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RUNNING HEAD: GUSTAFSON V.

ALLOYD (1995)

Arthur L. Gustafson, Et Al., Petitioners v. Alloyd Company


An Analysis of Defense Against Securities Fraud
Daniel Zemach
University of Florida

GUSTAFSON V. ALLOYD (1995)

When investing in a company, there is risk involved. There is risk that the investment will
underperform, but often there is also risk that incorrect business practices will endanger the stake
of a shareholder. That is why the government turned the securities market into a highly regulated
institution by implementing the Securities Act of 1933. The Securities Act of 1933 acted as a
regulatory set of rules that ensured a sense of security to those who participate in the purchase of
public securities. The laws pertain to transactions as well as the rights of investors during their
time of ownership (Securities Act 1933).
This paper will analyze, in depth, how the Securities Act of 1933 was created to protect
shareholders of companies and whether there should be a distinction between private and public
companies, when it comes to protecting shareholders. Arthur L. Gustafson, Et Al., Petitioners v.
Alloyd Company is a perfect example of how the Securities Act of 1933 did its job of
recognizing a potential problem in a transaction, in this case a misstatement of financials, and
how it gives appropriate solutions to those involved (petitioners, purchasers, courts, etc.) in how
to proceed. In addition, impacts on todays business environment will be discussed. However,
this case highlights a key deficit to the Securities Act, in that it fails to protect shareholders of
private companies, and how the legal system has corrected itself by defaulting to other statutes.
The Alloyd Company was organized in 1961 with three main shareholders. In 1989, the
shareholders decided to sell the company. They engaged Wind Point Partners II, L. P. to purchase
Alloyd Company. In preparation for the sale, the owners of Alloyd Company hired KPMG to
find a buyer and prepare a formal business review. Wind Point Partners II, L.P. created a
company, Alloyd Holdings, to affect the sale. The agreed on a price of $ 18,709,000 for the sale
of the stock plus a payment of $ 2,122,219, which reflected the estimated increase in Alloyd's net
worth from the end of the previous year (Petitioners v. Alloyd, 1995). An audit revealed

GUSTAFSON V. ALLOYD (1995)

misstated financials which entitled Alloyd Holdings to an $815,000 (plus interest) adjustment to
the extra $2,122,219 paid for the company, discovered after Wind Point brought a suit upon the
owners (collectively known as Arthur L. Gustafson). After the adjustment was determined Alloyd
Holdings, now reincorporated under the original name Alloyd Company, continued with suit in
pursuit of a rescission of sale.
This case began in the District Courts with summary judgment which ended with the
decision that the transaction could not be rescinded. However, this was appealed, and the the
Seventh Court of Appeals remanded the District Courts judgment for further proceeding in the
Court of Appeals due to a new case that was decided in 1993.The Court of Appeals determined
that it was possible for Wind Point to rescind the deal (Petitioners v. Alloyd, 1995). Then the
Supreme Court remanded the Court of Appeals judgment for further proceedings in the Supreme
Court. The reason this progression is interesting, is because the major contention in this case was
not ethical in nature nor about whether there should be some change to the initial sale offer. The
entire contention was over a specific definition of the word prospectus and how its defined in
the Securities Act of 1933 (15 USCS 77l(2)) (Petitioners v. Alloyd, 1995).
The Securities Act of 1933 is not a blanket Act. It serves a very specific purpose and only
covers a segment of securities sales. The distinctions within the act become very important in the
case Arthur L. Gustafson, Et Al., Petitioners v. Alloyd Company. In this case, the Petitioners
were shareholders in a company that had just sold to a newly created holding company that was
incorporated to effect the sale (Petitioners v. Alloyd, 1995). Post sale, the purchaser discovered
that a year end audit revealed that financials used to calculate the $18,709,000 sale price were
overstated (Petitioners v. Alloyd, 1995). While the issue of whether the seller was unethical in
the valuation of the company was never brought up, the seller did the correct thing and issued an

GUSTAFSON V. ALLOYD (1995)

adjustment to the price under the new information. The buyer, however, wanted to rescind the
deal. The buyer claimed that material misstatements in a companys prospectus, according to
the Securities Act of 1933, is grounds for rescission of the deal, regardless of the whether the
mistake was intentional or otherwise (Petitioners v. Alloyd, 1995).
While this case does not focus on it, its important to note how the Securities Act of 1933
played a key role in bringing this case to court. When the audit revealed a mistake in the stated
financials, both parties knew that the transaction could not stand as it was originally intended.
The Act eliminated any motivation for the sellers of Alloyd Company to purposefully misstate
financials or try to cheat the purchasers in terms of sale price. Therefore, when material
misinformation was discovered, it was not an issue of ethics or improper business practices, but
rather both sides attempting to find a solution to an issue. The clear consequences of the Act, in a
way, enabled the companies to not waste time and resources on fighting an ethical issue in court,
rather they just worked to revalue the company and make price adjustments.
While the sellers of the Alloyd company, known as the Petitioners, worked towards
making adjustments to the sale, the purchasers decided they no longer wanted to pursue the
transaction. However, since the contracts were already executed, this was a matter for courts to
settle as to whether it was legal for the purchaser to rescind the sale. This is the point of
contention for the entire case. In reality, the case hinged on two details, the Securities Exchange
Commissions (SEC) obsession with registration and the definition of a prospectus.
While the Securities Act of 1933 does extend beyond public companies in some respect,
certain details do not. Private companies are not registered with the SEC, and therefore many
laws in the the Securities Act of 1933 do not apply. If this were a sale of a public company, this
case would be cut and dry and would never have reached the Supreme Court. Since Securities

GUSTAFSON V. ALLOYD (1995)

Act of 1933 (15 USCS 77l (2)) indicates that any material misinformation in an investment
prospectus is grounds for rescission, the purchaser would have retained the right to end the
transaction and there would be no case. But this case hinges on the fact that Alloyd is private and
that the definition of prospectus is a term of art and relates only to the Initial, public offering
of a company (Securities Act 1933). Since the sale of Alloyd company was neither initial nor
public, it is impossible for Alloyd to even have issued a prospectus to the purchaser at the
beginning of the transactions. Since that is the case, there was no material misinformation in the
prospectus and the purchaser cannot rescind the transaction. There is also the issue that
prospectus, in every day meaning of the word, would be any document issued that offers the sale
of a security (Petitioners v. Alloyd, 1995). However, because there is a strict statutory definition
of the word prospectus in the Securities Act that limits it to initial and public offerings only, there
can be no case made that this is misleading or should change the facts of the case.
This raises the issue of whether private companies should be more heavily regulated than
they are now. The purchaser of Alloyd Company felt they had been defrauded by the false
statements made by the sellers. However, because Alloyd Co. was not registered with the SEC,
the purchasers were not afforded any protection from such fraudulence, intentional or otherwise,
and were forced to accept the price adjustments offered to the sellers. Alloyd Company could
have also issued false financial statements to its shareholders and defrauded them of proper
dividends. This case teaches us that section 12, referring to the consequences of making
fraudulent claims in a prospectus, is no longer a valid way to protect purchasers in a sale.
With Section 12 of the Securities Act of 1933 no longer a form of legal protection from
fraud due to the precedent set by Arthur L. Gustafson, Et Al., Petitioners v. Alloyd Company,
people participating in private business transactions needed another form of legal protection.

GUSTAFSON V. ALLOYD (1995)

After the resolution of this case, the law turned to Section 10b-5 under the US Securities
Exchange Act. Rule 10b-5 states:

for any person, directly or indirectly...(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...in
connection with the purchase or sale of any security. (Securities Exchange Act of 1934)

While 10b-5 is more complicated than Section 12 of the Securities Act of 1933, it
actually affords more legal protection to a broader range of parties than the original defense
against fraud. First and foremost, it does not differentiate between registered and unregistered
business entities, meaning one of the glaring weaknesses of the Section 12 is resolved (Neuville,
2014). It also does not specify where the material misinformation needs to be stated. For
example, if material misinformation is transmitted through email or over the phone, 10b-5
considers this a valid method for transferring fraudulent information despite its less official status
as a financial document. Unlike the Securities Act of 1933 which specifically states that any
material misinformation in a prospectus is grounds for rescission, 10b-5 clarifies that it does not
matter where or how the misinformation was given, just the fact that it was.
10b-5 actually improves on Section 12 in several other ways. It does not specify that the
law is only relevant to issuers or a specific party. It mentions that 10b-5 does not distinguish
between issuers and other parties, meaning it affords a greater range of protection to a larger
range of stakeholders in any particular company or transaction. In connection with other laws,

GUSTAFSON V. ALLOYD (1995)

10b-5 is used to establish liability and exempt some purchasers from transactions. The law has
continued to develop over time as more case law is established.
It is interesting to analyze how this law is partially a result of how shareholders and
corporations are viewed as separate entities. When the original shareholders of Alloyd Company
went to court to fight the purchasers ability to rescind the sale, they did do so as a part of the
Alloyd Company. They did it as a separate group of individuals that were arguing over the details
of a transaction that involved an additional separate entity, the Alloyd Company. If shareholders
were considered one and the same as the corporation, and not as separate entities, this case would
have been approached differently (Emerson, p.83).
This case also has a recent impact on todays business environment as well (Saproff,
2015). The JOBS Act of 2012 raised the maximum capital raising amount for small businesses
from $2 million to $50 million and made their shares freely tradable (Feigin, 2015). This could
have been an issue for many capital providers who are investing in small, private businesses, as
they could have been unprotected from fraud if not for the precedent set by Arthur L. Gustafson,
Et Al., Petitioners v. Alloyd Company (Mungovan, 2013).
Another aspect worth discussing is how developing case law impacted how this case
proceeded through the court system. A case from 1991 allowed the district courts to grant
summary judgment and a case from 1993 impacted the Court of Appeals decision to remand the
judgment decided by the District Court. These judgments contradicted each other and finally it
took the Supreme Court to establish the true ruling on the case and set the correct precedent from
1995 onward.
Ultimately, it was decided that the purchasers of Alloyd Company could not rescind the
sale based off of the fact that Alloyd Company was a private corporation and therefore issued no

GUSTAFSON V. ALLOYD (1995)

prospectus with material misinformation to the buyers. This judgment was reached through three
different court systems (Emerson, p. 38), all arguing the following aspects of the case:

Three sections of the 1933 Act are critical in resolving the definitional question on
which the case turns: 2(10), which defines a prospectus; 10, which sets forth the
information that must be contained in a prospectus; and 12, which imposes liability
based on misstatements in a prospectus. In seeking to interpret the term "prospectus,
(Petitioners v. Alloyd, 1995).

The outcome of this case permanently impacted the applications of Section 10 and 12 of
the Securities Act of 1933 and shifted the focus to 10b-5 of the Securities Exchange Act of 1934
when arguing cases of securities fraud. This shift was a positive change in business law as it
affords more protection to a broader range of stakeholders and protects those who may be
impacted by fraud in both the private and public sectors. This broader protection and general
impact has been seen in recent days including making possible the increase in capital limits for
small businesses by the JOBS Act of 2012, without sacrificing the security of small business
investors. In addition, Arthur L. Gustafson, Et Al., Petitioners v. Alloyd Company is an excellent
example of how a case can proceed through the court system and how case law is the foundation
for the American legal system.

GUSTAFSON V. ALLOYD (1995)

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References

Arthur L. Gustafson, Et Al., Petitioners v. Alloyd Company, 131 L. 2d 1 (U.S., 1995)


Feigin, P. (2015). The SECS New Regulation A+ and the States M Word.
JDSupra Business Advisor, Retrieved from
http://www.jdsupra.com/legalnews/the-secs-new-regulation-a-and-the-s-87128/
Mungovan, T. (2013). Probing Private Equity for Section 12(a)(2) Liability.
Law360, Retreived From
http://www.law360.com/articles/434915/probing-private-equity-for-section-12-a-2liability
Neuville, D. (2014). United States: Added Comfort.
Mondaq, Retrieved from
http://www.mondaq.com/unitedstates/x/328758/Audit/Added+comfort
Saproff, P., Hauer, D., & Nucci, J. F. (2015). United States: Expansion Of Issuer Liability For
Crowdfunding: What Might This Mean For The EB-5 Industry
Mondaq, Retrieved from
http://www.mondaq.com/unitedstates/x/424336/Investment+Immigration/Expansion+of+
Issuer+Liability+for+Crowdfunding+What+Might+this+Mean+for+the+EB5+Industry
Securities Act of 1933, 15 U.S.C.S. 77l(2),
Securities and Exchange Commission Rule 10b-5
Securities Exchange Act of 1934, 15 U.S.C. 78j(b)
Emerson, R. W., (2009). Government Under Law. Business Law (21-42). New York: Barrons.
Emerson, R. W., (2015). Agency. Law, Society, and Business (80-117). Florida: University of
Florida.

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