When Worlds Collide: Transfer Pricing Tax Strategies and the Securities Laws

Oren Amram



            In today’s global economy, multinational reporting companies[1]  routinely implement sophisticated, profit-boosting transfer pricing tax strategies.[2]  Nonetheless, the accounting methods, details and underlying assumptions, and an analysis of the degree of reliability underlying such tax strategies are not commonly disclosed to investors through external financial reporting.  Rather, companies often burry the details under general disclaimers regarding the risk of adjustment that may result from an IRS audit.  In recent years, however, “the accounting and reporting of income taxes has received increased scrutiny by investors, analysts, Congress and others.”[3]  This paper examines the significance of making meaningful transfer pricing disclosures under the reporting requirements of the securities laws.   The paper kicks off with a motivating hypothetical from which the discussion throughout is developed.  Part I lays out the basics of transfer pricing with the goal of exposing the magnitude and unique nature of the financial uncertainty involved.  Part II examines whether certain disclosure scenarios are in compliance with the securities laws.   Part III highlights the need for SEC mandated transfer pricing disclosure standards, and identifies the nature of transfer pricing disclosures that companies should proactively strive to make under the securities laws.


Motivating Hypothetical


Domestic parent company USCO owns foreign subsidiary CaymanCo located in the Cayman Islands.  USCO produces laptop computers in the US and sells them to CaymanCo, which then distributes the computers to third-party customers all over Europe.  The US and Cayman tax rates on corporate income are 35% and 0% respectively.  CaymanCo operates a sophisticated distribution facility with 350 employees, assumes full risk if the goods are damaged during inbound and outbound shipment, and utilizes an advanced supply chain software system to market and distribute the computers.  For simplicity, all prices are analyzed in US dollars. 

USCO sells each laptop to CaymanCo for $100.  USCO’s total cost of goods sold (“COGS”) [4] for each laptop is $50.  Accordingly, USCO reports taxable income of $50/computer, which is then taxed in the US at the US 35% rate.  Meantime, CaymanCo sells each laptop to its European customers for $1,000.  In addition to its $100 COGS/computer representing its costs to purchase from USCO, CaymanCo incurs insurance expenses, payroll expenses, and a variety of overhead expenses totaling $400.  Accordingly, its total cost assigned to each computer is $500.  Because it sells the laptops at $1,000, CaymanCo realizes taxable income of $500/computer, taxed in the Cayman Islands at the Cayman 0% tax free rate.

For financial reporting purposes, CaymanCo’s net profits are consolidated into USCO’s financial reports filed with the Securities and Exchange Commission (“SEC”) in accordance with Generally Accepted Accounting Principles (“GAAP”).  Accordingly, USCO reports in its Form 10K annual report to shareholders an after-tax profit of $482.50/computer, which consists of the $500/computer realized by USCO through CaymanCo sales, less US taxes of $17.50 (35% of the initial $50 transfer pricing profit on sale from USCO to CaymanCo).  USCO neither incurs nor reports any taxes paid in connection with CaymanCo profits of $500/computer.

Part I


Today, tax departments across corporate America play an important role in the company’s overall profitability.[5]  In fact, because the investment community exerts enormous pressures on executives to achieve earnings targets,[6] corporate managers are increasingly utilizing tax departments as another means of meeting targets.[7]   Transfer pricing is perhaps the most rewarding means of profit-boosting tax avoidance.[8]  Indeed, given the magnitude of cross border trade between the United States and foreign countries,[9] transfer pricing is a major component of any multinational’s overall tax strategy; companies commonly employ substantial human, technological, and other resources to design best-in-class transfer pricing strategies that most effectively shift profits from high tax to low tax jurisdictions.[10]

Although sophisticated sounding, the term transfer pricing essentially refers to the allocation of related-party income among taxing jurisdictions.  The “transfers” that are “priced” are purchases and sales by business entities under common control.  A high price means that the transferor books higher taxable income and the transferee books lower taxable income.  A low price means the opposite.  Transfer pricing is thus nothing more and nothing less than a term of art describing the internal accounting costs assigned to an exchange of goods, services, or intangibles between commonly controlled foreign and domestic entities.  Although these internal accounting costs wash out for external reporting under GAAP, a well-crafted pricing strategy ultimately reduces the company’s overall tax liability by diverting taxable income offshore.  

 As the Enron debacle[11] illustrates, however, modern corporate climate for tax departments encourages aggressive or even fraudulent tax planning.[12]   To illustrate the potential magnitude of such planning, in the context of our motivating hypothetical, USCO’s transfer pricing strategy allows it to defer $175/computer (35% of $500) in US taxes through shifting $500/comptuter of income offshore to CaymanCo.  The income shifted is thus reported to investors in USCO’s consolidated financial statements on a tax free basis.  As a result, assuming for instance that USCO sells one million computers annually, it will recognize $500 million in profits without having to recognize $175 million in taxes on those profits.  Essentially, the strategy allows USCO to report $500 million of tax free income! 

As attractive as the numbers may seem, however, the validity of any transfer pricing strategy turns on whether the income at issue is legitimately rather than artificially shifted offshore.[13]  If the income is artificially shifted offshore, then the IRS can reallocate that income, thereby retroactively increasing USCO’s previously reported tax liability and lowering its net profits.  As discussed below, whether the IRS determines that income was shifted artificially depends on whether USCO’s sales to CaymanCo for $100/computer represents the equivalent of an arm’s length transaction under the specifications of I.R.C. § 482.[14]  

Section 482

Section 482 is intended to prevent commonly controlled entities from shifting taxable income from high tax to low tax jurisdictions by charging each other artificial prices.   It authorizes the IRS to reallocate gross income, deductions, credits, and other transactions among two or more related entities in order to prevent evasion of taxes or to reflect clearly the economic realities of the entities’ taxable income.[15]  Accordingly, it forces companies to report taxable income by pricing transactions between commonly controlled taxpayers like comparable transactions between uncontrolled[16] taxpayers dealing at arm’s length, thereby yielding results consistent with unrelated taxpayers engaged in the same transaction under similar circumstances. 

There are three prerequisites to an IRS tax reallocation under § 482: (1) two or more entities, (2) common ownership or control, and (3) an IRS determination that a reallocation is necessary.[17]  In the motivating hypothetical, the first two elements are obviously satisfied because both USCO and CaymanCo are under 100% common ownership.  With respect to the third element, the IRS may make a reallocation whenever the taxable income of a controlled taxpayer differs from what it would have been had the taxpayer been dealing at arm’s length with an unrelated taxpayer using the reconstruction methods under § 482.  However, a § 482 adjustment need only be made if the IRS determines that the results reported by the taxpayer fall outside a range of reliable results, called the “arm’s length range,”[18] which is derived from analyzing all uncontrolled comparables meeting the criteria developed below.

Although the regulations provide different methods for applying the arm’s length standard to different transactions,[19] the best method must be used.[20]  Under the best-method rule, the company must select the method that is the most reliable measure.[21]  The most reliable measure turns on the degree of comparability between the controlled and uncontrolled transactions used in applying the method, and the quality of data and assumptions underlying the method’s application.[22]  The degree of comparability ultimately depends on the functions performed by the parties, the risks undertaken, the contractual terms, the economic conditions, the nature of the goods or services that are subject to the transaction, and all other factors that could potentially affect prices or profits in arm’s length dealings.[23]  The comparable transactions used in applying the analysis need not be identical, but must be at least substantially similar.[24]    

The Methods

Focusing on sales of tangible property,[25] as in USCO’s case, the following methods may be used:[26] first, under the comparable uncontrolled price method (“CUP”),[27] the arm’s length price is the sales price in a comparable uncontrolled transaction.  Under the best method rule, the CUP method is generally the best method if there are no differences between the controlled and uncontrolled transactions that would affect price or if there are minor differences that could be adequately adjusted for.[28]  USCO would likely apply this method because there should be many substantially similar uncontrolled laptop sales transactions in the market.  Second, under the resale price method,[29] the arm’s length price for a sale between controlled taxpayers is the price at which the goods are resold by the buyer (or CaymanCo in this case) to uncontrolled persons, less a gross profit comparable to that earned by an uncontrolled distributor.  Because this method measures the value of distribution functions, it is appropriate only for entities that buy and resell goods without adding substantial value.[30]  Thus, because CaymanCo adds substantial value under the motivating hypothetical, USCO should not use this method. 

Third, under the cost plus method,[31] the arm’s length price is the sum of the seller’s cost of goods sold and a gross profit markup determined from comparables.  This method could be applied by USCO but it is inferior to the CUP method because the rules favor application of CUP over all other methods where substantially similar comparable uncontrolled sales data is available.[32]  Fourth, under the comparable profits method (“CPM”),[33] operating profits reported by a party to a controlled transaction are compared with operating profits computed using objective profitability ratios derived from uncontrolled taxpayers that engage in similar business activities.  The CPM relies on the general principle that similarly situated taxpayers tend to earn similar returns.  USCO’s reliance on this method would be more complicated than is practically necessary, especially in light of the presumption in favor of the CUP method.  Lastly, under the profit split method,[34] an arm’s length return is estimated by dividing the overall return of a venture according to the relative economic contributions that the parties make to the success of that venture.  In practice, this is a method of last resort because it rests on internal data rather than data objectively derived from uncontrolled comparables.[35]

Essentially, § 482 centers on the arm’s length standard, which aims to identify a “range” of acceptable results using the “best” method that most reliably reflects the economic realities of an arm’s length transaction based on several different recommended methods depending on the nature of the transaction at issue.  The application process is complex, ambiguous, and uncertain by its very nature: successful application of the standards depends upon a fact-intensive review involving economic factors, subjective calculations, and comparable third party data determined by economists and accounting professionals.  The unique subjectivity involved creates the perfect environment for abuse.[36]  Even absent abuse, the tax positions taken are highly uncertain.  Accordingly, application of transfer pricing strategies is subject to close IRS scrutiny.[37]

To complicate matters further, the necessary data regarding comparable transactions by which to measure transfer pricing costs often do not exist in relevant form or, even worse, do not exist at all.  Compounding this uncertainty, foreign taxing jurisdictions interested to enhance their own tax revenues or to preserve their reputations as tax havens often disagree with the United States on the transfer pricing measurements employed and the resulting tax due. 

Simply put, especially in light of strict IRS and foreign oversight, companies face a substantial risk of noncompliance.  And because noncompliance leads to retroactive financial adjustments by authorities, substantial uncertainty exists as to the corporation’s true earnings.  In light of this risk and uncertainty, the following section analyzes what disclosures regarding the tax positions taken and probability of subsequent revisions are required to comply with the securities laws.

Part II


The aim of securities regulation:


Prior to 1933, US securities markets were largely self-regulated and dominated by a limited number of wealthy insiders having overwhelming informational advantages over average investors who lacked access to information.  Rising equities in the 1920s were driven not by economic fundamentals but rather by mere excitement about the booming market.  When the excitement faded and the stock market crashed in October 1929, the fortunes of countless investors were lost.  The crash caused a chain reaction which led to a protracted period of severe economic downturn known as the Great Depression.  In response, New Deal legislators enacted, among other statutes, the 1933 Securities Act[38] and 1934 Exchange Act.[39]   The acts essentially aim to achieve transparency in our capital markets ensured through a mandatory disclosure regime[40] that is based on honest, complete, and even-handed public dissemination of information.[41]  As Justice Brandeis eloquently observed, the securities laws originated based on the fundamental premise that “sunlight is the most powerful of all disinfectants.”[42]

To prevent fraud and to protect investors, the acts regulate the sale of securities to raise capital for profit-making purposes (the Securities Act), and the exchanges on which securities are traded (the Exchange Act).[43]  Under the Securities Act, the public offering process focuses on the creation of the registration statement and statutory prospectus: anyone offering or selling a security to the public must comply with the registration, prospectus delivery, and gun-jumping rules of § 5.[44]  The Exchange Act, on the other hand, regulates secondary trading activities on public exchanges, including the dissemination of quantitative and qualitative disclosures made to investors.[45]  By compelling disclosure and transparency of market information both at the initial issuance stage and throughout the life of the investment, the primary purpose of the acts is to eliminate the informational asymmetry and abuses in a largely unregulated market.[46]    

Transfer Pricing Disclosures & Sources of Liability


In the context of multinational reporting companies, however, tax information in financial statements is so limited that it is often difficult to discern even a generalized picture of a corporation’s tax position.[47]  “In almost no case do investors have information necessary to judge the tax risk of their investments.”[48]  Indeed, the methods used, details and underlying assumptions, and an analysis of the degree of comparability underlying particular transfer pricing strategies are not commonly disclosed to investors.  To the contrary, only general and rather opaque risk disclaimers are commonly reported regarding the potential risk of change to taxes and after-tax profits.  The obfuscatory disclaimers add little to illuminate the risks.  The resulting information asymmetry is the exact vice that the securities laws were originally intended to combat, and which only bright sunshine was entrusted to disinfect. 

Indeed, securities sellers have a straightforward duty to disclose honest and complete information that enables investors to appreciate the true nature of the investment through the eyes of management.  Although companies may naturally resist disclosing information that could potentially attract unwanted IRS attention, they should be acutely aware that the failure to make meaningful transfer pricing disclosures may instead attract unwanted SEC attention.  In fact, various sources of securities liability for improper transfer pricing disclosures arise in the course of a private placement, public offering, or periodic reporting.

The most far-reaching source of liability – which covers all security transactions – is contained in the general antifraud provisions of SEC Rule 10(b)(5)[49] as authorized by § 10(b)[50] of the Exchange Act.  With respect to the public offering process, another source of liability for material misrepresentations is triggered under §§ 11[51] and 12(a)(2)[52] of the Securities Act, which are considerably more generous to plaintiffs than Rule 10(b)(5).  Reporting companies are also subject to administrative liability for noncompliance with the securities laws,[53] including the specific disclosure requirements of Regulations S-K[54] (qualitative disclosures) and S-X[55] (financial disclosures).[56]  These twin regulations not only list a series of specific reporting obligations, but also contain a blanket provision for items not enumerated: “in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made not misleading.”[57] 

With these regulations in mind, assume that USCO is a reporting company that seeks to offer additional equity securities to the public.  Assume that USCO complied with § 5’s registration and gun-jumping rules for the new offering and properly filed a Form S-3[58] streamlined registration statement and prospectus prior to making any offers.  USCO filed its most recent annual report on Form 10-K,[59] which was properly incorporated into the prospectus on Form S-3 by reference.  Assume that, after a board meeting of top executives on the issue of transfer pricing disclosures, USCO decided to include only the following warning in its Management Discussion & Analysis section (“MD&A”) of Form10-K:


The Company’s federal income tax return for this year is under examination by the Internal Revenue Service. CHANGES IN EFFECTIVE TAX RATES OR ADVERSE OUTCOMES RESULTING FROM EXAMINATION OF OUR INCOME TAX RETURNS COULD ADVERSELY AFFECT OUR RESULTS.


Suppose that CaymanCo, contrary to the initial hypothetical, is merely a website operation which has no physical facility or employees, takes title to the goods only for a split second, and then passes title to external customers.  The IRS completes its audit and concludes that comparable uncontrolled transactions for the functions performed by CaymanCo would have resulted in significantly more profits being “priced” in the US by the transferor, USCO, for the initial “transfer” from USCO offshore to CaymanCo.  Accordingly, the IRS determines that USCO’s computed transfer price to CaymanCo was so understated that it was outside the arm’s length range of acceptable results under § 482.  Furthermore, as a result of the audit, the IRS also concludes that USCO did not keep adequate books and records regarding its transfer pricing methods and calculations.  Therefore, the IRS determines that USCO owes back taxes, interest,[60] and penalties under I.R.C. § 6662[61] and I.R.C. § 6655[62] to the extent it artificially shifted profits to its Cayman subsidiary.  After extensive litigation with the tax authorities, USCO is compelled to pay $175 million (35% tax on $500 million), which was originally taxed at the zero percent Cayman Islands rate, plus $50 million in interest and penalties.  USCO’s stock price plummets upon public release of the news.  Were the securities laws violated? 

Section 10(b) and Rule 10(b)(5)

Section 10 of the Exchange Act provides that “it shall be unlawful for any person, directly or indirectly . . . [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….”[63]  Pursuant to § 10’s grant of authority, the SEC in turn prescribed Rule 10b-5,[64] which provides the following:  

It shall be unlawful for any person, directly or indirectly . . . (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.


As authorized by § 10, Rule 10(b)(5) forms a legal basis for potential investor claims.

Significantly, however, a Rule 10(b)(5) claim must involve a scheme or artifice to defraud in connection with purchase or sale of a security; in light of the limited grant of authority under § 10, such scheme must in turn involve scienter in the form of “deception or manipulation.”[65]  Specifically, for liability to accrue, a plaintiff must prove that (1) the defendant made a material misrepresentation either by false statement or omission of fact, (2) with scienter,[66] (3) coinciding with the purchase or sale of the securities, (4) upon which the plaintiff justifiably relied, (5) and which proximately caused the plaintiff’s damages.[67] Notably, unlike §§ 11 and 12(a)(2) plaintiffs,[68] a Rule 10(b)(5) plaintiff must affirmatively establish that the defendant acted with scienter, and that the plaintiff’s reliance on the resulting misrepresentation caused the injury at issue.  Accordingly, if the defendant can show that full disclosure was made, there can be no deception or manipulation, and consequently no scienter.[69]

As to the first element, a misrepresentation is an affirmative statement or omission of material fact that would give a reasonable investor, in the exercise of due care, a false impression.[70]  A fact is material if there is a substantial likelihood that its disclosure would have been viewed by a reasonable investor as having significantly altered the total mix of information upon which to make informed investment decisions.[71]  The inquiry depends on the “probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.”[72]  As to the second element, scienter may be proven by either intentional misconduct[73] or recklessness,[74] but not mere negligence or corporate mismanagement.[75]  Moreover, in order to survive a motion to dismiss, private 10(b)(5) actions must clear the elevated hurdle of the Private Securities Litigation Reform Act of 1995 (“PSLRA”).[76]  Under PLSRA, plaintiffs must plead with particularity facts giving rise to a strong inference of fraud or recklessness, and discovery must be halted pending the outcome of a motion to dismiss.[77]

Motive and opportunity are generally relevant to finding an inference of fraud.[78]  However, general motive and opportunity alone, such as that tied to performance based compensation, a desire for increased profits, or maintenance of credit rating is not enough.  Instead, the incentive to defraud, as inferred from the timing, nature, and magnitude of the misrepresentation, must be particular and concrete; and the potential benefits of capitalizing upon such incentive must be personal to the wrongdoer.[79]  Even where an unusual motive is successfully alleged, without more, such motive does not establish scienter as a matter of law.[80]  Instead, there must be some other facts alleged that, in combination with the unusual motive, give rise to a strong inference of scienter.[81]  But in the absence of an unusual motive altogether, the other facts indicating scienter must be particularly strong.[82] 

As to the third element, a plaintiff must establish that the scheme was connected to the purchase or sale of securities.[83]  Essentially this element requires a showing that the scheme was part and parcel of a securities transaction.[84]  As to the fourth element, a plaintiff[85] must show that she purchased in reliance[86] on the misrepresentation, and would not have otherwise purchased had the hidden information been disclosed.  In cases of a material failure to disclose (omission) where there is a fiduciary duty to disclose, there is a rebuttable presumption of reliance.[87]  The burden thus shifts to the defendant to show that in fact plaintiff would have purchased even if she knew the omitted fact.  On the other hand, in cases of affirmative material misstatements, the plaintiff has to assert that she in fact read or heard the misstatement and, not having access to the truth, relied on the falsehood.  Significantly, both in the context of omissions and affirmative misstatements, a plaintiff may mobilize the “fraud on the market”[88] theory to establish reliance. 

Under this theory, a plaintiff need only establish the means of dissemination and the materiality of the misrepresentation, not “direct” reliance.[89]  The theory creates a rebuttable presumption of reliance hinged on the integrity and accuracy of market prices.[90]  It assumes that market prices reflect all publicly available information.   Accordingly, if the misrepresentation is disseminated to the public, then the market price reflects that false impression to the detriment of the plaintiff’s reliance on a sincere market price.  To rebut this presumption, the defendant would have to show that the misrepresentation did not affect the price.  As to the fifth element, a plaintiff must show that she realized some harm from the alleged scheme, and that the defendant’s misrepresentation was a substantial cause of that harm, which requires showing a direct or proximate relationship between the harm and the misrepresentation.[91]  

In the context of our hypothetical, assume that investors accuse USCO of creating a false impression in violation of Rule 10(b)(5) by misrepresenting taxes and net profits.  They claim that USCO affirmatively misstated taxes and net profits, as well as omitted any meaningful disclosure regarding its transfer pricing methods and the probability of future adjustment to tax.  USCO responds that nothing could have possibly been misrepresented in light of the risk disclaimer highlighting in bold letters that tax liability is subject to change pending the IRS audit.  It explains that taxes and net profits were qualified by this forward looking risk disclaimer, which fell squarely within the statutory forward-looking safe harbors[92] under the principles articulated in Baxter[93] as explained below.  USCO also asserts that (1) there could have been no deception as required under Rule 10(b)(5) because the risk disclaimer fully disclosed the risk and (2) the alleged misrepresentations are immaterial as a matter of law because no reasonable investor could consider them important in light of the cautionary language set out.[94]  

Forward Looking v. Backward Looking Disclosures

Cautionary language in financial reporting is universal.  And the presence of cautionary language is a relevant factor in deciding whether a reasonable investor could have been misled.[95]  If such language is considered forward-looking, for liability to attach, the plaintiff must at a minimum show that defendant had “actual knowledge” of its falsity.[96]  Even in those cases, under the “bespeaks caution” doctrine, which is essentially codified by the safe harbor rules,[97] alleged misrepresentations are nonactionable as a matter of law if it cannot be said that any reasonable investor could consider them important.[98]  The bespeaks caution doctrine “is essentially shorthand for the well-established principle that a statement or omission must be considered in context.”[99]  It refers to situations where “soft” information such as forecasts, estimates, opinions or projections are accompanied by cautionary disclosures.  If such cautions meaningfully warn of the inherent risk, then no misrepresentation can be said to have occurred. 

In Shaw v. Digital Equipment Corp. (“DEC”), [100] the court examined certain disclosures related to restructuring reserves.[101]  DEC disclosed that its reserves account was adequate to cover presently planned restructuring actions.  It also disclosed that it would continue to take actions necessary to achieve a level of costs appropriate for its revenues and competitive for its business.  As it turned out, DEC recognized an additional restructuring charge of $1.2 billion.  Investors sued in part under Rule 10(b)(5) alleging that DEC misrepresented the nature of its restructuring charges.  DEC moved to dismiss claiming that the context of the statements about the reserves sufficiently bespoke caution to render any misleading inference immaterial as a matter of law.  The court, however, disagreed.[102]  It reasoned that the disclosure at issue had both a forward-looking aspect and a present-fact aspect: the representation that DEC would continue to take restructuring actions was forward looking while the representation that it was then adequately reserved was one of present fact. [103]  The court explained that present facts are not covered under lenient bespeaks caution principles, and noted that, even if the disclosures had been purely forward looking, the warning that DEC intended to take further actions did not meaningfully caution against the extent and magnitude of the resulting restructuring charge. 

Indeed, cases that have applied the bespeaks caution principles have traditionally involved risk of uncertainty in pure forward looking projections not risk of uncertainty in present or past performance.[104]  Furthermore, to obtain forward looking leniency, courts have required that the disclosure of the risk be meaningful.[105]  Accordingly, before analyzing whether USCO’s transfer pricing disclaimer is “meaningful,” it is important to examine whether USCO’s disclaimer subjects reported tax liability and net profits to the forward-looking safe harbors. 

In the case of In re Yukos Oil Co.,[106] United States District Court Judge William H. Pauley III rejected the idea that a transfer pricing risk disclosure is forward looking.  Judge Pauley analyzed Rule 10(b)(5) liability based on allegations that Yukos engaged in a transfer pricing scheme by booking oil sales at substantially below market prices to its related trading companies who then, without taking physical possession, sold the oil to external customers at market prices.[107]  Yukos claimed certain regional tax benefits as a result.[108]  There, much like the disclosure in USCO, the Yukos disclosure publicly cautioned that “Russian tax legislation is subject to varying interpretations and [periodic/constant] changes, which may be retroactive” and that “transactions may be challenged by tax authorities and the Company may be assessed additional taxes, penalties and interest….”  Like USCO, the Yukos defendants argued that, by marshalling statements about the forward-looking risk, they were effectively shielded from liability for misrepresentations under the safe harbor rules.[109] 

Judge Pauley, however, found defendants’ argument fundamentally misguided: “The statements Plaintiffs allege were not forward looking but representations of present and historical facts or, at best, mixed statements containing both future projections and representations of existing facts.”[110]  He emphasized that the risk at issue had already transpired in light of the aggressive use of the transfer pricing strategy in question: “[c]autionary words about future risk cannot insulate from liability [for] the failure to disclose the risk that has transpired.”[111]  “The doctrine of bespeaks caution provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.”[112]  Under Judge Pauley’s persuasive analysis, USCO’s forward-looking theory should be rejected as a matter of common sense.  Once rejected, a court will simply analyze the traditional elements of a 10(b)(5) violation as outlined above, without extending USCO any special leniency under the forward-looking rules.

Assuming, however, that USCO’s tax risk disclosures are properly viewed as forward-looking in nature, then it still must be determined whether the disclosures are meaningful under the safe harbor rules.  But what does meaningful disclosure actually mean?[113] Although the word meaningful is nowhere expressly defined in the safe harbor rules, its implied meaning may be gleaned from the securities laws overall.  Proponents of a brief disclosure doctrine, for instance, might argue that the risk of future tax adjustment is quite analogous to the risk of uncertainty inherent in the outcome of a pending lawsuit.[114]  In both contexts, the events and positions giving rise to the future uncertainty have already transpired.  The only future factor at play is the formal findings and conclusions of the authorities.  In both contexts, GAAP accounting rules generally require reporting companies to record a contingent liability and reserve in advance for the inherent future risk of adjustment to current results.[115]  Because reserve estimates cannot precisely predict the final outcome, some warning is invariably required in both contexts.  In light of these substantive similarities, one might argue that whatever disclosure is required for lawsuit risks should be mirrored for tax related risks.  If this theory is adopted, then minimal disclosure will suffice to foreclose Rule 10(b)(5) liability for the transfer pricing risk. 

In fact, 17 C.F.R. § 229.103, which requires companies to report pending litigation matters meeting certain materiality criteria, mandates merely a brief description: “other than ordinary routine litigation incidental to the business, . . . [i]nclude the name of the court or agency in which the proceedings are pending, the date instituted, the principal parties thereto, a description of the factual basis alleged to underlie the proceeding and the relief sought.”  The description required does not include a detailed account of the conduct giving rise to the lawsuit, the probability of negative outcome, or the potential adverse affect on financial performance.  Rather, cursory facts combined with a general risk disclaimer, such as the one made by USCO in this case, would likely qualify as meaningful and foreclose liability as a matter of law. 

Proponents of the brief description school can also point to Judge Easterbrook’s Baxter[116] rule, which formulates a liberal approach for examining forward-looking disclosures.  Judge Easterbrook instructs that too much detail explaining the facts and circumstances giving rise to the forward-looking risk is not necessary.  He essentially places the disclosure at issue on a spectrum, where on the one extreme are boilerplate warnings, which even Easterbrook concedes are not meaningful, and on the other are warnings supported by underlying detailed assumptions, variances, probabilities, and calculations.  He then explains that statements like “all businesses are risky” or “the future lies ahead” are of the boilerplate category whereas warnings that are tailored to the risks that accompany the particular future events at issue are not.  While he emphasizes that non-boilerplate statements must be carefully tailored, his conception of such tailoring is rather undemanding: pointing out the principal contingencies, or important factors, that cause the uncertainty is enough.[117]  In fact, he cautions that attaching probabilities to each potential outcome or otherwise revealing detailed assumptions or calculations may actually be harmful to the company’s strategic advantage over competitors. [118] 

Judge Pauley, however, evaluated the concept of “meaningful” quite differently in Yukos.  He reasoned that the language disclosed could not have adequately informed investors of the true basis giving rise to the tax risk.  “Warnings of specific risks . . . do not shelter defendants from liability if they fail to disclose hard facts critical to appreciating the magnitude of the risks described.”[119]  “Once corporate officers undertake to make statements, they are obligated to speak truthfully and to make such additional disclosures as are necessary to avoid rendering the statements made misleading.”[120]  Yukos fell short of that obligation because it did not disclose that its related trading partners, upon whom the transfer pricing strategy was based, had few assets and employees and that no goods exchanged hands in the transactions giving rise to the tax benefits.[121]  Judge Pauley reasoned that withholding such details created a false impression about the true nature of the risk underlying tax liability and net profits.[122] 

Judge Pauley’s reasoning is actually more in line with those the SEC has in mind.  In a 2003 release,[123] the SEC highlighted the important purpose of making substantive disclosures and outlined obligations which are starkly different from those Judge Easterbrook articulated:[124]   identifying the intermediate effects of uncertainties alone, without describing and analyzing the reasons underlying these effects, may not provide sufficient insight for a reader who seeks to comprehend the business through the eyes and ears of management.  Rather, “companies should consider whether they have made accounting estimates or assumptions[125] where the nature of the estimates or assumptions is material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and the impact of the estimates and assumptions on financial condition or operating performance is material.”[126]  In such situations, companies should provide greater “insight into the quality and variability of information regarding financial condition and operating performance.”[127]  

A company should address specifically why its accounting estimates or assumptions bear the risk of change. The reason may be that there is an uncertainty attached to the estimate or assumption, or it just may be difficult to measure or value. Equally important, companies should address the questions that arise once the critical accounting estimate or assumption has been identified, by analyzing, to the extent material, such factors as how they arrived at the estimate, how accurate the estimate/assumption has been in the past, how much the estimate/assumption has changed in the past, and whether the estimate/assumption is reasonably likely to change in the future. Since critical accounting estimates and assumptions are based on matters that are highly uncertain, a company should analyze their specific sensitivity to change, based on other outcomes that are reasonably likely to occur and would have a material effect. Companies should provide quantitative as well as qualitative disclosure when quantitative information is reasonably available and will provide material information for investors.[128]


Therefore, when a description of known risks and uncertainties is set forth, companies may indeed be required to include a detailed analysis explaining the underlying details.[129]

In fact, in a relatively recent speech addressed to corporate tax practitioners,[130] the SEC Chief Accountant emphasized that the MD&A section encompasses much more than a cursory overview of the company’s tax strategy:  

[T]he Commission issued an Interpretive Release on MD&A. I suspect that you have read the release and, hopefully, are focusing, in particular, on your area of expertise - income taxes. Should the user of the financial statements know more? Does the reader understand or is the reader otherwise aware of the nature of the critical assumptions and estimates the company has made? Is it important for a reader to understand what your expectations are for the company’s effective tax rate? Do you expect income taxes to be a significant cash drain, or perhaps even a source, of liquidity for the company? The MD&A Release should lead you to disclose the answers to all of these questions, and more. I do want to be clear here.  Preparers of the financial statements should understand that if there are potentially significant impacts on cash flows or liquidity that could result from settlement of tax contingencies, that information is important to investors and must be disclosed.[131]


Moreover, as explained in the SEC release, companies in USCO’s situation may actually have an elevated duty to disclose their transfer pricing details due to the high degree of subjective judgment involved and the peculiar susceptibility of reported tax positions to future change. 

A 2006 SEC release responding to improprieties in executive compensation and corporate governance likewise underscores the SEC’s fundamental disagreement with the Baxter doctrine.[132]  In that release, the SEC adopted disclosure rules for arrangements that provide for “payments at, following, or in connection with the resignation, severance, retirement or other termination (including constructive termination) of a named executive officer, a change in his or her responsibilities, or a change in control of the company.”[133]  Under the new rules, “a company will be required to provide [detailed] quantitative disclosure . . . even where uncertainties exist as to amounts payable under these plans and arrangements.”[134]  In the event of such uncertainties, “the company is required to make a reasonable estimate (or a reasonable estimated range of amounts), and disclose material assumptions underlying such estimates or estimated ranges.”[135]  A disclosure is “meaningful” only if it includes such details and underlying assumptions.[136]

Accordingly, the Baxter rule, which requires companies merely to point out the important factors, directly contradicts the SEC’s through-the-eyes-of-management approach. Although the SEC has not yet specifically addressed transfer pricing disclosure, its unyielding bias in favor of detailed risk reporting is quite telling: USCO must at a minimum provide detailed quantitative disclosures regarding the tax risk at issue, make a reasonable estimate of the amounts in risk (or a reasonable estimated range of amounts), and disclose material assumptions underlying such estimates or estimated ranges.  USCO fell short of this obligation.  It merely reported that the outcome of an IRS audit could adversely impact its reported results, without even analyzing the probability or magnitude of such adverse impact. [137]  Thus, even assuming the transfer pricing risk is forward-looking, the disclosures are not “meaningful” under the safe harbor rules. 

Traditional 10(b)(5) Application without Forward Looking Protections

Therefore, the analysis in the current hypothetical ultimately centers on the traditional elements of Rule 10(b)(5), without any leniency under the safe harbor rules.  Applying those elements, USCO’s transfer pricing strategy and resulting tax adjustment of $175 million and penalties of $50 million are material because there is a substantial likelihood that a reasonable purchaser or seller of a security would consider the magnitude of USCO’s transfer pricing strategy and related risk of adjustment – including the facts that CaymanCo is merely a website operation with no real assets or employees – important in deciding whether to buy or sell the security.  In Yukos, for example, the tax strategy’s dependence on transactions with essentially sham companies having few assets and employees – including the fact that no goods actually changed hands but rather that it was merely a paper transactions to reduce taxes – would have drastically altered the total mix of information upon which Yukos investors would have made purchase and sale decisions.[138]  Precisely that logic extends to the hypothetical at hand.

As far as the reliance element, investors could form a rebuttable presumption of reliance pointing to the failure to disclose the details underlying the risk where USCO has a fiduciary duty to disclose.  Accordingly, the burden would shift to USCO to show that in fact investors would have purchased even if they had known of the omitted facts.  Alternatively, investors could likely establish that they directly relied on USCO’s affirmative statements relating to the tax risk, which were inaccurate or incomplete.  Investors may also establish reliance under the efficient market theory by arguing that USCO’s stock was artificially inflated in light of the hidden truth regarding the transfer pricing tax risk.  To avoid liability, USCO would the have to establish that the price of its stock did not reflect any of the misrepresented risk. 

Next, investors can prove causation by arguing that the misrepresentation caused an immediate drop in stock price.  Lastly, with respect to the scienter element, investors would argue that, either by intentional misconduct or recklessness, USCO deceptively misrepresented the transfer pricing risk in order to artificially reduce taxes and increase profits.  Investors might succeed in establishing an unusual opportunity in light of the unique flexibility inherent in transfer pricing rules.  In other words, they would argue that the high level of subjectivity created an unusual opportunity to defraud upon which executives capitalized.  They will also have to show unusual motive either by reference to insider-trading patterns or by inferences drawn from the magnitude of impact on earnings.  Perhaps the discovery process will yield some interesting facts regarding the board meeting decision on the transfer pricing disclosure.        

If these factors in combination establish a strong inference of intentional fraud, then USCO is likely liable for violating Rule 10(b)(5).  But even if intentional fraud cannot be established, investors can make a convincing argument that USCO acted recklessly: by pointing to the magnitude of the adjustment, especially since the regulations already allow a flexible range of acceptable results, investors can argue that USCO executives must have known the problem was brewing or, at the very least, recklessly disregarded it.  The board meeting and resulting decision not to disclose anything but a general risk disclaimer may again yield damaging evidence.  Therefore, a Rule 10(b)(5) violation would likely be established.

Section 11


            Section 11 of the Securities Act provides an alternative basis to antifraud liability for false registration statements in the public offering process.[139]  It creates liability “[i]n case any part of the registration statement . . . contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.”[140]  Unlike Rule 10(b)(5), § 11 imposes no reliance requirement, no scienter requirement, and only a weak showing of causation.[141]  Subject to certain narrow defenses, a plaintiff simply must show only a material misstatement or omission in the registration statement to prevail.  Upon prevailing, the plaintiff is entitled to actual damages.[142] 

While § 11 is a potent remedy for misrepresentations in the registration statement, its scope is quite limited.  First, potential damages are capped at the dollar amount raised by the offering.[143]  Second, only persons who hold or have held securities originating at the offering pursuant to the subject registration statement have standing to sue, a requirement otherwise known as tracing.[144]  The hurdle of tracing securities back to the original offering is quite burdensome because modern electronic clearing procedures make it exceedingly difficult for plaintiffs seeking to isolate shares from what is commonly a commingled pool containing a mishmash of outstanding securities.[145]  The task is often impossible to carry out.  Section 11 also limits the possible defendants to those who signed the registration statement,[146] directors,[147] various experts,[148] underwriters,[149] and control persons.[150]  No one else is liable under § 11.[151]  In the context of USCO, therefore, only those investors who can show that their shares are the subject of the registration statement containing the alleged misrepresentation would have standing to sue.  And only USCO and the listed statutory sellers are potentially liable.

Among the statutory sellers listed, underwriter liability plays a major role.  It is thus worthwhile to incorporate underwriter obligations into the analysis.  Because the underwriter’s liability cannot exceed that of the issuer, the elements required to mobilize a § 11 case, namely materiality and misrepresentation, are identical for issuers and underwriters; the analysis of those elements, including the question of whether the forward-looking safe harbors apply, is identical to the analysis in Rule 10(b)(5).  Thus, underwriters and their counsel should bear in mind that recent SEC releases adamantly favor a detail-oriented disclosure framework.  Here, because the failure to disclose the underlying assumptions and probability of adjustment created a material false impression, an actionable § 11 misrepresentation has likely occurred.    

Nonetheless, defendants may still avail themselves of certain defenses. One of those defenses is loss causation, which allows defendants to argue that the difference between the offering price and “depreciated value” of the stock is not due to any misrepresentation in the registration statement, but rather to some other unrelated factor.[152]  For example, if USCO can show that the market price declined because of general market conditions and not because of the misrepresentation at issue, then no damages would be allowed.  However, unlike Rule 10(b)(5), the defendant – not plaintiff – has the burden of proof on the issue of causation.[153]  This is generally the only defense available to an issuer,[154] USCO in this case.  Underwriters, however, can further avail themselves of the due diligence defense.

Due Diligence 

In fact, perhaps the most important defense available for underwriters is the affirmative defense of due diligence.[155]  Two important due diligence points in the context of underwriting should be made.  First, for underwriters, due diligence is not merely a defense but rather an obligation.[156]  Second, as the discussion below indicates, an underwriter’s due diligence obligations are considerably more extensive than would appear under a literal reading of § 11.[157]  Under § 11, the diligence due depends on whether the misrepresentation is contained in an “expertised” portion or “nonexpertised” portion of the registration statement.[158]  An expertised portion is one disclosed based on analysis by an expert, while a nonexpertised portion is one disclosed based on analysis by a nonexpert.   An expert is a professional such as an accountant or scientist making disclosures based on his or her capacity as a practitioner in that field, while a nonexpert is anyone else, typically including a corporate manager or underwriter. 

A basic example of an expretised portion is the audited financial statements, where the auditor acts as the accounting expert signing off on those statements.  By negative implication, all portions that are not purported to be made on the authority of an expert are considered nonexpertised and made by nonexperts.  A classic example of a nonexpertised portion is the MD&A section, where management prepares this section acting as nonexperts.  Only nonexperts, are subject to liability with respect to nonexpertised portions.  Experts are not.  To avoid liability, nonexperts must show that, after a reasonable investigation, they had reasonable ground to believe and did believe that the disclosure at issue is true.[159]   On the other hand, with respect to expertised portions, both experts and nonexperts are subject to liability.  To avoid liability, experts must show that after a reasonable investigation, they had reasonable grounds to believe and did believe that the disclosure at issue is true,[160] while nonexperts must merely show that they had no reason to believe the disclosure was not true.[161] 

Though underwriters and their counsel have traditionally considered the “no reason to believe” burden for nonexperts on expertised portions relatively undemanding, or at least substantially less demanding than the alternative “reasonable investigation” burden, a recent decision out of the Southern District of New York in the case of In re WorldCom, Inc.,[162] took them by surprise.[163]  The case established that underwriters, in light of their special function in the offering process as the first line of defense, [164]  are impliedly subject to a “red flag” standard, which informs the textual “no reason to believe” standard. They must spot red flags in expertised portions and conduct further investigation until those red flags are adequately explained away.[165]  While the court recognized that underwrites should not be asked to duplicate the work of auditors,[166] given the court’s application of facts, the digging and investigatory work required is apparently substantial. [167]  Thus, erring on the side of over-digging would be prudent.

The WorldCom decision, however, should not have come as a surprise.  As early as 1953, the SEC declared that underwriters “owe[d] a duty to the investing public to exercise a degree of care reasonable under the circumstances . . . [and] to assure the substantial accuracy of representations made in the prospectus. . . .”[168]  Shortly thereafter, the SEC criticized an underwriter for relying on the representations of management without performing a reasonable investigation.[169]  More recently, in 1992, the SEC released a report explicitly stating the obligation of underwriters “to adequately explore questions concerning the business and financial aspects of the offering which were raised during the due diligence process.”[170]

The courts have also been strict on underwriters’ duties: in BarChris,[171] for example, the underwriter’s investigation consisted of reading annual reports and prospectuses of other similar companies, historical reports of the company, and minutes of the company’s executive meetings.  The underwriter also contacted the company’s banks to inquire about the company and held a series of meetings regarding potential financial risks.  The court, however, found this review inadequate because the underwriter did not follow through on certain information related to missing minutes and notes, and did not review contracts with the company’s customers. 

Likewise, in Leasco Data Processing,[172] the court emphasized that the underwriter’s role is “to exercise a high degree of care in investigation and independent verification of the company’s representations” by constantly playing “devil’s advocate.”[173]  Similarly, the Second Circuit’s decision in Chris-Craft[174] also paved the road to WorldCom:

First Boston is a skilled, experienced and well respected dealer-manager and underwriter.  It had an obligation with respect to the [company’s] exchange offer to reach a careful, independent judgment based on facts known to it as to the accuracy of the registration statement.  Moreover, if it was aware of facts that strongly suggested, even though they did not conclusively show, that the registration materials were deceptive, it was duty-bound to make a reasonable further investigation. 


The WorldCom case was decided based on the same principles, yet explicitly extending those principles with respect to expertised portions of the registration statement: reliance on experts or comfort letters[175] from experts, without more, does not relieve underwriters from their important gate keeping duties.  Rather, the underwriter must essentially act as a quasi expert in reviewing the real expert’s report.  In so doing, she must identify any “red flags” that suggest a problem with the reported information, and then follow through with a diligent investigation.[176]    

With these principles in mind, assuming the plaintiff investors successfully establish § 11’s misrepresentation and materiality requirements, USCO’s underwriters can avoid liability based on the due diligence defense only if they performed a reasonable investigation.[177]  To that end, in addition to a reasonable investigation of USCO’s nonexpertised tax risk disclosures in the MD&A, the underwriters must also show that they have adequately covered all material red flags in the audited financial statements.  And because the financial impact of USCO’s strategy is material, the underwriters were likely expected to uncover that impact as a red flag.[178]    

In particular, USCO’s underwriters must show that they reviewed board and audit committee minutes on the issue of transfer pricing, material sales contracts between USCO and CaymanCo as well as between CaymanCo and external customers, industry reports and competitors’ financial ratios, and other important transfer pricing documents.[179]  They must also show that, after conducting such review, they believed that USCO’s reported transfer pricing strategy and related tax liabilities were made in conformity with the relevant accounting and tax rules.  Accordingly, even assuming that the underwriters properly conducted a transfer pricing investigation, they will have a difficult time asserting that they became satisfied with the accuracy of the disclosures: USCO’s aggressive transfer pricing strategy is based on an offshore website that has no real assets or employees, and takes title only for a split second.

Are there any limits on due diligence?

The WorldCom court emphasized that underwriters should not blindly rely on representations by corporate management without independent verification: a hear no evil see no evil underwriting approach will not be tolerated.  Although this standard sounds normatively appropriate in theory, it would be unreasonable to require underwriter verification of each and every statement made by the company in a registration statement, including each and every statement made on behalf of experts.[180]  While the WorldCom court did not lay out a legal framework for identifying red flags, the basics of due diligence have not changed.

Due diligence is an art rather than a science.  Its procedures may range from steps as simple as looking up corporate officers on Google or touring company facilities to steps as complex as dissecting the details of pension plans, executive compensation, derivative contracts, or off-balance arrangements to verify that disclosures are made in conformity with applicable rules.[181]  While there are many desirable due diligence procedures in theory, the process of verifying information must be actively managed in light of time and money constraints.  Underwriters must initially gain a sincere understanding of the company, its management, the industry, and the fundamental forces driving key transactions.  The extent to which underwriters should verify information depends in large part on this initial assessment, which sheds light on the significance of the information at issue, the risk that information is inaccurate, and a determination of whether management has an unusual opportunity to misstate the facts.[182] 

For example, USCO’s underwriters should initially seek to gain a sincere understanding of USCO’s corporate governance, the quality of internal controls, the integrity of management, its strategy and competitive advantages, and the effect of key transactions on the company’s financial condition.  To achieve this understanding, USCO’s underwriters should take such steps as interviewing employees, reviewing board and audit committee minutes, material contracts, industry reports, and the company’s website generally.[183]  Working through these key categories could quickly expose risky areas, including transfer pricing, that require additional verification.    

Would the outcome be any different under Section 12a2?

Section 12(a)(2) essentially aims to pick up where § 11 leaves off by imposing liability for securities sellers in the public markets, irrespective of whether the misrepresentation was contained in a registration statement.[184]  It provides for liability in connection with offers or sales by means of a prospectus or oral communication which contains the misrepresentation.[185]  However, its reach is quite limited: according to Gustafson v. Alloy Co,[186] because the term prospectus refers to widely disseminated sales materials used in a public offering, § 12(a)(2) applies only where the offering is public in nature.  Accordingly, because public offerings generally must be registered, § 12(a)(2)’s intended extension beyond the registration statement context is quite narrow.[187]   Nonetheless, the Section has some important practical effects: it exposes free writing prospectuses[188] to liability whereas § 11 does not.  And in light of the extensive deregulation in connection with the offering reforms of 2005, [189] § 12(a)(2)’s application to free writing prospectuses fills an important gap.  It is also sometimes preferable because it allows for rescission irrespective of proving actual damages whereas § 11 does not.[190] 

Unlike § 11, however, the seller of a security is liable under 12(a)(2) only to “the person purchasing such security from him.”[191]  The seller is the person who transfers title or solicits on behalf of that person.[192]  The purchaser is the person who buys from the seller.  In this respect, § 12(a)(2) is much narrower than § 11 because, in addition to tracing, a plaintiff must prove privity of contract with the original offeror.  Moreover, defendants, including the issuer itself, can escape liability by asserting the principal defense of reasonable care, [193] which is less demanding than the due diligence duties imposed under § 11.[194] 

Under the reasonable care defense, one who shall sustain the burden of proof that he did not know, and that in the exercise of reasonable care could not have known, of such misrepresentation shall not be liable.  The affirmative duty to conduct a reasonable investigation and the “red flag” standard with respect to expertised portions are specific to § 11 and do not apply under § 12.[195]  In all other respects, however, § 11 defenses mirror § 12(a)(2) defenses.  Therefore, in light of the fact that § 12(a)(2) standing requirements are narrower and defendants enjoy a greater protections, plaintiffs pursuant to a registered offering have little incentive to structure a cause of action under § 12(a)(2). 

But assuming that USCO plaintiffs sued under 12(a)(2), and assuming that they can prove a material misrepresentation, then USCO could avail itself of the more lenient “reasonable care” defense.  However, because USCO’s aggressive transfer pricing strategy is based on an offshore website that has no real assets and takes title only for a split second, it would be disingenuous to believe that USCO, in the exercise of reasonable care, could not have known of the misrepresentation.  To the contrary, it must have known that the website operation added, if anything at all, only minimal value to the goods; it must have known that the bulk of the profits should have been priced on the initial sale from USCO offshore.  It was unreasonable to overlook such a significant event.  Facts regarding what transpired at the board meeting might conclusively show that USCO knew of the true yet undisclosed risk inherent in its strategy. 

With respect to the underwriters, assuming again that the standing requirements are satisfied and that a material misrepresentation has been established, they too will encounter difficulties with the reasonable care defense. For example, in the exercise of reasonable care, a review of the board minutes from the board meeting on the issue of transfer pricing would have likely revealed the misrepresentation.  However, if USCO withheld the true facts regarding the offshore website operations, the underwriters could argue that they were not under a duty to conduct an affirmative investigation of USCO’s transfer pricing strategy, and that, though they exercised reasonable care, they could not have known about the misrepresentation. 


Full Compliance with § 482: 


Returning to the original motivating hypothetical, where CaymanCo operates a sophisticated distribution facility with 350 employees, assumes full risk on the goods, utilizes an advanced supply chain software system, and incurs substantial COGS and overhead expense, assume the IRS audits USCO’s transfer pricing strategy and determines that USCO is in full compliance with the transfer pricing rules under § 482.  Assume that USCO discloses the IRS’s clean audit results in a newsflash filed the same day, and that the price of USCO stock increases substantially on the day of the release.  The news flash read as follows:

During the fourth quarter of 2006, the Internal Revenue Service completed its examination of our federal income tax returns for the fiscal years ended December 31, 2004 through December 31, 2006. Based on the clean audit results of the examination, we have decreased previously recorded tax reserves by approximately $110 million and decreased income tax expense and increased net profits by a corresponding amount. 


Assume that USCO investors who have sold USCO stock just one day prior to the positive newsflash sue USCO under Rule 10(b)(5) and §§ 11 and 12(a)(2).

With respect to the Rule 10(b)(5) claim, investors assert that they were deceived as to the risk of future tax adjustment.  They seek redress for their damages measured by the difference between their sale price and the higher price on the market following the positive announcement.  Here too, perhaps the board meeting in combination with other facts may reveal that insiders were purchasing stock in anticipation of the positive newsflash, and overstated the risk in order to buy low and sell high.  Even absent intentional fraud, investors may establish a reckless failure to disclose the underlying methods and assumptions.  The important lesson is that, even if USCO’s transfer pricing strategy is in full compliance with § 482, the failure to make adequate disclosures may still expose the company to liability under Rule 10(b)(5). 

Similarly, the legitimacy of the transfer pricing strategy does not foreclose liability under §§ 11 and 12(a)(2).  Subject to the defenses previously discussed, investors may recover damages as long as they can show that the registration statement or prospectus contained a material misrepresentation of the transfer pricing risk.[196]  In fact, § 12(a)(2) provides a remedy even for those investors who still hold USCO stock and are not actually damaged: they may seek rescission of the original purchase transaction if they wish.[197]       

Now consider a situation with more disclosure than the summary risk disclosure above 


The following hypothetical[198] applies both to an overly aggressive transfer pricing strategy and to a strategy that is reasonable on its face.  Suppose that, instead of the generalized risk disclaimer in the previous hypothetical, USCO’s MD&A disclosed the following:

In reconciling the difference between the US federal income tax rate and its actual provision for income taxes, the company reported that the mix of foreign operations reduced its tax rate by over 8%.  The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes consisted of the following:












Years Ended


December 31,



December 31,



December 31,


Federal statutory rate










Effect of:










State taxes, net of federal tax benefit










Export sales benefit










Foreign income at other than U.S. rates










Nondeductible deferred stock-based compensation










Tax credits










Other, net


































The above graphical depiction was followed by the following warning: “The Company’s federal income tax returns for fiscal years ended December 31, 2004 through December 31, 2006 are under examination by the Internal Revenue Service…. The Company believes that adequate amounts have been reserved for any adjustments which may ultimately result from these examinations.”  In addition, the MD&A section further stated the following on income taxes:

We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in evaluating our tax positions and determining our provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain. We establish reserves for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes and interest will be due. These reserves are established when, despite our belief that our tax return positions are fully supportable, we believe that certain positions are likely to be challenged and may not be sustained on review by tax authorities. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate.


Further, USCO’s risk analysis disclosed included the following disclaimer:



Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates, by changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws, regulations, accounting principles or interpretations thereof. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse effect on our operating results.


And finally, in its summary of significant accounting policies USCO stated the following:


Income tax expense is based on pretax financial accounting income. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts. Valuation allowances are recorded to reduce deferred tax assets to the amount that will more likely than not be realized.


Assume that upon completion of the IRS audit in the first quarter of 2007 the following newsflash is released by USCO:

As a result of an IRS audit, we increased our tax liability for year 2006 by $150 Million and decreased net profits by $110 Million in light of inadequate reserves.  The increases to the provision for income taxes is made up of $75 Million related to foreign sales of laptop computers, $20 Million related to intercompany restructuring of certain of our foreign operations, and $15 Million related to the effects of new US tax regulations that require intercompany reimbursement of certain stock-based compensation expenses.


As a result, USCO’s stock price decreases substantially, and investors bring suit. 

The question now becomes whether USCO’s in-depth risk disclosures foreclose liability.  At first glance, the extensive risk discussion, including the data presented in tabular form, accounting policies, and related risk analysis, seems to have impressed upon investors the significant uncertainty underlying tax liabilities.  Upon careful reflection, however, USCO is not really offering any additional substantive details, methods, or assumptions that would enable investors to judge, through the eyes of management, the probability of tax adjustment and the magnitude which the uncertainty bears on financial results.[199]  Accordingly, the disclosures are unlikely “meaningful” under the safe harbor rules.   Therefore, investors can still attack USCO for creating a false impression of the tax liability under the same principles previously discussed.    

Assume now the SEC rather than investors file suit against USCO


The SEC has taken the position that “[s]erving as an officer or director of a pubic company is a privilege which carries with it substantial obligations….  If an officer or director knows or should know that his or her company’s [disclosures] concerning particular issues are inadequate or incomplete, he or she has an obligation to correct that failure.”[200]  The SEC’s primary administrative methods for shaping the contents, accuracy, and adequacy of disclosures include adopting registration forms and disclosure rules such as Regulations S-K and S-X, reviewing and commenting on Securities Act registration statements and Exchange Act periodic reports, and enforcing compliance with its rules via unilateral subpoena powers and a wide range of civil penalties.[201]  Its primary enforcement tool is a cease and desist proceeding under § 21C of the Exchange Act or its counterpart § 8A of the Securities Act, [202] which could result in disgorgement, civil penalties, an injunction, sanctions against executives, including a permanent bar from public company employment, and an order prohibiting continued violation of the securities laws.[203]  Indeed, the SEC boasts a unique ability to capture the profession’s attention through its viewpoints about the nature of disclosure required to inform investors best. 

For instance, § 13(b)(2)(A) of the Exchange Act requires that companies, including USCO, keep their books and records accurate as a matter of course.[204]  Significantly, the provisions impose strict liability for inaccuracies.  Essentially, any inaccuracy is actionable, irrespective of the company’s awareness of it or of the materiality of the particular inaccuracy at issue.[205]  The SEC can enforce accuracy-based provisions via an administrative proceeding for violations and sanctions.[206]  Furthermore, even if the disclosures are accurate, the SEC can attack the accounting process itself.  Indeed, § 13(b)(2)(B) of the Exchange Act requires that companies implement formal procedures and internal controls that provide independent checks on the accounting and reporting process in order to produce accurate books and records.[207] 

Apart from these accuracy and procedural aspects, the SEC can also impose sanctions for incomplete supporting details of the transfer pricing strategy in the MD&A. [208] 

Part III


The SEC considers disclosure as the cure for most, if not all, ailments that plague the capital markets. [209]  In fact, it is no coincidence that recent corporate scandals, including Enron’s off-balance sheet fraud, WorldCom’s fictitious profits scheme, United Healthcare Group’s options backdating practices, and Tyson Foods’ executive compensation fiasco, were all invariably met with extensive disclosure-based measures.  If corporate scandals emerge in the area of transfer pricing, the SEC will undoubtedly respond with a custom-tailored disclosure package.[210]  Moreover, in light of increased IRS and SEC focus on the defects of income tax reporting, perhaps some preemptive damage-control measures are already in the works. [211] 

While demanding more by way of disclosure increases the company’s compliance costs, the securities laws rest on the fundamental premise that efficient flow of capital in the markets is best ensured by eliminating informational asymmetry.  In fact, ever since the Great Depression, informational asymmetry has been considered the very evil that enables an abusive market environment to thrive.  To remove this evil, the SEC should utilize its rulemaking powers to adopt a comprehensive disclosure mandate that calls for expanded tax risk disclosure.  The mandate should authorize SEC administrative review to ensure compliance with such rules. 

Indeed, whenever a new disclosure-based regulatory system is introduced, behaviors must change in lockstep.[212]  Executives and corporate players who had prior grown accustomed to walking a fine line with little oversight or disclosure obligations suddenly find themselves with little choice but to operate in the sunshine subject to close scrutiny.  Not only would the financial markets benefit from an increased tax transparency that makes possible to evaluate tax risk, but a clear disclosure mandate will also have the effect of deterring aggressive income tax accounting and preventing the next big corporate scandal from materializing.  

Regardless of whether a custom-tailored transfer pricing package is in the works, however, companies should take unilateral steps to assemble a meaningful tax reporting framework.  The immediate motivating factor for unilateral action is prescribed under existing securities laws that broadly expose companies to liability for incomplete or inaccurate disclosures.  The long-term motivating factors include building goodwill and investor confidence, establishing best-in-class corporate governance policies, and preparing for a smooth transition in case an SEC- imposed tax mandate is in fact inevitable. 

A meaningful tax reporting framework may be modeled on the Enron-motivated reforms under Item 303[213] of Regulation S-K and § 2 of Form 8-K:[214] as directed by § 13(j) of the Exchange Act, the SEC adopted certain rules to require disclosure of off-balance sheet arrangements.[215] The new rules require a registrant to provide an explanation of its off-balance sheet arrangements in a separately captioned subsection of its MD&A section and to provide an overview of related obligations in a tabular format.[216]  

[W]e are adopting disclosure requirements that are more consistent with the principles-based approach found in current MD&A rules. The principle throughout the amendments is that the registrant should disclose information to the extent that it is necessary to an understanding of a registrant’s material off-balance sheet arrangements and their material effects on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Consistent with traditional MD&A disclosure, management has the responsibility to identify and address the key variables and other qualitative and quantitative factors that are peculiar to, and necessary for, an understanding and evaluation of the company.[217]


The off-balance sheet reforms also listed the following required disclosure items: [218] (1) the nature and business purpose of the registrant’s off-balance sheet arrangements;[219] (2) the importance of the off-balance sheet arrangements;[220] (3) the financial impact of the arrangements on the registrant (e.g., revenues, expenses, cash flows or securities issued) and the registrant’s exposure to risk as a result of the arrangements (e.g., retained interests or contingent liabilities);[221] (4) known events, demands, commitments, trends or uncertainties that affect the availability or benefits to the registrant of material off-balance sheet arrangements.[222] 

On the issue of risk and uncertainty, the SEC release expanded as follows:


The discussion also must identify any known event, demand, commitment, trend or uncertainty that will, or is reasonably likely to, result in the termination, or material reduction in availability to the registrant, of its off-balance sheet arrangements that provide the registrant with material benefits   . . . .  A registrant must disclose, for example, any material contractual provisions calling for the termination or material reduction of an off-balance sheet arrangement. The disclosure also should address factors that are reasonably likely to affect the registrant’s ability to continue using off-balance sheet arrangements that provide it with material benefits. For example, if a registrant’s credit rating were to fall below a certain level, some off-balance sheet arrangements may require the registrant to purchase the assets or assume the liabilities of an unconsolidated entity.[223]


This reporting framework is all but unique: the SEC’s recent response to executive compensation asymmetries also emphasized the importance of combining a broader-based tabular presentation with improved narrative disclosure supplementing the tables.[224]

This approach will promote clarity and completeness of numerical information through an improved tabular presentation, continue to provide the ability to make comparisons using tables, and call for material qualitative information regarding the manner and context in which compensation is awarded and earned.[225] 


The release “calls for a discussion and analysis of the material factors underlying compensation policies and decisions reflected in the data presented in the tables.”[226]   Disclosure might include descriptions of the material terms in executive officers’ employment agreements, including “a general description of the formula or criteria to be applied in determining the amounts payable, the vesting schedule, a description of the performance-based conditions and any other material conditions applicable to the award, whether dividends or other amounts would be paid, the applicable rate and whether that rate is preferential.”[227]  Like the off-balance sheet release, the executive compensation release provides as follows on the issue of risk and uncertainty:

A company will be required to provide quantitative disclosure under these requirements even where uncertainties exist as to amounts payable under these plans and arrangements. We clarify that in the event uncertainties exist as to the provision of payments and benefits or the amounts involved, the company is required to make a reasonable estimate (or a reasonable estimated range of amounts), and disclose material assumptions underlying such estimates or estimated ranges in its disclosure. In such event, the disclosure will be considered forward-looking information as appropriate that falls within the safe harbors for disclosure of such information.[228]


Following these models, a meaningful tax reporting framework should begin with an overview of the magnitude of tax savings in tabular presentation followed by a  separately captioned analysis in the MD&A section of the key variables and other qualitative and quantitative factors necessary to evaluate the tax strategy, including an assessment of any risk or uncertainty.  The analysis should explain the nature, business purpose, and financial impact of its tax strategy, including the factors that are reasonably likely to affect that strategy.  In the context of transfer pricing, these factors should at a minimum include the accounting methods, details and underlying assumptions of the transactions at issue, and an analysis of the degree of reliability of financial measures supporting the transfer pricing position reported.   

Making such disclosures is not economically burdensome because the information is already required by other law: I.R.C. § 6662,[229] which imposes accuracy-based penalties for tax deficiencies, already requires companies to maintain books and records that (1) establish its transfer pricing position provided the most accurate measure of an arm’s length result, (2) justify the use of a “best method” given the context of its strategy, (3) outline the details of its pricing policies, and (3) describe its international operations.[230]  The record keeping must also include a description of the transfer pricing method selected and reasons for selection, a description of alternative methods and reasons for not using them, and a description of comparables used. 

In addition, the Financial Accounting Standards Board has recently issued interpretation number 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), [231]  which essentially requires that companies evaluate the tax positions reported in their financial statements.  In particular, compliance with FIN 48 requires that the company determine whether it is more likely than not that the tax position at issue will be sustained upon IRS examination.  Accordingly, compliance with FIN 48 necessarily demands that the company analyze the technical merits of its tax strategy based on the results of the various transfer pricing methods under § 482 and the application of the best method rule.  Companies are therefore already doing all of the data-gathering legwork upon which a meaningful transfer pricing reporting framework may be based.    

As with all corporate governance, sunlight is the most powerful of all disinfectants.  Only through enhanced sunlight and transparency can the investment community evaluate the true tax risk of a company.  Companies that operate in the dark with respect to tax reporting are unguarded against a variety of securities violations.  In fact, it may only be a matter of time until the SEC sets forth a comprehensive package to increase tax reporting transparency.  In the meantime, to remove the wide-spread informational asymmetries in tax reporting, companies should unilaterally adopt a more meaningful tax disclosure framework modeled on the recently introduced disclosure requirements for off balance sheet financing and executive compensation.


[1] Reporting companies are those required to file periodic financial reports with the SEC generally because their securities are traded (1) on a regulated national securities exchange or (2) over the counter, and have assets of more than $10 million and 500 or more shareholders.  See 15 U.S.C. § 78l (2000) (“Every issuer of a security registered pursuant to [15 U.S.C. § 78m] of this title . . . shall file with the Commission, in accordance with such rules and regulations as the Commission may prescribe as necessary or appropriate for the proper protection of investors and to insure fair dealing in the security.”).

[2] See generally, Staff of the Joint Committee on Taxation, Study of Present-Law Penalty and Interest Provisions As Required By Section 3801 of the Internal Revenue Service Restructuring and Reform Act of 1998, JCS-3-99, at Vol. I, 173-250 (July 22, 1999) [hereinafter JCT Study], available at http://www.gpo.gov/congress/joint/hjoint01cp106 .html (identifying characteristics of corporate tax shelters and discussing their proliferation).

[3] See Speech by Donald T. Nicolaisen, SEC Chief Accountant, “Remarks at the Tax Council Institute Conference on the Corporate Tax Practice: Responding to the New Challenges of a Changing Landscape” (Feb. 11, 2004) [hereinafter Nicolaisen Speech], available at http://www.sec.gov/news/speech/spch021104dtn.htm (“[T]he financial reporting of income taxes is a very significant matter to the health and credibility of our capital markets.”).

[4] See Lilly v. IRS (In re Lilly), 76 F.3d 568, 572 (4th Cir. 1996) (explaining that COGS is an inventory accounting concept that measures the costs of purchases or production of goods, and may vary depending upon the method employed for valuing inventory).

[5] See Joint Committee on Taxation, Written Testimony of the Staff of the Joint Committee on Taxation on the Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCX-10-03), at 7, 9 (Feb. 13, 2003), available at http://www.house.gov/jct/x-10-03.pdf (explaining that Enron’s tax department became “a profit center for the company”).

[6] See, e.g., Bethany McLean & Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (2003) (detailing the culture that pressured Enron managers to achieve profit targets at all costs); see also Charles J. Johnson, Jr. & Joseph McLaughlin, Corporate Finance and the Securities Laws 5-55 (4th ed. 2006) [hereinafter Johnson & McLaughlin] (quoting Warren Buffet’s assertion that “managers that always promise to make the number will at some point be tempted to make up the number”).

[7] See, e.g., Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations, Vols. I, II, and III, (JCS-3-03), at 222 (Feb. 2003) [hereinafter Enron Report], available at http://www.gpo.gov/congress/joint/jcs-3-03/vol2/index.html (noting that corporate tax departments are evaluated based on tax savings achieved).

[8] See generally Mark Everson, Commissioner of Internal Revenue Service, IRS Commissioner Testifies before Senate Committee on Finance on Compliance Concerns Relative to Large and Mid-Size Businesses (June 13, 2006) [hereinafter Mark Everson Testimony], available at http://www.irs.gov/newsroom/article/0,,id=158644,00.html.

[9] See id. (explaining that estimated underreporting of income by larger corporations in 2001 was $25 billion and citing the major contributing factor as the proliferation and complexities of globalization and cross-border activity)

[10] See Linda M. Beale, Symposium: Evaluation and Response to Risk by Lawyers and Accountants in the U.S. and  E. U., 29 Iowa J. Corp. L. 219, 240 (2004); see also Mark Everson Testimony, supra note 8 (noting that “large businesses increasingly engage in sophisticated transactions for both non-tax purposes and tax purposes, resulting in complex relationships with multiple filing requirements”).

[11] See generally McLean & Elkind, supra note 6.

[12] See generally  Mark Everson Testimony, supra note 8; Nicolaisen Speech, supra note 3; Enron Report, supra note 7, at Vol. I, 2-22.

[13] Artificial shifting of income offshore is prevalent across large corporations.  See, e.g., Mark Everson Testimony, supra note 8 (“Taxpayers are continuing to shift significant profits offshore….  Taxpayers often manipulate the price of related transactions so that the income of an economic group is ostensibly earned in low tax jurisdictions, or in no jurisdiction, rather than in the U.S., thus lowering the enterprise’s worldwide tax burden.”).

[14] 26 U.S.C. § 482 (2000).

[15] Id.

[16] Uncontrolled means unrelated.  See 26 C.F.R. § 1.482-2 (2006) (requiring “unrelated” comparables to compute and arm’s length price in each of the various transaction contexts described).

[17] Id. § 1.482-1.

[18] Id. § 1.482-1(e).

[19] Id. § 1.482-3.

[20] Id. § 1.482-1(c).

[21] Id.

[22] Id. § 1.482-1(c)(2)(i).

[23] Id.

[24] Id. § 1.482-1(d).

[25] For application of the rules outside the context of USCO’s tangible property sales, such as in the context of intangible property transfers, performance of services, or making loans, see id. § 1.482-1 et seq. generally for the governing methods, which also center on the arm’s length principle.

[26] See id. 1.482-3(a)(6) (unspecified methods may be used provided they better satisfy the best method rule).

[27] Id. § 1.482-3(a)(1).

[28] Id. § 1.482-1(b)(4) (example 1).

[29] Id. § 1.482-3(a)(2).

[30] Id. § 1.482-3(c).

[31] Id. § 1.482-3(a)(3).

[32] Id. § 1.482-1(b)(4) (example 1).

[33] Id. § 1.482-3(a)(4).

[34] Id. § 1.482-3(a)(4).

[35] See Eli Lilly & Co. v. Comm’r, 856 F.2d 855, 872 (7th Cir. 1988) (explaining that allocations of combined revenues under the profit split method are inherently imprecise).

[36] See Mark Everson Report, supra note 8 (“[w]ith multiple domestic and global tiered entities, it is often difficult to determine the full scope and resulting tax impact of a single transaction or series of transactions….  Complexities of globalization and cross-border activity create opportunities for aggressive tax planning”).

[37] See id. (describing the tax challenges relating to cross-border trade and stating the following:

We have taken a proactive approach to dealing with the challenges of effective tax administration in the environment described above.  Overall, our strategy depends on making compliance checks as much as possible on a real-time or near-real-time basis, being as current in our examinations as possible, and having as much transparency to book-tax differences and other indicators of risk as possible.  To that end, we have initiated several programs that foster transparency, currency, pre-filing compliance opportunities, and improved efficiencies in issue and risk identification.)

[38] Pub. L. No. 73-22, 48 Stat. 74 (1933) (codified as amended at 15 U.S.C. § 77a-bbbb (2000)).

[39] Pub. L. No. 73-291, 48 Stat. 881 (1934) (codified as amended at 15 U.S.C. § 78a-mm (2000)).

[40] See generally John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717 (1984) (discussing the basis for mandatory disclosure); see also Louis Loss & Joel Seligman, Securities Regulation 36-40 (5th ed. 2004) (discussing the merits of mandatory disclosure).

[41] See United States v. O’Hagan, 521 U.S. 642, 658 (1997) (emphasizing that Congress intended “to insure honest securities markets and thereby promote investor confidence” after the market crash of 1929).

[42] Louis D. Brandeis, What Publicity Can Do, Other People’s Money 92 (1914).

[43] See Stephen J. Choi & A.C. Pritchard, Securities Regulation: Cases and Analysis 1-2 (2005) [hereinafter Choi & Pritchard].

[44] Section 5’s gun-jumping rules, which are codified by 15 U.S.C. § 77e, seek to prevent the offer or sale of unregistered securities.  See Loss & Seligman, supra note 40, at 92-97.

[45] See Loss & Seligman, supra note 40, at 45-47 (explaining that the Exchange Act embodies a philosophy of continuous disclosure throughout the life of the security).

[46] Preliminary Response of the Commission to the Recommendation of the Advisory Committee on Corporate Disclosure, Securities Act Release No. 5,906, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,505, at 80,048 (Feb. 15, 1978) (“The basic objective of the disclosure requirements is to increase investor confidence and to make the securities markets more efficient and as fair and honest as possible.”). 

[47] See Gary A. McGill & Edmund Outslay, Did Enron Pay Taxes? Using Accounting Information to Decipher Tax Status, 96 Tax Notes 1125 (2002) (finding that gaps in financial reporting make it almost impossible to determine a corporation’s federal income tax status from financial statements). 

[48] Beale, supra note 10, at 246.

[49] 17 C.F.R. § 240.10b-5 (2006).

[50] 15 U.S.C. § 78j(b).

[51] 15 U.S.C. § 77k (civil liabilities on account of false registration statement).

[52] 15 U.S.C. § 77l (civil liabilities in connection with prospectuses and communications).

[53] An agency’s power to administer a congressionally created program necessarily requires an express or implied congressional delegation of authority to that agency to elucidate a specific provision of the statute by regulation.  See Chevron, U.S.A., Inc. v. NRDC, Inc., 467 U.S. 837, 843-44 (1984).  Congress granted broad powers to the SEC to administer and enforce the securities laws, including a wide range of rulemaking and enforcement powers granted across various provisions of the acts.  See, e.g., 15 U.S.C. §§ 77g, 77aa (broad powers granted to define the contents of registration statement); 15 U.S.C. § 77j (broad powers granted to define the contents of a prospectus); 15 U.S.C. § 78u-3 (broad powers granted to conduct cease-and-desist proceedings); 15 U.S.C. § 78u (broad powers granted to investigate violations); 15 U.S.C. §§ 78n(e), 78j(b) (broad powers granted to define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative).

[54] 17 C.F.R. § 229.10 et seq. (2006).

[55] 17 C.F.R. § 210.1-01 et seq. (2006).

[56] Regulations S-K and S-X are the focal point of SEC integrated disclosure system, and carry a common link both across the initial offering and later periodic reporting.  See Loss & Seligman, supra note 40, at 150.

[57] 17 C.F.R. § 240.12b-20 (2006).

[58] Form S-3 is a streamlined registration form available only to certain well-capitalized and widely followed issuers about which a significant amount of public information is already available.  A registrant on Form S-3 accomplishes disclosure in part by incorporating in the prospectus by reference its most recent Form 10-K and Forms 10-Q filed pursuant to the Exchange Act. See 17 C.F.R. § 239-13(a) (2006); see also Instructions to Form S-3, Item 12(a), available at http://www.sec.gov/about/forms/forms-3.pdf.

[59] See 17 C.F.R. § 249.310 (2006).  Form 10-K is available at http://www.sec.gov/about/forms/form10-k.pdf.

[60] 26 U.S.C. § 6601 (2000) (interest on underpayment of income tax).

[61] Id. at § 6662 (accuracy-related and fraud penalties).

[62] Id. at § 6655 (failure by corporation to pay estimated income tax).

[63] 15 U.S.C. §78j(b).

[64] 17 C.F.R. § 240.10b-5.

[65] Santa Fe Ind., Inc., et al. v. Green et al., 430 U.S. 462, 473-74 (1977); see also Regents v. Credit Suisse First Boston (USA), Inc., No. 06-20856, 2007 U.S. App. LEXIS 6396, at *26 (5th Cir. 2007) (holding that scienter requires either (1) a deceptive act, which in turn requires an affirmative misstatement or omission in breach of a duty to disclose, or (2) a manipulative trading practice, which in turn requires fraudulent trading in the market for the particular security at issue).

[66] The term “scienter” has been defined by the Supreme Court as “a mental state embracing intent to deceive, manipulate, or defraud.”  Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12 (1976).

[67] Hillson Partners Ltd. P’ship v. Adage, Inc., 42 F.3d 204, 208 (4th Cir. 1994).

[68] A prima facie case for Sections 11 and 12(a)(2) has no element of scienter or reliance. 

[69] See Santa Fe Industries, Inc., 430 U.S. at 473-74 (holding there could have been no deception where the corporation fairly disclosed all relevant information on which investors can base their decision).

[70] See In re Par Pharm., Inc. Sec. Litig., 733 F.Supp. 668, 677 (1990) (explaining that the statements at issue gave investors the impression that corporate officials had special expertise in obtaining FDA approvals where in fact the approvals were obtained solely as a result of  illegal bribes).

[71] TSC Indus., Inc. v. Northway, 426 U.S. 438, 449 (1976); but see Longman v. Food Lion, Inc., 197 F.3d 675, 683 (4th Cir. 1999) (failing to disclosure information that is already public cannot be viewed as material by a reasonable investor because such disclosure does not alter the total mix of information already in the marketplace.).

[72] SEC v. Tex. Gulf Sulphur Co., 401 F.2d 833, 849 (1968).

[73] E.g., Zandford, 535 U.S. at 821 (finding scienter based on defendant’s intentional theft of client funds).

[74] Although the Supreme Court has not spoken on the issue of establishing a 10(b)(5) claim by reckless conduct, the majority of Circuits have held that recklessness satisfies the scienter element.  See Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1569-70 (9th Cir. 1990); Hudson v. Phillips Petroleum Co. (In re Phillips Petroleum Sec. Litig.), 881 F.2d 1236, 1244 (3rd Cir. 1989); Van Dyke v. Coburn Enter., 873 F.2d 1094, 1100 (8th Cir. 1989); McDonald v. Alan Bush Brokerage Co., 863 F.2d 809, 814 (11th Cir. 1989); First Commodity Corp. v. Commodity Futures Trading Comm’n, 676 F.2d 1, 7 (1st Cir. 1982); Hackbart v. Holmes, 675 F.2d 1114, 1117 (10th Cir. 1982); Broad v. Rockwell Int’l Corp., 642 F.2d 929, 961-62 (5th Cir. 1981); Mansbach v. Prescott, Ball & Turben, 598 F.2d 1017, 1023-24 (6th Cir. 1979); Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1044 (7th Cir. 1977).

[75] Courts hesitate to expand the reach of 10(b)(5) to matters of traditional corporate mismanagement primarily because of federalism concerns. See Santa Fe Indus., Inc., 430 U.S. at 477-79; Ernst & Ernst, 425 U.S. at 201.

[76] 15 U.S.C. § 78u-4(b).

[77] Id.

[78] Fla. St. Bd. Of Admin. v. Green Tree Fin. Corp., 270 F.3d. 645, 659-660 (2001).

[79] Id.

[80] Id. at 660.

[81] Id.

[82] Id.

[83] See Zandford, 535 U.S. at 821-25 (explaining the “in connection” requirement).

[84] See Id. (holding that the scheme was actionable because the broker misappropriated client funds by writing a check to himself from the client account, knowing that redeeming the check would require the sale of securities).

[85] The SEC does not need to establish reliance.  See Choi & Pritchard, supra note 43, at 315.

[86] Also known as transaction causation.  See, e.g., 9 Louis Loss & Joel Seligman, Securities Regulation 4407-08 (3d ed. 1992) (describing loss causation as a separate element from reliance, or transaction causation”).

[87] Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1972). USCO would likely fit into the omission-based presumption framework because investors allege that the true nature of the tax risk was not disclosed.  Even under the logic that the tax risk was partly disclosed in the brief disclaimer thereby creating a half truth – which is more akin to an affirmative misrepresentation than an omission – a presumption of reliance would nonetheless still arise.  See Loss & Seligman, supra note 40, at 1276-77 (explaining that the line between misrepresentations and omissions is “fuzzy”).

[88] See Basic Inc. v. Levinson, 485 U.S. 224, 241-47 (1988) (explaining that the efficient markets theory assumes an informationally efficient, liquid, transparent, well-followed market, where all public information is immediately valued by the investment community and reflected in the price of the stock).

[89] Id. at 243-47.

[90] For a detailed discussion of the fraud on the market theory, see Loss & Seligman, supra note 40, at 1279-85.

[91] Dura Parm., Inc. v. Boudo, 544 U.S. 336, 346-47 (2005).

[92] 15 U.S.C. § 78u-5(c) (foreclosing liability for forward-looking statements which are “accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.”).

[93] Asher v. Baxter Int’l Inc., 377 F.3d 727 (7th Cir. 2004).

[94] See, e.g., Halperin v. Ebanker USA.COM, Inc., 295F.3d 352, 357 (2d Cir. 2002) (finding that cautionary disclosure informed the total mix of information in such way that more information would not have altered a reasonable investor’s course of action); see also Santa Fe Indus., Inc., 430 U.S. at 474 (full disclosure and deception cannot coexist).

[95] Johnson & McLaughlin, supra note 6, at 3-51 to -55.

[96] Id. at 3-54.

[97] Shaw v. Digital Equip. Corp. (“DEC”), 82 F.3d 1194, 1213 n.23 (1st Cir. 1996); see also Securities Litigation Reform Act, Pub. L. No. 104-67, § 102, 109 Stat. 737, 750 (1995) (as codified by 15 U.S.C. 77z-2 (Securities Act Section 27A ) and 15 U.S.C. 78u-5 (Exchange Act Section 21E)).

[98] Halperin, 295 F.3d at 357 (2d Cir. 2002).

[99] In re Donald J. Trump Casino Sec. Litig., 7 F.3d 160, 167 (3d Cir. 1993).

[100] Shaw, 82 F.3d at 1212.

[101] The disclosure in issue was as follows:

While spending for R&E [research & engineering] and SG&A [selling, general & administrative] is declining, the Corporation believes its cost and expense levels are still too high for the level and mix of total operating revenues. The Corporation is reducing expenses by streamlining its product offerings and selling and administrative practices, resulting in reductions in employee population, closing and consolidation of facilities and reductions in discretionary spending. The Corporation believes that the remaining restructuring reserve of $ 443 million is adequate to cover presently planned restructuring actions. The Corporation will continue to take actions necessary to achieve a level of costs appropriate for its revenues and competitive for its business.

Id. at 1212.

[102] Id. at  1213.

[103] Id.

[104] Id.

[105] Id.

[106] 2006 U.S. Dist. LEXIS 13794, at *8-9 (Mar. 30, 2006), vacated “[t]o avoid the piecemeal issuance of memoranda and orders….” at 2006 U.S. Dist. LEXIS 78067 (Oct. 25, 2006).  The amended opinion does not make clear whether Judge Pauley still holds the view that risk disclosures about uncertainty in past performance are not subject to the forward-looking safe harbors.  The vacating opinion simply concluded that companies have no obligation to disclose risks if the risk is pure speculation.  The discussion in this paper is based on the original vacated opinion. 

[107] Yukos, 2006 U.S. Dist. LEXIS 13794, at *12, 52.

[108] Id. 

[109] See Halperin, 295 F.3d at 357 (“Certain alleged misrepresentations in a stock offering are immaterial as a matter of law because it cannot be said that any reasonable investor could consider them important in light of adequate [qualifying] cautionary language set out in the same offering.”); see also 15 U.S.C. §§ 77z-2, 28u-5 (statutory forward-looking safe harbor provisions).

[110] 2006 U.S. Dist. LEXIS 13794, at *51; See In re JP Morgan Chase Sec. Litig., 363 F. Supp. 2d 595, 626 n.20 (S.D.N.Y. 2005) (“Because plaintiffs have only pled scienter with respect to . . . statements that are inherently backward looking[,] the bespeaks caution and safe harbor doctrines do not apply.”); In re Am. Express Co. Sec. Litig., 2004 U.S.Dist. LEXIS 5497, at *33 (S.D.N.Y. Mar. 31, 2004) (“[A] statement will not be protected as forward-looking under . . . the bespeaks caution doctrine if it also includes representations as to current or historical facts.”).

[111] Rombach v. Chang, 355 F.3d 164, 173 (2d Cir. 2004).

[112] In re Prudential Sec. Inc. P’ships Litig., 930 F. Supp. 68, 72 (S.D.N.Y. 1996).

[113] “The fundamental problem is that the statutory requirement of ‘meaningful cautionary statements’ is not itself meaningful…. What must the firm say?” Asher v. Baxter Int’l Inc., 377 F.3d 727, 729 (7th Cir. 2004).

[114] See City of Phila. v. Fleming Cos., 264 F.3d 1245, 1249, 1266-67 (10th Cir. 2001) (discussing the following disclosure for lawsuit litigation risk:

The company is party to various other litigation, possible tax assessments and other matters, some of which are for substantial amounts, arising in the ordinary course of business. While the ultimate effect of such actions cannot be predicted with certainty, the company expects that the outcome of these matters will not result in a material adverse effect on its consolidated financial position or results of operations

and holding that it satisfied the reporting requirements).

[115] As explained by a Circuit Judge in the Ninth Circuit:

The mere possibility of future fines can have very real financial consequences for a publicly held corporation like Yahoo!. To the extent it is material to a corporation’s financial condition, such companies are required to disclose contingent liabilities in Form 10-Q and 10-K statements filed with the Securities and Exchange Commission. See Securities Exchange Act of 1934, §§ 10(b), 15(d), 15 U.S.C. §§ 78j(b), 78o(d); 17 C.F.R. §§ 240.10b-5, 240.12b-20; see also Financial Accounting Standards Board Statement of Financial Standards No. 5, available at http://www.fasb.org/pdf/fas5.pdf.

Yahoo! Inc. v. La Ligue Contre Le Racisme, 433 F.3d 1199, 1247 n.13 (9th Cir. 2006) (Fisher, J., dissenting).

[116] See Asher, 377 F.3d 727.

[117] Id. at 734.

[118] Asher, 377 F.3d at 733.

[119] 2006 U.S. Dist. LEXIS 13794, at *54(citing Credit Suisse First Boston Corp. v. ARM Fin. Group, Inc., 2001 U.S. Dist. LEXIS 3332, at *23 (S.D.N.Y. Mar. 28, 2001)).

[120] 2006 U.S. Dist. LEXIS 13794, at *54 (citing In re Par Pharm., Inc. Sec. Litig., 733 F. Supp. at 675).

[121] 2006 U.S. Dist. LEXIS 13794, at *54.

[122] See In re Par Pharm., Inc. Sec. Litig., 733 F. Supp. at 675 (finding a misstatement adequately pled where defendants cited the company’s high FDA approval rate without disclosing that the driving force behind the approvals was bribes to FDA officials).

[123]See Management’s Discussion and Analysis of Financial Condition and Results of Operations, Securities Act Release No. 8350, Exchange Act Release No. 48,960, 68 Fed. Reg. 75,056 (Dec. 29, 2003) [MD&A Release].

[124] The SEC describes the  aims of external financial reporting as follows:

MD&A should be a discussion and analysis of a company’s business as seen through the eyes of those who manage that business. Management has a unique perspective on its business that only it can present. As such, MD&A should not be a recitation of financial statements in narrative form or an otherwise uninformative series of technical responses to MD&A requirements, neither of which provides this important management perspective. Through this release we encourage each company and its management to take a fresh look at MD&A with a view to enhancing its quality. We also encourage early top-level involvement by a company’s management in identifying the key disclosure themes and items that should be included in a company’s MD&A.

MD&A Release, 68 Fed. Reg. at 75,056.

[125] The highly subjective determination of transfer pricing costs is a prime example of an accounting estimate or assumption that impacts financial performance of the company.

[126] Id. at 75,057.

[127] Id.

[128] Id. at 75,065.  The 2003 Release further provides the following example: “if reasonably likely changes in the long-term rate of return used in accounting for a company’s pension plan would have a material effect on the financial condition or operating performance of the company, the impact that could result given the range of reasonably likely outcomes should be disclosed and, because of the nature of estimates of long-term rates of return, quantified.”  Id.

[129] The 2003 Release spells out what disclosures are necessary; failure to make adequate disclosures can give rise to administrative liability irrespective of the safe harbor provisions.

[130] See Nicolaisen Speech, supra note 3 (explaining that “[m]anagement’s Discussion and Analysis is a critical supplement to the financial statements”).

[131] Id.

[132] See generally Executive Compensation and Related Person Disclosure, Securities Act Release Nos. 33-8732A, Exchange Act 34-54302A, 71 Fed. Reg. 53,158 (Sept. 8, 2006).

[133] Id. at 53,186.

[134] Id. at 53,189.

[135] Id.

[136] Id.

[137] Even under the more liberal Baxter rule, USCO’s transfer pricing disclaimer is more akin to a boilerplate warning than to a warning that identifies the important factors driving the risk.  Nonetheless, USCO might survive Baxter scrutiny by arguing that the only important factor is the existence of the IRS audit, which was adequately disclosed. 

[138] Yukos, 2006 U.S. Dist. LEXIS 13794, at *54-55.

[139] 15 U.S.C. § 77k.

[140] Id.

[141] Loss & Seligman, supra note 40, at 1232.

[142] Id. at 1238 (“Section 11 refer[s] to damages . . . as a substitute for rescission.”).

[143] 15 U.S.C. § 77k(g).

[144] Abbey v. Computer Memories, Inc., 634 F.Supp. 870 (N.D. Cal. 1986). 

[145] See Johnson & McLaughlin, supra note 6, at 5-6.

[146] 15 U.S.C. § 77k(a)(1).

[147] Id. §77k(a)(2)-(a)(3).

[148] Id. §77k(a)(4).

[149] Id. §77k(a)(5).

[150] See id. § 77o.

[151] See Escott v. Bar Chris Constr. Corp., 283 F.Supp. 643, 652 (S.D.N.Y. 1968) (grouping defendants into statutory categories before deciding liability);see also Choi & Pritchard, supra note 43, at 487 (listing the statutory defendants exposed to liability).

[152] 15 U.S.C. § 77k(e).

[153] Akerman v. Oryx Commc’n Inc., 810 F.2d 336, 340 (2d Cir. 1987).

[154] Issuers can also defend against liability if they can show that the plaintiff actually knew of the alleged misrepresentation.  Johnson & McLaughlin, supra note 6, at 5-6.

[155] Choi & Pritchard, supra note 43, at 491.

[156] Johnson & McLaughlin, supra note 6, at 5-20 to -21.

[157] See 15 U.S.C. § 77k(b)(3) (stating in part the grounds to avoid liability: “as regards any part of the registration statement purporting to be made on the authority of an expert . . . [defendant] had no reasonable ground to believe and did not believe . . . that the statements therein were untrue or that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading”).

[158] See Escott, 283 F.Supp. at 683 (using the word “expertised” to describe certain portions of the registration statement).  For a detailed discussion on when and how disclosures become expertised see Johnson & McLaughlin, supra note 6, at 5-11 to -12.

[159] 15 U.S.C. § 77k (b)(3)(A).

[160] Id. § 77k (b)(3) (B).

[161] Id. § 77k (b)(3) (C) (the requirement of “reasonable investigation” is absent from the statute in this context).

[162] 346 F. Supp. 2d 628 (S.D.N.Y. 2004).

[163] See Erica Fung, Practitioner Note, Regulatory Competition in International Capital Markets: Evidence From China in 2004-2005, 3 N.Y.U. J. L. & Bus. 243, 270 (2006) (“The [WorldCom] decision indicates that underwriters need to take heed of the post-WorldCom environment, and alter their due diligence practices to include a search for red flags.”). 

[164] See In re WorldCom, Inc., 346 F. Supp.2d at 684 (underwrites “have special access to information about an issuer at a critical time in the issuer’s corporate life, at a time it is seeking to raise capital.”).

[165] “WorldCom notwithstanding, there have been relatively few interpretations . . . as to the type of investigation that will satisfy the due diligence standard applicable to a particular offering.”  Johnson & McLaughlin, supra note 6, at 5-19.

[166] In re WorldCom, Inc., 346 F. Supp.2d at 684.

[167] The WorldCom court considered the following variance a “red flag” that should have been caught and investigated by the underwriters: a certain expense to revenue ratio was reported at 43% as compared to AT&T’s reported ratio of 46.8% and Sprint’s reported ration of 53.2%.  Id.; see also Johnson & McLaughlin, supra note 6, at 5-54 (“[A]s Judge Cote’s decision in WorldCom demonstrates, it is relatively easy for plaintiffs to allege and for a court to identify ‘red flags’ that should have alerted underwriters to the need to make further inquiries, and the failure to follow up on such ‘red flags’ relating to audited financial statements may well mean that it will be up to a jury to determine whether underwriters will be liable under Section 11.”).

[168] In re Charles E. Bailey & Co., 35 S.E.C. 33, 41, 1953 SEC LEXIS 294, at *19-20 (1953).

[169] In re The Richmond Corp., 41 S.E.C. 398, 405, 1963 SEC LEXIS 591, at *16 (1963) (noting that visits to company premises, an examination of a shareholder list, and obtaining a credit report is not enough to satisfy the underwriters due diligence duties).

[170] In re Donaldson, Lufkin & Jenrette Sec. Corp., Securities Act Release No. 6959, Exchange Act Release No. 31207, File No. 3- 7863, 1992 SEC LEXIS 2422, at *26 (Sept. 22, 1992).

[171] 283 F. Supp. 643 (S.D.N.Y 1968).

[172] Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544 (S.D.N.Y 1971).

[173] Id. at 582.

[174] Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F.2d 341 (2d Cir 1973), cert. denied, 414 U.S. 910 (1973).

[175] Comfort letters are written representations made by experts or others regarding the accuracy of disclosures.  See In re WorldCom, Inc. Sec. Litig., 346 F.Supp 3d at 637, 684.

[176] The red flag doctrine, however, apparently renders superfluous the distinction in the text of Section 11 between “reasonable investigation” – which is the standard for experts with respect to expertised portion and for nonexperts with respect to nonexpertised portions – and “no reason to believe” – the standard for nonexpert (i.e. underwriter) liability with respect to expertised portions.   WorldCom’s inescapable conclusion is that both standards require a diligent affirmative search as well as a persistent and diligent follow through where something smells fishy. 

[177] See, e.g., In re WorldCom, Inc. Sec. Litig., 346 F. Supp. 2d at 683.

[178] Because of the unusual subjectivity and high potential for abuse in the application of transfer pricing rules, a good argument could be made that transfer pricing investigations should probably be routine.

[179] For a discussion of due diligence procedures, see Johnson & McLaughlin, supra note 6, at 5-31 to -72.

[180] As a matter of simple common sense, efficient flow of capital would suffer a severe blow if underwriters were required to make sure each and every single fact and detail in a registration statement is correct.

[181] See generally John F. Seegal, Due Diligence Procedures, Initial Public Offerings, How to Prepare an Initial Public Offering (PLI Corp. Laws & Practice Course Handbook No. B4-7103 1995) (providing detailed procedures on how an underwriter should perform its due diligence obligations under the securities laws).

[182] Johnson & McLaughlin, supra note 6, at 5-32.

[183] Id.

[184] Id.

[185] The safe harbors for forward-looking statements also inform the liability determination under Section 12(a)(2).

[186] See 513 U.S. 561 (1995).

[187] The important transactions for which Section 12(a)(2) has practical utility include Section 3(a)(9) exchange offers and Section 3(a)(3) commercial paper programs and perhaps overseas offerings exempt under Regulation S, because all may involve public communications short of a registration statement. 

[188] Free Writing Prospectuses are communications outside the registration statement which are nonetheless deemed to comply with the § 10 prospectus requirements of the Securities Act.  See, e.g., 17 C.F.R. § 230.163 (2006).

[189] See generally Securities Offering Reform, Securities Act Release No. 8591, Exchange Act Release No. 52,056, 70 Fed. Reg. 44,722 (Aug. 3, 2005).  For an encompassing snapshot of the offering reforms, see Todd W. Eckland Et al., Practical Lessons Learned From the First 100 Days of Securities Offering Reform (Mar. 10, 2006), available at http://www.pillsburylaw.com/content/portal/publications/2006/3/200631082115543/Securities_ Corp %20&%20Sec%20Vol%200804%20No%208050%2003-10-06.pdf.

[190] 15 U.S.C. § 77k(a)(2). 

[191] Id.

[192] See Pinter v. Dahl, 486 U.S. 622, 647 (1988); see also Shaw, 82 F.3d at 1214 (applying the Pinter rule to resolve a section 12(a)(2) claim).

[193] The reasonable care defense under Section 12(a)(2) requires proof “that [seller] did not know, and in the exercise of reasonable care could not have known….” See 15 U.S.C. § 77k(a)(2).

[194] See In re Worldcom, Inc. Sec. Litig., 346 F. Supp.2d at 663-664 (describing the red flag standard).

[195] Johnson & McLaughlin, supra note 6, at 5-32.

[196] In this case, the misrepresentation complained of is the overstating of the true transfer pricing risk.

[197] Assuming the price of the stock is currently higher than the offering price, a reasonable investor would not desire to rescind the original purchase.

[198] The hypothetical presented in this section is modeled on actual Form 10-K reporting of a large corporation.

[199] Note also that the disclosures at issue necessarily have a present fact aspect, which is contained in the company’s affirmative statement that it believes its reserves are adequate to cover any future IRS adjustments to income taxes.  

[200] In re W.R. Grace & Co., 53 S.E.C. 235,  243, 1997 SEC LEXIS 2038, at *19 (1997).

[201] Choi & Pritchard, supra note 43, at 158, 186.

[202] 15 U.S.C. § 78u; 15 U.S.C. § 77t. 

[203] Other common enforcement-tools examples include broker-dealer registration proceedings under 15 U.S.C. § 78o and revocation of registration proceedings under 15 U.S.C. §78l(k)(1)(A).

[204] In re KPMG LLP, File No. 3-11905, 2005 SEC LEXIS 867, at *57 (Apr. 19, 2005).

[205] 15 U.S.C. § 78m; Choi & Pritchard, supra note 43, at 186.

[206] E.g., In re Tonka Corp., 48 S.E.C. 270, 270, 277, 1985 SEC LEXIS 2611, at *1, 18 (1985).

[207] Id. 

[208] See Johnson & McLaughlin, supra note 6, at 3- 48 to -49.

[209] See Choi & Pritchard, supra note 43, at 157 (noting that Congress adopted mandatory disclosure to combat abuses by insiders possessing informational advantages).                                                                            

[210] Dixie L. Johnson et al., Mind your T&Es: Anticipating the Next Problem in Executive Compensation Practices and Disclosures (2006), http://www.friedfrank.com/secreg/pdf/ sc061012.pdf .

[211] See Nicolaisen Speech, supra note 3 (“the area of income tax accounting could use more sunlight”); see also JCT Study, supra note 2, at 247 (“Any sanction for an aggressive transaction in which a significant purpose is the avoidance or evasion of Federal income tax may be indicative of conduct that is contrary to public policy and should be considered a qualitatively material item that warrants disclosure to a corporation’s shareholders.”).

[212] See Roberta S. Karmel, Realizing The Dream of William O. Douglas -- The Securities and Exchange Commission Takes Charge of Corporate Governance, 30 DEL. J. CORP. L. 79, 100 (2005) (“Perhaps making high-ranking corporate officers individually responsible for a corporation’s financial statements will lead to more accurate and more meaningful financial disclosure….  Probably executive greed has become so completely out of control that substantive regulation of executive compensation is the only way to curb management remuneration.”).

[213] 17 C.F.R. § 229.303 (2006).

[214] The disclosure rules for off-balance sheet arrangements were adopted in response to Enron’s creative efforts to shift underperforming assets and debt off its balance sheet, thereby artificially improving its financial condition.

[215] Disclosure in Management’s Discussion and Analysis About Off-Balance Sheet Arrangements and Aggregate Contractual Obligations, Securities Act Release No. 33-8182, Exchange Act Release No.34-47264, 68 Fed. Reg. 5982 (Feb. 5, 2003) [hereinafter Off-Balance Sheet Release].

[216] Id. at 5985; see also Management’s Discussion and Analysis of Financial Condition and Results of Operations, Release No. 33-6349, 23 SEC Docket 962 [Release not published in the Federal Register] (Sept. 28, 1981).

[217] Id.

[218] Off-Balance Sheet Release, supra note 215, at 5983.

[219] See 17 C.F.R. § 229.303(a)(4)(i)(A).

[220] See id. § 229.303(a)(4)(i)(B).

[221] See id. § 229.303(a)(4)(i)(C).

[222] See id. § 229.303(a)(4)(i)(D).

[223] Off-Balance Sheet Release, supra note 201, at 5989.

[224] Executive Compensation and Related Person Disclosure, Securities Act Release No. 33-8732A, Exchange Act Release No. 34-54302A, 71 Fed. Reg. 53,158, 53,160 (Sept. 8, 2006).

[225] Id.

[226] Id. at 53,166.

[227] Id. at 53,181.

[228] Id. at 53,189.

[229] 26 U.S.C. § 6662 (2000).

[230] See id. § 6662(e)(3); Treas. Reg. § 1.6662-6(d)(2)(iii)(B); see also Arup K. Bose, THE EFFECTIVENESS OF USING COST SHARING ARRANGEMENTS AS A MECHANISM TO AVOID INTERCOMPANY TRANSFER PRICING ISSUES WITH RESPECT TO INTELLECTUAL PROPERTY, 21 Va. Tax Rev. 553, 572 (Spring, 2002). (describing the documentation requirements that must set forth a very detailed analysis that supports the most reliable measure of an arm’s-length price).

[231] See generally FASB Interpretation No. 46 (June 2006), available at http://www.fasb.org/pdf/fin%2048.pdf.