Buckham Securities Outline

Buckham, Brian R.
Securities Outline (Spring 2005) -- Professor Macdonald

Brian Buckham
Section 1 Introduction to Securities
I.
The Framework of Securities Regulation

A.
B.
C.
Introduction
1.
Business Associations v. Securities
a)
BA = formation and management of various business entities.
b)
Securities = capital raising and trading.
2.
Value of a Security the Information Problem
a)
A security is worthless, except to the extent that it represents an ownership interest in something else or an
obligation.
(i)
This makes it a perfect breeding ground for fraud.
3.
Dual Focus of Securities Law:
a)
Disclosure
(i)
Must occur before the issuer can sell the securities to the investor. Tries to prevent people from
investing in things they do not know about.
b)
Anti-Fraud
(i)
Provides remedies after-the-fact.
4.
Closely Held v. Publicly Held Businesses
a)
Closely Held = the same people that own the business run the business.
(i)
Have an identity between ownership and management.
b)
Publicly Held = the people that own the business do not run the business.
(i)
Have a separation between ownership and management.
(ii)
Ownership is commonly very diffuse.
Issuer and Trading Transactions in Securities
1.
Generally
a)
Securities are bought and sold in two principle settings: issuer and trading transactions. The federal securities
laws are structured differently for each of the two settings.
b)
The mechanics, practices, and rules for disclosure, as well as other activities, differ significantly for primary
distributions (issuer transactions) and trading transactions.
2.
Issuer Transactions
a)
Issuer transactions = those involving the sale of securities by the issuer to investors.
(i)
This is the means by which the company raises capital.
(ii)
Most expeditious form is the private placement, where the issuer sells directly to a select number of
investors. On the other end of the spectrum, a primary distribution is a public offering to a large
number of diverse investors (IPO).
3.
Trading Transactions
a)
Trading transactions = the purchasing and selling of outstanding securities among investors.
(i)
Can be either privately negotiated or occur through public markets.
(ii)
Secondary distribution = a sale of a large amount of securities by an individual, large enough to
support a secondary public offering.
(a)
Most frequently occurs when someone who controls much of the issuer corporation
wishes to sell some of his shares.
b)
Securities Markets = the facilities through which outstanding securities are publicly traded.
(i)
Can be roughly divided between bond, equity market, and derivative/option markets.
Legal Framework of Securities Laws and Regulation
1.
Note on the Revolving Door
a)
Revolving Door concept the regulators and the regulated companies involve persons who go back and forth
between industry and government regulatory positions Ex: CEO of Freightliner becomes Head of Dept. of
Transportation.
(i)
Part of the rationale is that we want experts in these positions.
2.
Federal Securities Laws
a)
Securities Act of 1933 (Securities Act)
(i)
Enacted in response to the market collapse of October 1929.
(ii)
Regulates the public offering and sale of securities in interstate commerce. The Acts
disclosure demands apply to public offerings of securities that occur through the process of
registering such an offering with the SEC.
(iii)
Requires the preparation of a registration statement to assure full and fair disclosure.
(a)
The Registration Statement
i
Contents of the statement are industry-specific and spelled out by regulation, but
must generally contain a thorough description of the issuers business, property,
and management. Must disclose extensive financial information, and provide a
management analysis and review. Must disclose the rights, privileges, and
preferences of the security, as well as the existing capital structure. Must disclose
any risks.
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Buckham, Brian R.
The information filed by an unseasoned issuer with the SEC

undergoes several drafts and reviews under the demanding eye of the
SECs Corporate Finance staff.
ii
Most of the registration statements substantive information is also required to be
disclosed in the prospectus.
(b)
The underwriters selling efforts cannot commence until the registration statement has
been filed with the SEC, and no sales or deliveries of securities may occur until the
registration statement is effective.
(iv)
Exemptions from Registration
(a)
Section 3 of the 33 Act exempts numerous categories of securities from the Acts
registration requirements. Section 4 exempts certain types of transactions.
(v)
The 33 Act provides both public and private remedies to ensure compliance.
Securities Exchange Act of 1934 (Exchange Act)
(i)
Generally
(a)
The Exchange Act is in large part a laundry list of problems with the markets at the time
it was enacted. Congress, through Section 4 of the Exchange Act, created the SEC and
delegated to it the task of grappling with the listed problem areas. This makes the
regulations to the 34 Act very important.
(ii)
Continuous Disclosure Provisions
(a)
While the Securities Act deals with protecting investors in primary distributions, the
Exchange Acts concern is trading markets and their participants.
(b)
Three categories of companies subject to the 34 Acts continuous disclosure requirements
(called Reporting Companies):
i
Companies that have a class of securities listed on a national exchange (12(b));
ii
Companies that have assets in excess of $10 million and have a class of equity
securities held by at least 500 persons (12(g) and Rule 12g-1); and
iii
Companies that have filed a 33 Act registration statement that has become
effective.
(c)
Reporting companies are required to register with the SEC and make timely filings of the
reports required by Section 13 of the 34 Act.
i
Unlike the 33 Act, the disclosures under the 34 Act need not be sent to the
investors or market professionals. Filing w/ the SEC is done electronically or via
physical delivery in electronic form.
ii
Reports: 10-K, 10-Q, 8-K, etc.
iii
Integrated disclosure for established, large companies:
(a)
Certain companies registering securities under the 33 Act can fulfill
many of the 33 Act requirements by incorporating into the 33 Act
registration statement information from their 34 Act (e.g., 10-K)
filings.
(i)
Reduces the cost and delay that accompanies registering
securities.
(d)
The 34 Act also imposes rules on full and fair disclosure when the company solicits their
stockholders proxies. Also imposes, through the Williams Act Amendments, rules
regarding disclosure in tender offers when an outsider acquired more than 5% of a class
of registered equity securities.
(iii)
Regulation of Exchanges, Broker-Dealers, and Market Abuses
(a)
The Exchange Act arms the SEC with the ability to oversee SROs and gives the SEC
antifraud and anti-manipulation protection abilities, through both public and private
enforcement.
Sarbanes-Oxley Act of 2002
(i)
Generally
(a)
SOX sets forth broad prescriptions for corporate governance, authorizes the SEC to
develop rules for professional conduct for lawyers, and regulates areas that have always
been the province of the states, such as loans to officers and directors, among other areas.
(b)
SOX does not change the core features of the securities laws, but SOX introduces
important procedural and substantive requirements for public companies as additional
safeguards to protect investors.
(a)
b)
c)
d)
Regulation of Investment Advisors and Investment Companies [Not discussed in class]

(i)
The Investment Company Act
(a)
Investment Company = a company formed for the purpose of buying, selling, and holding a portfolio
of securities for investment, rather than for control purposes.
i
Common versions are money market funds and mutual funds.
(b)
The Investment Company Act regulates the independence of the companys board of directors,
requires annual review of management contracts between the investment company and its
investment advisor, places conditions on certain internal transactions upon approval by the SEC, and
regulates the capital structure of the company.
(ii)
Investment Advisers Act of 1940
(a)
Investment Advisor = one engaged in the business of rendering investment advice to others for
compensation.
(b)
3.
4.
Buckham, Brian R.
Investment Advisers Act of 1940 requires advisors to register with the SEC, establishes a few
minimum requirements for fair dealings by investment advisors, and prohibits fraudulent or
deceptive practices by investment advisors.
e)
Organizational Structure of the SEC

(i)
Generally
(a)
SEC is an independent, nonpartisan agency created by the 34 Act.
i
Note: the 33 Act, until the creation of the SEC under the 34 Act, was
administered by the FTC.
(b)
SEC is composed of 5 commissioners appointed by the President, on staggered terms of 5
years, and not more than three can be from the same party as the President.
(c)
Generally get high marks for a government agency. Seems fairly balanced between
needs of investors on one hand and corporations on the other. But
(ii)
Criticisms of the SEC:
(a)
33 and 34 Acts are substantially unchanged since originally promulgated. Some argue
that the system is overkill. They are still reacting to 1929.
(b)
SEC has a disinclination to adopt bright-line rules.
i
But this makes sense because people will find ways around bright-line rules. The
SEC does not want a lot of bright line rules, so it can keep the ability to go after
new schemes that people develop.
(c)
The SEC policymaking role is dominated by lawyers.
i
But it probably should be this way.
(iii)
SEC operates through 4 principal divisions: Division of Corporate Finance; Division of Market
Regulation; Division of Investment Management; Enforcement Division.
f)
Mediums of Action by SEC

(i)
Mechanisms to Act:
(a)
Rulemaking
(b)
Releases accompanying proposals to rulemaking
(c)
Enforcement actions
(d)
Amicus briefs filed in certain litigation
(e)
No-action letters
i
SEC staff responses to individual inquiries regarding the staffs interpretation of the federal
securities laws application to a specific transaction.
ii
Called a no action letter because in a favorable response toe staff states it will
recommend no action to the Commission if the transaction is carried out as stated.
iii
Are NOT the official view of the SEC. 17 CFR 202.1(d). But, the SEC will not challenge
the transaction as a violation of the law. Securities Act Release No. 4553 (1962).
Nonetheless, a no-action letter is not binding on private parties, who can challenge the
action. The SEC can reconsider its position on the no-action letter, and the no-action letters
are not judicially reviewable because they are not orders of the Commission.
iv
SEC refuses to provide no-action letters in certain areas. Securities Act Release No.
6253(1980).
v
No-action letters are not binding on the courts, and it does not prevent a private litigant
from suing.
Blue Sky Laws

a)
Blue sky laws are state securities laws.
(i)
The Uniform Securities Act was used by 39 states in enacting their state securities laws, but states
vary widely in their deviations.
b)
Blue sky laws focus on the Merit of the Investment
(i)
The SEC doesnt care much about the merit of the investment. If it is a bad investment idea, it is
irrelevant to the SEC, so long as it is disclosed.
(ii)
By contrast, most blue sky laws embrace some form of merit review, looking at whether to qualify a
security based on the substantive merits of the offering, rather than basing it on full disclosure.
c)
Federal Exemption of Some State Law Areas
(i)
In 1996, Congress amended Section 18 of the Securities Act to exempt from the states registration
procedures several categories of securities, called covered securities, including those that are or
will be listed on the NYSE, American Stock Exchange, or NASDAQ. As a result of the legislation,
the power of the states to compel registration of offerings is largely restricted to relatively small
offerings that are not made to sophisticated investors.
Self-Regulatory Organizations
a)
Generally
(i)
SROs are industry-sponsored groups.
(ii)
Govt delegates some of the functions that the govt could be doing to an SRO. SEC delegates a
portion of its responsibilities to these SROs.
(a)
These SROs also have regulatory responsibilities.
(b)
Problem w/ Delegation to SROs:
i
By delegating responsibilities, the voters do not control and the SRO is not
accountable.
ii
On the other hand, the SROs have expertise.
(iii)
The SEC has been willing to defer to SROs in many subject areas, and especially in the development
of procedures for the functioning of securities markets.
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b)
5.
Four Types of SROs:

(i)
National securities exchanges (NYSE, AMEX)
(a)
Section 5 of the Exchange Act requires all exchanges to register as national securities
exchanges. The national securities exchanges must also satisfy Section 6 regarding fair
dealing to protect investors.
(ii)
National securities association (NASD)
(a)
Section 15A of the Exchange Act requires creation of a national securities association to
prevent fraudulent and manipulative acts among over-the-counter brokers.
(b)
The NASD is the only such association, and it operates the NASDAQ, an OTC exchange.
(iii)
Registered clearing agencies, and
(iv)
Municipal Securities Rulemaking Board (MSRB)
Liability for Securities Acts Violations
a)
33 Act imposes strict liability on issuers (the company itself) in shareholder suits based on misrepresentations
in a registration statement. The remedy is rescission of the transaction.
(i)
The individuals involved (officers, directors, underwriters, lawyers), however, are NOT strictly
liable they have a due diligence defense.
b)
34 Act imposes liability only for intentional or reckless conduct.
Buckham, Brian R.
Section 2 Definition of a Security
I.
The Definition of a Security

A.
Introduction
1.
If it is not a security, then the impact is to alleviate the burden of many regulations.
2.
If it is found to be a security, failure to register the security gives the investors a potent weapon, in that the investors
have the right to rescission of the transaction! The regulations also provide private causes of action for violations of the
regulations, such as fraud.
a)
Generally it is a private litigant that brings the suit claiming it was a security. P uses this in hope of
recovering capital invested in a bad business deal or as a defense asserting the invalidity of a contractual
obligation to pay money.
b)
The remedy of rescission is likely to lead the company to insolvency and bankruptcy. The company is
incapable of giving back the money they raised because they likely invested it in their operations.
c)
Used For Fraud
(i)
The reason why plaintiffs (investors) want to use the securities laws for fraud instead of common
law remedies is that the securities laws are much more plaintiff-friendly.
3.
Two Ways to Avoid Registration:
a)
Structure the deal so it does not involve securities.
b)
Fit into one of the exemptions under the 33 Act.
(i)
Of course, the issuer is still not exempt from anti-fraud provisions of the Act.
B.
Definition of Security in the 33 and 34 Acts

1.
Definition of security is substantially the same in both Acts. 2 of the 33 Act provides a laundry list of examples
such as notes, stocks, bonds, debentures, CDs, investment contracts, certificates of interest in profit sharing agreements,
and interests commonly known as securities.
a)
This leaves great room for ambiguity. What is a profit sharing agreement or what specifically qualifies as a
note. The term investment contract seems extremely broad.
b)
The term investment contract has been the subject of the most debate.
2.
Intentionally Broad
a)
What Congress is trying to regulate with its definition of security is all the various types of schemes being
used to separate people from their money. This is an infinite variety that seems to defy categorization. We
dont want a solid definition of a security because people would engineer transactions to take advantage of such
a bright-line rule.
C.
Opting Out of Securities Treatment

1.
Should buyers and sellers be able to exempt transactions from the securities laws by opting-out via contract?
a)
14 of the 33 Act any conditions, stipulation, or provision for a person buying any security which waives
compliance w/ the securities laws is void.
b)
Parties can still avoid securities laws treatment by using certain types of entities. If corporate stock, limited pship interests, and interests in manager-managed LLCs generally are securities, while general p-ship interests
and interests in member-managed LLCs generally are not securities, promoters may control application of the
securities laws through the expedient of choosing one form of association over another.
(i)
This opt-out possibility is difficult to square with the anti-waiver provisions of the securities acts.
D.
Security Definition in State Law

1.
States often use the risk capital test. Some states, however, may use the Howey test.
a)
Idaho has used both in years past.
2.
The Risk Capital Test
a)
Risk capital is capital that gets something up and running.
b)
A security will not exist under the risk capital test unless capital provided by investors is at substantial risk
and the capital is economic capital placed subject to the risk of loss through operation of the scheme in
question.
(i)
Does NOT require a common enterprise among investors.
c)
The risk capital test is not used in federal securities law, but is employed by some states in blue sky laws.
E.
Defining an Investment Contract

1.
SEC v. W.J. Howey Co.
a)
Background on Howey
(i)
Involved the offering of units of a citrus grove development combined with a contract for
cultivating, marketing, and remitting the net proceeds to the investor.
(ii)
Each investor was offered both an installment land sale contract and a service contract (not all
investors entered into the service contract). The service contract gives a corporation a leasehold
interest and full and complete possession of the investors tract. The corporation is accountable only
for an allocation of the net profits of the entire citrus grove to the investors (a portion of the net
profits to each investor).
b)
Definition of Investment Contract

(i)
Elements:
(a)
A contract, transaction, or scheme
(b)
Investment of money in a common enterprise
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(c)
(d)
c)
d)
e)
f)
g)
F.
For an expectation of profits

Solely from the efforts of others.
Howey Applies to Investment Contracts Only

(i)
The definition in Howey is meant only to define an investment contract. It is not meant to define
any of the other items listed as a security in 33 and 34 Acts. (Landreth Timber Co.).
Passivity is a Red Flag
(i)
In Howey, it fell outside the realm of a mere real estate contract because there was an arrangement
where the investor expects a return and becomes a passive investor. Anytime you have a passive
investor where returns are based on the efforts of others, then there is probably a security.
This is a red-flag, at the very least.
Formal Certificates Not Necessary
(i)
It is immaterial whether the shares in the enterprise are evidenced by formal certificates or by
nominal interests in the physical assets employed in the enterprise.
Offer of Components of a Security is Sufficient
(i)
It is enough that the promoters merely OFFER the essential ingredients of an investment
contract.
(ii)
It is a violation of the registration provision to make an unregistered sale OR an unregistered
offer. You have to look at the offerees, rather than just the ultimate purchasers.
Risk/Speculation is Not a Factor (Traditionally)
(i)
It is immaterial whether the enterprise is speculative or non-speculative or whether there is a
sale of property with or without intrinsic value.
(a)
While Howey said that risk was not a factor; subsequent courts appear to consider risk as
a factor.
Howey Applied
1.
Investment in an Enterprise v. Consumption
a)
Investment Consumption Distinction
(i)
Issue:
(a)
What result if the expected returns are not in the usual form like dividends or price
appreciation, but instead involve some other benefit derived from use or enjoyment of the
underlying asset?
(ii)
General Rule:
(a)
Investment = security
(b)
Consumption = not a security
i
When a purchaser is motivated by a desire to use or consume the item purchased
to occupy the land or develop it themselves, the securities laws do NOT
apply. (United Housing Foundation v. Forman).
(a)
The 4th Circuit holds that a security is not present if the investors
were attracted primarily by the prospect of acquiring use and not by
financial returns on their investment.
2.
Common Enterprise
a)
The Meaning of Common Enterprise
(i)
Howey requires that there be a common enterprise. Courts are split, and the Supreme Court has
not resolved the question, as to what relationship is the relevant one for a common enterprise.
Two approaches are used to determine if there was a common enterprise:
(a)
Vertical Commonality
i
Emphasizes the relationship between the investors and the promoter. The
principal inquiry is whether the activities of the promoter are the controlling
factor in the success or failure of the investment.
(a)
Under this principle, a common enterprise may exist even though
there is no pooling of investors funds or interests.
ii
Two Approaches:
(a)
Strict Approach
(i)
Requires some risk sharing between the company and the
investor. There must be a direct relationship between the
success (as opposed to the efforts) of the promoter and that
of the investors.
(ii)
Strict vertical commonality is the majority rule. Only a
distinct minority accept broad vertical commonality.
(b)
Broad Approach
(i)
Courts look to the uniformity of the impact of the promoter
and require only a connection (but not necessarily risk)
between the efforts of the promoter and the collective
successes or losses of the investors.
(b)
Horizontal Commonality
i
Emphasizes the common enterprise among investors/offerees.
ii
Requires a pooling of investor funds.
(a)
This will typically involve a pro rata distribution of profits or sharing
of losses among investors, but may exist when promised returns are
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(b)
(c)
3.
fixed rather than variable, provided there is the requisite pooling of

investor funds.
A strict approach would require more than one investor.
(i)
But, at least one case held that a single investor is
sufficient, provided there was an original intention to
involve multiple investors.
Requiring multiple offerees makes some sense in that we may not
want securities law treatment when there is only one offeree; i.e., a
one-on-one relationship. If it becomes a relationship where there are
multiple offerees, then it invokes the securities laws.
Profits Solely from the Efforts of Others

a)
Profits
(i)
Fixed Returns Can Be Profits (SEC v. Edwards)
(a)
There is no reason to distinguish between promises of fixed returns and promises of
variable returns for purposes of the Howey test.
i
By profits, the Howey court meant profits that investors seek on their
investment.
ii
The fact that investors have bargained for a return on their investment does not
mean that the return is not also expected to come solely from the efforts of others.
The fact that returns are contractually guaranteed does not take them out of the
realm of securities.
b)
Solely from the Managerial Efforts of Others
(i)
Generally
(a)
Over time, the word solely has been taken out of the definition. The fact an investor
makes some effort does not take it out of the realm of securities.
(ii)
The critical inquiry is whether the efforts made by those other than the investor are the
undeniably significant ones, those essential management efforts which affect the failure or
success of the enterprise.
(a)
Thus, nominal participation by the investor does not circumvent application of the
securities laws.
i
Examples:
(a)
Was a security:
(i)
Promoters used a pyramid scheme of selling chinchillas to
persons and would then buy the offspring at inflated prices
to be resold.
(b)
Generally not a security:
(i)
Most franchise and distributorship arrangements.
Participation by investors is relatively large. But, if the
franchisee does not actively participate, it can be a security.
(iii)
Managerial Efforts Prior to Promotion/Sale to Investors
(a)
What if the efforts of others occurred before the investment contract was sold?
i
Ex: Viatical Settlements the efforts of others element was not satisfied when
the efforts of others occurred and ended prior to the sale (i.e., the company found
the AIDS patient, then secured the life insurance rights and paid the AIDS patient
X% of the face value of the insurance, then sold the interest). The efforts must
continue after the sale or else the element is not satisfied the investor must be
relying on the efforts of others in the future in getting the profit.
G.
Franchises as Securities
1.
Majority of franchises are not securities, because the investors participation is too great to be from the efforts of
others. It is a mixture of franchisee and franchisors efforts.
a)
The question is whether the franchisee is required to make significant efforts in the enterprise in order to get the
expected profit. When a franchisee is expected to work on-site as a manager, it is clearly not a security.
2.
Under State Securities Laws
a)
But, in states that use the risk capital approach for their blue sky laws, it may more likely be a security because
the capital was provided by the investor (franchisee) to the franchisor at substantial risk.
b)
Some states have special sections regarding franchises in their state statutory law they have state franchise
laws that are much like securities laws and require certain disclosures to people who are going to invest in
franchises, and the statutes also have an anti-fraud section, too.
3.
In any event, a franchise should be a red flag as something to check out.
H.
Interests in Corporations, Partnerships, and LLCs as Securities
1.
Stock as a Security
a)
Some types of stock are not securities.
(i)
Calling an instrument stock alone does not make it a security.
b)
Factors of stock:
(i)
The right to receive dividends contingent upon an apportionment of profits;
(ii)
Negotiability;
(iii)
The ability to be pledged or hypothecated;
(iv)
The conferring of voting rights in proportion to the number of shares owned; and
(v)
The capacity to appreciate in value.
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c)
Sale of a Wholly-Owned Business

(i)
Old Rule Sale of all or substantially all of the stock in a closely held corporation is exempt from
the securities laws.
(a)
This was the sale of a business doctrine.
(b)
It would not be treated as a securities deal. You are buying the whole business, not just
the stock (the substance was the sale of the business, not the sale of the stock itself). This
is true regardless of the form of the transaction.
(ii)
Landreth Timber It may still be a security when a person sells all or substantially all of the stock
of a closely held corporation.
(a)
Landreth eliminated the sale of a business doctrine.
i
If it has the characteristics of stock, it is stock. We look at substance over form.
ii
Applied the Forman factors.
2.
Partnership Interests as Securities
a)
Introduction
(i)
Because partnership interests are not among the items enumerated in the statutory definition of a
security, the issue in the partnership cases centers on the presence of an investment contract under
the Howey definition.
b)
General Partnerships (Williamson v. Tucker)
(i)
A general partnership or JV interest can be a security if the investor can establish that:
(a)
An agreement among the parties leaves so little power in the hands of the partner or
venturer that the agreement in fact distributes power as would a limited partnership; or
(b)
The partner or venturer is so inexperienced in business affairs that he is incapable of
intelligently exercising his partnership or venture powers; or
(c)
The partner or venturer is so dependent upon some unique entrepreneurial or managerial
ability of the promoter or manager that he cannot replace the manager of the enterprise or
otherwise exercise meaningful partnership or venture powers.
(ii)
Very few cases have treated general partnership interests as securities.
c)
Limited Partnerships
(i)
Given the passive investor status of limited partners, limited partners are often successful at
claiming the interest was a security.
(ii)
General Rule (Steinhardt Group v. Citicorp.):
(a)
If a limited partner has meaningfully participated in the management of the partnership in
which it has invested such that it has more than minimal control over the investments
performance, it is not a security.
3.
LLC Interests as Securities
a)
In evaluating whether LLC interests are investment contracts, the analysis parallels that of general and limited
partnerships.
(i)
Member-managed LLC interests are more likely to not be securities, whereas manager-managed
LLC interets approximate limited partnerships and are thus more likely to be considered securities.
(ii)
If the operating agreement says the LLC is member managed, a minority of courts will not look
beyond that fact and will say it is not a security. But, some courts will look beyond the operating
agreement and see how it is actually managed, looking at the day-to-day role of the investors in the
management.
I.
Club Memberships as Securities
1.
Membership in purely social organizations or clubs are not normally construed to be securities (e.g., memberships in
country clubs), but memberships in clubs that have some business aspect are generally held to involve the sale of
securities.
2.
If the money given by the investor gives more than access to the club, but is rather seed money to get the property up
and running, it is more likely to be considered a security.
3.
Another red flag is marketing. If it is marketed and sold as a buy now and sell higher later (like a membership to a
country club that you can buy and sell) then it may be considered a security.
J.
Real Estate as Securities
1.
Generally
a)
The red flag is: Real Estate + X.
(i)
The add-on X, whether it be a pooling agreement, service contract, etc. can transmute it into a
securities transaction.
(a)
X is commonly such things as rent pooling agreements, etc. In Howey, X was the
service contracts.
b)
A standard real estate transaction in the form of a sale or lease of property does NOT involve the offer of a
security. When the seller offers collateral arrangements promising postacquisition income to the buyer or
arrangements such as rent pooling agreements, however, an investment contract may be present.
(i)
An example is the marketing of resort condos that will not be occupied by the purchasers.
2.
Rotational Allocation Systems
a)
In a rotational allocation system, rather than pooling all the income and dividing it, there is a specific unit-byunit allocation of the income to each unit owned by an investor. This becomes a question of whether there is a
common enterprise (commonality), considering that different investors are not all in the same position. But, the
argument still exists for vertical commonality. In a no-action letter, the SEC distinguished these from pooling,
and said that this type of arrangement takes it out of the realm of securities.
3.
Example Case: Hocking v. Dubois
8
Buckham, Brian R.
a)
K.
L.
M.
A real estate agent in Hawaii informed P that a rental pool arrangement would be available if he bought a
condo in Hawaii and leased it to tourists. This was the offering of a security, even where the company
offering the rental pool agreement was not related to the real estate agents business.
Notes as Securities
1.
Generally
a)
The securities acts define a security to include any note. But, courts have limited this definition.
(i)
Context Clause 2(a) starts off to say, unless the context otherwise requires This provides
the court with the ability to say the term note in the definition can be limited.
(a)
Most courts and commentators have been unwilling to conclude that transactions such as
home mortgages, consumer installment purchases, and ordinary commercial financing
involve securities.
b)
Commercial Paper Exemption
(i)
The 33 and 34 Act differ slightly in their treatment of notes. In theory, the differing treatment
means that short-term notes (< 9 months) are exempt from the 34 Act, but are still subject to the
provisions of the 34 Act other than the registration provisions. (p. 62).
2.
Rule of Thumb for Notes Investment v. Consumer/Commercial
a)
The dichotomy between commercial or consumer v. investment will often be determinative of whether it is a
security or not.
(i)
If the note is issued in an investment context, it looks more like a security.
(ii)
If the note is issued in a consumer/commercial transaction (i.e., financing a house), it is not a
security.
3.
Analysis for Whether a Note is a Security the Family Resemblance Test
a)
Stage #1: If the transaction involves any of the following, it is NOT a note (this list is growing over time):
(i)
Notes delivered in consumer financing;
(ii)
Note secured by a mortgage on a home;
(iii)
Short-term note secured by a lien on a small business or its assets;
(iv)
Note evidencing a character loan to a bank customer;
(v)
Short-term notes secured by an assignment of accounts receivable;
(vi)
Note which formalizes an open account debt incurred in the ordinary course of business; or
(vii)
Notes evidencing loans by commercial banks for current operations.
b)
Stage #2: If the transaction is not one of the above-listed transactions, analyze the following elements:
(i)
Presumption
(a)
A note is presumed to be a security, and that presumption may be rebutted only by
looking at the four factors below (provided it didnt fit into one of the Stage 1 categories).
(ii)
Four Factors:
(a)
Motivation for Transaction
i
Examine the transaction to assess the motivations that would prompt a reasonable
seller and buyer to enter into it. If the sellers purpose is to raise money for the
general use of the business enterprise or to finance substantial investments and
the buyer is interested primarily in the profit the note is expected to generate, the
instrument is likely a security. If the note is exchanged to facilitate the purchase
and sale of minor assets or consumer good, to correct the sellers cash-flow
difficulties, or to advance some other commercial or consumer purpose, it is not a
security.
(b)
Offer and Sale to a Broad Segment of the Public
i
Examine the plan of distribution of the instrument to determine if it is an
instrument for which there is common trading for speculation or investment.
(a)
Common trading does not require trading on an exchange.
(c)
Reasonable Investor Inquiry
i
Examine the reasonable expectations of the investing public, despite what an
economic analysis suggests. Ask what the public would perceive about the note
did they think of it as an investment?
(d)
Risk-Reducing Factors
i
Examine whether some factor such as the existence of another regulatory scheme
significantly reduces the risk of the instrument, thereby rendering the protections
of the Securities Acts unnecessary.
ii
Ex: Marine Bank v. Weaver Court held that a bank CD was not a security
because holders of the bank CD are abundantly protected by the federal banking
laws.
Loan Participations as Securities
1.
Banks often package mortgages and create undivided interests in a pool of mortgages and offer those publicly. The key
factor as to whether these are securities is who they are offered to.
a)
One court held that the loan participations at issue were not securities because the investors were corporate and
institutional entities rather than the general public. Another court held that where the bank allowed investment
in the mortgages via a broker to the general public, the investment in the mortgages was a security.
Derivative Securities and Synthetic Investments as Securities [Not Discussed in Class]
1.
Generally
a)
Derivative = financial instruments that derive value from other assets to which their values are linked.
Buckham, Brian R.
(i)
(ii)
Options
Swaps
(a)
(b)
A negotiated arrangement between two parties in which each promises to make a payment to the
other, with the payments occurring at different times and determined under different formulas.
Simplest is the interest rate swap (aka plain vanilla swap) where one party agrees to make fixedrate payments to the other party, who agrees to make floating payments in return.
b)
N.
O.
II.
Synthetic Transactions
(i)
A contractual agreement between an investor and a counterparty, often a bank, that gives the investor the
economic equivalent of a position in a certain security or option on a security without the investor actually
buying that security or option.
(ii)
Ex: Caiola v. Citibank (p. 80)
(a)
Caiola and Citibank entered into a synthetic transaction whereby they used an equity swap combined
with synthetic options (the transactions did not involve the actual securities, but just simulated
purchases and simulated options transactions). Citibank also employed a delta hedge, where it took
a small position in the underlying Philip Morris stock. Caiola did not want Citibank to take a larger
position because it would have affected the actual trading price of the security, whereas the mere
simulated transactions would not. Over time, however, Citibank began to purchase large blocks of
Philip Morris, abandoning the agreed upon delta hedging strategy. This caused the market price to
fluctuate greatly, and Caiola alleged violations of 10(b) and Rule 10b-5. Citibank countered that
the transactions were beyond the reach of the securities laws because it had not sold Caiola
securities.
(b)
The Synthetic Options:
i
They were securities. An option on a security is clearly covered by the Act, but an option
based on the value of a security (a synthetic option) is also covered. The synthetic options
were simply cash-settled over-the-counter options on Philip Morris stock and therefore are
securities.
ii
The term option is not limited to conventional exchange-traded options.
iii
It does not matter that one can distinguish between cash-settled and physically-settled
options, nor that one can distinguish between options documented as swaps as opposed to
some other fashion.
(c)
The Equity Swap:
i
They were not securities.
(iii)
The Commodity Futures Modernization Act (CFMA) amended the 33 and 34 Acts and restricts SEC
jurisdiction over swaps and other derivatives.
Separate Securities and Pass-Throughs as Securities
1.
Generally
a)
A bank CD and a note issued in a consumer transaction are not securities. But, the activities of an intermediary in packaging
financial instruments may create a security out of something that is not. Almost any kind of income-producing instrument
can be pooled and packaged for sale as a pass through.
(i)
Ex: Many institutions will obtain mortgages, then create a pool of such mortgages, transfer them to a trust, and
cause the trust to sell undivided interests in itself to large numbers of investors. They are securities because any
profits realized by the investors are derived from the managerial efforts of those who run the pool and make such
decisions as determining which mortgages shall be in the pool, how the individual notes will be serviced and
managed, and other fund decisions.
b)
These pass-throughs may be securities under an investment contract (Howey) or a note (Reves).
Final Note: Macdonalds Red Flags

1.
Four types of deals that should always be red-flags:
a)
Tax shelters anything marketed and sold as a tax shelter.
b)
Oil and gas deals and alternative energy deals.
c)
Syndications anything marketed and sold as a real estate syndicate (multiple investors, etc.).
d)
Any get-rich-quick schemes and passive investments.
2.
Review:
Markets and Their Efficiency

A.
Introduction to Securities Markets
1.
The Structure of Trading Markets
a)
Exchanges v. OTC Markets
(i)
Exchanges
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Buckham, Brian R.
These are auction markets because buy and sell orders are executed at a central location
at the best available price.
(ii)
OTC Markets
(a)
Involves broker-dealers and market-makers.
b)
Other Terms
(i)
Block trades = institutional trades involving 10,000+ shares.
(ii)
Specialists = a designated dealer in a particular stock who has an inventory in that stock.
(a)
Come into play when there are more orders to buy or more orders to sell. Specialists are
required to maintain a balance between buyers and sellers.
i
Must take care of imbalance by buying for his own account or selling out of his
own inventory.
ii
Based on volume, not price. The transaction has to be executed at the market
price, but the specialist will have to sell or buy to make the transaction # of shares
the same.
(b)
Used to maintain liquidity for transactions that cannot be matched from normal market
orders.
(iii)
Market makers = used in OTC markets.
(a)
Used to maintain liquidity for transactions that cannot be matched from normal market
orders.
(iv)
Broker v. Dealer
(a)
Broker = a middleman operating as an agent for buyers and sellers.
(b)
Dealer = acting as a principle, dealing out of their own inventory.
(v)
Bond Markets
(a)
Bond markets are almost exclusively an institutional market; retail investors compose a
very small percentage of bond trading.
(b)
Total bond market underwritings vastly exceeds equity underwritings.
2.
Institutionalization and Globalization
a)
Institutionalization = the idea that institutions are owning and trading a large percentage of securities.
(i)
The % of total equity held by US institutions has increased from 7% in 1950 to 50% in 2003.
(ii)
Given that institutions hold much of the securities, this should influence the SEC disclosure policy.
The policies are based on the audience.
b)
Globalization = technology has contributed to globalizing the capital markets.
(i)
A potential problem w/ globalization is that it may result in US corporations making a race to the
bottom with regard to compliance with environmental and labor regulation. Companies will work
to do the least possible.
(a)
But, to the contrary, companies do not seem to react this way to increased securities
regulation. Companies seem to see some protection for themselves with increased
securities regulations. Capital seems to be attracted to the US because of, or despite, its
heavy security regulations.
3.
Derivative Markets
a)
Derivatives are financial instruments whose value depends on the price of some underlying instrument.
b)
Two types of derivatives:
(i)
Options rights to buy (call) or sell (put) securities from or to another person at some
predetermined price or date.
(ii)
Futures contracts that call for future delivery of some commodity at a fixed price and date.
(a)
Usually settled in cash rather than the underlying commodity.
(b)
Exclusive jurisdiction over futures is given to the Commodities Futures Trading
Commission.
The Efficient Market Hypothesis
1.
General Thesis:
a)
A securitys price can be seen as being established in an efficient market if, with respect to specific
information, the price that exists for the security is the same as the price it would have if everyone had
the same information.
(i)
This does not mean that everyone has the same opinion as to the price; an efficient market is the
result of their collective investment decisions.
(ii)
We are looking at the relationship between the price of the security (and its movement over time)
and the availability of information on the other.
(a)
Price and Information is the relationship.
(b)
It assumes equality of information on both sides of the deal.
b)
Random Walk Theory
(i)
It is the information presently available, not the shape of the curve from the past, which determines
the price today.
2.
Three Levels of Market Efficiency:
a)
Weak Form
(i)
Exists when security prices reflect all the information embodied in the past prices of that security.
(a)
Thus, investors cannot extrapolate a securitys future price from a series of past prices.
b)
Semi-Strong Form
(i)
Exists if security prices reflect all publicly available information.
(a)
B.
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Buckham, Brian R.
(a)
3.
4.
5.
If this is the case, then investors cannot generally beat the market by examining publicly
available information for determining what stocks are under or overvalued.
(ii)
This is where the battle-ground is today.
c)
Strong Form
(i)
Exists when security prices reflect all information, whether that information is publicly available or
not.
Information v. Allocation Efficiency
a)
Information efficiency = the speed with which market prices adjust to new information.
(i)
Markets will be more efficient with mandated disclosure so that there is somewhat of an even
informational field.
b)
Allocation efficiency = the allocation of resources to their best or highest use.
(i)
We want capital to go to relatively higher and more productive uses. We want the companies and
industries that are more efficient and higher uses to get the resources.
(ii)
Without informational efficiency, we wont get allocational efficiency.
Challenging the Efficient Market Hypothesis -- Noise
a)
Some theorists believe that noise pricing influences not associated with the rational expectations about an
asset value plays a significant role in stock market behavior.
(i)
Evidence of this is in the form of market participants who behave as though securities are not
efficient, pursuing strategies based on the belief that stocks are mispriced, and pursuing stocks they
believe are fads or fashions.
(ii)
Excessive trading, more than efficient markets would require, is additional evidence.
(iii)
Investors appear to routinely overreact and underreact to corporate announcements.
(iv)
Some believe that stock trades on a herd instinct, rather than on fundamentals.
b)
Behavioral finance has been developed to try to explain stock price movements.
c)
If this is what people are really doing (the herd trading), they is disclosure to these people a waste of time?
(i)
No. There is also evidence supporting the proposition that publicly available information does in
fact also affect investor trading. Not all investor trading is irrational. Disclosure will not rationalize
the market, but it will add to rationalization and information-based decision-making.
Notes on Disclosure
a)
A fundamental purpose of the securities acts was to substitute the philosophy of full disclosure for the
philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.
(i)
We have shifted from caveat emptor (buyer beware) to caveat vendor (seller beware). This is
because full and fair disclosure is the requirement.
b)
To Whom is Disclosure Made?
(i)
Are we making disclosures directed to the ordinary public, or to sophisticated analysts? This
determines the tone we use in the disclosures. Some use the creep-down or filter-down theory
to suggest it goes first to analysts, and then trickles down to the retail investors.
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Buckham, Brian R.
Section 3 Registration and the Public Offering
I.
The Public Offering

A.
Underwriting and Underwriters
1.
Introduction to Underwriting
a)
Two Types of Underwriting:
(i)
Firm Commitment
(a)
One or more investment banking firms agree to purchase the securities from the issuer for
resale to the public at a specified public offering price.
(b)
Usually involves a syndicate of investment banking firms and an underwriting
agreement with the issuer and an agreement among underwriters that establishes the
obligations of each member of the syndicate.
(ii)
Best Efforts
(a)
Broker-dealers agree for a fee to use their best efforts to sell the securities on behalf of
the issuer at the offering price.
i
Note: Does this unwillingness of the underwriter to make a firm commitment
signal something about the quality of the securities being issued and/or the
proposed price? Some commentators believe so.
(b)
Three Types:
i
Straight
(a)
There is no minimum amount that must be sold as a condition to the
deal closing. Those securities sold remain sold.
ii
Mini/Maxi
(a)
A minimum amount must be sold. Proceeds are placed in escrow
until the minimum is sold. If the minimum is not sold, the money is
returned to the potential purchasers.
iii
All or None
(a)
All securities must be sold for the deal to close.
b)
Relevant Underwriting Agreements (Discussed in Detail Below)
(i)
Letter of Intent
(ii)
Underwriters Agreement
(iii)
Agreement Amongst Underwriters
(iv)
Selected Dealer Agreements
(v)
Standby Agreement
c)
Compensating Underwriters
(i)
The Gross Spread
(a)
The underwriters sell the securities to the public at a fixed public offering price. The
difference between this price and the amount received by the issuer is the gross spread.
i
Public pays $100 Underwriters keep $5 Issuer gets $95. The gross spread
is $5.
(b)
The gross spread is composed of three parts:
i
The management fee charged by the underwriter;
ii
The underwriting compensation received by the underwriter; and
iii
The selling concession received for any securities sold to the public by any
broker-dealer participating in the distribution.
(c)
All members of the syndicate must sell the offered security to the public at a fixed price
that is stated in the registration statement and accompanying prospectus.
(ii)
Review of Underwriters Compensation by the NASD
(a)
The NASD reviews underwritings to ensure that the terms are fair and reasonable (the
amount the underwriter charges the issuer).
(b)
If a company wants its shares listed on a public exchange regulated by NASD (an SRO),
then it (and the underwriters) must comply with the rules that NASD sets.
(c)
Review by the NASD of member underwriters is required even if the offering is
otherwise exempt from registration with the SEC because, for example, it falls within the
intrastate exemption.
(d)
Underwriters may be paid by the spread, by a fixed percentage of the offering proceeds,
via warrants, or via options (cheap stock).
d)
Stabilization
(i)
The managing underwriter will elect to stabilize the market by having one member of the
syndicate bid to purchase the security at or just under the public offering price. This facilitates an
orderly distribution by preventing a marked decline in the price of the security.
(a)
Must comply with Rule 104 when conducting stabilizing activities.
e)
Dutch Auctions
(i)
Issuer solicits bids from institutions and broker-dealers for any amount of securities each bidder
wishes to acquire; the bidder states the amount of securities it wishes to purchase and the amount it
will pay for those securities. All bids are irrevocable offers to purchase that amount of securities.
At closing, the bids are arrayed from highest to lowest. The issuer first accepts the bid with the
highest price for the amount of securities covered in that bidders bid; other bids are accepted at
successively lower prices for the amount of securities covered in each bid until the issuer has placed
13
Buckham, Brian R.
2.
all the registered securities. The lowest price accepted by the issuer though this process is the price
paid by ALL the bidders whose bids were accepted through the process.
f)
Standby Agreements
(i)
A standby agreement says the underwriter will buy whatever the public does not buy in the offering.
(ii)
Such agreements are rare except in a rights offering. This is where the existing shareholders have
the right to purchase shares below price. In such case, the standby agreement says the underwriter
will pick up the excess shares not purchased by the existing shareholders.
Overview of the Underwriting Process
a)
Stage 1:
(i)
Company finds a managing underwriter and signs a letter of intent.
(a)
The letter of intent is used between the managing underwriter and issuer as a preliminary
understanding. It is non-binding.
(b)
The final underwriting agreement will not be signed until the very last moment before the
registration statement becomes effective.
b)
Stage 2:
(i)
Agreement Among Underwriters is executed.
(a)
The managing underwriter will seek out a syndicate, and this agreement is the formal
understanding among the members of the syndicate.
i
Gives the managing underwriter a power of attorney over the transaction.
ii
Sets forth the compensation for the managing, underwriting, and selling efforts in
connection with the offering.
iii
Customary Terms:
(a)
Allotment = the amount of shares given to each underwriter.
(b)
Shoe = the shares that were allocated in excess of what the
syndicate was obligated to sell.
(i)
A green shoe is an option by the syndicate to sell more
shares than obligated to sell, when investor interest is very
high. It results in an overallotment.
(ii)
NASD limits the permissible overallotment to 15% of the
shares the underwriters are obligated to purchase.
(c)
Anti-Flipping Clause
(i)
Imposes a penalty on syndicate members if flipped shares
are traced to their allotment.
c)
Stage 3:
(i)
Underwriters Agreement is executed.
(a)
The Underwriters Agreement is executed immediately before the registration statement
becomes effective. It contains terms such as the amount and type of securities to be
issued, the price to be paid the issuer, identification of the syndicate members, time of
payment, obligations of the issuer, etc.
(b)
Customary Terms:
i
Insider Lock-ups
(a)
Provision limiting senior managements ability to sell any of their shares
ii
iii
iv
v
B.
during the 180 days following the public offering.

Market Out Clause
(a)
Provision that permits the underwriters to withdraw any time prior to the
public offering and/or settlement date if one of several exigent changes in
circumstances develops.
(i)
SEC holds that some market out clauses are inappropriate in firm
commitment underwritings, because it turns the underwriting into a
mere best efforts underwriting.
Indemnification Clause
(a)
Requires the issuer to indemnify the underwriters for any liability they may
incur under federal or state laws because the registration statement or
prospectus is materially misleading.
Contribution Clause
(a)
Provides for contributions among those liable under a misleading registration
statement.
Comfort Letters
(a)
Certain persons must provide the underwriter with comfort letters covering
certain specified representations (e.g., that the corporation is validly
incorporated) made in the registration statement.
Stages of the Public Offering:

1.
Introduction
a)
Three Relevant Period
(i)
Pre-filing (5(c)) ---|--- Waiting Period (5(b)(1)) ---|---Post-Effective Period (5(b)(2))
b)
Application of 5 of the 33 Act to Registration
(i)
Section 5 of the Securities Act is relevant in the pre-filing, waiting, and post-effective periods.
(ii)
Summary of Sections:
(a)
5(c) Prohibits any offer to sell or buy prior to the filing of a registration statement.
14
Buckham, Brian R.
5(a) No sales or deliveries of sold securities can occur until the registration statement
is effective.
(c)
5(b)(1) After the registration statement is filed but not yet effective, all written offers
to sell must be in connection with a prospectus that complies w/ 10 of the 33 Act or
Rule 430.
If either the security is exempt or the transaction qualifies for an exemption, the regulatory demands
of 5 do not apply.
(b)
(iii)
2.
Pre-Filing Period
a)
Introduction
(i)
In addition to the activities regarding the registration statement, the underwriting agreements, etc.
are prepared in the pre-filing period.
b)
Registration of the Unseasoned Issuer
(i)
Generally
(a)
Section 5 of the 33 Act restricts the freedom of the issuer and underwriters to promote
the offering until the registration statement is filed.
(b)
Section 5 also states that in the period between the filing of the registration statement and
its becoming effective (the waiting period), when the statement is being reviewed by the
SEC staff, significant efforts are afoot to promote the offering.
(ii)
Introduction to the Registration Statement
(a)
Generally
i
The central objective of the 33 Act is the preparation of a registration statement
for securities offered to the public.
ii
Through various sections of the 33 Act, the SEC has broad power over the form
and content of the registration statement and prospectuses.
(b)
Contents of the Registration Statement (Regulation S-K says what must be in the forms).
i
Four General Categories (the first three must be reproduced in the prospectus
the prospectus is a key part of the registration statement, but it is not the whole
thing):
(a)
Information bearing on the registrant;
A thorough discussion of the registrants business, property, and
management, high and low security prices, frequency and amount
of dividends, security ownership by executives, etc.
Information about the distribution and use of its proceeds;
(i)
Underwriters must disclose the general terms of the underwriting
agreement. Must disclose the net expected proceeds and plans for
the proceeds, if any.
A description of the securities of the registrant; and
(i)
Must set forth the rights, privileges, and preferences of the security
being offered.
Various exhibits and undertakings.
(i)
Must include the articles, bylaws, attorneys opinion as to the
legality of the securities registered, and any 10-Q or 10-K reports
incorporated by reference in the registration statement.
(i)
(b)
(c)
(d)
(c)
(iii)
Registration Forms
i
Registration of securities is made on Form S-1 (the default form), S-2, or S-3.
ii
Each item on the form directs the preparer to Regulation S-K for detailed guides
on what precisely must be disclosed with respect to that item.
(d)
Electronic Filing
i
All registrants must file their 33 Act registration statements and periodic reports
under the 34 Act pursuant to EDGAR. The manner and protocol for making
electronic filings are set forth in Regulation S-T.
(e)
Role of the Prospectus: Selling or Insuring?
i
The burden of assuring the registration statement and prospectus is compliant
falls on the registrants attorney. In drafting the statement, the lawyer is torn
between putting his clients best foot forward and providing a candid view of the
risks the issuer is facing.
(a)
So, is the lawyer helping sell the securities or helping them insure
against something?
(i)
Really it should focus on insuring. In some cases, you have
to play-down certain things. The prospectus should not be
considered a sales document.
Preparing the Registration Statement for Filing
(a)
Pre-Offering Clean-Up Work
i
To have a vehicle for the offering, the business must be conducted by a single
corporation or a parent with subsidiaries. In many cases, there is not such a neat
package, so considerable work must be done in order to reorganize the various
entities by mergers, liquidations, and capital contributions.
(a)
A recapitalization almost always is required so that the company will
have an appropriate capital structure for the public offering.
15
Buckham, Brian R.
(b)
(b)
(c)
(iv)
c)
d)
Recapitalization is necessary so that after the offering the existing

shareholders still have working control. Use stock splits, different
share/voting classes, or some other mechanism so that before the
offering the existing shareholders still have enough shares to keep
control.
ii
The company must also adopt stock option plans, grant options, transfer real
estate, revise leases, rewrite the articles and bylaws, rearrange stockholdings of
insiders, cancel shareholders agreements, eliminate preemptive rights and
cumulative voting rights, etc.
Lawyers Role
i
The lawyer should be careful to dispel any impression that his assistance in
drafting the registration statement can ensure that it will be free from all
misleading, unclear, or ambiguous statements.
ii
The one certain area where the lawyer does in fact opine on the validity of a fact
represented in the registration statement is that the securities being offered have
been validly authorized.
After the registration statement is filed w/ the SEC, the waiting period begins. The SEC
reviews the registration statement and issues its letter of comments See below.
Specialized Rules
(a)
The Small Business Issuer System
i
For small business issuers, those whose revenues are less than $25 million or whose
FMV is less than $25 million. They can use Forms SB-1 and SB-2 provided certain criteria
are met. A separate continuous reporting system, Form 10-KSB and 10-QSB are sued, and
their guidelines for completion are in Regulation S-B rather than S-K.
(b)
Blank Check Companies
i
Blank check companies are those who are without any specific business plan or purpose or
whose plan is to engage in acquisitions of an unidentified company. They are subject to
Rule 419 of the 33 Act, which requires certain disclosures.
Integrated Disclosure for the Seasoned Company

(i)
Generally
(a)
Integrated disclosure involves the coordination of the disclosures required under the 33
and 34 Acts such that large publicly traded companies can satisfy the 33 Act
registration requirements for company-specific information by incorporating by reference
information from their current 34 Act filings.
i
The idea is to not have to repeat the company-specific information, but instead to
only re-file the transaction-specific information.
(ii)
Forms S-1, S-2, and S-3
(a)
Form S-1
i
Used by registrants who have not been in the reporting system for over three
years, or by any registrant who chooses to use it. Requires complete disclosure.
(b)
Form S-2
i
For registrants who have been in the reporting system for over three years.
ii
Information in the 10-K is incorporated by reference into the prospectus.
(c)
Form S-3
i
Will have transaction-specific information, just like the S-1 or S-2, but the
prospectus will not present any information concerning the registrants business
unless there has been a material change since the last 34 Act report.
Gun Jumping in the Pre-Filing Stage
(i)
Generally the Offer to Sell
(a)
5(c) Prohibits any offer to sell or buy prior to the filing of a registration statement.
i
Offer to sell = every attempt to offer to dispose of, or solicitation of an offer to
buy, a security or interest in a security, for value. 2(a)(3).
(a)
The SEC has interpreted offer to sell VERY expansively.
(i)
Offering is construed broadly to even include things
conditioning the market (sometimes referred to as preselling the securities).
(b)
Why prohibit offers before the effective date?
i
We dont want any investment decisions being made on something other than the
most reliable information that we can get into the hands of investors.
ii
We dont want people arousing public interest so as to condition the public
interest on the basis of incomplete information.
(ii)
Pre-Filing Conditioning of the Market as Gun Jumping
(a)
Generally
i
Because of 2(a)(3)s definition of offer to sell, an underwriter or dealer cannot
begin a public offering or initiate a public sales campaign prior to the filing of a
registration statement, or during the waiting period. The publication of
information and statements, and publicity efforts, made in advance of a proposed
financing, may be considered an offer of sale.
(b)
Examples:
16
ii
(c)
(d)
Buckham, Brian R.
An investment banking firm violated 5 when it was approached by a mining company, and
then mailed out numerous brochures to investors on the growth prospects of the uranium
industry. While not mentioning the issuer company, the investment banking companys
name was on the brochure.
Providing two news releases regarding development plans for a real estate venture,
including the announcement of the financing plans and the upcoming filing of a registration
statement, was a violation of 5.
(a)
The SEC determined the news releases aroused the market with the intent to
set into motion the plan of distribution.
(b)
The SEC rejected the contention that it was merely a news publication.
News v. Conditioning
i
There is a blurry line between releasing newsworthy information and
conditioning the market for the offering. Public corporations have obligations to
make timely disclosure of newsworthy information, but it may also be seen as a
solicitation while the issuer is in registration.
Permissible Information Releases
i
Rule 135 it is not an offer to sell securities (and thus does not violate 5(c))
if the issuer releases certain information about its operations and activities, even
though the issuer is in the registration process.
(a)
For example, the company can release its intent to make a public
offering, the amount and type of security, manner/purpose of
offering, etc.
ii
Disclosure of a material event would not ordinarily be subject to restrictions
under 5 of the Securities Act if it is purely factual and does not include
predictions or opinions.
(a)
So, the company can still make releases about the companys
products and services, business and financial developments, answers
to unsolicited inquiries about business matters, etc.
iii
Notes:
(a)
Numerous SEC releases provide clarification as to what types of information
can be released.
The SEC provides both informal consultation and no-action letter guidance to
gun jumping questions.
(b)
(iii)
(iv)
e)
Gun Jumping of a Participant in the Distribution

(a)
Rules 137 and 139 provide insight into what communications regarding an issuer a
broker-dealer may make. Much of the permissible communications are based on whether
the broker-dealer is a participant in the distribution.
i
If the broker-dealer is not involved in the deal, Rule 137 is triggered.
(a)
Rule 137 allows broker-dealers keep doing what they do: buy, sell,
hold, etc. ratings, so long as the communications about the issuer are
in the ordinary course of business and the broker-dealer doesnt
receive any commission from the transaction.
ii
Whether the broker-dealer is involved in the deal, Rule 139 is triggered.
(a)
Rule 139 permits the broker-dealer to issue opinions and
recommendations concerning an issuer so long as it does so in the
ordinary course of business and the issuer is entitled to file a Form S3.
Arrangements With and Among Underwriters NOT Gun Jumping
(a)
2(a)(3) excludes from the definition of offer to sell negotiations and agreements
between the issuer and underwriter, and between underwriters.
i
This does NOT extend to discussions with broker-dealers.
Pre-Filing Problems (p. 172)

(i)
Problem 4-1:
(a)
One issue is whether we are even in registration yet. If not, the 5(c) prohibition does not apply.
(b)
If this is in registration, and the company gave out the press releases, they are still okay because
they are just general advertisements about the products. You can keep doing what you have been
doing.
i
But, we need to be a little worried about the quote regarding Omega being a emerging
industry leader Are they now hyping their company instead of their product. Its
interesting that they moved the ad from a computer magazine to a business magazine.
ii
Always be wary that when you are in registration, it is a very hypersensitive time.
(ii)
Problem 4-2:
(a)
In essence, there is a solicitation/offer of sale of securities here. Not an offer for sale because
2(a)(3) provides the equivalent of an exception for discussions and agreements between an issuer
and the underwriter. This is true even if you file the final underwriting agreement (and in firm
commitment underwriting, the actual sale of the securities to the underwriter!!!).
i
This does not go beyond the issuer-underwriter relationship.
(iii)
Problem 4-3:
(a)
This also falls in the 2(a)(3) exception.
(iv)
Problem 4-4:
(a)
This also falls in the 2(a)(3) exception.
17
(v)
(vi)
(vii)
(viii)
(ix)
(x)
3.
Buckham, Brian R.
Problem 4-5:
(a)
If the broker-dealer is not involved in the deal, Rule 137 is triggered. It allows retail brokers to keep
doing what they do: buy, sell, hold, etc. ratings.
(b)
Whether the broker-dealer is involved in the deal, Rule 139 permits the broker-dealer to issue
opinions and recommendations concerning an issuer so long as it does so in the ordinary course of
business and the issuer is entitled to file a Form S-3.
Problem 4-6:
(a)
This is a retail dealer, not an underwriter in the syndicate. So, 2(a)(3) exception for underwriters
doesnt apply. Then we need to look at Rules 137 and 139.
(b)
If the dealer will be participating, then the underwriters cannot communicate with the dealer.
Problem 4-7:
(a)
When the broker makes an offer to purchase (soliciting upstream) the Omega shares, he is liable
under 5(c) for making an offer to buy the security. A broker is included in the definition of
dealer in 2(a)(12), so 5 does apply to brokers.
(b)
Rationale:
i
The underwriter could accept the offers to buy in their order of priority and thus put
pressure on dealers to rush their orders to buy w/o adequate considerations of the security
being offered (because there was no prospectus yet).
(c)
Note: An individual who is not a dealer, issuer, or underwriter CAN make an offer to buy before
there is as registration statement (4(1)). But, dealers cannot. In any event, the
dealer/underwriter/issuer CANNOT issue the securities, anyway.
Problem 4-8:
(a)
Rule 135 permits, during the pre-filing period, an issuer or a selling security holder to disclose
certain things about the offering, including the name of the issuer, the basic terms of the security
offered, etc. What they cannot do is disclose who the underwriter is.
Problem 4-9:
(a)
This seems to go beyond the ordinary course of business reporting. They made it significantly better
than last years reports. Release 5180 talks about allowing the company to provide factual
information. But, this annual report is questionable.
(b)
The remedy: The SEC might deny acceleration for this deal.
Problem 4-10:
(a)
Possibly a violation. Example 7 on p. 162 seems to suggest that the SEC will be upset because of
the forecasts. Should have counseled the client not to use any numbers.
Filing and Waiting Period

a)
Review of the Registration Statement by the SECs Staff: The Letter of Comment
(i)
Filing and Effective Date of Registration Statement; Delaying Amendments
(a)
Upon filing of the registration statement with the SEC and paying the filing fees, under
8(a) the registration statement can, barring any other actions, become effective 20 days
after filing. But, it can often take much longer than 20 days.
i
The concept of delaying amendments and acceleration (infra) do not show up
on the face of 8 of the 33 Act itself. It is in the Rules only. While 8 of the 33
Act has the 20 day automatic effectiveness concept, Rule 473 does away with this
automatic effectiveness by permitting delaying amendments.
(b)
The SEC will review the statement to determine its compliance w/ the informational
requirements of the 33 Act and the forms, regulations, and policies of the staff. It will
then issue an order declaring the registration statement effective, and the company can
commence the public offering.
(ii)
If the Registration Statement is Not Complete or Unsatisfactory to SEC
(a)
Under 8(b), the SEC may issue an order refusing to permit the effectiveness of the
registration statement if it appears incomplete or inaccurate.
(b)
Under 8(d), the SEC can issue a stop order for a registration statement that has become
effective.
(iii)
The SEC Letter of Comment During the Waiting Period
(a)
The SEC may issue a detailed letter of comment advising issuers counsel of any
deficiencies in the registration statement that the staff believes need correction.
i
While there are no legal consequences for failing to respond to the letter, the
issuers failure to respond carries with it the implied threat of a formal stop order
proceeding under 8(d) or the effect of 8(b) (delaying of the effective date).
ii
Companies readily comply with the letter of comment.
(iv)
Delaying Amendments
(a)
To prevent the registration statement from becoming effective in deficient form
automatically after the 20 day statutory period, issuers include a legend, called the
delaying amendment on the facing page of the initial filing of the registration
statement, thereby postponing the automatic effective date until the issuer has amended
the registration statement to comply with the letter of comment.
(b)
Rule 473 governs delaying amendments.
(v)
Acceleration of the Effective Date
(a)
After the issuer has complied w/ the letter of comment, the issuer will request that the
SEC accelerate the effective date of the registration statement.
(b)
8 provides the standard to be met in order for the SEC to accelerate the effective date.
18
Buckham, Brian R.
b)
(c)
Rule 461 governs acceleration of the effective date.
(d)
The SEC has discretion whether to accelerate the effective date.
(vi)
The Pricing Amendment
(a)
The pricing amendment is the last piece of information filed.
(b)
Rule 430A permits the price to be excluded from the registration statement for some
offerings, or provide only a range. The rule also permits a change in the number of
securities offered (up to 20%). This information can be excluded from the registration
statement if included in the prospectus.
(vii)
Liability
(a)
11 imposes liability on certain persons if the registration statement contains a material
misrepresentation when it becomes effective.
Gun Jumping in the Waiting Period
(i)
5(a) Triggered Upon Filing
(a)
After filing the registration statement, 5(c)s broad prohibitions on offers to sell and buy
disappear, and the waiting period starts. Though 5(c) doesnt apply, 5(a) is triggered.
(b)
5(a) states that no sales or deliveries of sold securities can occur until the registration
statement is effective. But, selling efforts can commence during the waiting period.
i
The form of the selling effort available in the waiting period is dictated by
5(b)(1). Oral offers are permitted, as are limited written offers via a prospectus.
ii
The term prospectus in 5(b)(1) is defined very broadly in 2(a)(10). Any
written communication, as well as radio and TV transmissions, are deemed to be
a prospectus whenever a communication through such medium offers a security
for sale or confirms a sale. Despite the broad definition, only very limited types
of prospectuses can be used to satisfy 5(b)(1) [see rules below].
(a)
Oral offer to sell are not within the definition of prospectus.
(ii)
Hyperlinks to the Prospectus
(a)
During the waiting period, the issue is whether information on a website is a prospectus
because it conditions the market; if so, 5(b)(1) is violated if the website information
does more than replicate the information in the 10 prospectus.
(b)
If there are hyperlinks on the website and a prospectus, the SEC may consider it all
together.
(iii)
Selling Practices Permitted During the Waiting Period
(a)
Generally
i
Significant promotional efforts occur outside the regulatory reach of 5 during
the waiting period. These selling efforts are primarily oral, though Rule 134 does
permit some limited written communication, and Rule 430/431 permit a
preliminary prospectus to be sufficient.
(b)
Limited Written Communications Permitted
i
General Rule:
(a)
Written communication must be accompanied by or preceded by a
prospectus meeting the requirements of 10. (5(b)(1)).
ii
Exceptions:
(a)
Tombstone Ads and Identifying Statements Rule 134
(i)
Under Rule 134, during the waiting period publicity can be
given through a tombstone ad without violating 5(b)(1).
(ii)
Rule 134 lists 14 categories of information that can be
contained in a tombstone ad.
(iii)
Rule 134 also permits the issuer to include a brief
description of the business; this is called an identifying
statement.
(iv)
The tombstone ad must indicate where prospective buyers
can get a prospectus.
(b)
Preliminary Prospectus (Red Herring) is Sufficient (Rule 430)
Written offers may be made during the waiting period through the
use of a red herring (aka preliminary prospectus). Rule 430
authorizes this communication, expressly providing an exception to
5(b)(1)s mandate that a prospectus meet the requirements of 10.
(i)
Prior to the effective date of the registration statement (but
after it is filed), 5(b)(1) is satisfied by the use of a
prospectus that includes substantially the same information
that will ultimately appear in the final prospectus under
10(a), except it may exclude certain items.
(ii)
This is called the red herring. Red Herring in red
ink, the prospectus has a legend saying that there can be no
acceptances, and that all offers are only preliminary. No
acceptance is permissible until the registration statement is
effective.
(iii)
The only difference between this preliminary prospectus
and the final prospectus is usually the numbers.
19
Buckham, Brian R.
(c)
(d)
c)
Problems:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
(viii)
4.
Oral Communications
i
Because oral offers to sell are not within the definition of prospectus under
5(b)(1) (it includes only written or radio or television communications), it is
permissible to solicit via oral offers during the waiting period.
(a)
But, the sale still cannot be consummated at this time.
ii
The commercial benefit of soliciting oral offers is that it allows significant
sampling of investor interest in the offering, called book building.
(a)
The targets of the oral selling efforts do not need to be provided w/ a
prospectus.
(b)
SEC Release No. 4968 and Rule 15c2-8 place certain restrictions on
this.
Road Shows
i
Roadshows are traditionally gatherings attended by potential underwriters, but it
later expanded to include institutional investors.
ii
In a series of no-action letters, the SEC has approved the increasing use of
electronic media, like the web and video teleconferencing, to make available to
prequalified investors a password so they can view a video of the road show.
Problem 4-14
(a)
2(a)(10), 10, 5(b)(1), Rule 134(d)
(b)
NO oral or written offers are permitted in the pre-filing period. But, oral offers are permitted in
waiting period, as are limited written offers.
(c)
Clearly we have a prospectus here in 2(a)(10), but is not a 10 prospectus. So, we look at Rule
134(d), which says you can have some communications, but you cant say This is still a good buy.
Have to put the boilerplate legend on it.
Problem 4-15
(a)
Rule 134(d), 5(a)(1)
(b)
Not okay. The brokerage firm should not accept the $, since no sales are permitted. Only offers are
permitted! Brokerage firm should return the check along with a copy of the boilerplate language in
Rule 134(d)!
Problem 4-16
(a)
Rules 137 and 139
(b)
Rule 137 says something like this would not even be an offer, since the brokerage firm is not
participating.
Problem 4-17
(a)
Envelope theory
i
Analogizes the link on the website back to the old-school written communications. If you
use the website to intermix the prospectus and the glowing report, and you would get busted
if you sent it in one envelope instead of two separate envelopes, then it is not permitted.
ii
Outcomes turn on analogies to paper-based settings. See p. 176.
(b)
5(b)(1), 2(a)(10), 10
Problem 4-18
(a)
Rule 138
(b)
Here they are talking about the preferred stock instead of the common stock being offered. Is it
liberalized to talk about another class of stock of the same issuer? Rule 138 explicitly addresses this
issue.
i
Rule 138(a) says it will NOT be considered an offering of the common stock!
(a)
The theory is that there is a different market for other forms of stock, such as
preferred stock.
Problem 4-19
(a)
Cold Calls
(b)
There is no limit on oral offers, so long as there is not a sale until after the effective date.
Problem 4-20
(a)
Wired Ventures, Inc. case. The company withdrew its registration statement and dropped the
offering when this happened.
Problem 4-21
(a)
5(b)(1) road show
(b)
This is probably an acceptable road show, though the password makes it more difficult.
Post-Effective Period
a)
Generally
(i)
Once the registration statement is effective, 5(a)(1) no longer prohibits the sale, and under 5(a)(2)
the security can be delivered to the purchaser. 5(b)(2) requires, however, that the security be
accompanied by or preceded by a prospectus (final) that meets the requirements of (a) of 10.
(ii)
At some point during the post-effective period, the duty to deliver a prospectus eventually
terminates under 4.
b)
Gun Jumping in the Post-Effective Period
(i)
Generally
(a)
When in the post-effective period, 5(b)(1) and (2) are violated if the prospectus delivery
requirement is still in effect and the person does not send a prospectus, or has not already
sent a prospectus, with the trade confirmation or offers.
20
Buckham, Brian R.
c)
d)
i
Rule 434 loosens the burden of this somewhat
(b)
The type of free-writing that is used in trading markets can now be used in the posteffective period as long as it is accompanied or preceded by the final statutory
prospectus.
(ii)
Rule 434 Term Sheets Permitted
(a)
Rule 434 facilitates the delivery of information to investors by allowing the required
disclosures, including pricing information, to be delivered to investors in more than one
document.
(b)
Pursuant to Rule 434 the underwriters can, for example, use a preliminary prospectus that
omits price-dependent information, orally solicit investors orders to buy during the
waiting period, and mail with their confirmation a term sheet that includes all the earlier
omitted information as well as any material changes in the earlier circulated preliminary
prospectus.
(c)
The rule distinguishes between offerings on an S-3 and other offerings.
(iii)
Electronic Delivery
(a)
The prospectus delivery requirements can be satisfied by encoding in electronic format
the 10 prospectus and sending it electronically to the customers computer (whether via
e-mail or on the issuers website).
i
Various restrictions apply, including the limitation that the prospectus can only
be sent electronically with the specific consent of the customer.
(b)
Access to the term sheet on a website is not sufficient to be delivery of the term sheet.
If it is a hyperlink in an e-mail, however, it may be permissible.
(iv)
Free Writing
(a)
Though 5(b)(1) continues to regulate written selling efforts, 2(a)(10) provides an
important exemption to the meaning of prospectus. The impact is as follows:
i
If the underwriter is aware that its offeree has already been sent a final
prospectus, it need not send another.
ii
Free writing permits participants in the offering to prepare and circulate their own
materials promoting the offered security.
(a)
The use of the supplementary selling materials is called free
writing.
(b)
Free writing is permitted in the post-effective period only if those
materials are accompanied or preceded by a final prospectus.
(v)
Duration of the Prospectus Delivery Requirement - 4
(a)
5 centers on the obligation to deliver a prospectus. But, this obligation is only for
issuers, underwriters, and dealers. (4(1)). Anyone not falling in one of these three
classes is free of the prospectus delivery requirements.
(b)
Under 4(3)(C), underwriters are subject to the prospectus delivery requirements of 5(b)
as long as their allotment or subscription in the distribution is unsold.
(c)
Under 4(4), brokers who do not solicit their clients interest are exempted from the
prospectus requirement.
Duty to Update the Prospectus
(i)
Though the registration statement speaks as of the day it becomes effective, and thus does not have
to be updated with material changes after the effective date, an issuer is obligated to reflect posteffective developments in a prospectus via amendment or supplement. Failure to do the updates
makes the prospectus non-compliant with 10(a), and thus a violation of 5(b)(2) [and therefore
liability under 12(b)(1) is triggered]. (See Manor Nursing).
Post-Effective Period Problems
(i)
Problem 4-22
(a)
5(b), 2(a)(10), Rule 434
(b)
Access to the term sheet on a website is not sufficient to be delivery of the term sheet. (Release
7856).
(ii)
Problem 4-23
(a)
12(1) liability, Diskin
(b)
If there is any remedy, it is under 12(a)(1), which is civil liability for anyone who offers or sells a
security in violation of 5.
(c)
This shows the need for absolute literal compliance with the rules.
(iii)
Problem 4-24
(a)
This is the free writing idea.
i
The basic rule is that free writing is okay as long as it is preceded or sent with a prospectus.
(b)
Is the hyperlink analogous to something going out in an envelope together with the prospectus?
i
Most sources seem to suggest that this would be okay it would be considered to be
sending the prospectus with the report to the customer.
(iv)
Problem 4-25
(a)
4(4), 4(3), Rule 174
(b)
4(4) = brokers.
(c)
4(3) and Rule 174 = dealers and underwriters.
(v)
Problem 4-26
(a)
Note even the Rule 434 sheet would be sufficient. The issuer cant just add a term sheet to the
summary prospectus. Only a preliminary prospectus can have a later term sheet used.
21
(vi)
(vii)
(viii)
C.
Buckham, Brian R.
Problem 4-27
(a)
2(a)(1) and 5(b)(2) require only that it be sent, not necessarily delivered.
Problem 4-28
(a)
This is a 4(4) transaction, since there is no promotional work being done by the broker here. So, it
is exempt.
Problem 4-29
(a)
Rule 15c2-8(g) and (h): seem to suggest that HH must send the prospectuses to the brokers only if
the brokers request them. But, it would be a good idea to go ahead and send a few boxes of them to
the brokers.
Remedies for Failure to Comply with 5 -- SEC v. Manor Nursing

1.
Relevant Sections: 11, 12(a)(1), 12(a)(2).
a)
11
(i)
If any part of the registration statement, when it became effective, has an untrue statement of
material fact or omitted a material fact, any person who bought the security may bring suit.
(ii)
The suit is to recover damages.
(iii)
11 is only for registered offerings.
b)
12(a)(1)
(i)
Any person who offers or sells a security in violation of 5 is liable.
(ii)
The suit is to recover the consideration paid for the security less the amount of income received, or
for damages if the person no longer owns the security.
c)
12(a)(2)
(i)
Any person who offers or sells a security with an untrue statement or omission of material fact is
liable.
(ii)
The suit is to recover the consideration paid for the security less the amount of income received, or
for damages if the person no longer owns the security.
(iii)
12(a)(2) applies whether it is a registered offering or not.
D.
Conducting Public Offerings Through the Internet
22
1.
Buckham, Brian R.
Example (Wit Capital):
a)
An internet based dealer of securities was permitted to participate in IPOs by including in a special section of its website a
Rule 134 notice and a copy of the prospectus for the issuer. The dealer sends an e-mail with the Rule 134 information to its
customers notifying them of the offering and availability of an electronic prospectus. The customers can place preliminary
offers through the website. If a prospectus is amended, it is e-mailed to the customer. There is no link between the offering
information and the dealers home website. Confirmation of the sale, after the effective date, is sent to the customer via email if the customer was allocated any shares. The Clearing House then sends a final prospectus to the customer.
E.
Shelf Registration Under Rule 415

1.
Generally
a)
There are situations where an issuer will find it desirable to register securities that either it does not presently
intend to offer for sale (to use in later acquisitions, shares convertible into common stock at a later date, etc.) or
that it is presently offering for sale, but there is reason to believe that a sale is not likely to occur. Registration
of such securities to be offered on a delayed or continuous basis is referred to as shelf registration, which is
authorized by Rule 415.
2.
Rule 415
a)
The shelf offering is authorized for transactions falling within Rule 415(a)(1)(i)-(xi).
b)
The shelf registrant must do an undertaking to file post-effective amendments to the registration for the
purpose of updating the information in the registration statement and prospectus.
(i)
Rule 415(a)(3) indicates the shelf registrant must comply with Item 512(a) of Regulation S-K.
Thus, the issuer must update its financial statements annually as well as amend the registration
statement for any fundamental changes in the information in the registration statement.
c)
Rule 415(a)(4) requires that when an issuer shelf registers equity securities for a trading market, it may only do
so, inter alia, if the issuer is qualified to use an S-3.
d)
Rule 415 does not state what form (S-1, S-3, etc.) must be used by the issuer to register the shelf registration.
The form used is based on the offerings ability to satisfy the particular forms eligibility requirements.
F.
Updating and Correcting the Registration Statement

1.
Refusal Orders and Stop Orders
a)
Generally
(i)
Deficiencies and problems with a filed registration statement are generally handled through the letter
of comment procedure. But, the SEC can proceed formally against a registrant under 8(b) or 8(d)
(usually when the registrant has shown a careless disregard for the rules).
b)
8(b) Refusal Order
(i)
SEC refuses to let effectiveness occur.
(ii)
Notes:
(a)
Reaches only patent misstatements and omissions in the registration statement.
(b)
Does not apply where the misstatement is not apparent on the face.
(c)
Must be issued before the registration statement becomes effective.
(d)
SEC must give notice of a hearing.
c)
8(c) Stop Order
(i)
Empowers the SEC to act if it appears that the registration statement includes any untrue statements
of material fact.
(ii)
Stop order authority exists only if the registration statement contained a material misrepresentation
at the time if became effective.
(a)
12(a)(2) does, however, give buyers of an offering a remedy if the registration statement
becomes misleading subsequent to the effective date.
(b)
The SEC can, however, under authority of 8A, issue a cease and desist order or invoke
20 to obtain orders in the federal courts to prevent a violation of any provision of the
Act, such as the antifraud provisions of 17(a).
(iii)
Can even be issued after all the registered securities have been sold and distributed.
d)
Result of Refusal or Stop Order
(i)
Under 5(c), no offers to buy or offers to sell can be made when a refusal or stop order has been
issued against a registration statement, and if the registration statement has not become effective,
5(c)s bar applies if any public proceeding or examination under 8 has been initiated.
2.
Post-Effective Amendments of the Registration Statement

a)
The registration statement can be amended after it has become effective. The principal purpose is to correct
any material inaccuracy in the registration statement when it became effective. Thus, the issuer will wish to
amend the prospectus used in the offering.
(i)
If it is New Information Use a Sticker
(a)
Information that does not portent the type of substantive change or addition referred to in
Rule 424(a) can occur w/o the filing of an amendment to the registration statement
(usually this occurs by merely placing a sticker with the new information on the
prospectus).
(ii)
If it is Substitute Information Use a Full Amendment
(a)
On the other hand, 10(a), which requires the prospectus to contain the information in the
registration statement, is applied in practice to require a full post-effective amendment to
the registration statement only when the post-effective information is to be substituted
for, but not added to, information appearing in the registration statement.
b)
Result of Sticker v. Full Amendment
23
Buckham, Brian R.
(i)
3.
Why prefer the sticker route over the amendment route?

(a)
Because post-effective amendments (that are not done via sticker to the prospectus) to the
registration statement do not become effective w/o action of the SEC. Thus, it opens the
door to 11 liability w/ a new statute of limitations.
Withdrawal of the Registration Statement
a)
Rule 477 permits an issuer to withdraw its registration statement, or any amendment thereto, and it is effective
immediately.
G.
The Trading Practice Rules

1.
Generally
a)
The trading practice rules are meant to reduce the temptations by the issuer and its underwriters to influence the
secondary trading market for the security being distributed (so that the distribution occurs more quickly and
possibly at a higher price).
2.
Purchases During a Distribution
a)
Rules 100 to 102 of Regulation M regulate trading activities by issuers and distribution participants during a
distribution.
b)
Prohibition against bids and purchases during a distribution applies until the regulated person has completed his
participation in the distribution.
c)
Regulation M exempts certain transactions from the prohibition on trading activity on the ground that they are
unlikely to affect the market price of the distributed security.
3.
Stabilization
a)
Stabilization is the fixing of a securitys market price through purchases or bids for the limited purpose of
preventing a decline in the securitys price during a public offering of the security.
b)
These transactions are seen as beneficial. A complex set of rules under Rule 104 of Regulation M evolved.
Also, Regulation S-K, Item 502(d), requires that disclosure of the stabilization be made on the inside cover of
the prospectus.
c)
One primary limit on stabilization is that the bid by the underwriter buying to stabilize the deal cannot exceed
the offering price of the security.
H.
Registration Under State Blue Sky Laws

1.
Three Methods of State Registration
a)
Notification
(i)
Entails filing a statement demonstrating that the issuer is eligible to register through notification,
some basic information about the offering, and a copy of the offering prospectus.
(ii)
Restricted to firms who have operated for the past 5 years and have not defaulted.
b)
Coordination
(i)
Entails filing a copy of the federal registration statement and any amendments with the state
administrator.
(ii)
Restricted to firms who have filed a registration statement w/ the SEC.
c)
Qualification
(i)
Entails filing a registration in each state where the offering will be made. Disclosure is quite
extensive.
(ii)
Often entails a review of not only the information in the disclosure, but also a merit review.
(iii)
Used by issuers who are not eligible for registration by notification or coordination.
(a)
Offers registered by qualification are those that have escaped registration with the SEC
because of an exemption provided by the 33 Act.
(iv)
Registration does not become effective until the state administrator so orders.
2.
Merit Review
a)
The NASAA is a set of model merit standards that many blue sky administrators follow in evaluating the
merit of an offering.
b)
The Small Corporate Offering Registration is available for companies with <$1 million raised.
3.
Exemption for Covered Securities
a)
The NSMIA amended 18 of the 33 Act to preempt the power of the states to require issuers to register with
the states covered securities.
(i)
Covered securities = those listed on the NYSE, AMEX, NASDAQ, the Pacific Exchange, the
Philadelphia Exchange, and the CBOE. It also includes some securities offered pursuant to some of
the 33 Act exemptions, such as SEC safe harbors for private offerings under 4(2).
b)
Each state continues to have power to enforce its antifraud provisions with respect to covered securities.
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Buckham, Brian R.
Section 4 - Exemptions
I.
Exemptions Introduction
A.
II.
Generally
1.
Every single offer or sale of securities needs either registration or an exemption.
2.
Sections 3 and 4 of the 1933 Act set forth a series of exemptions relieving those involved in securities transactions of the
need to comply with the registration provisions of the 33 Act and, to a limited extent, the antifraud provisions of the 33
and 34 Acts.
3.
Three classes of exemptions:
a)
Exempt Transactions
(i)
Provide an exemption from 5 of the 33 Act.
(ii)
Securities placed under the transaction exemption remain subject to both the 33 and 34 Acts and
cannot be resold unless either they are registered or there is another exemption available at the time
of the later re-sale.
(iii)
Two Kinds:
(a)
Trading Exemptions
i
4(1)
ii
4(4)
iii
Others
(b)
Issuer Exemptions
i
3(a)(11), Rule 147 intrastate offerings.
ii
4(2) private offerings.
iii
3(b), Reg. D
iv
Others
b)
Exempt Securities
(i)
Exempt from registration and can be sold free of the registration burden.
c)
Section 28 Exemption
(i)
Authorizes the SEC to exempt persons, securities, or transactions from all or part of the 33 Act.
4.
Exemptions are Not Perpetual
a)
Having an exemption at one time does not mean the securities or a later transaction will be exempt at a
later date.
(i)
For example, securities exempt under a transaction exemption cannot be resold unless the shares are
registered or there is an exemption for them again.
Exempt Transactions
A.
The Intrastate Offering Exemption: 3(a)(11)

1.
Generally
a)
3(a)(11) exempts any security which is a part of an issue offered and sold only to persons resident within a
single state, where the issuer of the security is a person resident and doing business, or if a corporation it is
incorporated and doing business within, the state.
b)
Despite its placement in 3, it is seen as a transactional exemption (it was a legislative mistake to put it in 3).
c)
Rationale for the Exemption:
(i)
State regulation of truly local issuances adequately protects investors. Local enforcement can
quickly discover and respond to offering violations.
(ii)
Local people are likely to be more familiar with the issuers business.
d)
Rule 147 provides a great deal of clarification on the exemption by making more objective what would
otherwise be a very broad statutory provision.
e)
Securities offered via intrastate exemption must have the legend and place restrictions stated in Rule 147(f).
2.
Scope of the Exemption
a)
Generally
(i)
It is important to always look at Rule 147, since it aids in delineating the boundaries of the 3(a)(11)
exemption.
b)
Part of an Issue Requirement
(i)
The SEC will look at whether the offerings were made at or about the same time. There are
additional factors, outlined in Rule 147.
(ii)
The entire issue of shares must be offered only to residents. If any part of the issue is offered or sold
to nonresidents, the exemption is unavailable to both residents and nonresidents.
(iii)
The Temporal Aspect
(a)
Rule 147(b)(2) has a safe-harbor saying that six months on either side of the issuance is
not an integration (not part of the same issue).
(b)
If the two potentially separate issuance are within six months within each other, then we
go to the 5-factor approach:
i
Are the offerings part of a single plan of financing?
ii
Do the offerings involve issuance of the same class of security?
iii
Are the offerings made at or about the same time?
iv
Is the same type of consideration to be received?
v
Are the offerings made for the same general purpose?
c)
Doing Business Within a State
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Buckham, Brian R.
(i)
d)
e)
f)
g)
Can only be satisfied by the performance of substantial operational activities in the State of
incorporation.
(ii)
Some cases say the issuer must conduct a predominant amount of his business within the same
state.
(iii)
The SEC may look at whether proceeds from the offering are to be employed in the same state.
Substantially all of the proceeds of the offering must be put to use within the state.
(iv)
Rule 147 Safe-Harbor: The Triple-80% Test
(a)
Rule 147(c)(2)
i
The issuer shall be deemed to be doing business within the state or territory if:
(a)
80% of revenues are from the state;
(b)
80% of assets are in the state; and
(c)
80% of net proceeds are planned to be used in the state.
ii
See Rule 147(c)(2)(i)-(iii).
Residence Within a State
(i)
Mere presence within the state by the buyers is insufficient. They must actually be residents.
(ii)
A single offer or sale to a nonresident destroys the availability of the exemption regardless of
whether the mistake was in good faith.
Resales
(i)
Residents can resell their securities to nonresidents. But, if the securities are resold a very short time
after the distribution to residents, although not conclusive, it may support an inference that the
original offering had not come to rest in the state, and that the resale therefore constituted a part of
the process of primary distribution.
(a)
Securities that have actually come to rest in the hands of resident investors who
purchased without view of resales to nonresidents may be sold w/o jeopardizing the
exemption.
(b)
Rule 147 Safe-Harbor
i
Rule 147(e) If the stock stays in the hands of a resident after sale for at least 9
months, then the resales by persons to non-residents after that 9 months will not
destroy the exemption.
(a)
The buyer is supposed to be taking it for investment, not as
underwriting for resale.
(ii)
Release 4434: The exemption may also be utilized for secondary offerings by person in control of
the issuer if the exemption would be available to the issuer for a primary offering in the state; the
residency of the controlling person will not affect the availability of the exemption in a secondary
distribution.
Use of the Mails and Facilities of Interstate Commerce
(i)
The exemption does not depend on whether the mails or telephones were used.
Problems in Text:
(i)
Problem 5-1
(a)
An offering may be so large that its success as a local offering appears doubtful from the outset.
(b)
The big problem is that some of these doctors may not be a resident of Massachusetts. Using the
Boston Globe and the website cause more problems, since these may reach outside of Massachusetts.
This is not an automatic killer that people outside Massachusetts will see the ad in the Boston Globe.
The exemption is not dependent upon nonuse of the mails or instruments of interstate commerce in
the distribution. They can use a disclaimer on the ad (p. 259).
(c)
Another problem is that there may be resales to people outside the state. There needs to be some
form of holding period.
(ii)
Problem 5-2
(a)
Problem is that they are not doing business in the state of Washington, because the performance of
substantial operational activities is not in Washington. Not just the investment, but instead all of the
business has to be within the same state as the investors. Rule 147(c).
(b)
Not acceptable. Chapman case said that the issuer must conduct a predominant amount of its
business within the same state [as the investors]. The fact it is a Washington entity is not good
enough. But, there are some no-action letters saying two-tier structures could work if the top tier has
operations out of state. From the no-action letters regarding multiple-tier structures looks like form
will win over substance in some cases.
(iii)
Problem 5-3
(a)
No-action letter said this was still an intrastate offering. He still had a house in Minnesota and still
intended to be in Minnesota.
(iv)
Problem 5-4
(a)
This is an integration question. We have to look at the 5 factors above. Its a close case. If
convertible to common stock, then it is indeed integrated.
(v)
Problem 5-5
(a)
Rule 147(c)(2)(i) is phrased to suggest you can do interstate business, provided the interstate
business is all from the relevant state.
(b)
But, this is again a close case, since the Rule 147 safe-harbor is ambiguous on the matter.
(vi)
Problem 5-6
(a)
The re-sale can occur nine months after the date of the last sale by the issuer of the securities. So,
the resale can occur on December 1.
(vii)
Problem 5-7
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Buckham, Brian R.
For purposes of the holding period, no-action letter said there is no actual sale until all of the
installment payments have been made.
(b)
Change of residence of one of the purchasers before the entire sum was paid off was a violation of
the exemption!
(c)
To make the time period end fast, the SEC said the company could just provide for substantial
penalties for default, or by having the investor give a promissory note for the security, and this
would accelerate the date of the sale back to the time the securities were actually sold, rather than
when the last installment payment was made.
Problem 5-8
(a)
This is based on the 80% tests. To have a public offering, you must have 3 years of GAAP, audited
statements. In the event the issuer can find an exemption, they must still use GAAP and rounding up
is not permitted.
(a)
(viii)
B.
The Private Offering Exemption: 4(2)

1.
Introduction
a)
4(2): The provisions of 5 shall not apply to transactions by an issuer not involving a public offering.
(i)
The exemption is meant to permit an issuer to make a specific or isolated sale of its securities to a
particular person or small number of persons.
b)
Two Approaches:
(i)
An issuer may rely on the naked statute itself, 4(2).
(ii)
The issuer may use Regulation D, which provides a safe-harbor for the otherwise ambiguous statute.
(a)
This is discussed further below.
2.
Resale of Securities Acquired in a Private Offering

a)
Because 4(2) is transactional in nature, the private offering cannot be used as a subterfuge for a public offering
by making a private placement to a small group of individuals who then proceed to sell the securities to the
public.
b)
But, resales are still permitted. The critical inquiry is whether any of the purchasers acquired the
securities with a view to their distribution, rather than as an investment.
c)
Issuers often do three things to protect themselves:
(i)
Require purchaser to sign statements of investment intent;
(ii)
Inscribe the securities to disclose that the securities are unregistered and a transfer may take place
only under specified conditions; and
(iii)
Put into effect stop-transfer orders instructing the transfer agent not to process any transfers of
restricted shares without the consent of the issuer.
3.
The Naked 4(2) Approach

a)
The Primary Case: SEC v. Ralston Purina
(i)
Purina allowed key employees to inquire about buying treasury stock, and if they inquired, they
could purchase stock at the market price directly from the company. Offers were made to
approximately 500 persons per year. The court held that the applicability of 4(2) depends on
whether the particular class of persons affected needs the protection of the Act. The number of
persons offered to is not the relevant inquiry there is no quantity limit for the exemption (but it is a
useful factor).
(ii)
The court did note that some employee offerings may come under 4(2) if they are made to
executive personnel who because of their position have access to the same kind of information
that the act would make available in the form of a registration statement.
b)
Other Early Decisions [Overruled]:
(i)
Hill York
(a)
Sophistication of offerees and purchasers in and of itself is not enough to qualify for the
exemption. There must be a prior relationship w/ the issuer.
(ii)
Continental Tobacco
(a)
The offerees need the relationship of an insider to qualify for the exemption.
(iii)
Problem 5-10
(a)
Result in 1973
i
Even though to only one person, this could have been a public offering requiring
registration under Ralston, Hill York, and Continental.
(a)
Ralston is all about access to information. He does not have access to
information in this case.
(b)
Hill York and Continental would require him to have a prior relationship and
insider status. This is not met here.
c)
Effect of Doran Case

(i)
Can satisfy 4(2) access to information by either by:
(a)
Disclosure, OR
i
Of course, if you go the disclosure route, it would make more sense to simply just
do the Reg. D disclosures. Just go all the way.
(b)
Access
i
Access is given by the position of the offeree or by the issuers promise to open
appropriate files and records to the offeree as well as to answer inquiries
regarding material information.
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ii
(ii)
(iii)
4.
C.
Sophistication is still important, because offerees must be able to ask the right
questions. Must show that the offeree could realistically have been expected to
take advantage of his access to ascertain the relevant information.
This case overruled the Hill York and Continental Tobacco case rulings. After Doran, there need
not be a prior relationship or insider status; the person receiving the security need only receive
disclosure or access to information.
Notes on Access or Disclosure
(a)
Sophistication does not eliminate the need for information. Availability of information
means either disclosure of or effective access to the relevant information.
i
If the disclosure option is exercised, absence of a relationship between the issuer
and the offeree does not necessarily mean it is a public offering.
ii
If access to information is the measure, the relationship between the issuer and
the offeree becomes the critical question.
(b)
Courts have held that access to information means access to information equivalent to
that which would have been provided in a registration statement.
i
The point of reference is thus Schedule A, which lists 32 items that must be in the
registration statement.
d)
9th Circuit Approach Under the Naked 4(2)

(i)
In determining whether it is a public offering, look at:
(a)
Sophistication of the investor(s);
(b)
Number of offerees;
(c)
Size and manner of offering;
(d)
Relationship of the offerees to the issuer.
e)
Three Safe Naked 4(2) Transactions:

(i)
Small, closely held corporations with offerings to corporate insiders.
(ii)
Offerings to large, institutional investors.
(iii)
Small acquisition deals X Corp. (the acquirer) could offer shares to the shareholders of Y Corp.
The Rule 506 Approach to Private Offerings

a)
See below for a discussion of Rule 506. This is the safe-harbor alternative to using naked 4(2) for the private
offering exemption.
b)
Rule 506 was enacted under 4(2). It is a nonexclusive safe harbor for 4(2).
(i)
Because it is nonexclusive, can still use the naked 4(2) statute. But, can also use Rule 506.
Regulation D and the Limited Offering Exemptions

1.
Generally
a)
Reg. D provides 3 exemptions (Rules 504, 505, and 506).
(i)
Rules 504 and 505 Special exemptions for offerings < $1 million and < $5 million, respectively.
(a)
Rules 504 and 505 were enacted under 3(b).
(ii)
Rule 506 Nonexclusive safe-harbor for the private offering exemption under 4(2).
(a)
Rule 506 was enacted under 4(2). It is a nonexclusive safe harbor for 4(2).
i
Because it is nonexclusive, can still use the naked 4(2) statute. But, can also use
Rule 506.
2.
Overview of Reg. D
a)
Rule 504
(i)
Available only for offerings of < $1 million.
(ii)
No limitations on the # of purchasers.
(iii)
No affirmative disclosure requirements.
(iv)
No sophistication requirement.
(v)
Resale is restricted.
b)
Rule 505
(i)
Available only for offerings of < $5 million.
(ii)
No more than 35 purchasers (not counting accredited investors).
(a)
Accredited investors are not included in the count.
(iii)
Affirmative disclosure obligation exists when there are any non-accredited investors.
(iv)
c)
Rule 506
(i)
No limit on maximum aggregate offering price.
(ii)
No more than 35 purchasers (not counting accredited investors).
(a)
Accredited investors are not included in the count.
(iii)
Affirmative disclosure obligation exists when there are any non-accredited investors.
(iv)
Non-accredited investors must meet sophistication requirements.
(a)
Recall that under 4(2), we had to worry about the sophistication of the offerees.
Under Reg. D Rule 506, we only worry about the sophistication of the purchasers.
(b)
Permits the purchaser OR the purchasers representative to have the requisite
sophistication.
(c)
See more information on this below.
(v)
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3.
Accredited Investors in Rule 505 and 506

a)
Generally
(i)
Status as an accredited investor is important in determining the disclosure obligations in Rules 505
and 506 (no disclosure is needed if all investors are accredited), and in calculating the number of
investors in Rules 505 and 506. For Rule 506, accredited investors are assumed to be
sophisticated under Rule 506(b)(2)(ii).
(ii)
Accredited investors are conclusively presumed to be sophisticated.
b)
Rule 501(a) defines accredited investor.
(i)
General classes of accredited investors:
(a)
Financial institutions;
(b)
Pension plans;
(c)
Venture capital firms;
(d)
Corporations and other organizations exceeding a certain size (> $5 million);
(e)
Insiders of the issuer;
i
These include the president, VP in charge of the principal business unit, and any
other person who performs a policymaking function for the issuer.
(f)
Natural persons with wealth or income exceeding threshold standards ($1 million net
worth or annual income of greater than $200k for each of the last 2 years); and
(g)
Entities owned by accredited investors.
c)
Reasonable Belief is Sufficient
(i)
Rule 501(a) says that the investor must meet the accredited investor requirements OR that the issuer
reasonably believe the investor meets the requirements.
d)
Some issuers limit their Rule 505 and 506 offerings to accredited investors in order to avoid inquiries into
sophistication (under Rule 506) and affirmative disclosure obligations under Rule 502(b).
e)
Problems on Accredited Investors
(i)
Problem 5-14
(a)
Rule 501(a)(4) and (f) applies. If she is an executive officer under the rule, she is an accredited
investor.
This person probably does not satisfy the definition, since she is not really involved in the policymaking function of the company.
Problem 5-15
(a)
The worry is that the financial statements may be incorrect, since they are estimates and unaudited.
(b)
Fortunately, Rule 501(a) says the person must meet the net worth requirement, OR who the issuer
reasonably believes meets the net worth requirement.
Problem 5-16
(a)
No impact. The investors qualified. That the issuer did not check to make sure is not relevant under
Rule 501(a).
Problem 5-17
(a)
We have to look to Rule 501(h).
(b)
a) This one is fine.
(c)
b) This is troubling under Rule 501(h)(1), since he is an insider. But, (h)(1)(i) saves this since they
are related by marriage.
(b)
(ii)
(iii)
(iv)
4.
Sophistication Standard of Rule 506

a)
Applicable Standard for Sophistication
(i)
Each non-accredited investor, either alone or with his purchaser representative, must have such
knowledge and experience in financial and business matters that he is capable of evaluating the
merits and risks of the prospective investment, or the issuer reasonably believes prior to making any
sale that such purchaser comes within the description.
b)
Imputed Sophistication of Advisors
(i)
If an unsophisticated investor is represented by a knowledgeable and disinterested expert, the
sophistication of the expert can be imputed to the offeree. These advisors are termed purchaser
representatives.
(a)
Rule 501(h) defines a purchaser representative.
(b)
This ONLY applies in Rule 506.
c)
Reasonable Belief is Sufficient
(i)
Rule 506 says that the investor must meet the sophistication requirements OR that the issuer
reasonably believe the investor meets the requirements, either by himself or with his purchaser
representative.
d)
Problems on Sophistication:
(i)
Problem 5-18
(a)
Status as a lawyer in and of itself is not determinative. You still must satisfy Rule 501(h)(2)
(ii)
(iii)
5.
regarding knowledge in financial and business matters.

Problem 5-19
(a)
Liability of attorney who acts as a purchaser representative who is not qualified: not much unless
there is some breach of fiduciary duty or fraud. What we are really concerned about is the liability
of the issuer with respect to the offering. The risk is really to the issuer.
Problem 5-20
(a)
Rules permit this. Under Rule 501(h)(4) and Note 3 require disclosure of the relationship, however.
Calculating the Number of Purchasers
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Buckham, Brian R.
6.
a)
Rule 501(e) provides that certain types of investors are excluded for purposes of the calculation, including
accredited investors, trusts and corporations of a certain ownership %, and others.
b)
Problems on Calculating the Number of Purchasers

(i)
Problem 5-21
(a)
Rule 501(e) would count the following as non-accredited investors:
i
Priscilla
ii
Priscillas father (the father and Priscilla are not counted as just one because they have
different residences)
iii
The corporation (under 501(e)(1)(iii)).
(ii)
Problem 5-22
(a)
Rule 501(e)(2) governs. The answer depends on whether the purpose of the partnership is to acquire
the securities. If that is its purpose, the answer is 11. If it has some other purpose, the answer is 1.
(iii)
Problem 5-23
(a)
Probably only one unaccredited investor, under Rule 501(e)(1)(i). They are grouped into one.
Limitations on the Manner and Scope of a Regulation D Offering

a)
Restrictions on General Solicitations or General Advertising
(i)
Rule 502(c) limits the process by which purchasers are solicited by prohibiting an issuer or any
person acting on its behalf from offering to sell securities by any form of general solicitation or
general advertising.
(a)
Applies in most, but not all 504 offerings, and in 505 and 506 offerings.
(ii)
Pre-Existing Relationship Required to Not be a General Solicitation
(a)
The SEC has interpreted 502(c) to require some form of pre-existing relationship
between the issuer and the offeree to establish the limited nature of a communication.
i
But, as far as the internet is concerned, the SEC seems to be more liberal with
general solicitations and advertising.
b)
Activities by Broker-Dealers Not a General Solicitation
(i)
Issuers in Reg. D offerings often solicit the marketing assistance of broker-dealers. In such cases, a
pre-existing relationship between a qualified offeree and the broker-dealer (rather than the issuer)
will suffice the render the communication limited under Rule 502(c) (and thus will not be a
prohibited general solicitation).
c)
Problems on General Solicitations
(i)
Problem 5-24
(a)
Based on the SECs idea about the necessity of pre-existing relationships, this appears to be a
violation of the general solicitation requirement. We have to ask if there are pre-existing
relationships with the issuer here.
7.
Aggregation of Reg. D (Rule 504 and 505) Offerings

a)
Generally
(i)
Generally
(a)
Aggregation is important with respect to calculating the offering price amount.
(b)
Rules 504 and 505 limit the aggregate offering price on offerings within any twelvemonth period.
i
It is not relevant in Rule 506 offerings, since there is not limit on the offering
amount.
(ii)
Aggregation v. Integration
(a)
Aggregation is a 504 and 505 problem only. Integration is relevant to 504, 505, and 506.
(b)
Integration looks at what offerings are related to one another such that they should be
considered just one offering.
(c)
Aggregation looks to how much each offering during a twelve month period was, and
adds them together for purposes of the aggregate offering price limits in Rules 504 and
505.
(d)
Source in Statute:
i
Aggregation is in sections like Rule 505(b)(2)(i), which says that shall not
exceed $5 million, less the aggregate offering price for all securities sold within
the 12 months before the start of and during the offering of securities under this
Rule 505 in reliance on a 3(b) exemption.
ii
Integration is in Rule 502(a), which talks about integrating offerings 6 months
before and 6 months after the current offering, and provides a set of five factors.
(iii)
Relevant Amount and Time Period
(a)
Aggregation occurs with respect to offerings pursuant to any of the 3(b) exemptions that
take place within the 12 month period preceding the start of the offering under Rule 504
or 505. If the offering is made within that twelve month period, the offering amounts will
be aggregated to determine the total offering amount for purposes of Rules 504 and
505.
(iv)
Calculating the Aggregate Offering Price
(a)
Defined:
i
Rule 501(c) defines aggregate offering price as the sum of all cash, services,
property, notes, cancellation of indebtedness, and other consideration the issuer
receives for the securities.
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(a)
(b)
(c)
b)
The maximum aggregate offering price is lowered by the amount of

any other securities sold within specified time periods in reliance
upon any of the 3(b) exemptions.
Cash + Non-cash Payment for Shares
i
If the issuer receives a mix of cash and non-cash, the aggregate offering price is
determined by reference to the cash (i.e, if 1/3 cash and 2/3 property, triple the
cash amount to determine the aggregate offering price).
Non-Cash Payment for Shares
i
If the issuer receives only non-cash, fair value of the non-cash is used.
Aggregation Problems
(i)
Problem 5-29
(a)
Jan 1 ---- April 1 ------------------ Jan 1 ---- April 1
(b)
There are rolling 12 month periods.
(c)
Under 504 or 505(b)(2), the 100% safe answer for a new offering would be April 1 of year 2.
(ii)
Problem 5-30
(a)
This question asks only about aggregation.
(b)
Basic problem is the overlap. Rule 505 begins Jan. 1, and it ends on June 1. You then begin the
Rule 504 on May 1 of Year 2 and it ends on July 1 of Year 2. The potential problem here if you
dont have good records is that you may have exceeded the $5 million during the one month time
period of overlap (5/1 of Year 2 with 6/1 of Year 1).
i
It is fine to sell $500k during 5/1 to 6/1 of year 2, but thats it. You could then sell as much
as you want from 6/1 to 7/1 of year 2.
(iii)
Problem 5-31
(a)
Rule 506 and 4(2) deals are not aggregated.
(b)
If you start out as a Rule 504 (which is a 3(b), which means it must be aggregated w/ any 505s
(which are also 3(b)), and then later recharacterize it as a Rule 506, can you get away without
aggregating? That is, can you recharacterize it after the fact?
i
Note 3 on Supp. 128 provides insight. Says that if you can characterize it as something
other than a 3(b) rule, then you dont have to worry about aggregation.
(iv)
Rule 5-32
(a)
Rule 501(c) base the value of the non-cash on the cash amount. If all you have is non-cash
consideration, then you then you use the reasonable fair value of the non-cash. Objective.
(b)
Proper lawyering in such a setting is to make sure there are appraisals or something in the file that
documents/establishes the value of the non-cash items paid for the shares.
8.
Integration of Offerings
a)
Generally
(i)
Integration is the idea that what appears to be separate financings could be treated by the law as one
transaction. There is a 6 months safe harbor, but also 5 factors that can be used if there are multiple
offerings within the 6 month period (Rule 147).
b)
Issue Integration
(i)
This is where several issuances are combined into one, because they appear to be part of the same
issuance.
(ii)
Presumption of non-Integration if no other offerings within 6 months on either side.
(a)
Safe Harbor ----| 6 months Offering 6 months |---- Safe Harbor
c)
Issuer Integration
(i)
Integration of issuers arises when offerings by ostensibly distinct and separate issuers are integrated
and treated as an offering by a single issuer.
(a)
This is things like separate partnerships, subsidiaries, etc.
9.
Disclosure Obligations in Offerings Under Rules 505 and 506

a)
Any nonaccredited investors in a Rule 505 or 506 offering must be given specified information a reasonable
time prior to sale.
b)
The nature of the disclosures required is specified in Rule 502(b) and depends upon the size of the offering and
the nature of the issuer.
(i)
If the issuer is not a reporting company, Rule 502(b)(2)(i) prescribes certain disclosures to the
extent material to an understanding of the issuer, its business, and the securities being offered.
c)
Rule 502(b)(iv) requires the issuer to provide nonaccredited investors with a summary of material written
information that has been given to any accredited investor.
d)
Rule 502(b)(v) requires the issuer to give each purchaser an opportunity to ask questions and receive answers
concerning the terms and conditions of the offering.
10.
Additional Regulation D Requirements and Features

a)
Substantial Compliance Standard
(i)
A failure to comply with a term, condition, or requirement of Rules 504, 505, or 506 will not result
in the loss of an exemption from the requirements in 5 (rescission) for any offer or sale to a person
who relies on the information, if the person shows:
(a)
The failure to comply did not pertain to a term, condition, or requirement that was
directly intended to protect that individual entity; and
(b)
The failure to comply was insignificant.
(ii)
Items that are always significant:
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Buckham, Brian R.
(a)
(iii)
b)
c)
d)
11.
502; 504(b)(2); 505(b)(2)(i), (ii); 506(b)(2)(i).
Problems on Substantial Compliance

(a)
Problem 5-33
i
For the first offering, it is not subject to rescission if the only failure was the failure to file
an after-the fact Form D. It may, however, impact a later offering.
ii
For the later offering, file it under 4(2) instead of 505.
(b)
Problem 5-34
i
We had only one individual who was non-accredited in a 506 offering. One of the
accredited investors wants to rescind. Can the issuer say that this substantial compliance,
despite offering to one non-accredited investor and not making required disclosures?
ii
508(a)(2) tells us what is considered per se substantial.
Limitations on Resale
(i)
Rule 502(d) requires that the issuer use care that the persons who receive the shares comply w/ the
resale restrictions.
Rule 505 and the Bad Boy Disqualifiers
(i)
Rule 505 is unavailable for the securities of any issuer described in Rule 262 of Regulation A. This
limitation arises if the issuer or person related to the issuer (including a director, officer, etc.) has
engaged in certain conduct violative of federal securities laws.
Form D
(i)
Rule 503 requires the filing of Form D with the SEC no later than 15 days after the first sale of
securities under Rules 504, 505, or 506.
Regulation D Miscellaneous Problems

a)
Problem 5-13
(i)
Probably best to use Rule 505 and only raise $3 million (because only want to offer to accredited investors and
thus wont have to do disclosures).
D.
Employee Benefit Plans and Contracts Relating to Compensation: Rule 701

1.
Generally
a)
Rule 701 exempts from the registration requirements of the 33 Act offers and sales under certain
compensatory benefit plans or written agreements relating to compensation. The exemptive scope covers
securities offered or sold under a plan or agreement between a non-reporting (private) company (or its
parents or majority-owned subsidiaries) and the companys employees, officers, directors, partners, trustees,
consultants, and advisors.
b)
Restricted to a maximum sales of the greatest of:
(i)
$1 million;
(ii)
15% of the issuers total assets, or
(iii)
15% of the outstanding securities of that class.
c)
If the sales in a 12 month period exceed $5 million, the issuer must make affirmative disclosures.
d)
Rule 701 is not available for reporting companies.
e)
Amounts sold under Rule 701 do not affect the aggregate offering price limitations for other offerings that may
occur under one of the 3(b) exemptions.
(i)
No Integration/Aggregation Rule 701(f) further provides that sales exempt under the rule are
deemed to be part of a single, discrete offering and are not subject to integration w/ any other offers
or sales.
f)
Need to make sure the corporate resolutions allowing the offering make some mention to the fact that the stock
is being issued as compensation.
E.
4(6) Exemption
1.
This is largely redundant of what you can do under 505 and 506, if you limit the offer solely to accredited investors. It
was passed prior to Reg. D, but now it is still used to reinforce the idea that you can limit it to accredited investors and
get away with a lot.
F.
Regulation A: Mini Registration

1.
Generally
a)
This is another section that is somewhat redundant because of Reg. D.
(i)
Ever since Reg. D, Regulation A isnt used too much.
(ii)
But, there are a few advantages of Regulation A. It has great potential for use in internet offerings.
2.
Overview
a)
Regulation A is Rules 251-264, promulgated under 3(b).
b)
Maximum offering of $5 million per year.
(i)
Available also for secondary offerings up to $1.5 million.
c)
Securities sold under the exemption are not restricted, so they can be resold immediately.
d)
The offerings will not be integrated w/ offerings made under Rule 701.
e)
Requires the filing of an Offering Statement (Form I-A) before the offering can commence. Prospective
purchasers must be provided with an Offering Circular.
f)
Rule 254 permits some testing of the waters by soliciting interest from prospective investors prior to filing
the Offering Statement.
G.
State Exemptions
1.
Must always remember that states have concurrent jurisdiction over securities laws.
2.
Exemption for Covered Securities
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Buckham, Brian R.
a)
III.
NSMIA amended 18 of the 33 Act to exempt from state registration requirements covered securities, which
include such things as listed securities, securities sold to qualified purchasers, and securities qualifying for an
exemption under Rule 306. This does not affect offerings under some key exemptions such as Regulation A,
Rule 504, and Rule 505.
Secondary Distributions
A.
Introduction
1.
Trading transactions are exempt from 5 (registration), but secondary distributions are not.
a)
Remember, EVERY sale (including resale) must be either registered or exempt.
2.
Transactions involving registered securities are also exempt from being registered again, since 5s prohibitions against
sale only applies when there is no registration statement effective with respect to the shares.
a)
Thus, when there are registered securities, 3 and 4s exemptions are irrelevantthere is a registration
statement in effect and thus no exemption is needed from 5.
3.
NOTE: IN THIS SETTING WE ARE RESELLING PUBLICLY via secondary transactions (offers/sales to a
large group of people from someone other than the issuer).
B.
Resales Under the 4(1) Exemption (the Underwriter Concept)

1.
Generally
a)
This section concerns the ability of persons to sell their restricted shares into the public markets. All the
persons in the secondary distribution, including the seller and the brokers, are implicated if there is no
exemption.
b)
4(1) is the central transaction exemption in the 33 Act. It exempts everyone except issuers, underwriters, and
dealers. The problem is that the term underwriter is broad under 2(11). In this setting, we are trying
to determine whether a particular resale is a trading transaction eligible for 4(1) or instead a
distribution (secondary) that is NOT eligible for 4(1) (and thus must be registered).
(i)
Absent Rule 144, the answer to this question turns on 2(a)(11)s definition of an underwriter.
(ii)
We also run into problems when the reseller is a control person.
c)
The reason we have the secondary transactions rule is because we dont want issuers to use an exemption on
one transaction as a conduit to get the shares into the public without registering in a second transaction. An
intermediary would be used simply as a conduit.
d)
The basic premise is to avoid being classified as a 2(a)(11) underwriter.
e)
Basic distinction for 4(1) purposes is between distributions and trading.
(i)
Trading means there is no 2(a)(11) underwriter.
(ii)
4(1) looks at whether the buyer had investment intent, as opposed to selling with a view to
distribution.
2.
Resale by Underwriters - (2(a)(11))

a)
Generally
(i)
Individual investors who are not professionals in the securities business may be considered
underwriters within the meaning of that term as used in the Act if they act as a link in the chain of
transactions through which securities move from an issuer to the public.
b)
Four roles that qualify someone as an underwriter:
(i)
Any person who purchases from an issuer w/ a view to the distribution of a security; or
(ii)
Any person who offers or sells for an issuer in connection with a distribution; or
(iii)
Any person who participates or has a direct or indirect participation in the activities covered by the
two above; or
(iv)
Any person who participates or has a participation in the direct of indirect underwriting of any such
undertaking.
c)
Distribution
(i)
Generally
(a)
To be an underwriter, the activity must be in connection w/ a distribution, but there is
no definition in the statute.
(ii)
The Meaning of Distribution
(a)
A distribution exists if there are sales to those who cannot fend for themselves.
(b)
It is not a distribution if the resale to the new person would not make the second
unregistered offering otherwise violative of the exemption used in the original offering by
the issuer.
i
Thus, distribution includes an offering of a security that is required to be
registered because the issuers offering did not come to rest only with investors
who satisfy the criteria of a single exemption from registration. If the resale
destroys the exemption, then there is an offering that has to be registered under
5, that is, a distribution.
(iii)
Investment Intent
(a)
Investment intent is the key to showing that it was a trading transaction, not a
distribution.
(b)
The length of time the purchaser has held the shares before reselling them plays a pivotal
role in determining whether the purchaser acquired the shares with a view to their
distribution.
(c)
Changes in Circumstances
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Buckham, Brian R.
d)
e)
One question that arises is when some change in circumstances could support a
resale before 2 years
(d)
Change in Circumstances Doctrine
i
When circumstances have changed, it may not be a distribution.
ii
The change of circumstances has to be the circumstances of the reseller, not the
issuer, which changed.
(iv)
Foreclosing Lenders
(a)
Lenders who foreclose and sell unregistered securities as their collateral may be
considered underwriters.
(b)
Good faith of the bank is not relevant.
(v)
Registered Shares
(a)
Provided the seller is not a control person, 5 problems only arise when the security
being resold has not been registered. If a control person sells shares, it could be a
distribution not exempt from 5.
Participation Underwriters
(i)
Participation Requirement (SEC v. Chinese Association)
(a)
The test in the case was the participation of the Association in the offering, by advertising
the offering. Privity is not required.
(ii)
Officers and Directors
(a)
Anyone who has arranged for public trading of an unregistered security or has stimulated
investor interest in such a security through advertisements, research reports, or other
promotional efforts can easily be considered to have participated in the issuers
distribution, and is thus an underwriter.
Problems
(i)
(ii)
(iii)
(iv)
(v)
(vi)
3.
Problem 6-1
(a)
Carl could be considered an underwriter because of his participation in the offering. We could even
take out the 500 shares paid to him and he could still be an underwriter under the Chinese
Association case.
Problem 6-2
(a)
How will we gauge her investment intent? This turns on whether there is a change in circumstances.
Regardless of her intent, she is not selling them in a distribution because the circumstances have
changed.
(b)
We are okay on the change in circumstance doctrine, because it was Beatrices circumstances that
changed, not the companys.
Problem 6-3
(a)
Is the banks resale arguably a distribution? The note at the bottom of p. 347 holds that a pledgee
(the foreclosing lender) could be an underwriter under facts like these.
(b)
If Janice had been a control person, it would make a big difference. Anyone who sells for a control
person is a statutory underwriter.
(c)
If bank had sold it to one identifiable person, instead of into the public market, it would not be a
distribution. If not a distribution, then it is a trade. And, if it is a trade, the seller is not an
underwriter.
Problem 6-4
(a)
Burt
i
Question is whether he purchased w/ a view to distribution. Then he is an underwriter.
(b)
Carol
i
Problem is whether Carol participated in such a distribution. If so, she is an underwriter.
(c)
Solution is to sell it to a person that qualifies for the original exemption that the issuer used for its
original offering.
Problem 6-5
(a)
Sale into any market is not consistent with the private placement exemption! So, dont do this.
(b)
If it had been 3 years, sale into this market is fine, if Burt is not a control person.
Problem 6-6
(a)
If the shares had been sold to him as part of a registered offering, and Burt is not a control person, he
can freely resell the stock into the market. This is because the shares are not restricted shares,
whether under Rule 144 or in the plain 4(1) exemption.
(b)
If Burt is instead a control person, then he may be locked-in and may not have the 4(1) exemption,
even though the shares were registered, because of the 2(a)(11) exemption.
(c)
The same shares had different resale status based on whose hands they are in control persons and
non-control persons.
Resales by Control Persons Under 4(1)

a)
Generally
(i)
One who purchases from a control person, or sells for a control person, or otherwise
participates in a distribution of the control persons securities, is an underwriter, and thus
not exempt from 5 under 4(1)s exemption.
(ii)
2(a)(11) provides that a control person is an issuer, but only for the purpose of determining whether
the person who purchases from or sells for the control person is an underwriter. A control person
is not an issuer for other purposes of the Act because the control person is not included within
2(4)s definition of an issuer.
(iii)
Two exceptions:
34
Buckham, Brian R.
Control person can sell an exempt security without violating 5.

Control persons resale of an unregistered security may occur under circumstances that
are consistent w/ the criteria of the exemption from 5 that the issuer sought.
Control = defined functionally in terms of a persons or groups influence over management and
business policies.
(i)
Possession, direct or indirect, of the power to direct or cause the direction of management and
policies of a person, whether through the ownership of voting securities, contracts, or otherwise.
(a)
Otherwise has been read to include directors and high executive officers.
US v. Wolfson
(i)
If a person sells into the public market, he is selling to people who cant meet the Ralston-Purina
standards. Everyone involved in a resale needs to identify its own separate exemption.
(a)
The fact the 4(4) broker has an exemption for the resale does NOT mean that the
reselling individual has an exemption.
(ii)
Brokers Exemption for Reselling Shares - 4(4)
(a)
The brokers transactions exemption of 4(4) protects only the broker executing the
transaction; the brokers client must seek his own exemption for a resale.
(a)
(b)
b)
c)
d)
Problems
(i)
(ii)
(iii)
Problem 6-7
(a)
There is no 2(a)(11) distribution problem here because the shares were registered and held for
four years. So, there is no argument they took with a view to distribution. So, they cant be
underwriters in that way. But, they may still be control persons, and thus underwriters. A person
can still become an underwriter under the last sentence of 2(a)(11).
(b)
Alice If she is a control person, her resale of the shares is problematic because of the last sentence
of 2(a)(11). Rule 405 gives guidance on the definition of control. Here, she is probably a control
person, since she had power over the Board.
(c)
Bob (broker) May get 4(4) exemption as a broker. The question will thus become when he sells
Alice and Carls shares, whether it is a distribution or a trade. Would need to look at various factors
to determine if it is a distribution or not, including the number of shares.
(d)
Carl Same issue as with Alice, but he appears to have less control. Rule 405 is vague, but it very
likely would include directors of the corporation.
(e)
Note: There can be more than one control person. Each member of the board is usually considered
a control person.
Problem 6-8
(a)
The 4(4) brokers exemption is only necessary if you dont qualify for the 4(3) dealers exemption.
Here, it would violate 5 unless the brokers exemption is available, since the 90 day requirement for
the dealers exemption has not been met yet. It also disqualifies for the 4(4) exemption because of
solicitation.
Problem 6-9
(a)
Just because someone is called a broker does not make it a 4(4) exempt transaction.
Resales Under Rule 144 Safe Harbor (to 4(1)) for Resales of Control and Restricted Securities
1.
Generally
a)
This is the safe-harbor to the 4(1) exemption.
b)
In broad overview, restricted securities are those acquired from an issuer in an unregistered offering. Rule
144 provides objective criteria for determining whether the purchaser has met the investment intent which
permits the purchaser to resell without becoming an underwriter. If the reseller meets the terms of Rule 144,
that person is not an underwriter, and is thus exempt from 5 via the 4(1) exemption.
c)
Two Uses of Rule 144
(i)
4(1) and Rule 144 is used for sale of restricted stock by a holder (not the issuer) into the
market.
(a)
If the shares are registered, there is no problem with the resale, since it is not a
2(a)(11) distribution and 5 has been satisfied (by registration), and thus no
exemption would be necessary for those shares.
(ii)
4(1) and Rule 144 is used for sale of stock (restricted or unrestricted) by a CONTROL
PERSON or affiliate into the public market.
d)
Resales Are to Public Market
(i)
4(1) and Rule 144 do not apply unless the shares are being sold into a public market.
(a)
Also, for a control person to sell privately, 4 (1 ) comes into play.
2.
Scope of Rule 144
a)
Rule 144 provides a safe harbor for resale of Restricted Securities, which includes:
(i)
Privately offered securities acquired directly or indirectly from the issuer or a control person
in a transaction not involving a public offering (i.e., via the 4(2) exemption); or
(ii)
Securities issued pursuant to Reg. D or 701 or 4(6) of the Act.
b)
Securities offered under 3(a)(11)s intrastate offering exemption are NOT restricted securities. But, Rule 147
has certain limits on resale of those securities. (Rule 147(f)).
3.
Two Key Factors:
a)
Whether someone is a control person;
b)
Whether the shares are restricted.
4.
Requirements of Rule 144
a)
Availability of Public Information
(i)
There must be available adequate public information with respect to the issuer of the securities.
35
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Buckham, Brian R.
b)
5.
6.
Holding Period
(i)
A minimum of one year must have elapsed between the acquirors payment of the purchase price of
the restricted securities to the issuer and the present holders sale of the securities.
(a)
Holding period is a bad term to use, since the relevant time is the time that elapses any
time after the issuer sells the securities.
c)
Limitation on Amount of Securities Sold
(i)
The amount of restricted securities sold cannot within the preceding 3 months exceed the greater of:
(a)
1% of the number of shares in that class; or
(b)
The average weekly reported trading volume in such security during the preceding 4
calendar weeks.
d)
Manner of Sale
(i)
To be under Rule 144s safe harbor, the sale must be made in transactions directly with a
market maker or in brokers transactions.
e)
Notice of Offering
(i)
A person desiring to sell securities in reliance upon the rule must file with the SEC a notice to that
effect.
f)
Bona Fide Intention to Sell
(i)
A person must have a bona fide intention to sell the securities within a reasonable time after the
filing of the notice.
Control Persons
a)
If someone is a control person, the fact that shares are restricted or unrestricted is irrelevant. The control
person cannot sell unless they meet Rule 144.
(i)
See problem 6-17, infra.
Problems
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
Problem 6-10
(i)
These are restricted securities, in that they were offered under a 4(2)/Reg. D private offering. These cannot
be dumped into the market w/o a broker w/o raising the issue of whether they qualify for the 4(1) exemption or
not.
(ii)
Has to meet the requirements:
(a)
Holding period;
(b)
Must go through a broker;
(c)
Has a volume limitation;
(d)
Etc.
Problem 6-11
(i)
These are not restricted securities, since they were sold under 3(a)(11).
(ii)
If he is not a control person, Rule 147 will govern whether he can sell the shares, including a 9 month holding
period.
Problem 6-12
(i)
Here we have a failed Rule 505 exemption. The company was thus deprived of its exemption. After the failed
Rule 505 offering, the holder is not impacted. She still has restricted securities.
Problem 6-13
(i)
This is NOT a Rule 144 transaction. Rule 144(b) says that an affiliate (an affiliate is a control person)
who sells for his account. This transaction is not even described in Rule 144(b). Rule 144 transactions apply
only to brokers transactions into a public market. Here we only have a private sale.
(ii)
This will raise the 4 (1 ) exemption concept, which we will see later.
Problem 6-14
(i)
This implicates Rule 144. Someone is selling for the account of a control person and it is a 144(f) brokers
transaction.
Problem 6-15
(i)
Rule 144(d)(1) says that a one year term is used. The one year period runs from the date the shares are acquired
from the issuer. It is an automatic tacking. We dont look at the shareholders holding period, we look at the
time it was issued.
(ii)
Rule 144(k) certain restrictions on resale are terminated upon certain periods (2 years after the original
purchase from the ISSUER).
(iii)
Alice does have Rule 144(c) problems, because the required information is not on file! Then, under Rule 144(k),
it waives some of the requirements if they have been held for two years.
Problem 6-16
(i)
Rule 15c2-11 discusses this issue.
Problem 6-17
(i)
She is probably a control person. It is unrestricted stock, but control persons are still subject to Rule 144 even
when they are unrestricted securities!
(ii)
Note that the holding period in Rule 144(d) does not apply to unrestricted securities.
Problem 6-18
(i)
Rule 144(d)(2) says his holding period has not even started to run! His only collateral for the note was the
shares, so there was no full payment yet.
Problem 6-19
(i)
Rule 144(d). Can the bank sell? Bank should be able to sell these, by getting around Johns problem, via the
from the issuer language for the holding period.
Problem 6-20
(i)
Rule 144(e) places a limit on the amount that can be sold. Can only sell 1% per three months or the average
weekly trading volume. She can sell 80,000 in April. It is a moving three month timeframe.
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m)
n)
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Buckham, Brian R.
Problem 6-21
(i)
Have to include those sold by the donee (Cornell). Have to subtract that from her permissible 180,000 shares, so
the answer is 180-120 = 60,000 shares.
Problem 6-22
(i)
Rule 144(g)(2) applies here, and says there can be no solicitation except as stated. It is probably okay here under
(g)(2)(i) and can still be a brokers transaction.
Problem 6-23
(i)
Even though the brokers themselves get the 4(4) exemption, the control person will not likely qualify for the
4(1) exemption.
(ii)
Rule 144(g)(3) does require the broker to make some reasonable inquiry into the circumstances.
Problem 6-24
(i)
Question is whether these two transactions will be integrated.
(ii)
Rule 144(e)(3)(vii) says there are certain protections against integration.
D.
Rule 144A Exemption for Resales to Institutional Investors

1.
Rule 144A
a)
Provides a non-exclusive safe-harbor from the registration requirements of 5 for the resale of restricted
securities to specified institutions by persons other than the issuer of the securities.
(i)
It provides that the transactions are not distributions, and thus the reseller is not an underwriter.
(ii)
Gives more liquidity to restricted securities, since it allows the shareholders to sell their restricted
securities to qualified institutional buyers (QIBs).
b)
Eligible Purchasers from the Reseller
(i)
An institution must have at least $100 million in securities of issuers that are not affiliated w/ the
institution. This can include:
(a)
Banks and S&Ls (must also have net worth of > $25 mm)
(b)
Registered Broker-Dealers (w/ $100 mm reduced to $10 mm).
(c)
Any corporation or partnership meeting the $100 million requirement.
c)
Note: In 2001, $480 billion in securities were sold under Rule 144A.
d)
USED ONLY FOR RESALES. COULD HAVE USED 4(2) ORIGINALLY TO GET IT TO THE
ACCREDITED INVESTORS. 144A IS FOR THE SHAREHOLDERS TO GET IT TO THE
INSTITUTIONS (ESSENTIALLY ACCREDITED INVESTORS) IN A RESALE.
E.
The Section 4 (1 ) Exemption for Resales by Control Persons

1.
Generally
a)
Because of the number of shares offered, the lack of a brokers transaction, or other problems, a control
person may in some cases be unable to bring his sale within Rule 144. This is where the 4(1 ) exemption
comes into play.
b)
Control persons have a problem because they are covered in the last sentence of 2(a)(11) (the definition of
underwriter), which refers to issuers. Thus, courts have looked to 4(2) private offering exemption for
control persons, combined somewhat with 4(1)s exemption of persons who are not underwriters.
2.
The 4(1 ) Exemption for Control Persons
a)
Generally
(i)
Since 2(a)(11) defines an underwriter as any person who has purchased from an issuer with a
view to the distribution of any security, and since a distribution requires a public offering, the
question of whether there is a 4(1) exemption is whether there has been a public offering.
(a)
Whether it is a public offering turns on the need of the investors of the protection of
registration.
(ii)
Uses the 4(1) exemption based on 4(2) criteria.
b)
Rule:
(i)
Resale is permitted under the auspice of 4(1) by control persons so long as the purchasers
would have qualified under Ralston Purina (the 4(2) criteria for the private offering
exemption).
3.
Buyer Sophistication
a)
One of the most uncertain areas under 4(1 ) is whether the control persons buyers must be sophisticated.
b)
Generally there is a view that there is also an information requirement for the exemption.
4.
Advertising
a)
Broad solicitation and advertising is believed to be inconsistent w/ the 4(1 ) exemption.
Resales Under State Blue Sky Laws
1.
Federal laws with respect to resales are often more stringent than state laws; thus, satisfying Rule 144 is more than
sufficient to qualify the resale under most state blue sky laws.
F.
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IV.
Recapitalizations, Reorganizations, and Acquisitions

A.
The For Value Requirement

1.
Generally
a)
Securities are issued when a corporation declares a stock dividend, there is a share conversion, there is an
acquisition involving issuance of shares in an acquisition, etc. But, 5 operates only when there is an offer for
sale. 2(a)(3) defines sale to involve every attempt to dispose of a security for value.
b)
Thus, only when there is a sale or offer to sell for value is there a 5 issue in the case of any given
transaction.
(i)
Stated differently, not every issuance is a sale of securities for purposes of 5. Though the
shares may have been issued, the transaction may not really involve a sale of securities (for value).
If it does not, then we dont need to worry about 5.
2.
Value Is Not Always What It Seems
a)
Gifts of Securities
(i)
A gift of securities is still considered for value when the gifts appear to be given with an eye
toward distribution.
b)
Dividends
(i)
The typical cash dividend does not involve the offer for sale of a security.
(ii)
The typical stock dividends in the form of stock does not implicate 5.
(a)
The rationale is that the shareholders interest in the corporation does not change when
there is a stock dividend. It just divides the pie into more pieces. It is an issuance of
stock, but not a sale, since there was no value given.
(iii)
A choice between taking cash or stock as a dividend does not involve the offer for sale of a
security.
(iv)
Dividend reinvestment programs, whereby the stockholders may by prior agreement have
their dividend applied toward the purchase of additional shares from the corporation at
current market prices, are subject to registration under the 33 Act.
c)
Warrants and Convertibles
(i)
Whether the underlying security (the securities obtained when the warrant or convertible is exercised) must be
registered depends on when, by the terms of the instrument, the holder can acquire the underlying security
through conversion or exercise. If the conversion terms provide that the second security can be obtained at any
time, the security must be registered or qualify for an exemption.
3.
d)
Amendments to Articles of Incorporation

(i)
The SEC is fairly consistent in viewing all material changes in a securitys economic or voting
rights as entailing the sale of a new security. On the other hand, a sale is not involved if the
change involves no economic consequences to the holders, such as altering the shares par
value.
(ii)
Registration under 5 is not required when a company reincorporates since it is a mere change in
form, not substance.
e)
Example Problems
(i)
Problem 7-1
(a)
A choice between taking cash or stock as a dividend does not involve the offer for sale of a security.
(b)
The SEC ruling on this matter seems to suggest that even when there are different classes of shares
involved, the result is the same no value given so no sale so no 5 implications.
(ii)
Problem 7-2
(a)
If the stock is cumulative, the company is in effect incurring a debt. In this case, the company is
converting this debt into equity.
(b)
The SEC has held that this constitutes giving value for the securities, and thus it is a sale for value.
The conversion is treated as new consideration.
(iii)
Problem 7-3
(a)
The SEC is fairly consistent in viewing all material changes in a securitys economic or voting rights
as entailing the sale of a new security. On the other hand, a sale is not involved if the change
involves no economic consequences to the holders, such as altering the shares par value.
(b)
(iv)
Problem 7-4
(a)
Shells and Spinoffs: Creating Value

a)
Spinoffs and the 33 Act
(i)
Spinoffs may be deemed a sale of a security under 5 of the 33 Act.
(ii)
The focus is on whether there is a proper business purpose for the transaction, as well as whether the
spinoff was accompanied by adequate information (information statement) available about the
spunoff company.
(a)
SEC requires all sales of spunoff shares to comply with Rule 144.
b)
Regulation of Spinoffs in the 34 Act
(i)
Rule 15c2-11 governs spin-offs.
(ii)
Subject to certain exceptions, the rule prohibits a broker or dealer from submitting a quotation for a
security in a quotation medium unless it has in its records specified information concerning the
security and the issuer and, in some circumstances, furnishes the information to the interdealer
quotation system two days before publication of the quotation.
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Buckham, Brian R.
Example Problems
(i)
Problem 7-5
(a)
This company is a 34 Act company because it has high assets and 7k shareholders. So, it must be a
reporting company.
(ii)
Problem 7-6
(a)
No, Alasko need not register its shares. This then becomes a 34 Act problem, but the securities here
are not restricted securities.
(b)
Because they are not restricted securities, there are no holding period requirements.
(iii)
Problem 7-7
(a)
Broker needs to be assured that the 34 Act reports are made.
B.
Mergers, Acquisitions, and Recapitalizations

1.
Introduction
a)
Types of M&A Under IRC 368(a)(1)
(i)
A Statutory (state statutes) merger or consolidation
(a)
Shareholders of the acquired company give up their shares and take shares in the other
corporation.
(b)
Merger = A acquires B and A remains.
(c)
Consolidation = A and B form a new corporation C.
(ii)
B Stock-for-stock exchange
(a)
A gets control of B by directly exchanging its stock with the B stockholders. It is a
negotiated deal, not a tender offer.
(iii)
C Stock-for-asset exchange
(a)
A gives stock to B to purchase Bs assets, and then B liquidates and gives the A stock to
its shareholders.
(iv)
Tender Offers
(a)
A solicits Bs shareholders directly.
2.
Rule 145 Transactions
a)
Business combinations and recapitalizations trigger 5 concerns whenever they involve the issuance of
securities. Today, Rules 145, 165, and 166 regulate much of the scope of 5 when securities are issued in
connection w/ most business combinations.
b)
Three Types of Rule 145 Transactions:
(i)
Recapitalizations
(ii)
Mergers
(iii)
Certain Transfers of Assets
c)
Rules 165 and 166 apply only to transfers that fall within Rule 145.
(i)
These rules greatly relax the 5 rules against release of deal-related information.
d)
Rule 145 does not affect the following statutory exemptions available under the 33 Act: 3(a)(9), (10), (11),
and 4(2).
3.
Rules 165 and 166
a)
The Rules permit parties to communicate freely about a planned business combination transaction before a
registration statement is filed, as well as during the waiting and post-effective period, so long as their written
communications (except mere internal communications between the parties) used in connection w/ or relating
to the transaction are filed beginning with the first public announcement and ending with the close of the
proposed transaction.
4.
Ability to Resell into a Public Market
a)
Rule 145(c) and (d) govern, which hold that persons acquiring shares in such a setting are underwriters. This
then leads to Rule 144s rules.
5.
General Notes
a)
Form S-4 is used to register securities issued in mergers and business combinations.
b)
Offers in connection w/ business combinations are continuing offers and hence must comply with the shelf
registration requirements of Rule 415(a)(1)(viii).
C.
Exempt Exchanges Under 3(a)(9)

1.
Generally
a)
3(a)(9) exempts any security exchanged by the issuer with its existing security holders exclusively
where no commission or other remuneration is paid or given directly or indirectly for soliciting such
exchange.
(i)
The traditional 3(a)(9) transaction is an issuers offer to swap a new security for its old security
(e.g., common stock for preferred stock).
(ii)
This is a broad exemption for recapitalizations, such as exchanging shares with its current
shareholders.
(iii)
This is an intra-organizational recapitalization.
b)
For an exchange to qualify for the exemption, it must be exclusively offered with the security holders of the
issuer.
(i)
This raises concerns with integration of several transactions.
c)
The exemption is lost if the security holders must, as a condition of the exchange, pay any consideration in
addition to their old securities.
(i)
Loss of voting rights, accrued dividends, or interest or collateral does not destroy the exemption.
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d)
e)
D.
V.
The exemption is only for the issuers exchange; an exchanging security holder must find his own exemption
for any subsequent sale of a security received in the exempted exchange.
QUESTION: Cant every M&A transaction fit into this exemption?
(i)
NO! This is only for intra-organization exchanges.
Exempt Reorganizations Under 3(a)(10)

1.
Nonbankruptcy Reorganizations
a)
3(a)(10) exempts the issuers exchange of securities for outstanding securities, claims, or property, provided
the transactions fairness has been approved, after a hearing, by a court, agency, commission, or other
government authority.
b)
Unlike 3(a)(9), the exemption is available for a reorganization involving two or more companies.
c)
Restriction on resale applies only to affiliates. Non-affiliates who obtain shares through the 3(a)(10)
exemption hold unrestricted securities.
2.
Bankruptcy Act Collision w/ Securities Laws
a)
1125 of the Bankruptcy Act requires that there be adequate disclosure accompanying the solicitation of the
debtors claimants approval of the reorganization plan.
b)
1145 of the Bankruptcy Act exempts from 5 of the Securities Act any securities issued in an Ch. 11
reorganization plan if they are issued principally in exchange for the debtors existing debts and securities.
Exempt Securities
A.
Introduction
1.
Generally
a)
Applicability of the Exemption
(i)
Exempt securities are permanently exempt from registration under 5; not only are issuers of exempt
securities free from the burden of registration, but also owners of the securities need no exemption
in order to resell their securities.
(ii)
3s exemptions do not exempt the securities from the 33 and 34 Acts in entirety the
antifraud and some other provisions remain. The exemption is from registration.
b)
Note: A number of 3s exemptions pertain to the transaction, rather than the security, and in these cases the
exemption does not extend to resales.
2.
Policy justifications for exempting securities:
a)
Character of the issuer (government);
b)
Existence of a regulatory regime that adequately protects investors;
c)
The instrument may not represent an investment (e.g., securities of non-for-profit issuers); or
d)
Political or constitutional considerations that makes registration problematic (e.g., municipal securities).
(i)
State sovereign immunity is one reason.
3.
Overview of 3
a)
3(a)(2) Government Securities, Bank Securities, and Collective, Common, or Single Trust Funds
(i)
Municipal bonds, however, are still subject to the restrictions in Rule 15c2-12.
b)
3(a)(3) Short-term Notes (Commercial Paper)
(i)
There is an exemption for any note, draft, etc. if the maturity at the time of issuance does not exceed
9 months.
(a)
Were it not for the exemption, these would clearly be securities.
c)
3(a)(4) Nonprofit Issuers
d)
3(a)(5) Securities Issued by Savings and Loans, Cooperative Banks, and Similar Organizations
e)
3(a)(8) Insurance Policies and Annuities
(i)
The debate is whether the insurance contracts are even securities at all.
(a)
Supererogation = doing more than duty requires. Exempting them appears to be more
than necessary, since they are probably already not securities.
B.
Focus on Municipal Securities

1.
Introduction
a)
These are any securities of the government below the level of the federal government.
b)
Types of Municipal Securities:
(i)
General Obligation Bonds
(a)
Backed by the taxing authority of the government.
(ii)
Revenue Bonds
(a)
Repaid, if at all, only from a limited source. Not backed by the taxing authority of the
government.
2.
Disclosure
a)
The SEC does not require municipal securities to be registered or have a prospectus.
(i)
The rational is that federal regulation may cause Constitutional law problems. As a result,
regulation of the area is focused on what brokers and dealers can do with respect to municipal
securities offerings.
(a)
This is done via Rule 15c2-12.
b)
Disclosure by Underwriters
(i)
For the sale of municipal securities, disclosures must be made by an underwriter by means of a
document called the Official Statement, which is a very rough counterpart to the corporate
prospectus.
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(a)
3.
4.
The Official Statement is prepared by the municipality, but distributed by underwriters

and broker-dealers.
(b)
Standards for disclosure are outlined in the Government Finance Officers Associations
Disclosure Guidelines for State and Local Government Securities.
(ii)
If a municipal security is insured, mandatory disclosure is not required.
c)
Obligation of Broker-Dealers -- Rule 15c2-12
(i)
Requires underwriters participating in a primary offering to obtain and review an official statement
that an issuer of such securities deems final.
(ii)
Requires underwriters to provide any potential customers who so request with a copy of the issuers
most recent preliminary official statement.
d)
Negotiated v. Competitively Bid Deals
(i)
Some issuances are negotiated between the municipality and the underwriter. In other cases, the
underwriters may engage in competitive bidding for the underwriting.
(ii)
If the deal is competitively bid, there is no enough time to prepare a preliminary official statement,
so there is an exemption for having to prepare it. If it is a negotiated deal, the preliminary official
statement is required. Rule 15c2-12(b)(2).
Industrial Development Bonds
a)
IDBs finance projects owned and operated by a private-sector party.
(i)
Example: municipal bonds to build a sports stadium. They build the stadium at public expense for
the benefit of the private sector.
b)
Rule 131
(i)
If the ultimate payback revenue will come from the private activity itself, then there is a separate
security. Rule 131 governs this.
Problems
a)
b)
Problem 8-1
(i)
Rule 15c2-12(b)(2) governs.
Problem 8-2
(i)
Rule 15c2-12(a) has a $1 million dollar limit. Then, there may be an integration problem in this case.
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Section 5 Liability Under the 33 Act
I.
Liability Under the 33 Securities Act

A.
11 Liability Misrepresentations in the Registration Statement

1.
Introduction
a)
Relevance
(i)
Section 11 liability comes into play only in the context of an actual registered deal in a public
offering. Thus, it is a narrow yet important provision.
b)
General Rule
(i)
A material misrepresentation or omission in a registration statement will subject the issuer
and (subject to a due diligence defense) a variety of persons associated with either the issuer or
the distribution to damages in a suit brought by any person who bought securities issued
pursuant to that registration statement.
c)
Limit of 11 Liability - 11(g)
(i)
Liability of the issuer is up to the amount of money raised pursuant to the registration statement in
the offering, but no more.
d)
Cf. 12(a)(1)
(i)
If you should register but do not, then liability is under 12(a)(1). If you DO register but do so
poorly, liability is under 11.
e)
Statute of Limitations
(i)
No action can be brought after one year after the discovery of the falsity or omission, or in no event
after three years after the security was offered to the public. (Via 13).
2.
11 Case Elements
a)
Material Misstatement or Omission
(i)
There must be a material misstatement or omission in the registration statement.
b)
Standing
(i)
Generally
(a)
Any person who bought shares under a defective registration statement has standing.
(ii)
Tracing
(a)
The person has to be able to trace the shares they purchased to the registration statement.
i
As long as the shares were originally sold under the defective registration
statement, it does not matter whether the shares were acquired by the P in an
issuer or trading transaction.
(a)
Thus, the share sold under the registration statement could be bought
and sold numerous times, and the person will still have standing. P
didnt have to get it directly in the underwriting market he could
have got it through a series of trading transactions. The only limit is
that P must trace the shares he bought back to the registration
statement some time in the past.
(b)
This can be problematic, since shares are fungible and there may be some shares trading
in the market in addition to those issued under the registration statement. Most people
dont even take actual possession of their stock certificates. And, when P acquires stock
in the secondary trading market, it gets very difficult (unless there was only one class of
shares and one offering).
(iii)
Reliance Not Necessary
(a)
P does not have to show reliance on the misrepresentation.
(iv)
Lack of Knowledge Required
(a)
P will have to show that he did not have knowledge of the defective portion or
misrepresentation in the registration statement.
(v)
Alternatives
(a)
If P cannot get standing, it will have to seek a remedy under other sections of the Act,
including 10b-5, 12, and 17. But, each of these has hurdles.
c)
Damages (11(e))
(i)
Generally
(a)
Ps are entitled to recover the difference between the original purchase price (not
exceeding the price at which the security was offered to the public) and the value of the
stock at the time of suit.
i
Value is the term used, since it allows P to argue that the market price at the
time the suit was filed was improperly inflated.
(ii)
Diminished Gain Insufficient
(a)
Must show monetary loss, which does NOT include a diminished gain argument.
(iii)
Maximum Damage Cap
(a)
Damages will be computed always with reference to the public offering price at the time
of the IPO. Maximum damages will be based on this amount.
i
Example:
(a)
IPO at $10, then runs up to $30, then falls to $5. Maximum damages
are $5 under 11.
(iv)
Causation Defense
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(a)
(b)
(c)
(v)
3.
4.
If D can prove the drop in price was caused by something other than the material
misstatement, then damages will be reduced or nonexistent.
i
Query whether the only decline that is compensable would be the amount of
decline after an announcement of the misstatement. Akerman and Beecher cases
say yes.
Negative Causation This is the 11(e) Provided That section. To the extent the D
can prove the loss was attributable to something unrelated to the misrepresentation in the
prospectus, the damages may be lowered or could be eliminated entirely.
i
D has the burden of proof to show that the losses were cause by other reasons.
Timing Issue
i
Suppose X is the effective date and Y is the disclosure of the misrepresentation
date. The theory of Akerman and Beecher is that only the decline AFTER the
disclosure of the misrepresentation is relevant for purposes of determining the
damages.
(a)
The theory is that any other declines must be attributable to some
other information.
Problem 9-2
(a)
There would not be any damages under the Akerman and Beecher cases. But, it is possible that the
court will take into account the fact the company carefully timed its misstatement announcement
with the announcement of its new major government contract. Clearly the drop from $10 to $7
cannot be recovered, since that was all pre-announcement.
Strict Liability for the Issuer

a)
There is no defense for an issuer with respect to culpability. The issuer is strictly liable for all material
misstatements or omissions in its registration statement.
11(b)(3) Due Diligence Defense for Persons Other Than the Issuer
a)
Generally
(i)
11(b)(3) provides a due diligence defense to persons, except the issuer.
b)
Three Key Subsections and Expertised v. Non-Expertised Portions
(i)
Generally
(a)
Expertised portions:
i
The expert is liable for misstatements or omissions unless he had, after
reasonable investigation, reasonable ground to believe and did believe, at the time
the registration statement became effective, that the statements therein were
complete and accurate.
(b)
Non-expertised portions:
i
Persons who are not experts have a duty to investigate and can raise the due
diligence defense only if after reasonable investigation they had reasonable
ground to believe and did believe that the statements in the registration statement
were true and correct.
(ii)
11(b)(3)(A) Standard of Non-Expert for Non-Expertised Portions

(a)
A non-expert must do a reasonable investigation and have reasonable grounds to
believe that there were no untrue statements in the non-expertised portions.
(iii)
11(b)(3)(B) Standard of Expert for Portion Prepared by that Expert

(a)
An expert must do a reasonable investigation and have reasonable grounds to
believe that there were no untrue statements in the portion that he expertised.
(iv)
11(b)(3)(C) Standard of Non-Expert for Expertised Portions

(a)
If a portion was prepared by an expert, non-experts may rely upon the statements of
the experts, as long as there were no reasonable grounds to believe and the person
did not believe the statements were untrue. 11(b)(3)(C).
c)
Sliding Scale Idea of 11(b)(3)

(i)
There is a sliding scale developed in the BarChris case.
(a)
This came out of the case, not on the basis of the statute itself.
(ii)
The statute does not differentiate as to how it classifies similar groups of persons. For example,
each director that signs the registration statement is liable. But, case law holds that there is a sliding
scale of liability for those directors more is expected of an inside director to show his due
diligence defense than is required of an outside director. Outsiders will get more slack as to what is
reasonable reliance.
d)
Example Liability
(i)
Liability of CEO and CFO
(a)
Potential liability of the CEO and CFO approach the absolute liability of the issuer. It is
very difficult to get the (b)(3) defense for the top officers, though it may be possible.
They were held liable in BarChris even for the material in the expertised portions. They
were not entitled to rely on anyone else.
(ii)
Liability of the Underwriters
(a)
The underwriter must conduct a lot of due diligence. Reasonable investigation requires
more than just reporting what the issuer gave them.
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e)
B.
What is Reasonable Investigation

(i)
11(c)
(a)
Under 11(c), the standard of reasonable investigation is the standard of reasonableness
required of a prudent man in the management of his own property.
(ii)
Rule 176
(a)
Factors determining whether there was reasonable investigation:
i
Type of issuer;
ii
Type of security;
iii
Type of person;
iv
Office held when the person is an officer;
v
Presence or absence of another relationship to the issuer;
vi
Reasonable reliance on officers, employees;
vii
Type of underwriting arrangement (if an underwriter); and
viii
Who had responsibility for the document or fact.
(iii)
Grants (from BarChris) Checklist
(a)
Do not accept the assurances of the executive officers;
(b)
Test oral information by examining the original written record;
(c)
Require a check of matters that are easily verifiable;
(d)
Conduct mini-audits, if necessary;
(e)
Make inquiry into questionable items.
5.
Indemnification and Contribution Under 11

a)
Indemnification v. Contribution
(i)
Indemnification = getting 100% off-the-hook.
(ii)
Contribution = natural outcome of joint and several liability; the person hit with the full damages
will be entitled to an apportionment from the other tortfeasors or breachers.
b)
Item 512(i) of Regulation S-K says that indemnification agreements must be approved by the court unless
counsel opines that the propriety of that agreement is settled by controlling precedent.
(i)
Thus, the Securities law is anti-indemnification and pro-contribution.
c)
21D(f) of the 34 Act
(i)
Imposes proportionate liability in class actions. Instruction goes to jury to apportion the liability
between and among the defendants.
(ii)
21D applies to both the 33 and 34 Act.
d)
11(f) of the 33 Act imposes joint and several liability.
(i)
21D(f) supersedes 11(f) when it is a class action.
6.
Policy Problem of 11
a)
Due diligence is expensive. It also results in companies underpricing their IPO, and the underwriters will want
a larger share of the amount to compensate for their risk. Net to the company is thus lower. Perhaps investors
would be willing to allow reduced due diligence to make sure more money gets to the company in the issuance.
Section 12(a)(1) Liability Unregistered Offerings

1.
Generally
a)
Applies ONLY to unregistered offerings.
(i)
12(a)(1) liability is triggered by any offer or sale in violation of 5 (fails to register the offering
when it should be registered).
2.
Remedy = Recission
a)
An illegal offer creates a right of rescission.
(i)
If P sold the shares, the difference between the price paid and the amount received in the subsequent
sale.
b)
There is no state of mind element; it is strict liability. There is also no requirement that P show an injury.
3.
No Defense
a)
It is strict liability. The only defense is to be able to show some exemption from registration.
4.
Who is a Seller in 12(a)(1)? Pinter v. Dahl
a)
12(a)(1) says any person who offers or sells a security in violation of the 33 Act registration requirements is
liable to the person purchasing such securities from him.
(i)
If A sells to B, and B sells to C, then B can recover from A, and C can recover from B, each for the
amount of the loss.
b)
12(a)(1) liability is imposed only on a person who successfully solicits a purchase, AND is motivated at
least in part by a desire to serve his own financial interests or those of the securities owner. This is true
even if the person is not the person passing title to the shares (i.e, an agent of the owner can be a seller).
(i)
A person can also be a seller even if that person does not pass title. 2(a)(3) has a broad
definition, which even includes a person who solicits an offer to buy, which indicates that the person
need not pass title to be a seller under 12(a)(1).
(ii)
Being merely a substantial factor in causing the sale of unregistered securities is not sufficient in
itself to render a D liable under 12(a)(1).
5.
Problems
a)
Problem 9-3
(i)
12(a) is a seller liability provision. Issue is who is a seller for 12(a) purposes. This is the Pinter case.
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Ruffa & Hanover firm is probably not liable under 12(a)(1), though the contingent fee arrangement does seem
to make it possibly within the Pinter range.
(iii)
Duff & Phelps are not liable under 12(a)(1).
Problem 9-6
(i)
Bob can recover $3 from Alice, and Alice can recover $5 from Ecto. Recall that privity is required under
12(a)(1).
(ii)
b)
C.
Section 12(a)(2) Liability Sale or Offer of Security With Misrepresentations or Omissions

1.
Introduction
a)
Applies ONLY to registered offerings (Gustafson).
b)
12(a)(2) extends the rescissionary remedy of 12(a)(1) to situations where a person offers or sells a security
by the means of a false or misleading prospectus or oral communication.
c)
Suit can be against any seller.
2.
Scope of the Rule:
a)
Applies ONLY to registered offerings (Gustafson).
b)
Some courts hold it applies only to issuer transactions, not trading transactions.
(i)
Some courts hold that the right of rescission in 12(a)(2), based on the definition of prospectus
applies only to issuer transactions (IPOs). It does not apply to resale transactions, and it also does
not apply to issuer transactions that are not public offerings (i.e., such as private placements).
(a)
Thus, aftermarket purchasers cannot bring suit, even if the purchaser can trace the share
to the IPO.
3.
Liability
a)
Defense
(i)
A defense based on lack of culpability is available if the D did not know and could not have known
through reasonable care, about the falsity or omission.
(a)
This includes an obligation to undertake a reasonable investigation.
b)
Defendants are not liable for any portion of the rescissionary measure of damages that represents a decline in
the value of the security unrelated to the subject of the misrepresentation or omission.
4.
Problems
a)
Problem 9-7
(i)
Alice can get her $5 from Ecto, but Bob is likely out of luck either because he is not asserting a claim from the
b)
D.
original issuance or because Alice may have a did not reasonably know defense.
Problem 9-8
(i)
Have to wonder if she is a seller, and if so, whether she can use the reasonably did not know defense. It
could be a close call.
Section 17(a) Liability Defrauding

1.
Introduction
a)
17(a) is very similar to 10(b) of the 34 Act. But, 17(a) does not create a private cause of action.
2.
Relevant Sections
a)
17(a)(1)
(i)
Makes it illegal to employ any device, scheme, or artifice to defraud.
(a)
This requires knowing and intentional misconduct.
b)
17(a)(2)
(i)
Prohibits any person from obtaining money or property by means of any untrue statement of a
material fact or any omission to state a material fact.
(a)
No scienter element.
c)
17(a)(3)
(i)
Prohibits any person to engage in any transaction, practice, or course of business which operates or
would operate as a fraud or deceit.
(a)
No scienter element.
3.
Extents
a)
Court has held that 17(a) is not limited to fraud in the process of a distribution of securities.
(i)
It has even been extended to apply to an individual investor who defrauds his broker in a trading
transaction.
b)
17(a) does NOT give a private right of action.
(i)
10(b) of the 34 Act does provide a private right of action, however, for similar violations.
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Section 6 The 34 Act
I.
Financial Reporting: Mechanisms, Duties, and Culture

A.
Introduction
1.
The goal of disclosure under the 34 Act is to ensure the company fairly presents its financial position and operations.
B.
Disclosure Requirements of Public Companies
1.
Origins and Metrics for Financial Information
a)
Although the SEC has authority to pronounce accounting rules, with rare exception it defers to GAAP, which
are promulgated by FASB (and supplemented by the AICPA).
b)
GAAP governs the internal accounting, and the SEC further requires that the financial statements filed be
certified by an independent auditor, in accordance with GAAS (promulgated by the PCAOB).
c)
In addition to financial information, the company must also disclose other information contained in Regulation
S-K.
2.
SOX and Accounting
a)
One thing SOX tried to do is improve the processes by which the financial information is originally generated
within the company. This goes beyond the area of outside auditors.
b)
Federalization
(i)
SOX has resulted in the SEC having a stake in the way corporations govern their affairs, including
requiring outside directors to act as internal auditors. The SEC has encroached upon state law
corporate governance.
(a)
This is a federalization of corporate governance (taking it away from the states).
(b)
Other examples of federalization from SOX:
i
Federal government funding of FASB via fees paid to the SEC from registrants
(used to be funded privately by the private sector).
ii
PCAOB has power over GAAS, and PCAOB is funded by fees paid to the SEC
from registrants (used to be governed privately by CPA firms).
3.
Exchange Acts Periodic Reporting Obligations
a)
The 34 Act requires that certain securities be registered with the SEC. Once a company has registered its
securities, it is subject to continued reporting under the Act and to regulation of many of its other activities.
b)
13 of the 34 Act contains a list of events for which the company must file with the SEC (such as a 10-K, 10Q, 8-K, etc.)
c)
13s reporting obligation is triggered if the issuer meets one of the following tests:
(i)
Exchange-Traded Company Test
(ii)
Over-the-Counter Stocks Test
(iii)
15(d) for Registered Companies
d)
Foreign Issuers
(i)
Relief from the 34 Act registration requirement is available only to issuers that have not chosen to
use the facilities of the American securities marketplace.
e)
Problem 10-1:
(i)
Rule 12g5-1(b)(3) suggests the persons cannot make the trust to avoid application of the securities laws. Cant
(ii)
4.
C.
manipulate the situation to avoid the 34 Act requirements.

(a)
This is a substance over form situation.
But the facts here are the reverse they want 100 trusts to make sure the 34 Act registration remains. We dont
know the solution to this. Bacardi case, however, said the determining factor for the number of shareholders was
the number of shareholders on the records in the companys books. Court would not look at substance over form
Court would not look at the reason for the creation of the trusts, and instead looked at form over substance.
Liability Under the 34 Act

a)
There is a private right of action in 18 of the 34 Act.
(i)
Liability is incurred by anyone who makes or causes to be made a false or misleading statement in a
filing under the Act. Recovery is permitted by anyone who, in reliance on such statement, has
purchased or sold a security which was impacted by the statement, unless the person sued can prove
he acted in good faith and had no knowledge that the statement was false or misleading.
b)
18 is largely dead because it has various procedural disadvantages. 10(b)(5) and Rule 10b generally provide
a better cause of action.
Reliable Records and the Foreign Corrupt Practices Act

1.
Introduction to the FCPA (13(b)(2) securities law section)
a)
Overview:
(i)
Requires companies to have internal systems to provide integrity to the ultimate financial statements
that come out of the system.
(ii)
13(b)(2) does two things:
(a)
Requires recordkeeping; and
(b)
Requires a system of internal accounting control.
b)
13(b)(2) of the 34 Act was added by the FCPA (the FCPA is large, and only part of it is in the securities
laws), and requires registered or reporting companies to:
(i)
Make and keep books and records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of assets of the issuer; and
(ii)
Have in place a system of internal accounting controls sufficient to provide reasonable
assurances that transactions are executed and reported properly.
c)
Notes:
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(i)
2.
D.
The motivations of those who erred is not relevant. There is no scienter requirement in
13(b)(2)(A).
(ii)
The accounting control systems need not be fail-safe. The business size, diversity of operations, etc.
can all influence the level of control needed. It is a reasonableness standard.
(a)
But no organization, no matter how small, should avoid the FCPA provisions in
13(b)(2).
d)
What is Sufficient to Prosecute?
(i)
The SEC has formally taken the position that enforcement action is warranted only with respect to:
(a)
Unreasonable deviations from an ideal of accurate books and records or internal controls;
(b)
Situations where top management is involved, whether through misfeasance, lack of
adequate supervision, or failure to take corrective action; and
(c)
Failures that are something more than occasional, inadvertent errors.
(ii)
Essentially there is prosecutorial discretion here. Thus, it is questionable whether any company is
practically within technical compliance with the section. It is hugely vague.
Other Provisions of the FCPA
a)
Rules 13b2-1 and 2 Impose upon persons an obligation to avoid falsification of books and records and
require officers and directors to provide accurate information to accountants for preparation of financial
statements.
b)
30A prohibits corrupt payments to foreign officials in order to gain business.
c)
CEO and CFO must certify financial statements under Item 601(31) of Regulation S-K.
d)
Rules 13a-15 and 15d-15 require registrants to establish an overall system of disclosure controls and
procedures.
The SEC and Governance

1.
Audit Committees
a)
Audit committees are made up of the companys directors and have as their central function oversight of the
companys audit and financial reporting practices.
b)
10A requires that each listed company have an audit committee comprised exclusively of independent
directors.
c)
Audit committee is directly responsible for the oversight of the independent auditors work.
d)
The independent auditors must report to the audit committee regarding the quality of the financial statements.
2.
Auditor Independence
a)
Generally
(i)
The need for auditor independence was prompted by the rising importance of non-auditor services
in the overall financial operations of the auditing firms, such as investment banking services.
b)
Independence of Outside Auditors
(i)
10A(g) makes it unlawful for an auditing firm to contemporaneously provide certain non-audit
services.
(a)
A notable exception is tax services.
(ii)
10A(j) -- The lead audit partner for a client must be rotated every 5 years, though the auditing firm
need not be rotated.
c)
Independence of Internal Auditing Committee
(i)
10A(m)(3) Each member of the audit committee must be a member of the board of directors and
shall otherwise be independent.
(a)
Thus, only outside directors can be members of the audit committee.
3.
CEO/CFO/Director Certification
a)
The Fairly Presents Requirement
(i)
The CEO and CFO are required on each quarterly and annual report filed w/ the SEC to certify,
among other things, that they believe the financial statements fairly present the firms financial
position.
(ii)
What Does Fairly Present Mean -- US v. Simon
(a)
The critical test is whether the financial statements as a whole fairly presented the
financial position of the company, not whether it accurately reported the operations.
(iii)
Level of Review Required
(a)
Does compliance with GAAP itself satisfy the fairly present requirement? NO. It is
persuasive, but not conclusive.
(b)
The critical test is whether the financial statements as a whole fairly presented the
financial position of the company, not whether it accurately reported the operations.
(c)
Proof of compliance with GAAP is evidence which may be persuasive but not necessarily
conclusive that they acted in good faith, and that the facts as certified were not materially
misleading or false.
(d)
The CFO and CEO must undertake some independent review. Total reliance on the
auditors is not good enough there must be some independent assessment.
i
Ultimate legal standard is still being determined. We dont have enough cases or
opinions yet to determine the total obligation of the CFO and CEO.
b)
Rules 13a-14 and 15d-14 require the CEO and CFO to certify each quarterly and annual report with the SEC:
(i)
That the officer has reviewed the report;
(ii)
That to the certifying officers knowledge it does not contain an untrue statement of material fact;
(iii)
That the report fairly presents the financial condition;
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That the officer is responsible for maintaining the firms internal controls and evaluated them in the
last 90 days; and
(v)
That the officer has brought to the audit committees attention any significant deficiencies in the
internal controls.
c)
Signature Requirement
(i)
Whether it be the registration statement, annual report, etc., CEO, CFO, and directors have to sign.
(a)
This can lead to liability.
Pro Forma Financial Statements
a)
Pro forma statements are financial statements for part of a quarter or year that are not audited.
b)
Pro forma statements need not conform to GAAP.
c)
This has led to a lot of abuses, since unsophisticated persons may believe they are real numbers.
d)
Regulation G Requires a reconciliation; have to reconcile the pro formas with GAAP, saying that if we had
applied GAAP principles to the pro forma statements, they would look like this
(iv)
4.
E.
II.
MD&A of SEC Filings

1.
Generally
a)
The MD&A portion of the SEC filing is set forth in Item 303 of Regulation S-K and calls on management to
provide narrative explanations of the financial statements for the purpose of increasing the transparency of a
companys financial performance and of providing overall better disclosure to investors.
b)
Must discuss the trends and risks that have shaped the past and are reasonably likely to have an impact on the
future long-term or short-term liquidity.
c)
Companies are required to report off-balance-sheet financing arrangements.
(i)
The arrangement must be reported only if events are reasonably likely to occur that will have a
current or future effect on the registrants financial condition.
d)
The events that trigger the need for Form 8-K filings was also increased.
2.
The SEC and the Environment
a)
The SEC, in following the command of NEPA, requires that registrants disclose pending government
proceedings, whether judicial or administrative, that involve material amounts and relate to the environment.
Materiality
A.
Introduction
1.
Once you get past the line-item disclosures that must be made (Regulation S-K, etc.), materiality becomes the key to
disclosure. For example, Rule 408 requires that registrants include in their 33 Act registration statement such further
material information as may be necessary to make the required statement not misleading. A similar requirement
applies to all 34 Act filings through the operation of Rule 12b-20.
B.
Defining the Materiality Standard

1.
Materiality Defined (TSC Industries)
a)
An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote (or whether to invest or make some other decision).
(i)
Ask whether the omitted fact would have assumed actual significance in the deliberations of the
reasonable shareholder.
(ii)
Ask whether there is a substantial likelihood that the omitted fact would have been viewed by
the reasonable investor as having significantly altered the total mix of information made
available.
b)
TSC Industries standard seems to look at facts of decisional magnitude.
(i)
If something rises to a reasonable person of decisional magnitude, in that it would affect the vote or
investment decision, it is material.
(ii)
Has to be enough to shift a decision.
c)
Objective reasonableness is the usual standard, but subjective reasonableness has been used in cases involving
defendants who have a closer relationship to the company.
2.
Buried Facts Doctrine
a)
Renders misleading a document in which all the substantive information has been set forth, but in such a
manner that the mosaic can only be assembled with great difficulty and only with advanced knowledge that the
whole picture requires a great deal of assembly.
3.
Duty to Disclose Required
a)
A corporation is not required to disclose a fact merely because a reasonable investor would very much like to
know that fact. Rather, an omission is actionable only when the corporation is subject to a duty to disclose
the omitted fact.
(i)
Assessing probabilities and magnitudes of the undisclosed event are a means of assessing whether
information currently in the public domain needs to be corrected or updated.
b)
Duty arises from providing information (like having a registration statement with omissions in it) or when some
statement is made and something material needs to be said to make it now not misleading.
C.
Materiality of Merger Negotiations (A New Standard?)

1.
The Probability/Magnitude Test -- Basic Inc. v. Levinson
a)
Generally
(i)
Where preliminary merger negotiations are based on a contingent and speculative outcomes, in that
the transaction may never be consummated, they are not material under the TSC Industries
standard. But, under some circumstances the merger negotiations could be material.
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(ii)
b)
c)
2.
After reciting and expressly adopting the TSC Industries standard, the court moved away from it and
adopted a standard based on probability/magnitude factors. This standard came from Texas Gulf
Sulphur, not TSC Industries!
Probability/Magnitude Test:
(i)
Materiality depends on a balancing of both the indicated probability that the event will occur
and the anticipated magnitude of the event in light of the totality of the company activity.
(a)
Whether merger discussions in any particular case are material depends on the facts.
Probability that the event will occur can be assessed by looking at indicia of interest in
the transaction at the highest corporate levels. Must also look at the magnitude of the
transaction to the issuer.
Does NOT Apply to Soft Information
(i)
Basic, Inc. said its test of probability/magnitude does not apply to soft information when
determining whether information is material.
Problem 11-2
a)
Whether the item is material depends on the TSC Industries or Basic, Inc. standard of whether or not the information is
material.
b)
Recall that this is a two-step analysis:
(i)
Is there a DUTY to disclose?
(a)
No statements have yet been made here, so there is no duty to disclose based on correcting
something already said.
i
Could argue they need to correct the earlier 10-K filings that had the omission.
(b)
But, there may be a duty to disclose in the MD&A section (Item 303) or under Item 102.
(ii)
Is the information MATERIAL?
(a)
Probability/Magnitude Test or TSC Industries Test
i
Probability the other person will assert a claim to the strip of land is very low, since the
plant has been there for 20 years. But, the magnitude of the problem if the event occurs is
very large. It is a potential contingent liability.
ii
Of course, this is not a merger case, so maybe the probability/magnitude test doesnt apply,
and we only look to the total mix standard of TSC Industries.
D.
The Total Mix of Information and Market Efficiency

1.
Truth on the Market
a)
This doctrine holds that some statements need not be made when the information is fairly obvious, and
thus has likely has already been incorporated into the market and countered by the market price.
(i)
Ex: A nuclear reactor builder need not state that its cost estimates would probably be revised, given
that the market already knew that estimates in the nuclear power market are low, and the market had
already factored that into the price.
(a)
Despite the statements being erroneous, there was no liability because information that
was in the market likely eliminated the potential of the information to mislead and was
incorporated into the price.
i
So, Commonwealth Edison neednt disclose business hazards that are apparent to
all serious observers and most casual ones.
(ii)
Ex: A computer manufacturer did not need to disclose that its new product would have a shelf life
of only six months, since the market knows that computer products do not last long in the market,
and the market had already factored that into the price.
b)
Limited to Specific Situations
(i)
This ruling is limited to soft information that was disclosed earlier but has become dated with
time in an active public trading market.
(a)
Should not count on taking this holding any further than this setting, with a very large
public company with lots of public information in the market. It is NOT an all-purpose
defense.
2.
Puffery (Eisenstadt v. Cental Corp.)
a)
Rule:
(i)
Vague, generally worded statements of optimism can be deemed immaterial because they are
understood as mere puffery.
b)
Case Example:
(i)
Nonspecific representations that an auction process is going well could not, in the circumstances of
this case, influence a reasonable investor to pay more for the stock than he otherwise would.
E.
Materiality of Forward-Looking (aka Soft) Information

1.
Generally
a)
Soft Information = forward-looking information.
b)
Old rule was that the issuer should not provide forward-looking information. In 1978, SEC Release No. 5992
was a change in the SECs position.
c)
The SEC permits and sometimes requires forward-looking information, whether optimistic or pessimistic, to be
published.
d)
The standard is usually not the preparers efforts, but instead whether the forecast was accompanied by
meaningful cautionary language.
e)
Two Protections for Companies:
(i)
The Bespeaks Caution Doctrine
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Buckham, Brian R.
(ii)
2.
Duty to Disclose Forward-Looking Information

a)
Duty to Disclose Required
(i)
In order to require disclosure, the information must be not only material, but there must also be a
duty to disclose the information.
(ii)
The duty to disclose soft information generally arises from the overall obligation that
announcements not be materially misleading.
(a)
When a statement is made there is a duty to make such additional disclosure as necessary
to assure that the statements that are made are not misleading in light of the
circumstances under which they are made.
b)
Courts are reluctant to deem disclosure of soft information misleading.
3.
The Bespeaks Caution Doctrine for Forward-Looking Statements

a)
Generally
(i)
This is a defense to liability for forward-looking statements that turn out to not be true.
b)
Rule:
(i)
When an offering documents forecasts, opinions, or projections are accompanied by
meaningful cautionary language, the forward-looking statements will not form the basis for a
securities fraud claim if those statements did not affect the total mix of information the
document provided investors. Cautionary language, if sufficient, renders the alleged omissions
or misrepresentations immaterial as a matter of law.
c)
Meaningful = Tailored to the Transaction
(i)
To suffice, the cautionary statements must be substantive and tailored to the specific future
projections, estimates, or opinions in the prospectus which the Ps challenge.
4.
Statutory Safe-Harbor for Forward-Looking Statements

a)
27A of the 33 Act and 21E of the 34 Act provides a statutory safe-harbor for certain forward-looking
statements made by companies that are subject to the 34 Acts continuous reporting requirements.
b)
The safe-harbor shields persons from liability in private actions if:
(i)
The statement is accompanied by meaningful cautionary statements identifying the important
factors that could cause actual results to differ materially from those in the forward-looking
statement; or
(a)
Meaningful means the cautionary statement was specifically tailored to the deal, as
opposed to boilerplate.
(ii)
The plaintiff fails to prove that the forward-looking statement was made with actual
knowledge it was misleading.
c)
Safe harbor is not available to forward-looking statements made in connection with IPOs, tender offers, or
going-private transactions.
d)
What is forward looking?
(i)
Announcements of projections, plans, and statements of future economic performance are forwardlooking.
(ii)
A statement about a company, the truth of which is discernable only after it is made is considered a
forward-looking statement.
(iii)
If a list has both facts and forward-looking information, the whole list will be considered forwardlooking.
e)
Misleading
(i)
Disclosure of assumptions underlying a forward-looking statement can itself prevent the statement
from being misleading. Mere disclosure of assumptions, however, do not generally rise to the level
of themselves being meaningful cautionary language.
5.
Problems
a)
b)
F.
27A and 21E Safe-Harbors
Problem 11-5
(i)
This is soft information management forecasts and appraisals.
(ii)
Does the probability/magnitude approach apply here?
(a)
Maybe it applies, since it is a merger deal. But, Basic, Inc. said its test of probability/magnitude test
does not apply to soft information.
(iii)
What standard applies to this soft information?
(a)
The independent duty to disclose soft information comes from the idea that no half-truths should be
made.
(iv)
This is a hard problem to decide. There may be a duty to disclose here if there were prior statements said
previously.
Problem 11-6
(i)
Does the approach of materiality change from context to context?
(a)
The issue is if it was material in the disclosure context, does it necessarily follow that it is material or
not in the insider trading context? Or, do the materiality standards change from context to context?
i
Some commentators say the standard of materiality should change from context to context.
Materiality in mergers should be different from materiality in insider trading.
The SEC and Corporate Governance

1.
Management Integrity
a)
Disclosure of Management Integrity
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Buckham, Brian R.
(i)
2.
Generally
(a)
Subpart 400 of Regulation S-K requires disclosure of information that bears on the
incentives, integrity, and commitment of the registrants management.
(b)
Disclosures relevant to an evaluation of management are particularly pertinent where
securities are sold largely on the personal reputation of a companys controlling person.
(ii)
Specific Provisions
(a)
Certain conflict-of-interest transactions must be disclosed under Item 404.
(b)
Disclosure about management integrity could sometimes be required by Rule 408, which
requires disclosure of any information (even if not listed in the statute or rules) as may be
necessary to make the expressly required statements in a registration statement not
misleading.
(c)
Item 406 (came from SOX) requires the corporation to describe its code of ethics for
executives, accountants, etc., or explain why it does not have one.
(d)
Item 401(f) of Regulation S-K requires certain civil and admin. actions against certain
personnel to be disclosed if the claims have been adjudicated.
b)
Disclosure of Executives Personal Information
(i)
Should the company have to disclose the terminal illness of one of its executives?
(a)
This is debatable.
Materiality of Illegal Transactions
a)
Generally
(i)
Suppose an executive violates the law with respect to the company. An example is paying bribes
that result in a positive effect on the bottom line, but violates the FCPA. Another example is that the
CEO is a notorious pot-smoker. Must this be disclosed?
b)
Are illegal actions always material, or only those that have a financial impact, or none at all?
(i)
Ninth Circuit said that a company did NOT need to disclose an illegal transaction (paying bribes)
because the SEC is not in the business of enforcing that type of claim shareholders have sufficient
state law claims against those executives and directors that made the decision.
(ii)
So, illegalities are not necessarily something that must be disclosed, unless it is a specific line-item
in the disclosure rules.
c)
Problem 11-11
(i)
Clearly have to disclose every adjudicated violation. Here, the claim is only currently in litigation. Only when
he has been adjudicated to have violated the law does it become material. But, Rule 408 could come into play
and require more.
III.
Fraud in Connection with the Purchase or Sale of a Security

A.
Rule 10b-5
1.
Introduction
a)
Generally
(i)
This is the most important liability provision in the securities laws.
(ii)
Applicable to the purchase or sale (buyer or seller) of ANY security. So, it applies in any context
where securities change hands.
(iii)
It is an implied cause of action. It isnt like 11 of the 33 Act which provides the elements of the
cause of action; as an implied cause of action, the elements of 10b-5 are absent. Thus, the elements
have developed via case law.
(iv)
This cause of action is used in a lot of different contexts.
b)
Attitude Toward 10b-5
(i)
Draconian liability from massive suits has curbed the favorability toward Rule 10b-5. The balance
used to be heavily in favor of the plaintiffs bar, such that there were abusive strike suits being filed
only hours after a price decline based on nothing more than a decline in stock price.
(a)
The abuse was the expensive discovery process that was initiated and the pressure on the
company to settle.
(ii)
Private Securities Litigation Reform Act of 1995 was in response to all of the strike suits brought,
intending to get a settlement despite speculative merits (but involved massive discovery).
(a)
21D(b)(3)(B) allows a stay of discovery when a defendant alleged to violate Rule
10b-5 files a motion to dismiss.
i
This is great for the defendant.
2.
Duty of Disclosure [MOSTLY SKIPPED IN CLASS]
a)
Possession
(i)
All courts agree that the mere possession of nonpublic information does not by itself give rise to a
duty to disclose. This is true even if the market is filled w/ rumors, so long as they are not
attributable to the issuer.
b)
Half-Truths
(i)
When voluntary statements are made, there is a duty to disclose completely. No half-truths can be
given.
c)
Duty to Update
(i)
Some courts indicate that when an issuer makes a statement that is true when released, it assumes a
duty to revise or update that statement to reflect subsequent events so long as the original statement
remains alivethat is, is still being relied upon in the marketplace.
d)
Duty to Correct
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Buckham, Brian R.
If a company makes a statement that is false at the time, but it didnt know the statement was false
and didnt intent to mislead, the company has an obligation to disclose the truth when it learns the
truth.
Aiders and Abetters
a)
There is no aider and abetter liability in 10b-5 cases. (Central Bank of Denver)
Elements of the 10b-5 Cause of Action:
a)
[Wrongful Activity] In Connection With the Purchase or Sale of Any Security
(i)
Texas Gulf Sulphur: Rule 10b-5 is violated whenever assertions are made in a manner
reasonably calculated to influence the investing public if such assertions are false and misleading
or are so incomplete as to mislead.
(a)
Thus, an actual purchase and sale of securities by the company or insiders is not required.
(ii)
Investment aspect, rather than an incidental result of the transaction, must be the basis of the
wrongful act.
(a)
Ex: Fraud on a bank to get a loan was not in connection with even though stock was
pledged as collateral in the loan. The use of the stock was too tangential; the stock was
not used for the investment aspect of the wrongful act.
(b)
Ex: If the press releases were about geology, not to affect the buying and selling of
securities, then it is not a 10b-5 violation.
(iii)
It is not necessary to show that the purpose of the misleading statement was to influence investors
only that a material misstatement was disseminated in a medium on which investors rely.
(iv)
Problem 12-1
(a)
Is the falsity or misleadingness in connection with the purchase or sale of a security?
(b)
The test is whether it was reasonably calculated to influence the investing public. The journal
(i)
3.
4.
(c)
b)
c)
d)
Standing
(i)
Standing to sue in private actions under Rule 10b-5 is limited to actual purchasers or sellers of
securities.
(a)
If the person does not buy the securities, or does not sell them, based on the information,
these bystanders do not have standing to sue.
i
Thus, if someone says I would have bought or I would have sold, had I
known, there is NO standing for that person.
(ii)
The SEC always has standing for public actions against the violator.
Deception
(i)
The behavior that is cognizable under 10b-5 does NOT include every type of corporate
mismanagement. Basic breaches of fiduciary duty, w/o deception, are not 10b-5 issues.
(ii)
The ultimate wrong has to involve some sort of informational deception.
Scienter
(i)
Defined
(a)
Scienter essentially refers to a mental state embracing intent to deceive, manipulate, or
defraud.
(ii)
Standard
(a)
Negligence in misleading is NOT good enough for a 10b-5 claim. Scienter requires more
than negligence.
(b)
Scienter requires awareness of the behavior beyond negligence, not necessarily
the motive to mislead.
i
Dont have to show actual motive to cheat the plaintiffs.
ii
The majority view is that it is enough the D was aware of the true state of affairs
and appreciated the propensity of the untrue statement or omission to mislead; D
need not be doing it for a self-serving purpose.
(c)
Many courts hold that recklessness is enough to satisfy the scienter element.
(iii)
Problem 12-3 (p. 651)
(a)
Ferguson (CEO)
i
Ferguson signed off on the release without saying anything about the acquisition and the
(b)
(iv)
where the ad was published appeared to be directed at doctors, not at investors.

2nd Circuit, however, held that these publications could be in connection with.
SEC investigation. She took for granted the outside auditors statement that the company
would be vindicated. Was she in violation of 10b-5?
ii
Should Ferguson be held to be aware that there was a propensity to mislead? We dont ask
whether she intended to mislead; the standard is not that high. Should she have had enough
doubt in her mind that she was being reckless?
iii
This is a close case. But, the fact the SEC was investigating suggests she was reckless in
signing off on the financials without investigating.
ATI (the Company)
i
Does the idea of corporate scienter make sense?
ii
At least one of the parties w/ primary responsibility for the information had to have been
acting w/ scienter.
Pleading Scienter
(a)
To bring a suit under 10b-5, P must include in their complaint enough substance to give
rise to a strong inference of a violation of 10b-5. 21D(b)(2).
i
The strong inference standard is satisfied by a showing of either actual factual
data or a strong motive and opportunity to commit fraud.
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Buckham, Brian R.
ii
e)
(a)
Intent to cause harm is not required.
9th Circuit is more strict, requiring at a minimum particular facts giving rise to a
strong inference of deliberate or conscious recklessness.
(a)
Because recklessness is the standard, intent to cause harm is not
required.
Causation (and Reliance)

(i)
Introduction
(a)
Difference Between Reliance and Causation
i
The real element that must be established is CAUSATION.
(a)
Reliance is just one way to establish causation, but not the only way.
We just need a nexus between the alleged wrongdoing and the
damages. Showing that P relied on the misrepresentation is the
easiest and strongest way to do that.
(ii)
Transaction Causation v. Loss Causation [ON EXAM]
(a)
Introduction
i
Loss causation requires greater evidence of the connection between the
wrongdoing and the loss than does transaction causation.
ii
Should transaction causation be enough for showing causation in 10b-5?
(b)
Transaction Causation =
i
Requires that the wrongful conduct was a but for cause for the Ps to
enter into the transaction.
(a)
The alleged fraud induces the person into the transaction. P would
not have entered into the transaction had they known the fraud.
(b)
This is purely but for thinking.
ii
The problem, however, is whether the fraud actually caused the loss P
complains of. This goes to loss causation
(c)
Loss Causation =
i
Requires that the loss P suffered was caused by the wrongful conduct.
(a)
Something other than the fraud could cause the price to go down.
ii
21D(b)(4) requires loss causation: P shall have the burden of proving that the
act or omission alleged to violate this title caused the loss for which the P
seeks to recover damages.
(d)
Standard:
i
Congress and the Courts both require loss causation as the standard, not
transaction causation.
(e)
Pleading Loss Causation
i
Will have to plead that the market actually reacted to the wrongful
misrepresentation or omission.
(a)
Have to show that when the misrepresentation became known to
the public, the price fell because of the publics realization that
there had been a misrepresentation, not because of some other
event.
ii
The Dura holding seems to suggest that management can put misrepresentations
into the market intentionally and then not have liability if it cant be shown that
those misrepresentations, when they became known as false, caused damages.
iii
The holding is very defendant-friendly.
(iii)
Presumption of Causation in Omission Cases
(a)
Affiliated Ute Presumption
i
Omission Cases v. Misrepresentation Cases
(a)
It is one thing to rely on something that was affirmatively stated or
misstated. But, there is a logical problem when there is an omission
case and someone claims to have relied on an omission. How will
the P prove reliance when the allegation of the wrong is an omission?
The person claims to be relying on something the person was never
presented with!
(b)
There is a presumption of reliance/causation in an omission case,
just by showing the materiality of the omission.
(i)
If you establish the materiality of what was omitted,
there is a presumption of reliance.
(ii)
This is not required in misrepresentation cases, where
the bad stuff is on the face of the document. There need
not be a presumption of reliance in misrepresentation cases,
but there is one in omission cases.
(iv)
Fraud on the Market Theory
(a)
Now, assuming P pleads loss causation adequately, must P show actual reliance on the
misrepresentation/omission, or can the P take advantage of another presumption the
fraud on the market theory?
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Buckham, Brian R.
(b)
(c)
(v)
B.
Problem 12-6 (p. 690)

(a)
Raises some of the problems with the fraud on the market theory in this setting.
Damages Under the 34 Act

1.
Introduction
a)
Punitive damages are NOT available in federal securities law violations.
b)
Since 10b-5 is an implied cause of action, the statute says nothing about damages.
2.
Face-to-Face Defrauding
a)
Defrauded Sellers
(i)
What seller received FMV seller would have received from the sale had there been no
fraudulent conduct,
(ii)
Exception:
(a)
Sometimes disgorgement of profits made by the defrauder are appropriate.
i
Dont worry about FMV look at profits D made.
b)
Defrauded Buyers
(i)
Difference between the amount the defrauding seller paid for the security and its actual value
as of the time of the transaction.
3.
Open Market Defrauding
a)
In the situation where the D is neither a buyer or a seller, the judicial preference for the out-of-pocket measure
is clear.
b)
Damages are measured by the difference between the price at which each investor traded and the fair value of
the security as of the date of the trade.
4.
21D(b)(4) suggests that the out-of-pocket measure is proper, not the disgorgement of profits. This allows the defrauder
to keep the windfall (profits it earned from defrauding).
5.
J&S and Proportionate Liability
a)
Joint and several liability applies to persons who acted knowingly.
(i)
Primary defendants.
b)
Proportionate liability (only liable for the % of responsibility) applies to persons who did not act knowingly.
(i)
Secondary defendants.
(ii)
Ex: accountants and lawyers.
6.
Problem 12-8 (p. 666)
a)
Question is whether the profits should be kept by the wrongdoer. The subsequent events seem to suggest that the out-ofb)
IV.
Can the court apply a rebuttable presumption of reliance because of the fraud on
the market theory (that purchasers need not rely directly on misstatements
because the companys stock is automatically affected by the misstatement)?
Time Period:
i
Any person trading in the market between the time of the misrepresentation
and the time it became known to the public is presumed to have relied on the
misrepresentation.
The efficient market and resulting fraud on the market theory is enough to create a
presumption that there was reliance on the misrepresentation/omission. But, the
presumption is rebuttable.
i
This is plaintiff-friendly.
ii
One form of rebuttal is to show that the P would have traded anyway, even if he
had known the truth.
pocket idea is not good enough, and equity should give the profits to the defrauded person. But, then again, it looks like it
took two years of efforts by the defrauding brother to make the profits.
We have to ask whether we want to be compensatory or whether we want to deter certain behavior.
C.
Statute of Limitations Under 10b-5

1.
SOL = An implied SOL under 10b-5 is no later than the earlier of:
a)
2 years after discovery of the facts constituting the violation, or
b)
5 years after the violation.
D.
Federalism and Rule 10b-5

1.
It is difficult to maintain a federal securities law not in conflict w/ state corporate laws.
a)
Ex: SOX federal statute requiring corporations to have internal audit committees and independent board
members.
2.
P does not state a federal claim simply by attacking the fairness of a merger. To have a federal securities law claim is
distinct from bringing a mere breach of fiduciary duty state corporate law case.
a)
The securities law case requires misleading information under 10b-5. There must be some deception, not
simply unfairness of breach of a fiduciary duty.
The Enforcement of the Securities Laws [A variety of items that come up in the enforcement of securities laws]
A.
More on the Private Enforcement of the Securities Laws
1.
Class Actions
a)
Generally
(i)
Recent changes to class action litigation have been the result of abuses in securities class actions.
b)
Selection of Lead Counsel
(i)
21D The presumptive lead plaintiff is the plaintiff with the biggest stake in the litigation, and
that plaintiff gets to select lead counsel.
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Buckham, Brian R.
c)
Federal Courts Get Exclusive Jurisdiction

(i)
28(b) of the 34 Act confers on the federal courts the exclusive jurisdiction over most securities
class actions.
(a)
Applies to any suit with 50 or more persons in the class.
2.
New Rules Regarding Discovery in Securities Suits

a)
PLSA bars discovery until after the Ds motion to dismiss and raises the pleading standard to require
pleading a strong inference the D has committed a violation.
3.
Primary and Secondary Liability

a)
Generally
(i)
Primary v. Secondary Violator
(a)
Primary = commits an act prohibited by the Act/Rules.
(b)
Secondary = assists or supports the primary violator.
i
Ex: accountants, lawyers, banks, underwriters, outside directors.
b)
Aiding and Abetting

(i)
There is NO aiding and abetting liability under Rule 10b-5 when a private litigant brings a
suit. (Central Bank).
(a)
Thus, secondary violators are not liable for aiding and abetting.
(ii)
The SEC DOES have authority to bring a suit for aiding and abetting.
c)
4.
V.
Liability of Secondary Participants

(i)
Generally
(a)
Secondary actors (like accountants and lawyers) cannot be liable in a private action for
aiding and abetting a violator, but they may be liable as primary violators if all the
requirements for primary liability under 10b are met, including a material misstatement
on which a purchaser or seller of securities acts.
(ii)
Two Approaches to Liability for Secondary Participants (Making them Primarily Liable)
(a)
Bright-line test
i
Unless the person has actually made the misrepresentation, the person
cannot be considered a primary participant.
(a)
The secondary actor must actually make a false or misleading
statement, not merely review and pass-off on a statement made by
another person, to be liable. The secondary actor must know that the
representation would be communicated to investors, but the
secondary actor need not be the direct communicator.
(b)
Merely reviewing and approving a misstatement is not sufficient.
(b)
Substantial Participation test
i
Unless the person has substantially participated in the misrepresentation, the
person cannot be considered a primary participant.
(a)
Looks like a run-around the Central bank holding.
(b)
SEC prefers this view.
(iii)
Secondary violators do not have joint and several liability; they have proportionate liability.
Accountants Duty to Blow the Whistle
a)
10A of the 34 Act imposes affirmative duties on accountants when they become aware of an illegal act of
their auditing client. If it will have a material impact on the financial statements, they must disclose it to the
audit committee or board of directors. If the corporation does not take remedial steps, the accountant must
report it to the SEC.
More on the Duties of a Securities Lawyer (802-817)

A.
Generally
1.
When lawyers represent clients in securities matters, the primacy of the legal ethics code may clash w/ notions of public
responsibility derived from the federal securities laws.
a)
Battle is to what extent the securities lawyer has a public duty to assure compliance w/ the securities laws and a
private duty to advance the interests of the client.
B.
NSMC Case
1.
Held that lawyers can be violators of 10b-5 (this was pre-Central Bank, so now the aiding and abetting liability is not a
concern). This was a very big case in the corporate finance world. But, after Central Bank, there is no aiding and
abetting liability.
2.
The court found that the attorneys knew there were problems in the financials, and the comfort letter thus did not
conform with the merger agreement.
C.
SECs Rules of Professional Conduct
1.
SOX Part 205: Standards of Professional Conduct for Attorneys
a)
If an attorney, appearing and practicing before the Commission in the representation of an issuer, becomes
aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the
issuer, the attorney shall report such evidence to the issuers chief legal officer or to both the issuers chief legal
officer and its chief executive officer.
b)
The attorney must also raise the concern with the audit committee or the full board of directors, unless the
attorney believes that the chief legal officer or CEO of the issuer has provided an appropriate response within a
reasonable time.
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Buckham, Brian R.
2.
3.
VI.
What the ABA Says:

a)
Lawyer who knows of the violation of a legal obligation to the organization or a violation by the organization,
then the lawyer shall proceed as is reasonably necessary in the best interest of the organization.
b)
Unless the lawyer reasonably believes it is not necessary in the best interests of the organization to do so, the
lawyer shall refer the matter to the highest authority
c)
When the higher authority fails to respond, and it is a clear violation of law, and the lawyer reasonably believes
the violation is reasonably certain to result in substantial injury to the organization, then the lawyer may reveal
information relating to the representation, but only to the extent necessary to prevent substantial injury to the
organization.
Withdrawal
a)
Attorney must withdraw if representing the client would have the effect of assisting the client in a continuing
crime or fraud, or if it would result in a violation of the rules of professional conduct.
Insider Trading Under the 34 Act (849-76; Minus Chiarella & Dirks)
A.
Elements of Insider Trading
1.
Generally
a)
Same as for 10b-5, except material misstatement is replaced with Material, non-public information.
2.
Elements of Insider Trading
a)
Misstatement or Omission
b)
Purchase or sale
c)
Nonpublic Material info
d)
Causation between purchase/sale and the disclosure
B.
Theories of Liability - Zones:
1.
Insiders
a)
Insider (Chiarella the photocopy guy)
(i)
D must be someone who, by virtue of a relationship with a corporation (director, officer,
employee) learns information through that relationship about that corporation and uses it to purchase
or sell the stock of that corporation.
(a)
So, not necessarily everyone who knowingly trades on insider information is going to get
nailed.
b)
Pre-Existing Duty Rule:
(i)
Must have a preexisting duty to the issuer in order to be held liable if you trade.
(a)
There is a duty to disclose material, non-public information before trading only by
someone in a fiduciary relationship to the corporation or whose stock the insider is
trading. If you do not disclose it or you dont abstain from trading, you are liable.
c)
Temporary Insider
(i)
Treated the same as an insider. Considered to still owe a duty, like a regular insider.
2.
Tippor / Tippee Liability
a)
Tippor Liability
(i)
An improper personal benefit is required to be held liable as a tippor for giving the tip.
(ii)
Tippor liable if breaches duty to the issuer. What is a breach? improper personal benefit.
(iii)
Tippor is an insider or temporary insider, but he is not the one making the purchase or sale of a
security. So, he has an obligation to the corporation.
(iv)
Only an illegal tippor if he makes a disclosure of material nonpublic information to a friend, relative,
or in the expectation that through tipping the tippor will receive, directly or indirectly, a pecuniary
gain or a reputational benefit. Gifts and quid-pro-quo are good enough.
(a)
Telling random people will not likely result in liability to tippor.
b)
Tippee Liability
(i)
Not like garden-variety, because a tippee who is outside the corporation does not owe a duty to the
corporation. The question is whether we can impose some derivative liability on the tippee because
he helped someone else who had a duty to the corporation. (similar to aiding and abetting).
(ii)
Liable for trading on material, nonpublic information only when he is NEGLIGENT in not knowing
that the tippor breached a duty.
(iii)
It is derivative liability. If tippor is not liable, neither is tippee.
3.
Misappropriation (part of 10b-5)
a)
A.k.a. fraud on the source. Defrauding a third-party unrelated to the issuer.
b)
An outside, not associated w/ the issuer, trades on information acquired by breaching a duty to a third party
who is not the issuer. Used when the information comes not from the issuer corporation, but from someone
else who is unconnected with the issuer corporation.
(i)
Examples:
(a)
Law clerk finds out from a judge that a big award will be given. Clerk has no
information from the issuer, he got it from the judge.
i
Chiarella says law clerk owed no duty to issuer, so no liability.
ii
Misappropriation would say law clerk is liable in deceiving the company.
(b)
OHagan gets information from the law firm regarding a transaction. OHagan is not a
temporary insider because he owes no duty to the issuer (he traded in Pillsbury, not
Grand Met). He would be a temporary insider if he traded in Grand Met stock. Also, no
tippor/tippee liability because no duty to Pillsbury, and there is really no tippor.
i
Misappropriation says the attorney is liable.
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Buckham, Brian R.
C.
D.
Reg. FD
1.
Cannot selectively disclose information to some persons but not others.
New 34 Act Statutes (884-894)
1.
20A 21A impose both civil and criminal liability on insider trading via treble damages, etc.
2.
16 short-swing profits idea.
a)
Have to publicly disclose all transactions in the companys stock if they are certain insiders.
b)
If there are short-swing profits obtained by the insiders within a certain period (6 months), those profits are to
be given back to the company.
READ: 877-881; 884-894; 436-438 (but not responsible for the details just the textual description).
58

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Securities Outline (Spring 2005) -- Professor Macdonald

Section 1 Introduction to Securities

The Framework of Securities Regulation

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The information filed by an unseasoned issuer with the SEC

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Regulation of Investment Advisors and Investment Companies [Not discussed in class]

Organizational Structure of the SEC

Mediums of Action by SEC

Blue Sky Laws

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Four Types of SROs:

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Section 2 Definition of a Security

The Definition of a Security

Definition of Security in the 33 and 34 Acts

Opting Out of Securities Treatment

Security Definition in State Law

Defining an Investment Contract

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Definition of Investment Contract

For an expectation of profits

Howey Applies to Investment Contracts Only

fixed rather than variable, provided there is the requisite pooling of

Profits Solely from the Efforts of Others

Sale of a Wholly-Owned Business

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Final Note: Macdonalds Red Flags

Markets and Their Efficiency

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Section 3 Registration and the Public Offering

The Public Offering

during the 180 days following the public offering.

Stages of the Public Offering:

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Recapitalization is necessary so that after the offering the existing

Integrated Disclosure for the Seasoned Company

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Gun Jumping of a Participant in the Distribution

Pre-Filing Problems (p. 172)

Filing and Waiting Period

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Remedies for Failure to Comply with 5 -- SEC v. Manor Nursing

Shelf Registration Under Rule 415

Updating and Correcting the Registration Statement

Post-Effective Amendments of the Registration Statement

Why prefer the sticker route over the amendment route?

The Trading Practice Rules

Registration Under State Blue Sky Laws

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The Intrastate Offering Exemption: 3(a)(11)

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The Private Offering Exemption: 4(2)