF OFFERINGS AND THE INTEGRATED DISCLOSURE

This article focuses on outside director liability under the

A. The Integrated Disclosure System

Under the old system, issuers were required to comply with

pointed out that the majority of information companies were required

B. Shelf Registration and Offerings

In theory, when offering their shares to the public, issuers

securities laws is to protect investors by imposing disclosure obligations on issuers.

becomes effective. However, in reality issuers often offer only a

effectively prohibited shelf registration by proscribing the

change to the information contained in it. 71 Consequently, a shelf

quality of information disseminated to investors. 80 Hence, the SEC

issuer may pre-register debt, equity and other classes of securities

sell securities in an immediate takedown on the same day. 98 What

IV. PRINCIPAL CIVIL LIABILITY PROVISIONS OF THE

This section of the article discusses the most significant civil

A. Rule 10b-5 of the Securities and Exchange Act of

As mentioned above, 102 the 1934 Acts central focus is

referred to as a fraud-on-the-market action); 112 and any oral or

B. Section 11 of the Securities Act of 1933

Section 11 120 of the 1933 Act was designed to assure

were involved in the preparation. 123 In addition to being more

1. Section 11s Due Diligence Defenses

The issuer of securities is strictly liable under Section 11 for

either the whistle-blower defense 139 or the due diligence

The reasonable reliance defense applies to expertized

2. What Constitutes Reasonable Due

As discussed above, determining what the plaintiff must

officer; 157 [t]he presence or absence of another relationship to the

For inside directorsthat is, directors with intimate

Judge Denise Cote of the Southern District of New York in In re

V. THE PROBLEM WITH SECTION 11 LIABILITY FOR OUTSIDE

Holding an outside director to the same standard of due

The picture of persons, assumed to be responsible

should assume the responsibility of directing and if

However, Congress continued with a caveat:

But to require [directors] to guarantee the absolute

Taken together, these two paragraphs evince Congresss intent to

A. Digression: Who is an Outside Director?

As an initial matter, the question who is an outside

the defendants were outside directors without discussing the issue

The lack of a uniform understanding of who is an